(State or Other Jurisdiction of
Incorporation or Organization)
(I.R.S. Employer
Identification No.)
417 FIFTH AVENUE, NEW YORK, NY10016
(Address of principal executive offices) (Zip code)
(212) 726-6500
(Registrant’s telephone number, including area code)
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ATARI, INC. AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
NOTE 1 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND OTHER MATTERS
Nature of Business
We are a publisher of video game software that is distributed throughout the world and a
distributor of video game software in North America. We publish, develop (through external
resources), and distribute video games for all platforms, including Sony PlayStation 2, PlayStation
3, and PSP; Nintendo Game Boy Advance, GameCube, Wii, and DS; and Microsoft Xbox and Xbox 360, as
well as for personal computers, or PCs. The products we publish or distribute extend across every
major video game genre, including action, adventure, strategy, role-playing, and racing.
Through our relationship with our majority stockholder, Infogrames Entertainment S.A., a
French corporation (“IESA”), listed on Euronext, our products are distributed exclusively by IESA
throughout Europe, Asia and certain other regions. Similarly, we exclusively distribute IESA’s
products in the United States and Canada. Furthermore, we distribute product in Mexico through
various non-exclusive agreements. At December 31, 2007, IESA owns approximately 51% of us through
its wholly-owned subsidiary California U.S. Holdings, Inc. (“CUSH”). As a result of this
relationship, we have significant related party transactions (Note 6).
Going Concern
Until 2005, we were actively involved in developing video games and in financing development
of video games by independent developers, which we would publish and distribute under licenses from
the developers. However, beginning in 2005, because of cash constraints, we substantially reduced
our involvement in development of video games, and announced plans to divest ourselves of our
internal development studios.
During fiscal 2006 and 2007, we sold a number of intellectual properties and development
facilities in order to obtain cash to fund our operations. During fiscal 2007, we raised
approximately $35.0 million through the sale of the rights to the Driver games and certain other
intellectual property, and the sale of our Reflections Interactive (“Reflections”) and Shiny
Entertainment (“Shiny”) studios. By the end of fiscal 2007, we did not own any development
studios.
The reduction in our development activities has significantly reduced the number of games we
publish. During fiscal 2007, our revenues from publishing activities were $104.7 million, compared
with $153.6 million during fiscal 2006 and $289.6 million during fiscal 2005. During the nine
months ended December 31, 2007, our revenues from our publishing business were $56.3 million.
For the year ended March 31, 2007, we had an operating loss of $77.6 million, which included a
charge of $54.1 million for the impairment of our goodwill, which is related to our publishing
unit. During the nine months ended December 31, 2007, we incurred an operating loss of
approximately $19.1 million. We have taken significant steps to reduce our costs such as our May
2007 and November 2007 workforce reduction of approximately 20% and 30%, respectively. Our ability
to deliver products on time depends in good part on developers’ ability to meet completion
schedules. Further, our expected releases in fiscal 2008 are even fewer than our releases in
fiscal 2007. In addition, most of our releases for fiscal 2008 were focused on the holiday season.
As a result our cash needs have become more seasonal and we face significant cash requirements to
fund our working capital needs.
The following series of events and transactions which have occurred since September 30, 2007,
have caused or are part of our current restructuring initiatives intended to allow us to devote
more resources to focusing on our distribution business strategy, provide liquidity, and to
mitigate our future cash requirements:
As of September 30, 2007, our only borrowing facility was an asset-based secured credit
facility that we established in November 2006 with a group of lenders for which Guggenheim
Corporate Funding LLC (“Guggenheim”) is the administrative agent. The credit facility
consisted of a secured, committed, revolving line of credit in an initial amount up to $15.0
million (subject to a borrowing base calculation), which initially included a $10.0 million
sublimit for the issuance of letters of credit. On October 1, 2007, the lenders provided a
waiver of covenant defaults as of June 30, 2007 and reduced the aggregate borrowing
commitment of the revolving line of credit to $3.0 million.
Removal of the Atari, Inc. Board of Directors
On October 5, 2007, CUSH, via a written consent, removed James Ackerly, Ronald C. Bernard,
Michael G. Corrigan, Denis Guyennot, and Ann E. Kronen from the Board of Directors of Atari.
On October 15, 2007, we announced the appointment of Wendell Adair, Eugene I. Davis, James
B. Shein, and Bradley E. Scher as independent directors of our Board. Further, we have also
appointed Curtis G. Solsvig III, as our Chief Restructuring Officer and have retained
AlixPartners (of which Mr. Solsvig is a Managing Director) to assist us in evaluating and
implementing strategic and tactical options through our restructuring process.
Transfer of the Guggenheim credit facility to BlueBay High Yield Investments (Luxembourg)
S.A.R.L.
On October 18, 2007, we consented to the transfer of the loans outstanding ($3.0 million)
under the Guggenheim credit facility to funds affiliated with BlueBay Asset Management plc
and to the appointment of BlueBay High Yield Investments (Luxembourg) S.A.R.L. , or BlueBay,
as successor administrative agent. BlueBay Asset Management plc is a significant
shareholder of IESA. On October 23, 2007, we entered into a waiver and amendment with
BlueBay for, as amended, a $10.0 million Senior Secured Credit Facility (“Senior Credit
Facility”). The Senior Credit Facility matures on December 31, 2009, charges an interest
rate of the applicable LIBOR rate plus 7% per year, and eliminates certain financial
covenants.
As of December 31,2007 and through February 12, 2008, we are in violation of
our weekly cash flow covenants. BlueBay our lender has not waived this violation
and we have entered into a forbearance agreement which states our lender will not
exercise its rights on our facility until the earlier of (i) March 3, 2008,
(ii) additional covenant defaults except for the ones existing as the date of
this report or (iii) if any action transpires which is viewed to be adverse to
the position of the lender (See Note 8).
Test Drive Intellectual Property License
On November 8, 2007, we entered into two separate license agreements with IESA pursuant to
which we granted IESA the exclusive right and license, under its trademark and intellectual
property rights, to create, develop, distribute and otherwise exploit licensed products
derived from our series of interactive computer and video games franchise known as “Test
Drive” and “Test Drive Unlimited” (the “Franchise”) for a term of seven years (collectively,
the “TDU Agreements”).
IESA paid us a non-refundable advance, fully recoupable against royalties to be paid under
each of the TDU Agreements, of (i) $4 million under a trademark agreement (“Trademark
Agreement”) and (ii) $1 million under an intellectual property agreement (“IP Agreement”),
both advances of which shall accrue interest at a yearly rate of 15% throughout the term of
the applicable agreement (collectively, the “Advance Royalty”). Under the Trademark
Agreement, the base royalty rate is 7.2% of net revenue actually received by IESA from the
sale of licensed products, or, in lieu of the foregoing royalties, 40% of net revenue
actually received by IESA from the exploitation of licensed products on the wireless
platform. Under the IP Agreement, the base royalty rate is 1.8% of net revenue actually
received by IESA from the sale of licensed products, or, in lieu of the foregoing royalties,
10% of net revenue actually received by IESA from the exploitation of licensed products on
the wireless platform.
Overhead Reduction
On November 13, 2007, we announced a plan to lower operating expenses by, among other
things, reducing headcount. The plan included (i) a reduction in force to consolidate
certain operations, eliminate certain non-critical functions, and refocus certain
engineering and support functions, and (ii) transfer of certain product development and
business development employees to IESA in connection with the termination of a production
services agreement between us and IESA. We expect that, after completion of the plan during
fiscal 2009, total headcount will be reduced by approximately 30.0%. See Note 10.
On December 4, 2007, we entered into a Global Memorandum of Understanding Regarding
Restructuring of Atari, Inc. (“Global MOU”) with IESA, pursuant to which we agreed, in
furtherance of our restructuring plan, to the supersession or termination of certain
existing agreements and the entry into certain new agreements between IESA and/or its
affiliates and us. See the Short Form Distribution Agreement, Termination and Transfer of
Assets Agreement, QA Service Agreement and the Intercompany Service Agreement described
below.
The Global MOU also contemplated the execution of a Waiver, Consent and Third Amendment to
the Credit Agreement, as amended, among us and BlueBay. This Third Amendment to the Credit
Agreement raised our credit limit with BlueBay to $14.0 million
(See Note 8).
Furthermore, we agreed with IESA that during the third fiscal quarter of 2008, IESA and us
shall discuss an extension of the termination date of the Trademark License Agreement, dated
September 4, 2003, as amended, between us and Atari Interactive, Inc., a majority owned
subsidiary of IESA, (“Atari Interactive”).
Short Form Distribution Agreement
We entered into a Short Form Distribution Agreement with IESA (together with two of its
affiliates) that supersedes, with respect to games to be distributed on or after the
effective date of the Short Form Distribution Agreement, the two prior Distribution
Agreements between us and IESA dated December 16, 1999 and October 2, 2000. The Short Form
Distribution Agreement is a binding agreement between the parties that sets forth the
principal terms of a Long Form Distribution Agreement to be negotiated and entered into by
the parties, as consented by BlueBay, on or before March 14,2008. Pursuant to the Short
Form Distribution Agreement, IESA granted us the exclusive right for the term of the Short
Form Distribution Agreement to contract with IESA for distribution rights in the
contemplated territory to all interactive entertainment software games developed by or on
behalf of IESA that are released in packaged media format. For any game, IESA may also grant
us the distribution rights to the game’s digital download format in the contemplated
territory, which will automatically revert to IESA if the annual gross revenues received by
us with respect to such game is less than the agreed upon target. With respect to massively
multiplayer online games, casual games and games played through an Internet browser, IESA
granted us the exclusive right to distribute and sell such games in both the packaged media
format and digital download format, if IESA makes such games available in the packaged media
format.
Our exclusive distribution territory is the region covered by the United States, Canada and
Mexico. However, if net receipts for games distributed in Mexico are less than the agreed
upon target during a given year, the distribution rights in Mexico shall automatically
revert to IESA at the end of the relevant year of the term of exclusivity.
The distribution of each game would be subject to a sales plan and specific
commitments (i)
by us, regarding the amount of the initial order, minimum number of units to be
manufactured, minimum amount required to be invested by us for marketing and promotion
of such game, and the royalties to be paid, which shall equal (x) a flat per-unit fee per
manufactured unit or (y) a percentage of net receipts less a distribution fee paid to us
equal to 30% of net receipts; and (ii) by IESA, regarding the anticipated delivery date and
expected quality and rating of the game. In the event we and IESA do not initially agree to
the terms of such commitments for a particular game, IESA may negotiate with third parties
regarding the distribution of such game, but IESA cannot accept a third party offer for
distribution rights without first giving us ten days to match the offer.
The term of exclusivity rights under the Short Form Distribution Agreement is three years,
unless terminated earlier in accordance with the agreement. The term may automatically be
shortened to two years if the net receipts from the games distributed thereunder after the
first year is less than 80% of a target to be mutually determined. Thereafter, the term
shall automatically extend for consecutive one year periods unless written notice of
non-extension is delivered within one-year of the expiration date.
IESA retains the rights to distribute games in the digital download format for which IESA
and we have not agreed to distribution commitments. IESA agreed to pay the Company a royalty
equal to 8% of the online net revenues that IESA receives via the online platform
attributable to such games in exchange for the grant of a trademark license for Atari.com.
Furthermore, IESA shall have the sole and exclusive right to operate the Atari.com Internet
site, for which the terms will be subject to a separate agreement to be entered into on or
before March 14, 2008. IESA agreed to place a link from the Atari.com Internet site to
the Company’s Internet site where we distribute games in the digital download format for
which IESA and us have agreed to distribution commitments.
We have entered into a Termination and Transfer of Assets Agreement (the “Termination and
Transfer Agreement”) with IESA (together with its affiliate), pursuant to which the parties
terminated the Production Services Agreement, between us and IESA, dated as of March 31,2006, IESA agreed to hire a significant part of our Production Department team and certain
related assets were transferred to IESA.
Pursuant to the Termination and Transfer Agreement, we agreed to transfer to IESA
substantially all of the computer, telecommunications and other office equipment currently
being used by the transferred Production team personnel to perform production services. In
consideration of the transfer, IESA agreed to pay us approximately $0.1 million,
representing, in aggregate, the agreed upon current net book value for the fixed assets
being transferred and the replacement cost for the development assets being transferred.
Furthermore, IESA agreed to offer employment to certain of our Production team personnel
identified to be transitioned. Certain of those employees are permitted to continue
providing oversight and supervisory services to us until January 31, 2008 at either no cost
or at a discounted cost plus a fee.
QA Services Agreement
We entered into the QA Services Agreement (“QA Agreement”) with IESA (together with two of
its affiliates), pursuant to which we would either directly or indirectly through third
party vendors provide IESA with certain quality assurance services until March 31, 2008.
Pursuant to the QA Agreement, IESA agreed to pay us the cost of the quality assurance
services plus a 10% premium. In addition, IESA agreed to pay certain retention bonuses
payable to employees providing the services to IESA or its affiliates who work directly on
IESA projects or are otherwise general QA support staff.
Intercompany Services Agreement
We entered into an Intercompany Services Agreement with IESA (together with two of its
affiliates) that supersedes the Management and Services Agreement and the Services
Agreement, each between us and IESA dated March 31, 2006.
Under the Intercompany Services Agreement, we will provide to IESA and its affiliates
certain intercompany services, including legal, human resources and payroll, finance, IT and
management information systems (MIS), and facilities management services, at the costs set
forth therein. The annualized fee is approximately $2.6 million. The term of the
Intercompany Services Agreement shall continue through June 30, 2008, with three-month
renewal periods.
Although, the above transactions provided cash financing through our fiscal 2008 holiday
season, Management continues to seek additional financing and is pursuing other options to meet our
working capital cash requirements but there is no guarantee that we will be able to do so.
Historically, we have relied on IESA to provide limited financial support to us, through loans
or, in recent years, through purchases of assets. However, IESA has its own financial needs, and
its ability to fund its subsidiaries’ operations, including ours, is limited. Therefore, there can
be no assurance we will ultimately receive any funding from IESA.
The uncertainty caused by these above conditions raises substantial doubt about our ability to
continue as a going concern. Our consolidated financial statements do not include any adjustments
that might result from the outcome of this uncertainty.
We continue to explore various alternatives to improve our financial position and secure other
sources of financing which could include raising equity, forming both operational and financial
strategic partnerships, entering into new arrangements to license intellectual property, and
selling, licensing or sub-licensing selected owned intellectual property and licensed rights.
Further, as we are contemplating various alternatives, we will be utilizing our new Chief
Restructuring Officer, AlixPartners, and our special committee of our board of directors,
consisting of our newly appointed independent board members, who are authorized to review
significant and special transactions. We continue to examine the reduction of working capital
requirements to further conserve cash and may need to take additional actions in the near-term,
which may include additional personnel reductions and suspension of certain development projects
during fiscal 2008.
The above actions may or may not prove to be consistent with our long-term strategic
objectives, which have been shifted in the last fiscal year, as we have discontinued our internal
and external development activities. We cannot guarantee the completion of these actions or that
such actions will generate sufficient resources to fully address the uncertainties of our financial
position.
NASDAQ Delisting Notice
On December 21, 2007, we received a notice from Nasdaq advising that in accordance with Nasdaq
Marketplace Rule 4450(e)(1), we have 90 calendar days, or until March 20, 2008, to regain
compliance with the minimum market value of our publicly held shares required for continued listing
on the Nasdaq Global Market, as set forth in Nasdaq Marketplace Rule 4450(b)(3). We received this
notice because the market value of our publicly held shares (which is calculated by reference to
our total shares outstanding, less any shares held by officers, directors or beneficial owners of
10% or more) was less than $15.0 million for 30 consecutive business days prior to December 21,2007. This notification has no effect on the listing of our common stock at this time.
The notice letter also states that if, at any time before March 20, 2008, the market value of
our publicly held shares is $15.0 million or more for a minimum of 10 consecutive trading days, the
Nasdaq staff will provide us with written notification that we have achieved compliance with the
minimum market value of publicly held shares rule. However, the notice states that if we cannot
demonstrate compliance with such rule by March 20, 2008, the Nasdaq staff will provide us with
written notification that our common stock will be delisted.
In the event that we receive notice that our common stock will be delisted, Nasdaq rules
permit us to appeal any delisting determination by the Nasdaq staff to a Nasdaq Listings
Qualifications Panel.
Basis of Presentation
Our accompanying interim condensed consolidated financial statements are unaudited, but in the
opinion of management, reflect all adjustments, consisting of normal recurring accruals, necessary
for a fair presentation of the results for the interim periods presented in accordance with the
instructions for Form 10-Q. Accordingly, they do not include all information and notes required by
accounting principles generally accepted in the United States of America for complete financial
statements. These interim condensed consolidated financial statements should be read in conjunction
with the consolidated financial statements and notes thereto included in our Annual Report on Form
10-K for the fiscal year ended March 31, 2007.
Principles of Consolidation
The condensed consolidated financial statements include the accounts of Atari, Inc. and its
wholly-owned subsidiaries. All significant intercompany transactions and balances have been
eliminated.
Reclassifications
We have made certain reclassifications on our condensed consolidated statements in order to
provide better insight into the results of operations and to align our presentation to certain
industry competitors.
Revenue recognition, sales returns, price protection, other customer related allowances and
allowance for doubtful accounts
Revenue is recognized when title and risk of loss transfer to the customer, provided that
collection of the resulting receivable is deemed reasonably probable by management.
Sales are recorded net of estimated future returns, price protection and other customer
related allowances. We are not contractually obligated to accept returns; however, based on facts
and circumstances at the time a customer may request approval for a return, we may permit the
return or exchange of products sold to certain customers. In addition, we may provide price
protection, co-operative advertising and other allowances to certain customers in accordance with
industry practice. These reserves are determined based on historical experience, market acceptance
of products produced, retailer inventory levels, budgeted customer allowances, the nature of the
title and existing commitments to customers. Although management believes it provides adequate
reserves with respect to these items, actual activity could vary from management’s estimates and
such variances could have a material impact on reported results.
We maintain allowances for doubtful accounts for estimated losses resulting from the inability
of our customers to make payments when due or within a reasonable period of time thereafter. If
the financial condition of our customers were to deteriorate, resulting in an inability to make
required payments, additional allowances may be required.
Concentration of Credit Risk
We extend credit to various companies in the retail and mass merchandising industry for the
purchase of our merchandise which results in a concentration of credit risk. This concentration of
credit risk may be affected by changes in economic or other industry conditions and may,
accordingly, impact our overall credit risk. Although we generally do not require collateral, we
perform ongoing credit evaluations of our customers and reserves for potential losses are
maintained.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally
accepted in the United States of America requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosures of contingent assets and
liabilities at the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could materially differ from those estimates.
Fair Values of Financial Instruments
Financial Accounting Standards Board (“FASB”) Statement No. 107, “Disclosures About Fair Value
of Financial Instruments,” requires disclosure of the fair value of financial instruments for which
it is practicable to estimate. We believe that the carrying amounts of our financial instruments,
including cash, accounts receivable, accounts payable, accrued liabilities, royalties payable, our
third party credit facility, assets and liabilities of discontinued operations, and amounts due to
and from related parties, reflected in the condensed consolidated financial statements approximate
fair value due to the short-term maturity and the denomination in U.S. dollars of these
instruments.
Long-Lived Assets
We review long-lived assets, such as property and equipment, for impairment annually or
whenever events or changes in circumstances indicate that the carrying amount of an asset may not
be fully recoverable. If the estimated fair value of the asset is less than the carrying amount of
the asset plus the cost to dispose, an impairment loss is recognized as the amount by which the
carrying amount of the asset plus the cost to dispose exceeds its fair value, as defined in FASB
Statement No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”
Research and Product Development Expenses
Research and product development expenses related to the design, development and testing of
newly developed software products are charged to expense as incurred. Research and product
development expenses also include payments for royalty advances (milestone payments) to third party
developers for products that are currently in development. Once a product is sold, we may be
obligated to make additional payments in the form of backend royalties to developers which are
calculated based on contractual terms, typically a percentage of sales. Such payments are expensed
and included in cost of goods sold in the period the sales are recorded.
Rapid technological innovation, shelf-space competition, shorter product life cycles and buyer
selectivity have made it difficult to determine the likelihood of individual product acceptance and
success. As a result, we follow the policy of expensing milestone payments as incurred, treating
such costs as research and product development expenses.
Licenses
Licenses for intellectual property are capitalized as assets upon the execution of the
contract when no significant obligation of performance remains with us or the third party. If
significant obligations remain, the asset is capitalized when payments are due or when performance
is completed as opposed to when the contract is executed. These licenses are amortized at the
licensor’s royalty rate over unit sales to cost of goods sold. Management evaluates the carrying
value of these capitalized licenses and records an impairment charge in the period management
determines that such capitalized amounts are not expected to be realized. Such impairments are
charged to cost of goods sold if the product has released or previously sold, and if the product
has never released, these impairments are charged to research and product development expenses.
In
connection with a recapitalization completed in fiscal 2004, Atari Interactive, Inc.
(“Atari Interactive”), a wholly-owned subsidiary of IESA, extended the term of the license under
which we use the Atari trademark to ten years expiring on December 31, 2013. We issued 200,000
shares of our common stock to Atari Interactive for the extended license and will pay a royalty
equal to 1% of our net revenues during years six through ten of the extended license. We recorded
a deferred charge of $8.5 million, representing the fair value of the shares issued, which was
expensed monthly until it became fully expensed in the first quarter of fiscal 2007. The monthly
expense was based on the total estimated cost to be incurred by us over the ten-year license period
($8.5 million plus estimated royalty of 1% for years six through ten); upon the full expensing of
the deferred charge, this expense is being recorded as a deferred liability owed to Atari
Interactive, to be paid beginning in year six of the license.
Net Loss Per Share
Basic
net loss per share is computed by dividing net loss by the weighted average number of
shares of common stock outstanding for the period. Diluted net loss per share reflects the
potential dilution that could occur from shares of common stock issuable through stock-based
compensation plans, including stock options and warrants, using the treasury stock method. The
number of antidilutive shares that was excluded from the diluted earnings per share calculation for
the three months ended December 30, 2006 and 2007 was
approximately 1.1 million and 0.4 million,
respectively, and for the nine months ended December 30, 2006
and 2007 was 0.9 million and 0.4 million, respectively.
Recent Accounting Pronouncements
In
September 2006, the FASB issued FASB Statement No. 157, “Fair Value Measurements,”
(“Statement No. 157”) which provides a single definition of fair value, together with a framework
for measuring it, and requires additional disclosure about the use of fair value to measure assets
and liabilities. Furthermore, in February 2007, the FASB issued FASB Statement No. 159, “The Fair
Value Option for Financial Assets and Liabilities,” (“Statement No. 159”) which permits an entity
to measure certain financial assets and financial liabilities at fair value, and report unrealized
gains and losses in earnings at each subsequent reporting date. Its objective is to improve
financial reporting by allowing entities to mitigate volatility in reported earnings caused by the
measurement of related assets and liabilities using different attributes without having to apply
complex hedge accounting provisions. Statement No. 159 is effective for fiscal years beginning
after November 15, 2007, but early application is encouraged. The requirements of Statement No.
157 are adopted concurrently with or prior to the adoption of
Statement No. 159. We do not anticipate the adoption of these
statements to have a material effect on our financial statements.
See
Note 5 regarding the Company’s adoption of FASB Interpretation No. 48 “Accounting for
Uncertainty in Income Taxes (an interpretation of FASB Statement No. 109)” which is effective for
fiscal years beginning after December 15, 2006.
NOTE 2 — STOCK-BASED COMPENSATION
Effective
April 1, 2006, we adopted FASB Statement No. 123(R), “Share-Based Payment,” which
requires the measurement and recognition of compensation expense at fair value for employee stock
awards. We adopted FASB Statement No. 123(R) using the modified prospective method in which we are
recognizing compensation expense for all awards granted after the required effective date and for
the unvested portion of previously granted awards that remain outstanding at the date of adoption.
At
December 31, 2007, we have one stock incentive plan, under which we could issue a total of
1,500,000 shares of common stock as stock options or restricted stock, of which 1,168,822 were
still available for grant as of December 31, 2007. Upon approval of this plan, our previous stock
option plans were terminated, and we were no longer able to issue options under those plans;
however, options originally issued under the previous plans continue to be outstanding. All
options granted under our current or previous plans have an exercise price equal to or greater than
the market value of the underlying common stock on the date of grant; options vest over four years
and expire in ten years.
The
recognition of stock-based compensation expense increased our net loss by $0.4 million for
the three months ended December 31, 2006 and decreased our net loss for the three months ended
December 31, 2007 by $(0.1) million, and
increased
our basic and diluted loss per share amount by $0.03 and $(0.00) for the three months
ended December 31, 2006 and 2007, respectively. For the nine months ended December 31, 2006 and
2007, stock-based compensation expenses increased our net loss by $1.1 million and $0.1 million,
respectively. Our basic and diluted loss per share increased due to stock-based compensation by
$0.03 and $0.00 for the nine months ended December 31, 2006 and 2007, respectively.
We have recorded a full valuation allowance against our net deferred tax asset, so the
settlement of stock-based compensation awards will not result in tax benefits that could impact our
consolidated statement of operations. Because the tax deduction from current period settlement of
awards has not reduced taxes payable, the settlement of awards has no effect on our cash flow from
operating and financing activities.
The following table summarizes the classification of stock-based compensation expense in our
condensed consolidated statements of operations for the three months ended December 31, 2006 and
2007 (in thousands):
The weighted average fair value of options granted during the three months ended December 31,2006 and 2007 was $3.70 and $2.55, respectively. The weighted average fair value of options
granted during the nine months ended December 31, 2006 and 2007 was $4.60 and $2.92, respectively.
The fair value of our options is estimated using the Black-Scholes option pricing model. This
model requires assumptions regarding subjective variables that impact the estimate of fair value.
Our policy for attributing the value of graded vest share-based payment is a single option
straight-line approach. The following table summarizes the assumptions used to compute the
weighted average fair value of option grants:
The weighted average risk-free interest rate (based on the three year and five year US
Treasury Bond average) for the three and nine months ended December 31, 2006 was 4.36% and for the
three months and nine months ended December 31, 2007 was 3.26%.
FASB Statement No. 123(R) requires that we recognize stock-based compensation expense for the
number of awards that are ultimately expected to vest. As a result, the expense recognized must be
reduced for estimated forfeitures prior to vesting, based on a historical annual forfeiture rate,
which is approximately 12%. Estimated forfeitures shall be assessed at each balance sheet date and
may change based on new facts and circumstances. Prior to the adoption of FASB Statement No.
123(R), forfeitures were accounted for as they occurred when included in required pro forma stock
compensation disclosures.
As of December 31, 2007, the weighted average remaining contractual term of options
outstanding and exercisable was 5.8 years and 3.6 years, respectively, and the aggregate intrinsic
value related to options outstanding and exercisable was $0.0 million and $0.0 million,
respectively as all of our options’ strike price were greater than the fair-market value as of
December 31, 2007. As of December 31, 2007, the total future unrecognized compensation cost
related to outstanding unvested options is $2.1 million, which will be recognized as compensation
expense over the remaining weighted average vesting period of 2.9 years.
Excluding international royalty, licensing, and other income.
With the exception of the largest customers noted above, accounts receivable balances from all
remaining individual customers were less than 10% of our total accounts receivable balance.
NOTE 4 — BALANCE SHEET DETAILS
Inventories
Inventories consist of the following (in thousands):
As of March 31, 2007, we had net operating loss carryforwards of $544.6 million for federal
tax purposes. These tax loss carryforwards expire beginning in the years 2012 through 2027, if not
utilized. Utilization of the net operating loss carryforwards may be subject to a restrictive
annual limitation pursuant to Section 382 of the Internal Revenue Code which may mechanically
prevent the Company from utilizing its entire loss carryforward.
In assessing the realizability of deferred tax assets, management considers whether it is more
likely than not that some portion or all of the deferred tax assets will be realized. The ultimate
realization of deferred tax assets is dependent upon the generation of future taxable income prior
to the expiration of any net operating loss carryforwards. Due to the uncertainty regarding our
ability to realize our net deferred tax assets in the future, we have provided a full valuation
allowance against our net deferred tax assets. Management reassesses its position with regard to
the valuation allowance on a quarterly basis.
During the three and nine months ended December 31, 2007, no net tax provisions were recorded
due to the taxable loss recorded for the respective quarters. During the nine months ended
December 31, 2006, we recorded a non-cash tax benefit of $4.8 million, which offsets a non-cash tax
provision of the same amount included in loss from discontinued operations, recorded in accordance
with FASB Statement No, 109, “Accounting for Income Taxes,” paragraph 140, which states that all
items should be considered for purposes of determining the amount of tax benefit that results from
a loss from continuing operations and that should be allocated to continuing operations. The
recording of a benefit is appropriate in this instance, under the guidance of Paragraph 140,
because such domestic loss offsets the domestic gain generated in
discontinued operations. The effect of this transaction on net loss for fiscal 2007 is zero,
and it does not result in the receipt
or payment of any cash. Further during the same period, we
recorded a $0.5 million of deferred tax liability recorded due to a temporary difference that arose
from a difference in the book and tax basis of goodwill.
In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income
Taxes” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in
an enterprise’s financial statement in accordance with FASB Statement No. 109, “Accounting for
Income Taxes”. This interpretation prescribes a comprehensive model for the financial statement
recognition, measurement, presentation and disclosure of uncertain tax positions taken or expected
to be taken in an income tax return. FIN 48 also provides guidance on derecognition of tax
benefits, classification on the balance sheet, interest and penalties, accounting in interim
periods, disclosure and transition.
The Company adopted FIN 48 effective April 1, 2007 and had approximately $0.4 million of
unrecognized tax benefits as of the adoption date and as of December 31, 2007. The Company has
decided to classify interest and penalties as a component of tax expense.
The Company is subject to taxation in the U.S. and various state jurisdictions. The Company
was previously subject to taxation in the United Kingdom. The Company’s federal tax returns for
tax year ended September 24, 2003 and March 31, 2004 through March 31, 2007 tax years remain
subject to examination. The Company files in numerous state jurisdictions with varying statues of
limitations. During fiscal 2007, the Company completed a tax examination in the United Kingdom
(“UK”) through the period ended March 31, 2004 and has terminated its UK business activities.
NOTE 6 — RELATED PARTY TRANSACTIONS
Relationship with IESA
As of December 31, 2007, IESA beneficially owned approximately 51% of our common stock. IESA
renders management services to us (systems and administrative support) and we render management
services and production services to Atari Interactive and other subsidiaries of IESA. Atari
Interactive develops video games, and owns the name “Atari” and the Atari logo, which we use under
a license. IESA distributes our products in Europe, Asia, and certain other regions, and pays us
royalties in this respect. IESA also develops (through its subsidiaries) products which we
distribute in the U.S., Canada, and Mexico and for which we pay royalties to IESA (Note 1). Both
IESA and Atari Interactive are material sources of products which we bring to market in the United
States, Canada and Mexico. During the nine months ended December 31, 2007, international royalties
earned from IESA were the source of 2.0% of our net revenues. Additionally, during the nine months
ended December 31, 2007, IESA and its subsidiaries (primarily Atari Interactive) were the source of
approximately 20.0%, respectively, of our net publishing product revenue.
Historically, IESA has incurred significant continuing operating losses and has been highly
leveraged. On September 12, 2006, IESA announced a multi-step debt restructuring plan, subject to
its shareholders’ approval, which would significantly reduce its debt and provide liquidity to meet
its operating needs. On November 15, 2006, IESA shareholders approved the debt restructuring plan,
permitting IESA to execute on this plan. As of December 31, 2007, IESA has raised 150 million
Euros, of which approximately 40 million Euros has paid down outstanding short-term and long-term
debt. The remaining 100 million euros (less approximately 6 million Euro in fees) will be
committed to fund IESA’s development program. Although this recent transaction has brought in
additional financing, IESA’s ability to fund, among other things, its subsidiaries’ operations
remains limited. Our results of operations
could be materially impaired if IESA fails to fund Atari Interactive, as any delay or cessation in
product development could materially decrease our revenue from the distribution of Atari
Interactive and IESA products. If the above contingencies occurred, we probably would be forced to
take actions that could result in a significant reduction in the size of our operations and could
have a material adverse effect on our revenue and cash flows.
Additionally, although Atari is a separate and independent legal entity and we are not a party
to, or a guarantor of, and have no obligations or liability in respect of IESA’s indebtedness
(except that we have guaranteed the Beverly, MA lease obligation of Atari Interactive), because
IESA owns the majority of our common stock, potential investors and current and potential
business/trade partners may view IESA’s financial situation as relevant to an assessment of Atari.
Therefore, if IESA is unable to address its financial issues, it may taint our relationship with
our suppliers and distributors, damage our business reputation, affect our ability to generate
business and enter into agreements on financially favorable terms, and otherwise impair our ability
to raise and generate capital.
The following table provides the details of related party amounts within each line of our
condensed consolidated statements of operations (in thousands):
Three Months
Nine Months
Ended
Ended
December 31,
December 31,
Income (expense)
2006
2007
2006
2007
Net revenues
$
47,277
$
41,115
$
95,338
$
64,845
Related party activity:
Royalty income (1)
909
506
1,886
1,322
License income (1)
285
709
1,394
5,697
Sale of goods
287
271
677
505
Production and quality and assurance testing
services
1,472
598
3,762
2,034
Total related party net revenues
2,953
2,084
7,719
9,558
Cost of goods sold
(27,117
)
(21,145
)
(56,296
)
(34,186
)
Related party activity:
Distribution fee for Humongous, Inc. product
(694
)
(4,368
)
(3,939
)
(5,820
)
Royalty expense (2)
(7,394
)
(2,058
)
(9,106
)
(3,403
)
Total related party cost of goods sold
(8,088
)
(6,426
)
(13,045
)
(9,223
)
Research and product development
(5,522
)
(4,423
)
(19,988
)
(12,425
)
Related party activity:
Development expenses (3)
(1,190
)
(82
)
(6,517
)
(247
)
Other miscellaneous development services
5
—
14
—
Total related party research and product
development
(1,185
)
(82
)
(6,503
)
(247
)
Selling and distribution expenses
(6,377
)
(7,123
)
(20,795
)
(15,882
)
Related party activity:
Miscellaneous purchase of services
(3
)
—
(82
)
(41
)
Total related party selling and distribution
expenses
(3
)
—
(82
)
(41
)
General and administrative expenses
(5,206
)
(3,341
)
(16,321
)
(13,894
)
Related party activity:
Management fee revenue
750
719
2,270
2,219
Management fee expense
(750
)
(529
)
(2,250
)
(2,030
)
Office rental and other services (4)
46
46
138
138
Total related party general and
administrative
expenses
46
236
158
327
Restructuring expenses
(224
)
(3,730
)
(558
)
(4,722
)
Related party activity:
Related party rent expense (4)
(116
)
—
(349
)
—
Total related party restructuring expenses
(116
)
—
(349
)
—
Interest expense (income), net
(45
)
(810
)
187
(855
)
Related party activity:
Related party interest on license advance (5)
—
(108
)
—
(108
)
Total related party interest expense
—
(108
)
—
(108
)
(Loss) income from discontinued operations of
Reflections Interactive Ltd., net of tax
(1,727
)
(33
)
146
(33
)
Related party activity:
Royalty income (1)
(864
)
—
(1,570
)
—
License income (1)
134
—
525
—
Total related party loss from discontinued
operations
We have entered into a distribution agreement with IESA and Atari Europe which provides for
IESA’s and Atari Europe’s distribution of our products across Europe, Asia, and certain other
regions pursuant to which IESA, Atari Europe, or any of their subsidiaries, as applicable, will
pay us 30.0% of the gross margin on such products or 130.0% of the royalty rate due to the
developer, whichever is greater. We recognize this amount as royalty income as part of net
revenues, net of returns. Additionally, we earn license income from related parties iFone and
Glu Mobile (see below).
(2)
We have also entered into a distribution agreement with IESA and Atari Europe, which
provides for our distribution of IESA’s (or any of its subsidiaries’) products in the United
States, Canada and Mexico, pursuant to which we will pay IESA either 30.0% of the gross margin
on such products or 130.0% of the royalty rate due to the developer, whichever is greater. We
recognize this amount as royalty expense as part of cost of goods sold, net of returns.
(3)
We engage certain related party development studios to provide services such as product
development, design, and testing.
(4)
In July 2002, we negotiated a sale-leaseback transaction between Atari Interactive and an
unrelated party. As part of this transaction, we guaranteed the lease obligation of Atari
Interactive. The lease provides for minimum monthly rental payments of approximately $0.1
million escalating nominally over the ten-year term of the lease. During fiscal 2006, when the
Beverly studio (which held the office space for Atari Interactive) was closed, rental payments
were recorded to restructuring expense. We also received indemnification from IESA from costs,
if any, that may be incurred by us as a result of the full guarantee.
We received a $1.3 million payment for our efforts in connection with the sale-leaseback
transaction. Approximately $0.6 million, an amount equivalent to a third party broker’s
commission, was recognized during fiscal 2003 as other income, while the remaining balance of
$0.7 million was deferred and is being recognized over the life of the sub-lease. Accordingly,
during the nine months ended December 31, 2006 and 2007, a nominal amount of income was
recognized in each period. As of December 31, 2007, the remaining balance of approximately $0.3
million is deferred and is being recognized over the life of the sub-lease. Although the
Beverly studio was closed in fiscal 2006 as part of a restructuring plan (Note 10), the space
was not sublet; the lease expired June 30, 2007.
Additionally, we provide management information systems services to Atari Australia for which we
are reimbursed. The charge is calculated as a percentage of our costs, based on usage, which is
agreed upon by the parties.
(5)
Represents interest charged to us from the license advance from the Test Drive license. See
Note 1 and Test Drive Intellectual Property License below.
The following amounts are outstanding with respect to the related party activities described above
(in thousands):
Balances comprised primarily of the management fees charged to us by IESA and other
charges of cost incurred on our behalf.
(2)
Balances comprised of royalty income or expense from our distribution agreements with
IESA and Atari Europe relating to properties owned or licensed by Atari Europe.
(3)
Represents net payables for related party development activities. (Note: Atari
Melbourne House, a related party development studio, was sold to a third party by IESA in
the third quarter of fiscal 2007. Balances due to Atari Melbourne House as of March 31,2007 were transferred to Atari Studio Asia.)
(4)
Represents primarily distribution fees owed to Humongous, Inc., a related party,
related to sale of their product.
(5)
Comprised primarily of royalties owed to Atari Interactive, offset by receivables
related to management fee revenue and production and quality and assurance testing services
revenue earned from Atari Interactive.
(6)
Balances comprised of license income from our licensing agreements with Glu Mobile,
Inc. (merged with Ifone in 2006) relating to properties in which we own or hold rights to
publish and/or sub-license.
Atari Name License
In May 2003, we changed our name to Atari, Inc. upon obtaining rights to use the Atari name
through a license from IESA, which IESA acquired as a part of the acquisition of Hasbro Interactive
Inc. (“Hasbro Interactive”). In connection with a debt recapitalization in September 2003, Atari
Interactive extended the term of the license under which we use the Atari name to ten years
expiring on December 31, 2013. We issued 200,000 shares of our common stock to Atari Interactive
for the extended license and will pay a royalty equal to 1% of our net revenues during years six
through ten of the extended license. We recorded a deferred charge of $8.5 million, which was
being amortized monthly and which became fully amortized during the first quarter of fiscal 2007.
The monthly amortization was based on the total estimated cost to be incurred by us over the
ten-year license period. Upon full amortization of the deferred charge, we began recording a
long-term liability at $0.2 million per month, to be paid to Atari Interactive beginning in year
six of the term of the license. During the quarters ended December 31, 2006 and 2007, we recorded
expense of $0.6 million and $0.6 million in each period, respectively. For the nine months ended
December 31, 2006 and 2007, we recorded license expense of $1.7 million in each period. As of
December 31, 2007, $3.0 million relating to this obligation is included in long-term liabilities
and approximately $0.6 is in short-term liabilities.
Sale of Hasbro Licensing Rights
On July 18, 2007, IESA, agreed to terminate a license under which it and we, and our
sublicensees, had developed, published and distributed video games using intellectual property
owned by Hasbro, Inc. In connection with that termination, on the same date, we and IESA entered
into an agreement whereby IESA agreed to pay us $4.0 million. In addition, pursuant to the
agreements between IESA and Hasbro, Hasbro agreed to assume our obligations under any sublicenses
that we had the right to assign to it. As of December 31, 2007, we have received full payment of
the $4.0 million and have recorded the same amount as other income as part of our publishing net
revenues for the nine months ended December 31, 2007.
Test Drive Intellectual Property License
On November 8, 2007, we entered into two separate license agreements with IESA pursuant to
which we granted IESA the exclusive right and license, under its trademark and intellectual and
property rights, to create, develop, distribute and otherwise exploit licensed products derived
from the Test Drive Franchise for a term of seven years. IESA paid us a non-refundable advance,
fully recoupable against royalties to be paid under each of the TDU Agreements, of (i) $4 million
under the Trademark Agreement and (ii) $1 million under the IP Agreement, both advances accrue
interest at a yearly rate of 15% throughout the term of the
applicable agreement (See Note 1).
Related Party Transactions with Employees or Former Employees
•
License Revenue from Glu Mobile
We record license income from Glu Mobile, for which a member of our Board of Directors, until
October 5, 2007, Denis Guyennot, is the Chief Executive Officer of activities in Europe, the Middle
East, and Africa. This results in treatment of Glu Mobile as a related party. During the three
months ended September 30, 2006 and 2007, license income recorded from Glu Mobile was $0.5 million
and $1.2 million, respectively. During the six months ended September 30, 2006 and 2007, license
income recorded from Glu Mobile was $1.5 million and $2.3 million, respectively. As of March 31,2007, receivables from Glu Mobile were $1.3 million. As of December 31, 2007, we had no related
party receivables from Glu Mobile. Upon the removal of Mr. Guyennot from our Board of Directors on
October 5, 2007, Glu Mobile no longer is a related party.
NOTE 7 — COMMITMENTS AND CONTINGENCIES
Contractual Obligations
As of December 31, 2007, royalty and license advance obligations, milestone payments and
future minimum lease obligations under non-cancelable operating and capital lease obligations were
as follows (in thousands):
We have committed to pay advance payments under certain royalty and
license agreements. The payments of these obligations are dependent on the delivery
of the contracted services by the developers.
(2)
Milestone payments represent royalty advances to developers for products
that are currently in development. Although milestone payments are not guaranteed,
we expect to make these payments if all deliverables and milestones are met timely
and accurately.
(3)
We account for our office leases as operating leases, with expiration
dates ranging from fiscal 2008 through fiscal 2022. These are future minimum annual
rental payments required under the leases net of $0.6 million of sublease income to
be received in fiscal 2008 and fiscal 2009. Rent expense and sublease income for
the three and nine months ended December 31, 2006 and 2007 is as follows (in
thousands):
During June 2006, we entered into a new lease with our current landlord at our New
York headquarters for approximately 70,000 square feet of office space for our
principal offices. The term of this lease
commenced on July 1, 2006 and is to expire
on June 30, 2021. Upon entering into the new lease, our prior lease, which was set
to expire in December 2006, was terminated. The rent under the new lease for the
office space was approximately $2.4 million per year for the first five years,
increased to approximately $2.7 million per year for the next five years, and
increased to $2.9 million for the last five years of the term. In addition, we must
pay for electricity, increases in real estate taxes and increases in porter wage
rates over the term. The landlord is providing us with a one year rent credit of
$2.4 million and an allowance of $4.5 million to be used for building out and
furnishing the premises, of which $1.2 million has been recorded as a deferred credit
as of March 31, 2007; the remainder of the deferred credit will be recorded as the
improvements are completed, and will be amortized against rent expense over the life
of the lease. A nominal amount of amortization was recorded during the year ended
March 31, 2007. For the nine months ended December 31, 2007, we recorded an
additional deferred credit of $2.8 million and amortization against the total
deferred credits of approximately $0.2 million. Shortly after signing the new lease,
we provided the landlord with a security deposit under the new lease in the form of a
letter of credit in the initial amount of $1.7 million, which has been cash
collateralized and is included in security deposits on our condensed consolidated
balance sheet. On August 14, 2007, we and our new landlord, W2007 Fifth Realty, LLC,
amended the lease under which we occupy space in 417 Fifth Avenue, New York City, to
reduce the space we occupy by approximately one-half, effective December 31, 2007. As
a result, our rent under the amended lease will be reduced from its current
approximately $2.4 million per year to approximately $1.2 million per year from
January 1, 2008 through June 30, 2011, approximately $1.3 million per year for the
five years thereafter, and approximately $1.5 million per year for the last five
years of the term.
(4)
We maintain several capital leases for computer equipment. Per FASB
Statement No. 13, “Accounting for Leases,” we account for capital leases by
recording them at the present value of the total future lease payments. They are
amortized using the straight-line method over the minimum lease term. As of March31, 2007, the net book value of the assets, included within property and equipment
on the balance sheet, was $0.1 million, net of accumulated depreciation of $0.5
million. As of December 31, 2007, the net book value of the assets was $0.1
million, net of accumulated depreciation of $0.5 million.
Litigation
As of December 31, 2007, our management believes that the ultimate resolution of any of the
matters summarized below and/or any other claims which are not stated herein, if any, will not have
a material adverse effect on our liquidity, financial condition or results of operations. With
respect to matters in which we are the defendant, we believe that the underlying complaints are
without merit and intend to defend ourselves vigorously.
Bouchat v. Champion Products, et al. (Accolade)
This suit involving Accolade, Inc. (a predecessor entity of Atari) was filed in 1999 in the
District Court of Maryland. The plaintiff originally sued the NFL claiming copyright infringement
of a logo being used by the Baltimore Ravens that plaintiff allegedly designed. The plaintiff then
also sued nearly 500 other defendants, licensees of the NFL, on the same basis. The NFL hired
White & Case to represent all the defendants. Plaintiff filed an amended complaint in 2002. In
2003, the District Court held that plaintiff was precluded from recovering actual damages, profits
or statutory damages against the defendants, including Accolade. Plaintiff has appealed the
District Court’s ruling to the Fourth Circuit Court of Appeals. White & Case continues to
represent Accolade and the NFL continues to bear the cost of the defense.
Ernst & Young, Inc. v. Atari, Inc.
On July 21, 2006 we were served with a complaint filed by Ernst & Young as Interim Receiver
for HIP Interactive, Inc. This suit was filed in New York State Supreme Court, New York County. HIP
is a Canadian company that has gone into bankruptcy. HIP contracted with us to have us act as its
distributor for various software products in the U.S. HIP is alleging breach of contract claims; to
wit, that we failed to pay HIP for product in the amount of $0.7 million. We will investigate
filing counter claims against HIP, as HIP owes us, via our Canadian Agent, Hyperactive, for our
product distributed in Canada. Our answer and counterclaim were filed in August of 2006 and we initiated discovery
against Ernst & Young at the same time. Settlement discussions commenced in September 2006 and are
currently on-going.
Research in Motion Limited v. Atari, Inc. and Atari Interactive, Inc.
On October 26, 2006, Research in Motion Limited (“RIM”) filed a claim against us and Atari
Interactive in the Ontario Superior Court of Justice. RIM is seeking a declaration that (i) the
game BrickBreaker, as well as the copyright, distribution, sale and communication to the public of
copies of the game in Canada and the United States, does not infringe any Atari copyright for
Breakout or Super Breakout in Canada or the United States, (ii) the audio-visual displays of
Breakout do not constitute a work protected by copyright under Canadian law, and (iii) Atari holds
no right, title or interest in Breakout under US or Canadian law. RIM is also requesting the costs
of the action and such other relief as the court deems. Breakout and Super Breakout are games
owned by Atari Interactive. On January 19, 2007, RIM added claims to its case requesting a
declaration that (i) its game Meteor Crusher does not infringe Atari copyright for its game
Asteroids in Canada, (ii) the audio-visual displays of Asteroids do not constitute a work protected
under Canadian law, and (iii) Atari holds no right, title or interest in Asteroids under Canadian
law. In August 2007, the Court ruled against Atari’s December 2006 motion to have the RIM claims
dismissed on the grounds that there is no statutory relief available to RIM under Canadian law.
Atari has appealed the same and was not successful. As of January
2008, Atari has filed its answer and counterclaims in response to
RIM’s original claims.
FUNimation License Agreement
We are a party to two license agreements with FUNimation Productions, Ltd. (“FUNimation”)
pursuant to which we distribute the Dragonball Z software titles. On October 18, 2007, FUNimation
delivered a notice purporting to terminate the license agreements based on alleged breaches of the
license agreements. We disputed the validity of the termination notices and continued to distribute
the titles covered by the license agreements. We and FUNimation settled this dispute for
approximately $3.3 million which is comprised of royalty expense of $1.7 million and $1.6 million
related to minimum advertising commitment shortfalls. This resulted in an additional charge of $2.8
million during the nine months ended December 31, 2007, recorded during the second quarter of
fiscal 2008. The settlement was paid for with $2.5 million in cash during the third quarter of
fiscal 2008 and a reduction of our FUNimation prepaid license advance by approximately $0.8
million.
NOTE 8 — DEBT
Credit Facilities
Guggenheim Credit Facility
On November 3, 2006, we established a secured credit facility with several lenders for which
Guggenheim was the administrative agent. The Guggenheim credit
facility was to terminate and be
payable in full on November 3, 2009. The credit facility
consisted of a secured, committed,
revolving line of credit in an initial amount up to $15.0 million, which included a $10.0 million
sublimit for the issuance of letters of credit. Availability under
the credit facility was determined by a formula based on a percentage of our eligible
receivables. The proceeds could be
used for general corporate purposes and working capital needs in the ordinary course of business
and to finance acquisitions subject to limitations in the Credit Agreement. The credit facility
bore interest at our choice of (i) LIBOR plus 5% per year, or (ii) the greater of (a) the prime
rate in effect, or (b) the Federal Funds Effective Rate in effect plus 2.25% per year.
Additionally, we were required to pay a commitment fee on the undrawn portions of the credit
facility at the rate of 0.75% per year and we paid to Guggenheim a closing fee of $0.2 million.
Obligations under the credit facility were secured by liens on substantially all of our present and
future assets, including accounts receivable, inventory, general intangibles, fixtures, and
equipment, but excluding the stock of our subsidiaries and certain assets located outside of the
U.S.
The
credit facility included provisions for a possible term loan facility and an increased
revolving credit facility line in the future. The credit facility
also contained financial
covenants that required us to maintain enumerated EBITDA, liquidity, and net debt minimums, and a
capital expenditure maximum. As of June 30, 2007, we were not in compliance with all
financial covenants. On October 1, 2007, the lenders provided a waiver of covenant defaults as
of June 30, 2007 and reduced the aggregate borrowing commitment of the revolving line of credit to
$3.0 million.
On October 18, 2007, we consented to the transfer of the loans outstanding ($3.0 million)
under the Guggenheim credit facility to funds affiliated with BlueBay Asset Management plc and to
the appointment of BlueBay High Yield Investments (Luxembourg) S.A.R.L. (“BlueBay”), as successor
administrative agent. BlueBay Asset Management plc is a significant shareholder of IESA. On
October 23, 2007, we entered into a waiver and amendment with BlueBay for, as amended, a $10.0
million Senior Secured Credit Facility (“Senior Credit Facility”). The Senior Credit Facility
matures on
December 31, 2009, charges an interest rate of the applicable LIBOR rate plus 7% per
year, and eliminates certain financial covenants. On December 4, 2007, under the Waiver Consent
and Third Amendment to the Credit Facility, as part of entering the Global MOU, BlueBay raised the
maximum borrowings of the Senior Credit Facility to $14.0 million. The maximum borrowings we can make under the Senior Credit Facility
will not by themselves provide all the funding we will need. As of December 31,2007 and through February 12, 2008, we are in violation of
our weekly cash flow covenants. BlueBay our lender has not waived this violation
and we have entered into a forbearance agreement which states our lender will not
exercise its rights on our facility until the earlier of (i) March 3, 2008,
(ii) additional covenant defaults except for the ones existing as the date of
this report or (iii) if any action transpires which is viewed to be adverse to
the position of the lender. Management continues
to seek additional financing and is pursuing other options to meet the cash requirements for
funding our working capital cash requirements but there is no guarantee that we will be able to do
so.
As of December 31, 2007, we have drawn the full $14.0 million on the Senior Credit Facility.
NOTE 9 — DISCONTINUED OPERATIONS
Sale of Reflections
In the first quarter of fiscal 2007, following the guidance established under FASB Statement
No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” management committed to
a plan to sell Reflections.
In August 2006, we sold to a third party the Driver intellectual property and certain assets
of Reflections for $24.0 million. We maintained sell-off rights for three months for all Driver
products, excluding Driver: Parallel Lines, which we maintained until the end of the third quarter
of fiscal 2007. The tangible assets included in the sale were property and equipment only.
Goodwill allocated to Reflections was $12.3 million. During the second quarter of fiscal 2007, we
recorded a gain in the amount of the difference between the proceeds from the sale and the book
value of Reflections’ property and equipment and the goodwill allocation. The gain recorded was
approximately $11.5 million, and was included in (loss) from discontinued operations of Reflections
in the second quarter of fiscal 2007.
Balance Sheets
At March 31, 2007 , the assets of Reflections are presented separately on our condensed
consolidated balance sheets. The balances at March 31, 2007 represent assets associated with
Reflections and the Driver franchise that were not included in the sale. Management’s intent is to
divest itself of the remaining assets associated with Reflections’ office lease during fiscal 2008.
The components of the assets of discontinued operations are as follows (in thousands):
As Reflections represented a component of our business and its results of operations and cash
flows can be separated from the rest of our operations, the results for the periods presented are
disclosed as discontinued operations on the face of the condensed consolidated statements of
operations. Net revenues and (loss) income from discontinued operations, net of tax, for the three
months and nine months ended December 31, 2006 and 2007, respectively, are as follows (in
thousands):
In the first quarter of fiscal 2008, management announced a plan to reduce our total
workforce by 20%, primarily in general and administrative functions.
(2)
In the third quarter of fiscal 2008, as part of the removal of the Board of Directors
and the hiring of a restructuring firm, management announced an additional workforce
reduction of 30%, primarily in research and development and general and administrative
functions. This restructuring is anticipated to cost us approximately $5.0 to $6.0 million
dollars of which $1.0 to $1.5 million would relate to severance arrangements (See Note 1).
(3)
As part of a restructuring plan implemented in fiscal 2005, we recorded the present
value of all future lease payments, less the present value of expected sublease income to
be recorded, primarily for the Beverly and Santa Monica offices, in accordance with FASB
Statement No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.”
Through the remainder of the related leases, FASB Statement No. 146 requires us to record
expense to adjust the present value recorded in 2005 to the actual expense and income
recorded for the month. For the three months ended June 30, 2006, we recorded $0.1 million
for the present value adjustments related to the Beverly and Santa Monica offices. The
Santa Monica lease ended during the second quarter of fiscal 2007; therefore the expense of
$0.2 million for the nine months ended December 31, 2006, relates to the Beverly lease,
which ended as of that date.
In the first quarter of fiscal 2007, we entered into a Purchase and Sale Agreement with a
third party to sell and assign all rights, title, and interest in the Stuntman franchise, along
with a development agreement with the current developer for the creation of this game. The cash
proceeds from the sale were $9.0 million, which was recorded as a gain on sale of intellectual
property during the three months ended June 30, 2006.
NOTE 12 — OPERATIONS BY REPORTABLE SEGMENTS
We have three reportable segments: publishing, distribution and corporate. Our publishing
segment is comprised of business development, strategic alliances, product development, marketing,
packaging, and sales of video game software for all platforms. Distribution constitutes the sale
of other publishers’ titles to various mass merchants and other retailers. Corporate includes the
costs of senior executive management, legal, finance, and administration. The majority of
depreciation expense for fixed assets is charged to the corporate segment and a portion is recorded
in the publishing segment. This amount consists of depreciation on computers and office furniture
in the publishing unit. Historically, we do not separately track or maintain records, other than
those for goodwill (all historically attributable to the publishing segment, and fully impaired as
of March 31, 2007) and a nominal amount of fixed assets, which identify assets by segment and,
accordingly, such information is not available.
The accounting policies of the segments are the same as those described in the summary of
significant accounting policies. We evaluate performance based on operating results of these
segments. There are no intersegment revenues.
The results of operations for Reflections are not included in our segment reporting below as
they are classified as discontinued operations in our condensed consolidated financial statements.
Prior to its classification as discontinued operations, the results for Reflections were part of
the publishing segment.
Our reportable segments are strategic business units with different associated costs and
profit margins. They are managed separately because each business unit requires different
planning, and where appropriate, merchandising and marketing strategies.
The following summary represents the consolidated net revenues, operating income (loss),
depreciation and amortization, and interest (expense) income by reportable segment for the three
months and nine months ended December 31, 2006 and 2007 (in thousands):
Operating loss for the Corporate segment for the three months ended December 31, 2006
and 2007, excludes restructuring charges of $0.2 million and $3.8 million, respectively,
and for the nine months ended December 31, 2006 and 2007 excludes $0.6 million and $4.7
million, respectively. Including restructuring charges, total operating income for the
three months ended December 31, 2006 and 2007 is $1.7 million and $0.5 million,
respectively, and operating (loss) for the nine months ended December 31, 2006 and 2007 is
$(12.6) million and $(19.1) million, respectively.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
This document includes statements that may constitute forward-looking statements made pursuant
to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. We caution
readers regarding certain forward-looking statements in this document, press releases, securities
filings, and all other documents and communications. All statements, other than statements of
historical fact, including statements regarding industry prospects and expected future results of
operations or financial position, made in this Quarterly Report on Form 10-Q are forward looking.
The words “believe,”“expect,”“anticipate,”“intend” and similar expressions generally identify
forward-looking statements. Forward-looking statements are necessarily based upon a number of
estimates and assumptions that, while considered reasonable by us, are inherently subject to
significant business, economic and competitive uncertainties and contingencies and known and
unknown risks. As a result of such risks, our actual results could differ materially from those
expressed in any forward-looking statements made by, or on behalf of, us. Some of the factors
which could cause our results to differ materially include the following: the loss of key
customers, such as Wal-Mart, Best Buy, Target, and GameStop; delays in product development and
related product release schedules; inability to secure capital; loss of our credit facility;
inability to adapt to the rapidly changing industry technology, including new console technology;
inability to maintain relationships with leading independent video game software developers;
inability to maintain or acquire licenses to intellectual property; fluctuations in our quarterly
net revenues or results of operations based on the seasonality of our industry; and the termination
or modification of our agreements with hardware manufacturers. Please see the “Risk Factors” in
our Annual Report on Form 10-K for the year ended March 31, 2007, or in our other filings with the
Securities and Exchange Commission (“SEC”) for a description of some, but not all, risks,
uncertainties and contingencies. Except as otherwise required by the applicable securities laws,
we disclaim any intention or obligation publicly to update or revise any forward-looking
statements, whether as a result of new information, future events or otherwise.
Going Concern
Until 2005, we were actively involved in developing video games and in financing development
of video games by independent developers, which we would publish and distribute under licenses from
the developers. However, beginning in 2005, because of cash constraints, we substantially reduced
our involvement in development of video games, and announced plans to divest ourselves of our
internal development studios.
During fiscal 2006 and 2007, we sold a number of intellectual properties and development
facilities in order to obtain cash to fund our operations. During fiscal 2007, we raised
approximately $35.0 million through the sale of the rights to the Driver games and certain other
intellectual property, and the sale of our Reflections Interactive Ltd. (“Reflections”) and Shiny
Entertainment (“Shiny”) studios. By the end of fiscal 2007, we did not own any development
studios.
The reduction in our development and development financing activities has significantly
reduced the number of games we publish. During fiscal 2007, our revenues from publishing
activities were $104.7 million, compared with $153.6 million during fiscal 2006 and $289.6 million
during fiscal 2005. During the nine months ended December 31, 2007, our revenues from our
publishing business were $56.3 million.
For the year ended March 31, 2007, we had an operating loss of $77.6 million, which included a
charge of $54.1 million for the impairment of our goodwill, which is related to our publishing
unit. During the nine months ended December 31, 2007, we incurred an operating loss of
approximately $19.1 million. We have taken significant steps to reduce our costs such as our May
2007, workforce reduction of approximately 20%. Our ability to deliver products on time depends in
good part on developers’ ability to meet completion schedules. Further, our expected releases in
fiscal 2008 are even fewer than our releases in fiscal 2007. In addition, most of our releases for
fiscal 2008 are focused on the holiday season. As a result our cash needs have become more
seasonal and we face significant cash requirements to fund our working capital needs during the
second and third quarter of our fiscal year.
The following series of events and transactions which have occurred since September 30, 2007,
have caused or are part of our current restructuring initiatives intended to allow the Company to
devote more resources to focusing on its distribution business strategy, provide liquidity, and to
mitigate our future cash requirements:
•
Guggenheim Corporate Funding LLC Covenant Default
•
Removal of the Atari, Inc. Board of Directors
•
Transfer of the Guggenheim credit facility to BlueBay High Yield Investments
(Luxembourg) S.A.R.L.
See Note 1 for detailed description of each transaction.
As of December 31,2007 and through February 12, 2008, we are in violation of
our weekly cash flow covenants. BlueBay our lender has not waived this violation
and we have entered into a forbearance agreement which states our lender will not
exercise its rights on our facility until the earlier of (i) March 3, 2008,
(ii) additional covenant defaults except for the ones existing as the date of
this report or (iii) if any action transpires which is viewed to be adverse to
the position of the lender (See Note 8).
Although the above transactions provided cash financing through our fiscal 2008 holiday
season, Management continues to seek additional financing and is pursuing other options to meet our
working capital cash requirements, but there is no guarantee that we will be able to
do so.
Historically, we have relied on IESA to provide limited financial support to us, through loans
or, in recent years, through purchases of assets. However, IESA has its own financial needs, and
its ability to fund its subsidiaries’ operations, including ours, is limited. Therefore, there can
be no assurance we will ultimately receive any funding from IESA.
The uncertainty caused by these above conditions raises substantial doubt about our ability to
continue as a going concern. Our condensed consolidated financial statements do not include any
adjustments that might result from the outcome of this uncertainty.
We continue to explore various alternatives to improve our financial position and secure other
sources of financing which could include raising equity, forming both operational and financial
strategic partnerships, entering into new arrangements to license intellectual property, and
selling, licensing or sub-licensing selected owned intellectual property and licensed rights.
Further, as we are contemplating various alternatives, we will be utilizing our new Chief
Restructuring Officer, AlixPartners, and our special committee of our board of directors,
consisting of our newly appointed independent board members who are authorized to review
significant and special transactions. We continue to examine the reduction of working capital
requirements to further conserve cash and may need to take additional actions in the near-term,
which may include additional personnel reductions and suspension of certain development projects
during fiscal 2008.
The above actions may or may not prove to be consistent with our long-term strategic
objectives, which have been shifted in the last fiscal year, as we have discontinued our internal
and external development activities. We cannot guarantee the completion of these actions or that
such actions will generate sufficient resources to fully address the uncertainties of our financial
position.
Related party transactions
We are involved in numerous related party transactions with IESA and its subsidiaries. These
related party transactions include, but are not limited to, the purchase and sale of product, game
development, administrative and support services and distribution agreements. In addition, we use
the name “Atari” under a license from Atari Interactive (a wholly-owned subsidiary of IESA) that
expires in 2013. See Note 6 to the condensed consolidated financial statements for details.
Business and Operating Segments
We are a global publisher and developer of video game software for gaming enthusiasts and the
mass-market audience, and a distributor of video game software in North America. We develop,
publish, and distribute (both retail and digital) games for all platforms, including Sony
PlayStation 2, PlayStation 3, and PSP; Nintendo Game Boy Advance, GameCube, DS, and Wii; Microsoft
Xbox and Xbox 360; and personal computers, referred to as PCs. We also publish and sublicense
games for the wireless, internet (including casual games and MMOGs),
and other evolving platforms, areas to
which we expect to devote increasing attention. Our diverse portfolio of products extends across
most major video game genres, including action, adventure, strategy, role-playing, and racing.
Our products are based on intellectual properties that we have created internally and own or that
have been licensed to us by third parties. We leverage external resources in the
development of our games, assessing each project independently to determine which development team
is best suited to handle the product based on technical expertise and historical development
experience, among other factors. During fiscal 2007, we sold our remaining internal development
studios; we believe that through the use of independent developers it will be more cost efficient
to publish certain of our games. Additionally, through our relationship with IESA, our products
are distributed exclusively by IESA throughout Europe, Asia and other regions. Through our
distribution agreement with IESA, we have the rights to publish and sublicense in North America
certain intellectual properties either owned or licensed by IESA or its subsidiaries, including
Atari Interactive. We also manage the development of product at studios owned by IESA that focus
solely on game development.
In addition to our publishing and development activities, we also distribute video game
software in North America for titles developed by third party publishers with whom we have
contracts. As a distributor of video game software throughout the U.S., we maintain distribution
operations and systems, reaching well in excess of 30,000 retail outlets nationwide. Consumers
have access to interactive software through a variety of outlets, including mass-merchant retailers
such as Wal-Mart and Target; major retailers, such as Best Buy and Toys ‘R’ Us; and specialty
stores such as GameStop. Our sales to key customers GameStop, Wal-Mart, and Best Buy accounted for
approximately 28.1%, 18.5%, and 11.7%, respectively, of net revenues for the nine months ended
December 31, 2007. No other customers had sales in excess of 10% of net product revenues.
Additionally, our games are made available through various internet, online, and wireless networks.
Key Challenges
The video game software industry has experienced an increased rate of change and complexity in
the technological innovations of video game hardware and software. In addition to these
technological innovations, there has been greater competition for shelf space as well as increased
buyer selectivity. There is also increased competition for creative and executive talent. As a
result, the video game industry has become increasingly hit-driven, which has led to higher per
game production budgets, longer and more complex development processes, and generally shorter
product life cycles. The importance of the timely release of hit titles, as well as the increased
scope and complexity of the product development process, have increased the need for disciplined
product development processes that limit costs and overruns. This, in turn, has increased the
importance of leveraging the technologies, characters or storylines of existing hit titles into
additional video game software franchises in order to spread development costs among multiple
products.
We suffered large operating losses during fiscal 2007 and 2006. To fund these losses, we sold
assets, including intellectual property rights related to game franchises that had generated
substantial revenues for us and including our development studios. Further significant asset sales
may not be practical if we are going to continue to engage in our current activities. However, we
have both short and long term need for funds. Our only credit line is $14.0 million and fully
drawn; our lenders will have the right to cancel it if, as is likely, we fail to meet
financial covenants. The
maximum borrowings we can make under the Senior Credit Facility will not by themselves provide all
the funding we will need. Further, the Senior Credit Facility may be terminated
if we do not comply with financial and other covenants. As of December 31,2007 and through February 12, 2008, we are in violation of
our weekly cash flow covenants. BlueBay our lender has not waived this violation
and we have entered into a forbearance agreement which states our lender will not
exercise its rights on our facility until the earlier of (i) March 3, 2008,
(ii) additional covenant defaults except for the ones existing as the date of
this report or (iii) if any action transpires which is viewed to be adverse to
the position of the lender (See Note 8). Historically, IESA has sometimes provided
funds we needed for our operations, but it is not certain that it will be able, or will be willing,
to provide the funding we will need for the remainder of fiscal 2008 and fiscal 2009 or subsequent
to that. Management continues to seek additional financing and is pursuing other options to meet
the cash requirements for funding to meet our working capital cash requirements but there is no
guarantee that we will be able to do so.
The “Atari” name (which we license) has been an important part of our branding strategy, and
we believe it provides us with an important competitive advantage in dealing with video game
developers and in distributing products. Further, our management has been working on a strategic
plan to replace part of the revenues we lost in recent years by expanding into new emerging aspects
of the video game industry, including casual games, on-line sites, and digital downloading. In
addition, we are considering licensing the “Atari” name for use in products other than video games.
However, our ability to do at least some of those things will require expansion and extension of
our rights to use and sublicense others to use the “Atari” name. We have no agreements or
understandings that assure us that we will be able to expand the purposes for which we can use the
“Atari” name or extend the period during which we will be able to use it.
Critical Accounting Policies
Our discussion and analysis of financial condition and results of operations are based upon
our condensed consolidated financial statements, which have been prepared in accordance with
accounting principles generally accepted in the United States of America. The preparation of these
financial statements requires us to make estimates and judgments that
affect the reported amounts of assets, liabilities, revenues and expenses, and related
disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates,
including those related to accounts receivable, inventories, intangible assets, investments, income
taxes and contingencies. We base our estimates on historical experience and on various other
assumptions that we believe to be reasonable under the circumstances, the results of which form the
basis for making judgments about the carrying values of assets and liabilities that are not readily
apparent from other sources. Actual results could differ materially from these estimates under
different assumptions or conditions.
We believe the following critical accounting policies affect our more significant judgments
and estimates used in the preparation of our condensed consolidated financial statements.
Revenue recognition, sales returns, price protection, other customer related allowances and
allowance for doubtful accounts
Revenue is recognized when title and risk of loss transfer to the customer, provided that
collection of the resulting receivable is deemed probable by management.
Sales are recorded net of estimated future returns, price protection and other customer
related allowances. We are not contractually obligated to accept returns; however, based on facts
and circumstances at the time a customer may request approval for a return, we may permit the
return or exchange of products sold to certain customers. In addition, we may provide price
protection, co-operative advertising and other allowances to certain customers in accordance with
industry practice. These reserves are determined based on historical experience, market acceptance
of products produced, retailer inventory levels, budgeted customer allowances, the nature of the
title and existing commitments to customers. Although management believes it provides adequate
reserves with respect to these items, actual activity could vary from management’s estimates and
such variances could have a material impact on reported results.
We maintain allowances for doubtful accounts for estimated losses resulting from the failure
of our customers to make payments when due or within a reasonable period of time thereafter. If
the financial condition of our customers were to deteriorate, resulting in an inability to make
required payments, additional allowances may be required.
For the three months ended December 31, 2006 and 2007, we recorded allowances for bad debts,
returns, price protection and other customer promotional programs of approximately $7.3 million and
$5.1 million, respectively. For the nine months ended December 31, 2006 and 2007, we recorded
allowances for bad debts, returns, price protection and other customer promotional programs of
approximately $16.1 million and $12.5 million, respectively. As of March 31, 2007 and December31, 2007, the aggregate reserves against accounts receivable for bad debts, returns, price
protection and other customer promotional programs were approximately $14.1 million and $15.1
million, respectively.
Inventories
We write down our inventories for estimated slow-moving or obsolete inventories equal to the
difference between the cost of inventories and estimated market value based upon assumed market
conditions. If actual market conditions are less favorable than those assumed by management,
additional inventory write-downs may be required. For the three months ended December 31, 2006 and
2007, we recorded obsolescence expense of approximately $0.6 million and $0.4 million,
respectively. For the nine months ended December 31, 2006 and 2007 we recorded obsolescence
expense of approximately $1.4 million and $0.7 million, respectively.
Research and product development costs
Research and product development costs related to the design, development, and testing of
newly developed software products, both internal and external, are charged to expense as incurred.
Research and product development costs also include royalty payments (milestone payments) to third
party developers for products that are currently in development. Once a product is sold, we may be
obligated to make additional payments in the form of backend royalties to developers which are
calculated based on contractual terms, typically a percentage of sales. Such payments are expensed
and included in cost of goods sold in the period the sales are recorded.
Rapid technological innovation, shelf-space competition, shorter product life cycles and buyer
selectivity have made it difficult to determine the likelihood of individual product acceptance and
success. As a result, we follow the policy of expensing milestone payments as incurred, treating
such costs as research and product development expenses.
Licenses for intellectual property are capitalized as assets upon the execution of the
contract when no significant obligation of performance remains with us or the third party. If
significant obligations remain, the asset is capitalized when payments are due or when performance
is completed as opposed to when the contract is executed. These licenses are amortized at the
licensor’s royalty rate over unit sales to cost of goods sold. Management evaluates the carrying
value of these capitalized licenses and records an impairment charge in the period management
determines that such capitalized amounts are not expected to be realized. Such impairments are
charged to cost of goods sold if the product has released or previously sold, and if the product
has never released, these impairments are charged to research and product development.
Atari Trademark License
In connection with a recapitalization completed in fiscal 2004, Atari Interactive, Inc.
(“Atari Interactive”), a wholly-owned subsidiary of IESA, extended the term of the license under
which we use the Atari trademark to ten years expiring on December 31, 2013. We issued 200,000
shares of our common stock to Atari Interactive for the extended license and will pay a royalty
equal to 1% of our net revenues during years six through ten of the extended license. We recorded
a deferred charge of $8.5 million, representing the fair value of the shares issued, which was
expensed monthly until it became fully expensed in the first quarter of fiscal 2007 ($8.5 million
plus estimated royalty of 1% for years six through ten). The monthly expense was based on the
total estimated cost to be incurred by us over the ten-year license period; upon the full expensing
of the deferred charge, this expense is being recorded as a deferred liability owed to Atari
Interactive, to be paid beginning in year six of the license.
Goodwill
Goodwill is the excess purchase price paid over identified intangible and tangible net assets
of acquired companies. Goodwill is not amortized, and is tested for impairment at the reporting
unit level annually or when there are any indications of impairment, as required by FASB Statement
No. 142, “Goodwill and Other Intangible Assets.” A reporting unit is an operating segment for
which discrete financial information is available and is regularly reviewed by management. We only
have one reporting unit, our publishing business, to which goodwill is assigned.
A two-step approach is required to test goodwill for impairment for each reporting unit. The
first step tests for impairment by applying fair value-based tests (described below) to a reporting
unit. The second step, if deemed necessary, measures the impairment by applying fair value-based
tests to specific assets and liabilities within the reporting unit. Application of the goodwill
impairment tests require judgment, including identification of reporting units, assignment of
assets and liabilities to each reporting unit, assignment of goodwill to each reporting unit, and
determination of the fair value of each reporting unit. The determination of fair value for each
reporting unit could be materially affected by changes in these estimates and assumptions. Such
changes could trigger impairment.
During the fourth quarter of fiscal 2007, our market capitalization declined significantly. As
this measure is our primary indicator of the fair value of our publishing unit, management
considered this decline to be a triggering event, requiring us to perform step two of the
impairment test. As of March 31, 2007, we completed the second step and our management, with the
concurrence of the Audit Committee of our Board of Directors, concluded that a material impairment
charge of $54.1 million should be recognized. This was a non-cash charge and was recorded in the
fourth quarter of fiscal 2007.
As anticipated we recognized the majority of our publishing revenues in our third quarter of fiscal
2008, a similar trend as compared to fiscal 2007. During our third quarter of fiscal 2008, we
released four major new releases of which comprised 74.6% of our quarter’s publishing net revenues.
However, these releases plus our catalogue sales for the quarter were still less by approximately
$10.8 million as compared to last year’s comparable quarter. The quarter over quarter comparison
includes the following trends:
•
Net publishing product sales during the three months ended December 31, 2007 were driven
by new releases of Dragon Ball Z Tenkaichi 3 (Wii and PS2), Godzilla Unleashed (Wii, PS2,
and DS), Jenga (Wii and DS) and The Witcher (PC). These titles comprised approximately
53.2% of our net publishing product sales. The three months ended December 31, 2006 sales
were driven by the new releases Neverwinter Nights 2 (PC) and DragonBall Z Tenkaichi 2 (PS2
and Wii).
•
International royalty income decreased by $0.4 million as the prior period income
contained international sales of Test Drive Unlimited.
•
The overall average unit sales price (“ASP”) of the publishing business has increased
slightly from $23.65 in the prior comparable quarter to $24.80 in the current period due to
a higher percentage of next generation product sales as compared to the prior year’s
comparable quarter..
Total distribution net revenues for the three months ended December 31, 2007 more than tripled from
the prior comparable period due to new releases from our Humongous distribution business.
Cost of Goods Sold
Cost of goods sold as a percentage of net revenues can vary primarily due to segment mix,
platform mix within the publishing business, average unit sales prices, mix of royalty bearing
products and the mix of licensed product. These expenses for the three months ended December 31,2007 decreased by 22.0%. As a percentage of net revenues, cost of goods sold decreased from 57.4%
to 51.4% due to the following:
savings in related party royalty expense (20% of net revenues in third quarter fiscal
2008 versus 28% in 2007) as our product mixed favored products licensed or owned by us
which carry a lower royalty rate as opposed to IESA product, offset by
•
a higher mix of higher cost third-party distributed product sales as a percentage of net
revenues (14.5% in fiscal 2008 compared with 2.8% in fiscal 2007).
Research and Product Development Expenses
Research and product development expenses consist of development costs relating to the design,
development, and testing of new software products whether internally or externally developed,
including the payment of royalty advances to third party developers on products that are currently
in development and billings from related party developers. We expect to increase the use of
external developers as we have sold all of our internal development studios. By leveraging
external developers, we anticipate improvements in liquidity as we will no longer carry fixed
studio overhead to support our development efforts. However, due to our cash constraints we have
not been able to fully fund our development efforts. These expenses for the three months ended
December 31, 2007 decreased approximately $1.1 million or 20.0% due primarily to:
•
decreased spending of $1.2 million at our related party development studios due to the
completion of Test Drive Unlimited, which was released in the second quarter of fiscal
2007,
•
decreased salaries and other overhead of $2.0 million due to the sale of our Shiny
studio in the second quarter of fiscal 2007, as well as additional executive and other
personnel reductions, offset by
•
a write-off of licenses which will no longer be exploited of approximately $2.0 million.
Selling and Distribution Expenses
Selling and distribution expenses primarily include shipping, personnel, advertising,
promotions and distribution expenses. During the three months ended December 31, 2007, selling and
distribution expenses increased $0.7 million or approximately 12.0%, due to:
•
increased spending on advertising of $0.9 million to support the period’s new releases ,
offset by
•
savings in salaries and related overhead costs due to reduced headcount resulting from
studio closure and personnel reductions.
General and Administrative Expenses
General and administrative expenses primarily include personnel expenses, facilities costs,
professional expenses and other overhead charges. During the three months ended December 31, 2007,
general and administrative expenses decreased by $1.9 million. As a percentage of net revenues,
general and administrative expense decreased from 11.0% to 8.1%. Trends within general and
administrative expenses related to the following:
•
a reduction in salaries and other overhead costs of $1.3 million due to studio closures
and other personnel reductions, and
•
savings in legal and audit fees of approximately $0.4 million.
In the third quarter of fiscal 2008, the Board of Directors approved a plan to reduce our
total workforce by an additional 30%, primarily in production and general and administrative
functions. This plan resulted in restructuring charges of approximately $3.7 million for the three
months ended December 31, 2007 of which $0.9 million related to severance arrangements. The
remaining charges relate to restructuring consulting and legal fees.
Depreciation and Amortization
Depreciation and amortization for three months ended December 31, 2007 decreased 42.8% due to:
•
savings in depreciation relate to the closure of offices and reduction of staffing and
associated overhead.
Provision for Income Taxes
During the three months ended December 30, 2006, we recorded a $0.7 million non-cash provision
for income taxes, which offsets a non-cash tax benefit of the same amount included in loss from
discontinued operations, recorded in accordance with FASB Statement No, 109, “Accounting for Income
Taxes,” paragraph 140, which states that all items should be considered for purposes of determining
the amount of tax benefit that results from a loss from continuing operations and that should be
allocated to continuing operations. We also recorded a $0.1 million reduction of a deferred tax
liability recorded due to a temporary difference that arose from a difference in the book and tax
basis of goodwill.
During the three months ended December 31, 2007, no net tax provision was recorded due to the
taxable loss recorded.
Loss from Discontinued Operations of Reflections Interactive Ltd., net of tax
Loss from discontinued operations of Reflections Interactive Ltd. decreased $1.7 million from
a loss from discontinued operations of $1.7 million in the second quarter of fiscal 2007 to a
nominal amount in the second quarter of fiscal 2008, which relates to remaining lease costs. The
$1.7 million loss from discontinued operations includes a $0.7 million tax benefit as described
above.
As anticipated we recognized the majority of our publishing revenues in our third quarter of fiscal
2008, a similar trend as compared to fiscal 2007. During our third quarter of fiscal 2008, we
released four major new releases of which comprised 38.9% of our quarter’s publishing net revenues.
However, these release plus our catalogue sales for the quarter were still less by approximately
$22.6 million as compared to last year’s comparable quarter. The year over year comparison
includes the following trends:
•
Net publishing product sales during the nine months ended December 31, 2007 were driven
by new releases of Dragon Ball Z Tenkaichi 3 (Wii and PS2), Godzilla Unleashed (Wii, PS2,
and DS), Jenga (Wii and DS) and The Witcher (PC). These titles comprised approximately
50.7% of our net publishing product sales. The nine months ended December 31, 2006 sales
were driven by the new releases of Test Drive Unlimited (Xbox 360), Neverwinter Nights 2
(PC) and DragonBall Z Tenkaichi 2 (PS2 and Wii).
•
International royalty income decreased by $0.5 million as the prior period contained
income from the international release of Test Drive Unlimited offset by reductions due
to returns on international sales of Matrix: Path of Neo and Getting Up: Contents Under
Pressure, released in the third quarter and fourth quarter, respectively, of fiscal 2006.
•
The nine months ended December 31, 2007 contains a one-time license payment of $4.0
million related to the sale of Hasbro, Inc. publishing and licensing rights which IESA sold
back to Hasbro in July 2007. We anticipate the sale of these rights will reduce the amount
of immediate license opportunities we have.
The overall average unit sales price (“ASP”) of the publishing business increased from $20.63 in
the prior comparable quarter versus $22.08 in the current period. Total distribution net revenues
for the nine months ended December 31, 2007 decreased by 47.9% from the prior comparable period due
to the overall decrease in product sales of third party publishers as a result of management’s
decision to reduce our third party distribution operations in efforts to move away from lower
margin products in fiscal 2006. Due to our financial constraints related to fully funding our
product development program, we will attempt to increase our focus on higher-margin distribution in
the future.
Cost of goods sold for the nine months ended December 31, 2007 decreased by 39.3%. As a
percentage of net revenues, cost of goods sold decreased from 59.0% to 52.7 due to the following:
•
a lower mix of higher cost third-party distributed product sales as a percentage of net
revenues (13.2% in fiscal 2008 compared with 17.3% in fiscal 2007), and
•
a higher average sales price on our publishing products in the current period driven by
new release sales on next generation hardware, offset by
•
an additional $1.2 million royalty reserve related to the FUNimation dispute.
Research and Product Development Expenses
We expect to increase the use of external developers as we have sold all of our internal
development studios. By leveraging external developers, we anticipate improvements in liquidity as
we will no longer carry fixed studio overhead to support our development efforts. These expenses
for the nine months ended December 31, 2007 decreased approximately 37.8%, due primarily to:
•
decreased spending of $6.3 million at our related party development studios due to the
completion of Test Drive Unlimited, which was released in the second quarter of fiscal
2007, and
•
decreased salaries and other overhead of $5.3 million due to the sale of our Shiny
studio in the second quarter of fiscal 2007, as well as additional executive and other
personnel reductions, offset by
•
a write-off of licenses which will no longer be exploited of approximately $2.0 million,
and
•
increased spending of $1.5 million for projects with external developers, as we completed
certain development projects.
Selling and Distribution Expenses
During the nine months ended December 31, 2007, selling and distribution expenses decreased
$4.9 million or approximately 23.6%, due to:
•
decreased spending on advertising of $4.1 million, and
•
savings in salaries and related overhead costs due to reduced headcount resulting from
studio closure and personnel reductions, offset by
•
an additional $1.6 million expense related to minimum advertising commitment shortfalls
to be paid to FUNimation.
General and Administrative Expenses
General and administrative expenses as a percentage of net revenues increased to 21.4% due to
the decreased sales volume in the nine months ended December 31, 2007. During the nine months
ended December 31, 2007, general and administrative expenses decreased by $2.4 million. Trends
within general and administrative expenses related to the following:
•
a reduction in salaries and other overhead costs of $2.4 million due to studio closures
and other personnel reductions.
Restructuring Expenses
In the first quarter of fiscal 2008, management announced a plan to reduce our total workforce
by 20%, primarily in general and administrative functions. This restructuring resulted in
restructuring charges of approximately $1.0 million. The first two quarters of fiscal 2007
contains $0.3 million of additional restructuring expense from the fiscal 2006 restructuring plan.
During the third quarter of fiscal 2008, the Board of Directors announced a further reduction
of our total workforce totaling an additional 30% primarily in the production and general and
administrative functions. This resulted in a charge of approximately $3.7 million in the third
quarter of fiscal 2008 of which $0.9 million related to severance arrangements. The remaining
charge relates to restructuring consulting and legal fees.
Gain on Sale of Intellectual Property
In the fiscal 2007 first quarter, we sold the Stuntman intellectual property to a third party
for $9.0 million, which was recorded as a gain. No such gain was recorded in the current period.
Gain on Sale of Development Studio Assets
During
the nine months ended December 30, 2006, we sold certain development studio assets of
Shiny to a third party for a gain of $0.9 million. The gain represents the proceeds of $1.8
million (of which $0.2 million is held in escrow for nine months), less the net book value of the
development studio assets sold of $0.9 million.
Depreciation and Amortization
Depreciation and amortization for nine months ended December 31, 2007 decreased 46.2% due to:
•
savings in depreciation relate to the closure of offices and reduction of staffing and
associated overhead
(Benefit from) Income Taxes
During the nine months ended December 31, 2006, a $4.2 million benefit from income taxes
primarily results from a non-cash tax benefit of $4.7 million, which offsets a non-cash tax
provision of the same amount included in loss from discontinued operations, recorded in accordance
with FASB Statement No, 109, “Accounting for Income Taxes,” paragraph 140, which states that all
items should be considered for purposes of determining the amount of tax benefit that results from
a loss from continuing operations and that should be allocated to continuing operations. The
recording of a benefit is appropriate in this instance, under the guidance of Paragraph 140,
because such domestic loss offsets the domestic gain generated in discontinued operations. The
effect of this transaction on net loss for fiscal 2007 is zero, and it does not result in the
receipt or payment of any cash. This non-cash tax benefit is offset by $0.5 million of deferred
tax liability recorded due to a temporary difference that arose from a difference in the book and
tax basis of goodwill.
During the nine months ended December 31, 2007, no net tax provision was recorded due to the
taxable loss recorded.
Income
(loss) from Discontinued Operations of Reflections Interactive Ltd., net of tax
Income (loss) from discontinued operations of Reflections Interactive Ltd. decreased $0.1
million from a gain from discontinued operations of $0.1 million during the nine months ended
December 31, 2006 to a nominal amount in the nine months fiscal 2008, which relates to remaining
lease costs. The fiscal 2007 gain was driven by the gain of sale of Reflections of $11.4 million
(sold in August 2006) offset by the operating costs of the Reflections studio of $6.6 million and a
tax provision associated with discontinued operations of $4.7 million, recorded in accordance with
FASB Statement No, 109, “Accounting for Income Taxes,” paragraph 140, and offset by a tax benefit
of an equal amount in continuing operations (see Benefit from Income Taxes above).
A
need for increased investment in development and increased need to spend advertising dollars
to support product launches, caused in part by “hit-driven” consumer taste, have created a
significant increase in the amount of financing required to sustain operations, while negatively
impacting margins. Further, our business continues to be more seasonal, which creates a need for
significant financing to fund manufacturing activities for our working capital requirements. Our
only credit line is limited to $14.0 million and is fully drawn;
and which our lenders will have
the right to cancel it if we fail to meet financial and other covenants. As of December 31,2007 and through February 12, 2008, we are in violation of
our weekly cash flow covenants. BlueBay our lender has not waived this violation
and we have entered into a forbearance agreement which states our lender will not
exercise its rights on our facility until the earlier of (i) March 3, 2008,
(ii) additional covenant defaults except for the ones existing as the date of
this report or (iii) if any action transpires which is viewed to be adverse to
the position of the lender (See Note 8). Even if the credit line
remains in effect, it will not provide all the funds we will need. Historically, IESA has
sometimes provided funds we needed for our operations, but it is not certain that it will be able,
or willing to provide the funding we will need for our working capital requirements.
Because of our funding difficulties, we have sharply reduced our expenditures for research and
product development. During the year ended March 31, 2007, our expenditures on research and
product development decreased by 42.0%, to $30.1 million, compared with $51.9 million in fiscal
2006. During the nine months ended December 31, 2007, expenditures on research and product
development was $12.4 million versus $20.0 million in the comparable fiscal 2007 period. This will
reduce the flow of new games that will be available to us in fiscal 2008 and 2009, and possibly
after that. Our lack of financial resources to fund a full product development program has led us
to focus on distribution and acquisition of finished goods. As such, we have exited all internal
development activities and have limited the amount of our investment in external development.
During fiscal 2007, we raised approximately $35.0 million through the sale of certain
intellectual property and the divestiture of our internal development studios. In May 2007, we
announced a plan to reduce our total workforce by approximately 20% as a cost cutting initiative.
Further in November 2007, we announced a plan to reduce our total workforce by an additional 30%.
To reduce working capital requirements and further conserve cash we will need to take additional
actions in the near-term, which may include additional personnel reductions and suspension of
additional development projects. However, these steps may not fully resolve the problems with our
financial position. Also, lack of funds will make it difficult for us to undertake a strategic
plan to generate new sources of revenues and otherwise enable us to attain long-term strategic
objectives. We continue to seek additional funding.
During
the nine months ended December 31, 2007, our operations used cash of approximately
$21.1 million to support our net loss of $20.0 million for the period. During the nine months
ended December 31, 2006, our operations used cash of approximately $46.6 million driven by the net
loss of $8.0 million for the period, compounded by increased payments of trade payables and
royalties payable and timing of accounts receivable collections.
During the nine months ended December 31, 2007, cash provided by
investing activities of $0.3 million due to a refund from our
New York office security deposit of $0.8 million offset by purchases of property and equipment. During the
nine months ended December 31, 2006, investing activities provided cash of $28.5 million due to
several sale transactions completed during the period:
•
proceeds of $21.6 million received in connection with the sale of our Reflections
studio,
•
proceeds of $9.0 million from the sale of the Stuntman intellectual property,
•
and proceeds of $1.6 million from the sale of our Shiny studio in the current
period
The cash proceeds are partially offset by the increase in restricted cash of $1.8 million for
the collateralizing of a letter of credit related to our new office lease and the purchase of
assets (intangibles and property and equipment) of $2.1 million.
During the nine months ended December 31, 2006 and 2007, our financing activities provided
cash primarily from borrowings from our credit facilities. During the nine months ended December31, 2007, we also received $5.0 million in cash proceeds from the related party license advance.
See Note 1 and 10.
Our $10.0 million Senior Credit Facility with BlueBay matures on December 31, 2009, charges
an interest rate of the applicable LIBOR rate plus 7% per year. On December 4, 2007, under the
Waiver Consent and Third Amendment to the Credit Facility, as part of entering the Global MOU,
BlueBay raised the maximum borrowings of the Senior Credit Facility to $14.0 million.
The
maximum borrowings we can make under the Senior Credit Facility will not by themselves
provide all the funding we will need for our working capital needs. Further, the
Senior Credit Facility may be terminated if we do not comply with
financial and other covenants. As of December 31,2007 and through February 12, 2008, we are in violation of
our weekly cash flow covenants. BlueBay our lender has not waived this violation
and we have entered into a forbearance agreement which states our lender will not
exercise its rights on our facility until the earlier of (i) March 3, 2008,
(ii) additional covenant defaults except for the ones existing as the date of
this report or (iii) if any actions transpires which is viewed to be adverse to
the position of the lender (See Note 8). Management continues to seek additional financing and is pursuing other options to meet the cash
requirements for funding our working capital cash requirements but there is no guarantee that we
will be able to do so.
Our outstanding accounts receivable balance varies significantly on a quarterly basis due to
the seasonality of our business and the timing of new product releases. There were no significant
changes in the credit terms with customers during the three month period.
Due to our reduced product releases, our business has become increasingly seasonal. This
increased seasonality has put significant pressure on our liquidity prior to our holiday season as
financing requirements to build inventory are high. During fiscal 2007, our third quarter (which
includes the holiday season) represented approximately 38.7% of our net revenues for the entire
year. In fiscal 2008, our third quarter represented approximately 63.4% of our net revenues for the
nine months ended December 31, 2007.
We do not currently have any material commitments with respect to any capital expenditures.
However, we do have commitments to pay royalty and license advances, milestone payments, and
operating and capital lease obligations.
Our ability to maintain sufficient levels of cash could be affected by various risks and
uncertainties including, but not limited to, customer demand and acceptance of our new versions of
our titles on existing platforms and our titles on new platforms, our ability to collect our
receivables as they become due, risks of product returns, successfully achieving our product
release schedules and attaining our forecasted sales goals, seasonality in operating results,
fluctuations in market conditions and the other risks described in the “Risk Factors” as noted in
our Annual Report on Form 10-K for the year ended March 31, 2007.
We are also party to various litigations arising in the normal course of our business.
Management believes that the ultimate resolution of these matters will not have a material adverse
effect on our liquidity, financial condition or results of operations.
Selected Balance Sheet Accounts
Receivables, net
Receivables, net, increased by $9.7 million from $6.5 million at March 31, 2007 to $16.2
million at December 31, 2007. This increase is due to the majority of our holiday season sales
occurring in the second half of the third quarter of fiscal 2008 leading to a higher ending quarter
accounts receivable balance as compared to the lower sales recorded in our fourth quarter of fiscal
2007.
Due from related parties decreased by $1.4 million and due to related parties decreased by
$0.4 million from March 31, 2007 to December 31, 2007 driven by balances between parties settled by
netting during the quarter.
Prepaid and other current assets
Prepaid and other current assets decreased approximately $4.6 million from March 31, 2007 to
December 31, 2007 primarily from the amortization of licenses at the licensor’s royalty rate over
unit sales. $2.0 million of this decrease is due to the write-off of licenses which we will no
longer exploit and have been charged to research and development expense during the three months
ended December 31, 2007.
Long-term liabilities and Property and Equipment
Long-term liabilities
and property and equipment increased during the nine months ended
December 31, 2007 approximately $3.6 million and $2.1 million, respectively, primarily due to the
capitalization of assets and deferred effect of landlord contributions related to our corporate
headquarters located at 417 5th Avenue, New York, New York.
NASDAQ Delisting Notice
On December 21, 2007, we received a notice from Nasdaq advising that in accordance with Nasdaq
Marketplace Rule 4450(e)(1), we have 90 calendar days, or until March 20, 2008, to regain
compliance with the minimum market value of our publicly held shares required for continued listing
on the Nasdaq Global Market, as set forth in Nasdaq Marketplace Rule 4450(b)(3). We received this
notice because the market value of our publicly held shares (which is calculated by reference to
our total shares outstanding, less any shares held by officers, directors or beneficial owners of
10% or more) was less than $15.0 million for 30 consecutive business days prior to December 21,2007. This notification has no effect on the listing of our common stock at this time.
The notice letter also states that if, at any time before March 20, 2008, the market value of
our publicly held shares is $15.0 million or more for a minimum of 10 consecutive trading days, the
Nasdaq staff will provide us with written notification that we have achieved compliance with the
minimum market value of publicly held shares rule. However, the notice states that if we cannot
demonstrate compliance with such rule by March 20, 2008, the Nasdaq staff will provide us with
written notification that our common stock will be delisted.
In the event that we receive notice that our common stock will be delisted, Nasdaq rules
permit us, to appeal any delisting determination by the Nasdaq staff to a Nasdaq Listings
Qualifications Panel.
Credit Facilities
Guggenheim Credit Facility
On November 3, 2006, we established a secured credit facility with several lenders for which
Guggenheim was the administrative agent. The Guggenheim credit
facility was terminate and be
payable in full on November 3, 2009. The credit facility
consisted of a secured, committed,
revolving line of credit in an amount up to $15.0 million, which includes a $10.0 million sublimit
for the issuance of letters of credit. Availability under the credit
facility was determined by a
formula based on a percentage of our eligible receivables. The
proceeds could be used for general
corporate purposes and working capital needs in the ordinary course of business and to finance
acquisitions subject to limitations in the Credit Agreement. The
credit facility bore interest at
our choice of (i) LIBOR plus 5% per year, or (ii) the greater of (a) the prime rate in effect, or
(b) the Federal Funds Effective Rate in effect plus 2.25% per
year. Additionally, we were required
to pay a commitment fee on the undrawn portions of the credit facility at the rate of 0.75% per
year and we paid to Guggenheim a closing fee of $0.2 million. Obligations under the credit
facility were secured by liens on substantially all of our present and future assets, including
accounts receivable, inventory, general intangibles, fixtures, and equipment, but excluding the
stock of our subsidiaries and certain assets located outside of the U.S.
The
credit facility included provisions for a possible term loan facility and an increased
revolving credit facility line in the future. The credit facility
also contained financial
covenants that required us to maintain enumerated EBITDA, liquidity, and net debt minimums, and a
capital expenditure maximum. As of June 30, 2007, we were not in compliance with all financial
covenants. On October 1, 2007, the lenders provided a waiver of covenant defaults as of June 30,2007 and reduced the aggregate borrowing commitment of the revolving line of credit to $3.0
million.
On October 18, 2007, we consented to the transfer of the loans outstanding ($3.0 million)
under the Guggenheim credit facility to funds affiliated with BlueBay Asset Management plc and to
the appointment of BlueBay High Yield Investments (Luxembourg) S.A.R.L. (“BlueBay”), as successor
administrative agent. BlueBay Asset Management plc is a significant shareholder of IESA. On
October 23, 2007, we entered into a waiver and amendment with BlueBay for, as amended, a $10.0
million Senior Secured Credit Facility (“Senior Credit Facility”). The Senior Credit Facility
matures on December 31, 2009, charges an interest rate of the applicable LIBOR rate plus 7% per
year, and eliminates certain financial covenants. On November 6, 2007, we entered into a waiver
and amendment to the BlueBay Senior Credit Facility for certain financial covenants as of November1, 2007. On December 4, 2007, under the Waiver Consent and Third Amendment to the Credit Facility,
as part of entering the Global MOU, BlueBay raised the maximum borrowings of the Senior Credit
Facility to $14.0 million. The
maximum borrowings we can make under the Senior Credit Facility will not by themselves provide all
the funding we will need for fiscal 2009. As of December 31,2007 and through February 12, 2008, we are in violation of
our weekly cash flow covenants. BlueBay our lender has not waived this violation
and we have entered into a forbearance agreement which states our lender will not
exercise its rights on our facility until the earlier of (i) March 3, 2008,
(ii) additional covenant defaults except for the ones existing as the date of
this report or (iii) if any action transpires which is viewed to be adverse to
the position of the lender (See Note 8). Management continues to seek additional financing and is
pursuing other options to meet the cash requirements for funding our working capital cash
requirements but there is no guarantee that we will be able to do so.
As of December 31, 2007, we have drawn the full $14.0 million on the Senior Credit Facility.
Contractual Obligations
As of December 31, 2007, royalty and license advance obligations, milestone payments and
future minimum lease obligations under non-cancelable operating and capital lease obligations were
as follows (in thousands):
We have committed to pay advance payments under certain royalty and
license agreements. The payments of these obligations are dependent on the delivery
of the contracted services by the developers.
(2)
Milestone payments represent royalty advances to developers for products
that are currently in development. Although milestone payments are not guaranteed,
we expect to make these payments if all deliverables and milestones are met timely
and accurately.
(3)
We account for our office leases as operating leases, with expiration
dates ranging from fiscal 2008 through fiscal 2022. These are future minimum annual
rental payments required under the leases net of $0.6 million of sublease income to
be received in fiscal 2008 and fiscal 2009. Rent expense and sublease income for
the three and nine months ended December 31, 2006 and 2007 is as follows (in
thousands):
• Renewal of New York lease
During June 2006, we entered into a new lease with our current landlord at our New
York headquarters for approximately 70,000 square feet of office space for our
principal offices. The term of this lease
commenced on July 1, 2006 and is to expire on June 30, 2021. Upon entering into the
new lease, our prior lease, which was set to expire in December 2006, was terminated.
The rent under the new lease for the office space was approximately $2.4 million
per year for the first five years, increased to approximately $2.7 million per year
for the next five years, and increased to $2.9 million for the last five years of the
term. In addition, we must pay for electricity, increases in real estate taxes and
increases in porter wage rates over the term. The landlord is providing us with a
one year rent credit of $2.4 million and an allowance of $4.5 million to be used for
building out and furnishing the premises, of which $1.2 million has been recorded as
a deferred credit as of March 31, 2007; the remainder of the deferred credit will be
recorded as the improvements are completed, and will be amortized against rent
expense over the life of the lease. A nominal amount of amortization was recorded
during the year ended March 31, 2007. For the nine months ended December 31, 2007,
we recorded an additional deferred credit of $2.8 million and amortization against
the total deferred credits of approximately $0.2 million. Shortly after signing the
new lease, we provided the landlord with a security deposit under the new lease in
the form of a letter of credit in the initial amount of $1.7 million, which has been
cash collateralized and is included in security deposits on our condensed
consolidated balance sheet. On August 14, 2007, we and our new landlord, W2007 Fifth
Realty, LLC, amended the lease under which we occupy space in 417 Fifth Avenue, New
York City, to reduce the space we occupy by approximately one-half, effective
December 31, 2007. As a result, our rent under the amended lease will be reduced from
its current approximately $2.4 million per year to approximately $1.2 million per
year from January 1, 2008 through June 30, 2011, approximately $1.3 million per year
for the five years thereafter, and approximately $1.5 million per year for the last
five years of the term.
(4)
We maintain several capital leases for computer equipment. Per FASB Statement
No. 13, “Accounting for Leases,” we account for capital leases by recording them at the
present value of the total future lease payments. They are amortized using the
straight-line method over the minimum lease term. As of March 31, 2007, the net book
value of the assets, included within property and equipment on the balance sheet, was
$0.1 million, net of accumulated depreciation of $0.5 million. As of December 31,2007, the net book value of the assets was $0.1 million, net of accumulated
depreciation of $0.5 million.
Effect of Relationship with IESA on Liquidity
Historically, we have relied on IESA to provide limited financial support to us; however, IESA
has its own financial needs and, as it assesses its business operations/plan, its ability and
willingness to fund its subsidiaries’ operations, including ours, is uncertain. See Note 6 for a
discussion of our relationship with IESA.
Recent Accounting Pronouncements
See Note 1 to the condensed consolidated financial statements.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Our carrying values of cash, trade accounts receivable, inventories, prepaid expenses and
other current assets, accounts payable, accrued liabilities, royalties payable, assets of
discontinued operations, and amounts due to and from related parties are a reasonable approximation
of their fair value.
Foreign Currency Exchange Rates
We earn royalties on sales of our product sold internationally. These revenues, which are
based on various foreign currencies and are billed and paid in U.S. dollars, represented a $1.3
million of our revenues for the nine months ended December 31, 2007. We also purchase certain of
our inventories from foreign developers and pay royalties primarily denominated in euros to IESA
from the sale of IESA products in North America. While we do not hedge against foreign exchange
rate fluctuations, our business in this regard is subject to certain risks, including, but not
limited to, differing economic conditions, changes in political climate, differing tax structures,
other regulations and restrictions and foreign exchange rate volatility. Our future results could
be materially and adversely impacted by changes in these or other factors. For the nine months
ended December 31, 2007, we did not have any net revenues from our foreign subsidiaries; these
subsidiaries represent $0.8 million, or 1.7%, of our total assets, of which $0.7 million is
associated with our previously wholly-owned Reflections studio and is included in assets of
discontinued operations on our condensed consolidated balance sheet. We also recorded a nominal
amount of operating expenses attributed to foreign operations of Reflections, included in loss from
discontinued operations on our condensed consolidated statement of operations. Currently,
substantially all of our
business is conducted in the United States where revenues and expenses are transacted in U.S.
dollars. As a result, the majority of our results of operations are not subject to foreign exchange
rate fluctuations.
Item 4T. Controls and Procedures
Evaluation of disclosure controls and procedures
We maintain disclosure controls and procedures that are designed to ensure that information
required to be disclosed in our reports under the Securities Exchange Act of 1934 is recorded,
processed, summarized and reported within the time periods specified in the SEC’s rules and forms,
and that such information is accumulated and communicated to management, as appropriate, to allow
timely decisions regarding required disclosure. Management, with participation of our Chief
Restructuring Officer and Acting Chief Financial Officer, has conducted an evaluation of the
effectiveness of the Company’s disclosure controls and procedures (as defined in the Securities
Exchange Act of 1934 Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this
quarterly report on Form 10-Q.
As previously disclosed in our Annual Report on Form 10-K for the fiscal year ended March 31,2007, we determined that, as of March 31, 2007, there were three material weaknesses affecting our
internal control over financial reporting and, as a result of those weaknesses, our disclosure
controls and procedures were not effective. As described below, we plan to begin the remediation of
those material weaknesses during the fourth quarter of fiscal 2008. Therefore, as the three
material weaknesses at March 31, 2007 have not been remediated, the Company’s management, including
our Chief Restructuring Officer and Acting Chief Financial Officer, has concluded that, as of December31, 2007, the Company’s disclosure controls and procedures were not effective.
Management’s Remediation Initiatives
As previously reported in our Annual Report on Form 10-K for the fiscal year ended March 31,2007, management determined that, as of March 31, 2007, there were material weaknesses in our
internal control over financial reporting relating to (i) ineffective controls relating to the
financial closing and reporting process that failed to detect certain accounting errors, (ii)
communication controls between us and our majority shareholder, IESA, which lead to the failure to
detect certain required accounting entries (see below) and (iii) control failures over income tax accounts and
related disclosures. Management will leverage internal resources and seek assistance from outside
consultants to help design and implement necessary controls. Management is currently determining
what level of support will be needed. Management believes our remediation efforts will be completed
prior to the end of the fourth quarter of our fiscal year 2008.
Changes in Internal Control over Financial Reporting
During the third quarter of fiscal 2008, we implemented a formula communication procedure
between us and IESA. This procedure provides a formal communication on a quarterly basis between
IESA and us disclosing any transactions that may have an effect on our financial statements.
Other
than disclosed above, there have been no changes in our internal control over financial
reporting that occurred during the quarter ended December 31, 2007 that have materially affected,
or are reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
Litigation
As of December 31, 2007, our management believes that the ultimate resolution of any of the
matters summarized below and/or any other claims which are not stated herein, if any, will not have
a material adverse effect on our liquidity, financial condition or results of operations. With
respect to matters in which we are the defendant, we believe that the underlying complaints are
without merit and intend to defend ourselves vigorously.
This suit involving Accolade, Inc. (a predecessor entity of Atari) was filed in 1999 in the
District Court of Maryland. The plaintiff originally sued the NFL claiming copyright infringement
of a logo being used by the Baltimore Ravens that plaintiff allegedly designed. The plaintiff then
also sued nearly 500 other defendants, licensees of the NFL, on the same basis. The NFL hired
White & Case to represent all the defendants. Plaintiff filed an amended complaint in 2002. In
2003, the District Court held that plaintiff was precluded from recovering actual damages, profits
or statutory damages against the defendants, including Accolade. Plaintiff has appealed the
District Court’s ruling to the Fourth Circuit Court of Appeals. White & Case continues to
represent Accolade and the NFL continues to bear the cost of the defense.
Ernst & Young, Inc. v. Atari, Inc.
On July 21, 2006 we were served with a complaint filed by Ernst & Young as Interim Receiver
for HIP Interactive, Inc. This suit was filed in New York State Supreme Court, New York County. HIP
is a Canadian company that has gone into bankruptcy. HIP contracted with us to have us act as its
distributor for various software products in the U.S. HIP is alleging breach of contract claims; to
wit, that we failed to pay HIP for product in the amount of $0.7 million. We will investigate
filing counter claims against HIP, as HIP owes us, via our Canadian Agent, Hyperactive, for our
product distributed in Canada. Our answer and counterclaim were filed in August of 2006 and we
initiated discovery against Ernst & Young at the same time. Settlement discussions commenced in
September 2006 and are currently on-going.
Research in Motion Limited v. Atari, Inc. and Atari Interactive, Inc.
On October 26, 2006, Research in Motion Limited (“RIM”) filed a claim against us and Atari
Interactive in the Ontario Superior Court of Justice. RIM is seeking a declaration that (i) the
game BrickBreaker, as well as the copyright, distribution, sale and communication to the public of
copies of the game in Canada and the United States, does not infringe any Atari copyright for
Breakout or Super Breakout in Canada or the United States, (ii) the audio-visual displays of
Breakout do not constitute a work protected by copyright under Canadian law, and (iii) Atari holds
no right, title or interest in Breakout under US or Canadian law. RIM is also requesting the costs
of the action and such other relief as the court deems. Breakout and Super Breakout are games
owned by Atari Interactive. On January 19, 2007, RIM added claims to its case requesting a
declaration that (i) its game Meteor Crusher does not infringe Atari copyright for its game
Asteroids in Canada, (ii) the audio-visual displays of Asteroids do not constitute a work protected
under Canadian law, and (iii) Atari holds no right, title or interest in Asteroids under Canadian
law. In August 2007, the Court ruled against Atari’s December 2006 motion to have the RIM claims
dismissed on the grounds that there is no statutory relief available to RIM under Canadian law.
Atari has appealed the same and was not successful. As of January
2008, Atari has filed its answer and counterclaims in response to
RIM’s original claims.
Item 4. Submission of Matters to a Vote of Security Holders
Action by Written Consent
On
October 5, 2007, California U.S. Holdings, Inc., a record holder of 6,926,245 shares of our
common stock, representing approximately 51% of our common stock, executed and delivered a written
consent to the Company providing for the removal of Messrs. James Ackerly, Ronald C. Bernard,
Michael G. Corrigan, Denis Guyennot and Ms. Ann E. Kronen from their positions on our Board of
Directors.
Annual Meeting of Stockholders
The Annual Meeting of Stockholders was held on November 6, 2007. Of the 13,477,920 shares of
common stock outstanding and entitled to vote at the Annual Meeting, 10,979,482 shares were present
in person or by proxy, each entitled to one vote on each matter to come before the meeting. The
matters acted upon at our 2007 Annual Meeting of Stockholders and the voting tabulation for each
such matter are as follows:
Proposal 1. To elect two Class III directors to hold office until the 2010 Annual Meeting of Stockholders.
With respect to the election of directors, there were no abstentions or broker non-votes
because, pursuant to the terms of the Notice of Annual Meeting and Proxy Statement, proxies
received were voted, unless authority was withheld, in favor of the election of the nominees named.
As set forth above, at the Annual Meeting, Evence-Charles Coppee and Jean-Michel Perbet were
elected as Class III directors. The five remaining members of our Board of Directors, who are in
Classes I and II and have terms that do not expire until the 2008 Annual Meeting of Stockholders and
2009 Annual Meeting of Stockholders, respectively, are Wendell H. Adair, Jr., Eugene I. Davis,
Bradley E. Scher, Thomas Schmider and James B. Shein.
Item 5. Other
Matters
On
February 12, 2008, we entered into a forbearance agreement with
our lender BlueBay providing for BlueBay’s forbearance of enforcement of its rights and
remedies with respect to our noncompliance with certain financial covenants under the
credit agreement governing the BlueBay Senior Credit Facility. As of December 31, 2007 and through February 12,2008, we have not complied with the cash flow covenants under the credit agreement
governing the BlueBay Senior Credit Facility, which noncompliance BlueBay has not waived. Under the
forbearance agreement, our lender will not exercise its rights on our facility
related to this violation until the earliest of (i) March 3, 2008, (ii) the occurrence
of additional covenant defaults, other than defaults existing as the date of this report
or occurring under certain financial covenants or (iii) the
occurrence of any action against us under other loans, credit or other agreements evidencing
indebtedness or other obligations that is reasonably considered to be
materially adverse to our lender’s interests.
We
continue to pursue a resolution with our lender; however, there is no guarantee a resolution will ultimately be made.
Pursuant to the requirements of the Section 13 or 15(d) 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.
