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Microprose Inc/DE · 10-Q · For 6/30/98

Filed On 8/12/98   ·   Accession Number 1047469-98-30753   ·   SEC File 0-19463

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  As Of                Filer                Filing    For/On/As Docs:Size              Issuer               Agent

 8/12/98  Microprose Inc/DE                 10-Q        6/30/98    2:79K                                    Merrill Corp/New/FA

Quarterly Report   —   Form 10-Q
Filing Table of Contents

Document/Exhibit                   Description                      Pages   Size 

 1: 10-Q        Quarterly Report                                      26    148K 
 2: EX-27       Financial Data Schedule                                2      8K 


10-Q   —   Quarterly Report
Document Table of Contents

Page (sequential) | (alphabetic) Top
 
11st Page   -   Filing Submission
2Item 1. Financial Statements
9Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
12Risk Factors
21Item 1. Legal Proceedings
23Item 6. Exhibits and Reports on Form 8-K
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SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 _____________________ FORM 10-Q QUARTERLY REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For Quarter Ended: June 30, 1998 Commission File Number: 0-19463 ------------- MICROPROSE, INC. ---------------- Exact Name of registrant as specified in its charter Delaware 52-1728656 ------------------------------- ---------------------------- (State or other jurisdiction of (IRS Employer Identification Incorporation or organization) Number) 2490 Mariner Square Loop, Suite 100, Alameda, CA 94501 ------------------------------------------------ ----- (Address of Principal Executive Offices) (Zip Code) (510) 864-4440 -------------------------------------------------- Registrant's telephone number, including area code 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 ----- ---- 5,754,000 shares of Common Stock were outstanding as of August 3, 1998.
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MICROPROSE, INC. TABLE OF CONTENTS [Download Table] Page ---- PART I - FINANCIAL INFORMATION  ITEM 1. FINANCIAL STATEMENTS Consolidated Balance Sheets at June 30 and March 31, 1998 3 Consolidated Statements of Operations for the three months ended June 30, 1998 and 1997 4 Consolidated Statements of Cash Flows for the three months ended June 30, 1998 and 1997 5 Notes to Consolidated Financial Statements 6 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 9 PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS 21 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K 23 SIGNATURES 26 EXHIBITS 27 2
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MICROPROSE, INC. CONSOLIDATED BALANCE SHEETS (In thousands, except per share amounts) [Enlarge/Download Table] JUNE 30, MARCH 31, 1998 1998 -------------- ------------- (UNAUDITED) ASSETS Current assets: Cash and cash equivalents $ 4,289 $ 14,087 Accounts receivable, less allowances of $4,634 and $5,077 at June 30 and March 31, 1998, respectively 7,076 7,506 Inventories 1,491 1,559 Current portion of prepaid royalties 4,233 3,195 Other current assets 3,371 2,064 -------------- ------------- Total current assets 20,460 28,411 Property, plant and equipment, net of accumulated depreciation of $14,409 and $13,819 at June 30 and March 31, 1998, respectively 7,216 7,595 Goodwill, net 783 903 Investments 3,485 3,485 Prepaid royalties 2,565 2,565 Other assets 818 870 -------------- ------------- $ 35,327 $ 43,829 -------------- ------------- LIABILITIES AND STOCKHOLDERS' DEFICIT Current liabilities: Accounts payable $ 4,603 $ 6,153 Salaries, wages and related accruals 4,810 5,059 Royalties payable 1,321 642 Current portion of redeemable preferred stock 2,940 2,940 Other current liabilities 5,872 5,201 -------------- ------------- Total current liabilities 19,546 19,995 Other liabilities 907 1,028 Long-term debt 32,340 32,348 -------------- ------------- Total liabilities 52,793 53,371 -------------- ------------- Redeemable preferred stock (net of current portion) , $0.001 par value, 4,000 shares designated Series A, issued and outstanding, redemption and liquidation amount of $2,807 and $2,772 at June 30, 1998, and March 31, 1998, respectively. - - Stockholders' Deficit: Preferred stock, $0.001 par value, 9,000 shares authorized (of which 4,000 shares have been designated Series A), no amounts were issued and outstanding at June 30, 1998 or March 31, 1998 - - Common stock, $0.001 par value, 40,000 shares authorized, 5,754 and 5,754 shares issued and outstanding at June 30 and March 31, 1998, respectively 6 6 Additional paid-in capital 144,525 144,525 Accumulated deficit (161,424) (153,609) Accumulated other comprehensive income (573) (464) -------------- ------------- Total stockholders' deficit (17,466) (9,542) -------------- ------------- $ 35,327 $ 43,829 -------------- ------------- -------------- ------------- THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE CONSOLIDATED FINANCIAL STATEMENTS. 3
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MICROPROSE, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share amounts) (UNAUDITED) [Download Table] Three Months Ended June 30, ------------------------- 1998 1997 ---------- ----------- Net revenue $ 12,195 $ 13,580 Cost of revenue 4,954 5,778 ---------- ----------- Gross profit 7,241 7,802 Operating expenses: Sales and marketing 4,975 4,181 General and administrative 2,644 3,173 Research and development 6,238 5,863 Restructuring charges 431 - ---------- ----------- Total operating expenses 14,288 13,217 ---------- ----------- Operating loss (7,047) (5,415) Interest expense, net (492) (151) Other income (expense), net (250) (2,746) ---------- ----------- Net loss before provision for income taxes (7,789) (8,312) ---------- ----------- Provision for income taxes 26 - ---------- ----------- Net loss $ (7,815) $ (8,312) ---------- ----------- ---------- ----------- ---------- ----------- Basic loss per share: $ (1.36) $ (1.48) ---------- ----------- ---------- ----------- ---------- ----------- Diluted loss per share: $ (1.36) $ (1.48) ---------- ----------- Weighted average shares used to calculate: Basic loss per share 5,754 5,661 Diluted loss per share 5,754 5,661 THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE CONSOLIDATED FINANCIAL STATEMENTS. 4
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MICROPROSE, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands, except per share amounts) (UNAUDITED) [Enlarge/Download Table] Three Months Ended June 30, -------------------------- 1998 1997 ----------- ----------- OPERATING ACTIVITIES: Net loss $ (7,815) $ (8,312) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization 802 1,031 Minority interest in joint venture losses - (18) Loss on write-down of investment - 2,605 Changes in assets and liabilities: Accounts receivable 370 2,893 Inventories 54 854 Prepaid royalties (1,038) (1,812) Other current assets (1,329) 684 Accounts payable (1,517) (868) Salaries, wages and related accruals (240) (2,133) Royalties payable 681 (277) Other current liabilities 745 (23) Other liabilities (107) 132 ----------- ----------- Net cash used in operating activities (9,394) (5,244) INVESTING ACTIVITIES: Acquisitions of property, plant and equipment (305) (613) ----------- ----------- Net cash used in investing activities (305) (613) FINANCING ACTIVITIES: Proceeds from issuance of common stock, net of issuance costs - 181 Repayments under notes and lines of credit (9) (122) Principal payments on capital lease obligations (33) (72) ----------- ----------- Net cash used in financing activities (42) (13) Effect of exchange rate changes on cash (57) (77) ----------- ----------- Decrease in cash and cash equivalents (9,798) (5,947) Cash and cash equivalents at beginning of period 14,087 47,110 ----------- ----------- Cash and cash equivalents at end of period $ 4,289 $ 41,163 ----------- ----------- SUPPLEMENTAL CASH FLOW DISCLOSURES: ----------- ----------- Cash paid for interest $ 39 $ 41 Cash paid for income taxes 23 79 THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE CONSOLIDATED FINANCIAL STATEMENTS 5
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MICROPROSE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE 1. BASIS OF PRESENTATION The consolidated financial statements are the unaudited historical financial statements of MicroProse, Inc. and subsidiaries (the "Company") and reflect all adjustments (consisting only of normal recurring accruals) that, in the opinion of management, are necessary for a fair presentation of interim period results. The consolidated financial statements should be read in conjunction with the financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the fiscal year ended March 31, 1998, as filed with the Securities and Exchange Commission on June 29, 1998, and amended on July 27, 1998. The March 31, 1998, consolidated balance sheet included herein was derived from audited financial statements, but does not include all disclosures, including notes, required by generally accepted accounting principles. The results of operations for the current interim period are not necessarily indicative of results to be expected for the entire current year or other future interim periods. For the purposes of presentation, the Company has indicated its interim fiscal periods as ended on June 30, 1998 and 1997, and its prior fiscal year as ended on March 31, 1998. As the Company's annual fiscal period is accounted for on a 52-53 week year, the interim period financial statements included herein represent interim results through June 28, 1998, and June 27, 1997, respectively, and the end of the prior fiscal year included herein represents amounts as of March 29, 1998. The consolidated financial statements have been presented on a going-concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The Company has reported net losses of $7.8 million and $33.1 million for the quarter ended June 30, 1998, and fiscal 1998, respectively. Moreover, the Company has generated an accumulated deficit of $161.4 million at June 30, 1998. In addition, the Company's cash and cash equivalents have declined by $33.0 million during fiscal 1998 and by $9.8 million for the quarter ended June 30, 1998. There can be no assurance that the Company's business strategies and tactics will be successful and that the Company will be profitable in future periods. As noted in the report of independent accountants for the year ended March 31, 1998, the above issues and related liquidity concerns raise substantial doubt about the Company's ability to continue as a going concern. On May 19, 1998, the Company released fourth quarter and fiscal year 1998 results. In that press release, the Company's management indicated that they believe that the Company can perhaps best prosper and leverage its assets in combination with another Company or through a strategic partner. As a result, the Company's Board of Directors has authorized management to investigate strategic alternatives for the Company. NOTE 2. REVERSE COMMON STOCK SPLIT At a special meeting on May 11, 1998, the stockholders approved and made effective a one for five reverse stock split whereby each five shares of the Company's presently outstanding common stock were automatically converted into one share (the "Reverse Stock Split"). Common stock and additional paid-in capital as of March 31, 1998, have been restated to reflect this reverse split. Par value will remain unchanged at $0.001 per share. The number of common shares issued at June 30 and March 31, 1998, after giving effect to the split, was 5,753,800 (28,769,000 shares issued before the Reverse Stock Split). The effect of the Reverse Stock Split has been retroactively reflected as of March 31, 1998, in the consolidated balance sheet. All references to the number of common shares and per share amounts have been restated as appropriate to reflect the effect of the reverse split for all periods presented. 6
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MICROPROSE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE 3. RESTRUCTURING In June 1998, the Company approved a restructuring plan that called for the closure of its Austin, Texas studio. The Company is re-evaluating that studio's development projects but will retain all future rights and intellectual property related to those projects. In connection with this closure, the Company accrued a total of $431,000 for severance related to the elimination of approximately 35 positions plus amounts for facility shutdown and contract cancellation costs. NOTE 4. INVENTORIES Inventories are stated at the lower of cost or market on a first-in, first-out (FIFO) basis. Inventories consisted of the following: [Download Table] JUNE 30, MARCH 31, 1998 1998 -------------------- (In thousands) -------------- Raw materials $ 137 $ 256 Finished goods 1,354 1,303 ------------------ $1,491 $1,559 -------------------- -------------------- NOTE 5. NET LOSS PER SHARE In accordance with the disclosure requirements of SFAS 128, a reconciliation of the numerator and denominator of basic and diluted earnings per share (EPS) is provided below. All references to the number of common shares and per share amounts have been restated as appropriate to reflect the effect of the one for five reverse split (see note 2). The reconciliations for the three months ended June 30 are as follows (in thousands, except per share amounts): [Download Table] Three Months Ended June 30, ------------------------ 1998 1997 ----------- --------- Numerator - Basic and diluted EPS Net loss $(7,815) $(8,312) Preferred stock dividends (35) (70) ----------- --------- Net loss available to common shareholders $(7,850) $(8,382) ----------- --------- Denominator - Basic and diluted EPS Weighed average shares outstanding 5,754 5,661 ----------- --------- Basic and diluted earnings per share: ----------- --------- Net loss $ (1.36) $(1.48) ----------- --------- ----------- --------- 7
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MICROPROSE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) Options to purchase 799,731 and 567,789 shares of common stock were outstanding for the periods ended June 30, 1998 and 1997, respectively. These options were not included in the calculations of diluted EPS because their effect on reported losses would be anti-dilutive. Preferred stock dividends relate to Series A convertible preferred stock. These shares were not included in diluted EPS as their effect would be antidilutive. NOTE 6. COMPREHENSIVE INCOME The Company has adopted the provisions of Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive Income," effective April 1, 1998. This statement requires the disclosure of comprehensive income and its components in a full set of general-purpose financial statements. Comprehensive income is defined as net income plus revenues, expenses, gains and losses that, under generally accepted accounting principles, are excluded from net income. The components of comprehensive income which are excluded from income are not significant, individually or in the aggregate, and therefore, no separate statement of comprehensive income has been presented. NOTE 7. RECENT PRONOUNCEMENTS In June 1997, the Financial Accounting Standards Board ("FASB") issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," which supersedes SFAS No. 14, "Financial Reporting for Segments of a Business Enterprise." SFAS No. 131 requires disclosure about operating segments in annual financial statements and selected information in interim financial reports. It also establishes standards for related disclosures about products and services, geographic areas and major customers. This statement is effective for fiscal years beginning after December 15, 1997. The statement's interim reporting disclosures are not required until the first quarter immediately subsequent to the fiscal year in which SFAS 131 is effective. In June of 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," which establishes accounting and reporting standards for derivative instruments and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. Management has not yet evaluated the effects of this change on its operations. The Company will adopt SFAS No. 133 as required for its first quarterly filing of fiscal year 2000. NOTE 8. SUBSEQUENT EVENT On July 14, 1998, subsequent to quarter end, the Company signed a binding letter of intent to allow Virtual World Entertainment Group, Inc. ("VWEG") to repurchase the Company's equity interest in VWEG in exchange for a promissory note in the amount of $1.8 million and credits totaling $1,570,000 in the form of an advance against royalties. The advance is for a license to develop computer and video games based on VWEG's AEROTECH property. The Company also agreed to terminate its affiliated label agreement with VWEG. 8
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following information should be read in conjunction with the consolidated historical financial information and the notes thereto included in ITEM 1 of this Quarterly Report and Management's Discussion and Analysis of Financial Condition and Results of Operations contained in the Company's Annual Report on Form 10-K for the fiscal year ended March 31, 1998, as filed with the Securities and Exchange Commission on June 29, 1998, and amended on July 27, 1998. This Quarterly Report on Form 10-Q contains forward-looking statements which involve risks and uncertainties. The Company may, from time to time, make oral forward-looking statements. The factors discussed in "Risk Factors" below are important issues that could cause actual results to differ materially from those projected in any such forward-looking statements. OVERVIEW MicroProse, Inc. (the "Company") derives revenue primarily from publishing and distributing entertainment software. This software is generally published by the Company for the following platforms: - Compact-Disc Read-Only Memory ("CD-ROM") for the personal computer ("PC") - Videogame consoles In addition, the Company generates revenue from the licensing of its products to third-party publishers and the distribution of third-party software and related products. See additional discussion in "Risk Factors" below. OPERATING RESULTS Consolidated net revenue for the three-month periods ended June 30, 1998 and 1997, consisted of the following [Download Table] % OF CONSOLIDATED AMOUNT NET REVENUE -------------------- ----------------- 1998 1997 % CHANGE 1998 1997 -------------------- --------- ------------------ (In thousands) -------------- By Territory: North America $ 6,961 $ 3,435 102.6 % 57.1% 25.3% International 5,234 10,145 (48.4)% 42.9% 74.7% -------------------- --------- ------------------ Consolidated $12,195 $13,580 (10.2)% 100.0% 100.0% -------------------- --------- ------------------ By Platform/Type: CD-ROM $ 8,114 $10,845 (25.2)% 66.6% 79.9% Videogame 2 276 (99.3)% 0.0% 2.0% Licensing/OEM 2,479 1,080 129.5 % 20.3% 8.0% Distribution 976 1,124 (13.2)% 8.0% 8.3% Floppy disk and other 624 255 144.7 % 5.1% 1.8% -------------------- --------- ------------------ Consolidated $12,195 $13,580 (10.2)% 100.0% 100.0% -------------------- --------- ------------------ -------------------- --------- ------------------ Consolidated net revenues for the three months ended June 30, 1998, decreased by 10.2 percent from the corresponding period in the prior fiscal year due in part to the release of 9
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MECHCOMMANDER only in North America rather than worldwide. For marketing reasons, this title was released in Europe in the second fiscal quarter. With a partial release, MECHCOMMANDER accounted for more than 25 percent ($3.2 million) of total net revenue for the quarter. A second title, X-COM INTERCEPTOR, also released in the first fiscal quarter, generated revenues in excess of $1.8 million or 15 percent of total net revenue. In the prior year, the release of STAR TREK: GENERATIONS, which accounted for 34 percent of consolidated net revenue, combined with the strong sales of the back-catalogue titles GRAND PRIX II and SID MEIER'S CIVILIZATION II ("CIVILIZATION II"), pushed consolidated net revenues to $13.6 million. The increase in North American net revenue was due principally to sales of MECHCOMMANDER. In the prior year, international net revenue was buoyed by the success of STAR TREK: GENERATIONS and GRAND PRIX II; both titles did not experience the same level of market acceptance in North America. The decline in videogame revenue in the quarter ended June 30, 1998, was due to no significant releases or sales on console platforms. The increase in license/OEM ("Original Equipment Manufacturer") revenue was due in part to the settlement and licensing agreement with Activision (SEE PART II, ITEM 1) and back catalog licenses with other software publishers. Distribution revenue includes shipments of computer software and related products published or manufactured by third parties and distributed by the Company. Substantially all of the distribution revenue generated in the first quarter of fiscal 1999 related to shipments by Leisuresoft Vertiebs GmbH ("Leisuresoft"), a German distributor of computer software and related products. Net revenue in the first quarter of fiscal 1999 was also negatively impacted by a percentage increase in the provisions recorded for returns and markdowns. This increase was due largely to potential returns and discounts on prior year releases that did not achieve anticipated market acceptance. Gross profit for the three-month periods ended June 30, 1998 and 1997, consisted of the following: [Download Table] % OF CONSOLIDATED AMOUNT NET REVENUE --------------------- ---------------- 1998 1997 % CHANGE 1998 1997 --------------------- --------- ---------------- (In thousands) -------------- Gross profit $7,241 $7,802 (7.2)% 59.4% 57.5% --------------------- --------- ---------------- --------------------- --------- ---------------- Gross profit as a percent of consolidated net revenue increased slightly due to higher licensing revenue in the first quarter of fiscal 1999. This increase is partially offset by higher provisions for returns and markdowns. Total gross profit, however, decreased consistent with lower net revenues. 10
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The following table sets forth operating expenses, interest and other income (expense) for the three-month periods ended June 30, 1998 and 1997: [Download Table] % OF CONSOLIDATED Amount NET REVENUE --------------------- ------------------ 1998 1997 % CHANGE 1998 1997 --------------------- -------- ------------------ (In thousands) -------------- Sales and marketing $ 4,975 $ 4,181 19.0 % 40.8% 30.8% General and administrative 2,644 3,173 (16.7)% 21.7% 23.3% Research and development 6,238 5,863 6.4 % 51.2% 43.2% Restructuring charges 431 - - 3.5% - --------------------- -------- ------------------ Total operating expenses $14,288 $13,217 8.1% 117.2% 97.3% --------------------- -------- ------------------ --------------------- -------- ------------------ Interest and other income (expense) $ (742) $ (2,897) 74.4% (6.1)% (21.3)% --------------------- -------- ------------------ --------------------- -------- ------------------ The increase in sales and marketing expense in the first quarter of fiscal 1999 was largely due to variable marketing costs in support of the three new quarterly releases (MECHCOMMANDER, X-COM INTERCEPTOR, and ADDICTION PINBALL) compared to one release in the first quarter fiscal 1998. In addition, the Company incurred additional cooperative advertising expenses in fiscal 1999 also in support of these releases. The reduction in general and administrative spending in the first three months of fiscal 1999 was due primarily to decreased charges for bad debt expense ($380,000). Reduced headcount and tighter controls on spending also contributed to this reduction. Research and development costs in the current year included additional quality assurance testing related to MECHCOMMANDER and X-COM INTERCEPTOR both released in the first quarter. Restructuring charges related to management's decision to close the Austin development studio in June 1998. These charges include full severance payouts to employees, lease abandonment costs and amounts for various contract cancellation costs. The change in other income (expense) in the prior year included a $2.6 million charge to write-down the Company's investment in Total Entertainment Network, Inc. due to management's estimate that a decline in fair value had occurred that was other than temporary in nature. The balance of the account is principally interest expense related to long-term debt. LIQUIDITY AND CAPITAL RESOURCES Working capital decreased to $914,000 and cash decreased $9.8 million for the quarter ended June 30, 1998, to approximately $4.3 million. The main uses of cash were to fund operating losses, short-term royalty advances and payments on accounts payable. Partially offsetting these decreases were increases in cash from strong collections of revenue for MECHCOMMANDER and increases in the amounts of royalties and other liabilities payable. The Company recently renewed an overdraft/line of credit facility in the United Kingdom that is based upon qualifying receivables and certain other bank requirements for amounts up to a maximum credit limit of 1,640,000 pounds sterling (approximately $2.7 million at June 30, 1998). This facility bears interest at the rate of 1.75 percent over the bank's base rate, and expires June 30, 1999. As of June 30, 1998, total amount available based upon qualifying assets totaled approximately $2.0 million. However, as of June 30, 1998 the Company had not utilized any part of this facility. There can be no assurance that the Company will be able to renegotiate this facility upon its 11
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expiration or that any additional borrowing facilities will be made available to the Company on acceptable terms. The Company has authorized 9,000,000 shares of preferred stock, $0.001 par value, of which 4,000,000 shares are designated Series A redeemable preferred stock ("Series A Stock"). During the quarter ended December 31, 1997, 2,000,000 of the outstanding shares of Series A Stock were redeemed for approximately $2.7 million. At June 30, and March 31, 1998, there were 2,000,000 shares of Series A Stock outstanding which are convertible into 19,608 shares of common stock and which accrue dividends at an annual rate of 7 percent. Preferred stockholders receive one vote for each common share into which their preferred shares are convertible. The Series A Stock is redeemable for $1.00 per share plus all accumulated but unpaid dividends (total redemption of $2.8 million as of June 30, 1998) (i) at any time by the Company, or (ii) in its entirety at any time on or after September 24, 1998, within 180 days of receipt of written demand from the majority of Series A Stock holders. Management believes that existing cash and cash equivalents, together with cash generated from operations, will need to be supplemented in the near term by cash flows from new financing arrangements, including asset-based financing arrangements, to meet the Company's liquidity and capital needs for the next 12 months. Limited new asset-based financing arrangements have recently been secured. However, there can be no assurances that such asset-based financing will be sufficient to meet the Company's capital and liquidity needs for the next 12 months or that the Company's products will generate receivables and other assets sufficient to support an adequate level of financing. The Company's ability to support an adequate level of financing depends on the timely release of new products in anticipated quantities. Failure to secure and maintain adequate financing would have a material and adverse effect on the Company's business, financial condition and ability to continue as a going concern.  RISK FACTORS THE FOLLOWING RISK FACTORS SHOULD BE CAREFULLY CONSIDERED IN EVALUATING THE COMPANY AND ITS BUSINESS PROSPECTS. OPERATING RESULTS. The Company reported a net loss for the quarter ended June 30, 1998, of $7.8 million, or $1.36 per share with an accumulated deficit of $161.4 million. For fiscal year 1998, the Company had reported a net loss of $33.1 million or $5.86 per share and had an accumulated deficit of $153.6 million at March 31, 1998. There can be no assurance that the Company's business strategies and tactics will be successful and that the Company will be profitable in future quarterly or annual periods. CASH FLOWS. For the quarter ended June 30, 1998, the Company's cash and cash equivalents declined by $9.8 million. Moreover, cash and cash equivalents declined by $33.0 million during fiscal 1998. Management believes that existing cash and cash equivalents, together with cash generated from operations, will need to be supplemented in the near term by cash flows from new financing arrangements, including asset-based financing arrangements, to meet the Company's liquidity and capital needs for the next 12 months. Limited new asset-based financing arrangements have recently been secured. However, there can be no assurances that such asset-based financing will be sufficient to meet the Company's capital and liquidity needs for the next 12 months or that the Company's products will generate receivables and other assets sufficient to support an adequate level of financing. The Company's ability to support an adequate level of financing depends on the timely release of new products in anticipated quantities. Failure to secure and maintain adequate financing would have a material and adverse effect on the Company's business, financial condition and ability to continue as a going concern. 12
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TERMINATED BUSINESS COMBINATION. In October 1997, the Company entered into an agreement to merge with GT Interactive Software Corp. ("GT"). Under the terms of the proposed merger, the Company's outstanding shares of common and preferred stock were to be exchanged for a proportional number of shares of GT stock. On December 5, 1997, the Company and GT announced their mutual agreement to terminate the merger. The termination of the merger has had a material adverse impact on the Company including: (a) the Company's sales and operating results, (b) the Company's ability to attract and retain key sales and administrative personnel, (c) the progress of certain development projects, and (d) the trading price of the Company's Common Stock. There can be no assurance that the termination of the merger will not continue to adversely impact the Company's business and results of operations in future periods. NASDAQ LISTING/REVERSE SPLIT. The Company was notified in February 1998 by the Nasdaq Stock Market ("Nasdaq") that the Company was no longer in compliance with the net tangible assets requirement or the alternative minimum bid price requirement for continued listing on the Nasdaq National Market. Pursuant to National Association of Securities Dealers Marketplace Rules, the Company was given a period of 90 days to regain compliance with the minimum bid price requirement, which calls for a minimum common stock bid price of $5.00 per share. On May 11, 1998, the Company's stockholders approved a one for five reverse stock split whereby each five shares of the Company's outstanding common stock were automatically converted into one share (the "Reverse Stock Split"). During the fourth quarter of fiscal 1998, prior to the Reverse Stock Split, the Company's common stock traded between $2.75 and $1.50 per share. On May 12, 1998, following the Reverse Stock Split, the Company's common stock opened at a bid price of $9.38 per share. Subsequently, the Company's common stock price continued to trade at a price above the $5.00 minimum bid price for a period of 18 days. On May 19, 1998, and June 3, 1998, the Company received notice from Nasdaq that the Company was not in compliance with either the market capitalization requirement or the minimum bid price requirement for continued listing on the Nasdaq National Market. The Company has responded to Nasdaq with respect to both of these issues and is evaluating plans for compliance with the requirements for continued listing on the Nasdaq National Market. There can be no assurance that the Company's minimum bid price or market capitalization will be sufficient to allow the Company to comply with the requirements for continued listing on the Nasdaq National Market. If the Company is unable to maintain compliance with such requirements, the Company may be able to qualify for listing under the Nasdaq SmallCap Market. However, at the present time, the Company does not meet all of the requirements for listing on the Nasdaq SmallCap Market. If for any reason the Company is unable to achieve and maintain compliance with the Nasdaq SmallCap Market listing requirements and is delisted from both the Nasdaq National Market and the Nasdaq SmallCap Market, the holders of the Company's 6.5 percent Convertible Subordinated Notes Due 2002 (the "Notes") would be entitled to require the Company, within 55 days, to repurchase all or any portion of such holders' Notes for cash at a price equal to the principal amount plus accrued interest. In such event, the Company's business, results of operations, financial condition and ability to continue as a going concern would be materially and adversely affected. FLUCTUATIONS IN OPERATING RESULTS; SEASONALITY. The Company's operating results have varied significantly in the past and are expected to vary significantly in the future. This variability is a result of factors such as: 1) volume shipments of significant new products, 2) the degree of market acceptance of the Company's products, 3) the introduction of products competitive with those of the Company, 4) the timing and market acceptance of new hardware and software 13
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product introductions, 5) the size and growth rate of the consumer software market, 6) the seasonality of sales, 7) development and promotional expenses relating to the introduction of new products or new versions of existing products, 8) product returns and markdowns, 9) changes in pricing policies by the Company and its competitors, 10) the accuracy of retailers' forecasts of consumer demand, 11) the timing of orders from major customers, 12) order cancellations, 13) delays of shipment, and 14) write-offs of advance royalty payments. Because a majority of the unit sales for a product typically occurs in the first 90 to 120 days following the introduction of the product, the Company's revenue may increase significantly in a period in which a major product introduction occurs and may decline in following periods or in periods in which there are no major product introductions. The Company's expenses are based, in part, on expected future revenue. Certain overhead and product development expenses are fixed and do not vary directly in relation to revenue. Consequently, if net revenue is below expectations, the Company's operating results are likely to be materially and adversely affected. In certain past periods, the Company's revenue or operating results were below the expectations of, and certain new products were not introduced when anticipated by, public market analysts and investors. These circumstances could recur in future periods, and in such event, the prices of the Company's common stock and Notes would likely be materially and adversely affected. The entertainment software business is highly seasonal. Typically, net revenue is highest during the last calendar quarter (which includes the holiday buying season), declines in the first calendar quarter, is lowest in the second and increases in the third calendar quarter. This seasonal pattern is due primarily to the increased demand for entertainment software products during the year-end holiday buying season. The Company's net revenue, however, is largely dependent on releases of major new products and, as such, may not necessarily reflect the seasonal patterns of the industry as a whole. The Company expects that its net revenue and operating results will continue to fluctuate significantly in the future. SIGNIFICANT LEVERAGE. As of June 30, 1998, the Company had outstanding indebtedness for borrowed funds of approximately $32.3 million and cumulative mandatorily redeemable preferred stock of $2.9 million. This substantial leverage will have several important consequences for the Company's future operations, including the following: (i) a substantial portion of the Company's cash flows from operations will be dedicated to the payment of interest on, and principal of, its indebtedness; (ii) the Company's ability to obtain additional financing in the future for capital expenditures, acquisitions, general corporate purposes or other purposes may be impaired; (iii) the Company's ability to withstand competitive pressures, adverse economic conditions and adverse changes in governmental regulations may be negatively impacted, and (iv) the Company's ability to comply with certain alternative listing requirements for the Nasdaq Stock Market may be adversely affected. The Company has recently secured an asset based financing arrangement and may in the future obtain lines of credit or enter into other borrowing arrangements, any of which would add to the total outstanding indebtedness of the Company. The Company's ability to meet its debt service obligations and to reduce its total indebtedness will be dependent upon the Company's future performance, which will be subject to financial, business and other factors affecting the operations of the Company, many of which are beyond its control. If the Company is unable to generate sufficient cash flow from operations in the future to service its debt, it may be required to convert or refinance all or a portion of such debt, including the Notes (see above), or to obtain additional financing. However, there can be no assurance that any refinancing would be possible or that any additional financing could be obtained. DEPENDENCE ON NEW PRODUCT INTRODUCTIONS; PRODUCT DELAYS. A significant portion of the Company's fiscal year revenue is generated by products introduced during that fiscal year. The Company depends on both the timely introduction of successful new products or sequels to existing products to replace declining revenue from older products and to provide continued 14
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revenue from back-catalog products. If for any reason revenue from new products or other activities fails to replace declining revenue from existing products, or if revenue from back-catalog titles declines significantly, the Company's business, operating results and financial condition may be materially and adversely affected. In order to maintain or grow its current revenue levels, the Company believes it will be necessary to develop or obtain rights to new products that achieve and sustain market acceptance, are developed for the appropriate platforms and are introduced in a timely manner. The Company is continuing to devote considerable resources toward the development of new products and has secured rights to intellectual properties owned by third parties. As is typical in the industry, while the Company maintains internally developed release schedules, there can be no assurance that new products under development will be released on schedule or at all, or that any such products will generate significant revenue. Historically, the Company has frequently missed product release schedules. To the extent that major new products are not released on schedule, both net revenue and gross profit are likely to be materially and adversely affected. In addition, access to distribution channels and retail shelf space is increasingly competitive. The Company's ability to produce and bring to market new and compelling products in a timely fashion plays an increasingly important role in the Company's ability to retain adequate access to these channels. The process of developing software products such as those offered by the Company is extremely complex and is expected to become more complex and expensive as consumers demand products with more sophisticated and elaborate multimedia features and as new platforms and technologies are supported. At the same time, the introduction of new technologies and competitive products, the increase in competition for retail shelf space among software products and other factors may cause the effective lives of the Company's products to become shorter. The Company's current production schedules contemplate that the Company will continue to ship a number of new products for the balance of fiscal 1999. As with any software product, however, until all aspects of the development and initial distribution of a game are completed, there can be no assurance of its release date. Release dates will vary depending on quality assurance testing and other development factors. If the Company were unable to commence volume shipments of a significant new product during the scheduled quarter, the Company's revenue and earnings would likely be materially and adversely affected in that quarter. In the past, the Company has experienced significant delays in the introduction of certain new products. It is likely in the future that certain new products will not be released in accordance with the Company's internal development schedule or the expectations of public market analysts and investors. A significant delay in the introduction of, or the presence of a defect in, one or more new products could have a material adverse effect on the ultimate success of such products and on the Company's business, operating results and financial condition, particularly in the quarter in which such products were scheduled to be introduced. UNCERTAINTY OF MARKET ACCEPTANCE; UNPREDICTABLE PRODUCT LIFE CYCLES. Consumer preferences for entertainment software products are continually and rapidly changing and are extremely difficult to predict. Few entertainment software products achieve sustained market acceptance beyond one holiday buying season. There can be no assurance that new products introduced by the Company will achieve any significant degree of market acceptance, or that acceptance, if achieved, will be sustained for any significant period. Further, there can be no assurance that such products will not be subject to changes in consumer preferences or that product life cycles will be sufficient to permit the Company to recover development and other associated costs. In addition, sales of any single title of the Company's entertainment software products will decline over time. A majority of the unit sales for a product typically occurs in the first 90 to 120 days after the product is introduced. Therefore, the Company cannot rely on the sales current products to sustain its business in the future. Failure of new products or platforms to achieve or sustain market acceptance would have a material and adverse effect on the Company's business, operating results and financial condition. In addition, the Company does not carry significant 15
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inventory of its new products. As a result, significant production delays would have a material and adverse effect on the Company's business and operating results. Further, if demand for a particular product is greater than anticipated, the Company may not have sufficient inventory to meet customer demands. COMPETITION. The entertainment software industry is intensely competitive and in the process of consolidation. The Company's competitors vary in size from very small companies with limited resources to very large corporations with greater financial, marketing and product development resources than those of the Company. The Company competes primarily with other developers of PC entertainment and video game entertainment software. Significant competitors of the Company in the entertainment software industry include Electronic Arts, Inc., Cendant Corporation, Lucas Arts, Interplay Entertainment Corporation, GT Interactive Software Corporation, Activision, Acclaim Entertainment, Inc., Hasbro Interactive, Inc., and Virgin Interactive. The success of one or more of these companies or the entry and participation of new companies, including diversified entertainment companies, may adversely affect the Company's future performance. The availability of significant financial resources has become a major competitive factor in the entertainment software industry, principally as a result of the technical sophistication of advanced multimedia computer game products requiring substantial investments in research and development and the increasing need to license products and rights to use other intellectual properties from third parties. Also, competitors with large product lines and popular titles typically have greater leverage with retailers and distributors and other customers who may be willing to promote titles with less consumer appeal in addition to such competitors' most popular titles. Many of the Company's competitors are developing on-line interactive computer games that will be competitive with the Company's products. As competition increases, significant price competition and reduced profit margins may result. In addition, competition from new technologies may reduce demand in markets in which the Company has traditionally competed. Prolonged price competition or reduced demand as a result of competing technologies would have a material and adverse effect on the Company's business, financial condition and operating results. There can be no assurance that the Company will continue to compete successfully against current or future competitors or that competitive pressures faced by the Company will not materially and adversely affect its business, operating results and financial condition. Retailers of the Company's products typically have a limited amount of shelf space and promotional resources, and there is intense competition among consumer software producers for adequate levels of shelf space and promotional support from retailers. To the extent that the number of consumer software products and computer platforms increases, this competition for shelf space may intensify. Due to increased competition for limited shelf space, retailers and distributors are increasingly in a better position to negotiate favorable terms of sale, including promotional discounts and product return policies. Retailers often require software publishers to pay fees in exchange for preferred shelf space. The Company's products constitute a relatively small percentage of a retailer's sales volume, and there can be no assurance that retailers will continue to purchase the Company's products or provide the Company's products with adequate levels of shelf space , promotional support or be available at an affordable cost. As more consumers own multimedia PCs, the distribution channels for entertainment software have changed, and are expected to continue to change, to increasingly depend on mass merchandisers, on-line services and the Internet to reach the broader market. In addition, while this trend has increased the number of distribution channels, it has intensified competition for shelf space because these new channels generally carry only top-selling titles. In addition, other types of retail outlets and methods of product distribution, such as on-line services and the Internet, may become important in the future, and it will be important for the Company to gain access to these channels of distribution. There can be no assurance that the Company will gain 16
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such access or that the Company's access will allow the Company to maintain its historical levels of sales volume. CONCENTRATION OF CUSTOMER BASE; RISK OF CUSTOMER BUSINESS FAILURE; PRODUCT RETURNS. The Company principally sells its products to retailers and distributors, who in turn resell the products to consumers. During the year ended March 31, 1998, sales to the top ten such customers represented approximately 53 percent of the Company's net revenue. Sales are typically made on credit, with terms that vary depending upon the customer and the nature of the product. The Company does not require collateral to secure payment. Retailers and distributors compete in a volatile industry and are subject to the risk of business failure. Certain of the Company's distributors and retailers have recently experienced financial difficulties and the Company has increased its reserves accordingly. However, the business failure of a significant distributor or customer could have a material and adverse effect on the Company's business, operating results and financial condition. The Company is exposed to the risk of product returns from distributors and retailers. The Company currently maintains a stock balancing policy that allows distributors and retailers to return products subject to certain conditions. The Company provides reserves for returns that it believes are adequate, and the Company's agreements with various customers place certain limits on product returns. However, new product introductions by the Company or its competitors, or changes in consumer demand from that anticipated, could cause customers to seek to return inventory to the Company in excess of those limits. Due to the unpredictability of consumer demand and the uncertainties associated with a rapidly changing market, there can be no assurance that the Company or its customers will be able to forecast demand accurately. Any significant amount of product returns or markdowns could have a material and adverse effect on the Company's business, operating results and financial condition. DEPENDENCE UPON STRATEGIC RELATIONSHIPS. The Company's business strategy relies to a significant extent on its strategic relationships with other companies and on its alliances with key software developers. Certain agreements require third parties to approve a product prior to its release, and therefore, subject the product to delay. There can be no assurance that these relationships will be successful or that the Company will continue to maintain and develop strategic relationships, or that licenses between the Company and any third party will be renewed or extended at their expiration dates. The Company's failure to renew or extend a key license or maintain its strategic relationships could materially and adversely affect the Company's business, operating results and financial condition. In addition, under certain key license agreements, the Company must obtain approval on a timely basis from the licensor in order to market products it develops under the license. There can be no assurance that the Company will obtain such approval, and failure to do so could have a material and adverse effect on the Company's operating results, financial condition and business prospects. The Company has made certain minority equity investments that it believes will provide future access to products, technologies or distribution channels. Management performs ongoing evaluations of the future realization of these investments, and charges any declines in value that are other than temporary in nature to other expense in its quarterly Consolidated Statements of Operations. A write down of one or more of these investments could have a material adverse impact on the Company's operating results and financial condition. CHANGES IN TECHNOLOGY AND PRODUCT PLATFORMS. The market for entertainment software, including entertainment software platforms, is undergoing rapid technological change. As a result, the Company must continually anticipate and adapt its products to emerging platforms and evolving consumer preferences. The introduction of new platforms and technologies can render existing products obsolete and unmarketable. Development of entertainment software products for new hardware platforms requires substantial investments in research and 17
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development for technologies such as enhanced sound, digitized speech, music and video and requires the Company to anticipate and develop products for those platforms that will ultimately be successful. Such research and development efforts, which generally require 18 to 24 months, must occur well in advance of the release of new platforms in order to introduce products on a timely basis following the release of such platforms. In addition, the Company expects that the trend toward more complex multimedia products and increasing product development costs will continue for the foreseeable future. Although the Company intends to develop and market games for certain advanced and emerging platforms, these development and marketing efforts may require greater financial and technical resources than those currently possessed by the Company. In addition, there can be no assurance that the platforms for which the Company develops products will achieve market acceptance and, as a result, there can be no assurance that the Company's development efforts with respect to such new platforms will lead to marketable products or products that generate sufficient revenue to offset research and development costs incurred in connection with their development. There can be no assurance that the Company will be successful in developing and marketing products for new platforms. Failure to develop products for new platforms that achieve significant market acceptance may have a material and adverse effect on the Company's business, operating results and financial condition. The Company is developing games that may be played interactively over on-line services and the Internet, but there can be no assurance that the market for networked videogame play will evolve or develop as anticipated. Consumer preferences change continually and are extremely difficult to predict. Even if a market for networked videogame play develops, no assurance can be given that the Company's products will meet the requirements of such market and achieve market acceptance. The Company is heavily dependent on the success of the entertainment software developed for use on the PC. There are multiple, competing and incompatible formats being introduced in the entertainment software market. There can be no assurance that the Company's strategy of developing primarily for the PC or the other platforms the Company chooses to support ultimately will be successful. For game console platforms the Company chooses to support, the development, marketing and distribution of products will involve substantial investment and risks. The Company believes that the principal target audience for game consoles may be younger than the Company's traditional customers, and there can be no assurance that the Company's products will be successful with this different audience. In addition, the Company anticipates that products in the game console market will require substantially greater expenditures for marketing, advertising and inventory buildup, often before the market acceptance of a product is known. Inventory will be two or more times more expensive as a result of license fees that are required to be prepaid to the manufacturers of the hardware platforms. Further, game console products will be sold through channels that overlap with, but are somewhat different from, the retail channels currently utilized by the Company, and the Company will be competing in distribution against much larger organizations with greater financial resources. There can be no assurance that the Company will be successful in marketing and distributing software for game consoles. RISK OF SOFTWARE ERRORS OR FAILURES. Software products as complex as those offered by the Company may contain undetected errors when first introduced or when new versions are released. In the past, the Company has discovered software errors in certain of its product offerings after their introduction and has experienced delays or lost revenue during the period required to correct these errors. The Company's products must maintain compatibility with certain hardware, software and accessories. Any changes that result in incompatibility could result in significant product returns and customer service costs. In particular, the PC hardware environment is characterized by a wide variety of nonstandard peripheral equipment (such as sound and graphics cards) and configurations that make prerelease testing for programming or compatibility errors very difficult and time consuming. There can be no assurance that, despite 18
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testing by the Company, errors will not be found in new products or releases after commencement of commercial shipments, resulting in loss of or delay in market acceptance, which could have a material and adverse effect on the Company's business, operating results and financial condition. The risk of undetected product errors can be expected to increase as products and their development processes become more complex and as growing competition leads to increased pressure to reduce time to market. DEPENDENCE ON KEY PERSONNEL; MANAGEMENT CHANGES. The Company's future success depends in large part on the continued service of its key product development, technical and management personnel and on its ability to continue to attract, motivate and retain highly qualified employees, including additional management personnel. The loss of certain key employees could have a material and adverse effect on the Company's business. In addition, the Company depends on teams of programmers, game designers and artists. Competition for these skilled employees is intense, and the loss of the services of key development personnel could have a material and adverse effect upon the Company's current business, new product development efforts and prospects. There can be no assurance that qualified personnel can be readily identified and hired wherever necessary, that any new personnel will be successfully integrated into the Company, its operations and culture, or that new personnel, if hired, will improve the Company's business, operations or operating results. The Company does not currently have key person life insurance on any employees. USE OF INDEPENDENT SOFTWARE DEVELOPERS. In addition to marketing internally developed software, the Company also markets entertainment software created by independent software developers. The cost to retain independent developers is increasing in the form of guaranteed advances and royalties. Additionally, the Company has less control over the scheduling and the quality of work of independent contractors than that of its own employees. Furthermore, the Company's agreements to publish and market certain independent software developers' titles will terminate after specified dates unless renewed. The Company's business and future operating results will depend in part on the Company's continued ability to attract and maintain relationships with skilled independent software developers, and to enter into and renew product development agreements with such developers. There can be no assurance that the Company will be able to maintain such relationships or enter into and renew such agreements. INTERNATIONAL REVENUE. International net revenue represented approximately 42 percent, 67 percent, and 64 percent of the Company's net revenue for first quarter of fiscal 1999 and for the fiscal years 1998, and 1997, respectively. The Company expects that international net revenue will continue to account for a significant portion of its net revenue in future periods. International revenue is subject to inherent risks, including unexpected changes in regulatory requirements, tariffs and other economic barriers, fluctuating exchange rates, difficulties in staffing and managing foreign operations and the possibility of difficulty in accounts receivable collection. For example, the Company has attempted to minimize its exposure to currency fluctuations by entering into forward currency contracts, however, there can be no assurance that the Company will be successful at mitigating currency risks. In some markets, localization of the Company's products is essential to achieve market penetration. The Company may incur substantial costs and experience delays in localizing its products, and there can be no assurance that any localized product will ever generate significant revenue. These or other factors could have a material and adverse effect on the Company's future international revenue and, consequently, on the Company's business, operating results and financial condition. RECOVERY OF PREPAID ROYALTIES AND GUARANTEES. The Company, from time to time, enters into agreements with licensors of intellectual property and developers of games that involve royalty advances and guaranteed minimum royalty payments. If the sales volumes of products subject to such arrangements are not sufficient to recover such advances and guarantees, the Company provides a reserve for the anticipated portion of such payments that will not be recovered. If 19
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existing advances are determined to be unrecoverable in future periods, the Company's results of operations may be materially and adversely affected. INTELLECTUAL PROPERTY. The Company regards the software that it owns or licenses as proprietary and relies primarily on a combination of copyrights and trademarks and U.S and international, trade secret, patent and trademark laws, and nondisclosure agreements to protect its proprietary rights to its products. It is the Company's current policy that employees and third-party developers sign nondisclosure agreements. The Company owns or licenses various trademarks and copyrights. However, the Company has only standard "shrink wrap" license agreements or no license agreements at all with the end users of its products and does not copy-protect its software. The Company relies largely on the copyright and trademark laws to prevent unauthorized distribution of its software. There can be no assurance that these measures will be sufficient to protect the Company's intellectual property rights against infringement. Existing copyright laws afford only limited protection. It may be possible for unauthorized third parties to copy the Company's products or to reverse engineer or otherwise obtain and use information that the Company regards as proprietary. Policing unauthorized use of the Company's products is difficult, and software piracy can be expected to be a persistent problem. Further, the laws of certain countries in which the Company's products are or may be distributed do not protect the Company's products and intellectual rights to the same extent as the laws of the United States. The Company believes that its products, trademarks and other proprietary rights do not infringe on the proprietary rights of third parties. As the number of entertainment software products in the industry increases, the Company believes that software increasingly will become the subject of claims that such software infringes upon the rights of others. From time to time, the Company has received communications from parties asserting that features or content of certain of its products may infringe upon intellectual property rights of such parties. To date, other than the cost of litigation, no such claims have had a materially adverse effect on the Company's ability to develop, market or sell its products. However, there can be no assurance that future infringement claims against the Company will not result in further costly litigation or require the Company to license the intellectual property rights of parties. There can be no assurance that such licenses will be available on reasonable terms or at all. VOLATILITY OF PRICE OF STOCK AND NOTES. There has been a history of significant volatility in the market prices of companies engaged in the entertainment software industry, including the Company. It is likely that the market price of the Company's common stock will continue to be highly volatile and the price of the Company's Notes will also be subject to such fluctuations. Factors such as the timing and market acceptance of new product introductions by the Company, the introduction of new products by the Company's competitors, loss of key personnel of the Company, variations in quarterly operating results or changes in market conditions in the entertainment software industry may have a significant impact on the market price of the Company's common stock and Notes. In the past, the Company has experienced fluctuations in its operating results, and it is likely that in some future quarter the Company's revenue or operating results will be below the expectations of, and certain new products will not be introduced when anticipated by, public market analysts and investors. In such event, the price of the Company's common stock would likely be materially adversely affected. Volatility in the price of the Company's common stock, changes in prevailing interest rates and changes in perceptions of the Company's creditworthiness may in the future adversely affect the price of the Notes. 20
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PART II - OTHER INFORMATION  ITEM 1. LEGAL PROCEEDINGS ACTIVISION, INC.: On November 12, 1997, a lawsuit entitled Activision, Inc. and The Avalon Hill Game Company v. MicroProse Software, Inc., MicroProse, Inc., and Spectrum HoloByte, Inc., Case No. 97-8302ER, was filed in the United States District Court for the Central District of California. The complaint alleged causes of action for trademark infringement, trademark dilution, false designation of origin, false advertising, unfair competition, and deceptive trade practices in connection with the Company's publication of certain CIVILIZATION computer game products. On January 21, 1998, the Company and its Maryland subsidiary, MicroProse Software, Inc., filed an action against Activision, Inc. and The Avalon Hill Game Company in the United States District Court for the Central District of California. The Company's complaint alleges that the defendants have engaged in false advertising, trademark infringement, and unfair business practices in connection with announced plans to develop and publish CIVILIZATION computer games under a claimed licensing relationship between Activision and Avalon Hill. The Company also seeks cancellation of Avalon Hill's related trademark registration. On February 4, 1998, Activision and the Avalon Hill Game Company filed a First Amended Complaint, correcting certain statements in their original complaint and adding claims for declaratory relief and cancellation of the Company's related trademark registration. The action was served upon the Company for the first time on February 5, 1998. On April 7, 1998, the Company amended its answer and filed counterclaims on behalf of the Company and its two subsidiaries, MicroProse Software, Inc. and Hartland Trefoil, Ltd., asking for declaratory relief and seeking to enforce the intellectual property rights of these entities in both board games and computer games under the CIVILIZATION name. All of the related actions involving CIVILIZATION trademarks or games have now been settled in their entirety. Under the terms of the settlement, the Company will retain ownership of the CIVILIZATION trademarks and copyrights for computer and board games. Activision and Avalon Hill have recognized the Company's ownership of the property, and Avalon Hill has transferred all of its rights in CIVILIZATION trademarks, board games, and computer games to the Company. Activision will publish its CIVILIZATION: CALL TO POWER game and related add-on product and conversions under license from the Company. Activision will also publish the PlayStation version of CIVILIZATION II under license from the Company for territories outside of Japan. Under the provisions of the settlement, all financial terms, including advances and royalties under the license to Activision, remain confidential. UNITED SOFTWARE GmbH: In March 1993, MicroProse acquired United Software, GmbH ("United"). In September 1993, MicroProse became aware of several non-disclosed liabilities of United, including a claim by a German bank of approximately $2,000,000. MicroProse also became aware of the deterioration of the financial condition of the seller and the seller's parent (which had guaranteed the seller's obligations under the United purchase agreement) and by October 29, 1993, determined that the seller and its parent were incapable of complying with the guarantees and warranties included in the purchase agreement. Therefore, primarily as a result of the seller's nondisclosure of the bank debt described above and the misrepresentations as to the financial condition of the seller and its 21
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parent, MicroProse assessed its options and decided to rescind the agreement as provided under German law. On October 29, 1993, MicroProse notified the seller and its parent of the rescission of the March 1993 agreement. This action resulted in a charge of approximately $4.9 million, which was recorded in the quarter ended September 30, 1993. This charge consisted primarily of the original purchase price, asset write-offs of approximately $1.8 million and rescission-related liabilities of approximately $1.6 million. United and its parent company are now in receivership. The Company has maintained an accounting reserve in order to meet any remaining liabilities under German law as a result of the receivership proceeding. On March 18, 1998, the Company received a demand from the receiver in the insolvency proceeding for payment of 1.95 million DM (approximately $1.1 million), based on the receiver's position that MicroProse is liable for contribution of share capital to the insolvent company. On approximately May 28, 1998, the Company's U.K. subsidiary was served with a legal action by the receiver seeking enforcement of the demand. The Company is represented by German counsel and intends to defend itself vigorously in this action. 22
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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (A) THE FOLLOWING EXHIBITS ARE FILED HEREWITH: [Download Table] Exhibit Page Number Description No. ------- ----------- ------ 2.1 Agreement and Plan of Reorganization, dated as of July 14, 1993, as amended as of November 15, 1993, by and among MicroProse, Inc., MicroProse Merger Sub, Inc. and Spectrum HoloByte, Inc. (incorporated by reference to Exhibit 2 of MicroProse, Inc.'s Registration Statement on Form S-4, File No. 33-72216, filed on November 29, 1993) + 2.2 Amendment No. 1 to Amended and Restated Agreement and Plan of Reorganization, dated November 28, 1993 + 2.3 Agreement and Plan of Reorganization, dated as of September 14, 1992, by and between Spectrum HoloByte, Inc. and Sphere, Inc. + 2.4 Stock Purchase and Exchange Agreement by and among Spectrum HoloByte, Inc., SimTex Software Corporation, Stephen Barcia and Maria Barcia, dated as of June 6, 1995 (incorporated by reference to Exhibit 2.1 of Spectrum HoloByte, Inc.'s Form 8-K filed on June 27, 1995) + 3.1 Certificate of Incorporation of the Registrant + 3.2 Amended Bylaws of Registrant + 4.1 Specimen Common Stock Certificate of the Registrant + 4.2 Warrants issuable to the Grotech Investors and Corporate Venture Partners, L.P., dated as of October 17, 1991 + 4.3 Form of Warrant issuable to Paragron Investors, dated July 1992 + 4.4 Amended and Restated Investor Rights Agreement, dated December 8, 1993 + 4.5 Form of Warrant, issued to Ince & Co. (incorporated by reference to Exhibit 4.8 of Spectrum HoloByte, Inc.'s Form 10-Q filed on December 31,1994) + 10.1 Sterling Overdraft and Barclays Tradeline Facilities between MicroProse Limited and Barclays Bank PLC, dated July 2, 1993 (incorporated by reference to Exhibit of same number of MicroProse, Inc.'s Annual Report on Form 10-K filed on July 14, 1993) + 10.2 Sterling Overdraft and Barclays Tradeline Facilities between MicroProse Limited and Barclays Bank PLC, dated July 2, 1993, as amended + 10.3 Agreement between MicroProse, Inc. and WordStar International Corporation, dated May 23, 1991 (incorporated by reference to Exhibit 10.6 of MicroProse, Inc.'s Registration Statement on Form S-1, File No. 33-42238, filed on August 13, 1991) + 10.4 MicroProse, Inc. 1991 Employee Stock Option Plan, as amended and restated + 10.5 Lease Agreement between MicroProse, Inc. and Lakefront Limited Partnership, dated July 9, 1987, as amended (incorporated by reference to Exhibit 10.11 of MicroProse, Inc.'s Registration Statement on Form S-1, File No. 33- 42238, filed on August 13, 1991) + 10.6 Second Amendment to Lease Agreement between MicroProse, Inc. and Lakefront Limited Partnership III, dated June 12, 1992 (incorporated by reference to Exhibit 10.14 of MicroProse, Inc.'s Annual Report on Form 10-K filed on July 14, 1993) + 10.7 Lease Agreement between MicroProse, Inc. and Saft America, Inc., dated March 19, 1991 (incorporated by reference to Exhibit 10.12 of MicroProse, Inc.'s Registration Statement on Form S-1, File No. 33-42238, filed on August 13, 1991) + 23
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Exhibit Page Number Description No. ------- ----------- ------ 10.8 Lease Agreement between Ashpalm PLC and MicroProse Unlimited, dated June 9, 1993 (incorporated by reference to Exhibit 10.16 of MicroProse, Inc.'s Annual Report on Form 10-K filed on July 14, 1993) + 10.9 Lease Agreement by and between MicroProse Limited and ARC Limited, dated September 25, 1992 (incorporated by reference to Exhibit 10.17 of MicroProse, Inc.'s Annual Report on Form 10-K filed on July 14, 1993) + 10.10 Underlease Agreement between MicroProse Limited and London and Metropolitan Investments Limited, dated May 11, 1993 (incorporated by reference to Exhibit 10.18 of MicroProse, Inc.'s Annual Report on Form 10-K filed on July 14, 1993) + 10.11 Consulting and Product Development Agreement between MicroProse, Inc. and Sidney K. Meier, dated August 12, 1991 (incorporated by reference to Exhibit 10.17 of MicroProse, Inc.'s Registration Statement on Form S-1, File No. 33- 42238, filed on August 13, 1991) + 10.12 Option Agreement and Irrevocable Proxy by and among Spectrum HoloByte, Inc., John W. Stealey, Sr. and MicroProse, Inc. (incorporated by reference to Exhibit 99.2 of MicroProse, Inc.'s Report on Form 8-K filed on July 7, 1993) + 10.13 Consulting Services Agreement between MicroProse, Inc. and John W. Stealey, Sr., dated June 22, 1993 (incorporated by reference to Exhibit 10.38 of MicroProse, Inc.'s Annual Report on Form 10-K filed on July 14, 199 + 10.14 Master Lease Agreement between General Electric Capital Corporation and MicroProse, Inc., dated December 31, 1992 (incorporated by reference to Exhibit 10.41 of MicroProse, Inc.'s Annual Report on Form 10-K filed on July 14, 1993) + 10.15 Lease Agreement between Ashpalm PLC and MicroProse Unlimited, dated August 8, 1989 (incorporated by reference to Exhibit 10.13 to MicroProse, Inc.'s Registration Statement on Form S-1, File No. 33042238, filed on August 13, 1991) + 10.16 Lease Agreement between Paragon Alameda Gateway Associates, Ltd. and Sphere, Inc., dated May 5, 1992 + 10.17 Underlease Agreement between MicroProse Limited and Thamsedown Computer Supplies Limited, dated 1993 + 10.18 Merchandising License Agreement between Paramount Pictures Corporation and Sphere, Inc. dated October 1, 1991 +* 10.19 License Agreement between V/O Electronorgtechnica, Moscow and Sphere, Inc., dated June 1, 1990, and all amendments thereto +* 10.20 Super Tetris License Agreement between A/O Elorg and Sphere, Inc., dated September 1, 1991 +* 10.21 Master Lease Agreement between General Electric Corporation and MicroProse Software, Inc., dated December 31, 1992 (incorporated by reference to Exhibit 10.44 to MicroProse, Inc.'s Annual Report on Form 10-K filed on July 14, 1993) + 10.22 First Amendment to Lease between Paragon Alameda Gateway Associates, Ltd. and Sphere, Inc., dated July 28, 1992 + 10.23 Master Lease Agreement between Comdisco, Inc. and Spectrum HoloByte, Inc., dated December 16, 1992 + 10.24 Security and Loan Agreement among Spectrum HoloByte, Inc., MicroProse Software, Inc. and Imperial Bank, dated as of December 30, 1993 + 24
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Exhibit Page Number Description No. ------- ----------- ------ 10.25 Security and Loan Agreement among Spectrum HoloByte, Inc., MicroProse Software, Inc. and Imperial Bank, dated as of December 30, 1993, as amended (incorporated by reference to Exhibit 10.89 and 10.90 of Spectrum HoloByte, Inc.'s Form 10-Q filed on December 31, 1994) + 10.26 Spectrum HoloByte, Inc. 1992 Stock Option Plan + 10.27 MicroProse, Inc. 1994 Employee Stock Purchase Plan + 10.28 401(k) Plan of the Company + 10.29 Form of Indemnification Agreement between the Company and each of its officers and directors + 10.30 Amended and Restated Employment and Consulting Agreement between Patrick S. Feely and the registrant, dated December 13, 1994 (incorporated by reference to Exhibit 10.90 of Spectrum HoloByte, Inc.'s Form 10-Q filed on December 31, 1994) + 16.1 Letter from Ernst & Young regarding change in certifying accountant (incorporated by reference to Exhibit 7(c)(3) of the Company's Amendment No. 2 to Form 8-K filed on March 22, 1994) + 27 Financial Data Schedule for the Three Months Ended June 30, 1998
+ Incorporated by reference to an exhibit to the Company's Registration Statement on Form S-1 (Registration No. 33-75408), as amended. * Confidential treatment granted as to certain portions of these exhibits. (B) REPORTS ON FORM 8-K: No reports on Form 8-K were filed during the quarter ended June 30, 1998. 25
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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, on August 12, 1998. MICROPROSE, INC. By: /s/ Stephen M. Race -------------------------- Stephen M. Race CHIEF EXECUTIVE OFFICER AND DIRECTOR /s/ John M. Belchers -------------------------- John M. Belchers CHIEF FINANCIAL OFFICER 26

Dates Referenced Herein   and   Documents Incorporated By Reference

Referenced-On Page
This 10-Q Filing   Date First   Last      Other Filings
5/5/9224
6/12/9223
7/28/9224
9/14/9223
9/25/9224
12/16/9224
12/31/9224
5/11/9324
6/9/9324
6/22/9324
7/2/9323
7/7/9324
7/14/932324
9/30/9322
10/29/932122
11/15/9323
11/28/9323
11/29/9323
12/8/9323
12/30/932425
3/22/9425
12/13/9425
12/31/9425
6/6/9523
6/27/9523
6/27/976
6/30/9721110-K, 10-Q, S-8
11/12/9721
12/5/9713
12/15/978
12/31/971210-Q
1/21/9821
2/4/9821
2/5/9821
3/18/9822
3/29/986
3/31/9831710-K, 10-K405/A
4/1/988
4/7/9821
5/11/98613DEFS14A, PRES14A
5/12/9813
5/19/98613
5/28/9822
6/3/9813
6/28/986
6/29/986910-K
For The Period Ended6/30/98125
7/14/988SC 13G/A
7/27/986910-K405/A
8/3/981
Filed On / Filed As Of8/12/9826
9/24/9812
6/30/9911
 
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