Realnetworks 10Q 2004 Q2 Quarterly report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

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, 2004


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

Commission File Number 0-23137

REALNETWORKS, INC.

(Exact name of registrant as specified in its charter)


Washington		91-1628146
(State of incorporation)		(I.R.S. Employer Identification Number)

2601 Elliott Avenue, Suite 1000
Seattle, Washington		98121
(Address of principal executive offices)		(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.

Yesx Noo

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).

Yesx Noo

The number of shares of the registrant’s Common Stock outstanding as of July 26, 2004 was 169,492,058.

TABLE OF CONTENTS

RealNetworks, Inc.

FORM 10-Q

FOR THE QUARTER ENDED June 30, 2004

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		18
Item 3. Quantitative and Qualitative Disclosures About Market Risk		44
Item 4. Controls and Procedures		45
Part II. Other Information
Item 1. Legal Proceedings		46
Item 2. Changes in Securities and Use of Proceeds and Issuer Purchases of Equity Securities		47
Item 4. Submission of Matters to a Vote of Security Holders		47
Item 6. Exhibits and Reports on Form 8-K		48
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

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,
	2004			2003
ASSETS
Current assets:
Cash, cash equivalents and short-term investments	$	363,227			373,593
Trade accounts receivable, net of allowances for doubtful accounts and sales returns		11,746			10,618
Prepaid expenses and other current assets		9,759			8,879

Total current assets		384,732			393,090

Equipment and leasehold improvements, at cost:
Equipment and software		40,891			37,110
Leasehold improvements		25,777			26,085

Total equipment and leasehold improvements		66,668			63,195
Less accumulated depreciation and amortization		37,088			33,258

Net equipment and leasehold improvements		29,580			29,937

Restricted cash equivalents		20,151			19,953
Notes receivable from related parties		813			771
Investments		38,425			34,577
Other assets		3,412			4,069
Goodwill, net		119,371			97,477
Other intangible assets, net		6,634			1,065

Total assets	$	603,118			580,939

LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	9,452			6,865
Accrued and other liabilities		46,632			39,400
Deferred revenue, excluding non-current portion		30,357			31,186
Accrued loss on excess office facilities and content agreement, excluding non-current portion		7,294			4,960

Total current liabilities		93,735			82,411

Deferred revenue, excluding current portion		1,505			4,561
Accrued loss on excess office facilities and content agreement, excluding current portion		22,293			24,099
Deferred rent		3,361			3,382
Convertible debt		100,000			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 169,465 shares in 2004 and 164,197 shares in 2003		169			164
Additional paid-in capital		664,434			639,369
Notes receivable from shareholders		(58	)		(58	)
Deferred stock compensation		(363	)		(620	)
Accumulated other comprehensive income		12,651			7,184
Accumulated deficit		(294,609	)		(279,553	)

Total shareholders’ equity		382,224			366,486

Total liabilities and shareholders’ equity	$	603,118			580,939

See accompanying notes to unaudited condensed consolidated financial statements

REALNETWORKS, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF
OPERATIONS AND COMPREHENSIVE LOSS
(In thousands, except per share data)


	Quarters ended						Six Months ended
	June 30,						June 30,
	2004			2003			2004			2003
Net revenue (A)	$	65,473			49,646			125,863			96,512
Cost of revenue (B)		21,735			14,920			43,496			28,704
Loss on content agreement		—			—			4,938			—

Gross profit		43,738			34,726			77,429			67,808

Operating expenses:
Research and development (excluding non-cash stock-based compensation, of $121 and $295 for the quarter and six months ending June 30, 2004, respectively and $193 and $494 for the comparable periods during 2003, included below)		13,219			11,826			25,470			22,733
Sales and marketing		23,247			19,296			45,450			37,599
General and administrative (excluding non-cash stock-based compensation of $92 and $184 for the quarter and six months ending June 30, 2004, respectively, and zero for the comparable periods during 2003, included below)		8,599			5,864			15,420			11,361
Loss on excess office facilities		—			7,098			—			7,098
Antitrust litigation		2,756			—			5,077			—
Stock-based compensation		213			193			479			494

Total operating expenses		48,034			44,277			91,896			79,285

Operating loss		(4,296	)		(9,551	)		(14,467	)		(11,477	)

Other income (expense), net:
Interest income, net		800			1,186			1,660			2,451
Equity in net loss of MusicNet		(1,019	)		(1,394	)		(2,134	)		(3,125	)
Impairment of equity investments		—			—			—			(424	)
Other, net		10			209			100			265

Other income (expense), net		(209	)		1			(374	)		(833	)

Net loss before income taxes		(4,505	)		(9,550	)		(14,841	)		(12,310	)
Income tax provision		(113	)		(82	)		(215	)		(160	)

Net loss	$	(4,618	)		(9,632	)		(15,056	)		(12,470	)
									��
Basic and diluted net loss per share	$	(0.03	)		(0.06	)		(0.09	)		(0.08	)
Shares used to compute basic and diluted net loss per share		168,846			158,158			167,930			157,797
Comprehensive loss:
Net loss	$	(4,618	)		(9,632	)		(15,056	)		(12,470	)
Unrealized gain on investments:
Unrealized holding gains		4,425			3,344			5,734			2,540
Adjustments for gains (losses) reclassified to net loss		—			(115	)		(53	)		309
Foreign currency translation gains (losses)		(21	)		138			(214	)		148

Comprehensive loss	$	(214	)		(6,265	)		(9,589	)		(9,473	)

(A) Components of net revenue:
License fees	$	17,136			16,595			35,382			32,867
Service revenue		48,337			33,051			90,481			63,645

	$	65,473			49,646			125,863			96,512

(B) Components of cost of revenue:
License fees	$	6,745			2,239			12,955			3,562
Service revenue		14,990			12,681			30,541			25,142

	$	21,735			14,920			43,496			28,704

See accompanying notes to unaudited condensed consolidated financial statements

REALNETWORKS, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)


	Six Months Ended
	June 30,
	2004			2003
Cash flows from operating activities:
Net loss	$	(15,056	)		(12,470	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Depreciation and amortization		6,979			5,410
Stock-based compensation		479			494
Equity in net losses of equity method investees		2,134			3,125
Accrued loss on excess office facilities and content agreement		528			5,202
Loss on disposal of equipment		176			—
Gain on sale of investments		(66	)		(158	)
Impairment of equity investments		—			424
Net change in certain operating assets and liabilities		6,146			(9,464	)

Net cash provided by (used in) operating activities		1,320			(7,437	)

Cash flows from investing activities:
Purchases of equipment and leasehold improvements		(4,688	)		(5,228	)
Purchases of short-term investments		(205,559	)		(137,303	)
Proceeds from sales and maturities of short-term investments		221,558			233,848
Purchases of long-term investments		—			(9,220	)
Increase in restricted cash equivalents		(198	)		(2,500	)
Proceeds from sale of investments		77			238
Payment of acquisition costs, net of cash acquired		(10,477	)		—

Net cash provided by investing activities		713			79,835

Cash flows from financing activities:
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		4,155			6,704

Net cash provided by financing activities		4,155			103,954

Effect of exchange rate changes on cash and cash equivalents		(275	)		319
Net increase in cash and cash equivalents		5,913			176,671
Cash and cash equivalents at beginning of period		198,028			121,779

Cash and cash equivalents at end of period		203,941			298,450
Short-term investments at end of period		159,286			90,482

Total cash, cash equivalents and short-term investments at end of period	$	363,227			388,932

Supplemental disclosure of non-cash investing and financing activities:
Non-cash consideration in business combinations:
Common stock and options issued in business combination	$	20,901			—

Accrued acquisition costs	$	110			—

See accompanying notes to unaudited condensed consolidated financial statements

REALNETWORKS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

(a) Description of Business

Inherent in the Company’s business are various risks and uncertainties, including the limited operating history of certain of its product and service offerings and the limited history of premium subscription services on the Internet. The Company’s success will depend on the acceptance of the Company’s technology and services and the ability to generate related revenue.

(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, 2004 are not necessarily indicative of the results that may be expected for any subsequent quarter or for the year ending December 31, 2004. 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 audited consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

Cash, cash equivalents and short-term investments are comprised of the following (in thousands):


	June 30, 2004		December 31, 2003
Cash and cash equivalents	$	203,941		198,028
Short-term investments		159,286		175,565

Total cash, cash equivalents and short-term investments	$	363,227		373,593

Restricted cash equivalents	$	20,151		19,953

Restricted cash equivalents at June 30, 2004 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, (c) cash equivalents of $2.75 million pledged as collateral against guaranteed minimum payments under a discontinued content agreement, and (d) $0.1 million pledged as collateral in connection with credit agreements with certain financial institutions.

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 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), net. The cost basis for determining realized gains and losses on available-for-sale securities is determined using the specific identification method.

(d) Notes Receivable from Related Parties and Shareholders

Notes receivable from related parties consist of cash advances made in 2000 by Listen.com, Inc. (Listen) to certain former officers of Listen that are current employees of the Company. The notes bear interest at rates ranging from 6.13% to 6.60% and are due between February 2005 and September 2005.

Notes receivable from shareholders consist of full recourse notes issued as consideration for the exercise of Listen stock options by certain former employees of Listen in 1999 that are current employees of the Company. The notes bear interest at rates ranging from 5.28% to 6.23% and are due seven years from the date of issuance.

(e) Investments

The Company has certain 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 one investment that is 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.

(f) 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, which approximates the effective interest method, over a 5-year period.

(g) Revenue Recognition

The Company recognizes revenue in connection with its software products 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” (SOP 98-9). Some of the Company’s software arrangements include consulting implementation services sold separately under consulting engagement contracts. If the consulting services are essential to the functionality of the software, or payment of the license fee depends on the performance of the services, both the software license and consulting fees are recognized under the percentage of completion method of contract accounting.

For transactions not falling under the scope of SOP 97-2, the Company’s revenue recognition policies are in accordance with Emerging Issues Task Force Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” (EITF 00-21) and Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin 104, “Revenue Recognition” (SAB 104).

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 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 the Company’s technology to the customer. For software license fees in single element arrangements such as consumer software sales and music copying or “burning,” revenue recognition typically occurs when the product is made available to the customer for download.

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, 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. Service revenue also includes fees generated from advertising appearing on the Company’s Web sites and products. 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.

(h) Net Loss Per Share

Basic net loss per share is computed by dividing net loss by the weighted average number of common shares outstanding during the period. Diluted net loss per share is computed by dividing net loss by the weighted average number of common and dilutive common equivalent shares outstanding during the period.

The share count used to compute basic and diluted net loss per share is calculated as follows (in thousands):


	Quarter						Six Months
	Ended June 30,						Ended June 30,
	2004			2003			2004			2003
Weighted average common shares outstanding		169,028			158,484			168,134			158,123
Less restricted shares		(182	)		(326	)		(204	)		(326	)

Shares used to compute basic and diluted net loss per share		168,846			158,158			167,930			157,797

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, 2004 included options to purchase approximately 35,256,000 common shares and approximately 10,750,000 contingently issuable common shares related to convertible debt as described in Note 7. Potential dilutive securities for the quarter and six months ended June 30, 2003 included options to purchase approximately 32,410,000 common shares and approximately 10,750,000 contingently issuable shares related to convertible debt.

(i) Derivative Financial Instruments

During the six months ended June 30, 2004, 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 meet the criteria for hedge accounting under Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (SFAS 133), as amended.

At June 30, 2004, 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 receive GBP/pay US$)	(GBP)	1,200	$	2,187	$	(20	)
Euro (“EUR”)
(contracts to pay EUR/receive US$)	(EUR)	1,390	$	1,668	$	(11	)
Japanese Yen (“YEN”)
(contracts to pay YEN/receive US$)	(YEN)	234,000	$	2,127	$	(34	)

At December 31, 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 receive GBP/pay US$)	(GBP)	1,100	$	1,926	$	34
Euro (“EUR”)
(contracts to pay EUR/receive US$)	(EUR)	2,150	$	2,648	$	(48	)
Japanese Yen (“YEN”)
(contracts to pay YEN/receive US$)	(YEN)	295,200	$	2,749	$	(2	)

No derivative instruments designated as hedges for accounting purposes were outstanding at June 30, 2004 or December 31, 2003.

(j) Comprehensive Loss

The Company’s comprehensive loss for the quarters and six months ended June 30, 2004 and 2003 consisted of net loss, net unrealized gains on investments and the net amount of foreign currency translation adjustments. The tax effect of the foreign currency translation adjustments and unrealized gains and losses on investments has been taken into account if applicable. The components of accumulated other comprehensive income are as follows (in thousands):


	June 30,			December 31,
	2004			2003
Unrealized gains on investments, net of taxes of $16,916 in 2004 and 2003	$	13,082			7,401
Foreign currency translation adjustments		(431	)		(217	)

	$	12,651			7,184

(k) Stock-Based Compensation

The Company has elected to apply the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (SFAS 123) and Statement of Financial Accounting Standards No. 148, “Accounting for Stock Based Compensation, Transition and Disclosure” (SFAS 148). 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” (FIN 28). At June 30, 2004, the Company has six 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):


	Quarters Ended June 30,						Six Months Ended June 30,
	2004			2003			2004			2003
Net loss as reported	$	(4,618	)		(9,632	)		(15,056	)		(12,470	)
Plus: stock-based employee compensation expense included in reported net loss, net of related tax effects		213			193			479			494
Less: stock-based employee compensation expense determined under fair value based methods for all awards, net of related tax effects		(5,679	)		(7,613	)		(12,327	)		(18,197	)

Pro forma net loss	$	(10,084	)		(17,052	)		(26,904	)		(30,173	)

Net loss per share:
Basic and diluted — as reported	$	(0.03	)		(0.06	)		(0.09	)		(0.08	)
Basic and diluted — pro forma	$	(0.06	)		(0.11	)		(0.16	)		(0.19	)

(l) Recently Issued Accounting Standards

In March 2004, the FASB’s Emerging Issues Task Force (EITF) reached a consensus on EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (EITF 03-1). The guidance prescribes a three-step model for determining whether an investment is other-than-temporarily impaired and requires disclosures about unrealized losses on investments. The accounting guidance is effective for reporting periods beginning after June 15, 2004, while the disclosure requirements are effective for annual reporting periods ending after June 15, 2004. Although the Company will continue to evaluate the application of EITF 03-1, the Company does not currently believe adoption will have a material impact on its consolidated financial statements.

In April 2004, the FASB issued FASB Staff Position 129-1, “Disclosure Requirements under FASB Statement No. 129, Disclosure of Information about Capital Structure, Relating to Contingently Convertible Securities,” (FSP 129-1). The FASB staff confirmed through FSP 129-1 that the disclosure requirements of Statement of Financial Accounting Standard No. 129, “Disclosure of Information About Capital Structure” (SFAS 129) apply to all contingently convertible financial instruments, including those containing contingent conversion requirements that have not been met and are not otherwise required to be included in the computation of diluted earnings per share. This guidance is effective immediately and applies to all existing and newly created securities. The Company’s disclosures have previously conformed to SFAS 129, and therefore, adoption of this pronouncement did not have an impact on its consolidated financial statements.

In April 2004, the Emerging Issues Task Force reached a consensus on Issue No. 03-06 “Participating Securities and the Two-Class Method Under FASB Statement No. 128, Earnings Per Share “ (EITF 03-06). EITF 03-06 addresses the computation of earnings per share by companies that have issued securities other than common stock that contractually entitle the holder to participate in dividends and earnings of the company when, and if, it declares dividends on its common stock. The Statement also provides further guidance in applying the two-class method of calculating earnings per share, clarifying what constitutes a participating security and how to apply the two-class method of computing earnings per share once it is determined that a security is participating, including how to allocate undistributed earnings to such a security. EITF 03-06 is effective for fiscal periods beginning after March 31, 2004. The adoption of EITF 03-06 did not impact the Company’s consolidated financial statements.

In June 2004, the Emerging Issues Task Force reached a consensus on Issue No. 02-14, “Whether an Investor Should Apply the Equity Method of Accounting to Investments Other Than Common Stock” (EITF 02-14). EITF 02-14 addresses whether the equity method of accounting applies when an investor does not have an investment in voting common stock of an investee but exercises significant influence through other means, how the equity method should be applied to investments other than common stock, and for securities with a readily determinable fair market value, how the provisions of Accounting Principles Board Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock” (APB 18), and Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (SFAS 115), interact. The consensus in this EITF is effective for reporting periods beginning after September 15, 2004. The Company is currently evaluating the potential impact of EITF 02-14 on its consolidated financial statements.

(m) Reclassifications

Certain reclassifications have been made to the June 30, 2003 consolidated financial statements to conform to the June 30, 2004 presentation.

NOTE 2 — SEGMENT INFORMATION

Prior to 2004, the Company operated in one business segment: media delivery. The Company began measuring its business by segments beginning in the quarter ended March 31, 2004, and now operates in two business segments: Consumer Products and Services and Business Products and Services, for which the Company receives revenue from its customers. Since the Company began measuring its business by segments beginning in the quarter ended March 31, 2004, comparable results of segment profit and loss for 2003 are not presented, as they are not available. 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, Chief Financial Officer, Executive and Senior Vice Presidents, General Counsel, and the Company’s Chief Strategy Officer. The CEOS reviews financial information presented on both a consolidated basis and on a business segment basis, accompanied by disaggregated information about products and services and geographical regions for purposes of making decisions and assessing financial performance. The CEOS reviews discrete financial information regarding profitability of the Company’s Consumer Products and Services and Business Products and Services and, therefore, the Company reports these as operating segments as defined by Statement of Financial Accounting Standards No. 131, “Disclosure About Segments of an Enterprise and Related Information” (SFAS 131).

The Company’s customers consist primarily of business customers and individual consumers located in the United States and various foreign countries. Revenue by geographic region is as follows (in thousands):


	Quarters Ended				Six Months Ended
	June 30,				June 30,
	2004		2003		2004		2003
United States	$	50,949		36,009		94,912		69,778
Europe		9,101		7,990		19,831		14,904
Rest of the world		5,423		5,647		11,120		11,830

Total net revenue	$	65,473		49,646		125,863		96,512

		The Company’s segment revenue is defined as follows:

•		Consumer Products and Services revenue is derived from sales of digital media subscription services, content such as games and music, the Company’s RealPlayer Plus and other related products, sales and distribution of third party software products and services, and advertising. These products and services are sold and provided primarily through the Internet, and the Company charges customers’ credit cards at the time of sale. Billing periods for subscription services occur monthly, quarterly or annually, depending on the service purchased.

•		Business Products and Services revenue is derived from sales of media delivery system software, including RealServers and Helix system software for both wireline and wireless systems, related authoring and publishing tools, digital rights management technology, support and maintenance services, broadcast hosting services and consulting services offered to the Company’s customers. These products and services are primarily sold to corporate customers.

		Net revenue by segment is as follows (in thousands):


	Quarters				Six Months
	Ended June 30,				Ended June 30,
	2004		2003		2004		2003
Consumer Products and Services	$	53,061		33,172		99,575		66,058
Business Products and Services		12,412		16,474		26,288		30,454

Total net revenue	$	65,473		49,646		125,863		96,512

Consumer Products and Services revenue is comprised of the following (in thousands):


	Quarters				Six Months
	Ended June 30,				Ended June 30,
	2004		2003		2004		2003
Video, consumer software and other	$	29,129		28,830		56,623		58,475
Music		15,580		1,670		27,845		2,501
Games		8,352		2,672		15,107		5,082

Total Consumer Products and Services revenue	$	53,061		33,172		99,575		66,058

Consumer Products and Services revenue is also comprised of the following (in thousands):


	Quarters				Six Months
	Ended June 30,				Ended June 30,
	2004		2003		2004		2003
Consumer subscription services	$	34,777		25,470		66,339		49,109
Consumer software and related services		18,284		7,702		33,236		16,949

Total Consumer Products and Services revenue	$	53,061		33,172		99,575		66,058

Long-lived assets by geographic region are as follows (in thousands):


	June 30,		December 31,
	2004		2003
United States	$	154,910		127,694
Europe		196		230
Rest of world		480		555

Total	$	155,586		128,479

Goodwill, net is assigned to the Company’s segments as follows (in thousands):


	June 30,		December 31,
	2004		2003
Consumer Products and Services	$	111,556		89,662
Business Products and Services		7,815		7,815

Total goodwill, net	$	119,371		97,477

Reconciliation of segment operating income (loss) to net loss before income taxes for the quarter and six months ended June 30, 2004 is as follows (in thousands):


	Consumer Products		Business Products
For the Quarter Ended June 30, 2004	and Services		and Services			Reconciling Amounts			Consolidated

Net revenue	$	53,061		12,412			—			65,473
Cost of revenue		19,713		2,022			—			21,735
Loss on content agreement		—		—			—			—

Gross profit		33,348		10,390			—			43,738
Antitrust litigation		—		—			2,756			2,756
Stock based compensation		—		—			213			213
Other operating expenses		31,251		13,814			—			45,065

Operating income (loss)		2,097		(3,424	)		(2,969	)		(4,296	)
Total non-operating expenses, net		—		—			(209	)		(209	)

Net income (loss) before income taxes	$	2,097		(3,424	)		(3,178	)		(4,505	)


	Consumer Products			Business Products
For the Six Months Ended June 30, 2004	and Services			and Services			Reconciling Amounts			Consolidated

Net revenue	$	99,575			26,288			—			125,863
Cost of revenue		39,256			4,240			—			43,496
Loss on content agreement		4,938			—			—			4,938

Gross profit		55,381			22,048			—			77,429
Antitrust litigation		—			—			5,077			5,077
Stock based compensation		—			—			479			479
Other operating expenses		59,740			26,600			—			86,340

Operating loss		(4,359	)		(4,552	)		(5,556	)		(14,467	)
Total non-operating expenses, net		—			—			(374	)		(374	)

Net loss before income taxes	$	(4,359	)		(4,552	)		(5,930	)		(14,841	)

Operating expenses of both Consumer Products and Services and Business Products and Services include costs directly attributable to those segments and an allocation of general and administrative expenses and other corporate overhead costs. General and administrative and other corporate overhead costs are allocated to the segments are generally based on the relative head count of each segment. The accounting policies used to derive segment results are generally the same as those described in Note 1.

The Company was able to identify historical information for segment cost of revenue and as a result presents net revenue and cost of revenue by segment for the quarter and six months ended June 30, 2003 as follows (in thousands):


	Consumer Products		Business Products
For the Quarter Ended June 30, 2003	and Services		and Services		Consolidated

Net revenue	$	33,172		16,474		49,646
Cost of revenue		12,903		2,017		14,920

Gross profit	$	20,269		14,457		34,726


	Consumer Products		Business Products
For the Six Months Ended June 30, 2003	and Services		and Services		Consolidated

Net revenue	$	66,058		30,454		96,512
Cost of revenue		25,200		3,504		28,704

Gross profit	$	40,858		26,950		67,808

Since the Company began measuring its business by segments beginning in the quarter ended March 31, 2004, comparable results of segment profit and loss for 2003 are not presented, as they are not available.

NOTE 3 — ACQUISITION

On January 30, 2004, the Company acquired all of the outstanding securities of GameHouse, Inc. (GameHouse) in exchange for approximately $9.1 million in cash payments, including an estimated future payment of $0.1 million to cover certain tax obligations of the selling shareholders, and 3.0 million shares and options to acquire 0.3 million shares of RealNetworks common stock valued at approximately $20.9 million. The value assigned to the stock portion of the purchase price is $6.40 per share based on the average closing price of RealNetworks’ common stock for the five days beginning two days prior to and ending two days after January 26, 2004 (the date of the Agreement and Plan of Merger). Options issued were valued based on the Black-Scholes options pricing model. Included in the purchase price is $0.4 million in estimated acquisition-related expenditures consisting primarily of professional fees. Certain former GameHouse shareholders are eligible to receive up to $5.5 million over a four-year period, payable in cash or, at the Company’s discretion, in RealNetworks common stock valued in that amount provided they remain employed by RealNetworks during such period. In addition, the Company may be obligated to pay up to $1.0 million over a four-year period to certain GameHouse employees in the form of a management incentive plan. Such amounts are not included in the aggregate purchase price and, to the extent earned, will be recorded as compensation expense over the related employment periods.

GameHouse is a developer, publisher and distributor of downloadable PC games. The Company believes that combining GameHouse’s assets with RealNetworks’ subscription games service and downloadable games distribution platform will strengthen the

Company’s position in the PC games market. The results of GameHouse’s operations are included in RealNetworks’ consolidated financial statements starting from the date of acquisition.

A summary of the purchase price for the acquisition is as follows (in thousands):


Cash	$	9,131
Fair value of RealNetworks common stock and options issued		20,901
Direct acquisition costs		350

Total	$	30,382

The aggregate purchase consideration has been allocated to the assets and liabilities acquired, including identifiable intangible assets, based on their respective estimated fair values as summarized below. The respective estimated fair values were determined as of the acquisition date and resulted in excess purchase consideration over the net tangible and identifiable intangible assets acquired of $21.9 million.

A summary of the allocation of the purchase price is as follows (in thousands):


Current assets	$	1,315
Property and equipment		82
Technology/Games		5,200
Tradename		1,600
Customer list		400
Goodwill		21,894
Current liabilities		(331	)
Deferred stock compensation		222

Net assets acquired	$	30,382

Technology/Games have a weighted average estimated useful life of two years. Tradename and customer list have a weighted average estimated useful life of four years.

NOTE 4 — OTHER INVESTMENTS

RealNetworks has made minority equity investments for business and strategic purposes through the purchase of voting capital stock of certain 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 of 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 the quarter ended March 31, 2003, 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 $0.4 million. Based upon an evaluation of the facts and circumstances at June 30, 2004, the Company determined that there were no other-than-temporary declines in fair value for the quarter then ended.

As of June 30, 2004, 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 of approximately $1.0 million, resulting in a carrying value at June 30, 2004 of $31.2 million. The increase over the Company’s cost basis, net of tax effects is $13.3 million and is reflected as a component of accumulated other comprehensive income. The market for this company’s shares is relatively limited, and the share price is volatile. Accordingly, there can be no assurance that a gain of this magnitude, or any gain, can be realized through the disposition of these shares.

NOTE 5 — 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 loss, which was $1.0 million for the quarter and $2.1 million for the six months ended June 30, 2004 and $1.4 million and $3.1 million for the comparable periods of 2003. The Company owns preferred stock in MusicNet and also owns convertible notes that are convertible into shares of MusicNet preferred stock. During 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. The Company is not obligated to provide additional funding. For purposes of calculating the Company’s equity in net loss of MusicNet for the quarter ended June 30, 2004, the convertible notes were treated on an “as if” converted basis due to the nature and terms of the convertible notes. As a result, the losses recorded by the Company for the quarter ended June 30, 2004 represent approximately 36.9% of MusicNet’s net loss. As of June 30, 2004, 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 $4.4 million. The Company recognized approximately $0.2 million and $0.4 million of revenue during the quarter and the six months ended June 30, 2004, and $0.3 million and $0.6 million for the quarter and six months ended June 30, 2003, respectively, related to license and services agreements with MusicNet.

NOTE 6 — LOSS ON EXCESS OFFICE FACILITIES AND CONTENT AGREEMENT

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 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. The loss estimate includes $14.7 million of sublease income, of which $8.0 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, 2004. The Company also recorded an accrual for estimated future losses on excess office facilities in its allocation of the Listen purchase price. The Company regularly evaluates the market for office space. If the market for such space declines further in future periods or if the Company is unable to sublease the space based on its current estimates, 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.

During the quarter ended March 31, 2004, the Company cancelled a content licensing agreement with one of its content partners. Under the terms of the cancellation agreement, the Company gave up rights to use the content, and ceased using the content in any of its products or services as of March 31, 2004. The resulting expense of $4.9 million represents the estimated fair value of payments to be made in accordance with the terms of the cancellation agreement.

A summary of activity for the accrued loss on excess office facilities and content agreement is as follows (in thousands):


Accrued loss at December 31, 2003	$	29,059
Less amounts paid, net of sublease income		(3,725	)
Accrued loss on content agreement		4,938
Less amounts paid on content agreement		(685	)

Accrued loss at June 30, 2004	$	29,587

NOTE 7 — CONVERTIBLE DEBT

During 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 per share 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 a 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 has received proceeds of $97.0 million, net of offering costs. The offering costs are included in other assets and are being amortized over a five-year period. Interest expense from the amortization of offering costs in the amount of $0.2 million and $0.4 million is recorded in interest income, net for the quarter and six months ended June 30, 2004, respectively. Interest expense for the quarter and the six months ended June 30, 2003 was not significant. The net proceeds of the issuance are intended to be used for general corporate purposes, acquisitions, other strategic transactions including joint ventures, and other working capital requirements.

NOTE 8 — GUARANTEES

In the ordinary course of business, the Company is not subject to potential obligations under guarantees that fall within the scope of FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees and Indebtedness of Others (“FIN 45”) an interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB interpretation No. 34, except for standard indemnification and warranty provisions that are contained within many of the Company’s customer license and service agreements, and give rise only to the disclosure requirements prescribed by FIN 45.

Indemnification and warranty provisions contained within the Company’s customer license and service agreements are generally consistent with those prevalent in the Company’s industry. The duration of the Company’s product warranties generally does not exceed 90 days following delivery of the Company’s 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 9 — LITIGATION

On March 9, 2004, the Company sued MLB Advanced Media, L.P. (MLBAM) in the U.S. District Court for the Western District of Washington, asserting a claim for breach of contract relating to an agreement between the Company and MLBAM, which requires MLBAM to provide certain streaming media content in the Company’s formats. The Company is seeking injunctive relief requiring MLBAM to perform its obligations under that agreement. The Company is also seeking monetary damages and reasonable attorneys fees. MLBAM has filed counterclaims in the action alleging false advertising, trademark infringement and related allegations, all of which the Company has denied.

In December 2003, the Company filed suit against Microsoft Corporation in the U.S. District Court for the Northern District of California, pursuant to U.S. and California antitrust laws. The Company alleged that Microsoft has illegally used its monopoly power to restrict competition, limit consumer choice and attempt to monopolize the field of digital media. Microsoft has filed an answer denying the claims and raising a variety of defenses. The Company believes it has a strong case and intends to vigorously pursue the litigation. If successful, the Company may be entitled to both monetary and injunctive relief from Microsoft. The Company expects that the litigation will carry on for several years before it can be resolved through trial.

In September 2003, a lawsuit was filed against the Company in federal court in Marshall, Texas, alleging that the Company infringes certain patents relating to the transmittal of information recorded on information storage “means” from a central server to subscribers via a high data rate digital telecommunications network. The plaintiff seeks to enjoin the Company from the alleged infringing activity and to recover damages from the alleged infringement. The Company has answered the complaint and filed a counterclaim against plaintiff challenging the validity of its patents at issue and asserting inequitable conduct. The Company disputes plaintiff’s allegations in this action and intends to vigorously defend itself against these claims.

In June 2003, a lawsuit was filed against the Company and Listen in federal district court for the Northern District of Illinois, alleging that certain features of the Company’s and Listen’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 damages from the alleged infringement. The Company has filed its answer and a counterclaim against plaintiff challenging the validity of the patents at issue. The trial court has also granted the Company’s motion to transfer the action to the Northern District of California. The Company disputes plaintiff’s allegations in this action and intends to vigorously defend itself.

Company’s motion to stay the action pending arbitration on an individual, non-class basis and the Court of Appeals and the Washington Supreme Court have rejected the plaintiff’s appeal. The Company disputes plaintiff’s allegations in this action and intends to vigorously defend itself against these claims.

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 its recovery of damages for plaintiff’s infringement of a Company patent, and reasonable attorneys fees and costs. The Company disputes plaintiff’s allegations in this action and intends to vigorously defend itself.

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, including those described above, even if not meritorious, could force the Company to spend significant financial and managerial resources. 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. 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 RealNetworks’ Annual Reports onForm 10-K, other Quarterly Reports onForm 10-Q and any Current Reports on Form 8-K. You should also read the following discussion and analysis in conjunction with our condensed consolidated financial statements and related notes included in this report.

Overview

RealNetworks, Inc. and subsidiaries (RealNetworks or Company) is a leading global provider of network-delivered digital media content and services. The Company also develops and markets software products and services that enable the creation, distribution and consumption of digital media, including audio and video. Consumers use our services and software to find, play, purchase and manage free and premium digital content, including music, video and games. Broadcasters, network operators, media companies and enterprises use our products and services to create and deliver digital media to PCs, mobile phones and consumer electronics devices.

We have been a pioneer in the development of technology for the transmission of digital media over the Internet, and we have used this technology leadership to create a large base of consumers, network operators and content owners who use our products and services to create, send and receive both free and paid content. Our strategy is to continue to grow and leverage this base of users to drive the creation of a market for premium digital audio and video content online and generate profitable revenue from this market in two primary ways:

(1) as a creator, packager and seller of software and digital content to consumers; and

(2) as a supplier of the underlying technology and business to business services to content owners and network operators to create and distribute digital content.

Over the last several years, our core business has evolved to address changing dynamics in our industry. We initially developed our business as a leading provider of software technology for the delivery and playback of digital media content over digital networks, and became a leader in that market. We have recently leveraged our technology business and large technology user base to define and develop new markets and businesses predicated on digital media technology. These new businesses principally involve paid digital media content. We have aggressively pursued development of these new businesses, through both internal initiatives and strategic acquisitions of businesses and technologies. As these new businesses have developed, the focus of our core business, including our promotional efforts, has shifted toward these markets and has resulted in significant increases in the number of subscribers to our service offerings. This shift in focus and number of subscribers is reflected in our results of operations in the following primary ways:

•

A significant increase in service revenue, including primarily consumer subscription services;

•

A significant increase in revenue in our music and games businesses; and

•

A higher percentage of our total revenue relating to the above areas of our business.

Despite the aggregate growth of our consumer subscription businesses, our overall results have been substantially affected over the last several years by slower sales and usage of our business products and services. The reduction in sales and usage of our business products and services during this period has been caused primarily by Microsoft’s continuing practice of bundling its competing Windows Media Player and server software for free with its Windows NT operating system products, which we believe is an illegal practice, and also by general macroeconomic conditions. The macroeconomic conditions resulted in cutbacks in capital and information technology spending by our customers and potential customers in prior periods. Our Business Products and Services revenue tends to be comprised of a number of larger transactions, which tend to have lengthy and variable sales cycles. Due to the length and variability of these sales cycles and the size of the transactions, our sequential quarterly revenue has fluctuated based on the timing of the consummation of sales. Additionally, companies within the wireless telecommunications industry have introduced mobile products and services slower than we had expected, which has also contributed to the decreased revenue related to our business products and services. We believe that some or all of these factors have resulted in reduced sales of our business products and services, resulting in declines in related revenue.

We manage our business, and correspondingly report revenue, based on our two operating segments: Consumer Products and Services and Business Products and Services.

•

Consumer Products and Services, which primarily include: revenue from digital media subscription services such as RealOne SuperPass, RadioPass, Rhapsody, GamePass and stand-alone and add-on subscriptions; revenue from sales and distribution of third party software and services; sales of content such as music and game downloads; revenue from sales of premium versions of our RealPlayer and related products; and advertising revenue.

•

Business Products and Services, which primarily include: sales of our media delivery system software, including Helix system software and related authoring and publishing tools, both directly to customers and indirectly through original equipment manufacturer (OEM) channels; revenue from support and maintenance services that we sell to customers who purchase our software products; revenue from broadcast hosting services; and revenue from consulting services we offer to our customers.

In August 2003, we acquired all of the outstanding securities of Listen.com, Inc. (Listen). Listen had developed and operated an on-demand streamed music subscription service called the Rhapsody service, which is now operated and integrated as part of our music services. Rhapsody subscribers pay a monthly subscription fee and also have the ability to burn compact discs for which they are charged a per-track fee. The results of Listen’s operations are included in our unaudited condensed consolidated financial statements and related notes thereto since the date of acquisition and impact the comparability of the 2004 results when compared to 2003.

In January 2004, we acquired all of the outstanding securities of GameHouse, Inc. (GameHouse). GameHouse is a developer, publisher and distributor of downloadable PC games. The acquisition is designed to strengthen our position in the downloadable PC games market by combining the assets of GameHouse with RealNetworks’ downloadable games distribution platform. The results of GameHouse’s operations are included in our unaudited condensed consolidated financial statements since the date of acquisition and impact the comparability of the 2004 results when compared to 2003.

Critical Accounting Policies and Estimates

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. 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; and

•

Valuation of deferred income tax assets.

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.

For software related products and services, 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” (SOP 98-9). 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. Some of our software

arrangements include consulting implementation services sold separately under consulting engagement contracts. If the consulting services are essential to the functionality of the software, or payment of the license fee depends on the performance of the services, both the software license and consulting fees are recognized under the percentage of completion method of contract accounting.

In addition, for transactions not falling under the scope of SOP 97-2, our revenue recognition policies are in accordance with EITF 00-21 and Securities and Exchange Commission (SEC) Staff Accounting Bulletin 104, “Revenue Recognition” (SAB 104).

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 that do not include customization or consulting services, delivery typically occurs when the product is made available to the customer for download. 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 transaction 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 consider the fee to not be 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.

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 future upgrades, enhancements or other services over the term of the contract, all of the revenue under the arrangement is generally recognized ratably over the term of the contract.

Service revenue includes payments under support and upgrade contracts, RealOne and Rhapsody 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. Fees generated from advertising are recognized as advertising is delivered over the term of the contract. Other service revenue is recognized as the services are performed.

Sales Returns and the Allowance for Doubtful Accounts.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. 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. 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 were to make different judgments or utilize different estimates.

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. We have revised our original estimate three times in the last two years, increasing the accrual for loss on excess office facilities each time. These first two revisions were the result of changes in the market for commercial real estate where we operate. The third revision, which took place in 2003, was the result of adding an additional tenant at a sublease rate lower than the rate used in previous estimates. If the market for such space declines further in future periods or if we are unable to sublease the space based on our current estimates, we may have to revise our estimates, which may result in additional losses on excess office facilities.

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; and

•

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 would measure 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. Judgment is required in determining what our reporting units are for the purpose of assessing fair value compared to carrying value.

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, our ability to project future results and any appreciation of our investments and other assets. As of June 30, 2004 and December 31, 2003, we had established valuation allowances equal to our net deferred tax assets.

Revenue by Segment

We operate our business in two segments: Consumer Products and Services and Business Products and Services.


	Quarters Ended June 30,							Six Months Ended June 30,
	2004		2003		Change			2004		2003		Change
			(Dollars in thousands)							(Dollars in thousands)
Consumer Products and Services	$	53,061		33,172		60	%	$	99,575		66,058		51	%
Business Products and Services		12,412		16,474		(25	)		26,288		30,454		(14	)

Total net revenue	$	65,473		49,646		32		$	125,863		96,512		30


	Quarters Ended June 30,					Six Months Ended June 30,
	2004			2003		2004		2003
	(As a percentage of total net revenue)					(As a percentage of total net revenue)
Consumer Products and Services		81	%		67		79		68
Business Products and Services		19			33		21		32

Total net revenue		100	%		100		100		100

Consumer Products and Services.Consumer Products and Services revenue is derived from sales of digital media subscription services, the Company’s RealPlayer Plus and other related products, sales and distribution of third party software products and services, sales of digital content such as games and music, and advertising. These products and services are sold primarily through the Internet, and the Company charges customers’ credit cards at the time of sale. Billing periods for subscription services occur monthly, quarterly or annually, depending on the service purchased. Consumer Products and Services revenue increased in the quarter and six months ended June 30, 2004 primarily due to: (1) growth in aggregate subscribers to our digital media subscription services and the related growth in revenue; (2) revenue related to new third party product distribution agreements; (3) revenue from our Rhapsody music service since the date of our acquisition of Listen, and subsequent growth in the number of Rhapsody subscribers; and (4) approximately $2.9 million for the quarter and $4.8 million for the six months ended June 30, 2004, respectively, of revenue resulting from our acquisition of GameHouse in January 2004. These increases were partially offset by decreases in sales of our premium consumer license products. We believe the growth in certain of our subscription services is due in part to the continued shift in our marketing and promotional efforts to these services as well as product improvements. While revenue related to our digital media subscription services has increased substantially on a year-over-year basis, the rate of growth has fluctuated on a quarterly basis. We cannot predict with accuracy how these subscription offerings will perform in the future, at what rate digital media subscription service revenue will grow, if at all, or the nature or potential impact of anticipated competition.

Business Products and Services.Business Products and Services revenue is derived from the licensing of our media delivery system software, including 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 and consulting services we offer to our customers. These products and services are primarily sold to corporate customers. We do not require collateral from our customers, but we often require payment before or at the time products and services are delivered. Many of our customers are given standard commercial credit terms, and for these customers we do not require payment before products and services are delivered. Business Products and Services revenue decreased in the quarter and six months ended June 30, 2004 due primarily to decreases in revenue from certain of our business software products, including revenue from our OEM partners. In addition, in the quarter ended June 30, 2003, we recognized revenue related to a past contract with a customer who had filed for bankruptcy protection. The bankruptcy court relieved us of any future support or other obligations and as a result, we recognized the remaining amount of deferred revenue in June 2003. The decrease in revenue was partially offset by an increase in sales of our system software to mobile and wireless infrastructure companies and favorable foreign exchange rates in the quarter and six months ended June 30, 2004, as compared to the same periods in 2003. We believe the decreases in sales of certain of our business software products were substantially affected by Microsoft’s continuing practice of bundling its competing Windows Media Player and server software for free with its Windows NT operating system products, which we believe is an illegal practice. Our Business Products and Services revenue tends to be comprised of a number of larger transactions, which tend to have lengthy and variable sales cycles. Due to the length and variability of these sales cycles and the size of the transactions, our sequential quarterly revenue has fluctuated based on the timing of the consummation of the related agreements. Additionally, companies within the wireless telecommunications industry have introduced mobile products and services more slowly than we had expected, which has also contributed to the decreases in Business Products and Services revenue for the quarter and six months ended June 30, 2004. No assurance can be given when, or if, we will experience increased sales of our business products and services to customers in these markets.

Consumer Products and Services Revenue

A further analysis of our Consumer Products and Services revenue is as follows:


	Quarters Ended June 30,							Six Months Ended June 30,
	2004		2003		Change			2004		2003		Change
	(Dollars in thousands)							(Dollars in thousands)
Video, consumer software and other	$	29,129		28,830		1	%	$	56,623		58,475		(3	)%
Music		15,580		1,670		833			27,845		2,501		1013
Games		8,352		2,672		213			15,107		5,082		197

Total Consumer Products and Services revenue	$	53,061		33,172		60		$	99,575		66,058		51

Video, Consumer Software and Other.Video, consumer software and other revenue includes primarily revenue from our RealOne and stand-alone premium video subscription services, RealPlayer Plus and related products, revenue from support services that we sell to customers who purchase these products, and sales and distribution of third-party software products and all advertising other than that related directly to games and music. Revenue increased in the quarter ended June 30, 2004 primarily due to new third party distribution agreements, which were offset by decreases in revenue in our RealOne Superpass subscription service and decreased sales of our premium consumer license products. Revenue decreased in the six months ended June 30, 2004 due to decreases in our RealOne SuperPass subscription service and decreased sales of our premium consumer license products. The decrease was partially offset by the increase due to new third party distribution agreements. The decrease in revenue from our RealOne Superpass subscriptions and premium consumer license products is due primarily to a shift in our marketing and promotional efforts towards our music subscription services, which we believe represent a greater growth opportunity for us.

Music.Music revenue primarily includes revenue from our Rhapsody and RadioPass subscription services, sales of music content and advertising from our music web sites. The increase in revenue during the quarter and six months ended June 30, 2004 is due primarily to the inclusion and subsequent growth of the Rhapsody service (which we began selling after we acquired Listen in August 2003) and the growth of our RadioPass service that we introduced in the fourth quarter of 2002. We also launched additional international versions of RadioPass during the second half of 2003 and 2004, which contributed to the growth of our music revenue in the first six months of 2004. Also, during the quarter ended March 31, 2004, we began offering on-line sales of individual songs through our new music store, which further contributed to revenue growth. We believe the growth is due primarily to the increased focus of our marketing efforts on our music offerings and the broader acceptance of paid on-line music services.

Games.Games revenue primarily includes revenue from game downloads through our RealArcade service and our GameHouse Web site, revenue from our GamePass subscription service and related advertising. The increase in revenue during the quarter and six months ended June 30, 2004 is due primarily to an increase in the number of subscribers and related revenue for our GamePass subscription service since its introduction in the fourth quarter of 2002 and approximately $2.9 million and $4.8 million of revenue during the quarter and six months ended June 30, 2004, respectively, related to our acquisition of GameHouse. In addition to the acquisition of GameHouse, the growth in Games is due to increased focus of our marketing efforts and the addition of new game titles to our RealArcade and GamePass offerings.

Geographic Revenue


	Quarters Ended June 30,							Six Months Ended June 30,
	2004		2003		Change			2004		2003		Change
	(Dollars in thousands)							(Dollars in thousands)
United States	$	50,949		36,009		41	%	$	94,912		69,778		36	%
Europe		9,101		7,990		14			19,830		14,904		33
Rest of the world		5,423		5,647		(4	)		11,121		11,830		(6	)

Total	$	65,473		49,646		32		$	125,863		96,512		30

Revenue generated in the United States increased in absolute dollars for the quarter and six months ended June 30, 2004 primarily due to the growth of our Music and Games businesses and revenue from distribution of third party software and services. See theGamesandMusicsections above for further discussion of the

changes.

International revenue increased in absolute dollars for the quarter and six months ended June 30, 2004 are primarily due to increased sales of our system software to mobile and wireless infrastructure companies as well as the launch of our international RadioPass subscription service during 2004. International revenue decreased as a percentage of overall revenue to 22% from 27% for the quarter and to 25% from 28% for the six months ended June 30, 2004 principally due to our U.S. consumer related revenue growing at a faster rate than International revenue.

Revenue

In accordance with SEC regulations, we also present our revenue based on License Fees and Service Revenue as set forth below.


	Quarters Ended June 30,							Six Months Ended June 30,
	2004		2003		Change			2004		2003		Change
	(Dollars in thousands)							(Dollars in thousands)
License fees	$	17,136		16,595		3	%	$	35,382		32,867		8	%
Service revenue		48,337		33,051		46			90,481		63,645		42

Total net revenue	$	65,473		49,646		32		$	125,863		96,512		30


	Quarters Ended June 30,					Six Months Ended June 30,
	2004			2003		2004		2003
	(As a percentage of total net revenue)					(As a percentage of total net revenue)
License fees		26	%		33		28		34
Service revenue		74			67		72		66

Total net revenue		100			100		100		100

License Fees.License fees primarily include: sales of our media delivery system software, including Helix system software and related authoring and publishing tools, both directly to customers and indirectly through OEM channels; revenue from sales of premium versions of our RealPlayer Plus and related products; sales of third-party products and content such as game downloads and digital music. License fees include revenue from both our Consumer and Business Products and Services segments. The increase in license fees for the quarter and six months ended June 30, 2004 was primarily due to an increase in incremental revenue of approximately $2.9 million and $4.8 million, respectively, resulting from the acquisition of GameHouse in January 2004, revenue from the on-line sale of individual songs through our Rhapsody music subscription service (which we began selling after we acquired Listen in August 2003) and through our new RealPlayer Music Store, which we launched in January 2004, and increased sales of our system software to mobile and wireless infrastructure companies. These increases were offset by decreases in revenue from certain of our business software products, including revenue from our OEM partners and decreased sales of our premium consumer license products. See “Revenue by Segment — Consumer Products and Services” and “Revenue by Segment — Business Products and Services” above for further detailed explanation of changes.

Service Revenue.Service revenue primarily includes: revenue from digital media subscription services such as RealOne SuperPass, RadioPass, Rhapsody, GamePass and stand-alone and add-on subscriptions; revenue from support and maintenance services that we sell to customers who purchase our software products; revenue from broadcast hosting services; revenue from consulting services we offer to our customers; and revenue from distribution of third party software and advertising revenue. Service revenue includes revenue from both our Consumer and Business Products and Services segments. The increase in service revenue during the quarter and six months ended June 30, 2004 was primarily attributable to growth in aggregate subscribers to our digital media subscription services and an increase in revenue related to third-party product distribution agreements, partially offset by decreases in other service offerings including support and upgrades. Our subscription services accounted for approximately $34.8 million and $25.5 million of service revenue during the quarters ended June 30, 2004 and 2003, respectively. Our subscription services accounted for approximately $66.3 million and $49.1 million of service revenue during the six months ended June 30, 2004 and 2003, respectively. The reasons for increases in subscription revenue are described in more detail in “Revenue by Segment — Consumer Products and Services” above. We believe the decreased revenue in our other service offerings, including support and upgrades, are due primarily to the factors described above in “Revenue by Segment — Business Products and Services.”

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. Deferred revenue at June 30, 2004 was $31.9 million compared to $35.7 million at December 31, 2003. The decrease in deferred revenue during 2004 is primarily due to prepayments received under contracts occurring at a slower rate than recognition of revenue on existing contracts. The slower rate of prepayment receipts has been largely due to the decrease in new contracts in our Business Products and Services business segment in recent periods, which represent a significant portion of deferred revenue. We believe the decrease in new contracts in our Business Products and Services business segment results primarily from the conditions described in “Revenue by Segment — Business Products and Services” above. The decrease in prepayments under contracts was partially offset by an increase in deferred revenue from subscription services resulting from an increase in subscribers.

Cost of Revenue by Segment


	Quarters Ended June 30,								Six Months Ended June 30,
	2004			2003		Change			2004			2003		Change
	(Dollars in thousands)								(Dollars in thousands)
Consumer Products and Services	$	19,713			12,903		53	%	$	44,194			25,200		75	%
Business Products and Services		2,022			2,017		—			4,240			3,504		21

Total cost of revenue	$	21,735			14,920		46		$	48,434			28,704		69

As a percentage of total net revenue		33	%		30					38	%		30

Cost of Consumer Products and Services.Cost of Consumer Products and Services revenue includes cost of content, and delivery of the content, included in our digital media subscription service offerings, royalties paid on sales of games, music and other third-party products, amounts paid for licensed technology, costs of product media, duplication, manuals, packaging materials, and fees paid to third-party vendors for order fulfillment and support services. Cost of Consumer Products and Services revenue increased by 53% and 75% for the quarter and six months ended June 30, 2004, respectively. The increase in absolute dollars was due to an increase in licensing costs associated with the on-line sale of individual songs, increased costs associated with delivering content to a greater number of subscribers, costs associated with the Rhapsody subscription service resulting from our acquisition of Listen and the amortization of intangible assets resulting from the acquisition of GameHouse. The increase in our costs for the six-month period was also due to theLoss on Content Agreement, as described below. Cost of Consumer Products and Services decreased as a percentage of Consumer Products and Services revenue from 39% to 37% for the quarter ended June 30, 2004 was primarily due to the application of fixed content costs for certain contracts against a higher revenue base, the renegotiation of certain content agreements with more favorable financial terms and the discontinuation of certain content. Cost of Consumer Products and Services increased as a percentage of Consumer Products and Services revenue from 38% to 44% for the six months ended June 30, 2004 primarily due to the Loss on Content Agreement, increased costs associated with delivering content to a greater number of subscribers and the costs of content included in our digital media subscription services

Cost of Business Products and Services.Cost of Business Products and Services revenue includes amounts paid for licensed technology, costs of product media, duplication, manuals, packaging materials, fees paid to third-party vendors for order fulfillment, cost of in-house and contract personnel providing support and consulting services, and expenses incurred in providing our streaming media hosting services. Cost of Business Products and Services revenue for the quarter ended June 30, 2004 was consistent with the same period in 2003 and increased as a percentage of Business Products and Services revenue to 16% from 12%. Cost of Business Products and Services revenue for the six months ended June 30, 2004 increased by 21% and increased as a percentage of Business Products and Services revenue to 16% from 12%. The increase during the quarter and six months ended June 30, 2004 was primarily due to higher costs of revenue related to custom development work and a shift in mix towards products with higher product royalty costs.

Cost of Revenue


	Quarters Ended June 30,								Six Months Ended June 30,
	2004			2003		Change			2004			2003		Change
	(Dollars in thousands)								(Dollars in thousands)
License fees	$	6,745			2,239		201	%	$	12,955			3,562		264	%
Service revenue		14,990			12,681		18			30,541			25,142		21
Loss on content agreement		—			—		—			4,938			—		—

Total cost of revenue	$	21,735			14,920		46		$	48,434			28,704		69

As a percentage of total net revenue		33	%		30					38	%		30

Cost of License Fees.Cost of license fees includes royalties paid on sales of games, music and other third-party products, amounts paid for licensed technology, costs of product media, duplication, manuals, packaging materials, and fees paid to third-party vendors for order fulfillment. Cost of license fees for the quarter ended June 30, 2004 increased in absolute dollars and increased as a percentage of license fees revenue to 39% from 13%. Cost of license fees for the six months ended June 30, 2004 increased by 264% from the same period in 2003 and increased as a percentage of license fees to 37% from 11%. The increases in costs both in dollars and as a percentage of license fees were primarily due to the licensing costs associated with the on-line sale of individual songs. The increase is also due to an increase in royalties resulting from a shift in product mix towards products with higher third party product royalties and the amortization of intangibles resulting from the acquisition of GameHouse.

Cost of Service Revenue.Cost of service revenue includes the cost of content, and delivery of the 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 for the quarter ended June 30, 2004 increased 18% but decreased as a percentage of service revenue to 31% from 38%. Cost of service revenue for the six months ended June 30, 2004 increased 21% but decreased as a percentage of service revenue to 34% from 40%. The increase in costs was primarily due to increased costs associated with delivering content to a greater number of subscribers and the costs of content included in our digital media subscription services. The content costs increased due to an increase in paying subscribers and the costs of adding new content to our services as well as the increase in costs associated with revenue from the Rhapsody service. The decrease in cost of service revenue as a percentage of service revenue was due to the application of fixed content costs for certain contracts against a higher revenue base, the renegotiation of certain content agreements with more favorable financial terms and the discontinuation of certain content.

Loss on Content Agreement.During the quarter ended March 31, 2004, we cancelled a content licensing agreement with PGA TOUR. Under the terms of the cancellation agreement, we gave up rights to use the PGA TOUR content and ceased using their content in any of our products or services as of March 31, 2004. The expense represents the estimated fair value of payments to be made in accordance with the terms of the cancellation agreement.

Our digital media subscription services, including Rhapsody, are a relatively new and growing portion of our business and, to date, have been characterized by 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 net revenue, our cost of service revenue may grow at an increased rate relative to net revenue and thereby will lead to reductions in our gross margin percentages 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.

Operating Expenses

Research and Development


	Quarters Ended June 30,								Six Months Ended June 30,
	2004			2003		Change			2004			2003		Change
	(Dollars in thousands)								(Dollars in thousands)
Research and development	$	13,219			11,826		12	%	$	25,470			22,733		12	%
As a percentage of total net revenue		20	%		24					20	%		24

Research and development expenses consist primarily of salaries and related personnel costs and consulting fees associated with product 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, increased in the quarter ended June 30, 2004 primarily due to an increase in personnel and related costs and the inclusion of personnel and operating expenses resulting from our acquisitions of Listen and GameHouse since the dates of each of those acquisitions. The decrease as a percentage of total net revenues was a result of our total net revenue growing more rapidly than our research and development expenses.

Sales and Marketing


	Quarters Ended June 30,								Six Months Ended June 30,
	2004			2003		Change			2004			2003		Change
	(Dollars in thousands)								(Dollars in thousands)
Sales and marketing	$	23,247			19,296		20	%	$	45,450			37,599		21	%
As a percentage of total net revenue		36	%		39					36	%		39

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 expense increased in the quarter and six months ended June 30, 2004 primarily due to the inclusion of personnel and operating expenses resulting from our acquisition of Listen and an increase in payments made to third parties for referrals of new customers and advertising costs. We expect that our sales and marketing expenses will increase as we shift the focus of our marketing efforts to our consumer products and services. The decrease as a percentage of total net revenues was a result of our total net revenue growing more rapidly than our sales and marketing expenses.

General and Administrative


	Quarters Ended June 30,								Six Months Ended June 30,
	2004			2003		Change			2004			2003		Change
	(Dollars in thousands)								(Dollars in thousands)
General and administrative	$	8,599			5,864		47	%	$	15,420			11,361		36	%
As a percentage of total net revenue		13	%		12					12	%		12

General and administrative expenses consist primarily of salaries, related personnel costs, fees for professional, temporary services and contractor costs and other general corporate costs. General and administrative expenses, excluding non-cash stock-based compensation, increased in the quarter and six months ended June 30, 2004 primarily due to increased personnel and related costs, increased contractor costs, increased litigation defense costs, costs related to our continued implementation efforts related to the Sarbanes-Oxley Act of 2002, specifically Section 404, and the inclusion of personnel and operating expenses resulting from our acquisition of Listen.

Antitrust Litigation

Antitrust litigation of $2.8 million and $5.1 million in the quarter and six months ended June 30, 2004, respectively, consists of legal fees, personnel costs, communications, equipment, technology and other professional services, incurred related to antitrust complaints against Microsoft, including proceedings in the European Union. Only costs that are directly attributable to these antitrust complaints are included.

Stock-Based Compensation

Stock-based compensation expense represents restricted stock and assumption of stock options in our acquisitions. Stock-based compensation was $0.2 million and $0.5 million for each of the quarters and six months ended June 30, 2004 and 2003, respectively.

Other Income (Expense), Net


	Quarters Ended June 30,									Six Months Ended June 30,
	2004			2003			Change			2004			2003			Change
	(Dollars in thousands)									(Dollars in thousands)
Interest income, net	$	800			1,186			(33	)%	$	1,660			2,451			(32	)%
Equity in net loss of MusicNet		(1,019	)		(1,394	)		(27	)		(2,134	)		(3,125	)		(32	)
Impairment of equity investments		—			—			—			—			(424	)		—
Other, net		10			209			(95	)		100			265			(62	)

Other income (expense), net	$	(209	)		1			(210	)	$	(374	)		(833	)		(55	)

Other income (expense), net consists primarily of interest earnings on our cash, cash equivalents and short-term investments, which are net of interest expense due to the amortization of offering costs related to our convertible debt, equity in net loss of MusicNet, Inc. (“MusicNet”) and impairment of certain equity investments. Other income (expense), net decreased in the quarter and six months ended June 30, 2004 primarily due to lower equity in net losses of MusicNet, which was offset by decreased interest income due to lower effective interest rates on investment balances and interest expense associated with the amortized offering costs. Additionally, for the six-month period the decrease was also attributed to the impairment of equity investments during 2003.

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 record in our statement of operations our equity share in MusicNet’s net loss, which was $1.0 million and $2.1 million for the quarter and six months ended June 30, 2004. In 2003, MusicNet raised additional capital from its investors to fund its business. In connection with this fund raising, we contributed additional capital in the amount of $3.0 million for which we received convertible notes that are convertible into additional shares of MusicNet capital stock. We anticipate that MusicNet will continue to incur losses in the foreseeable future and will require additional funding, although we are not obligated to provide additional funding. Because of this, in the future, our investment may be diluted or we could be required to record an impairment charge to reduce the carrying value of this investment. Based on the nature and terms of the convertible notes, 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 represent approximately 36.9% of MusicNet’s net loss. As of June 30, 2004, our ownership interest in outstanding shares of capital stock of MusicNet was approximately 25.5% and the carrying value of our investment was $4.4 million.

We have made minority equity investments for business and strategic purposes through the purchase of voting capital stock of several 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 any declines in fair value 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 by which its accounting basis exceeds its quoted market price. We consider additional 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. Based upon an evaluation of the facts and circumstances during the quarter ended March 31, 2003, we determined that other-than-temporary declines in fair value had occurred in two of our publicly traded investments resulting in impairment charges of $0.4 million to reflect changes in the fair value of these investments in the results of operations. There were no such impairments during the six months ended June 30, 2004.

As of June 30, 2004, we owned marketable equity securities of a Japanese digital media company. We own approximately 14% of the outstanding shares and this investment is accounted for as an available-for-sale security. The market value of these shares has significantly increased from our original cost of approximately $1.0 million, resulting in a carrying value at June 30, 2004 of $31.2 million. The increase over our cost basis, net of tax effects is $13.3 million and is reflected as a component of accumulated other comprehensive income. The market for this company’s shares is relatively limited and the share price is volatile. Accordingly, there can be no assurance that a gain of this magnitude can be realized through the disposition of these shares.

Income Taxes

We recognized income tax expense of $0.1 million during each of the quarters and $0.2 million during each of the six month periods ended June 30, 2004 and 2003, related to current foreign income taxes. 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. At June 30, 2004 and December 31, 2003, we recorded a valuation allowance sufficient to net deferred tax assets to zero.

Impact of Recently Issued Accounting Standards

In March 2004, the FASB’s Emerging Issues Task Force reached a consensus on EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (EITF 03-1). The guidance prescribes a three-step model for determining whether an investment is other-than-temporarily impaired and requires disclosures about unrealized losses on investments. The accounting guidance is effective for reporting periods beginning after June 15, 2004, while the disclosure requirements are effective for annual reporting periods ending after June 15, 2004. Although we will continue to evaluate the application of EITF 03-1, we do not currently believe adoption will have a material impact on our results of our consolidated financial statements.

In April 2004, the FASB issued FASB Staff Position 129-1, “Disclosure Requirements under FASB Statement No. 129, Disclosure of Information about Capital Structure, Relating to Contingently Convertible Securities,” (FSP 129-1). The FASB staff confirmed through FSP 129-1 that the disclosure requirements of Statement of Financial Accounting Standard No. 129, “Disclosure of Information About Capital Structure” (SFAS 129) apply to all contingently convertible financial instruments, including those containing contingent conversion requirements that have not been met and are not otherwise required to be included in the computation of diluted EPS. This guidance is effective immediately and applies to all existing and newly created securities. Our disclosures have previously conformed to SFAS 129, and therefore, adoption of this pronouncement did not have an impact on our consolidated financial statements.

In June 2004, the Emerging Issues Task Force reached a consensus on Issue No. 02-14, “Whether an Investor Should Apply the Equity Method of Accounting to Investments Other Than Common Stock” (EITF 02-14). EITF 02-14 addresses whether the equity method of accounting applies when an investor does not have an investment in voting common stock of an investee but exercises significant influence through other means, how the equity method should be applied to investments other than common stock, and for securities with a readily determinable fair market value, how the provisions of Accounting Principles Board Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock” (APB 18), and Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (SFAS 115), interact. The consensus in EITF 02-14 is effective for reporting periods beginning after September 15, 2004. We are currently evaluating the potential impact of EITF 02-14 on our financial statements.

Liquidity and Capital Resources

Net cash provided by operating activities was $1.3 million for the six months ended June 30, 2004 and net cash used in operating activities was $7.4 million for the six months ended June 30, 2003. Net cash provided by operating activities in 2004 was the result of a net loss of $15.1 million offset by net changes in certain operating assets and liabilities of $6.1 million, due primarily to the timing of cash receipts or payments at the beginning and end of the period and a decrease in deferred revenue, depreciation and amortization of $7.0 million, an accrued loss on content agreement of $4.3 million, and equity in net losses of equity method investments of $2.1 million. Net cash used in operating activities in 2003 was the result of a 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 provided by investing activities was $0.7 million and $79.8 million for the six months ended June 30, 2004 and 2003, respectively. Net cash provided by investing activities in 2004 was primarily due to net sales and maturities of short-term investments offset by the payment of acquisition costs and purchases of equipment and leasehold improvements. Net cash provided by investing activities in 2003 was primarily related to net proceeds of short-term investments, offset by purchases of equipment and leasehold improvements and purchases of equity securities held as long-term investments.

Net cash provided by financing activities was $4.2 million and $104.0 million for the six months ended June 30, 2004 and 2003, respectively. Net cash provided by financing activities during 2004 was related to proceeds from exercise of stock options and stock sold related to our employee stock purchase plan. Net cash provided by financing activities during 2003 was primarily from proceeds from our convertible debt offering.

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. There were no repurchases during the quarter or six months ended June 30, 2004 or during the year ended December 31, 2003. As of June 30, 2004, we had repurchased approximately 9.1 million shares at an average cost of $4.64 per share. We currently intend to continue our stock repurchase program depending on market conditions and other factors until we reach the $50 million limit authorized by our Board of Directors, which will be a further use of cash.

We currently have no planned significant capital expenditures for the remainder of 2004 other than those in the ordinary course of business. In the future, we may seek to raise additional funds through public or private equity financing, or through other sources such as credit facilities. The sale of additional equity securities could result in dilution to our shareholders. In addition, in the future, we may enter into cash or stock acquisition transactions or other strategic transactions that could reduce cash available to fund our operations or result in dilution to shareholders.

At June 30, 2004, we had approximately $383.4 million in cash, cash equivalents, short-term investments and restricted cash equivalents. Our principal commitments include office leases and contractual payments due to content and other service providers. We believe that our current cash, cash equivalents and short-term investments will be 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 the majority 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, Germany, France, the United Kingdom and Australia, where we invoice our customers primarily in yen, euros (for Germany and France), 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. Our exposure to foreign exchange rate fluctuations also arises from intercompany payables and receivables to and from our foreign subsidiaries. Foreign exchange rate fluctuations did not have a material impact on our financial results in either of the quarter and six-month periods ended June 30, 2004 or 2003.

Our only significant off-balance sheet arrangements relate to operating lease obligations for office facility leases and other contractual obligations related primarily to minimum contractual payments due to content and other service providers.

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 with our paid media content businesses, which makes it difficult to evaluate our business.

We have a relatively limited history operating with our paid media content businesses, including our subscription businesses, which in recent periods have become an increasingly important part of our business and now represent a majority of our revenue. As a result, we have limited financial results from these businesses on which you can assess our future prospects. Our prospects must be considered in light of the risks, expenses and difficulties frequently encountered by companies in new and rapidly evolving businesses, such as the paid media content businesses in which we operate. Our paid content business revenue and subscriber/user base have grown relatively rapidly in the early phases of the development of these businesses. If these businesses continue to grow, the growth rates we have experienced to date are unlikely to be sustainable.

We have a history of losses, and we cannot be sure that we will be able to return to profitability in the future.

We have incurred significant losses since our inception. As of June 30, 2004, we had an accumulated deficit of $295 million. We have had net losses for each year subsequent to the year ended December 31, 1999, and we may not generate sufficient revenue to be profitable on a quarterly or annual basis in the future. We have announced our intention to achieve quarterly profitability (excluding antitrust litigation expense) by the end of 2004. No assurance can be provided that we will achieve quarterly profitability (excluding antitrust litigation expense) in 2004 or in any subsequent period. We devote significant resources to developing and enhancing our technology and to 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 difficult to predict and may fluctuate, which may contribute to fluctuations in our stock price.

As a result of the rapidly changing and uncertain nature of the markets in which we compete, our quarterly and annual revenue and operating results may 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. Our operating results may be adversely affected by similar or other charges or events in future periods, which could cause the trading price of our stock to decline.

Certain of our expense decisions (for example, research and development and sales and marketing efforts, our media content licensing efforts and other business expenditures generally) are based on predictions regarding our business and the markets in which we compete. 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 suit against Microsoft for antitrust violations may not be successful and could harm our financial results.

In December 2003, we filed suit against Microsoft Corporation in the U.S. District Court for the Northern District of California, alleging that Microsoft violated U.S. and California antitrust laws. In our lawsuit, we allege that Microsoft has illegally used its monopoly power to restrict competition, limit consumer choice and attempt to monopolize the field of digital media. We expect that the litigation, if it is not resolved before trial, will carry on for several years. It is not possible to predict accurately how much the litigation will cost, or its duration. The costs of the litigation could have an adverse impact on our operating results in excess of our

current expectations. The litigation may also distract our management team from operational matters, which could harm our business results. We may not prevail in our claims against Microsoft, in which case our costs of litigation will not be recovered. Even if we do prevail, the litigation may not be successful in causing Microsoft to alter its anticompetitive behavior. Furthermore, Microsoft’s defense strategy may include the assertion of counterclaims against us, as well as leveraging its power in the commercial marketplace to adversely affect our current and potential business relationships, either of which may have an adverse affect on our business results.

Our online paid content businesses have generally lower margins than our traditional software license business.

Costs of our online paid content services as a percentage of the revenue generated by those businesses are higher than the ratio of costs to revenue in our historical software licensing business. This includes our music subscriptions and sales, video subscription services and games licensing. We expect this trend will continue to negatively impact our overall gross margins as our online paid content businesses grow. If paid content revenue grows as a percentage of our overall revenue, our margins may further decrease which may affect our ability to achieve profitability.

Our digital content subscription businesses depend on our continuing ability to license compelling content on commercially reasonable terms.

We must continue to obtain compelling digital media content for our video, music and games subscription services in order to maintain and increase subscriptions and subscription service revenue and overall customer satisfaction for these products. In some cases, we have had to pay substantial fees to obtain premium content. In particular, we have had to pay substantial fees to obtain premium video content even though we have limited experience determining what video content will be successful with current and prospective customers. In addition, certain of our content licensing agreements have high fixed costs associated with them, and we have decided not to renew certain of these agreements. During the quarter ended March 31, 2004, we incurred a charge of approximately $4.9 million due to the cancellation of a content licensing agreement with PGA TOUR and we did not renew our content license agreement with MLB Advanced Media because we believe the proposed cost of the license renewal was unreasonably high and not economically viable. Failure to renew these contracts has resulted, and may in the future result, in the loss of subscribers to our video subscription offerings and a corresponding loss of revenue. If we cannot obtain premium digital content for any of our digital content subscription services on commercially reasonable terms, or at all, our business will be harmed.

Our subscription levels may vary due to the seasonal or periodic nature of some popular content and as we experiment with different types of content offerings.

Some of the most popular premium content that we have offered in our premium video subscription services is seasonal or periodic in nature. Additionally, as we develop our video subscription business, we are experimenting with different types of content to determine what consumers prefer. We have limited experience with these types of offerings and cannot predict how the seasonal or periodic nature of these offerings will impact our subscriber growth rates for these products, future subscriber retention levels or our quarterly financial results. We anticipate that subscriber levels for our video subscription offerings will fluctuate due to seasonally available popular content and as we experiment with new types of content offerings.

The success of our subscription services businesses depends upon our ability to add new subscribers and minimize subscriber churn.

If we do not continue to add new subscribers each quarter to our subscription services while minimizing the rate of loss of existing subscribers, our operating results will be adversely impacted. Because Internet subscription content businesses are a relatively new media delivery model and a new business for us, we cannot predict with accuracy our long-term ability to retain subscribers or add new subscribers. Subscribers may cancel their subscriptions to our services for many reasons, including a perception that they do not use the 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 (including Internet piracy), or because customer service issues are not satisfactorily resolved. In addition, the costs of marketing and promotional activities necessary to add new subscribers, and the costs of obtaining content that customers desire, may adversely impact our margins and operating results.

Our online music services depend upon our licensing agreements with the major music label and music publishing companies.

Our online music service offerings depend on music licenses from the major music labels and publishers. The current license agreements are for relatively short terms (some of these licenses are due to expire and will need to be renewed in 2004), and we cannot be sure that the music labels will renew the licenses on commercially viable terms, or at all. Due to the increasing importance of our music services to

our overall revenue, the failure of the major music labels or publishers to renew these licenses under terms that are acceptable to us will harm our ability to offer successful music subscription services and would harm our operating results.

Music publishing royalty rates for streaming are not yet established; a determination of high royalty rates could negatively impact our operating results.

Royalty rates associated with streaming musical compositions in the U.S. have not yet been established with respect to public performances and, if required, reproductions. Public performance licenses are negotiated individually, and we have not yet agreed to rates with all of the performing rights societies for all of our music streaming activities. We may be required to pay a rate that is higher than we expect, or the issue may be submitted to a “Rate Court” for judicial determination. We have a license agreement with the Harry Fox Agency, an agency that represents music publishers, to reproduce musical compositions as required in the creation and delivery of on-demand streams, but this license agreement does not include a rate. The license agreement anticipates industry-wide agreement on rate, or, if no industry-wide agreement can be reached, determination by a copyright arbitration royalty panel (“CARP”), an administrative judicial proceeding supervised by the United States Copyright Office. If the rates agreed to or determined by a CARP are higher than we expect, this expense could negatively impact our operating results. The publishing rates associated with our international music streaming services are also not yet determined, and may be higher than we anticipate.

Our products and services must compete with the products and services of strong or dominant competitors.

Our software and services must compete with strong existing competitors, and new competitors may enter with competitive new products, services and technologies. These market conditions have in the past resulted in, and could likely continue to result in the following consequences, any of which could adversely affect our business, our operating results and the trading price of our stock:

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reduced prices, revenue and margins;

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increased expenses in responding to competitors;

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loss of current and potential customers, market share and market power;

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lengthened sales cycles;

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degradation of our stature in the market and reputation;

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changes in our business and distribution and marketing strategies;

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changes to our products, services, technology, licenses and business practices, and other disruption of our operations;

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strained relationships with partners; and

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pressure to prematurely release products or product enhancements.

Many of our current and potential competitors have longer operating histories, greater name recognition, more employees and significantly greater resources than we do. Our competitors across the breadth of our product line include a number of large and powerful companies, such as Microsoft, Apple Computer, Yahoo! and others. Some of our competitors have in the past and may in the future enter into collaborative arrangements with each other that enable them to better compete with our business.

Microsoft is one of our strongest competitors, and employs highly aggressive tactics against us.

Microsoft is one of our principal competitors in the development and distribution of digital media and media distribution technology. Microsoft’s market power in related markets such as personal computer operating systems, office software suites and web browser software give it unique advantages in the digital media markets. We expect that Microsoft will continue to increase pressure in the digital media markets in the future. Microsoft’s dominant position in certain parts of the computer and software markets, and its aggressive activities have had, and in the future will likely continue to have, adverse effects on our business and operating results.

We believe that Microsoft has employed, and will likely continue to employ illegal and highly aggressive tactics against us

such as leveraging Microsoft’s market dominating position in operating systems and servers to distribute and promote its digital media products. We also believe that Microsoft limits exposure to third parties (including us) of the interfaces to its operating systems, which limits the ability of our products to take full advantage of the features and functionality of Microsoft’s operating systems and harms our ability to compete effectively with Microsoft. The effects of Microsoft’s activities include loss of customers and market share, unnatural pressure on the pricing of our products and continuing costs of developing and revising business strategies in response to these activities.

Our consumer businesses face substantial competitive challenges that may prevent us from being successful in those businesses.

Video Products and Services.Our video content services (including our RealOne SuperPass subscription service) face competition from existing competitive alternatives and other emerging services and technologies. We face competition in these markets from traditional media outlets such as television, radio, CDs, DVDs, videocassettes and others. We also face competition from emerging Internet media sources and established companies entering into the Internet media content market, including Time Warner’s AOL subsidiary, Microsoft, Apple, Yahoo! and broadband Internet service providers. We expect that, as the market for Internet video content matures, more competitors will enter these new markets, making competition even more intense. Competing services may be able to obtain better or more favorable access to compelling video content than us, may develop better offerings than us and may be able to leverage other assets to promote their offerings.

Music.Our music service offerings face competition from traditional offline music distribution competitors and from other online digital music services. Some of these competing services have been the subject of substantial marketing efforts and have received significant media attention, including Apple’s iTunes music download service and Roxio’s Napster online music subscription service. We expect that Microsoft will also begin offering premium music services in conjunction with its Windows Media Player and MSN services, and we also expect increasing competition from online retailers such as Amazon.com and WalMart.com. Our current music service offerings may not be able to compete effectively in this highly competitive market. Our music services also face significant competition from “free” peer-to-peer services, which allow consumers to directly access an expansive array of free content without securing licenses from content providers. 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.

Games.Our RealArcade service competes with other online distributors of downloadable PC games focused on the non-core segment of the market. Some of these distributors have high volume distribution channels and greater financial resources than us, including Yahoo Games, MSN Gamezone, Pogo.com and Shockwave. We expect competition to intensify in this market from these and other competitors and no assurance can be made that we will be able to continue to grow our games distribution business or that we will be able to remain competitive in the downloadable games category in the future. We recently completed the acquisition of GameHouse, a developer of downloadable PC games and now also compete with other developers of downloadable games for the non-core segment of the market.

We may not be successful in the market for downloadable media and personal music management software.

The market for software products that enable the downloading of media and personal music management software is 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 our media player products as their primary application to play, record, download and manage their digital music, especially in light of the fact that Microsoft bundles its competing Windows Media Player with its Windows operating system. Our inability to achieve widespread acceptance for our digital music architecture or widespread distribution of our player products could hold back the development of revenue streams from these market segments, including digital music content, and therefore could harm the prospects for our business.

Our paid content businesses depend upon effective digital rights management solutions.

Our paid content businesses depend upon effective digital rights management solutions that allow control of accessibility to online digital content. These solutions are important to the economics of these businesses and also to address concerns of content providers regarding online piracy. We cannot be certain that we can develop, license or acquire such solutions, or that content licensors, electronic device makers 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. We may need to license digital rights management solutions to support our products. No assurance can be given that such solutions will be available to us on reasonable terms or at all. If digital rights management solutions are not effective, or are perceived as not effective, content providers may not be willing to include content in our services, which would harm our business and operating results.

Digital rights management technologies are frequently the subject of hostile attack by third parties seeking to illegally obtain content. If our digital rights management technology is compromised or otherwise malfunctions, we could be subject to lawsuits seeking compensation for any harm caused and our business could be harmed if content providers lose confidence in our ability to protect their content.

We may not be able to successfully operate our software game development business because it is a new business for us, and certain distribution partners for our game development business compete with other products and services we offer.

We recently completed the acquisition of GameHouse, a developer of downloadable PC games. Game development is a new business for us, and we may not be able to successfully develop and market software games in the future. In addition, certain competitors of our RealArcade service also distribute and promote games developed by GameHouse. No assurance can be made that these distributors will continue to distribute and promote games in the same manner as a result of our acquisition of GameHouse.

Our systems software business has been negatively impacted by the efforts of our competitors, and this business may not return to previous levels.

The aggressive, and we believe illegal, competitive efforts of Microsoft, including the provision of free software and other incentives to induce customers to use its competing technology, have negatively impacted our systems software sales to customers in a variety of business market segments in recent periods. We cannot predict when, or if, we will experience increased demand for our systems software products from customers in these markets.

Our Helix open source initiative is subject to risks associated with open source technology.

There are a number of risks associated with our Helix Community initiative, including risks associated with market and industry acceptance, development processes and software licensing practices, and software license and development support business models. The broader media technology and product industry may not adopt the Helix DNA Platform and/or the Helix Community as a development platform for media delivery and playback products and third parties may not enhance, develop or introduce technologies or products based on Helix DNA technology. While we have invested substantial resources in the development of the underlying technology within the Helix DNA and the Helix Community process itself, the market and industry may not accept them and we may not derive royalty or support revenues from them. Additionally, the introduction of broadly available open source software licensing and community source licensing may adversely affect sales of our commercial system software products to mobile operators, broadband providers, corporations, government agencies, educational institutions and other business and non-business organizations. In those areas where adoption of the Helix Community and Helix DNA occurs, our community and open source approach means that we no longer exercise sole control over many aspects of the development of the Helix DNA technology.

If we do not timely and successfully develop, market and implement new products and services, our business and operating results will suffer.

Our business and operating results would be harmed if we fail to timely and successfully develop, market and deliver products and services that achieve widespread market acceptance or if the products and services we develop fail to generate significant revenue or gross profits to offset our development and operating costs. Competitive or technological developments may require us to make substantial 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.

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. Also, our products 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.

Our business is dependent in part on third party vendors whom we do not control.

Certain of our products and services are dependent in part on the licensing and incorporation of technology from third party vendors. The markets in which we compete are new and rapidly evolving and, in some cases, significant technology innovation occurs at very early-stage companies. In some cases, we rely on the technology of these types of vendors in order to make our products and

services more competitive. If the technology of these vendors fails to perform as expected or if key vendors do not continue to support their technology because the vendor has gone out of business or otherwise, then we may incur substantial costs in replacing the products and services, or we may fall behind in our development schedule while we search for a replacement. These costs or the potential delay in the development of our products and services could harm our business and our prospects.

We enter into strategic transactions that may not yield direct financial benefits.

Because of the evolving and dynamic nature of the markets in which we compete, from time to time we enter into strategic transactions that have uncertain financial impact on our business and operations. We often enter into these types of transactions with infrastructure providers and other large companies to broaden the reach of our technology, media formats and products. While we believe that these types of transactions are important for our overall business, they may not yield the desired benefits to our business or result in meaningful direct revenue.

If our products are not able to support the most popular digital media formats, our business will be substantially impaired.

The success of our products and services depends upon our products’ support for a variety of media formats and wireless data formats. Technical formats and consumer preferences change over time, and we may be unable to adequately address consumer preferences or fulfill the market demand for new and evolving formats. Changing formats may give our competitors an opportunity to gain market share if they can respond to or anticipate market demand for formats before we do. We also may not be able to license technologies, like codecs or digital rights management technology, 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 codecs and formats created by Microsoft or industry standard formats created by MPEG, become more readily available.

Our Harmony Technology may not achieve consumer or market acceptance and has drawn a negative reaction from a competitor.

We recently announced the creation of a new digital rights management translation technology, called Harmony, which enables consumers to securely transfer purchased music to digital music devices, including the iPod line of digital music players sold by Apple Computer, Inc. as well as certain devices that use Microsoft Windows Media DRM. Harmony is designed to enable consumers to transfer music purchased from our RealPlayer Music Store to a wide variety of portable music devices, rather than being restricted to a specific portable device. We do not know whether consumers will accept Harmony or whether it will lead to increased sales of any of our consumer products or services or increased usage of our media player products.

There are other risks associated with the launch of Harmony, including the risk that Apple will try to modify its technology to “break” the interoperability that Harmony provides to consumers. If Apple chooses this course of action, Harmony may no longer work with Apple’s products, which could harm our business and reputation, or we may be forced to incur additional development costs to refine Harmony to make it interoperate again. We believe our Harmony technology is completely legal, however, there is no assurance that a court would agree with our position. If Apple decides to commence litigation against us in order to prevent interoperation with its products, we may be forced to spend money defending their legal challenge, which could harm our operating results.

Our mobile products will not be successful if consumers do not use mobile devices to access digital media.

In order for our investments in the development of mobile products to be successful, consumers must adopt and use mobile devices for consumption of digital media. To date, consumers have not widely adopted these products for use in accessing and consuming digital media and if the rate of adoption of these products to consume digital media does not increase, our business could be harmed.

We depend on key personnel who may not continue to work for us.

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, we could face high costs and substantial difficulty in hiring qualified successors and could experience a loss in productivity while any such successor obtains the necessary training and experience. 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 and retain experienced management personnel to help us grow and manage our business, and skilled software engineers to further our research and development efforts. At times, we have experienced difficulties in hiring and retaining 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.

Our industry is experiencing consolidation that may cause us to lose key relationships and intensify competition.

The Internet and media distribution industries are undergoing substantial change, which has resulted in increasing consolidation and formation of strategic relationships. We expect this consolidation and strategic partnering to continue. Acquisitions or other consolidating transactions could harm us in a number of ways, including:

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we could lose strategic relationships if our strategic partners are acquired by or enter into relationships with a competitor (which could cause us to lose access to distribution, content, technology and other resources);

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we could lose customers if competitors or users of competing technologies consolidate with our current or potential customers; and

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our current competitors could become stronger, or new competitors could form, from consolidations.

Any of these events could put us at a competitive disadvantage, which could cause us to lose customers, revenue and market share. Consolidation could also force us to expend greater resources to meet new or additional competitive threats, which could also harm our operating results.

Potential acquisitions involve risks that could harm our business and impair our ability to realize potential benefits from acquisitions.

As part of our business strategy, we have acquired technologies and businesses in the past, and expect that we will 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 and prevent us from realizing the benefits of the acquisitions. Financial risks related to acquisitions may harm our financial position, reported operating results or stock price, and include:

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potential equity dilution, use of cash resources and incurrence of debt and contingent liabilities in funding acquisitions;

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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

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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:

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difficulties and expenses in assimilating the operations, products, technology, information systems or personnel of the acquired company and difficulties in retaining key management or employees of the acquired company;

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diversion of management’s attention from other business concerns and the potential disruption of our ongoing business;

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impairment of relationships with employees, affiliates, advertisers and content providers of our business and the acquired business;

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the assumption of known and unknown liabilities of the acquired company, including intellectual property claims; and

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entrance into markets in which we have no direct prior experience.

We acquired Listen.Com, Inc. in August 2003, and the operations associated with Listen will remain in San Francisco. This is our first experience operating and integrating a substantial acquired business in a remote location. The geographic separation could increase the operational risks described above. We also acquired GameHouse, Inc. in January 2004. The acquisition of GameHouse is our first attempt to operate and manage a content creation business. We may not be successful in operating this type of business, which could harm our business and our prospects.

Our strategic investments may not be successful and we may have to recognize expenses in our income statement in connection with these investments.

We have made, and in the future we may continue to make, strategic investments in other companies, including joint ventures. These investments often involve immature and unproven businesses and technologies, and involve a high degree of risk. We could lose the entire amount of our investment. We also may be required to record on our financial statements significant charges from reductions in the value of our strategic investments, and, potentially from the net losses of the companies in which we invest. We have taken these charges in the past, and these charges could adversely impact our reported operating results in the future. No assurance can be made that we will realize the anticipated benefits from any strategic investment.

We have a substantial investment in MusicNet, a joint venture formed with several leading media companies to create a

technology platform for online digital music subscription sales. We rely on financial statements provided by MusicNet in determining the amount of our equity share of MusicNet’s net loss. MusicNet has incurred substantial losses since its inception and we record our equity share of its losses on our financial statements for each of our reporting periods. We do not control MusicNet and we do not participate in the preparation of its financial statements. If the financial statements supplied to us by MusicNet are inaccurate, we may be forced to adjust or restate our operating results. If MusicNet does not provide its financial statements to us in a timely manner, we may not be able to timely satisfy our Securities and Exchange Commission reporting obligations. We anticipate that MusicNet will continue to incur losses in the foreseeable future and will need additional funding although we are not obligated to provide additional funding.

Changes in network infrastructure, transmission methods and protocols, and broadband technologies pose risks to our business.

Our products and services depend upon the means by which users access media content over the Internet and wireless networks. If popular technologies, transmission methods and protocols used for accessing digital media content change, and we do not timely and successfully adapt our products and services to these new technologies, transmission methods and protocols, our reputation could be damaged, use of our technologies and products would decrease, and our business and operating results would be harmed. Communicating Internet access through cable television set-top boxes, cable lines, digital subscriber lines or wireless connections could dramatically reduce the demand for our products and services by utilizing alternate technology that more efficiently or conveniently transmits data and media. This could harm our business as currently conducted. Also, our products and services adapted to new technologies and transmission methods and protocols 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 new technologies, products and services for new transmission infrastructure could increase our vulnerability to competitors by enabling 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. Our current competitors may also develop relationships with, or ownership interests in, companies that have significant access to or control over the broadband transmission infrastructure or content.

We need to develop relationships with manufacturers of non-PC media and communication devices to grow our business.

Access to 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, has increased dramatically and is expected to continue to increase. 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 a substantial number of alternative device manufacturers do not license and incorporate our technology into their devices, we may fail to capitalize on the opportunity to deliver digital media to non-PC devices. A failure to develop revenue-generating relationships with a sufficient number of device manufacturers could harm our business prospects. We have invested significant resources in adapting our technologies and products to these new technologies, networks and devices (wireless networks in particular), and we will not recoup these investments if they are not widely adopted for accessing data and multimedia content. 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 our ability to secure relationships with these key operators.

Emerging new standards for non-PC devices could harm our business if our products and technologies are not compatible with the new standards.

We do not believe that complete standards have emerged with respect to non-PC wireless and cable-based systems. If we do not successfully make our products and technologies compatible with emerging standards, we may miss market opportunities and our business and results will suffer. If other companies’ products and services, including industry-standard technologies or other new standards emerge or become dominant in any of these areas, or differing standards emerge among different global markets, demand for our technology and products could be reduced or they could become obsolete.

If we are not successful in maintaining, managing and adding to our strategic relationships, our business and operating results will be adversely affected.

We rely on many strategic relationships with third parties in connection with our business, including relationships providing for the distribution of our products, licensing of technology and licensing of content for our paid content services. The loss of current strategic relationships, the inability to find other strategic partners, our failure to effectively manage these relationships or the failure of our existing relationships to achieve meaningful positive results for us could harm our business. We may not be able to replace

these relationships with others on acceptable terms, or at all, or find alternative sources for resources that these relationships provide.

If we fail to maintain an effective system of internal controls, we may not be able to accurately report our financial results or prevent fraud. As a result, current and potential shareholders could lose confidence in our financial reporting, which would harm our business and the trading price of our stock.

Effective internal controls are necessary for us to provide reliable financial reports and effectively prevent fraud. If we cannot provide reliable financial reports or prevent fraud, investors may lose confidence in our financial reporting and the trading price of our stock could be harmed. In addition, we are now in the process of complying with requirements resulting from the Sarbanes-Oxley Act of 2002 (“SOX”), including those provisions of Section 404 of SOX that establish requirements for both management and auditors of public companies with respect to reporting on internal control over financial reporting. In 2004, we have devoted significant financial and other resources to review and strengthen our internal controls in advance of complying with the Section 404 requirements. The requirements and processes associated with Section 404 are new and untested and we cannot be certain that the measures we have taken will be sufficient to meet the Section 404 requirements or that we will be able to implement and maintain adequate controls over our financial processes and reporting in the future. Moreover, we cannot be certain that the costs associated with such measures will not exceed our estimates, which could impact our overall operating results. Any failure to meet the Section 404 requirements or to implement required new or improved controls, or difficulties or unanticipated costs encountered in their implementation, could cause investors to lose confidence in our reported financial information or could harm our financial results, which could have a negative effect on the trading price of our stock.

Our business and operating results will suffer if our systems or networks fail, become unavailable or perform poorly so that current or potential users do not have adequate access to our products, services and websites.

Our ability to provide our products and services to our customers and operate our business depends on the continued operation of our information systems and networks. A significant or repeated reduction in the performance, reliability or availability of our information systems and network infrastructure could harm our ability to conduct our business, and harm our reputation and ability to attract and retain users, customers, advertisers and content providers.

We have on occasion experienced system errors and failures that cause interruption in availability of products or content or an increase in response time. Problems with our systems and networks could result from our failure to adequately maintain and enhance these systems and networks, natural disasters and similar events, power failures, intentional actions to disrupt our systems and networks and many other causes. The vulnerability of our computer and communications infrastructure is enhanced because it is located at a single leased facility in Seattle, Washington, an area that is at heightened risk of earthquake, flood, 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.

We rely on the continued reliable operation of third parties’ systems and networks and, if these systems and networks fail to operate or operate poorly, our business and operating results will be harmed.

Our operations are in part dependent upon the continued reliable operation of the information systems and networks of third parties. If these third parties do not provide reliable operation, our ability to service our customers will be impaired and our business, reputation and operating results could be harmed.

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 and store such information and data securely, and any costs associated with preventing or eliminating such problems, 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 also 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. Any successful attack or breach of our security could hurt consumer demand for our products and services, expose us to consumer class action lawsuits and harm our business.

Our international operations expose our business to additional operational and financial risks.

We operate subsidiaries in several foreign countries, and market and sell products in a number of countries. We have also entered into joint ventures internationally. A significant portion of our revenue is derived from international operations. Our foreign operations involve 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. Our foreign currency exchange risk management program reduces, but does not eliminate, the impact of currency exchange rate movements.

The growth of our business is dependent in part on successfully implementing our international expansion strategy.

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, successfully take advantage of international opportunities 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, who we do not control, 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.

We may be unable to adequately protect our proprietary rights.

Our ability to compete partly depends 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. Despite these efforts, any of the following occurrences may reduce the value of our intellectual property:

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Our applications for patents and trademarks relating to our business may not be granted and, if granted, may be challenged or invalidated.

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Issued patents and trademarks may not provide us with any competitive advantages.

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Our efforts to protect our intellectual property rights may not be effective in preventing misappropriation of our technology.

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Our efforts may not prevent the development and design by others of products or technologies similar to or competitive with, or superior to those we develop.

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Another party may obtain a blocking patent so 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.

We may be forced to litigate to defend our intellectual property rights, or to defend against claims by third parties against us relating to intellectual property rights.

Disputes regarding the ownership of technologies and rights associated with streaming media, digital distribution and online businesses are common and likely to arise in the future and may be very costly. 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. The existence and/or outcome of any 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, some of which are described in Part II of this report under the heading “Legal Proceedings.”

Interpretation of existing laws that did not originally contemplate the Internet could harm our business and operating results.

There is uncertainty regarding how existing laws governing issues such as property ownership, copyright and other intellectual property issues apply to the Internet. Many of these laws were adopted before the advent of the Internet and do not address the unique issues associated with the Internet and related technologies. In many cases, the relationship of these laws to the Internet has not yet been interpreted. New interpretations of existing laws may increase our costs, require us to change business practices and otherwise harm our business.

It is not yet clear how laws designed to protect children that use the Internet may be interpreted, and such laws may apply to our business in ways that may harm our business.

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.

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 our servers. 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.

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. Our agreements with these parties may not adequately protect us from these potential liabilities. 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 one third of our stock, which gives them significant control over certain major decisions on which our shareholders may vote, may discourage an acquisition of us, and any significant sales of stock by our officers and directors could have a negative effect on our stock price.

Our executive officers, directors and affiliated persons beneficially own more than one third of our common stock. Robert Glaser, our Chief Executive Officer and Chairman of the Board, beneficially owns the majority of that stock. As a result, our executive officers, directors and affiliated persons will have significant influence to:

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elect or defeat the election of our directors;

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amend or prevent amendment of our articles of incorporation or bylaws;

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effect or prevent a merger, sale of assets or other corporate transaction; and

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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:

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adopt a plan of merger;

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authorize the sale, lease, exchange or mortgage of assets representing more than 50% of the book value of our assets prior to the transaction or on which our long-term business strategy is substantially dependent;

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authorize our voluntary dissolution; or

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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 zero coupon convertible subordinated 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.

If we account for employee stock options using the fair value method, it could significantly reduce our results of operations.

On March 31, 2004, the FASB issued an Exposure Draft, “Share-Based Payment: an amendment of FASB statements No. 123 and 95”, which would require a company to recognize, as an expense, the fair value of stock options and other stock-based compensation to employees beginning in 2005 and subsequent reporting periods. If we are required to record an expense for our stock-based compensation plans using the fair value method as described in the Exposure Draft, we could have significant and ongoing accounting charges. Stock options are also a key part of the compensation packages that we offer our employees. If we are forced to curtail our broad-based option program, it may become more difficult for us to attract and retain employees.

Our stock price has been volatile in the past 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, 2004, the price of our common stock ranged from $8.00 to $4.73 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 or changes in financial estimates or recommendations by securities analysts, as well as any of the other risk factors described above.

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.

Financial forecasting of our operating results will be difficult because of the changing nature of our products and business, and our actual results may differ from forecasts.

As a result of the dynamic and changing nature of our products and business, and of the markets in which we compete, it is

difficult to accurately forecast our revenue, gross margin, operating expenses, number of subscribers and other financial and operating data. Our inability or the inability of the financial community to accurately forecast our operating results could result in our reported net income (losses) in a given quarter to differ from expectations, which could cause a decline in the trading price of our common stock.

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 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 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 would likely have to pay such taxes out of our own funds.

Effective July 1, 2003, we began collecting Value Added Tax, or VAT, on sales of “electronically supplied services” provided to European Union residents, including software products, games, data, publications, music, video and fee-based broadcasting services. There can be no assurance that the European Union will not make further modifications to the VAT collection scheme, 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. The collection and remittance of VAT subjects us to additional currency fluctuation risks.

The Internet Tax Freedom Act, or ITFA, expired November 2003 and Congress is currently considering an extension. Among other things, the ITFA imposed a moratorium on discriminatory taxes on electronic commerce. The imposition by state and local governments of various taxes upon Internet commerce could create administrative burdens for us and could decrease our future sales.

We donate a portion of net income to charity.

In future periods, if we achieve profitability (excluding the effects of 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 “may”, “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:

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the future development and growth of, and opportunities for, premium digital audio and video content online;

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the future development and growth of digital media delivery to mobile devices, and our position in that market;

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our ability to leverage our digital media delivery technology and user base to generate revenue from the sale of digital media products and services;

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the future success of, and anticipated benefits from, our open source technology initiatives;

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competition from existing and new competitors in each of our markets, and our ability to compete with such competitors;

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anticipated future competitive activities of Microsoft, and the anticipated results of those activities;

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potential future growth of service revenue, and the rate of that growth;

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anticipated fluctuation in our paid content subscriber base and revenue;

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our costs of service revenue and its impact on our gross margins;

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anticipated fluctuations in our revenue and cost of service revenue;

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anticipated future increases in our sales and marketing expenses;

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anticipated effects of potential content acquisition transactions;

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anticipated effects of recent and potential future business and technology acquisitions and strategic investments by us;

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the impact of our interest in MusicNet on our operating results;

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our future activities under our stock repurchase program;

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future capital needs and capital expenditures;

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the impact of our acquisition of GameHouse on our position in the downloadable PC games market;

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the future impact of interest and foreign exchange rates on our operating results and cash flows;

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our ability to achieve quarterly profitability by the end of 2004;

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the impact of current litigation in which we are involved, including our suit with Microsoft for alleged antitrust violations;

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the likelihood of, and the likely effect of, potential future litigation involving us;

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anticipated consolidation and strategic partnering activities in our markets;

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the future effectiveness of our intellectual property rights and potential future litigation involving us regarding intellectual property matters; and

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potential future charges relating to excess facilities, impairment of assets and reduction in value of investments.

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 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, 2003.

Investment Risk. As of June 30, 2004, 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, 2004 would have had an approximate $3.2 million impact on the value of our investments in publicly traded companies at June 30, 2004, related primarily to our investment in a publicly traded Japanese company.

Foreign Currency Risk. International revenue accounted for approximately 20% of total net revenue for the six months ended June 30, 2004. 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 ended June 30, 2004 and 2003.

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.

(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 during the quarter ended June 30, 2004, including any corrective actions with regard to significant deficiencies and material weaknesses.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

On March 9, 2004, the Company filed suit against MLB Advanced Media, L.P. (“MLBAM”) in the U.S. District Court for the Western District of Washington, asserting a claim for breach of contract relating to an agreement between the Company and MLBAM which requires MLBAM to provide certain streaming media content in the Company’s formats. The Company is seeking injunctive relief requiring MLBAM to perform its obligations under that agreement. The Company is also seeking monetary damages and reasonable attorneys fees. MLBAM has filed counterclaims in the action alleging false advertising, trademark infringement and related allegations, all of which the Company has denied.

In March 2003, William Cirignani filed a putative 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. The trial court has granted the Company’s motion to stay the action pending arbitration on an individual, non-class basis and the Court of Appeals and the Washington Supreme Court have rejected the plaintiff’s appeal. The Company disputes plaintiff’s allegations in this action and intends to vigorously defend itself against these claims.

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, Use of Proceeds and Issuer Purchases of Equity Securities

(c)

Between April 1, 2004 and June 30, 2004, the Company has issued and sold unregistered securities as follows:

(1)

On June 30, 2004, the Company issued an aggregate of 2,082 shares of Common Stock to two non-employee directors as compensation for board service during the second quarter of 2004 pursuant to the RealNetworks, Inc. Director Compensation Stock Plan. The aggregate value of the shares was approximately $14,241. The shares were issued in reliance on Section 4(2) under the Securities Act of 1933, as amended, on the basis that the transactions did not involve a public offering.

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 4, 2004. The matters voted on at the Annual Meeting and votes cast on such matters were as follows:

The election of three Class 1 directors to serve until the 2007 Annual Meeting of Shareholders, or until such director’s earlier retirement, resignation or removal, or the election of their successors.


Directors Elected	For		Withheld
Eric Benhamou		150,741,203		2,809,815
Edward Bleier		149,639,023		3,911,995
Kalpana Raina		150,699,319		2,851,699

The terms of the following directors continued after the Annual Meeting:

James W. Breyer
Robert Glaser
Jeremy Jaech
Jonathan D. Klein

The approval of the RealNetworks, Inc. Director Compensation Stock Plan.


					Broker
For	Against		Abstain		Non-votes
101,093,454		8,542,289		3,208,988		40,706,287

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits Required by Item 601 of Regulation S-K:


Exhibit Number				Description
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 Roy B. Goodman, Senior Vice President, Chief Financial Officer and Treasurer 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 Roy B. Goodman, Senior Vice President, Chief Financial Officer and Treasurer 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 January 29, 2004, RealNetworks, Inc. furnished a report on Form 8-K relating to its announcement on January 29, 2004 of the results for its year and fourth quarter ended December 31, 2003.

On March 31, 2004, RealNetworks filed a report on Form 8-K to provide certain December 31, 2003 pro forma financial information related to its acquisition of Listen.Com, Inc. in August 2003.

On April 28, 2004, RealNetworks, Inc. furnished a report on Form 8-K related to its announcement on April 28, 2004 of certain executive changes and the results for its first quarter ended March 31, 2004.

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 4, 2004.


	REALNETWORKS, INC.
	By:	/s/ Roy B. Goodman
		Roy B. Goodman
		Senior Vice President, Chief Financial Officer and Treasurer (Principal Financial and Accounting Officer)

INDEX TO EXHIBITS


Exhibit Number				Description
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 Roy B. Goodman, Senior Vice President, Chief Financial Officer and Treasurer 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 Roy B. Goodman, Senior Vice President, Chief Financial Officer and Treasurer 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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Realnetworks (RNWK) 10-Q2004 Q2 Quarterly report

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