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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
| x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) | |
| OF THE SECURITIES EXCHANGE ACT OF 1934 | ||
For the Quarterly Period Ended June 30, 2003
OR
| o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) | |
| OF THE SECURITIES EXCHANGE ACT OF 1934 | ||
Commission File Number 0-23137
REALNETWORKS, INC.
| Washington (State of incorporation) | 91-1628146 (I.R.S. Employer Identification Number) | |
| 2601 Elliott Avenue, Suite 1000 Seattle, Washington (Address of principal executive offices) | 98121 (Zip Code) |
| (206) 674-2700 (Registrant’s telephone number, including area code) |
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No[ ]
Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes [X] No[ ]
The number of shares of the registrant’s Common Stock outstanding as of August 7, 2003 was 163,284,614.
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REALNETWORKS, INC.
FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 2003
TABLE OF CONTENTS
| Page | ||||||||
| PART I. | FINANCIAL INFORMATION | |||||||
| Item 1. | Financial Statements | 3 | ||||||
| Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations | 15 | ||||||
| Item 3. | Quantitative and Qualitative Disclosures About Market Risk | 45 | ||||||
| Item 4. | Controls and Procedures | 46 | ||||||
| PART II. | OTHER INFORMATION | |||||||
| Item 1. | Legal Proceedings | 47 | ||||||
| Item 2. | Changes in Securities and Use of Proceeds | 48 | ||||||
| Item 4. | Submission of Matters to a Vote of Security Holders | 48 | ||||||
| Item 6. | Exhibits and Reports on Form 8-K | 49 | ||||||
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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
| REALNETWORKS, INC. AND SUBSIDIARIES | ||
| UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS | ||
| (In thousands, except per share data) |
| June 30, | December 31, | |||||||||||
| 2003 | 2002 | |||||||||||
ASSETS | ||||||||||||
| Current assets: | ||||||||||||
| Cash, cash equivalents and short-term investments | $ | 388,932 | 309,071 | |||||||||
| Trade accounts receivable, net of allowances for doubtful accounts and sales returns | 8,285 | 6,560 | ||||||||||
| Prepaid expenses and other current assets | 6,596 | 7,278 | ||||||||||
| Total current assets | 403,813 | 322,909 | ||||||||||
| Equipment and leasehold improvements, at cost: | ||||||||||||
| Equipment and software | 32,317 | 27,536 | ||||||||||
| Leasehold improvements | 25,584 | 25,227 | ||||||||||
| Total equipment and leasehold improvements | 57,901 | 52,763 | ||||||||||
| Less accumulated depreciation and amortization | 28,011 | 22,718 | ||||||||||
| Net equipment and leasehold improvements | 29,890 | 30,045 | ||||||||||
| Restricted cash equivalents | 19,800 | 17,300 | ||||||||||
| Investments | 37,900 | 29,196 | ||||||||||
| Other assets | 4,494 | 1,726 | ||||||||||
| Goodwill, net | 60,077 | 60,077 | ||||||||||
| Other intangible assets, net | 690 | 848 | ||||||||||
| Total assets | $ | 556,664 | 462,101 | |||||||||
LIABILITIES AND SHAREHOLDERS’ EQUITY | ||||||||||||
| Current liabilities: | ||||||||||||
| Accounts payable | $ | 9,138 | 7,830 | |||||||||
| Accrued and other liabilities | 31,805 | 31,083 | ||||||||||
| Deferred revenue, excluding non-current portion | 26,492 | 31,771 | ||||||||||
| Accrued loss on excess office facilities, excluding non-current portion | 4,983 | 3,825 | ||||||||||
| Total current liabilities | 72,418 | 74,509 | ||||||||||
| Deferred revenue, excluding current portion | 7,875 | 12,446 | ||||||||||
| Accrued loss on excess office facilities, excluding current portion | 26,154 | 22,110 | ||||||||||
| Deferred rent | 3,359 | 3,271 | ||||||||||
| Convertible debt | 100,000 | — | ||||||||||
| Shareholders’ equity: | ||||||||||||
| Preferred stock, $0.001 par value, no shares issued and outstanding | ||||||||||||
| Series A: authorized 200 shares | — | — | ||||||||||
| Undesignated series: authorized 59,800 shares | — | — | ||||||||||
| Common stock, $0.001 par value | ||||||||||||
| Authorized 1,000,000 shares; issued and outstanding 159,338 shares in 2003 and 157,681 shares in 2002 | 159 | 158 | ||||||||||
| Additional paid-in capital | 615,904 | 609,833 | ||||||||||
| Deferred stock compensation | (576 | ) | (1,070 | ) | ||||||||
| Accumulated other comprehensive income (loss) | 1,943 | (1,054 | ) | |||||||||
| Accumulated deficit | (270,572 | ) | (258,102 | ) | ||||||||
| Total shareholders’ equity | 346,858 | 349,765 | ||||||||||
| Total liabilities and shareholders’ equity | $ | 556,664 | 462,101 | |||||||||
See accompanying notes to unaudited condensed consolidated financial statements
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REALNETWORKS, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND
COMPREHENSIVE LOSS
(In thousands, except per share data)
| Quarters ended June 30, | Six months ended June 30, | ||||||||||||||||||
| 2003 | 2002 | 2003 | 2002 | ||||||||||||||||
| Net revenue: | |||||||||||||||||||
| Software license fees | $ | 16,595 | 17,255 | 32,867 | 41,609 | ||||||||||||||
| Service revenue | 31,515 | 24,917 | 60,759 | 46,264 | |||||||||||||||
| Advertising | 1,536 | 1,586 | 2,886 | 3,177 | |||||||||||||||
| Total net revenue | 49,646 | 43,758 | 96,512 | 91,050 | |||||||||||||||
| Cost of revenue: | |||||||||||||||||||
| Software license fees | 2,239 | 1,604 | 3,562 | 3,812 | |||||||||||||||
| Service revenue | 12,140 | 9,021 | 24,214 | 18,272 | |||||||||||||||
| Advertising | 541 | 390 | 928 | 1,143 | |||||||||||||||
| Total cost of revenue | 14,920 | 11,015 | 28,704 | 23,227 | |||||||||||||||
| Gross profit | 34,726 | 32,743 | 67,808 | 67,823 | |||||||||||||||
| Operating expenses: | |||||||||||||||||||
| Research and development (excluding non-cash stock-based compensation of $193 and $494 for the quarter and six months ended June 30, 2003, respectively, and $368 and $532 for the comparable periods in 2002, included below) | 12,275 | 12,750 | 23,712 | 24,594 | |||||||||||||||
| Sales and marketing | 18,847 | 19,025 | 36,620 | 36,683 | |||||||||||||||
| General and administrative | 5,864 | 5,542 | 11,361 | 9,996 | |||||||||||||||
| Loss on excess office facilities | 7,098 | — | 7,098 | — | |||||||||||||||
| Stock-based compensation | 193 | 368 | 494 | 532 | |||||||||||||||
| Total operating expenses | 44,277 | 37,685 | 79,285 | 71,805 | |||||||||||||||
| Operating loss | (9,551 | ) | (4,942 | ) | (11,477 | ) | (3,982 | ) | |||||||||||
| Other income (expense): | |||||||||||||||||||
| Interest income, net | 1,186 | 1,807 | 2,451 | 4,424 | |||||||||||||||
| Equity in net loss of MusicNet | (1,394 | ) | (1,342 | ) | (3,125 | ) | (3,523 | ) | |||||||||||
| Impairment of equity investments | — | (704 | ) | (424 | ) | (704 | ) | ||||||||||||
| Other expense, net | 209 | 2,548 | 265 | 3,276 | |||||||||||||||
| Other income (expense), net | 1 | 2,309 | (833 | ) | 3,473 | ||||||||||||||
| Net loss before income taxes | (9,550 | ) | (2,633 | ) | (12,310 | ) | (509 | ) | |||||||||||
| Income tax provision (benefit) | 82 | (1,078 | ) | 160 | (2 | ) | |||||||||||||
| Net loss | $ | (9,632 | ) | (1,555 | ) | (12,470 | ) | (507 | ) | ||||||||||
| Basic and diluted net loss per share | $ | (0.06 | ) | (0.01 | ) | (0.08 | ) | (0.00 | ) | ||||||||||
| Shares used to compute basic and diluted net loss per share | 158,158 | 160,744 | 157,797 | 159,805 | |||||||||||||||
| Comprehensive loss: | |||||||||||||||||||
| Net loss | $ | (9,632 | ) | (1,555 | ) | (12,470 | ) | (507 | ) | ||||||||||
| Unrealized gain (loss) on investments: | |||||||||||||||||||
| Unrealized holding gains (losses) | 3,344 | (6,042 | ) | 2,540 | (21,699 | ) | |||||||||||||
| Adjustments for losses (gains) reclassified to net loss | (115 | ) | (1,705 | ) | 309 | (1,705 | ) | ||||||||||||
| Foreign currency translation adjustments | 138 | (38 | ) | 148 | (53 | ) | |||||||||||||
| Comprehensive loss | $ | (6,265 | ) | (9,340 | ) | (9,473 | ) | (23,964 | ) | ||||||||||
See accompanying notes to unaudited condensed consolidated financial statements
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REALNETWORKS, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
| Six Months Ended June 30, | |||||||||||
| 2003 | 2002 | ||||||||||
| Cash flows from operating activities: | |||||||||||
| Net loss | $ | (12,470 | ) | (507 | ) | ||||||
| Adjustments to reconcile net loss to net cash used in operating activities: | |||||||||||
| Depreciation and amortization of equipment and leasehold improvements | 5,410 | 5,861 | |||||||||
| Stock-based compensation | 494 | 532 | |||||||||
| Equity in net losses of equity method investees | 3,125 | 3,775 | |||||||||
| Accrued loss on excess office facilities | 5,202 | (1,921 | ) | ||||||||
| Impairment of equity investments | 424 | 704 | |||||||||
| Gain on sale of investment | (158 | ) | (2,409 | ) | |||||||
| Net change in certain operating assets and liabilities | (9,464 | ) | (9,049 | ) | |||||||
| Net cash used in operating activities | (7,437 | ) | (3,014 | ) | |||||||
| Cash flows from investing activities: | |||||||||||
| Purchases of equipment and leasehold improvements | (5,228 | ) | (3,979 | ) | |||||||
| Purchases of short-term investments | (137,303 | ) | (283,063 | ) | |||||||
| Proceeds from sales and maturities of short-term investments | 233,848 | 290,958 | |||||||||
| Purchases of long-term investments | (9,220 | ) | (350 | ) | |||||||
| Increase in restricted cash equivalents | (2,500 | ) | — | ||||||||
| Proceeds from sale of investments | 238 | 3,247 | |||||||||
| Payment of acquisition costs, net of cash acquired | — | (2,422 | ) | ||||||||
| Net cash provided by investing activities | 79,835 | 4,391 | |||||||||
| Cash flows from financing activities: | |||||||||||
| Repurchase of common stock | — | (9,510 | ) | ||||||||
| Proceeds from sale of convertible debt, net of offering costs of $2,750 | 97,250 | — | |||||||||
| Net proceeds from sale of common stock under employee stock purchase plan and exercise of stock options | 6,704 | 6,328 | |||||||||
| Net cash provided by (used in) financing activities | 103,954 | (3,182 | ) | ||||||||
| Effect of exchange rate changes on cash | 319 | (9 | ) | ||||||||
| Net increase (decrease) in cash and cash equivalents | 176,671 | (1,814 | ) | ||||||||
| Cash and cash equivalents at beginning of period | 121,779 | 104,182 | |||||||||
| Cash and cash equivalents at end of period | 298,450 | 102,368 | |||||||||
| Short-term investments at end of period | 90,482 | 232,096 | |||||||||
| Total cash, cash equivalents and short-term investments at end of period | $ | 388,932 | 334,464 | ||||||||
| Supplemental disclosure of non-cash investing activities: | |||||||||||
| Common stock issued in business combination, excluding deferred compensation | $ | — | 1,003 | ||||||||
See accompanying notes to unaudited condensed consolidated financial statements
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REALNETWORKS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
| (a) | Description of Business |
RealNetworks, Inc. and subsidiaries (RealNetworks or Company) is a leading global provider of network-delivered digital media services and the technology that enables digital media creation, distribution and consumption. The Company develops and markets software products and services designed to enable users of personal computers and other consumer electronic devices to send and receive audio, video and other multimedia services using the Internet and other digital networks.
Inherent in the Company’s business are various risks and uncertainties, including its limited operating history and the limited history of premium subscription services on the Internet. The Company’s success may depend in part upon the emergence of the Internet and corporate intranets as a communications medium, the acceptance of the Company’s technology and services by the marketplace and the Company’s ability to generate license, service and advertising revenue from the use of its technology on the Internet.
| (b) | Basis of Presentation |
The accompanying unaudited condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
These financial statements reflect all adjustments, consisting only of normal, recurring adjustments that, in the opinion of the Company’s management, are necessary for a fair presentation of the results of operations for the periods presented. Operating results for the quarter and six months ended June 30, 2003 are not necessarily indicative of the results that may be expected for any subsequent quarter or for the year ending December 31, 2003. Certain information and disclosures normally included in financial statements prepared in conformity with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission.
These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002.
| (c) | Cash, Cash Equivalents and Short-Term Investments |
Cash, cash equivalents and short-term investments are comprised of the following (in thousands):
| June 30, 2003 | December 31, 2002 | ||||||||
| Cash and cash equivalents | $ | 298,450 | 121,779 | ||||||
| Short-term investments | 90,482 | 187,292 | |||||||
| Total cash, cash equivalents and short-term investments | $ | 388,932 | 309,071 | ||||||
| Restricted cash equivalents | $ | 19,800 | 17,300 | ||||||
Restricted cash equivalents at June 30, 2003 represent (a) cash equivalents pledged as collateral against a $10.0 million letter of credit in connection with a lease agreement for the Company’s corporate headquarters, (b) cash equivalents pledged as collateral against a $7.3 million letter of credit with a bank which represents collateral on the lease of a building located near the Company’s corporate headquarters, and (c) cash equivalents of $2.5 million pledged as collateral against guaranteed minimum payments in connection with a contract for services.
The majority of short-term investments mature within twelve months from the date of purchase.
The Company has classified as available-for-sale all marketable debt and equity securities for which there is a determinable fair market value and on which the Company has no restrictions to sell within the next 12 months. Available-for-sale securities are carried at fair value, with unrealized gains and losses reported as a separate component of shareholders’ equity, net of applicable income taxes. Realized gains and losses and declines in value judged to be other-than-temporary on available-for-sale securities are included in other income (expense). The cost basis for determining realized gains and losses on available-for-sale securities is determined using the specific identification method. In
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instances where there are multiple cost bases for the same security, the Company uses the average cost method in determining the cost of the security sold.
| (d) | Investments |
The Company has investments that are accounted for under the cost method of accounting. The cost method is used to account for equity investments in companies in which the Company holds less than a 20 percent voting interest, does not exercise significant influence and for which the related securities do not have a quoted market price.
The Company also has investments that are accounted for under the equity method of accounting. Under the equity method of accounting, the Company’s share of the investee’s earnings or loss is included in the Company’s consolidated operating results. In certain cases where the Company has loaned the investee funds, the Company may record more than its relative equity share of the investee’s losses.
| (e) | Other Assets | |
Other assets primarily consist of offering costs and other long-term deposits. The Company incurred the offering costs as a result of its convertible debt offering. These costs are deferred and are being amortized using the straight-line method over a 5-year period.
| (f) | Revenue Recognition |
The Company recognizes revenue pursuant to the requirements of Statement of Position No. 97-2, “Software Revenue Recognition” (SOP 97-2), as amended by Statement of Position No. 98-9, “Software Revenue Recognition with Respect to Certain Arrangements.”
Under SOP 97-2, revenue attributable to an element in a customer arrangement is recognized when persuasive evidence of an arrangement exists and delivery has occurred, provided the fee is fixed or determinable, collectibility is probable and the arrangement does not require significant customization of the software. If at the outset of the customer arrangement, the Company determines that the arrangement fee is not fixed or determinable or that collectibility is not probable, the Company defers the revenue and recognizes the revenue when the arrangement fee becomes due and payable or as cash is received when collectibility concerns exist.
For multiple element arrangements when Company-specific objective evidence of fair value exists for all of the undelivered elements of the arrangement, but does not exist for one or more of the delivered elements in the arrangement, the Company recognizes revenue under the residual method. Under the residual method, at the outset of the arrangement with a customer, the Company defers revenue for the fair value of its undelivered elements such as consulting services and product support and upgrades, and recognizes the revenue for the remainder of the arrangement fee attributable to the elements initially delivered, such as software licenses, when the criteria in SOP 97-2 have been met. If specific objective evidence does not exist for an undelivered element in a software arrangement, which may include distribution or other term-based arrangements in which the license fee includes support during the arrangement term, revenue is recognized over the term of the support period commencing upon delivery of the Company’s technology to the customer. For arrangements in which the Company commits to significantly alter the features and functionality of its software or build complex interfaces necessary for the Company’s software to function in the customer’s environment, revenue associated with the software and/or service elements is generally recognized as the services are performed.
Revenue from software license agreements with original equipment manufacturers (OEM) is recognized when the OEM delivers its product incorporating the Company’s software to the end user. In the case of prepayments received from an OEM, the Company generally recognizes revenue based on the actual products sold by the OEM. If the Company provides ongoing support to the OEM in the form of future upgrades, enhancements or other services over the term of the contract, revenue is generally recognized ratably over the term of the contract.
Service revenue includes payments under support and upgrade contracts, RealOne media subscription services, and fees from consulting services and streaming media content hosting. Support and upgrade revenue is recognized ratably over the term of the contract, which typically is twelve months. Media subscription service revenue is recognized ratably over the period that services are provided, which is generally one to twelve months. Other service revenue is recognized when the services are performed.
Fees generated from advertising appearing on the Company’s Web sites, and from advertising included in the Company’s products, such as fees for distribution of RealChannels, LiveStations, and e-commerce and other links in the RealOne Player, are recognized as revenue over the terms of the contracts. The Company may guarantee a minimum number of advertising impressions, click-throughs or other criteria on the Company’s Web sites or products for a specified period. To the extent these guarantees are not met, the Company defers recognition of the corresponding revenue until guaranteed delivery levels are achieved.
| (g) | Net Income (Loss) Per Share |
Basic net income (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted net income (loss) per share is computed by dividing net income (loss) by the weighted average number of common and dilutive common equivalent shares outstanding during the period.
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The share count used to compute basic and diluted net loss per share is calculated as follows (in thousands):
| Quarters Ended June 30, | ||||||||
| 2003 | 2002 | |||||||
| Weighted average shares outstanding | 158,484 | 161,151 | ||||||
| Less restricted shares | 326 | 407 | ||||||
| Shares used to compute basic and diluted net loss per share | 158,158 | 160,744 | ||||||
Potential dilutive securities outstanding were not included in the computation of diluted net loss per common share, because to do so would have been anti-dilutive. Potential dilutive securities for the quarter and six months ended June 30, 2003 included options to purchase approximately 43,160,000 common shares. Included in this amount are approximately 10,750,000 contingently issuable shares related to convertible debt issued as described in Note 6. Potential dilutive securities for the quarter and six months ended June 30, 2002 included options to purchase approximately 33,123,000 common shares.
| (h) | Derivative Financial Instruments |
During the six months ended June 30, 2003, the Company entered into foreign currency forward contracts to manage the foreign currency risk of certain intercompany balances denominated in a foreign currency. Although these instruments are effective as a hedge from an economic perspective, they do not qualify for hedge accounting under Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities”, as amended.
At June 30, 2003, the following foreign currency contracts were outstanding and recorded at fair value (in thousands):
| Contract Amount | Contract Amount | |||||||||||
| (Local Currency) | (US Dollars) | Fair Value | ||||||||||
| British Pounds (“GBP”) (contracts to pay US$/receive GBP) | (GBP) | 1,100 | $ | 1,830 | $ | (16 | ) | |||||
| Japanese Yen (“YEN”) (contracts to pay YEN/receive US$) | (YEN) | 235,200 | $ | 2,000 | $ | 33 | ||||||
At December 31, 2002, the following foreign currency contracts were outstanding and recorded at fair value (in thousands):
| Contract Amount | Contract Amount | |||||||||||
| (Local Currency) | (US Dollars) | Fair Value | ||||||||||
| British Pounds (“GBP”) (contracts to pay US$/receive GBP) | (GBP) | 1,000 | $ | 1,590 | $ | 12 | ||||||
| Euro (“EUR”) (contracts to pay US$/receive EUR) | (EUR) | 240 | $ | 247 | $ | 5 | ||||||
| Japanese Yen (“YEN”) (contracts to pay YEN/receive US$) | (YEN) | 293,200 | $ | 2,410 | $ | (70 | ) | |||||
No derivative instruments were outstanding at June 30, 2003, or December 31, 2002, which were designated as hedges for accounting purposes.
| (i) | Comprehensive Income (Loss) |
The Company’s comprehensive loss for the quarters and six months ended June 30, 2003 and 2002 consisted of net loss, net unrealized gains and losses on investments and the gross amount of foreign currency translation adjustments. The tax effect of the foreign
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currency translation adjustments and unrealized gains and losses on investments has been taken into account if applicable. The components of accumulated other comprehensive income (loss) are as follows (in thousands):
| June 30, | December 31, | |||||||
| 2003 | 2002 | |||||||
| Unrealized gains/(losses) on investments, net of taxes of $16,479 in 2003 and 2002 | $ | 2,271 | (578 | ) | ||||
| Foreign currency translation adjustments | (328 | ) | (476 | ) | ||||
| $ | 1,943 | (1,054 | ) | |||||
| (j) | Stock-Based Compensation |
The Company has elected to apply the disclosure-only provisions of Statement of Financial Accounting Standards (SFAS) No.123, “Accounting for Stock-Based Compensation” (SFAS 123). Accordingly, the Company accounts for stock-based compensation transactions with employees using the intrinsic value method prescribed in Accounting Principles Board Opinion No.25, “Accounting for Stock Issued to Employees”, (APB 25) and related interpretations. Compensation cost for employee stock options is measured as the excess, if any, of the fair value of the Company’s common stock at the date of grant over the stock option exercise price. Compensation cost for awards to non-employees is based on the fair value of the awards in accordance with SFAS 123 and related interpretations.
The Company recognizes compensation cost related to fixed employee awards on an accelerated basis over the applicable vesting period using the methodology described in Financial Accounting Standards Board (FASB) Interpretation No. 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans.” At June 30, 2003, the Company has five stock-based employee compensation plans. The following table illustrates the effect on net loss and net loss per share if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation (in thousands, except per share data):
| Quarter Ended June 30, | Six Months Ended June 30, | ||||||||||||||||
| 2003 | 2002 | 2003 | 2002 | ||||||||||||||
| Net loss as reported | $ | (9,632 | ) | (1,555 | ) | (12,470 | ) | (507 | ) | ||||||||
| Plus: stock-based employee compensation expense included in reported net loss, net of related tax effects | 193 | 368 | 494 | 532 | |||||||||||||
| Less: stock-based employee compensation expense determined under fair value based methods for all awards, net of related tax effects | 7,613 | 24,116 | 18,197 | 50,176 | |||||||||||||
| Pro forma net loss | $ | (17,052 | ) | (25,303 | ) | (30,173 | ) | (50,151 | ) | ||||||||
| Net loss per share: | |||||||||||||||||
| Basic and diluted - as reported | $ | (0.06 | ) | (0.01 | ) | (0.08 | ) | (0.00 | ) | ||||||||
| Basic and diluted - pro forma | (0.11 | ) | (0.16 | ) | (0.19 | ) | (0.31 | ) | |||||||||
| (k) | Recently Issued Accounting Standards |
In November 2002, the EITF reached a consensus on Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables’’ (EITF 00-21). EITF 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which the vendor will perform multiple revenue generating activities. EITF 00-21 became effective for periods beginning after June 15, 2003. The Company does not expect the adoption of EITF 00-21 to have a material impact on its financial position or results of operations.
In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51” (FIN 46). FIN 46 addresses the consolidation by business enterprises of variable interest entities as defined in FIN 46. FIN 46 applies immediately to variable interests in variable interest entities created after January 31, 2003, and to variable interests in variable interest entities obtained after January 31, 2003. For public enterprises with a variable interest in a variable interest entity created before February 1, 2003, FIN 46 applies to that enterprise no later than the beginning of the first interim or annual reporting period beginning after June 15, 2003. The application of FIN 46 is not expected to have a material effect on the Company’s financial statements. FIN 46 requires certain disclosures in
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financial statements issued after January 31, 2003 if it is reasonably possible that the Company will consolidate or disclose information about variable interest entities when FIN 46 becomes effective.
In April 2003, the FASB issued Statements of Financial Accounting Standards No. 149 (SFAS 149), “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative Instruments embedded in other contracts and for hedging activities under FASB Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS 149 is generally effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. The Company does not expect the adoption of SFAS 149 to have a material impact on its financial position or results of operations.
In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150 (SFAS 150), “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. SFAS 150 is to be implemented by reporting the cumulative effect of a change in an accounting principle for financial instruments created before the issuance date of the statement and still existing at the beginning of the interim period of adoption. The Company does not expect the adoption of SFAS 150 to have a material impact on its financial position or results of operations.
NOTE 2 - SEGMENT INFORMATION
The Company operates in one business segment, media delivery, for which the Company receives revenue from its customers. The Company’s Chief Operating Decision Maker is considered to be the Company’s CEO Staff (CEOS), which is comprised of the Company’s Chief Executive Officer, President, Executive and Senior Vice Presidents, General Counsel, and the Company’s Vice President of Media Web Services. The CEOS reviews financial information presented on a consolidated basis accompanied by disaggregated information about products and services and geographical regions for purposes of making decisions and assessing financial performance. The CEOS does not review discrete financial information regarding profitability of the Company’s different products or services and, therefore, the Company has only one operating segment as defined by SFAS No. 131, “Disclosure About Segments of an Enterprise and Related Information.”
The Company’s customers consist primarily of end users located in the United States and various foreign countries. Revenue by geographic region is as follows (in thousands):
| Quarters Ended June 30, | Six Months Ended June 30, | ||||||||||||||||
| 2003 | 2002 | 2003 | 2002 | ||||||||||||||
| United States | $ | 36,009 | 32,739 | $ | 69,778 | 64,262 | |||||||||||
| Europe | 7,990 | 5,370 | 14,904 | 14,235 | |||||||||||||
| Asia | 4,977 | 4,833 | 10,328 | 10,250 | |||||||||||||
| Rest of the world | 670 | 816 | 1,502 | 2,303 | |||||||||||||
| Total net revenue | $ | 49,646 | 43,758 | $ | 96,512 | 91,050 | |||||||||||
The Company’s product types are defined as follows:
Consumer software and related services revenue is derived from sales of the Company’s RealOne Player Plus, RealJukebox Plus and other related products, revenue from support and maintenance services that the Company sells to customers who purchase these products and sales of third-party software products, including games. These products and services are sold primarily through the Internet, and the Company charges customers’ credit cards at the time of sale.
Consumer subscription services revenue is derived from sales of digital media subscription services, including RealOne SuperPass, RealOne RadioPass, RealOne Rhapsody and stand-alone and add-on subscriptions. These services are sold primarily through the Internet, and the Company charges the customers’ credit cards at the time of sale. Billing periods for consumer subscriptions services occur monthly, quarterly or annually, depending on the service purchased.
Systems revenue is derived from sales of media delivery system software, including RealServers and Helix system software, related authoring and publishing tools, digital rights management technology, support and maintenance services that the Company sells to customers who purchase these products, broadcast hosting services provided through the Real Broadcast Network and consulting services offered to the Company’s customers. These products and services are primarily sold to corporate customers.
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Advertising revenue is derived from sales of advertising on the Company’s Web sites and consumer software and within the media streams that the Company hosts on behalf of its corporate customers.
Revenue from external customers by product type is as follows (in thousands):
| Quarters Ended June 30, | Six Months Ended June 30, | ||||||||||||||||
| 2003 | 2002 | 2003 | 2002 | ||||||||||||||
| Consumer software and related services | $ | 6,166 | 7,225 | 14,063 | 16,680 | ||||||||||||
| Consumer subscription services | 25,470 | 17,800 | 49,109 | 31,422 | |||||||||||||
| Systems | 16,474 | 17,147 | 30,454 | 39,771 | |||||||||||||
| Advertising | 1,536 | 1,586 | 2,886 | 3,177 | |||||||||||||
| Total net revenue | $ | 49,646 | 43,758 | 96,512 | 91,050 | ||||||||||||
Long-lived assets by geographic location are as follows (in thousands):
| June 30, | December 31, | ||||||||
| 2003 | 2002 | ||||||||
| United States | $ | 89,886 | 90,234 | ||||||
| Asia/Rest of the world | 556 | 518 | |||||||
| Europe | 215 | 218 | |||||||
| Total | $ | 90,657 | 90,970 | ||||||
NOTE 3 - OTHER INVESTMENTS
RealNetworks has made minority equity investments for business and strategic purposes through the purchase of voting capital stock of companies. The Company’s investments in publicly traded companies are accounted for as available-for-sale, carried at current market value and are classified as long-term as they are strategic in nature. The Company periodically evaluates whether declines in fair value, if any, of its investments are other-than-temporary. This evaluation consists of a review of qualitative and quantitative factors. For investments with publicly quoted market prices, these factors include the time period and extent for which the quoted market price is less than its accounting basis. The Company also considers other factors to determine whether declines in fair value are other-than-temporary, such as the investee’s financial condition, results of operations and operating trends. The evaluation also considers publicly available information regarding the investee companies. For investments in private companies with no quoted market price, the Company considers similar qualitative and quantitative factors and also considers the implied value from any recent rounds of financing completed by the investee. During 2002, certain of the Company’s investments were written down to fair value based upon the Company’s analysis that the declines in fair value were other-than-temporary resulting in an impairment charge of $704,000 for the quarter and six months ended June 30, 2002. Based upon an evaluation of the facts and circumstances at June 30, 2003, the Company determined that there were no other-than-temporary declines in fair value for the quarter ended June 30, 2003. Impairment charges for other-than-temporary declines in fair value of investments for the six months ended June 30, 2003 were $0.4 million.
As of June 30, 2003, the Company owned marketable equity securities of a Japanese company, representing approximately 14% of the investee’s outstanding shares, accounted for as available-for-sale securities. The market value of these shares has increased from the Company’s original cost, resulting in a carrying value at June 30, 2003 of $19.7 million. The increase over the Company’s cost basis, net of tax effects, is reflected as a component of accumulated other comprehensive income. The market for this company’s shares is relatively limited, the share price is volatile and the investment is strategic in nature. Accordingly, there can be no assurance that a gain of this magnitude, or any gain, can be realized through the disposition of these shares.
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NOTE 4 – INVESTMENT IN MUSICNET
The Company’s investment in MusicNet, Inc. (MusicNet), a joint venture with several media companies to create a platform for online music subscription services, is accounted for under the equity method of accounting. As a result, the Company records in its statement of operations its equity share of MusicNet’s net income (loss) which was a loss of $1.4 million and $3.1 million for the quarter and six months ended June 30, 2003 and $1.3 million and $3.5 million for the comparable periods in 2002. The Company owns common and preferred stock in MusicNet and also owns convertible notes, convertible into shares of MusicNet preferred stock. In April 2003, the Company and the other investors in MusicNet contributed additional capital to MusicNet to fund its business. The Company contributed $3.0 million and received additional convertible notes for this investment. The Company anticipates that MusicNet will continue to incur losses in the foreseeable future and will require additional funding to support the development of its business model. Based on the nature and terms of the convertible notes, for the quarter and six months ended June 30, 2003, for purposes of calculating the Company’s equity in net loss of MusicNet, the convertible notes were treated on an “as if” converted basis. As a result, the losses recorded by the Company for the quarter and six months ended June 30, 2003, represent approximately 36.9% of MusicNet’s loss. As of June 30, 2003, the Company’s ownership interest in outstanding shares of capital stock of MusicNet was approximately 25.5% and the carrying value for its investment was $8.8 million. During the quarter and six months ended June 30, 2003, the Company recognized approximately $0.3 million and $0.6 million of revenue related to license and services agreements with MusicNet, respectively.
NOTE 5 – LOSS ON EXCESS OFFICE FACILITIES
In October 2000, the Company entered into a 10-year lease agreement for additional office space located near its corporate headquarters in Seattle, Washington. Due to the decline in the market for office space in Seattle and the Company’s re-assessment of its facilities requirements, the Company has accrued for estimated future losses on excess office facilities. The Company’s estimates are based upon many factors including projections of sublease rates and the time period required to locate tenants. During the quarter ended June 30, 2003, the Company secured an additional tenant at a sublease rate lower than the rate used in previous loss estimates. As a result, the Company adjusted its estimates to reflect the lower lease rate and recorded additional losses of $7.1 million during the quarter and six months ended June 30, 2003. The loss estimates include $14.7 million of sublease income, of which $8.9 million is committed under current sublease contracts. The Company did not identify any factors which caused it to revise its estimates during the quarter and six months ended June 30, 2002. The Company regularly evaluates the market for office space in Seattle. If the market for such space declines further in future periods, the Company may have to revise its estimates which may result in additional losses on excess office facilities. Although the Company believes its estimates are reasonable, additional losses may result if actual experience differs from projections.
A summary of activity for the accrued loss on excess office facilities is as follows (in thousands):
| Accrued loss at December 31, 2002 | $ | 25,935 | |||
| Revisions to estimates | 7,098 | ||||
| Less amounts paid, net of sublease income | (1,896 | ) | |||
| Accrued loss at June 30, 2003 | $ | 31,137 | |||
NOTE 6 – CONVERTIBLE DEBT
During June 2003, the Company issued $100 million aggregate principal amount of zero coupon convertible subordinated notes due July 1, 2010, pursuant to Rule 144A under the Securities Act of 1933, as amended. The notes are subordinated to any Company senior debt, and are also effectively subordinated in right of payment to all indebtedness and other liabilities of its subsidiaries. The notes are convertible into shares of the Company’s common stock based on an initial effective conversion price of approximately $9.30 if (1) the closing sale price of the Company’s common stock exceeds $10.23, subject to certain restrictions, (2) the notes are called for redemption, (3) the Company makes a significant distribution to its shareholders or becomes a party to a transaction that would result in a change in control, or (4) the trading price of the notes falls below 95% of the value of common stock that the notes are convertible into, subject to certain restrictions; one of which allows the Company, at its discretion, to issue cash or common stock or combination thereof upon conversion. On or after July 1, 2008, the Company has the option to redeem all or a portion of the notes that have not been previously purchased, repurchased or converted, in exchange for cash at 100% of the principal amount of the notes. The purchaser may require the Company to purchase all or a portion of its notes in cash on July 1, 2008 at 100% of the principal amount of the notes. As a result of this issuance, the Company received proceeds of $97.3 million, net of estimated offering costs. The Company expects to pay additional offering costs of approximately $0.3 million in the quarter ending September 30, 2003. The offering costs are being amortized over a 5-year period. The net proceeds of the issuance are intended to be used for general corporate purposes, acquisitions, other strategic transactions including joint ventures, and working capital requirements.
NOTE 7 – GUARANTEES
In November 2002, the FASB issued FIN 45. FIN 45 provides expanded accounting guidance surrounding liability recognition and disclosure requirements related to guarantees, as defined by this Interpretation. In the ordinary course of business, the Company is not subject to potential obligations under guarantees that fall within the scope of FIN 45 except for standard indemnification and warranty provisions that are contained within many of its customer license and service agreements, and give rise only to the disclosure requirements prescribed by FIN 45.
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Indemnification and warranty provisions contained within the Company’s customer license and service agreements are generally consistent with those prevalent in its industry. The duration of its product warranties generally does not exceed 90 days following delivery of its products. The Company has not incurred significant obligations under customer indemnification or warranty provisions historically and does not expect to incur significant obligations in the future. Accordingly, the Company does not maintain accruals for potential customer indemnification or warranty-related obligations.
NOTE 8 - LITIGATION
Between November 1999 and March 2000, fourteen lawsuits were filed against the Company in federal and/or state courts in California, Illinois, Pennsylvania, Washington and Texas. All state court cases have been dismissed, the most recent being the California case, which was dismissed pursuant to a settlement in June 2003. The settlement did not have a material adverse effect on the Company’s financial position or results of operations. On February 10, 2000, the federal Judicial Panel on Multidistrict Litigation transferred all pending federal cases to the federal district court for the Northern District of Illinois. On the same day, that court granted the Company’s motion to stay the court proceedings because the claims are subject to arbitration under the Company’s End User License Agreement.
In July 2002, a lawsuit was filed against the Company in federal court in Boston, Massachusetts, alleging that the Company willfully infringes certain patents relating to “the downloading of data from a server computer to a client computer.” The plaintiff seeks to enjoin the Company from the alleged infringing activity and to recover treble damages from the alleged infringement. The Company has filed counterclaims against the plaintiff seeking a declaratory judgment that the patents at issue are invalid and unenforceable due to plaintiff’s inequitable conduct, as well as recovery of damages for plaintiff’s infringement of a RealNetworks patent, and its reasonable attorneys fees and costs. Although no assurance can be given as to the outcome of this lawsuit, the Company believes that the allegations in this action are without merit and intends to vigorously defend itself. The Company believes the ultimate outcome will not have a material adverse effect on its financial position or results of operations. If the plaintiffs prevail in their claims, the Company could be required to pay damages or other penalties in addition to complying with injunctive relief, which could harm the Company’s business and its operating results.
In March 2003, William Cirignani filed a consumer class action against the Company in Washington state court, alleging causes of action based on the Washington Consumer Protection Act and unjust enrichment. The plaintiff alleges that consumers who attempted to download or purchase certain of the Company’s products and services were fraudulently and deceptively enrolled in, and prevented from canceling, the Company’s subscription services. The plaintiff seeks compensatory damages, equitable relief in the form of an order prohibiting the alleged false and deceptive practices, treble damages and other relief. On June 2, 2003, the Company filed a motion to stay the case pending arbitration, based on the provisions in the Company’s End User License Agreements with consumers for the relevant products and services, which provide for disputes to be resolved through arbitration. On July 15, 2003, the trial court granted the Company’s motion staying the litigation pending arbitration. Although no assurance can be given as to the outcome of this lawsuit, the Company believes that the allegations in this action are without merit and intends to vigorously defend itself against these claims. The Company believes the ultimate outcome will not have a material adverse effect on its financial position or results of operations. If the plaintiffs prevail in their claims, the Company could be required to pay damages or other penalties in addition to complying with injunctive relief, which could harm the Company’s business and its operating results.
In June 2003, a lawsuit was filed against the Company and Listen.Com in federal district court for the Northern District of Illinois, alleging that certain features of the Company’s and Listen.Com’s products and services willfully infringe certain patents relating to allowing users “to search for streaming media files, to create custom playlists, and to listen to the streaming media file sequentially and continuously.” The plaintiff seeks to enjoin the Company from the alleged infringing activity and to recover treble dames from the alleged infringement. Although no assurance can be given as to the outcome of this lawsuit, the Company believes the allegations are without merit and intends to vigorously defend itself. The Company believes the ultimate outcome will not have a material adverse effect on its financial position or results of operations. If the plaintiff prevails in its claims, the Company could be required to pay damages or other penalties in addition to complying with injunctive relief, which could harm the Company’s business and its operating results.
From time to time the Company is, and expects to continue to be, subject to legal proceedings and claims in the ordinary course of its business, including employment claims, contract-related claims and claims of alleged infringement of third-party patents, trademarks and other intellectual property rights. These claims, even if not meritorious, could force the Company to spend significant financial and managerial resources. The Company currently has a number of such claims threatened against it relating to intellectual property infringement or employment, though it believes these claims are without merit. The Company is not aware of any legal proceedings or claims that the Company believes will have, individually or taken together, a material adverse effect on the Company’s business, prospects, financial condition or results of operations. However, the Company may incur substantial expenses in defending against third party claims. In the event of a determination
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adverse to the Company, the Company may incur substantial monetary liability, and/or be required to change its business practices. Either of these could have a material adverse effect on the Company’s financial position and results of operations.
NOTE 9 – SUBSEQUENT EVENT
On April 21, 2003, the Company announced it entered into a definitive agreement to acquire Listen.Com, Inc. (Listen.Com), a digital music service provider, for approximately $36 million in cash and Company common stock. The Company closed this transaction on August 4, 2003. Approximately $17.3 million of the consideration was paid in cash and the remainder with 4.1 million shares and options to acquire shares of Company common stock. The former common shareholders of Listen.Com also have the right to receive up to an additional $1.5 million on or prior to the one-year anniversary of the consummation of the acquisition if certain conditions are satisfied. As of June 30, 2003, the Company had also invested approximately $6.2 million in Listen.Com in the form of convertible promissory notes.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The discussion in this report contains forward-looking statements that involve risks and uncertainties. RealNetworks’ actual results could differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section titled “Factors that May Affect Our Business, Future Operating Results and Financial Condition,” included elsewhere in this Report. You should also carefully review the risk factors set forth in other reports or documents that RealNetworks files from time to time with the Securities and Exchange Commission, particularly Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and any Current Reports on Form 8-K. You should also read the following discussion and analysis in conjunction with our unaudited condensed consolidated financial statements and related notes included in this report.
Overview
RealNetworks, Inc. is a leading global provider of network-delivered digital media services and the technology that enables digital media creation, distribution and consumption.
Our primary strategy is to drive the creation of a market for digital audio and video content online, including subscription-based content. We believe we are positioned to benefit from this market in three primary ways: (1) as an electronic retailer of digital content and software to consumers; (2) as a business-to-business services provider to third parties who wish to distribute their content to consumers via digital networks; and (3) as a supplier of the underlying technology needed by content owners and network operators to create and distribute digital content. Since our inception we have helped to create a large ecosystem of consumers, network operators and content owners who use our products and services to create, send and receive both free and paid content.
We report revenue in three categories:
| • | Software license fees, which primarily includes revenue from sales of premium versions of our RealOne Player and RealJukebox products, sales of our media delivery system software, including RealServer and Helix system software, and related authoring and publishing tools, both directly to customers and indirectly through original equipment manufacturer (OEM) channels, and sales of third-party products, including games. The English language version of our RealOne Player Plus and RealJukebox Plus products, which have previously contributed to software license fees, are now combined in our RealOne subscription offering, the revenue from which is included in service revenue. | ||
| • | Service revenue, which primarily includes revenue from digital media subscription services such as SuperPass, RadioPass, MusicPass, and stand-alone and add-on subscriptions, support and maintenance services that we sell to customers who purchase our RealOne Player Plus, RealJukebox Plus, and media delivery system software including RealServer and Helix system software, and related authoring and publishing tools, broadcast hosting services we provide through our Real Broadcast Network and consulting services we offer to our customers. | ||
| • | Advertising revenue, which is derived from sales of advertising on our Web sites and consumer software and within the media streams that we host on behalf of our corporate customers. |
Critical Accounting Policies and Estimates
Our critical accounting policies and estimates are as follows:
| • | Revenue recognition | ||
| • | Estimating sales returns and the allowance for doubtful accounts | ||
| • | Estimating losses on excess office facilities | ||
| • | Determining whether declines in the fair value of investments are other-than-temporary and estimating fair market value of investments in privately held companies | ||
| • | Valuation of goodwill | ||
| • | Valuation of deferred income tax assets | ||
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Revenue Recognition.As described below, significant management judgments and estimates must be made and used in connection with the revenue recognized in any accounting period. Material differences may result in the amount and timing of our revenue for any period if our management made different judgments or utilized different estimates.
We recognize revenue pursuant to the requirements of Statement of Position No. 97-2, “Software Revenue Recognition” (SOP 97-2), as amended by Statement of Position No. 98-9, “Software Revenue Recognition with Respect to Certain Arrangements.” Under SOP 97-2, revenue attributable to an element in a customer arrangement is recognized when persuasive evidence of an arrangement exists and delivery has occurred, provided the fee is fixed or determinable, collectibility is probable and the arrangement does not require significant customization of the software.
For all sales, except those completed via credit card transactions through the Internet, we use either a binding purchase order or signed agreement, depending on the nature of the transaction, as evidence of an arrangement. For sales made via the Internet, we use the customer’s authorization to charge their credit card as evidence of an arrangement. Sales through our distributors are evidenced by a master agreement governing the relationship together with binding purchase orders on a transaction by transaction basis.
For software license fees in single element arrangements and multiple element arrangements which do not include customization or consulting services, delivery typically occurs when the product is made available to the customer for download or when products are shipped to customers. For service and advertising revenue, delivery typically occurs as the services are being performed.
At the time of each transaction, we assess whether the fee associated with our revenue transactions is fixed and determinable and whether or not collection is probable. We assess whether the fee is fixed and determinable based on the payment terms associated with the transaction. If a significant portion of a fee is due after our normal payment terms, is based upon a variable matrix such as a minimum level of distribution or is subject to refund, we account for the fee as not being fixed and determinable. In these cases, we defer revenue and recognize it when it becomes due and payable.
We assess the probability of collection based on a number of factors, including past transaction history with the customer and the current financial condition of the customer. We do not request collateral from our customers but often require payments before or at the time products and services are delivered. If we determine that collection of a fee is not probable, we defer revenue until the time collection becomes probable, which is generally upon receipt of cash.
For multiple element arrangements, when company-specific objective evidence of fair value exists for all of the undelivered elements of the arrangement, but does not exist for one or more of the delivered elements in the arrangement, we recognize revenue under the residual method. Under the residual method, at the outset of the arrangement with a customer, we defer revenue for the fair value of the arrangement’s undelivered elements such as consulting services and product support and upgrades, and recognize the revenue for the remainder of the arrangement fee attributable to the elements initially delivered, such as software licenses, when the criteria in SOP 97-2 have been met. Company-specific objective evidence is established for support and upgrades of standard products for which no installation or customization is required based upon the amounts we charge when support and upgrades are sold separately. Company-specific objective evidence is established for consulting and installation services based on the hourly rates we charge for our employees when they are performing these services provided we have the ability to accurately estimate the hours required to complete a project based upon our experience with similar projects. For multiple element arrangements involving installation or customization, company-specific objective evidence is established for support and upgrade arrangements if our customers have an optional annual renewal rate specified in the arrangement and the rate is substantive. For arrangements in which the Company commits to significantly alter the features and functionality of its software or build complex interfaces necessary for the Company’s software to function in the customer’s environment, revenue associated with the software and/or service elements is generally recognized as the services are performed.
If company specific objective evidence does not exist for an undelivered element in a software arrangement, which may include distribution or other term-based arrangements in which the license fee includes support during the arrangement term, revenue is recognized over the term of the support period commencing upon delivery of our technology to the customer.
Revenue from software license agreements with OEMs is recognized when the OEM delivers its product incorporating our software to the end user. In the case of prepayments received from an OEM, we typically recognize revenue based on the actual products sold by the OEM. If we provide ongoing support to the OEM in the form of
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future upgrades, enhancements or other services over the term of the contract, revenue is generally recognized ratably over the term of the contract.
Service revenue includes payments under support and upgrade contracts, and payments for RealOne media subscription services, consulting services and streaming media content hosting. Support and upgrade revenue is recognized ratably over the term of the contract, which typically is twelve months. Media subscription service revenue is recognized ratably over the period that services are provided. Other service revenue is recognized as the services are performed.
Fees generated from advertising are recognized as advertising is delivered over the terms of the contracts. We may guarantee a minimum number of advertising impressions, click-throughs or other criteria on our Web sites or products for a specified period. To the extent these guarantees are not met, we defer recognition of the corresponding revenue until guaranteed delivery levels are achieved.
Sales Returns and the Allowance for Doubtful Accounts.The preparation of our financial statements requires us to make estimates and assumptions that affect the reported amount of assets and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reported period. Specifically, we must make estimates of potential future product returns related to current period product revenue. We analyze historical returns, current economic trends, and changes in customer demand and acceptance of our products when evaluating the adequacy of the sales returns and other allowances. Significant judgments and estimates must be made and used in connection with establishing allowances for sales returns and the allowance for doubtful accounts in any accounting period. Material differences may result in the amount and timing of our revenue for any period if we made different judgments or utilized different estimates. Similarly, we must make estimates of the uncollectibility of our accounts receivables. We specifically analyze the age of accounts receivable and analyze historical bad debts, customer credit-worthiness and current economic trends when evaluating the adequacy of the allowance for doubtful accounts.
Accrued Loss On Excess Office Facilities.We have made significant estimates in determining the appropriate amount of accrued loss on excess office facilities. If we made different estimates, our loss on excess office facilities would be significantly different from that recorded, which could have a material impact on our operating results. Our estimates are based upon many factors including projections of sublease rates and the time period required to locate tenants. We regularly evaluate the market for office space in Seattle. If the market for such space declines further in future periods, we may have to revise our estimates which may result in additional losses on excess office facilities. We have revised our original estimate three times in the last two years, increasing the accrual for loss on excess office facilities each time. The first two revisions were in both cases the result of changes in the market for commercial real estate in the Seattle, Washington area. For the third revision during the quarter ended June 30, 2003, we revised our estimate and increased our accrual as a result of securing an additional tenant at a sublease rate lower then the rate used in previous estimates. The loss estimates include $14.7 million of sublease income, of which $8.9 million is committed under current sublease contracts.
Impairment of Investments.As part of the process of preparing our consolidated financial statements we periodically evaluate whether any declines in the fair value of our investments are other-than-temporary. Significant judgments and estimates must be made to assess whether an other-than-temporary decline in fair value of investments has occurred and to estimate the fair value of investments in privately held companies. See “Other income (expense), net” in the following pages for a discussion of the factors we considered in evaluating whether declines in fair value of our investments were other-than-temporary and the factors we considered in estimating the fair value of investments in private companies.
Valuation of Goodwill.We assess the impairment of goodwill on an annual basis or whenever events or changes in circumstances indicate that the fair value of the reporting unit to which goodwill relates is less than the carrying value. Factors we consider important which could trigger an impairment review include the following:
| • | poor economic performance relative to historical or projected future operating results | ||
| • | significant negative industry, economic or company specific trends | ||
| • | changes in the manner of our use of the assets or the plans for our business | ||
| • | loss of key personnel |
If we were to determine that the fair value of a reporting unit was less than its carrying value, including goodwill, based upon the annual test or the existence of one or more of the above indicators of impairment, we measure
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impairment based on a comparison of the implied fair value of reporting unit goodwill with the carrying amount of goodwill. The implied fair value of goodwill is determined by allocating the fair value of a reporting unit to its assets (recognized and unrecognized) and liabilities in a manner similar to a purchase price allocation. The residual fair value after this allocation is the implied fair value of reporting unit goodwill. To the extent the carrying amount of reporting unit goodwill is greater than the implied fair value of reporting unit goodwill, we would record an impairment charge for the difference.
Valuation of Deferred Income Tax Assets.In accordance with generally accepted accounting principles, we must periodically assess the likelihood that our deferred tax assets will be recovered from future taxable income, and to the extent that recovery is not likely, a valuation allowance must be established. The establishment of a valuation allowance and increases to such an allowance result in either increases to income tax expense or reduction of income tax benefits in the statement of operations. Factors we consider in making such an assessment include, but are not limited to, past performance and our expectation of future taxable income, macro-economic conditions and issues facing our industry, existing contracts, backlog, our ability to project future results and any appreciation of our investments and other assets. As of December 31, 2002, and June 30, 2003 we had established valuation allowances equal to our net deferred tax assets.
RESULTS OF OPERATIONS
REVENUE
Software License Fees. Software license fees were $16.6 million for the quarter ended June 30, 2003, a decrease of 4% from $17.3 million for the quarter ended June 30, 2002. Software license fees were $32.9 million for the six months ended June 30, 2003, a decrease of 21% from $41.6 million for the six months ended June 30, 2002. The decreases were due primarily to lower revenue from certain of our systems software products. In particular, sales to Internet service providers and customers in the systems software and original equipment manufacturer industries have declined. We believe that the decreases in these systems sales were primarily due to continued cutbacks in capital and information technology spending by our customers and potential customers caused by macroeconomic conditions and the fact that Microsoft has continued to bundle its competing Windows Media Player and server software for free with its operating system products, causing certain potential customers to adopt Microsoft’s media delivery products. We believe the macroeconomic environment and competition from Microsoft, including Microsoft’s conduct described below in “Factors that may Affect our Business, Future Operating Results and Financial Condition,” have negatively impacted sales to, and the rate of adoption of our systems software products by, consumers, including customers in the corporate enterprise, broadcast hosting, Internet content provider, non-PC device manufacturer, systems software, telecommunication and original equipment manufacturer markets. No assurance can be given when, or if, customers in these markets will begin to increase capital spending levels or whether, if capital spending increases, it will result in increased revenue for our systems products. We have also focused our consumer promotional activities to feature our RealOne and stand-alone subscription services, the revenue from which is reflected in service revenue. In June 2002, we launched a European edition of our RealOne subscription service and began promoting this service to our European customers. Both of these factors have resulted in a shift of revenue from software license fees to service revenue. These decreases were partially offset by revenue from increased sales of our system software to mobile and wireless infrastructure companies. In addition, revenue for software license fees increased related to a past contract with a customer who filed for bankruptcy protection. In the quarter ended June 30, 2003, a bankruptcy court relieved us of any future support or other obligations. As a result, we recognized the remaining amount of deferred revenue as revenue in the quarter ended June 30, 2003.
Service Revenue. Service revenue was $31.5 million for the quarter ended June 30, 2003, an increase of 26% from $24.9 million for the quarter ended June 30, 2002. Service revenue was $60.8 million for the six months ended June 30, 2003, an increase of 31% from $46.3 million for the six months ended June 30, 2002. The increases in service revenue were primarily attributable to growth in the number of subscribers to our subscription services and the introduction of new digital media subscription services, such as RadioPass, partially offset by decreases in other product offerings, including content hosting revenue and support and upgrades revenue. Revenue from our digital media subscription services was $25.5 million and $17.8 million of service revenue for the quarters ended June 30, 2003 and 2002, respectively, and $49.1 million and $31.4 million for the six months ended June 30, 2003 and 2002, respectively. The reasons for increases in subscription revenue are described in more detail in “Revenue By Product Type — Consumer Subscription Services” below. We believe the decreased revenue in our other product offerings, including content hosting, were due primarily to competition from Microsoft and the macroeconomic conditions described above in “Software License Fees.”
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Advertising. Advertising revenue was $1.5 million for the quarter ended June 30, 2003, a decrease of 3% from $1.6 million for the quarter ended June 30, 2002. Advertising revenues were $2.9 million for the six months ended June 30, 2003, a decrease of 9% from $3.2 million for the six months ended June 30, 2002. We believe the decrease in advertising revenue was due in part to the continued depressed environment for Internet advertising, which resulted in lower volumes. We also believe the focus of our promotional and marketing efforts to more prominently feature our digital media subscription offerings contributed to the decrease in advertising revenue, as we removed paid advertising from certain Web pages and used our advertising space to promote our digital media subscription services.
REVENUE BY PRODUCT TYPE
Consumer Software and Related Services.Consumer software and related services revenue is derived from sales of our RealOne Player Plus and related products, revenue from support and maintenance services that we sell to customers who purchase these products and sales of third-party software products, including games. Consumer software and related services revenue was $6.2 million for the quarter ended June 30, 2003, a decrease of 15% from $7.2 million for the quarter ended June 30, 2002. Consumer software and related services revenue was $14.1 million for the six months ended June 30, 2003, a decrease of 16% from $16.7 million for the six months ended June 30, 2002. The decreases were primarily due to a change in focus of our promotional activities to feature our digital media subscription services over our traditional consumer products as well as competition from Microsoft described in “Revenue – Software License Fees” above. Additionally, in June 2002, we launched a European edition of our RealOne digital media subscription service which has caused a shift from consumer software and related services revenue to consumer subscription services revenue.
Consumer Subscription Services. Consumer subscription services revenue consists of our digital media subscription services, including SuperPass, RadioPass, MusicPass, and stand-alone and add-on subscriptions. Consumer subscription services revenue was $25.5 million for the quarter ended June 30, 2003, an increase of 43% from $17.8 million for the quarter ended June 30, 2002. Consumer subscription services revenue was $49.1 million for the six months ended June 30, 2003, an increase of 56% from $31.4 million for the six months ended June 30, 2002. The increases were primarily attributable to the increased focus of our promotional activities on our digital media subscription services, the introduction of new subscription services, including RadioPass and GamePass, the introduction of new standalone subscription services, including OpenPass, and the related increase in paying subscribers. We also believe that the continued increase in exclusive and premium content available to our digital media subscribers has resulted in a broader reach among consumers, thereby leading to greater consumer adoption rates and higher revenue. Additionally, in June 2002 we launched a European edition of our RealOne subscription service with premium content from European content partners. Our subscription services offerings represent a relatively new business model for Internet media delivery and a new business model for us and, to date, we have not faced significant direct competition with these offerings. While consumer subscription revenue has increased substantially on a year-over-year basis, the rate of growth has slowed in recent periods. The $25.5 million of consumer subscription services revenue in the second quarter of 2003 represents an 8% increase over consumer subscription services revenue of $23.6 million in the first quarter of 2003. We cannot predict with accuracy how these subscription offerings will perform in the future, at what rate subscription revenue will grow, if at all, or the nature or potential impact of anticipated competition.
Systems. Systems revenue is derived from sales of our media delivery system software, including RealServer and Helix system software, and related authoring and publishing tools, digital rights management technology, support and maintenance services that we sell to customers who purchase these products, broadcast hosting services we provide through our Real Broadcast Network and consulting services we offer to our customers. Systems revenue was $16.5 million for the quarter ended June 30, 2003, a decrease of 4% from $17.1 million for the quarter ended June 30, 2002. Systems revenue was $30.5 million for the six months ended June 30, 2003, a decrease of 23% from $39.8 million for the six months ended June 30, 2002. See “Revenue – Software License Fees” above for the analysis of the decrease in revenue.
Advertising. Advertising revenue was $1.5 million for the quarter ended June 30, 2003, a decrease of 3% from $1.6 million for the quarter ended June 30, 2002. Advertising revenue was $2.9 million for the six months ended June 30, 2003, a decrease of 9% from $3.2 million for the six months ended June 30, 2002. See “Revenue – Advertising” above for the analysis of the decrease in revenue.
GEOGRAPHIC REVENUE
International revenue represented 27% of total net revenue for the quarter ended June 30, 2003, compared to 25% for the quarter ended June 30, 2002. International revenue increased as a percentage of total net revenue in the second quarter of 2003 primarily due to increased revenue from our European edition of our RealOne digital media
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subscription service launched in June 2002, as well as from revenue from European mobile infrastructure providers. Revenue generated in Europe was 16% of total net revenue for the quarter ended June 30, 2003, compared to 12% for the quarter ended June 30, 2002, and revenue generated in Asia and the rest of the world was 11% of total net revenue for the quarter ended June 30, 2003, compared to 13% for the quarter ended June 30, 2002. The increase in European revenue as a percentage of total revenue is due to an increase in new systems contracts in that region and the European edition of our RealOne digital media subscription service. The decrease in Asia and the rest of the world revenue as a percentage of total revenue is due to a slower rate of revenue growth in Asia and the rest of the world as compared to the other geographies as discussed above. Revenue generated in Europe was 15% of total net revenue for the six months ended June 30, 2003, compared to 16% for the six months ended June 30, 2002, and revenue generated in Asia and the rest of the world was 12% of total net revenue for the six months ended June 30, 2003, compared to 14% for the six months ended June 30, 2002. At June 30, 2003, accounts receivable due from international customers represented approximately 30% of trade accounts receivable. The functional currency of our foreign subsidiaries is the local currency of the country in which the subsidiary operates. Results of operations of our foreign subsidiaries are translated from local currency into U.S. dollars based on average monthly exchange rates. We currently do not hedge the majority of our foreign currency exposures and therefore are subject to the risk of changes in exchange rates. We currently manage a portion of our foreign currency exposures through the use of foreign currency exchange forward contracts and therefore are still subject to some risk of changes in exchange rates. Our foreign currency exchange risk management program reduces, but does not eliminate, the impact of currency exchange rate movements. The costs of both domestic and international revenue are substantially the same.
DEFERRED REVENUE
Deferred revenue is comprised of the unrecognized revenue related to support contracts, prepayments under OEM arrangements, unearned subscription services and other prepayments for which the earnings process has not been completed. Revenue from contracts with customers developing content delivery networks is generally recognized over the term of the arrangement commencing upon the customer’s deployment of our technology in their network. Because many of the agreements related to content delivery networks have been with companies that have had limited operating histories, we have historically required prepayments from such customers to mitigate our credit risk. Cash prepayments associated with these contracts are recorded as deferred revenue and amounted to $16.4 million and $24.0 million at June 30, 2003 and December 31, 2002, respectively. The decrease in deferred revenue related to these contracts during the quarter and six months ended June 30, 2003 is primarily due to prepayments received under contracts occurring at a slower rate than recognition of revenue on existing contracts. We believe the decrease has been largely due to the decrease in new systems contracts in recent periods, which represent a significant portion of deferred revenue. We believe the decrease in new systems contracts results primarily from the conditions described in “Revenue — Software License Fees” above.
COST OF REVENUE
Cost of Software License Fees. Cost of software license fees includes costs of product media, duplication, manuals, packaging materials, amounts paid for licensed technology, fees paid to third-party vendors for order fulfillment and royalties paid on sales of games and other third-party products. Cost of software license fees was $2.2 million for the quarter ended June 30, 2003, an increase of 40% from $1.6 million for the quarter ended June 30, 2002, and increased as a percentage of software license fees to 13% for the quarter ended June 30, 2003 from 9% for the quarter ended June 30, 2002. The increases were due primarily to costs of revenue related to custom development work and an increase in royalties resulting from a shift in product mix towards products with higher royalty related costs. Cost of software license fees was $3.6 million for the six months ended June 30, 2003, a decrease of 7% from $3.8 million for the six months ended June 30, 2002, but increased as a percentage of software license fees to 11% for the six months ended June 30, 2003 from 9% for the six months ended June 30, 2002. The decrease in costs was due primarily to lower sales volumes. Lower sales volumes resulted in lower royalties, packaging and shipping costs, partially offset by costs of revenue related to custom development work and a shift in product mix towards products with higher royalty related costs.
Cost of Service Revenue. Cost of service revenue includes the cost of content included in our digital media subscription service offerings, cost of in-house and contract personnel providing support and consulting services and expenses incurred in providing our streaming media hosting services. Cost of service revenue was $12.1 million for the quarter ended June 30, 2003, an increase of 35% from $9.0 million for the quarter ended June 30, 2002, and increased as a percentage of service revenue to 39% for the quarter ended June 30, 2003 from 36% for the quarter ended June 30, 2002. Cost of service revenue was $24.2 million for the six months ended June 30, 2003, an increase of 33% from
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$18.3 million for the six months ended June 30, 2002, and increased as a percentage of service revenue to 40% for the six months ended June 30, 2003 from 39% for the six months ended June 30, 2002. The increase in costs was primarily due to costs associated with content included in our digital media subscription services, which has fixed and variable components. The content costs increased due to an increase in paying subscribers and the costs of adding new content to our services. The increase in cost of service revenue as a percentage of service revenue was due to higher fixed content costs for certain contracts.
Our digital media subscription services are a relatively new and growing portion of our business and, to date, have been characterized by relatively higher costs of revenue than our other products and services, primarily due to the cost of licensing media content to provide these services. As a result, if this portion of our business continues to grow as a percentage of revenue, we anticipate that our cost of service revenue may grow at an increased rate relative to net revenue and thereby may lead to reductions in our gross margins in the future. In addition, we anticipate that our cost of service revenue as a percentage of service revenue will fluctuate on a quarter to quarter basis due to seasonal characteristics of certain popular subscription content and as we periodically enter into new agreements for subscription content.
Cost of Advertising. Cost of advertising includes the cost of personnel associated with maintenance of programming services, content creation and maintenance and advertising delivery services. Cost of advertising was $0.5 million for the quarter ended June 30, 2003, an increase of 39% from $0.4 million for the quarter ended June 30, 2002, and increased as a percentage of advertising revenue to 35% for the quarter ended June 30, 2003 from 25% for the quarter ended June 30, 2002. The increase was due primarily to higher advertising delivery costs. Cost of advertising was $0.9 million for the six months ended June 30, 2003, a decrease of 19% from $1.1 million for the six months ended June 30, 2002, and decreased as a percentage of advertising revenues to 32% for the six months ended June 30, 2003 from 36% for the six months ended June 30, 2002. The decrease in costs was primarily due to lower sales volumes and shifting programming personnel to other areas of our business. The decrease in cost of advertising as a percentage of advertising revenue was due to fixed expenses decreasing at a faster rate than the decrease in revenue.
OPERATING EXPENSES
Research and Development. Research and development expenses consist primarily of salaries and related personnel costs, consulting fees associated with product development and costs of technology acquired from third parties to incorporate into products currently under development. To date, all research and development costs have been expensed as incurred because technological feasibility for software products is generally not established until substantially all development is complete. Research and development expenses, excluding non-cash stock-based compensation, were $12.3 million for the quarter ended June 30, 2003, a decrease of 4% from $12.8 million for the quarter ended June 30, 2002, and decreased as a percentage of total net revenue to 25% for the quarter ended June 30, 2003 from 29% for the quarter ended June 30, 2002. The decrease in expenses was due primarily to lower salary expense resulting from a reduction in personnel and related costs in the third quarter of 2002 as part of an overall plan to control costs, partially offset by an increase in expenses for contract labor. Research and development expenses, excluding non-cash stock-based compensation, were $23.7 million for the six months ended June 30, 2003, a decrease of 4% from $24.6 million for the six months ended June 30, 2002, and decreased as a percentage of total net revenue to 25% for the six months ended June 30, 2003 from 27% for the six months ended June 30, 2002. The decrease in expenses was primarily due to a reduction in personnel and related costs in the third quarter of 2002 as part of an overall plan to control costs, partially offset by an increase in expenses for contract labor. The decreases in percentage terms for the quarter and year to date were primarily the result of expenses decreasing while net revenue increased.
Sales and Marketing. Sales and marketing expenses consist primarily of salaries and related personnel costs, sales commissions, credit card fees, subscriber acquisition costs, consulting fees, trade show expenses, advertising costs and costs of marketing collateral. Sales and marketing expenses were $18.8 million for the quarter ended June 30, 2003, a decrease of 1% from $19.0 million for the quarter ended June 30, 2002, and decreased as a percentage of total net revenue to 38% for the quarter ended June 30, 2003 from 43% for the quarter ended June 30, 2002. Sales and marketing expenses were $36.6 million for the six months ended June 30, 2003, a decrease of less than 1% from $36.7 million for the six months ended June 30, 2002, and decreased as a percentage of total net revenue to 38% for the six months ended June 30, 2003 from 40% for the six months ended June 30, 2002. The decrease in expenses was primarily due to lower salary expense resulting from a reduction in personnel and contract labor as part of our third quarter 2002 personnel reduction. This decrease was offset by an increase in advertising and marketing activities, promotional activities, and subscriber referral fees. Subscriber referral fees increased due to an increase in the number of content partners that refer new subscribers to us via their Web sites and a corresponding increase in related payments to such partners. The decreases as a percentage of total net revenue resulted primarily from our sales and marketing expenses decreasing while our net revenue increased.
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General and Administrative. General and administrative expenses consist primarily of salaries, related personnel costs, and fees for professional and temporary services. General and administrative expenses were $5.9 million for the quarter ended June 30, 2003, an increase of 6% from $5.5 million for the quarter ended June 30, 2002, and decreased as a percentage of total net revenue to 12% for the quarter ended June 30, 2003 from 13% for the quarter ended June 30, 2002. The increase in expense was primarily due to litigation defense costs and litigation settlement costs. The decrease in percentage terms was due to expenses increasing at a lower rate than the increase in net revenue. General and administrative expenses were $11.4 million for the six months ended June 30, 2003, an increase of 14% from $10.0 million for the six months ended June 30, 2002, and increased as a percentage of total net revenue to 12% for the six months ended June 30, 2003 from 11% for the six months ended June 30, 2002. The increase in expenses was primarily due to increased patent filing fees, litigation defense costs and litigation settlement costs.
Stock-Based Compensation. Stock-based compensation which pertains to research and development personnel was $0.2 million for the quarter ended June 30, 2003, a decrease of 48% from $0.4 million for the quarter ended June 30, 2002 and decreased as a percentage of total net revenue to less than 1% for the quarter ended June 30, 2003 from 1% for the quarter ended June 30, 2002. The decrease in expense was related to the use of accelerated amortization in earlier periods. Stock-based compensation was $0.5 million for the six months ended June 30, 2003 and 2002, and remained unchanged as a percentage of total net revenue at 1% for the six months ended June 30, 2003 and 2002.
OTHER INCOME (EXPENSE), NET
Other income (expense), net consists primarily of interest earnings on our cash, cash equivalents and short-term investments, equity in net loss of MusicNet, Inc. (MusicNet) and impairment of certain equity investments. For the quarter and six months ended June 30, 2003, interest income declined from the comparable period in 2002. The decrease was primarily due to lower effective interest rates and lower average investment balances. Lower average investment balances were primarily the result of cash used in operations and investing activities such as the purchase of short-term investments.
We have made minority equity investments for business and strategic purposes through the purchase of voting capital stock of companies. Our investments in publicly traded companies are accounted for as available-for-sale, carried at current market value and are classified as long-term as they are strategic in nature. We periodically evaluate whether declines in fair value, if any, of our investments are other-than-temporary. This evaluation consists of a review of qualitative and quantitative factors. For investments with publicly quoted market prices, these factors include the time period and extent for which the quoted market price is less than its accounting basis. We also consider other factors to determine whether declines in fair value are other-than-temporary, such as the investee’s financial condition, results of operations and operating trends. The evaluation also considers publicly available information regarding the investee companies. For investments in private companies with no quoted market price, we consider similar qualitative and quantitative factors and also consider the implied value from any recent rounds of financing completed by the investee. During 2002, certain of the Company’s investments were written down to fair value based upon the Company’s analysis that the declines in fair value were other-than-temporary, resulting in an impairment charge of $704,000 for the quarter and six months ended June 30, 2002. Based upon an evaluation of the facts and circumstances during the quarter and six months ended June 30, 2003, we determined that there were no other-than-temporary declines in value for the quarter ended June 30, 2003. Impairment charges for other-than-temporary declines in fair value of investments for the six months ended June 30, 2003 were $0.4 million.
As of June 30, 2003, we owned marketable equity securities of a Japanese company, representing approximately 14% of the investee’s outstanding shares, accounted for as available-for-sale securities. The market value of these shares has increased from our original cost, resulting in a carrying value at June 30, 2003 of $19.7 million. The increase over our cost basis, net of tax effects, is reflected as a component of accumulated other comprehensive income. The market for shares of this company is relatively limited, the share price is volatile and the investment is strategic in nature. Accordingly, there can be no assurance that a gain of this magnitude, or any gain, can be realized through the disposition of these shares.
Our investment in MusicNet, a joint venture with several media companies to create a platform for online music subscription services, is accounted for under the equity method of accounting. As a result, we recorded in our statement of operations our equity share of MusicNet’s net loss which resulted in a loss of $1.4 million and $3.1 million for the quarter and six months ended June 30, 2003, respectively, and $1.3 million and $3.5 million for the comparable periods in 2002. We own common and preferred stock in MusicNet and also own convertible notes, convertible into additional shares of MusicNet preferred stock. In April 2003, we and the other investors in MusicNet contributed additional capital to MusicNet to fund its business. We contributed $3.0 million and received additional convertible notes for this investment. We anticipate that MusicNet will continue to incur losses in the foreseeable future and will
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require additional funding to support the development of its business model. Based on the nature and terms of the convertible notes, for the quarter and six months ended June 30, 2003, for purposes of calculating our equity in net loss of MusicNet, the convertible notes were treated on an “as if” converted basis. As a result, the losses recorded by us for the quarter and six months ended June 30, 2003, represent approximately 36.9% of MusicNet’s loss. As of June 30, 2003, our ownership interest in outstanding shares of capital stock of MusicNet was approximately 25.5% and the carrying value for our investment was $8.8 million. In the quarter and six months ended June 30, 2003, we recognized approximately $0.3 million and $0.6 million, respectively, of revenue related to license and services agreements with MusicNet.
INCOME TAXES
For the quarter and six months ended June 30, 2003, we recorded an income tax expense of $82,000 and $160,000, primarily related to foreign income taxes. We did not recognize a deferred tax benefit for the loss during the quarter and six months ended June 30, 2003. For the quarter and six months ended June 30, 2002, we recorded income tax benefits of $1.1 million and $2,000, respectively.
We must assess the likelihood that our deferred tax assets will be recovered from future taxable income. In making this assessment, all available evidence must be considered including the current economic climate, our expectations of future taxable income and our ability to project such income and the appreciation of our investments and other assets. Because of unfavorable economic conditions and uncertainty, net losses, and declines in the value of our investments, we determined that it was appropriate to increase our valuation allowance for our net deferred tax assets which resulted in not recognizing the potential future benefits of our current operating losses.
RECENTLY ISSUED ACCOUNTING STANDARDS
In November 2002, the EITF reached a consensus on Issue No. 00-21, “Revenue Arrangements With Multiple Deliverables” (EITF 00-21). EITF 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which the vendor will perform multiple revenue generating activities. EITF 00-21 became effective for periods beginning after June 15, 2003. We do not expect the adoption of EITF 00-21 to have a material effect on our financial position or results of operations.
In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51” (FIN 46). FIN 46 addresses the consolidation by business enterprises of variable interest entities as defined in FIN 46. FIN 46 applies immediately to variable interests in variable interest entities created after January 31, 2003, and to variable interests in variable interest entities obtained after January 31, 2003. For public enterprises with a variable interest in a variable interest entity created before February 1, 2003, FIN 46 applies to that enterprise no later than the beginning of the first interim or annual reporting period beginning after June 15, 2003. FIN 46 requires certain disclosures in financial statements issued after January 31, 2003 if it is reasonably possible that we will consolidate or disclose information about variable interest entities when FIN 46 becomes effective. The application of FIN 46 is not expected to have a material effect on our financial statements.
In April 2003, the FASB issued Statements of Financial Accounting Standards No. 149 (SFAS 149), “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under FASB Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities.” SFAS 149 is generally effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. We do not expect the adoption of SFAS 149 to have a material effect on our financial position or results of operations.
In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150 (SFAS 150), “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. SFAS 150 is to be implemented by reporting the cumulative effect of a change in an accounting principle for financial instruments created before the issuance date of the statement and still existing at the beginning of the interim period of adoption. We do not expect the adoption of SFAS 150 to have a material effect on our financial position or results of operations.
LIQUIDITY AND CAPITAL RESOURCES
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Net cash used in operating activities was $7.4 million for the six months ended June 30, 2003 and net cash used in operating activities was $3.0 million for the six months ended June 30, 2002. Net cash used in operating activities for the six months ended June 30, 2003 resulted primarily from the net loss of $12.5 million and a decrease in deferred revenue of $9.8 million, partially offset by non-cash depreciation and amortization expense of $5.4 million, equity in net losses of MusicNet of $3.1 million, and accrued loss on excess office facilities of $5.2 million. Net cash used in operating activities for the six months ended June 30, 2002 resulted primarily from net loss of $507,000 and decreases in deferred revenue of $5.8 million and accrued and other liabilities of $2.3 million, partially offset by non-cash depreciation expense of $5.9 million and equity in net losses of equity method investees of $3.8 million.
Net cash provided by investing activities was $79.8 million and $4.4 million for the six months ended June 30, 2003 and 2002, respectively. Net cash provided by investing activities for the six months ended June 30, 2003 resulted primarily from the sales and maturities of short-term investments partially offset by purchases of short-term investments, long-term investments, and equipment and leasehold improvements. Net cash provided by investing activities for the six months ended June 30, 2002 resulted primarily from sales and maturities of short-term investments and proceeds from the sales of other investments, partially offset by purchases of short-term investments, equipment, leasehold improvements and cash used for acquisitions.
Net cash provided by financing activities was $104.0 million for the six months ended June 30, 2003 and net cash used in financing activities was $3.2 million for the six months ended June 30, 2002. Net cash provided by financing activities for the six months ended June 30, 2003 resulted primarily from proceeds from our convertible debt offering. Net cash used in financing activities for the six months ended June 30, 2002 resulted from our repurchase of approximately $9.5 million of our common stock, partially offset by exercises of employee stock options.
In September 2001, we announced a share repurchase program. Our Board of Directors authorized the repurchase of up to an aggregate of $50 million of our outstanding common stock. Any purchases of common stock under our share repurchase program will be made from time-to-time, in the open market, through block trades or otherwise. Depending on market conditions and other factors, these purchases may be commenced or suspended at any time without prior notice. During the six months ended June 30, 2003, we did not repurchase any shares of our common stock.
We currently intend to continue our share repurchase program into 2003 until we reach the $50 million limit authorized by our Board of Directors, which will be a further use of cash. In 2003, we anticipate that we will have to make capital expenditures to purchase equipment in the ordinary course of our business. In the future, we may seek to raise additional funds through public or private equity or debt financing, or through other sources such as credit facilities. The sale of additional equity securities could result in dilution to our shareholders.
On April 21, 2003, we announced that we had entered into a definitive agreement to acquire Listen.Com, Inc. for approximately $36 million in cash and common stock. We closed this transaction on August 4, 2003. Approximately $17.3 million of the consideration was paid in cash and the remainder with 4.1 million shares and options to acquire shares of our common stock. The former common shareholders of Listen.Com also have the right to receive up to an additional $1.5 million on or prior to the one-year anniversary of the consummation of the acquisition if certain conditions are satisfied. As of June 30, 2003, we had also invested approximately $6.2 million in Listen.Com in the form of convertible promissory notes.
During June 2003, we issued $100 million aggregate principal amount of zero coupon convertible subordinated notes due July 1, 2010, pursuant to Rule 144A under the Securities Act of 1933, as amended. The notes are subordinated to any senior debt, and are also effectively subordinated in right of payment to all indebtedness and other liabilities of our subsidiaries. The notes are convertible into shares of our common stock based on an initial effective conversion price of approximately $9.30 if (1) the closing sale price of our common stock exceeds $10.23, subject to certain restrictions, (2) the notes are called for redemption, (3) we make a significant distribution to our shareholders or become a party to a transaction that would result in a change in control, or (4) the trading price of the notes falls below 95% of the value of common stock that the notes are convertible into, subject to certain restrictions; one of which allows us, at our discretion, to issue cash or common stock or a combination thereof upon conversion. On or after July 1, 2008, we have the option to redeem all or a portion of the notes that have not been previously purchased, repurchased or converted, in exchange for cash at 100% of the principal amount of the notes. The purchaser may require that we purchase all or a portion of its notes in cash on July 1, 2008 at 100% of the principal amount of the notes. As a result of this issuance, we received proceeds of $97.3 million, net of estimated offering costs. We expect to pay additional offering costs of approximately $0.3 million in the quarter ended September 30, 2003. The offering costs are being amortized over a 5-year period. The net proceeds of the issuance are intended to be used for general corporate purposes, acquisitions, other strategic transactions including joint ventures, and working capital requirements.
At June 30, 2003, we had $409 million in cash, cash equivalents, short-term investments and restricted cash equivalents. Our principal commitments include office leases, contractual payments due to content and other service providers and convertible debt. We believe that our current cash, cash equivalents, and short-term investments will be
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sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months.
We do not hold derivative financial instruments or equity securities in our short-term investment portfolio. Our cash equivalents and short-term investments consist of high quality securities, as specified in our investment policy guidelines. The policy limits the amount of credit exposure to any one non-U.S. Government or non-U.S. Agency issue or issuer to a maximum of 5% of the total portfolio. These securities are subject to interest rate risk and will decrease in value if interest rates increase. Because we have historically had the ability to hold our fixed income investments until maturity, we would not expect our operating results or cash flows to be significantly affected by a sudden change in market interest rates in our securities portfolio.
We conduct our operations in ten primary functional currencies: the United States dollar, the Japanese yen, the British pound, the Euro, the Mexican peso, the Brazilian real, the Australian dollar, the Hong Kong dollar, the Singapore dollar and the Korean won. Historically, neither fluctuations in foreign exchange rates nor changes in foreign economic conditions have had a significant impact on our financial condition or results of operations. We currently do not hedge all of our foreign currency exposures and are therefore subject to the risk of exchange rate fluctuations. We invoice our international customers primarily in U.S. dollars, except in Japan, Europe, the United Kingdom and Australia, where we invoice our customers primarily in yen, euros, pounds and Australian dollars, respectively. We are exposed to foreign exchange rate fluctuations as the financial results of foreign subsidiaries are translated into U.S. dollars in consolidation and as our foreign currency consumer receipts are converted into U.S. dollars. Our exposure to foreign exchange rate fluctuations also arises from payables and receivables to and from our foreign subsidiaries, vendors and customers. Foreign exchange rate fluctuations did not have a material impact on our financial results in either of the six months ended June 30, 2003 and 2002.
Factors That May Affect Our Business, Future Operating Results and Financial Condition
You should carefully consider the risks described below together with all of the other information included in this quarterly report on Form 10-Q. The risks and uncertainties described below are not the only ones facing our company. If any of the following risks actually occurs, our business, financial condition or operating results could be harmed. In such case, the trading price of our common stock could decline, and investors in our common stock could lose all or part of their investment.
We have a relatively limited operating history, which makes it difficult to evaluate our business.
We were incorporated in February 1994 and have a relatively limited operating history, particularly in our consumer subscription businesses. We have limited financial results on which you can assess our future success. Our prospects must be considered in light of the risks, expenses and difficulties frequently encountered by growing companies in new and rapidly evolving markets, such as the markets for online consumer subscription services and digital media software in which we operate.
To address the risks and uncertainties faced by our business, we must meet many challenges including:
| • establishing and maintaining broad market acceptance of our products and services and converting that acceptance into direct and indirect sources of revenue; |
| • establishing and maintaining our brand name; |
| • timely and successfully developing new products, product features and services and increasing the functionality and features of existing products and services; |
| • developing subscription services products that result in high degrees of consumer satisfaction and high levels of consumer usage; |
| • successfully responding to competition from Microsoft, Yahoo!, Apple and others, including competition from emerging technologies and solutions; and |
| • developing and maintaining strategic relationships to enhance the distribution, features, content and utility of our products and services. |
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Our business strategy may be unsuccessful and we may be unable to address the risks we face in a cost-effective manner, if at all. If we are unable to successfully address these risks our business will be harmed.
We have a history of losses.
We have incurred significant losses since our inception. As of June 30, 2003, we had an accumulated deficit of approximately $271 million. We had net losses for the quarter and six months ended June 30, 2003 and the years ended December 31, 2002, 2001 and 2000, and we may not generate sufficient revenue to be profitable on a quarterly or annual basis in the future. We devote significant resources to developing, enhancing, selling, marketing and obtaining content for our products and services. As a result, we will need to generate significant revenue to be profitable in the future.
Our operating results are likely to fluctuate significantly, which may cause our stock price to fluctuate.
As a result of our relatively brief operating history and the rapidly changing and uncertain nature of the markets in which we compete, our quarterly and annual revenue and operating results are likely to fluctuate from period-to-period, and period-to-period comparisons may not be meaningful. These fluctuations are caused by a number of factors, many of which are beyond our control. In past periods, our operating results have been affected by personnel reductions and related charges, charges relating to losses on excess office facilities, and impairment charges for certain of our equity investments. No assurance can be given that our operating results will not be affected by similar charges in future periods. Our future operating results could fall below the expectations of public market analysts or investors, which would likely significantly reduce the market price of our common stock. Fluctuations in our operating results will likely increase the volatility of our stock price.
Our research and development and sales and marketing efforts, and other business expenditures generally, are partially based on predictions regarding certain developments for media delivery and digital media distribution and on the consumption of online consumer subscription services. To the extent that these predictions prove inaccurate, our revenue may not be sufficient to offset these expenditures, and our operating results may be harmed.
Our revenue may be harmed if general economic conditions do not improve.
In recent periods, general adverse economic conditions have caused many customers and prospective customers of our media delivery system software to experience financial difficulties. As a result, some of these companies have ceased or consolidated operations, some are continuing to experience financial difficulty and sales cycles for many of our customers and potential customers have become longer and less predictable than in the past. In addition, certain customers have attempted to refuse to pay us under existing contracts and other customers have adopted the media delivery products of our primary competitor because it bundles its competing media delivery products with its operating system for no additional charge. The macroeconomic environment and Microsoft’s bundling practices have also impacted sales to, and the rate of adoption of our systems software products by, consumers, customers in the corporate enterprise, broadcast hosting, Internet content provider, non-PC device manufacturer, systems software, telecommunication and original equipment manufacturer markets. No assurance can be given when, or if, customers in these markets will increase capital spending levels. In the event that a substantial number of our current or potential customers experience financial difficulties in the future, the rate of adoption of our products may be slowed, our ability to increase or maintain sales to such customers will be adversely affected and our ability to generate revenue from these companies will also be adversely impacted. Further, if U.S. or global economic conditions worsen, our business, operating results, and financial condition could be harmed.
Our consumer subscription services are a new business model for us and we believe these services represent a discretionary spending item for many consumers. Accordingly, the development of these services could be negatively impacted by a general decline in consumer spending levels or other changes in consumer habits caused by macroeconomic conditions, which would harm our business and our business prospects.
Our acquisition of Listen.Com may not be successful.
On April 21, 2003, we announced that we entered into a definitive agreement to acquire Listen.Com and on August 4, 2003 we closed the transaction.
The acquisition may not be successful and will not achieve its anticipated benefits unless we successfully integrate Listen.Com’s operations with those of RealNetworks in a timely manner. Prior to the acquisition, RealNetworks and Listen.Com operated independently, each with its own business, business culture, markets, customers, employees and systems.
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Integrating the operations associated with Listen.Com will be a complex, time-consuming and expensive process that may result in revenue disruption, loss of key employees, customer uncertainty, and other operational difficulties if not completed in a timely and efficient manner. The operations associated with Listen.Com will remain in San Francisco after the closing. This will be our first experience operating and integrating a substantial acquired business in a remote location. The geographic separation could increase the operational risks described below under the caption “Potential acquisitions involve risks that we may not adequately address”. If we are not successful in addressing these risks or any other problems encountered in connection with the acquisition, our business could be harmed.
Anticipated losses from our Listen.Com acquisition may harm our business.
Following the closing of our acquisition of Listen.Com, we expect the operations associated with Listen.Com to incur operating losses of approximately $2.0 million per quarter in 2003, and to decrease thereafter. Our expectation regarding the initial operating losses, and their decrease over time, is subject to risk and uncertainty. The operating losses could adversely affect our ability to achieve profitability in any given fiscal period, which could result in a decrease in our stock price. If the operating losses continue longer than we expect, or are greater than we expect, such losses could harm our financial position, reported operating results or stock price. Our estimate of the operating losses we are likely to incur is based on Listen.Com’s past performance and anticipated future performance. Factors that might contribute to the operating losses continuing longer than we expect, or being greater than we expect, include Listen.Com’s ability to renew existing music licenses with the major music labels on commercially reasonable terms, or at all, rates of subscriber retention, price pressure from competitors, the development of the market for online music subscription services, and others factors described under the caption “Our online music services initiatives may not be successful, including our acquisition of Listen.Com”.
There are a number of risks associated with our recently announced Helix initiative.
In July 2002, we announced the introduction of Helix, a combination of technology and a new licensing model designed to create an open, comprehensive platform and development community to enable the creation of digital media products and applications for multiple formats, operating systems and devices. Under the new licensing model, Helix community members can access, use and modify RealNetworks source code. This enables a large group of developers to extend the Helix technology to other platforms, fix software bugs and create their own applications using the Helix platform.
Because these initiatives and products were introduced so recently, there are a number of risks associated with them, including risks associated with open source and community source technology licensing, development and business models and the risks typically associated with the introduction of new products and technologies. There can be no assurance that the industry will adopt the Helix Platform or the Helix Community, or that third parties will develop and introduce technologies or products based on them. Further, there can be no assurance that new or existing customers will license the Helix Universal Server. While we have invested substantial resources in the development of these initiatives and products, there can be no assurance that they will be accepted by the market, that we will derive substantial revenue from such initiatives and products or that the introduction of Helix and the Helix Universal Server will not adversely affect our sales.
Our subscription services may not be successful.
Members of one of our RealOne subscription services gain access to premium subscription content and are able to take advantage of certain enhanced features of the RealOne Player. These subscription services are a relatively new business model for delivering media over the Internet and represent a new and rapidly evolving business model for us. It is too early to predict whether consumers will accept in significant numbers our subscription services or whether the services will otherwise be financially viable. To date, costs of our subscription services as a percentage of subscription services revenue are significantly higher than such costs represented in our business historically, and we expect this trend will continue to negatively impact our overall gross margins as we grow our consumer subscription business and it becomes a larger portion of our overall revenue. Our subscription services compete with both traditional and online entertainment service providers although, to date, we have not faced significant direct competition with our subscription service offerings. We anticipate that we will face increasing competition for online subscription service revenue from a wide range of companies, including AOL Time Warner, Microsoft and Yahoo!, which has recently launched a subscription service that competes with the offerings of certain of our subscription services, and from broadband Internet service providers. In addition, Apple’s recently released iTunes digital music store provides additional competition for our music offerings. Many of our competitors have significantly more resources than us, including access to content, and some of our competitors may be able to leverage their experience in providing subscription or similar services to customers in other businesses to the sale of digital media subscriptions.
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We must continue to obtain premium digital content in order to maintain and increase subscriptions and subscription service revenue and overall customer satisfaction. It is too early to predict whether our subscription business will require highly popular content to increase or maintain subscriptions, and, if so, whether we will be able to obtain such content on a consistent basis, or on commercially acceptable terms. To date, a limited amount of premium digital content has been made available for delivery over the Internet that can only be accessed through a for-pay service and not for free. If we are unable to obtain premium digital content on commercially reasonable terms, or at all, or if we do not successfully market our subscription services to our end users and other potential subscribers, our business could be harmed. In addition, if the adoption of broadband services is slower than anticipated it may impact the desirability of our services as users encounter content over slower connections, which degrade the quality of the user experience. In the future, increased competition for subscription services may make it more difficult to secure content licenses under reasonable terms.
If we do not continue to add subscribers to our subscription services or if we experience excessive rates of subscriber churn, our revenue and business will be harmed.
Our subscription services have become an increasingly important source of our total revenue. We believe the subscription business represents a major growth opportunity for us and also creates substantial risks. Subscribers may cancel their subscriptions to our subscription services for many reasons, including a perception that they do not use the subscription services sufficiently or that the service does not provide enough value, a lack of attractive or exclusive content generally or as compared to competitive service offerings, or because customer service issues are not satisfactorily resolved. In order to increase our number of subscribers and subscription revenue, we must continue to add new subscribers each quarter while minimizing the rate of loss of existing subscribers. Because the Internet subscription content business is a relatively new media delivery model and a relatively new business for us, we cannot predict with accuracy our long-term ability to retain subscribers or add new subscribers. If our marketing and promotional activities fail to add significant numbers of new subscribers or if too many of our subscribers cancel their memberships because they are dissatisfied with the service or otherwise, our revenue and business will suffer. In addition, if the costs of such marketing and promotional activities increase in order to add new subscribers, our margins and operating results will suffer. Our subscription revenue and subscriber base have grown on a percentage basis in the early phases of the development of our subscription business. If our subscription revenue and subscriber base continue to grow, the percentage growth rates we have experienced to date are unlikely to be sustainable.
Many of our subscribers subscribe to our premium subscription service products, some of which are seasonal or periodic in nature, such as our Major League Baseball Advanced Media and CBS Big Brother offerings. We have limited experience with these types of offerings and cannot predict how the seasonal or periodic nature of these offerings or our experimentation with new content offerings will impact our subscriber growth rates, future subscriber retention levels or our quarterly financial results. Accordingly, we anticipate that subscriber levels for our various subscription service offerings will fluctuate as we develop this business and experiment with new types of content offerings. No assurance can be given that subscribers to our seasonal or periodic offerings will renew their subscriptions for future offerings. In addition, no assurance can be given that the gross margins associated with these offerings will be consistent with our historical gross margins or our gross margins for our other subscription products, such as RealOne SuperPass.
Our online music services initiatives, including our acquisition of Listen.Com, may not be successful.
In 2001, we announced the formation of a joint venture called MusicNet with several leading media companies to create a technology platform for online music subscription services. We also entered into an agreement with MusicNet to license the MusicNet platform and service for sale to our own customers. In December 2001, we began offering the RealOne MusicPass subscription service, a for-pay music subscription service based on the MusicNet platform. We recently replaced that offering with an online music subscription service using Listen.Com’s technology and marketed as RealOne RHAPSODY, as discussed further below. The business models, technologies and market for online music subscription services are new and unproven and no assurance can be given that our online music initiatives will be successful. In addition, we record in our statement of operations our equity share in MusicNet’s net income (loss), which was a loss of $1.4 million and $3.1 million for the quarter and six months ended June 30, 2003, respectively. We anticipate that MusicNet will continue to incur losses in the foreseeable future and will need additional funding to support the development of its business model. No assurance can be made that MusicNet will ever contribute net income to our statement of operations or that losses recorded from MusicNet will not increase in the future. MusicNet also is a licensee of our technology and has used our digital music architecture to build its technology platform. If MusicNet is not successful and other online music subscription services do not license our technology, our business and business prospects could be harmed. The Antitrust Division of the U.S. Department of Justice and certain European antitrust regulatory authorities have commenced investigations into music licensing and other business practices related to online music businesses, including the business of MusicNet. If the business of MusicNet is harmed or materially modified as a result of these investigations, our financial results and business prospects could be harmed.
On April 21, 2003, we announced that we entered into a definitive agreement to acquire Listen.Com and on August 4, 2003 we closed the transaction. Prior to the closing of our acquisition of Listen.Com, we began distributing an online music subscription service using
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Listen.Com’s technology and marketed as RealOne RHAPSODY pursuant to an arms-length distribution agreement. We intend to continue offering RealOne’s RHAPSODY as our primary music subscription service offering through our Web sites and distribution channels. However, our ability to provide this music service will be dependent on music licenses from the major music labels. While we have received consent to transfer Listen.Com’s existing music licenses with the major music labels, no assurance can be given that these labels will renew the licenses upon their expiration or that such renewals will be on terms that are commercially viable. The failure of the major music labels to license their music catalogs under terms that are acceptable to us and to consumers will harm our ability to offer successful music subscription services.
Our online music offerings may not be able to successfully compete with other online music services or traditional music distribution channels.
Our music subscription services face competition from traditional offline music distribution competitors and from other new online music services, including pressplay, a joint venture formed between two leading media companies which was recently acquired by Roxio and Apple’s recently announced music service, which has received significant initial media exposure. Competing services may be able to obtain more or better music content or may be able to license such content on more favorable terms than us, which could harm the ability of our music subscription services to compete effectively in the marketplace.
Our music subscription services also face significant competition from “free” peer-to-peer services, such as KaZaA and Morpheus, which allow consumers to directly access an expansive array of free content without securing licenses from content providers. Although several of these “free” services have been found to be illegally violating copyright laws, enforcement efforts to date have not effectively shut down these services, and there can be no assurance that these services will ever be shut down. The ongoing presence of these “free” services, even if they are subsequently found to be illegal, substantially impairs the marketability of legitimate services like ours.
We may be unable to successfully compete with Microsoft and other companies in the media delivery market.
The market for software and services for media delivery over the Internet is relatively new, constantly changing and intensely and increasingly competitive. As media delivery evolves into a central component of the Internet experience, more companies are entering the market for, and expending increasing resources to develop, media delivery software and services. We expect that competition will continue to intensify. Increased competition could hurt our business and the trading price of our stock. Increased competition may also result in price reductions, reduced margins, loss of customers, and a change in our business and marketing strategies, any of which could harm our business.
Many of our current and potential competitors have longer operating histories, greater name recognition, more employees and significantly greater financial, technical, marketing, public relations and distribution resources than we do. In addition, new competitors with potentially unique or more desirable products or services are entering the market all the time. The competitive environment may require us to make changes in our products, pricing, licensing, services or marketing to maintain and extend our current brand and technology franchise. Price concessions or the emergence of other pricing, licensing and distribution strategies or technology solutions of competitors may reduce our revenue, margins or market share, any of which will harm our business. Other changes we have to make in response to competition could cause us to expend significant financial and other resources, disrupt our operations, strain relationships with partners, or release products and enhancements before they are thoroughly tested, any of which could harm our operating results and stock price.
Microsoft is a principal competitor in the development and distribution of digital media and media distribution technology. Microsoft currently competes with us in the market for digital media servers, players, encoders, digital rights management, codecs and other technology and services related to digital distribution of media. Microsoft’s commitment to and presence in the media delivery industry has increased. Microsoft recently announced the settlement of antitrust litigation with AOL Time Warner in which Microsoft reportedly paid AOL Time Warner $750 million and the two companies agreed to collaborate on long-term digital media initiatives, an announcement which may or may not have a substantive business impact. We expect that Microsoft will continue to increase competitive pressure in the overall market for digital media and media distribution.
Microsoft distributes its competing streaming media server, player, tools and digital rights management products by bundling them with its Windows operating systems and servers at no additional cost or otherwise making them available free of charge. Microsoft’s practices have caused, and may continue to cause, pricing pressure on our revenue generating products and services and affect usage of our competing products and formats. Microsoft’s practices have led in some cases, and could continue to lead to, longer sales cycles, decreased sales, loss of existing and potential
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customers and reduced market share. In addition, we believe that Microsoft has used and may continue to use its monopoly position in the computer industry and its financial resources to secure preferential or exclusive distribution, use and bundling contracts for its media delivery technologies and products with third parties, such as ISPs, content delivery networks, content providers, entertainment and media companies, VARs and OEMs, including third parties with whom we have relationships. Microsoft has also invested significant money in, has provided substantial financial incentives to, or offered or conditioned placement on or through the Windows operating system, the Internet Explorer Web browser and Microsoft’s MSN service to, certain of our current and potential customers and content suppliers. We expect this trend to continue, which may cause those customers to stop using or reduce their use of our products and services and which may cause those content suppliers to withhold desirable media content from us or end users of our products and services. Such arrangements, together with Microsoft’s aggressive marketing of its Windows operating systems, server products and digital media products, may reduce our share of the streaming media and digital distribution markets. While courts have ruled that several of Microsoft’s practices violated relevant laws related to illegal maintenance of monopoly power, court remedies to date have had only a minor impact. There can be no assurance that there will be future court remedies against Microsoft’s illegal actions, or if there are any such future remedies, there can be no assurance that these remedies will be effective in curtailing these activities.
Microsoft’s Windows Media Player competes with our media player products. Certain versions of the Windows Media Player are available for download from Microsoft’s Web site for free, and the Windows Media Player is bundled with Microsoft’s Windows XP operating system and the Windows 98, Windows 2000 and Windows ME operating systems, the Internet Explorer Web browser, and Microsoft’s MSN service. Windows XP, a significant focus of which is digital media delivery, gives very prominent and persistent placement to Microsoft’s Windows Media Player, Windows Media Guide, music services, and other media delivery services in the operating system and on the end user’s desktop. In some cases, the Windows Media Player may override default playback settings set by end users or by our software. New versions of Internet Explorer and MSN Explorer also prominently feature and promote Windows Media. We expect that by leveraging its monopoly position in operating systems and tying streaming or digital media into its operating systems and its Web browser, Microsoft will distribute substantially more copies of the Windows Media Player in the future than it has in the past and may be able to attract more users and content providers to use its streaming or digital media products. In addition, Microsoft does not document or expose all of the interfaces that would allow our products to take full advantage of the features and functionality of Windows XP that it makes available to the Windows Media Player. In light of Microsoft’s efforts and dominant position in operating systems, our market position may be difficult to sustain. The ubiquitous distribution of Windows Media Player with Microsoft’s Windows operating systems may make it less likely that Internet content providers would use our technology. We may have to use additional resources, personnel and capital to effectively counter Microsoft’s competitive tactics and use of its operating system monopoly.
Microsoft’s Windows Media Player also competes with the personal music management features of the RealOne Player. Microsoft has made strategic investments in other digital distribution technologies that compete with RealJukebox and with the RealOne Player. The Windows Media Player supports the Windows Media format, but not our media formats. Microsoft also licenses various Windows Media Technology applications, a platform for authoring, delivering and playing digital media intended to compete with our system software products, and supports and promotes other third party products competitive to our products. In addition, Microsoft provides servers that support Windows Media Technologies at no additional cost to customers who purchase its Windows servers, whereas we offer versions of our competitive servers for sale. Microsoft bundles its Windows Media Server product with its server operating systems. In some cases, Microsoft has conditioned use of the Windows Media Digital Rights Management and security technologies supported by Windows XP to support for Windows Media formats and use of Windows Media Player and servers.
We compete with Microsoft, Sony Corporation and others in the market for digital rights management technologies. Sony’s acquisition of digital rights management patents from Intertrust in conjunction with Philips Electronics indicates that Sony may increase its focus on competing with us in the market for digital rights management technology. We expect Microsoft, Sony and other competitors to devote significantly greater resources to product development in the music management and digital media categories in the future.
Microsoft also competes with us to attract broadcasters and owners of high quality or popular content to promote and deliver such content in Microsoft’s formats, in some cases on an exclusive or preferential basis. While we have rights to play back certain content in Microsoft formats through our player products under a limited set of conditions, we may not secure necessary rights from Microsoft to enable our products to play back all such content or content in Microsoft’s newest formats, or such rights may not be available to us on commercially reasonable terms. Our player products may be disadvantaged if they cannot play content in Windows Media formats or content that is secured by the Windows Media Digital Rights Management technology, or if such content providers do not also make their content available in our media formats using digital rights management systems supported by us. In some cases, we believe Microsoft uses its financial resources and monopoly leverage to obtain rights to such content, and to provide incentives to content providers to prepare their content in Microsoft’s formats. If content providers use Microsoft’s digital media
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technology rather than ours, it may harm our ability to sell subscription services, players and Helix technology. Microsoft’s commitment to and presence in the media delivery industry has increased and we believe that Microsoft will continue to increase competitive pressure in the overall market for streaming media and media distribution.
Microsoft has aggressively marketed and licensed its Windows Media technology to consumer electronics companies, a number of which have built support for Windows Media in their products. If Microsoft is successful in spreading Windows Media technology to non-PC devices — in part through leveraging their operating system monopoly — and we are not, it could harm our business.
In addition to Microsoft, we face competition from other companies that develop and market streaming media products. For example, Apple Computer offers the QuickTime streaming media technology and other technology based on MPEG-4 standards, including a free media player and a free streaming media server, and licenses for free source code to the server under the conditions of Apple’s end user license agreement. Apple also offers competitive music management software and hardware. Apple has recently begun to devote significant resources to developing and marketing digital media products and we expect they will continue to do so to enable them to compete vigorously with us in the marketplace. Apple has also enlisted the open source code development community to assist its development of competitive products. Companies such as AOL Time Warner and Yahoo! and many smaller competitors also offer various products that compete with our player products and content subscription services. In connection with the deployment of our system software in AOL’s Internet service, we also licensed our technology to AOL for use with its own Internet service media player application. Such licensing may impact the number of end users of our player products if AOL users only use AOL applications. As more companies enter the market with products that compete with our servers, players and tools, the competitive landscape could change rapidly to our disadvantage. If our player products and formats do not continue to achieve a high level of consumer adoption and usage, our revenue and business could be harmed.
We may be unable to successfully compete in other parts of our business.
Media Hosting and Delivery.Our media hosting and delivery service, the Real Broadcast Network, competes with a variety of companies that provide streaming media hosting and broadcast services. These companies include Akamai, Yahoo! Broadcast Services and other emerging broadcast networks. Some of these competitors have cost or other advantages over our services and offer other services that the Real Broadcast Network does not offer, such as creating corporate intranet portals or hosting in media formats not supported by the Real Broadcast Network. We may not establish or sustain our competitive position in this market segment. In recent periods, many of the customers of the Real Broadcast Network have either gone out of business or reduced their usage of our media hosting services. Some of our media hosting competitors are also customers on whom we rely to help drive product download traffic to our Web sites through their broadcast events. We also sell servers and tools to companies that compete with the Real Broadcast Network. If our relationship with these companies becomes more competitive, such companies may reduce their level of usage and purchases of our products or services.
Web Site Destinations, Content and Advertising.Our Web sites and the Real.com Network compete for user traffic and Internet advertising revenue with a wide variety of Web sites, Internet portals and ISPs. In particular, aggregators of audio, video and other media, such as Yahoo! Broadcast Services and Microsoft’s Windows Media Guide, compete with us and generate substantially more traffic than we do.
We cannot be certain that advertisers will place advertising with us or that revenue derived from such advertising will be meaningful. Internet advertising revenue across the industry has decreased substantially in recent periods and our advertising revenue has substantially declined during that time. We cannot predict when, or if, advertising revenue will stabilize and it is unlikely that it will return to previous levels. If we lose advertising customers, fail to attract new customers, are forced to reduce advertising rates or otherwise modify our rate structure to retain or attract customers, our business could be harmed. Our business could also be harmed if we lose Web site traffic or if the usage of our player products fails to produce a sufficient amount of advertising inventory.
We may not be successful in the market for downloadable media and personal music management systems.
The market for products that enable the downloading of media and that provide a personal music management system is relatively new and still evolving. We may be unable to develop a revenue model or sufficient demand to take advantage of this market opportunity. We cannot predict whether consumers will adopt the RealOne Player as their primary application to play, record, download and manage their digital music. There are a number of competitive products on the market that offer certain of the music management features currently offered by the RealOne Player. Given the size and importance of the general market for music distribution, competitors will likely release additional products that directly compete with the RealOne Player, which could harm our business. Our competitors may develop
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new features and technology not available in the RealOne Player, including advanced codecs and digital rights management technology, which could harm our business.
The RealOne Player also faces competition from the emergence of widespread peer-to-peer file sharing services and programs such as KaZaA and Morpheus, and a variety of other similar services that allow computer users to connect with each other and to copy many types of program files, including music and other media, from one another’s hard drives. These services allow consumers to directly access an expansive array of content without relying on content providers to make the content available for streaming or digital download, and without relying on products such as the RealOne Player to be able to play, record and store such content. Our inability to achieve widespread acceptance for our digital music architecture or our player products or to create new revenue streams from the new market segments, including digital music content, could harm the prospects for our business.
We must also provide digital rights management solutions and other security mechanisms in order to address concerns of content providers, and we cannot be certain that we can develop, license or acquire such solutions, or that content licensors or consumers will accept them. In addition, consumers may be unwilling to accept the use of digital rights management technologies that limit their use of content, especially with large amounts of free content readily available. In connection with the continued development of our products, particularly with respect to the adaptation of our products on non-PC devices, we may need to license other digital rights management solutions to support our products. No assurance can be given that such solutions will be available to us, or, if they will be available to us at reasonable rates or upon reasonable terms, which could harm the development of our products and our business.
Our industry is experiencing consolidation that may intensify competition.
The Internet and media distribution industries are undergoing substantial change which has resulted in increasing consolidation and a proliferation of strategic transactions. Many companies in these industries have been going out of business or are being acquired by competitors. As a result, we are increasingly competing with larger competitors that have substantially greater resources than we do. We expect this consolidation and strategic partnering to continue. Acquisitions or strategic relationships could harm us in a number of ways. For example:
| • | competitors could acquire or enter into relationships with companies with which we have strategic relationships and discontinue our relationship, resulting in the loss of distribution opportunities for our products and services or the loss of certain enhancements or value-added features to our products and services; | ||
| • | competitors could obtain exclusive access to desirable multimedia content and prevent that content from being available in our formats, thus decreasing the use of our products and services and hurting our ability to attract advertisers to our Web sites and product offerings; | ||
| • | suppliers of important or emerging technologies could be acquired by a competitor or other company which could prevent us from being able to utilize such technologies in our offerings, and disadvantage our offerings relative to those of competitors; | ||
| • | a competitor could be acquired by a party with significant resources and experience that could increase the ability of the competitor to compete with our products and services; and | ||
| • | other companies with related interests could combine to form new, formidable competition, which could preclude us from obtaining access to certain markets or content, or which could dramatically change the market for our products and services. |
Any of these events could put us at a competitive disadvantage which could cause us to lose customers, revenue and market share. They could also force us to expend greater resources to meet new or additional competitive threats, which could also harm our operating results.
We rely on content provided by third parties to increase market acceptance of our products and services.
If third parties do not develop or offer compelling content to be delivered over the Internet, or grant necessary licenses to us or our customers to distribute or perform such content, our business will be harmed and our products and services may not achieve or sustain broad market acceptance. We rely on third-party content providers, such as radio and television stations, record labels, media companies, Web sites and other companies, to develop and offer content in our formats that can be delivered using our server products and played back using our player products. We also rely
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entirely on third-party content for the programming and content offerings that comprise our RealOne and stand-alone subscription services. In some cases, we pay substantial fees to obtain content for these services. In order to provide a compelling subscription service, we must be able to offer unique and in some cases exclusive content and programming to our customers. We face competition in the market for subscription content services from companies such as AOL Time Warner, Microsoft and Yahoo!, who may have greater access to content or the ability to pay substantially higher fees to content providers. We cannot guarantee that third-party content providers will continue to rely on our technology or offer compelling content in our formats, nor can we guarantee that we will be able to secure licenses to their content or that such licenses will be available at commercially reasonable rates, to encourage and sustain broad market acceptance of our products and services. The failure to do so would harm our business and our business prospects.
While we have a number of short-term agreements with third parties to provide content from their Web sites in our formats, most third parties are not obligated to develop or offer content using our technology. In addition, some third parties have entered into and may in the future enter into agreements with our competitors, principally Microsoft, to develop or offer all or a substantial portion of their content in our competitors’ formats and using their digital rights management technology. This may prevent such content from being playable through our products. Microsoft has substantially more resources than us that may enable it to secure preferential and even exclusive relationships with content providers, including preferential placement on or through the Windows Operating System, Internet Explorer or MSN. There could be less demand for and use of our products if Microsoft or another competitor were to secure preferential or exclusive relationships with the leading content providers, Web sites or broadcasters.
Our success also depends on the availability of third-party content, especially music, that current users of our RealJukebox and RealOne Player can lawfully and easily access, record and play back. Our products may not achieve or sustain market acceptance if third parties are unwilling to offer their content for free download, streaming or purchase by users of our player products. Current concerns regarding the secure distribution of music over the Internet, and the difficulties and high costs associated with obtaining necessary or desirable licensing rights, are contributing to the delay or unavailability of music content for distribution.
We may not successfully develop new products and services.
Our growth depends on our ability to continue to develop leading edge media delivery and digital distribution products and services. Our business and operating results would be harmed if we fail to develop products and services that achieve widespread market acceptance or that fail to generate significant revenue or gross profits to offset our development and operating costs. We may not timely and successfully identify, develop and market new product and service opportunities. If we introduce new products and services, they may not attain broad market acceptance or contribute meaningfully to our revenue or profitability. Competitive or technological developments may require us to make substantial, unanticipated investments in new products and technologies, and we may not have sufficient resources to make these investments. If we are unable to be a technological leader in our market our business is likely to be harmed. In addition, with the recent introduction of our Helix initiative, we no longer exercise control over many aspects of the development of the open source technology that comprises our Helix initiative and accordingly, there can be no assurance that the industry will adopt the Helix Platform or the Helix Community, or that third parties will develop and introduce technologies or products based on them.
Because the markets for our products and services are changing rapidly, we must develop new offerings quickly. We have experienced development delays and cost overruns in our development efforts in the past and we may encounter such problems in the future. Delays and cost overruns could affect our ability to respond to technological changes, evolving industry standards, competitive developments or customer requirements. Our products also may contain undetected errors that could cause increased development costs, loss of revenue, adverse publicity, reduced market acceptance of our products or services or lawsuits by customers.
The RealOne Player supports a variety of audio formats, including RealAudio, MP3, Windows Media Audio, Apple QuickTime and MPEG-4. Support for some formats, including Windows Media Audio and Apple QuickTime, requires the user to have additional third party software installed. However, technical formats and consumer preferences evolve very rapidly, and we may be unable to adequately address consumer preferences or fulfill the market demand to the extent it exists. We may be unable to license technologies, like codecs, that obtain widespread consumer and developer use which would harm consumer and developer acceptance of our products and services. In addition, our codecs and formats may not continue to be in demand or as desirable as other third party codecs and formats, including industry standard codecs and formats created by MPEG, become more readily available.
We depend on key personnel who may not continue to work for us.
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Our success substantially depends on the continued employment of certain executive officers and key employees, particularly Robert Glaser, our founder, Chairman of the Board and Chief Executive Officer. The loss of the services of Mr. Glaser or other key executive officers or employees could harm our business. If any of these individuals were to leave RealNetworks, we could face substantial difficulty in hiring qualified successors and could experience a loss in productivity while any such successor obtains the necessary training and experience. A number of our key employees have reached or will soon reach the five-year anniversary of their RealNetworks hiring date and, as a result, will have become or will shortly become fully vested in their initial stock option grants. While most personnel are typically granted additional five-year stock options subsequent to their hire date to provide additional incentive to remain at RealNetworks, the initial option grant is typically the largest and an employee may be more likely to leave our employ upon completion of the vesting period for the initial option grant. We do not maintain “key person” life insurance policies. If we do not succeed in retaining and motivating existing personnel, our business could be harmed.
Our failure to attract, train or retain highly qualified personnel could harm our business.
Our success also depends on our ability to attract, train or retain qualified personnel in all areas, especially those with management and product development skills. In particular, we must hire additional experienced management personnel to help us continue to grow and manage our business, and skilled software engineers to further our research and development efforts. At times, we have experienced difficulties in hiring personnel with the proper training or experience, particularly in technical and media areas. Competition for qualified personnel is intense, particularly in high-technology centers such as the Pacific Northwest, where our corporate headquarters are located. If we do not succeed in attracting new personnel or in retaining and motivating our current personnel, our business could be harmed.
In making employment decisions, particularly in the Internet and high-technology industries, our current employees and prospective job candidates often consider the value of stock options they hold or that they may receive in connection with their employment. As a result of recent volatility in our stock price, we may be disadvantaged in competing with companies that have not experienced similar volatility or that have not yet sold their stock publicly.
Potential acquisitions involve risks we may not adequately address.
As part of our business strategy, we have acquired technologies and businesses in the past, and expect that we will to continue to do so in the future. The failure to adequately address the financial, legal and operational risks raised by acquisitions of technology and businesses could harm our business. Acquisition or business combination transactions are accompanied by a number of significant risks. Financial risks related to acquisitions may harm our financial position, reported operating results or stock price, and include:
| • | potentially dilutive issuances of equity securities; | ||
| • | use of cash resources; | ||
| • | the incurrence of debt and contingent liabilities; | ||
| • | large write-offs and difficulties in assessment of the relative percentages of in-process research and development expense that can be immediately written off as compared to the amount which must be amortized over the appropriate life of the asset; and | ||
| • | amortization expenses related to other intangible assets. |
Acquisitions also involve operational risks that could harm our existing operations or prevent realization of anticipated benefits from an acquisition. These operational risks include:
| • | difficulties in assimilating the operations, products, technology, information systems or personnel of the acquired company; | ||
| • | diversion of management’s attention from other business concerns and the potential disruption of our ongoing business; | ||
| • | the difficulty of incorporating acquired technology or content and rights into our products and services and unanticipated expenses related to such incorporation; | ||
| • | impairment of relationships with our employees, affiliates, advertisers and content providers; |
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| • | inability to maintain uniform standards, controls, procedures and policies; | ||
| • | the assumption of known and unknown liabilities of the acquired company, including intellectual property claims; | ||
| • | entrance into markets in which we have no direct prior experience; and | ||
| • | subsequent loss of key employees of the acquired company. |
On April 21, 2003, we announced that we had entered into a definitive agreement to acquire Listen.Com and on August 4, 2003 we closed the transaction. The acquisition may not be successful and is subject to the operational risks set forth above, in addition to the risks discussed above under the caption “Our acquisition of Listen.Com may not be successful”.
We may not be successful in making strategic investments.
We have made, and in the future we may continue to make, strategic investments in other companies. These investments have been made, and future investments will likely be made, in immature businesses with unproven track records and technologies. Such investments have a high degree of risk, with the possibility that we may lose the total amount of our investment. We have in the past recorded significant charges from reductions in the value of our strategic investments. We may have similar charges in the future. We may not be able to identify suitable investment candidates, and, even if we do, we may not be able to make those investments on acceptable terms. In addition, even if we make investments, we may not gain strategic benefits from those investments.
The growth of our business depends on the increased use of the Internet for communications, electronic commerce and advertising.
The growth of our business depends on the continued growth of the Internet as a medium for media consumption, communications, electronic commerce and advertising. Our business will be harmed if Internet usage does not continue to grow, particularly as a source of media information and entertainment and as a vehicle for commerce in goods and services. Our success also depends on the efforts of third parties to develop the infrastructure and complementary products and services necessary to maintain and expand the Internet as a viable commercial medium. We believe that other Internet-related issues, such as security, privacy, reliability, cost, speed, ease of use and access, quality of service and necessary increases in bandwidth availability, remain largely unresolved and may affect the amount and type of business that is conducted over the Internet, and may impact our ability to sell our products and services and ultimately impact our business results and prospects.
If Internet usage grows, the Internet infrastructure may not be able to support the demands placed on it by such growth, specifically the demands of delivering high-quality media content. As a result, its performance and reliability may decline. In addition, Web sites have experienced interruptions in service as a result of outages, system attacks and other delays occurring throughout the Internet network infrastructure. If these outages, attacks or delays occur frequently or on a broad scale in the future, Internet usage, as well as the usage of our products, services and Web sites, could grow more slowly or decline.
Rate of adoption of broadband technologies poses risks to our business.
We believe that increased Internet use and especially the increased use of media over the Internet may depend on the availability of greater bandwidth or data transmission speeds (also known as broadband transmission). If broadband technologies do not become widely available or widely adopted, our products and services, particularly our subscription services, may not achieve broad market acceptance and our business and prospects could be harmed. To date, we believe that broadband technologies have been adopted at a slower rate than expected, which we believe has slowed the level of use of media over the Internet and may harm our business and prospects if the rate of adoption does not increase.
Changes in network infrastructure, transmission methods and broadband technologies pose risks to our business.
If broadband access becomes widely available, we believe it presents both a substantial opportunity and a significant business challenge for us. Internet access through cable television set-top boxes, digital subscriber lines or wireless connections could dramatically reduce the demand for our products and services by utilizing alternate technology that more efficiently transmits data and media. This could harm our business as currently conducted.
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Also, our products and services may not achieve market acceptance or generate sufficient revenue to offset our costs of developing products and services compatible with broadband transmission formats and infrastructure. Development of products and services for a broadband transmission infrastructure involves a number of additional risks, including:
| • | changes in content delivery methods and protocols; | ||
| • | the emergence of new competitors, such as traditional broadcast and cable television companies, which have significant control over access to content, substantial resources and established relationships with media providers; | ||
| • | the development by our current competitors, particularly Microsoft, Yahoo! and AOL Time Warner, of relationships with, or ownership interests in, companies that have significant access to or control over the broadband transmission infrastructure or content; and | ||
| • | the need to establish new relationships with non-PC based providers of broadband access, such as providers of television set-top boxes and cable television, some of which may compete with us. |
More individuals are utilizing non-PC devices to access the Internet and we may not be successful in developing versions of our products and services that will gain widespread adoption by users of such devices.
In the coming years, the number of individuals who access the Internet through devices other than a personal computer, such as personal digital assistants, cellular telephones, television set-top devices, game consoles and Internet appliances, is expected to increase dramatically. Manufacturers of these types of products are increasingly investing in media-related applications, but development of these devices is still in an experimental stage and business models are new and unproven. If we are unable to attract and retain a substantial number of alternative device manufacturers to license and incorporate our technology into their devices, we may fail to capture a sufficient share of an increasingly important portion of the market for digital media delivery. Further, a failure to develop revenue-generating relationships with a sufficient number of device manufacturers could harm our business prospects.
We do not believe that complete standards have emerged with respect to non-PC wireless and cable-based systems, though participants in those industries generally express support for the evolution of industry-wide standards which may disfavor proprietary solutions. Likewise, no single company has yet gained a dominant position in the mobile device market. However, certain third party products and services in these markets support our technology, and certain products and services support our competitors’ technologies, especially Microsoft, which can use its monopoly position in the operating system business and other financial resources to gain access to these markets, potentially to our exclusion. In addition, our brand and capabilities are not as well known in these market sectors which has and may continue to create opportunities for smaller competitors to effectively compete with us, especially in the market for mobile devices outside the United States. Other companies’ products and services, including industry-standard technologies like MPEG-4 and 3GPP, or other new standards may emerge or become dominant in any of these areas, and differing standards may emerge among different global markets, which could reduce demand for our technology and products or render them obsolete. In addition, our ability to reach customers in these markets is often controlled by large network operators and our success in these markets is dependent on securing relationships with these key operators.
We have also recently announced our Helix initiative, which is aimed, in part, at stimulating the development of Internet media technology on non-PC devices. If the open-source features of Helix do not successfully stimulate the development of technology on non-PC devices using our platform, our business and prospects could be harmed.
We could lose strategic relationships that are essential to our business.
The loss of certain current strategic relationships or key licensing arrangements, the inability to find other strategic partners or the failure of our existing relationships to achieve meaningful positive results for us could harm our business. We rely in part on strategic relationships to help us:
| • | increase adoption of our products through distribution arrangements; | ||
| • | increase the amount and availability of compelling media content on the Internet to help boost demand for our products and services, including our RealOne subscription services; | ||
| • | acquire desirable or necessary technology components and intellectual property rights; |
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| • | establish and maintain our brands; | ||
| • | expand the range of commercial activities based on our technology; and | ||
| • | increase the performance and utility of our products and services. |
We would be unable to accomplish many of these goals without the assistance of third parties. For example, we may become more reliant on strategic partners to provide multimedia content and technology, to provide alternative distribution channels, to provide more secure and easy-to-use electronic commerce solutions and to build out the necessary infrastructure for media delivery. We may not be successful in forming or managing strategic relationships and, in particular, we may meet resistance in forging such relationships if our potential strategic partners desire to minimize their dependency on any one technology provider.
Our business will suffer if our systems fail or become unavailable.
A reduction in the performance, reliability or availability of our Web sites and network infrastructure may harm our ability to distribute our products and services to our users, as well as our reputation and ability to attract and retain users, customers, advertisers and content providers. Our revenue depends in large part on the number of users that download our products from our Web sites, access the content services on our Web sites and use our subscription services. Our systems and operations are susceptible to, and could be damaged or interrupted by, outages caused by fire, flood, power loss, telecommunications failure, Internet breakdown, earthquake and similar events. Our systems are also subject to human error, security breaches, power losses, computer viruses, break-ins, “denial of service” attacks, sabotage, intentional acts of vandalism and tampering designed to disrupt our computer systems, Web sites and network communications, and our systems could be subject to greater vulnerability in periods of high employee turnover, such as after our recent staff reductions. A sudden and significant increase in traffic on our Web sites could strain the capacity of the software, hardware and telecommunications systems that we deploy or use. This could lead to slower response times or system failures.
Our operations also depend on receipt of timely feeds from our content providers, and any failure or delay in the transmission or receipt of such feeds could disrupt our operations. We also depend on Web browsers, ISPs and online service providers to provide Internet users access to our Web sites. Many of these providers have experienced significant outages in the past, and could experience outages, delays and other difficulties due to system failures unrelated to our systems. In addition, certain ISPs have temporarily interrupted our Web site operations and ability to communicate with certain customers in response to the heavy volume of email transmissions we generate and send to our large user base. These types of interruptions could continue or increase in the future.
Our electronic commerce and digital distribution activities are managed by complex software and computer systems. We must continually develop and update these systems over time as our business and business needs grow and change, and these systems may not adequately reflect the current needs of our business. We may encounter delays in developing these systems, and the systems may contain undetected errors that could cause system failures, authentication or payment processing problems, or security issues. We have on occasion experienced system errors and failures that cause interruption in availability of products or content or an increase in response time, and any such errors or failures could result in a loss of potential or existing business services customers, users, subscribers, advertisers or content providers. If we suffer sustained or repeated interruptions, our products, services and Web sites could be less attractive to such entities or individuals and our business could be harmed.
Real Broadcast Network’s business is dependent on providing customers with efficient and reliable services to enable such customers to broadcast content to large audiences on a live or on-demand basis. Real Broadcast Network’s operations are also dependent in part upon transmission capacity provided by third-party telecommunications network providers. Any failure of such network providers to provide the capacity we require may result in a reduction in, or interruption of, service to our customers. If we do not have access to third-party transmission capacity, we could lose customers and if we are unable to obtain such capacity on terms commercially acceptable to us, our business and operating results could suffer.
Our computer and communications infrastructure is located at a single leased facility in Seattle, Washington, an area that is at heightened risk of earthquake and volcanic events. We do not currently have fully redundant systems or a formal disaster recovery plan, and we may not have adequate business interruption insurance to compensate us for losses that may occur from a system outage. Despite our efforts, our network infrastructure and systems could be subject to service interruptions or damage and any resulting interruption of services could harm our business, operating results and reputation.
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Our network is subject to security risks that could harm our business and reputation and expose us to litigation or liability.
Online commerce and communications depend on the ability to transmit confidential information and licensed intellectual property securely over private and public networks. Any compromise of our ability to transmit such information and data securely, and any costs associated with preventing or eliminating such problems, could harm our business. Online transmissions are subject to a number of security risks, including:
| • | our own or licensed encryption and authentication technology, and access and security procedures, may be compromised, breached or otherwise be insufficient to ensure the security of customer information or intellectual property; | ||
| • | we could experience unauthorized access, computer viruses, system interference or destruction, “denial of service” attacks and other disruptive problems, whether intentional or accidental, that may inhibit or prevent access to our Web sites or use of our products and services; and | ||
| • | someone could circumvent our security measures and misappropriate our, our partners’ or our customers’ proprietary information or content or interrupt operations. |
The occurrence of any of these or similar events could damage our business, hurt our ability to distribute products and services and collect revenue, threaten the proprietary or confidential nature of our technology, harm our reputation, and expose us to litigation or liability. We may be required to expend significant capital or other resources to protect against the threat of security breaches or hacker attacks or to alleviate problems caused by such breaches or attacks.
Our international operations involve operational and financial risks.
We operate subsidiaries in ten foreign countries, and market and sell products in a number of other countries. We have also entered into joint ventures internationally. For the quarter ended June 30, 2003, approximately 27% of our revenue was derived from international operations.
A key part of our strategy is to develop localized products and services in international markets through joint ventures, subsidiaries and branch offices. If we do not successfully implement this strategy, we may not recoup our international investments and we may lose worldwide market share. To date, we have only limited experience in developing localized versions of our products and services and marketing and operating our products and services internationally, and we often rely on the efforts and abilities of our foreign business partners in such activities. We believe that in light of the potential size of the customer base and the audience for content, and the substantial anticipated competition, we need to continue to expand into international markets in order to effectively obtain and maintain market share. International markets we have selected may not develop at a rate that supports our level of investment. In particular, international markets typically have been slower in adoption of the Internet as an advertising and commerce medium, which is reflected in our international revenue results.
In addition to uncertainty about our ability to continue to generate revenue from our foreign operations and expand our international presence, there are certain risks inherent in doing business on an international level, including difficulties in managing operations due to distance, language and cultural differences, different or conflicting laws and regulations and exchange rate fluctuations.
Any of these factors could harm our future international operations, and consequently our business, operating results and financial condition. We currently manage a portion of our foreign currency exposures. Our foreign currency exchange risk management program reduces, but does not eliminate, the impact of currency exchange rate movements.
We may be unable to adequately protect our proprietary rights and may be subject to intellectual property infringement claims, which are costly to defend and could limit our ability to use certain technologies in the future.
Our inability to protect our proprietary rights, and the costs of doing so, could harm our business. Our success and ability to compete partly depend on the superiority, uniqueness or value of our technology, including both internally developed technology and technology licensed from third parties. To protect our proprietary rights, we rely on a combination of patent, trademark, copyright and trade secret laws, confidentiality agreements with our employees and third parties, and protective contractual provisions. These efforts to protect our intellectual property rights may not be effective in preventing misappropriation of our technology. These efforts also may not prevent the development and design by others of products or technologies similar to or competitive with, or superior to those we develop. Any of
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these results could reduce the value of our intellectual property.
As of June 30, 2003, we had 46 registered U.S. trademarks or service marks, and had applications pending for several more U.S. trademarks. We also have several unregistered trademarks. In addition, we have several foreign trademark registrations and pending applications. Many of our marks begin with the word “Real” (such as RealOne, RealAudio and RealVideo). We are aware of other companies that use “Real” in their marks alone or in combination with other words, and we do not expect to be able to prevent all third-party uses of the word “Real” for all goods and services.
As of June 30, 2003, we had 21 U.S. patents and numerous patent applications on file relating to various aspects of our technology. We intend to increase our investment in filing additional patent applications on other features of our technology. Patents with respect to our technology may not be granted and, if granted, may be challenged or invalidated. Issued patents may not provide us with any competitive advantages and may be challenged by third parties.
Many of our current and potential competitors dedicate substantially greater resources to protection and enforcement of their intellectual property rights, especially patents. Many parties are actively developing streaming media and digital distribution-related technologies, e-commerce and other Web-related technologies, as well as a variety of online business methods and models. We believe that these parties will continue to take steps to protect these technologies, including, but not limited to seeking patent protection. As a result, disputes regarding the ownership of these technologies and rights associated with streaming media, digital distribution and online businesses are likely to arise in the future and may be very costly. In addition to existing patents and intellectual property rights, we anticipate that additional third-party patents related to our products and services will be issued in the future. If a blocking patent has been issued or is issued in the future, we would need to either obtain a license or design around the patent. We may not be able to obtain such a license on acceptable terms, if at all, or design around the patent, which could harm our business.
Companies in the technology and content-related industries have frequently resorted to litigation regarding intellectual property rights. We may be forced to litigate to enforce or defend our intellectual property rights, to protect our trade secrets or to determine the validity and scope of other parties’ proprietary rights. Any such litigation could be very costly and could distract our management from focusing on operating our business. In addition, we believe these industries are experiencing an increased level of litigation to determine the applicability of current laws to, and impact of new technologies on, the use and distribution of content over the Internet and through new devices, especially in the music industry, and as we develop products and services that provide or enable the provision of content in such ways, our litigation risk may increase. The existence and/or outcome of such litigation could harm our business.
From time to time we receive claims and inquiries from third parties alleging that our internally developed technology or technology we license from third parties may infringe the third parties’ proprietary rights, especially patents. Third parties have also asserted and most likely will continue to assert claims against us alleging infringement of copyrights, trademark rights, trade secret rights or other proprietary rights, or alleging unfair competition or violations of privacy rights. We are now investigating a number of such pending claims.
In July 2002, a lawsuit was filed against us in federal court in Boston, alleging that we willfully infringe certain patents relating to the downloading of data from a server computer to a client computer. The plaintiff seeks to enjoin us from the alleged infringing activity and to recover treble damages from the alleged infringement. We have filed counterclaims against the plaintiff seeking a declaratory judgment that the patents at issue are invalid and unenforceable due to plaintiff’s inequitable conduct, as well as recovery of damages for plaintiff’s infringement of a RealNetworks patent, and its reasonable attorneys fees and costs. We could be required to spend significant amounts of time and money to defend ourselves against such claims. If any of these claims were to prevail, we could be forced to pay damages, comply with injunctions, or stop distributing our products and services while we re-engineer them or seek licenses to necessary technology, which might not be available on reasonable terms. We could also be subject to claims for indemnification resulting from infringement claims made against our customers and strategic partners, which could increase our defense costs and potential damages. Any of these events could require us to change our business practices and harm our business.
In June 2003, a lawsuit was filed against RealNetworks and Listen.Com in federal district court for the Northern District of Illinois, alleging that certain features of RealNetwork’s and Listen.Com’s products and services willfully infringe certain patents relating to allowing users “to search for streaming media files, to create custom playlists, and to listen to the streaming media file sequentially and continuously.” The plaintiff seeks to enjoin us from the alleged infringing activity and to recover treble dames from the alleged infringement. Although no assurance can be given as to the outcome of this lawsuit, we believe the allegations are without merit and intend to vigorously defend ourselves. We believe the ultimate outcome will not have a material adverse effect on our financial position or results
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of operations. If the plaintiff prevails in its claims, we could be required to pay damages or other penalties in addition to complying with injunctive relief, which could harm our business and our operating results.
We are subject to risks associated with governmental regulation and legal uncertainties.
Few existing laws or regulations specifically apply to the Internet, other than laws and regulations generally applicable to businesses. Certain U.S. export controls and import controls of other countries, including controls on the use of encryption technologies, may apply to our products. Many laws and regulations, however, are pending and may be adopted in the United States, individual states and local jurisdictions and other countries with respect to the Internet. These laws may relate to many areas that impact our business, including content issues (such as obscenity, indecency and defamation), copyright and other intellectual property rights, digital rights management, encryption, caching of content by server products, personal privacy, taxation, e-mail, sweepstakes, promotions, network and information security and the convergence of traditional communication services with Internet communications, including the future availability of broadband transmission capability and wireless networks. These types of regulations are likely to differ between countries and other political and geographic divisions. Other countries and political organizations are likely to impose or favor more and different regulation than that which has been proposed in the United States, thus furthering the complexity of regulation. In addition, state and local governments may impose regulations in addition to, inconsistent with, or stricter than federal regulations. The adoption of such laws or regulations, and uncertainties associated with their validity, interpretation, applicability and enforcement, may affect the available distribution channels for and costs associated with our products and services, and may affect the growth of the Internet. Such laws or regulations may harm our business. Our products and services may also become subject to investigation and regulation of foreign data protection and e-commerce authorities, including those in the European Union. Such activities could result in additional product and distribution costs for us in order to comply with such regulation.
There is uncertainty regarding how existing laws governing issues such as property ownership, copyright and other intellectual property issues, digital rights management, taxation, gambling, security, illegal or obscene content, retransmission of media, and personal privacy and data protection apply to the Internet. The vast majority of such laws were adopted before the advent of the Internet and related technologies and do not address the unique issues associated with the Internet and related technologies. Most of the laws that relate to the Internet have not yet been interpreted. In addition to potential legislation from local, state and federal governments, labor guild agreements and other laws and regulations that impose fees, royalties or unanticipated payments regarding the distribution of media over the Internet may directly or indirectly affect our business. While we and our customers may be directly affected by such agreements, we are not a party to such agreements and have little ability to influence the degree such agreements favor or disfavor Internet distribution or our business models. Changes to or the interpretation of these laws and the entry into such industry agreements could:
| • | limit the growth of the Internet; | ||
| • | create uncertainty in the marketplace that could reduce demand for our products and services; | ||
| • | increase our cost of doing business; | ||
| • | expose us to increased litigation risk, substantial defense costs and significant liabilities associated with content available on our Web sites or distributed or accessed through our products or services, with our provision of products and services, and with the features or performance of our products and Web sites; | ||
| • | lead to increased product development costs or otherwise harm our business; or | ||
| • | decrease the rate of growth of our user base and limit our ability to effectively communicate with and market to our user base. |
The Digital Millennium Copyright Act (DMCA) includes statutory licenses for the performance of sound recordings and for the making of recordings to facilitate transmissions. Under these statutory licenses, we and our broadcast customers may be required to pay licensing fees for digital sound recordings we deliver in original and archived programming and through retransmissions of radio broadcasts. The DMCA does not specify the rate and terms of the licenses, which are determined by arbitration proceedings, known as CARP proceedings, supervised by the United States Copyright Office. Past CARP proceedings have resulted in proposed rates for statutory webcasting that were significantly in excess of rates requested by webcasters. CARP proceedings relating to music subscription and non-subscription services offering music programming that qualify for various licenses under U.S. copyright law are pending. We cannot predict the outcome of these CARP proceedings and may elect instead to directly license music content for our subscription and/or non-subscription services, either alone or in concert with other affected companies.
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Such licenses may only apply to music performed in the United States, and the availability of corresponding licenses for international performances is unclear. Therefore, our ability to find rights holders and negotiate appropriate licenses is uncertain. Many of our systems software and Real Broadcast Network customers may be affected by these rates, which may negatively impact our revenue. Several CARP proceedings are pending for subscription music services and services that deliver digital downloads of music, and the outcome of these CARPs will also likely affect our business in ways that we cannot predict. Depending on the rates and terms adopted for the statutory licenses, our business could be harmed both by increasing our own cost of doing business, as well as by increasing the cost of doing business for our customers. We anticipate future CARPs relating to music subscription delivery services, which may also adversely affect the online distribution of music and, in particular, our RealOne Music subscription service.
The Child Online Protection Act and the Child Online Privacy Protection Act impose civil and criminal penalties on persons distributing material harmful to minors (e.g., obscene material) over the Internet to persons under the age of 17, or collecting personal information from children under the age of 13. We do not knowingly distribute harmful materials to minors or collect personal information from children under the age of 13. The manner in which these Acts may be interpreted and enforced cannot be fully determined, and future legislation similar to these Acts could subject us to potential liability if we were deemed to be non-compliant with such rules and regulations, which in turn could harm our business.
There are a large number of legislative proposals before the United States Congress and various state legislatures regarding intellectual property, digital rights management, copy protection requirements, privacy, email marketing and security issues related to our business. It is not possible to predict whether or when such legislation may be adopted, and certain proposals, if adopted, could materially and adversely affect our business through a decrease in user registration and revenue, and influence how and whether we can communicate with our customers.
We may be subject to market risk and legal liability in connection with the data collection capabilities of our products and services.
Many of our products are interactive Internet applications that by their very nature require communication between a client and server to operate. To provide better consumer experiences and to operate effectively, our products send information to servers at RealNetworks. Many of the services we provide also require that a user provide certain information to us. We post an extensive privacy policy concerning the collection, use and disclosure of user data involved in interactions between our client and server products. Any failure by us to comply with our posted privacy policy and existing or new legislation regarding privacy issues could impact the market for our products and services, subject us to litigation and harm our business.
Between November 1999 and March 2000, fourteen lawsuits were filed against us in federal and/or state courts in California, Illinois, Pennsylvania, Texas and Washington. All state court cases have been dismissed, the most recent being the California case, which was dismissed pursuant to a settlement in June 2003. The settlement did not have a material adverse effect on our financial position or results of operations. On February 10, 2000, the federal Judicial Panel on Multidistrict Litigation transferred all pending federal cases to the federal district court for the Northern District of Illinois. On the same day, that court granted RealNetworks’ motion to stay the court proceedings because the claims are subject to arbitration under our End User License Agreement.
On or about March 29, 2003, William Cirignani filed a consumer class action against us in Washington state court, alleging causes of action based on the Washington Consumer Protection Act and unjust enrichment. The plaintiff alleges that consumers who attempted to download or purchase certain of our products and services were fraudulently and deceptively enrolled in, and prevented from canceling, our subscription services. The plaintiff seeks compensatory damages, equitable relief in the form of an order prohibiting the alleged false and deceptive practices, treble damages, and other relief. On June 2, 2003, we filed a motion to stay the case pending arbitration, based on the provisions in our End User License Agreements with consumers for the relevant products and services, which provide for disputes to be resolved through arbitration. On July 15, 2003, the trial court granted the Company’s motion staying the litigation pending arbitration. Although no assurance can be given as to the outcome of this litigation, we believe that the allegations in this action are without merit, and intend to vigorously defend ourselves. If the plaintiff prevails in his claims, we could be
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required to pay damages or other penalties, in addition to complying with injunctive relief, which could harm our business and our operating results.
In June 2003, a lawsuit was filed against RealNetworks and Listen.Com in federal district court for the Northern District of Illinois, alleging that certain features of RealNetworks’ and Listen.Com’s products and services willfully infringe certain patents relating to allowing users “to search for streaming media files, to create custom playlists, and to listen to the streaming media file sequentially and continuously.” The plaintiff seeks to enjoin us from the alleged infringing activity and to recover treble dames from the alleged infringement. Although no assurance can be given as to the outcome of this lawsuit, we believe the allegations are without merit and intend to vigorously defend ourselves. We believe the ultimate outcome will not have a material adverse effect on our financial position or results of operations. If the plaintiff prevails in its claims, we could be required to pay damages or other penalties in addition to complying with injunctive relief, which could harm our business and our operating results.
We may be subject to legal liability for the provision of third-party products, services or content.
We periodically enter into arrangements to offer third-party products, services, content or advertising under the RealNetworks brand or via distribution on our Web sites, in products or service offerings. We may be subject to claims concerning these products, services, content or advertising by virtue of our involvement in marketing, branding, broadcasting or providing access to them, even if we do not ourselves host, operate, provide, or provide access to these products, services, content or advertising. While our agreements with these parties often provide that we will be indemnified against such liabilities, such indemnification may not be adequate. It is also possible that, if any information provided directly by us contains errors or is otherwise negligently provided to users, third parties could make claims against us, including, for example, claims for intellectual property infringement. Investigating and defending any of these types of claims is expensive, even if the claims do not result in liability. If any of these claims do result in liability, we could be required to pay damages or other penalties, which could harm our business and our operating results.
Our directors and executive officers beneficially own approximately 37.1% of our stock; their interests could conflict with yours; significant sales of stock held by them could have a negative effect on our stock price; shareholders may be unable to exercise control.
As of June 30, 2003, our executive officers, directors and affiliated persons beneficially owned approximately 37.1% of our common stock. Robert Glaser, our Chief Executive Officer and Chairman of the Board, beneficially owns approximately 33.6% of our common stock. As a result, our executive officers, directors and affiliated persons will have significant influence to:
| • | elect or defeat the election of our directors; | ||
| • | amend or prevent amendment of our articles of incorporation or bylaws; | ||
| • | effect or prevent a merger, sale of assets or other corporate transaction; and | ||
| • | control the outcome of any other matter submitted to the shareholders for vote. |
Management’s stock ownership may discourage a potential acquirer from making a tender offer or otherwise attempting to obtain control of RealNetworks, which in turn could reduce our stock price or prevent our shareholders from realizing a premium over our stock price.
Provisions of our charter documents, Shareholder Rights Plan, and Washington law could discourage our acquisition by a third party.
Our articles of incorporation provide for a strategic transaction committee of the board of directors. Without the prior approval of this committee, and subject to certain limited exceptions, the board of directors does not have the authority to:
| • | adopt a plan of merger; | ||
| • | authorize the sale, lease, exchange or mortgage of: |
| (A) assets representing more than 50% of the book value of our assets prior to the transaction; or |
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| (B) any other asset or assets on which our long-term business strategy is substantially dependent; |
| • | authorize our voluntary dissolution; or | ||
| • | take any action that has the effect of any of the above. |
RealNetworks also entered into an agreement providing Mr. Glaser with certain contractual rights relating to the enforcement of our charter documents and Mr. Glaser’s roles and authority within RealNetworks.
We have adopted a shareholder rights plan that provides that shares of our common stock have associated preferred stock purchase rights. The exercise of these rights would make the acquisition of RealNetworks by a third party more expensive to that party and has the effect of discouraging third parties from acquiring RealNetworks without the approval of our board of directors, which has the power to redeem these rights and prevent their exercise.
Washington law imposes restrictions on some transactions between a corporation and certain significant shareholders. The foregoing provisions of our charter documents, shareholder rights plan, our agreement with Mr. Glaser, the notes and Washington law, as well as those relating to a classified board of directors and the availability of “blank check” preferred stock, could have the effect of making it more difficult or more expensive for a third party to acquire, or of discouraging a third party from attempting to acquire, control of us. These provisions may therefore have the effect of limiting the price that investors might be willing to pay in the future for our common stock.
Our stock price has been and may continue to be volatile.
The trading price of our common stock has been and is likely to continue to be highly volatile. For example, during the 52-week period ended June 30, 2003, the price of our common stock ranged from $2.68 to $9.29 per share. Our stock price could be subject to wide fluctuations in response to factors such as:
| • | actual or anticipated variations in quarterly operating results; | ||
| • | announcements of technological innovations, new products or services by us or our competitors; | ||
| • | changes in financial estimates or recommendations by securities analysts; | ||
| • | the addition or loss of strategic relationships or relationships with our key customers; | ||
| • | conditions or trends in the Internet, streaming media, media delivery and online commerce markets; | ||
| • | changes in the market valuations of other Internet, online service or software companies; | ||
| • | announcements by us or our competitors of significant acquisitions, strategic partnerships, joint ventures or capital commitments or of significant new product developments or changes in business strategy; | ||
| • | legal, regulatory or political developments; | ||
| • | additions or departures of key personnel; | ||
| • | sales of our common stock; and | ||
| • | general market conditions. |
In addition, the stock market in general, and the Nasdaq National Market and the market for Internet and technology companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of these companies. These broad market and industry factors have in the past and may in the future reduce our stock price, regardless of our operating performance.
We may be subject to assessment of sales and other taxes for the sale of our products, license of technology or provision of services.
We may have to pay past sales or other taxes that we have not collected from our customers. We do not currently collect sales or other taxes on the sale of our products, license of technology or provision of services in states and countries other than those in which we have offices or employees. Our business would be harmed if one or more states
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or any foreign country were able to require us to collect sales or other taxes from past sales of products, licenses of technology or provision of services, particularly because we would be unable to go back to customers to collect sales taxes for past sales and may have to pay such taxes out of our own funds.
In October 1998, the Internet Tax Freedom Act, or ITFA, was signed into law. Among other things, the ITFA imposed a three-year moratorium on discriminatory taxes on electronic commerce which expired October 20, 2001. In November 2001, the moratorium was extended another two years until November 2003. Nonetheless, foreign countries or, following the expiration of the moratorium, one or more states, may seek to impose sales or other tax obligations on companies that engage in such activities within their jurisdictions. The European Union introduced legislation effective July 1, 2003, requiring all non-European Union vendors to collect Value Added Tax, or VAT. VAT is imposed on sales of all electronically supplied software and services including software products, games, data, publications, music, video and fee-based broadcasting services. It is our intention to comply with the European Union VAT legislation upon its effective date. In order to comply with the VAT legislation, we must modify our existing customer transaction processing system to meet the requirements imposed by the legislation. While we anticipate that our systems will be able to accommodate the requirements of the legislation, there can be no assurance that the European Union will not make further modifications to the legislation, the effects of which could require significant enhancements to our systems and increase the cost of selling our products and services into the European Union. Additionally, we have not determined the impact VAT will have on the pricing and demand for our products and services, the effects of which may adversely impact our revenue and profit. We anticipate the collection and remittance of VAT will subject us to additional currency fluctuation risks.
We donate a portion of net income to charity.
In periods where we achieve profitability (excluding the effects of goodwill and other acquisition charges), we intend to donate 5% of our annual pre-tax net income to charitable organizations, which will reduce our net income for those periods. The non-profit RealNetworks Foundation manages our charitable giving efforts.
Special Note Regarding Forward-Looking Statements
We have made forward-looking statements in this document, all of which are subject to risks and uncertainties. When we use words such as “anticipate,” “expect,” “intend,” “plan,” “believe,” “seek” and “estimate” or similar words, we are making forward-looking statements. Forward-looking statements include information concerning our possible or assumed future business success or financial results. Such forward-looking statements include, but are not limited to, statements as to our expectations regarding:
| • | the future development and growth of, and opportunities for, the Internet and the online media delivery market; | ||
| • | the features and functionality of our future products, services and technologies; | ||
| • | the future adoption of our current and future products, services and technologies; | ||
| • | future revenue opportunities; | ||
| • | the future growth of our customer base; | ||
| • | our ability to successfully develop and introduce future products and services; | ||
| • | future expense levels (including cost of revenue, research and development, sales and marketing and general and administrative); | ||
| • | future sales and marketing efforts; | ||
| • | future capital needs and capital expenditures; | ||
| • | the effect of past and future acquisitions; | ||
| • | future charges for impairment of long-lived assets and goodwill; | ||
| • | future prepayment requirements in our customers’ contracts and the associated effect on deferred revenue; | ||
| • | future rates of growth of our costs of service revenue and future reductions in gross margins; |
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| • | the impact of our interest in MusicNet on our operating results; | ||
| • | whether we will pay federal income taxes in the near future; | ||
| • | potential effects of interest rates on our operating results; | ||
| • | future competition from existing and new competitors and our ability to compete with such competitors; | ||
| • | the anticipated benefits of allowing access to our source code by the open source community; | ||
| • | whether our products and services will be accepted in international markets; | ||
| • | our future charitable donations; | ||
| • | the future effectiveness of our intellectual property rights; | ||
| • | the impact of current litigation in which we are involved; | ||
| • | the impact of recently issued accounting standards on financial position or results of operations; | ||
| • | our intent to continue the share repurchase program; | ||
| • | the effect of the restructuring steps on our operating efficiency; | ||
| • | continuation of consolidation and strategic partnering in the industry; and | ||
| • | our intent to continue making strategic investments in other companies. |
You should note that an investment in our common stock involves certain risks and uncertainties that could affect our future business success or financial results. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth in “Factors That May Affect Our Business, Future Operating Results and Financial Condition” and elsewhere in our Quarterly Report on Form 10-Q.
We believe that it is important to communicate our expectations to our investors. However, there may be events in the future that we are not able to predict accurately or over which we have no control. Before you invest in our common stock, you should be aware that the occurrence of the events described in the “Factors That May Affect Our Business, Future Operating Results and Financial Condition” and elsewhere in our Quarterly Report on Form 10-Q could materially and adversely affect our business, financial condition and operating results. We undertake no obligation to publicly update any forward-looking statements for any reason, even if new information becomes available or other events occur in the future.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
The following discussion about our market risk involves forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements.
Interest Rate Risk. Our exposure to interest rate risk from changes in market interest rates relates primarily to our short-term investment portfolio. We do not hold derivative financial instruments or equity investments in our short-term investment portfolio. Our short-term investments consist of high quality securities as specified in our investment policy guidelines. Investments in both fixed and floating rate instruments carry a degree of interest rate risk. The fair value of fixed rate securities may be adversely impacted due to a rise in interest rates, while floating rate
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securities may produce less income than expected if interest rates fall. Additionally, in a falling rate environment there may be a degree of reinvestment risk since as securities mature the proceeds are reinvested at a lower rate, generating less interest income. Due in part to these factors, our future interest income may be adversely impacted due to changes in interest rates. In addition, we may incur losses in principal if we are forced to sell securities which have declined in market value due to changes in interest rates. Because we have historically had the ability to hold our short-term investments until maturity and the substantial majority matures within one year of purchase, we would not expect our operating results or cash flows to be significantly impacted by a sudden change in market interest rates. There have been no material changes in our investment methodology regarding our cash equivalents and short-term investments, and as such, the descriptions under the captions “Interest Rate Risk” remain unchanged from those included in our Annual Report on Form 10-K for the year ended December 31, 2002.
Investment Risk. As of June 30, 2003, we had investments in voting capital stock of both public and privately-held technology companies for business and strategic purposes. Some of these securities do not have a quoted market price. Our investments in publicly traded companies are carried at current market value and are classified as long-term as they are strategic in nature. We periodically evaluate whether any declines in fair value of our investments are other-than-temporary. This evaluation consists of a review of qualitative and quantitative factors. Equity price fluctuations of plus or minus 10% of prices at June 30, 2003 would have had an approximate $2.0 million impact on the value of our investments in publicly traded companies at June 30, 2003, related primarily to our investment in a publicly traded Japanese company.
Foreign Currency Risk. International revenue accounted for approximately 28% of total net revenue for the six months ended June 30, 2003. Our international subsidiaries incur most of their expenses in the local currency. Accordingly, all foreign subsidiaries use the local currency as their functional currency.
Our exposure to foreign exchange rate fluctuations arise in part from: (1) translation of the financial results of foreign subsidiaries into U.S. dollars in consolidation, (2) the re-measurement of non-functional currency assets, liabilities and intercompany balances into U.S. dollars for financial reporting purposes, and (3) non-U.S. dollar denominated sales to foreign customers.
A portion of these risks is managed through the use of financial derivatives, but fluctuations could impact our results of operations and financial position.
Generally, our practice is to manage foreign currency risk for the majority of material short-term intercompany balances through the use of foreign currency forward contracts. These contracts require us to exchange currencies at rates agreed upon at the contract’s inception. Because the impact of movements in currency exchange rates on forward contracts offsets the related impact on the short-term intercompany balances, these financial instruments help alleviate the risk that might otherwise result from certain changes in currency exchange rates. We do not designate our foreign exchange forward contracts related to short-term intercompany accounts as hedges and, accordingly, we adjust these instruments to fair value through results of operations; however, we may periodically hedge a portion of our foreign exchange exposures associated with material firmly committed transactions, long-term investments, highly predictable anticipated exposures and net investments in foreign subsidiaries.
Our foreign currency risk management program reduces, but does not entirely eliminate, the impact of currency exchange rate movements.
Historically, neither fluctuations in foreign exchange rates nor changes in foreign economic conditions have had a significant impact on our financial condition or results of operations. Foreign exchange rate fluctuations did not have a material impact on our financial results for the quarters and six months ended June 30, 2003 and 2002.
Item 4. Controls and Procedures
(a)Evaluation of Disclosure Controls and Procedures.Based on their evaluation as of the end of the period covered by this report, the Company’s principal executive officer and principal financial officer have concluded that the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)) are effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.
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(b) Changes in Internal Controls.There were no significant changes in the Company’s internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
Between November 1999 and March 2000, fourteen lawsuits were filed against the Company in federal and/or state courts in California, Illinois, Pennsylvania, Washington and Texas. All state court cases have been dismissed, the most recent being the California case, which was dismissed pursuant to a settlement in June 2003. The settlement did not have a material adverse effect on the Company’s financial position or results of operations. On February 10, 2000, the federal Judicial Panel on Multidistrict Litigation transferred all pending federal cases to the federal district court for the Northern District of Illinois. On the same day, that court granted RealNetworks’ motion to stay the court proceedings because the claims are subject to arbitration under RealNetworks’ End User License Agreement.
In July 2002, a lawsuit was filed against the Company in federal court in Boston, Massachusetts, alleging that RealNetworks willfully infringes certain patents relating to “the downloading of data from a server computer to a client computer.” The plaintiff seeks to enjoin the Company from the alleged infringing activity and to recover treble damages from the alleged infringement. The Company has filed counterclaims against the plaintiff seeking a declaratory judgment that the patents at issue are invalid and unenforceable due to plaintiff’s inequitable conduct, as well as recovery of damages for plaintiff’s infringement of a RealNetworks patent, and its reasonable attorneys fees and costs. Although no assurance can be given as to the outcome of this lawsuit, the Company believes that the allegations in this action are without merit and intends to vigorously defend itself. The Company believes the ultimate outcome will not have a material adverse effect on its financial position or results of operations. If the plaintiffs prevail in their claims, the Company could be required to pay damages or other penalties in addition to complying with injunctive relief, which could harm the Company’s business and its operating results.
In March 2003, William Cirignani filed a consumer class action against the Company in Washington state court, alleging causes of action based on the Washington Consumer Protection Act and unjust enrichment. The plaintiff alleges that consumers who attempted to download or purchase certain of the Company’s products and services were fraudulently and deceptively enrolled in, and prevented from canceling, the Company’s subscription services. The plaintiff seeks compensatory damages, equitable relief in the form of an order prohibiting the alleged false and deceptive practices, treble damages and other relief. On June 2, 2003, the Company filed a motion to stay the case pending arbitration, based on the provisions in the Company’s End User License Agreements with consumers for the relevant products and services, which provide for disputes to be resolved through arbitration. On July 15, 2003, the trial court granted the Company’s motion staying the litigation pending arbitration. Although no assurance can be given as to the outcome of this lawsuit, the Company believes that the allegations in this action are without merit and intends to vigorously defend itself against these claims. The Company believes the ultimate outcome will not have a material adverse effect on its financial position or results of operations. If the plaintiffs prevail in their claims, the Company could be required to pay damages or other penalties in addition to complying with injunctive relief, which could harm the Company’s business and its operating results.
In June 2003, a lawsuit was filed against the Company and Listen.Com in federal district court for the Northern District of Illinois, alleging that certain features of the Company’s and Listen.Com’s products and services willfully infringe certain patents relating to allowing users “to search for streaming media files, to create custom playlists, and to listen to the streaming media file sequentially and continuously.” The plaintiff seeks to enjoin the Company from the alleged infringing activity and to recover treble dames from the alleged infringement. Although no assurance can be given as to the outcome of this lawsuit, the Company believes the allegations are without merit and
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intends to vigorously defend itself. The Company believes the ultimate outcome will not have a material adverse effect on its financial position or results of operations. If the plaintiff prevails in its claims, the Company could be required to pay damages or other penalties in addition to complying with injunctive relief, which could harm the Company’s business and its operating results.
From time to time RealNetworks is, and expects to continue to be, subject to legal proceedings and claims in the ordinary course of its business, including employment claims, contract-related claims and claims of alleged infringement of third-party patents, trademarks and other intellectual property rights. These claims, even if not meritorious, could force the Company to spend significant financial and managerial resources. The Company currently has a number of such claims threatened against it relating to intellectual property infringement or employment, though it believes these claims are without merit. The Company is not aware of any legal proceedings or claims that the Company believes will have, individually or taken together, a material adverse effect on the Company’s business, prospects, financial condition or results of operations. However, the Company may incur substantial expenses in defending against third party claims. In the event of a determination adverse to the Company, the Company may incur substantial monetary liability, and/or be required to change its business practices. Either of these could have a material adverse effect on the Company’s financial position and results of operations.
Item 2. Changes in Securities and Use of Proceeds
(c) Since April 1, 2003, the Company has issued and sold unregistered securities as follows:
(1) On June 11, 2003, the Company sold approximately $100 million aggregate principal amount of zero coupon convertible subordinated notes due 2010 (the “Notes”) to the initial purchaser, Goldman, Sachs & Co., the principal underwriter in the offering. The aggregate underwriting discount was $2.75 million. The Notes were offered and sold to qualified institutional buyers by the initial purchaser in reliance on Rule 144A under the Securities Act of 1933, as amended.
Item 4. Submission of Matters to a Vote of Security Holders
An Annual Meeting of Shareholders of RealNetworks, Inc. (the “Annual Meeting”) was held on June 3, 2003. The matter voted on at the Annual Meeting and votes cast on such matter was the election of one Class 2 director to serve until the 2005 Annual Meeting of Shareholders and two Class 2 directors to serve until the 2006 Annual Meeting of Shareholders, or until such director’s earlier retirement, resignation or removal, or the election of their successors.
| For | Withheld | |||||||
| Jonathan D. Klein | 145,170,565 | 1,082,905 | ||||||
| (Class 2 Director) | ||||||||
| Robert Glaser | 145,926,752 | 326,718 | ||||||
| (Class 3 Director) | ||||||||
| Jeremy Jaech | 145,170,880 | 1,082,590 | ||||||
| (Class 3 Director) | ||||||||
The terms of the following directors continued after the Annual Meeting:
| Edward Bleier |
| James W. Breyer |
| Kalpana Raina |
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Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits Required by Item 601 of Regulation S-K:
| Exhibit Number | Description | |||||
| 2.1 | Agreement and Plan of Merger and Reorganization by and among RealNetworks, Inc., Symphony Acquisition Corp. I, Symphony Acquisition Corp. II, Listen.Com, Inc., Mellon Investor Services LLC, as Escrow Agent and Robert Reid, as the Shareholder Representative dated as of April 21, 2003 | |||||
| 3.1 | Amendment No. 1 dated April 22, 2003 to Amended and Restated Bylaws of RealNetworks, Inc. Adopted July 16, 1998 | |||||
| 31.1 | Certification of Robert Glaser, Chairman and Chief Executive Officer of RealNetworks, Inc., Pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | |||||
| 31.2 | Certification of Lawrence Jacobson, President of RealNetworks, Inc., Pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | |||||
| 32.1 | Certification of Robert Glaser, Chairman and Chief Executive Officer of RealNetworks, Inc., Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | |||||
| 32.2 | Certification of Lawrence Jacobson, President of RealNetworks, Inc., Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | |||||
(b) Reports on Form 8-K:
On April 23, 2003, RealNetworks filed a report on Form 8-K relating to its announcement on April 21, 2003 that it had entered into a definitive agreement to acquire Listen.Com, Inc. in a cash and stock transaction valued at approximately $36 million.
On April 30, 2003, RealNetworks, Inc. furnished a report on Form 8-K relating to its announcement on April 29, 2003 of the results for its first quarter ended March 31, 2003.
On May 16, 2003, RealNetworks filed a report on Form 8-K relating to its announcement on May 15, 2003 that Brian V. Turner, Senior Vice President, Finance and Operations, Chief Financial Officer and Treasurer of RealNetworks, will resign due to health issues.
On June 11, 2003, RealNetworks filed a report on Form 8-K relating to its announcement of its intention to offer, subject to market and other conditions, approximately $100 million aggregate principal amount of zero coupon convertible subordinated notes due 2010 through an offering to qualified institutional buyers.
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On June 13, 2003, RealNetworks filed a report on Form 8-K relating to its announcement on June 12, 2003 of the pricing of its offering of $100 million of zero coupon convertible subordinated notes due in 2010 to qualified institutional buyers.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized, on August 13, 2003.
| REALNETWORKS, INC. | ||||
| By: | /s/ Lawrence Jacobson | |||
| Lawrence Jacobson | ||||
| President | ||||
| (Principal Financial and Accounting Officer) | ||||
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INDEX TO EXHIBITS
| Exhibit Number | Description | |||||
| 2.1 | Agreement and Plan of Merger and Reorganization by and among RealNetworks, Inc., Symphony Acquisition Corp. I, Symphony Acquisition Corp. II, Listen.Com, Inc., Mellon Investor Services LLC, as Escrow Agent and Robert Reid, as the Shareholder Representative dated as of April 21, 2003 | |||||
| 3.1 | Amendment No. 1 dated April 22, 2003 to Amended and Restated Bylaws of RealNetworks, Inc. Adopted July 16, 1998 | |||||
| 31.1 | Certification of Robert Glaser, Chairman and Chief Executive Officer of RealNetworks, Inc., Pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | |||||
| 31.2 | Certification of Lawrence Jacobson, President of RealNetworks, Inc., Pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | |||||
| 32.1 | Certification of Robert Glaser, Chairman and Chief Executive Officer of RealNetworks, Inc., Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | |||||
| 32.2 | Certification of Lawrence Jacobson, President of RealNetworks, Inc., Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | |||||
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