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CENTERSPAN COMMUNICATIONS CORP
10-Q, 2000-11-14
COMPUTER PERIPHERAL EQUIPMENT, NEC

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

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FORM 10-Q

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(Mark One)

/x/	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2000

OR

/ /	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                to               

Commission file number 0-25520

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CENTERSPAN COMMUNICATIONS CORPORATION
(Exact name of registrant as specified in its charter)

Registrant's telephone number, including area code: 503-615-3200

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    Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes /x/  No / /

    Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

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CENTERSPAN COMMUNICATIONS CORPORATION
FORM 10-Q
INDEX

PART I—FINANCIAL INFORMATION				Page
Item 1.		Financial Statements
		Consolidated Balance Sheets—September 30, 2000 (Unaudited) and December 31, 1999		2
		Consolidated Statements of Operations (Unaudited)—Three and Nine Month Periods Ended September 30, 2000 and 1999		3
		Consolidated Statements of Cash Flows (Unaudited)—Nine Months Ended September 30, 2000 and 1999		4
		Notes to Consolidated Financial Statements (Unaudited)		5
Item 2.		Management's Discussion and Analysis of Financial Condition and Results of Operations		7
Item 3.		Quantitative and Qualitative Disclosures About Market Risk		10
PART II—OTHER INFORMATION
Item 1.		Legal Proceedings		11
Item 6.		Exhibits and Reports on Form 8-K		11
		Signatures		11

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PART I

Item 1. Financial Statements

CENTERSPAN COMMUNICATIONS CORPORATION
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands)

					September 30, 2000			December 31, 1999
					(Unaudited)
ASSETS
Current assets:
	Cash and cash equivalents				$	10,320		$	16,467
	Restricted cash					2,385			2,282
	Prepaid expenses and other					80			183
		Total current assets				12,785			18,932
Plant and equipment, net of accumulated depreciation of $868 and $601						1,473			400
Other assets						13			25
		Total assets			$	14,271		$	19,357
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
	Accounts payable				$	912		$	1,055
	Accrued liabilities					1,921			2,342
			Total current liabilities			2,833			3,397
Shareholders' equity:
	Preferred stock, no par value, 5,000,000 shares authorized; none issued or outstanding					—			—
	Common stock, no par value, 25,000,000 shares authorized; 6,255,732 and 5,950,120 shares issued and outstanding					33,818			31,736
	Common stock warrants					4,830			3,530
	Accumulated deficit					(27,210	)		(19,306	)
		Total shareholders' equity				11,438			15,960
		Total liabilities and shareholders' equity			$	14,271		$	19,357

The accompanying notes are an integral part of these consolidated financial statements.

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CENTERSPAN COMMUNICATIONS CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)

				Three Months Ended September 30,						Nine Months Ended September 30,
				2000			1999			2000			1999
Revenue				$	—		$	85		$	1		$	806
Cost of goods sold					—			14			—			254
Gross profit					—			71			1			552
Operating expenses:
	Research and engineering				1,086			148			3,796			278
	Selling, general and administrative				1,565			916			4,161			1,820
		Total operating expenses			2,651			1,064			7,957			2,098
Loss from continuing operations					(2,651	)		(993	)		(7,956	)		(1,546	)
Interest income					241			26			736			26
Expense related to beneficial conversion feature					—			(757	)		—			(987	)
Loss from continuing operations before income taxes					(2,410	)		(1,724	)		(7,220	)		(2,507	)
Provision for income taxes					—			—			—			4,532
Loss from continuing operations					(2,410	)		(1,724	)		(7,220	)		(7,039	)
Loss from discontinued operations:
	Loss from discontinued operations				—			—			—			(5,207	)
Net loss				$	(2,410	)	$	(1,724	)	$	(7,220	)	$	(12,246	)
Basic and diluted loss per share from continuing operations				$	(0.39	)	$	(0.34	)	$	(1.17	)	$	(1.44	)
Basic and diluted loss per share from discontinued operations				$	—		$	—		$	—		$	(1.07	)
Basic and diluted net loss per share				$	(0.39	)	$	(0.34	)	$	(1.17	)	$	(2.51	)
Weighted average common shares—basic and diluted					6,250			5,004			6,174			4,887

The accompanying notes are an integral part of these consolidated financial statements.

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CENTERSPAN COMMUNICATIONS CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

					Nine Months Ended September 30,
					2000			1999
Cash flows from operating activities:
	Loss from continuing operations				$	(7,220	)	$	(7,039	)
	Loss from discontinued operations					—			(5,207	)
		Net loss				(7,220	)		(12,246	)
	Adjustments to reconcile net loss to net cash used in operating activities:
		Depreciation				267			165
		Deferred income taxes				—			4,677
		Beneficial conversion feature on debt				—			987
		Warrant issued for technology				1,300			—
	Changes in operating assets and liabilities:
		Restricted cash				(103	)		—
		Inventories				—			(295	)
		Prepaid expenses and other				115			(344	)
		Income taxes receivable				—			2,078
		Accounts payable and accrued liabilities				(564	)		(7,085	)
		Net assets from discontinued operations				—			6,437
			Net cash used in operating activities			(6,205	)		(5,626	)
Cash flows from investing activities:
	Purchases of plant and equipment					(1,340	)		165
Cash flows from financing activities:
	Payments on operating line of credit, net					—			(5,821	)
	Proceeds from issuance of convertible debt					—			6,000
	Proceeds from issuance of common stock and warrants					1,398			9,608
			Net cash provided by financing activities			1,398			9,787
Increase (decrease) in cash and cash equivalents						(6,147	)		4,326
Cash and cash equivalents:
	Beginning of period					16,467			460
	End of period				$	10,320		$	4,786

The accompanying notes are an integral part of these consolidated financial statements.

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CENTERSPAN COMMUNICATIONS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 1. Basis of Presentation

    The accompanying unaudited consolidated financial statements of CenterSpan Communications Corporation ("CenterSpan" or the "Company") have been prepared in accordance with generally accepted accounting principles for interim financial information with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not contain all of the information and footnotes required by generally accepted accounting principles for complete financial statements. However, in the opinion of management, such statements reflect all adjustments, consisting of only normal recurring adjustments, necessary for a fair presentation of interim period results. These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company's 1999 Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 30, 2000. The Company operates within a single segment and therefore, no segment disclosures are included herein. The results of operations for the interim periods are not necessarily indicative of results to be expected for the entire year or for other future interim periods.

Note 2. Earnings Per Share

    Basic earnings per share ("EPS") and diluted EPS are the same for all periods presented as the Company was in a loss position in all periods.

    Potentially dilutive securities that were not included in the diluted loss per share calculations because they would be antidilutive were as follows:

Note 3. Intel License Agreement

    In April 2000, the Company signed an amendment to its August 1999 license agreement with Intel Corporation ("Intel"). The amendment provides CenterSpan with rights to all current and future development of "Launch and Connect" technology, which is a significant component of the Company's Socket^TM product. The amendment grants CenterSpan exclusive rights, subject to performance obligations, to all engineering development, support, marketing and licensing of the "Launch and Connect" technology with a final expiration date of April 21, 2005. In exchange for the license, the Company issued a warrant to Intel to purchase 125,000 shares of the Company's Common Stock at $13.41 per share. The warrant vested immediately and expires on April 21, 2005. The warrant has been valued at $1.3 million using Black-Scholes methodology using the following assumptions and was expensed to research and engineering expenses in the second quarter of 2000:

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Note 4. Contingency

    On June 15, 2000, CenterSpan filed a lawsuit for breach of contract against Guillemot Corporation S.A. ("Guillemot") in the United States District Court for the District of Oregon. On July 26, 1999, Guillemot contracted to purchase certain CenterSpan assets for a total price of $15,000,000, of which $2,250,000 was to be retained in escrow and released to CenterSpan pursuant to a schedule provided in the parties' Escrow Agreement. CenterSpan alleges that Guillemot breached the terms of the Escrow Agreement by prohibiting the scheduled release of escrow funds to CenterSpan. CenterSpan seeks to recover the amounts due it under the Escrow Agreement as well as costs of the lawsuit and any other proper relief.

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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Forward Looking Statements

    This Form 10-Q contains "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. The Act provides a "safe harbor" for forward-looking statements to encourage companies to provide prospective information about themselves so long as they identify these statements as forward-looking and provide meaningful cautionary statements identifying important factors that could cause actual results to differ from the projected results. All statements other than statements of historical fact that the Company makes in this Report on Form 10-Q are forward-looking. In particular, statements regarding the development of the Company's software products; the Internet community, collaboration and communications market; and the Company's future results of operations or financial position, including, without limitation, statements regarding the timing or magnitude of revenue which may be generated from the Company's products, are forward-looking statements. Words such as "anticipates," "expects," "intends," "plans," "believes," "seeks," "estimates," and similar expressions identify forward-looking statements. However, the absence of these words does not mean the statement is not forward-looking. The Company cannot guarantee any of the forward-looking statements, which are subject to risks, uncertainties and assumptions that are difficult to predict. Actual results may differ materially from those the Company forecasts in forward-looking statements due to a variety of factors, including some of those set forth in the Company's report on Form 10-K for the year ended December 31, 1999. The Company does not intend to update any forward-looking statements due to new information, future events or otherwise.

Results of Continuing Operations

    The continuing operations of the Company consist of its software business, which began in mid-1998. The Company's Internet community, collaboration and communications business develops and markets Internet software products including Socket^TM, which is based on three cutting-edge technologies developed by the Intel Architecture Labs. These technologies facilitate PC-to-PC text messaging and multi-point audio over the Internet, enabling communication and collaborative information sharing.

Revenue

    At the end of the first quarter of 2000, the Company released a beta version of its Socket^TM product and during the second quarter of 2000 released Socket^TM 1.0. However, the Company did not generate any revenues during the first and third quarters of 2000 and only $1,000 in the second quarter of 2000 related to the Socket^TM releases. The Company anticipates 2000 to be an investment year, in which the focus will be on the distribution of Socket^TM to end-users and does not expect to generate significant revenue until 2001. To date, the Company has three distribution arrangements and has placed over one million copies of Socket^TM with promotional CD's distributed with three major gaming publications. For its Socket^TM product, the Company is pursing an Internet e-commerce transaction business model, with revenue expected to be generated from Internet and e-commerce partners. Revenue generated in the quarter and year to date periods ended September 30, 1999 was from the sale of Talk n'Play and iConference, both products the Company is no longer marketing. The Company has approximately ten e-commerce partners from which it will earn commissions of between 5% and 25% of the retail price of merchandise sold to customers referred to them through Socket^TM.

    The Company anticipates releasing a beta version of a new product in the first quarter of 2001. The new product will facilitate the secure sale and transfer of legitimate digital content over the Internet. The capabilities of the new software are expected to allow users to:

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Publish legitimate sharable content;

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Search the peer-to-peer network for content and capabilities;



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Purchase and transfer multiple types of content;



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Compare content and capabilities among multiple users; and



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Communicate with other users regardless of firewalls.

    The Company anticipates that revenue from the new software product will be generated from fees related to the distribution and purchase of digital content, applications and physical goods including:

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Fees for the sale of licensed digital content;



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Service fees for enabling individuals to wrap, publish and sell personal content;



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Service fees from major content owners for providing a turnkey secure digital distribution channel; and



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Fees for the direct licensing of the underlying technology to major portals and ISP's.

Gross Profit

    Gross profit for the three and nine month periods ended September 30, 1999 was $71,000 and $552,000, respectively (83.5% and 68.5% of revenue, respectively) and was generated from the retail sale of Talk n'Play and iConference products.

Research and Engineering

    Research and engineering expenses consist primarily of salaries and related expenses, consultant fees and the cost of software used in product development. Research and engineering expenses were $1.1 million and $3.8 million, respectively, in the three and nine month periods ended September 30, 2000 compared to $148,000 and $278,000, respectively, in the comparable periods of 1999. Included in the amount for the nine months ended September 30, 2000 is $1.3 million related to the value of a warrant issued to Intel in exchange for the license of certain technology in the second quarter of 2000. See Note 3. The Company is making significant investments in research and engineering in 2000 related to its Internet community, collaboration and communications software business. The Company has significantly increased the size of the engineering department during 2000 and at September 30, 2000 the Company had 35 in the engineering group compared to 21 at December 31, 1999.

Selling, General and Administrative

    Selling, general and administrative expenses consist of salaries and related expenses for personnel engaged in direct sales, partner development, consultant fees, advertising, promotional materials, executive, legal, accounting and administrative personnel, professional services and general corporate expenses. Selling, general and administrative expenses increased to $1.6 million and $4.2 million, respectively, in the three and nine month periods ended September 30, 2000 from $916,000 and $1.8 million, respectively, in the comparable periods of 1999, primarily as a result of expanding the Company's workforce and marketing activities related to the Internet community, collaboration and communications software business.

Interest Income

    Interest income increased to $241,000 and $736,000, respectively, in the three and nine month periods ended September 30, 2000 from $26,000 in the comparable periods of 1999 as a result of increased cash balances, which resulted primarily from private placements of debt and equity securities during 1999 and the sale of the Company's hardware business in October 1999 for $15.0 million.

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Expense Related to Beneficial Conversion Feature

    On June 9, 1999, the Company issued and sold to two investors $6.0 million aggregate principal amount of the Company's zero coupon Convertible Debentures due June 9, 2002 for $6.0 million in cash. The Convertible Debentures were recorded as debt. The beneficial conversion feature was recorded as additional capital and as a discount against long-term debt. The total beneficial conversion feature of $987,000 was recognized over 90 days using the effective interest method. The debt was converted to equity prior to December 31, 1999.

Provision for Income Taxes

    A valuation allowance has been recorded for the full amount of deferred tax assets due to the uncertainty regarding the utilization of the net operating loss and credit carryforwards.

Results of Discontinued Operations

    The Company sold its hardware business in October 1999. The sale of the Company's hardware business was accounted for as discontinued operations and, accordingly, its operations are segregated in the statements of operations.

    Loss from discontinued operations was $0 for the three and nine month periods ended September 30, 2000 compared to $0 and $5.2 million, respectively, for the comparable periods of 1999. The loss from discontinued operations represents the net activity of the discontinued hardware business, including revenue and associated expenses. Revenue from discontinued operations was $0 for the three and nine month periods ended September 30, 2000 compared to $0 and $11.2 million, respectively for the comparable periods of 1999. For the three and nine month periods ended September 30, 1999, certain expenses were allocated to continuing operations, based on the number of employees remaining with the software business, their related employee costs and overhead for facilities and other related costs and corporate overhead expenses that were expected to represent continuing expenses.

Liquidity and Capital Resources

    The Company has financed its activities to date with a combination of cash flow from operations, borrowed funds, proceeds from the sale of its hardware business and proceeds from the sale of debt and equity securities. At September 30, 2000, the Company had $10.0 million of working capital and a current ratio of 4.5:1.0. Included in total working capital is $2.4 million of restricted cash, which relates to amounts held in escrow related to the sale of the Company's hardware business. The entire amount may not be received by the Company in certain circumstances that relate to the ability of the purchaser to renew a certain contract, collect accounts receivable and sell through inventory that existed at the date of purchase. See Part II, Item 1. Legal Proceedings.

    Net cash used by operating activities was $6.2 million in the first nine months of 2000 primarily as a result of a cash loss from operations of $5.7 million, a $564,000 decrease in accounts payable and accrued liabilities and $1.3 million used for the purchase of property and equipment, offset by proceeds from issuance of common stock of $1.4 million. The decrease in accounts payable and accrued liabilities is primarily a result of a decrease in trade purchases.

New Accounting Pronouncements

    In June 2000, the FASB issued Statement of Financial Accounting Standards No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities-an amendment of FASB Statement No. 133" ("SFAS 138"). In June 1999, the FASB issued Statement of Financial Accounting Standards No. 137, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 137"). SFAS 137 is an

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amendment to Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS 137 and 138 establish accounting and reporting standards for all derivative instruments. SFAS 137 and 138 are effective for fiscal years beginning after June 15, 2000. The Company does not currently have any derivative instruments and, accordingly, does not expect the adoption of SFAS 137 and 138 to have an impact on its financial position, results of operations or cash flows.

    In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101 ("SAB 101"). SAB 101 summarized certain areas of the Staff's views in applying generally accepted accounting principles to revenue recognition in financial statements. In June 2000, SAB 101B was issued which defers the implementation date of SAB 101 until October 1, 2000. The Company does not expect that SAB 101 will have a significant impact on its financial condition or results of operations.

    In March 2000, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation—an Interpretation of APB Opinion No. 25 ("FIN 44"). FIN 44 applies prospectively to new awards, exchanges of awards in a business combination, modifications to outstanding awards, and changes in grantee status that occur on or after July 1, 2000, except for the provisions related to repricings and the definition of an employee, which apply to awards issued after December 15, 1998. The provisions related to modifications to fixed stock option awards to add a reload feature are effective for awards modified after January 12, 2000. The Company does not expect that this statement will have a significant impact on its financial position, results of operations or cash flows.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

    None.

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PART II—OTHER INFORMATION

Item 1. Legal Proceedings

    On June 15, 2000, CenterSpan filed a lawsuit for breach of contract against Guillemot Corporation S.A. ("Guillemot") in the United States District Court for the District of Oregon (Case No. Civ. 00-830-ST). On July 26, 1999, Guillemot contracted to purchase certain CenterSpan assets for a total price of $15,000,000, of which $2,250,000 was to be retained in escrow and released to CenterSpan pursuant to a schedule provided in the parties' Escrow Agreement. CenterSpan alleges that Guillemot breached the terms of the Escrow Agreement by prohibiting the scheduled release of escrow funds to CenterSpan. CenterSpan seeks to recover the amounts due it under the Escrow Agreement as well as costs of the lawsuit and any other proper relief.

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits

    The exhibits filed as a part of this report are listed below and this list is intended to constitute the exhibit index.

Exhibit No.
10		Software Development and License Agreement dated August 9, 1999 between Intel Corporation and the Company, as amended (confidential treatment requested for portions of this exhibit). Incorporated by reference to the Company's Form 10-Q for the quarter ended June 30, 2000.
27		Financial Data Schedule

(b) Reports on Form 8-K

    There were no reports on Form 8-K filed during the quarter ended September 30, 2000.

SIGNATURES

    Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Date: November 10, 2000		CENTERSPAN COMMUNICATIONS CORPORATION
		By:		/s/ MARK B. CONAN    Mark B. Conan Vice President, Finance and Administration and Chief Financial Officer (Principal Financial and Accounting Officer)

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QuickLinks

CENTERSPAN COMMUNICATIONS CORPORATION FORM 10-Q INDEX
PART I
CENTERSPAN COMMUNICATIONS CORPORATION CONSOLIDATED BALANCE SHEETS (Dollars in thousands)
CENTERSPAN COMMUNICATIONS CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share amounts) (Unaudited)
CENTERSPAN COMMUNICATIONS CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) (Unaudited)

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