- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
<Table>
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTER ENDED SEPTEMBER 30, 2002
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
</Table>
COMMISSION FILE NUMBER 0-21126
SONICBLUE INCORPORATED
(Exact name of registrant as specified in its charter)
<Table>
DELAWARE 77-0204341
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
2841 MISSION COLLEGE BOULEVARD
SANTA CLARA, CALIFORNIA 95054
(Address of principal executive offices) (Zip Code)
</Table>
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (408) 588-8000
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
The number of shares of the Registrant's Common Stock, $0.0001 par value,
outstanding at November 1, 2002 was 97,748,427.
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
SONICBLUE INCORPORATED
FORM 10-Q
INDEX
<Table>
<Caption>
PAGE
----
PART I. CONDENSED CONSOLIDATED FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements:
Condensed Consolidated Balance Sheets at September 30, 2002
and December 31, 2001....................................... 2
Condensed Consolidated Statements of Operations for the
three months and nine months ended September 30, 2002 and
2001........................................................ 3
Condensed Consolidated Statements of Cash Flows for the nine
months ended September 30, 2002 and 2001.................... 4
Notes to Unaudited Condensed Consolidated Financial
Statements.................................................. 5
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 16
Item 3. Quantitative and Qualitative Disclosures About Market
Risk........................................................ 41
Item 4. Controls and Procedures..................................... 42
PART II. OTHER INFORMATION
Item 1. Legal Proceedings........................................... 42
Item 6. Exhibits and Reports on Form 8-K............................ 44
Signatures........................................................... 46
Certifications....................................................... 47
Exhibit Index........................................................ 49
</Table>
1
PART I. CONDENSED CONSOLIDATED FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SONICBLUE INCORPORATED
CONDENSED CONSOLIDATED BALANCE SHEETS
<Table>
<Caption>
SEPTEMBER 30, DECEMBER 31,
2002 2001
------------- ------------
(UNAUDITED)
(IN THOUSANDS, EXCEPT
PER SHARE DATA)
ASSETS
Current assets:
Cash and other investments................................ $ 12,818 $ 22,081
Investment -- UMC......................................... 64,679 75,907
Accounts receivable, net.................................. 60,664 30,986
Inventories............................................... 28,834 20,571
Prepaid expenses and other................................ 6,685 8,003
--------- ---------
Total current assets.............................. 173,680 157,548
Property and equipment, net................................. 6,164 7,218
Investment -- UMC........................................... 25,184 86,886
Deferred income taxes....................................... 7,665 15,197
Goodwill and intangible assets.............................. 124,514 128,426
Other assets................................................ 5,664 18,232
--------- ---------
Total................................................ $ 342,871 $ 413,507
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Line of credit............................................ $ 28,533 $ 15,826
Accounts payable.......................................... 40,496 46,556
Accrued liabilities....................................... 88,485 116,304
Deferred income taxes..................................... 7,665 15,197
--------- ---------
Total current liabilities......................... 165,179 193,883
Other long-term liabilities................................. 23,945 22,764
Convertible subordinated notes.............................. 146,349 103,300
--------- ---------
Total liabilities................................. 335,473 319,947
--------- ---------
Stockholders' equity:
Preferred stock, $0.0001 par value; 5,000,000 shares
authorized; none issued or outstanding................. -- --
Common stock, $0.0001 par value; 175,000,000 shares
authorized; 97,675,790 and 93,464,528 shares issued and
outstanding at September 30, 2002 and December 31,
2001, respectively..................................... 10 9
Additional paid-in capital................................ 614,380 583,922
Unearned stock based compensation......................... (1,628) (3,801)
Accumulated other comprehensive gain (loss)............... (45,415) 993
Retained earnings (accumulated deficit)................... (559,949) (487,563)
--------- ---------
Stockholders' equity........................................ 7,398 93,560
--------- ---------
Total............................................. $ 342,871 $ 413,507
========= =========
</Table>
See accompanying notes to the unaudited condensed consolidated financial
statements.
2
SONICBLUE INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
<Table>
<Caption>
THREE MONTHS ENDED NINE MONTHS ENDED
----------------------------- -----------------------------
SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30,
2002 2001 2002 2001
------------- ------------- ------------- -------------
(UNAUDITED) (UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Net sales................................. $ 78,393 $ 54,783 $205,143 $ 134,177
Cost of sales............................. 73,289 46,572 175,267 210,246
-------- -------- -------- ---------
Gross profit (loss)....................... 5,104 8,211 29,876 (76,069)
Operating expenses:
Research and development................ 3,925 6,627 12,330 23,748
Selling, marketing and administrative... 14,916 19,246 44,354 78,231
Restructuring, impairment and in-process
R&D.................................. 7,603 11,426 21,234 134,537
Amortization of goodwill, intangibles
and deferred compensation............ 3,883 5,402 11,984 27,690
-------- -------- -------- ---------
Total operating expenses........ 30,327 42,701 89,902 264,206
-------- -------- -------- ---------
Loss from operations...................... (25,223) (34,490) (60,026) (340,275)
Gain (loss) on UMC investment............. -- (17,715) 5,133 (545,672)
Gain (loss) on other investments.......... (2,927) (3,119) (6,593) (24,709)
Interest expense.......................... (5,548) (2,696) (12,159) (8,844)
Other income (expense), net............... 1,336 2,730 1,259 1,666
-------- -------- -------- ---------
Income (loss) before income taxes......... (32,362) (55,290) (72,386) (917,834)
Income tax expense (benefit).............. -- -- -- (214,233)
-------- -------- -------- ---------
Net income (loss)......................... $(32,362) $(55,290) $(72,386) $(703,601)
======== ======== ======== =========
Earnings (loss) per share amounts
Basic................................... $ (0.33) $ (0.62) $ (0.75) $ (8.34)
Diluted................................. $ (0.33) $ (0.62) $ (0.75) $ (8.34)
Shares used in computing per share
amounts:
Basic................................... 97,650 89,873 96,165 84,346
Diluted................................. 97,650 89,873 96,165 84,346
</Table>
See accompanying notes to the unaudited condensed consolidated financial
statements.
3
SONICBLUE INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
<Table>
<Caption>
NINE MONTHS ENDED
-----------------------------
SEPTEMBER 30, SEPTEMBER 30,
2002 2001
------------- -------------
(UNAUDITED)
(IN THOUSANDS)
Operating activities
Net income (loss)......................................... $ (72,386) $(703,601)
Adjustments to reconcile net income (loss) to the net cash
used for operating activities:
Deferred income taxes.................................. -- (214,233)
Depreciation........................................... 2,040 4,697
Amortization........................................... 11,984 27,394
Restructuring, impairment & write-off of in-process
R&D................................................... (130) 5,078
Impairment/write-off of long-lived assets.............. 223 113,975
(Gain) loss on UMC investment.......................... (5,132) 545,672
Loss on other investments.............................. 6,592 25,005
Interest expense accretion............................. 3,743 --
Changes in assets and liabilities:
Accounts receivable.................................. (31,513) 15,397
Inventories.......................................... (8,263) 30,117
Prepaid expenses and other assets.................... 1,282 153
Accounts payable..................................... (3,721) (3,170)
Accrued liabilities and other long-term
liabilities......................................... (15,811) 36,740
--------- ---------
Net cash used for operating activities............ (111,094) (116,776)
--------- ---------
Investing activities
Property and equipment purchases.......................... (1,209) (802)
Sales and maturities of short-term investments............ 38,877 178,925
Acquisitions, net of cash acquired........................ -- (27,218)
Equity investment in technology companies................. (700) --
Other..................................................... (600) (7,618)
--------- ---------
Net cash from (used for) investing activities..... 36,368 143,287
--------- ---------
Financing activities
Sale of common stock...................................... 1,130 3,670
Net borrowing (repayments) under credit lines............. 12,707 (53,644)
Proceeds from convertible debt, net....................... 58,470 --
--------- ---------
Net cash provided by (used for) financing
activities...................................... 72,307 (49,974)
--------- ---------
Effect of exchange rate changes............................. (14) (16)
--------- ---------
Net increase (decrease) in cash and cash equivalents........ (2,433) (23,479)
Cash and cash equivalents at beginning of period............ 15,251 36,582
--------- ---------
Cash and cash equivalents at end of period.................. $ 12,818 $ 13,103
========= =========
</Table>
See accompanying notes to the unaudited condensed consolidated financial
statements.
4
SONICBLUE INCORPORATED
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
The condensed consolidated financial statements have been prepared by
SONICblue Incorporated, without audit, pursuant to the rules and regulations of
the Securities and Exchange Commission and include the accounts of SONICblue
Incorporated and its wholly owned subsidiaries ("SONICblue" or collectively the
"Company"). All significant inter-company balances and transactions have been
eliminated. Investments in entities in which the Company does not have control,
but has the ability to exercise significant influence over operating and
financial policies, are accounted for by the equity method. Certain information
and footnote disclosures, normally included in financial statements prepared in
accordance with generally accepted accounting principles, have been condensed or
omitted pursuant to such principles and the rules and regulations of the
Securities and Exchange Commission. In the opinion of the Company, the financial
statements reflect all adjustments, consisting only of normal recurring
adjustments, necessary for a fair presentation of the financial position of the
Company at September 30, 2002 and December 31, 2001, and the operating results
and cash flows for the nine months ended September 30, 2002 and 2001. These
financial statements and notes should be read in conjunction with the Company's
audited financial statements and notes thereto for the year ended December 31,
2001, included in the Company's Form 10-K filed with the Securities and Exchange
Commission.
The results of operations for the three and nine months ended September 30,
2002 are not necessarily indicative of the results that may be expected for the
future periods or the year ending December 31, 2002. Certain reclassifications
of 2001 amounts were made in order to conform to the 2002 presentation.
This Quarterly Report on Form 10-Q contains forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933 and Section 21E
of the Securities Exchange Act of 1934. In particular, the Management's
Discussion and Analysis section of this Quarterly Report on Form 10-Q regarding
revenue growth, gross margin trends, amortization of intangible assets and cost
trends contain forward-looking statements and are qualified by the risks
detailed in "Factors That May Affect Our Results" and other risks detailed in
the Company's Annual Report on Form 10-K for the year ended December 31, 2001,
and other reports filed by SONICblue with the Securities and Exchange Commission
from time to time. Actual results could differ materially from those discussed
in this Quarterly Report on Form 10-Q as a result of the risks described above
as well as other risks set forth in SONICblue's periodic reports both previously
and hereafter filed with the Securities and Exchange Commission.
2. SIGNIFICANT TRANSACTIONS
PURCHASE OF SENSORY SCIENCE CORPORATION
On June 27, 2001, SONICblue completed the acquisition of Sensory Science
Corporation, a developer of consumer electronics products, including dual deck
videocassette player/recorders and DVD players. The acquisition was accounted
for as a purchase. At closing, SONICblue issued approximately 1.3 million shares
of SONICblue common stock to Sensory Science stockholders in exchange for the
common stock of Sensory Science outstanding, and Sensory Science became a wholly
owned subsidiary of SONICblue. In connection with the acquisition of Sensory
Science, SONICblue had made loans to Sensory Science in the amount of $9.8
million, which became part of the purchase price.
The purchase price of $21.7 million includes $7.2 million of stock issued
at fair value (fair value being determined as the average price of SONICblue
common stock at the date the exchange ratio was fixed per the merger agreement),
$0.3 million of stock option costs, cash paid to Sensory Science of $9.8 million
and $4.4 million in estimated expenses of the transaction. The purchase price
was allocated as follows: $(1.6) million to the estimated fair value of the
Sensory Science net tangible assets purchased, $0.9 million to purchased
in-process research and development, $0.9 million to purchased existing
technology, $1.2 million to trade names, $5.0 million to distribution channel
relationships and $15.3 million to goodwill and workforce in
5
SONICBLUE INCORPORATED
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
place. Goodwill is recorded as a result of consideration paid in excess of the
fair value of net tangible and intangible assets acquired, principally due to
estimated synergies of the acquisition. Identified acquisition related
intangible assets are amortized on a straight-line basis, generally over a
five-year period. In accordance with Statement of Financial Accounting Standards
No. 142, goodwill amortization ceased effective January 1, 2002. The allocation
of the purchase price to intangibles was based upon management's estimates.
PURCHASE OF REPLAYTV, INC.
On August 1, 2001, SONICblue completed the acquisition of ReplayTV, Inc., a
developer of personal television technology. The acquisition was accounted for
as a purchase. At closing, SONICblue issued 10.4 million shares of common stock
and an aggregate of 5.1 million options and warrants to purchase shares of
SONICblue common stock in exchange for all of ReplayTV's outstanding equity, and
ReplayTV became a wholly owned subsidiary of SONICblue. In connection with the
acquisition of ReplayTV, SONICblue had made loans to ReplayTV in the amount of
$20.0 million, which became part of the purchase price.
The purchase price of $50.1 million includes $26.5 million of stock, $2.8
million of stock option costs, cash paid to ReplayTV of $20.0 million and $0.8
million in estimated expenses of the transaction. The purchase price was
allocated as follows: $(49.1) million to the estimated fair value of the
ReplayTV net tangible assets purchased, $4.2 million to purchased in-process
research and development, $17.5 million to purchased existing and core
technology, $19.5 million to non-compete agreements, $4.8 million to deferred
compensation and $53.2 million to goodwill. Goodwill is recorded as a result of
consideration paid in excess of the fair value of net tangible and intangible
assets acquired, principally due to estimated synergies of the acquisition and
the value of the workforce acquired. Goodwill will not be amortized, but will be
reviewed periodically for potential impairment, in accordance with SFAS 142. The
identified acquisition related intangible assets are amortized on a
straight-line basis, generally over a five-year period. The allocation of the
purchase price to intangibles was based upon a third party appraisal.
3. SIGNIFICANT ACCOUNTING POLICIES
REVENUE RECOGNITION
Revenue for product sales to customers where (a) persuasive evidence that
an arrangement exists, (b) delivery has occurred or services have been rendered,
(c) our price to the buyer is fixed or determinable, and (d) collectibility is
reasonably assured is recognized upon product shipment. Revenue for product
sales to customers where one of these criteria are not initially met is deferred
until such criteria have been met. SONICblue recognizes revenue on all Rio brand
players and Diamond brand modems sold through distribution channels on a
sell-through basis deferring all revenue until product is sold to the final
customer. Revenue from our ReplayTV branded products is recognized ratably over
the estimated service period.
SONICblue records estimated reductions to revenue for customer programs and
incentive offerings, including price protection, promotions and special pricing
agreements. If a different number of customers redeem incentives than estimated,
additional adjustments to revenue may be required. Accruals for estimated sales
returns are recorded at the time of the sale. These estimates are based on
historical sales returns, analysis of credit memo data and other known factors.
If the historical data used to calculate these estimates is not representative
of future returns, additional adjustments to revenue may be required.
INVENTORIES
Inventories consist of raw materials, work in process and finished goods
and are stated at the lower of cost (first-in, first-out) or market. Our
products are manufactured, assembled and tested by contract manufacturers. In
determining market value, we make assumptions about future demand and market
conditions. We
6
SONICBLUE INCORPORATED
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
utilize a rolling forecast to determine excess and obsolete or slow moving
inventory reserve requirements. We may apply judgment to the amounts thus
identified in establishing the reserve requirements. If actual conditions are
less favorable than the assumptions used, additional inventory write-downs may
be required.
Inventories consisted of:
<Table>
<Caption>
SEPTEMBER 30, DECEMBER 31,
2002 2001
------------- ------------
(IN THOUSANDS)
Raw materials............................................... $ 3,957 $ 2,819
Work in process............................................. 3,372 1,188
Finished goods.............................................. 21,505 16,564
------- -------
Total..................................................... $28,834 $20,571
======= =======
</Table>
HEDGE ACCOUNTING
In April 2002, we completed a private placement of $75.0 million in
aggregate principal amount of our 7 3/4% secured senior subordinated convertible
debentures due 2005 to three institutional investors. Our repayment obligation
on the debentures is secured by a pledge of 24,640,574 shares of United
Microelectronics Corporation stock. The institutional investors also have an
option to purchase these UMC shares from us at an exercise price of $1.78 per
share. We recorded the liability associated with this option of $9.9 million as
of April 2002. For the three months ended June 30, 2002 and September 30, 2002,
respectively, we recorded gains of $6.4 million and 1.9 million in gain (loss)
on other investments due to the mark-to-market gain on this option. In the nine
months ended September 30, 2002, we recorded gains of $8.3 million in gain
(loss) on other investments due to the mark-to-market gain on this option from
April 19, 2002 to July 31, 2002. Effective July 31, 2002, we authorized the
option to purchase UMC shares as a hedge transaction and in accordance with SFAS
133 any future fluctuations in market value will be offset as a perfect hedge
against our underlying UMC holdings. As part of our overall objectives and risk
management strategies we do not actively pursue hedge instruments. This hedge
resulted from our recent debt financing.
4. INVESTMENTS
INVESTMENT IN UMC
In 1995, SONICblue entered into a joint foundry venture with UMC to build
United Semiconductor Corporation, or USC, a semiconductor manufacturing facility
in Taiwan, R.O.C. In January 2000, USC merged with UMC and, as a result of the
merger SONICblue received 252 million UMC shares in exchange for 252 million USC
shares. The Company also received stock dividends of approximately 50, 32 and 15
million shares of UMC stock, in April 2000, August 2001 and August 2002,
respectively. The Company sold 191 million shares of UMC stock in 2001 and 23
million shares in the first nine months of 2002 on the Taiwan Stock Exchange.
Under the terms of the USC merger with UMC, a portion of the original number of
UMC shares received by SONICblue are subject to restrictions on their sale that
lapse over a three-year period from the date of the merger. At September 30,
2002, approximately 25 million shares were subject to restrictions on sale that
will lapse in one year or more and are recorded at adjusted cost as a long-term
investment. The unrestricted shares and shares where the restrictions will lapse
in one year or less are recorded as a current asset and are marked-to-market
value through other comprehensive income as required by SFAS 115.
At December 31, 2000, the market value of the investment in UMC had
declined to an amount significantly below its original cost basis. It was
determined at that point that this decline was related to the
7
SONICBLUE INCORPORATED
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
downturn in the semiconductor industry as a whole and was temporary in nature
due to the historically cyclical nature of the industry. During the first half
of 2001, the Company concluded that the downturn in the semiconductor industry
and the economy in general appeared to be more severe than previously
anticipated and that there was a great deal of uncertainty regarding when the
semiconductor industry would recover from this down cycle. At that time
SONICblue concluded that the decline in value of UMC was other than temporary
and it reported an unrealized loss on the UMC investment of $468 million based
on the market value at June 20, 2001. For the nine months ended September 30,
2002, the Company realized a gain of $5.1 million related to its sale of 23
million UMC shares.
As of September 30, 2002, SONICblue's 120 million short and long-term UMC
shares were worth approximately $90 million, based on the closing price of UMC
shares on the Taiwan Stock Exchange and the prevailing U.S. dollar to New Taiwan
Dollar exchange rate on that date. The Company's available-for-sale portion of
its UMC shares is marked-to-market through other comprehensive income as
required by SFAS 115 for changes in market value. If any future decline is
considered to be other than temporary, the decrease in value of both the
available-for-sale and long-term portions of the Company's UMC investment will
be recorded as expense in the statement of operations.
INVESTMENT IN RIOPORT, INC.
In October 1999, SONICblue caused RioPort, Inc. (formerly RioPort.com,
Inc.), which was a wholly owned subsidiary of SONICblue, to sell shares of its
preferred stock to third party investors. RioPort is developing an integrated
platform for acquiring, managing and experiencing music and spoken audio
programming from the Internet. As a result, SONICblue retained a minority
investment in RioPort and accounts for its investment using the equity method.
In addition, in November 1999, SONICblue received $10.9 million for the sale to
RioPort of OneStep, LLC, a software development company. In June 2000, RioPort
sold additional preferred stock to third party investors. As part of this
financing, the Company invested an additional $10.7 million in RioPort,
maintaining its percentage ownership of RioPort. In the fourth quarter of 2000,
RioPort sold additional preferred stock to third party investors. In the first
nine months of 2002 the Company provided $1 million of bridge financing to
RioPort along with two other investors for a total bridge loan of $3 million. In
the third quarter 2002, RioPort raised additional financing in which SONICblue
did not participate. On October 16, 2002, RioPort announced that it had
completed a merger transaction with Ecast, Inc. and, as a result, SONICblue's
debt and equity investments in RioPort were converted into Ecast stock.
SONICblue now holds less than 2% of Ecast's outstanding stock and director's and
officer's of the Company hold less than 1% of Ecast's outstanding stock. The
Company recorded its equity in the loss on RioPort of $2.0 million and $0.1
million for the nine months ended September 30, 2002 and 2001, respectively. As
of September 30, 2002, the Company was a contingent guarantor of RioPort's $2
million bank line of credit. As of September 30, 2002 the bank balance was $0.3
million and is included in SONICblue's cumulative reported losses related to its
RioPort investments.
INVESTMENT IN S3-VIA, INC.
In November 1999, the Company established a 50.1% majority-owned corporate
joint venture with VIA Technologies, Inc. to bring high-performance integrated
graphics and core logic chip sets to the volume OEM desktop and notebook PC
markets. S3-VIA has exclusive access to both companies' technology and
distribution rights for developed products between SONICblue and VIA. The
Company consolidated the accounts of S3-VIA in its consolidated financial
statements through the third quarter of 2001. VIA, acting as S3-VIA's exclusive
distributor, orders product from S3-VIA upon VIA's receipt of a third-party
order. Revenues are recognized by S3-VIA upon shipment to VIA. In the fourth
quarter of 2001, the Company terminated its participation in the management of
S3-VIA. As a result, the Company wrote off the net assets of the joint venture,
which resulted in an unrecognized gain of $0.7 million. Since the actual process
of
8
SONICBLUE INCORPORATED
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
withdrawing from the venture will continue and ultimately be a part of other
negotiations that are on-going with VIA, the Company has deferred recognition of
any gain until a comprehensive settlement of all outstanding issues is reached
with VIA.
5. INTANGIBLE ASSETS
Intangible assets subject to amortization at December 31, 2001 totaled
$56.5 million, which we expect will be amortized as follows: $13.6 million for
the year 2002, $12.9 million for the year 2003, $12.1 million for the year 2004,
$10.4 million for the year 2005 and $7.5 million for the year 2006. Intangible
assets were $43.9 million at September 30, 2002.
We had goodwill of $80.6 million at September 30, 2002. Consistent with the
implementation of SFAS 142, we ceased to amortize goodwill beginning January 1,
2002. In accordance with SFAS 142, we assess goodwill for impairment on at least
an annual basis and will record any impairment charge in the period of the
assessment. We adopted SFAS 142 on January 1, 2002. During the second quarter of
2002, we performed the first of the required impairment tests of goodwill as of
January 1, 2002, and determined that no impairment had occurred.
In accordance with SFAS 142, companies are required in the year of adoption
to exclude the impact of SFAS 142 from comparable interim periods until
pre-adoption periods are no longer presented. The following table adjusts the
Company's net loss to exclude the effects of goodwill and assembled workforce
amortization during the period ended September 30, 2001:
<Table>
<Caption>
THREE MONTHS ENDED
SEPTEMBER 30,
-------------------
2002 2001
-------- --------
(IN THOUSANDS)
Reported net loss........................................... $(32,362) $(55,290)
Plus FAS 142 adjustments:
Goodwill amortization..................................... -- 1,716
Assembled workforce amortization.......................... -- 187
-------- --------
Adjusted net loss........................................... $(32,362) $(53,387)
======== ========
Adjusted net loss per share................................. $ (0.33) $ (0.59)
</Table>
6. LINE OF CREDIT
Sensory Science Corporation has loans under a line of credit with a
financial institution. The line of credit was amended on September 30, 2002 and
October 29, 2002 to, among other things, change the maturity date, increase the
maximum amount of the line of credit, delete a borrowing limit and delete a
collateral requirement. The amended line of credit has a maturity date of March
1, 2003, and the maximum line of credit is $40.0 million limited by a borrowing
base determined by specific inventory and receivable balances of Sensory Science
and an availability block of $5.0 million. The line of credit is collateralized
by assets of Sensory Science and by a guarantee of SONICblue. Interest is
charged at prime plus 1.0%. Borrowings were $28.5 million under this facility at
September 30, 2002.
7. EARNINGS (LOSS) PER SHARE
Basic earnings (loss) per share ("EPS") are computed by dividing income
available to common stockholders by the weighted average number of common shares
outstanding for the period. Diluted EPS reflects the potential dilution that
would occur from any instrument or options, which could result in additional
9
SONICBLUE INCORPORATED
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
common shares being issued. When computing earnings (loss) per share, the
Company includes only potential common shares that are dilutive. Exercise of
options and conversion of convertible debt in the three months and nine months
ended September 30, 2002 and 2001 are not assumed because the result would have
been anti-dilutive.
8. COMPREHENSIVE INCOME (LOSS)
The Company's available-for-sale securities and foreign currency
translation adjustments are included in other comprehensive income (loss).
The following are the components of accumulated other comprehensive income
(loss), net of tax:
<Table>
<Caption>
SEPTEMBER 30, DECEMBER 31,
2002 2001
------------- ------------
(IN THOUSANDS)
Unrealized gain (loss) on investments....................... $(37,004) $ 9,390
Foreign currency translation adjustments.................... (8,411) (8,397)
-------- -------
Accumulated other comprehensive income (loss)............... $(45,415) $ 993
======== =======
</Table>
The following schedule of other comprehensive income (loss) shows the gross
current-period income (loss):
<Table>
<Caption>
NINE MONTHS ENDED
SEPTEMBER 30,
-------------------
2002 2001
-------- --------
(IN THOUSANDS)
Net unrealized gain (loss) on investments................... $(46,394) $(40,029)
Foreign currency translation adjustments.................... (14) (8,418)
-------- --------
Other comprehensive income (loss)........................... $(46,408) $(48,447)
======== ========
</Table>
9. CONTINGENCIES
The Internet, digital media, entertainment and consumer electronics
industries are characterized by frequent litigation, including litigation
regarding patent and other intellectual property rights. SONICblue is party to
various legal proceedings that arise in the ordinary course of business. While
the Company currently believes that the ultimate outcome of these proceedings,
individually and in the aggregate, will not have a material adverse effect on
the Company's financial position or overall trends in results of operations,
litigation is subject to inherent uncertainties. There can be no assurance that
an adverse result or settlement with regard to these lawsuits would not have a
material adverse effect on SONICblue's financial condition or results of
operations.
Beginning in November 1997, a number of complaints were filed in federal
and state courts seeking unspecified damages on behalf of an alleged class of
persons who purchased shares of SONICblue's common stock at various times
between April 18, 1996, and November 3, 1997. The complaints named as defendants
SONICblue, certain of its officers and former officers, certain directors of
SONICblue, and Deloitte & Touche, the company's former auditors, and asserted
that they violated federal and state securities laws by misrepresenting and
failing to disclose certain information about SONICblue's business. In addition,
certain stockholders filed derivative actions in the state courts of California
and Delaware seeking recovery on behalf of SONICblue, alleging, among other
things, breach of fiduciary duties by such individual defendants. The plaintiffs
in the derivative action in Delaware took no steps to pursue their case. The
derivative cases in California State court were consolidated, and plaintiffs
filed a consolidated amended complaint. The court
10
SONICBLUE INCORPORATED
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
entered a stipulated order in those derivative cases suspending court
proceedings and coordinating discovery in them with discovery in the class
actions in California State courts. In late 2001, the derivative plaintiffs gave
notice terminating that stay, and the parties stipulated that a second amended
consolidated complaint might be filed in April 2002. On plaintiffs' motion, the
federal court dismissed the federal class actions without prejudice. The class
actions in California State court were consolidated, and plaintiffs filed a
consolidated amended complaint. SONICblue answered that complaint and discovery
proceeded. In January 2001, four of the insurance carriers which issued
directors and officers insurance to SONICblue filed suit against all parties
named as defendants in the securities litigation, claiming that the carriers
have no obligation to provide coverage under the California Insurance Code. In
May 2001, the court entered an order staying the insurance action pending
resolution of the securities litigation. In February 2002, the California
Superior Court for Santa Clara County entered its preliminary approval of an
agreement to settle the consolidated state court class action lawsuit. Under the
terms of the class action settlement, SONICblue will contribute 2,401,501 shares
of SONICblue common stock and Deloitte & Touche will contribute up to $250,000
in full settlement of all claims. In April 2002, the Superior Court granted
final approval to that settlement, dismissing the case. In May 2002, the
Superior Court also approved the settlement of the related California derivative
litigation. The derivative settlement calls for the defendants to contribute to
the settlement their respective benefits under certain directors and officers
insurance policies in an amount of approximately $4.6 million which, net of
attorneys' fees and litigation costs, would be paid to SONICblue, which payments
have been made. The total net cost of these settlements to SONICblue, net of
insurance, is expected to approximate $8.6 million. These charges were recorded
in SONICblue's fourth quarter ended December 31, 2001. In addition the Company
settled the claim of a purchaser of the Company's common stock in 1996 and 1997,
by payment of $100,000 and 300,000 shares of the Company's common stock, the net
cost of which was recorded in the quarter ended March 31, 2002. The judgments in
the class action and the derivative litigation are both final, and the insurance
litigation has been dismissed.
SONICblue has also been defending several putative class action lawsuits
naming Diamond, which were filed in June and July 1996 and June 1997 in the
California Superior Court for Santa Clara County and the U.S. District Court for
the Northern District of California. The plaintiffs alleged that Diamond and the
other defendants made various material misrepresentations and omissions during
the class period. The parties have agreed to settle this matter for a payment of
$15.0 million, and final court approval of that settlement was obtained, and the
cases dismissed, in April 2002. SONICblue funded $4.5 million of the settlement
in November 2000. SONICblue previously accrued this amount in connection with
the merger with Diamond. SONICblue believes that Diamond's insurance covers the
remaining $10.5 million of the settlement; Diamond's insurers have funded that
amount into the settlement, although one of these insurers has commenced
arbitration disputing its obligation to pay $3.0 million of the $10.5 million.
The contesting insurer maintains that indemnification of its share of the
settlement is barred by virtue of a recent California appellate decision. The
arbitration tribunal issued an order in April 2002, stating that the California
state law claim in the class action was uninsurable, but that factual questions
were presented as to the allocation of the settlement amount as between the
state law claim and other claims included in the settlement documents. Further
briefs have been submitted on the allocation issue and, on November 13, 2002,
the arbitration tribunal issued its order awarding the insurer $1,914,250 plus
interest from November 1, 2000.
On February 14, 2000, Robert C. Price filed a purported class action
lawsuit in the Circuit Court of Monroe County, State of Indiana against the
Company and Diamond alleging violations of the California Business and
Professions Code section 17200 and the California Song-Beverly Act, which covers
consumer warranties. The lawsuit alleges that certain of the Company's Rio 300
MP3 player retail boxes, which were discontinued in approximately 1999, are
misleading because the boxes indicate that computer software included in the
package allows the purchaser to convert audio tracks on CDs to the MP3 audio
format, but the software included with the product permitted only 50
conversions. The Company answered the complaint on
11
SONICBLUE INCORPORATED
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
April 27, 2000, denying plaintiff's allegations. Status conferences were
conducted on July 26, 2000, January 10, 2001, and April 17, 2002. Discovery has
commenced. No class has been certified, but the briefing on the plaintiff's
motion for class certification is expected to be completed by Winter 2002/03,
with a hearing on class certification issues to be scheduled thereafter.
SONICblue intends to contest the certification of the purported class, dispute
the lawsuit's allegations and defend this action vigorously.
In October and November, 2001, a group of 28 entertainment companies
including, among others, Paramount Pictures Corporation, Disney Enterprises,
Inc. and the three major television networks filed four lawsuits against
SONICblue and its ReplayTV, Inc. subsidiary in the U.S. District Court in Los
Angeles, California. The lawsuits allege that the Company's manufacture and sale
of the ReplayTV 4000 and subsequent iterations of digital recorders, which allow
users to skip commercials, delete recordings only when instructed to by users,
and enable use of the Internet to send recorded material to other ReplayTV
users, constitutes copyright infringement, among other claims. The plaintiffs in
the lawsuits are seeking an injunction prohibiting the Company from including
these features in its video products. The parties have commenced discovery. The
District Court has scheduled a trial for October 2003. SONICblue disputes the
plaintiffs' claims and intends to defend this action vigorously.
In June, 2002, a group of five individual ReplayTV 4000 owners filed a
lawsuit in the United States District Court in Los Angeles against the 28
entertainment companies described above, seeking a declaration that their use of
the ReplayTV 4000 device is fair use and does not infringe copyrights. Those
individuals named SONICblue and its ReplayTV, Inc. subsidiary as nominal
defendants, although those individuals' interests are substantially aligned with
the Company's position. This complaint does not demand any affirmative relief
against the Company, but purports to reserve the right to amend to seek an
injunction to prohibit the Company from discontinuing support for features that
were advertised or served as inducements for consumers' purchases, absent
restitution to such consumers. This lawsuit has been consolidated for discovery
with the Paramount Pictures and related lawsuits.
In November 2001, Pac Tec, a division of La France Corporation, filed a
civil action against the Company and one of its suppliers, Manufacturers'
Services Limited, in the United States District Court for the Eastern District
of Pennsylvania, alleging claims against both defendants jointly for breach of
contract and promissory estoppel. The plaintiff seeks damages in excess of $2.5
million, plus prejudgment interest and costs of suit. In August 2002, the Court
granted the Company's motion to dismiss the plaintiff's claims for recovery of
consequential damages. The parties have propounded written discovery, and the
Court has set a tentative trial date in the case of March 10, 2003. SONICblue
intends to dispute the plaintiff's claims and vigorously defend itself against
this action.
In November 2001, four former holders of ReplayTV preferred shares filed a
petition for appraisal in the Chancery Court in the State of Delaware asserting
their dissenters rights of appraisal and seeking the fair value of their
ReplayTV shares in cash in lieu of the SONICblue shares to be issued to them as
provided in SONICblue's merger agreement with ReplayTV. In December 2001,
ReplayTV filed its response to plaintiffs' petition. In addition, in December
2001, the same four former holders of ReplayTV preferred shares filed a
complaint in the Chancery Court in the State of Delaware asserting that ReplayTV
and its former directors breached their fiduciary duties in connection with
Replay TV's merger by engaging in self-dealing, failing to make appropriate
disclosures to shareholders and failing to maximize the value for them in the
merger, resulting in an allocation of an insufficient amount of the merger
consideration to the ReplayTV preferred stockholders. The complaint seeks "at
least $7,249,990.50" in damages. In its merger agreement with ReplayTV,
SONICblue agreed to indemnify ReplayTV's former directors against this type of
lawsuit, among other things. In February 2002, ReplayTV and the former ReplayTV
directors filed their answer. SONICblue and ReplayTV intend to dispute the
plaintiffs' claims and vigorously defend these actions. The cases are currently
in the pretrial discovery stage.
12
SONICBLUE INCORPORATED
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
On November 28, 2001, TechSearch, LLC filed a complaint for patent
infringement against a number of consumer electronics companies, including
SONICblue, in the United States District Court for the Northern District of
Illinois. TechSearch's complaint generally alleges that SONICblue is infringing
one of its patents by making, selling, and offering to sell its Rio Volt CD
players that are capable of playing CDs encoded with audio tracks in the MP3
format. SONICblue intends to dispute the plaintiff's claims and vigorously
defend itself against the allegations made in TechSearch's complaint. This
action was stayed by order of the Court on or about May 1, 2002, pending a
reexamination of the patent asserted by TechSearch by the U.S. Patent and
Trademark Office. The stay was extended by court order on or about September 10,
2002.
On December 12, 2001, SONICblue filed a complaint for patent infringement
against TiVo Inc. in the United States District Court for the Northern District
of California. SONICblue's complaint generally alleges that TiVo is infringing
one of its patents by licensing and offering to license its DVR technology and
offering its program guide service. In response, TiVo filed an answer and
counterclaim against SONICblue that denies infringement of SONICblue's patent
and that alleges that the patent is invalid. On January 23, 2002, TiVo filed a
separate action in the same court, but assigned to a different judge, that
generally alleges that SONICblue is infringing one of TiVo's patents by making,
selling and offering to sell its ReplayTV DVRs. In response to TiVo's complaint,
SONICblue filed an answer and counterclaim denying infringement and alleging
that TiVo's patent is invalid. The parties have settled the cases, and each has
lodged stipulations for dismissal with the Court.
On October 17, 2001, Skyline Capital Associates, LLC filed a lawsuit in the
San Mateo County Superior Court alleging that SONICblue breached an agreement
for tax consulting services and seeking payment of $3.2 million for consulting
fees and interest. In November 2001, SONICblue filed a counter claim against
Skyline for $750,000. In March 2002, SONICblue, Skyline and Skyline's principal
entered into a settlement agreement pursuant to which the parties would resolve
their dispute for $2.4 million. In June 2002, after SONICblue had paid
approximately $2.3 million under the settlement agreement, a dispute over the
settlement arose. SONICblue intends to dispute the plaintiff's claims and defend
this action vigorously.
The investment agreement between SONICblue, VIA and S3 Graphics provides
that under certain circumstances, SONICblue may be required to pay VIA
significant liquidated damages if, unless as a result of certain acts or
omissions on the part of either VIA or S3 Graphics, S3 Graphics is prevented by
court order from utilizing SONICblue's patent cross-license with Intel
Corporation or if SONICblue enters into a settlement agreement with Intel such
that S3 Graphics can no longer operate under the patent cross-license. In
September 2001, Intel filed a patent infringement lawsuit against S3 Graphics
and VIA. SONICblue is not a party to the lawsuit. The lawsuit is in early
stages. Any liquidated damages that SONICblue might be required to pay to VIA
under the investment agreement may under certain circumstances be reduced by
amounts paid by SONICblue to Intel in connection with any lawsuit and amounts
owed to SONICblue by either VIA or S3 Graphics.
On or about August 21, 2001, VIA Technologies, Inc. commenced an
arbitration proceeding against the Company that is currently pending before the
International Centre for Dispute Resolution (the international division of the
American Arbitration Association). In November 2001, the Company responded to
the demand for arbitration, denying liability and asserting various other
defenses. An arbitrator was appointed on July 24, 2002, and on or about
September 20, 2002, VIA, joined by S3 Graphics Co., Ltd. as a co-claimant, filed
a First Amended Demand for Arbitration, seeking, among other things, damages of
approximately $8.0 million and an order of specific performance to correct
alleged errors in the Closing Balance Sheet for the transactions contemplated by
the investment agreement between the parties in the amount of approximately $4.1
million as well as recovery of costs and attorneys' fees. The Company filed a
Statement of Defense to the First Amended Demand for Arbitration and
Counterclaim in which it, among other things, denied liability, alleged that the
tribunal lacked jurisdiction over certain of the claims included in the First
Amended Demand
13
SONICBLUE INCORPORATED
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
for Arbitration and conditionally asserted counterclaims for breach of the
investment agreement. The parties are presently briefing the jurisdictional
issues. There has been no discovery in the proceeding, and a hearing date has
not yet been set. SONICblue intends to defend this action vigorously.
While we currently believe that the ultimate outcome of these proceedings
will not have a material adverse effect on the Company's financial position or
overall trends in results of operations, litigation is subject to inherent
uncertainties. An adverse result or settlement with regard to these proceedings
could have a material adverse effect on SONICblue's financial condition or
results of operations.
10. NEW ACCOUNTING PRONOUNCEMENTS
On July 30, 2002, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards Statement No. 146, Accounting for Costs
Associated with Exit or Disposal Activities (SFAS No. 146). The standard
replaces EITF Issue No. 94-3, "Liability Recognition for Certain Employee
Termination Benefits and Other Costs to Exit an Activity (including Certain
Costs Incurred in a Restructuring)" and requires companies to recognize costs
associated with exit or disposal activities when they are incurred rather than
at the date of a commitment to an exit or disposal plan. Examples of costs
covered by the standard include lease termination costs and certain employee
severance costs that are associated with a restructuring, discontinued
operation, plant closing, or other exit or disposal activity. SFAS 146 is
effective prospectively to exit or disposal activities initiated after December
31, 2002.
In August 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." SFAS 144 addresses financial
accounting and reporting for the impairment of long-lived assets and for
long-lived assets to be disposed of. The provisions of SFAS 144 were effective
January 1, 2002. The adoption of SFAS 144 did not have an impact on the
Company's consolidated financial position and results of operations.
11. RESTRUCTURING EXPENSE AND IMPAIRMENT CHARGE
In April 2001, the Company adopted a restructuring plan relating to the
change in its business strategy to address changes in the market due to
technology changes, customer demands, and methods of distribution to reflect its
long-term strategy and focus. Specific actions taken in 2001 included reducing
the Company's workforce worldwide by approximately 200 employees, consolidating
facilities, discontinuing unprofitable products and closing offices in
unprofitable locations. Restructuring expenses of $130 million in 2001 related
to the restructuring plan primarily included the write-off of goodwill and other
intangibles ($110 million), facilities closure expenses ($9 million), personnel
severance compensation and related expenses ($6 million) and contract
termination and other costs ($5 million). As part of the restructuring, the
Company also wrote off $60 million of inventory, through cost of sales in 2001.
Due to the circumstances created by the significant downturns in the
digital media markets, the Company recorded an impairment charge against the
goodwill and intangibles associated with its acquisitions of Diamond Multimedia,
RioPort, and Empeg Limited in the second quarter of 2001. These downturns
negatively affected the forecasted revenues and cash flows from the Diamond and
Empeg Limited businesses acquired in 1999 and 2000, respectively. In accordance
with the Company's policy, undiscounted cash flows indicated that the assets
were impaired. The Company calculated the impairment charge by comparing the
expected discounted future cash flows to the carrying amount of the related
intangible assets.
In the first nine months of 2002, the Company continued the restructuring
efforts described above. Specific actions taken included a further reduction of
the Company's workforce worldwide by approximately 170 employees and
consolidation of facilities. Restructuring expenses of $21.2 million in the
first nine months
14
SONICBLUE INCORPORATED
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
of 2002 related to the restructuring plan included personnel severance
compensation and related expenses ($4.1 million), and facilities related
expenses and other costs ($17.1 million).
The related accrued restructuring charges activity was as follows:
<Table>
<Caption>
SEVERANCE REDUNDANT
COMPENSATION AND FACILITIES CONTRACT AND
RELATED EXPENSES RELATED COSTS OTHER COSTS TOTAL
---------------- ------------- ------------ -------
(IN THOUSANDS)
Balance at December 31, 2001............... $ 2,643 $ 6,563 $1,387 $10,593
Restructuring Charges.................... 4,074 16,853 307 21,234
Cash Payments............................ (2,459) (2,669) (447) (5,575)
Non-Cash Charges......................... -- (619) (348) (967)
------- ------- ------ -------
Balance at September 30, 2002.............. $ 4,258 $20,128 $ 899 $25,285
======= ======= ====== =======
</Table>
12. SENIOR SUBORDINATED CONVERTIBLE DEBT
In April 2002, we completed a private placement of $75.0 million in
aggregate principal amount of our 7 3/4% secured senior subordinated convertible
debentures due 2005 to three institutional investors. We also issued warrants to
purchase up to 7,500,000 shares of our common stock in the transaction to the
investors, and a warrant to purchase 293,805 shares of our common stock to the
placement agent for the transaction. The private placement resulted in gross
proceeds to us, prior to the exercise of the warrants, of approximately $62.3
million. The sale of the debentures and the warrants closed on April 22, 2002.
The debentures are convertible into SONICblue common stock at a conversion price
of $19.22 per share subject to standard anti-dilution adjustments. The warrants
are fully vested and exercisable at any time until April 22, 2007 at an exercise
price of $3.39 per share subject to standard anti-dilution adjustments. Our
repayment obligation on the debentures is secured by a pledge of 24,640,574
shares of UMC stock. The institutional investors also have an option to purchase
these UMC shares from us. The value of these equity instruments and the discount
on the face value of the debt have been recorded as an offset to the $75 million
face value of the debt on the balance sheet at September 30, 2002. These items
are amortized to interest expense under the effective interest method over the
term of the debentures. Under the terms of the debentures we may pay up to 50%
of the interest payments on the debentures in shares of our common stock.
15
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
When used in this discussion, the words "expects," "anticipates,"
"believes," "estimates" and similar expressions are intended to identify
forward-looking statements. These statements, which include statements as to the
Company's sources of revenues, development of technology and products, product
mix, the percentage of net sales represented by any particular new or current
product, customer concentration, trends in average selling prices, seasonality
and trends in shipment levels, the percentage of export sales, interest charges
and fees associated with the Company's outstanding debt and bank financing,
income tax benefits, the use of the proceeds from the Company's private
financing of its secured senior subordinated convertible debentures, trends in
net loss, net income, gross margins and cash flow, expected cash requirements,
expected expense levels and plans to reduce expenses, improve supply chain
management and focus on higher volume and margin products, the Company's focus
on its core technology and products, the availability and cost of products from
the Company's suppliers, shortening product life cycles, ability to compete,
investments in research and development, capital expenditures, capital
requirements and adequacy of capital resources, plans regarding future financing
alternatives, the impact and timing of the Company's current and future
litigation, the Company's strategy with regard to protecting its proprietary
technology, and the Company's ability to forecast demand for its products, are
subject to risks and uncertainties that could cause actual results to differ
materially from those projected. These risks and uncertainties include, but are
not limited to, those risks discussed below, as well as risks relating to
SONICblue's ability to develop and timely introduce and ship in volume products
that address market demands, manufacturing difficulties, the cost and
availability of component products, decreases in average selling prices, timing
and volume of shipments of new products, SONICblue's ability to work with
strategic partners and OEMs, the ability of the Company to obtain and retain
customers, the impact of alternative technological advances and competitive
products, the value of the Company's shares of UMC common stock and declines in
the semiconductor industry, market fluctuations, developments in and expenses
relating to litigation, SONICblue's ability to complete business transactions
and integrate acquired businesses in a timely manner, the costs of integrating
acquired businesses and technologies, and the matters discussed in "Factors That
May Affect Our Results." These forward-looking statements speak only as of the
date hereof. The Company expressly disclaims any obligation or undertaking to
release publicly any updates or revisions to any forward-looking statements
contained herein to reflect any change in the Company's expectations with regard
thereto or any change in events, conditions or circumstances on which any
statement is based.
OVERVIEW
SONICblue designs, develops and markets products for the converging
Internet, digital media, entertainment and consumer electronics markets. Our
products include Rio digital audio players, ReplayTV personal television
technology and software solutions, and Go-Video Dual-Deck VCRs and integrated
DVD+VCRs. Prior to the transfer in January 2001 of our graphics chips business
to S3 Graphics Co., Ltd., we were a supplier of graphics and multimedia
accelerator subsystems for PCs for over ten years.
On October 7, 2002, the Board of Directors appointed L. Gregory Ballard as
the Company's Chief Executive Officer and Marcus Smith as the Company's Chief
Financial Officer. Each had been serving on an interim basis since August 8,
2002 and April 18, 2002, respectively. Mr. Ballard was also appointed to the
Company's Board of Directors. On October 23, 2002, James T. Schraith resigned
from our Board of Directors for personal reasons.
ACQUISITIONS AND DIVESTITURES
On August 1, 2001, SONICblue completed the acquisition of ReplayTV, Inc., a
developer of personal television technology. The acquisition was accounted for
as a purchase. At closing, SONICblue issued 10.4 million shares of common stock
and assumed an aggregate of 5.1 million options and warrants to purchase shares
of SONICblue common stock in exchange for all of ReplayTV's outstanding equity,
and ReplayTV became a wholly owned subsidiary of SONICblue. Prior to closing the
acquisition, SONICblue made loans to ReplayTV in the amount of $20.0 million,
which became part of the purchase price.
16
On June 27, 2001, SONICblue completed the acquisition of Sensory Science
Corporation, a developer of consumer electronics products, including dual deck
videocassette player/recorders and DVD players. The acquisition was accounted
for as a purchase. At closing, SONICblue issued approximately 1.3 million shares
of SONICblue common stock to Sensory Science stockholders in exchange for the
common stock of Sensory Science outstanding, and Sensory Science became a wholly
owned subsidiary of SONICblue. Prior to closing the acquisition, SONICblue made
loans to Sensory Science in the amount of $9.8 million, which became part of the
purchase price.
In March 2001, SONICblue completed the sale to ATI Technologies, Inc.
("ATI") of its professional graphics division, based in Starnberg, Germany,
which produced the Fire GL line of graphics accelerators. Under the terms of an
Asset Purchase Agreement, SONICblue has received $9.2 million in cash through
September 30, 2002, which fulfills ATI's financial obligations to SONICblue.
In January 2001, SONICblue completed the transfer of its graphics chips net
assets, other than its shares of common stock of S3-VIA, Inc. ("S3-VIA"), to S3
Graphics Co., Ltd. ("S3 Graphics"), a joint venture between VIA Technologies,
Inc. ("VIA") and a wholly owned subsidiary of SONICblue. The joint venture
manufactures and distributes semiconductor products and conducts related
research and development activities. Pursuant to the joint venture agreement
with VIA, SONICblue received 13 million shares of SONICblue common stock in
return for a reduction of its economic interest in the future operations of the
joint venture to 0.1%. Under the joint venture agreement, SONICblue will also
receive earn-out payments if the venture meets specified profitability goals.
In November 2000, SONICblue acquired United Kingdom digital audio equipment
manufacturer Empeg Limited, known as Empeg, at an initial purchase price of $1.9
million. This acquisition was accounted for as a purchase. In November 2001, a
purchase price adjustment of $1.1 million was recorded resulting in a total
purchase price of $3.0 million.
In August 2000, SONICblue shut down its Diamond Multimedia-branded graphics
add-in board business. The shutdown did not extend to SONICblue's professional
graphics division, headquartered in Germany, which continued to develop and
market its line of Fire GL graphics accelerators until, as discussed above,
SONICblue sold its professional graphics division to ATI Technologies.
17
RESULTS OF OPERATIONS
The following table sets forth certain financial data for the periods
indicated as a percentage of net sales:
<Table>
<Caption>
THREE MONTHS ENDED NINE MONTHS ENDED
------------------------------- -------------------------------
SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30,
2002 2001 2002 2001
------------- ------------- ------------- -------------
Net sales........................... 100.0% 100.0% 100.0% 100.0%
Cost of sales....................... 93.5 85.0 85.4 156.7
----- ------ ----- ------
Gross profit (loss)................. 6.5 15.0 14.6 (56.7)
Operating expenses:
Research and development.......... 5.0 12.1 6.0 17.7
Selling, marketing and
administrative................. 19.0 35.1 21.6 58.3
Restructuring, impairment and in-
process R&D.................... 9.7 20.9 10.4 100.3
Amortization of goodwill,
intangibles and deferred
compensation................... 5.0 9.9 5.8 20.6
----- ------ ----- ------
Total operating
expenses................ 38.7 78.0 43.8 196.9
----- ------ ----- ------
Loss from operations................ (32.2) (63.0) (29.2) (253.6)
Gain (loss) on UMC investment....... -- (32.3) 2.5 (406.7)
Gain (loss) on other investments.... (3.7) (5.7) (3.2) (18.4)
Interest expense.................... (7.1) (4.9) (5.9) (6.6)
Other income (expense), net......... 1.7 5.0 0.6 1.2
----- ------ ----- ------
Income (loss) before income taxes... (41.3) (100.9) (35.5) (684.1)
Income tax expense (benefit)........ -- -- -- (159.7)
----- ------ ----- ------
Net income (loss)................... (41.3)% (100.9)% (35.5)% (524.4)%
===== ====== ===== ======
</Table>
NET SALES
Our products are used in, and our business is dependent upon, the
converging Internet, digital media, entertainment and consumer electronics
markets. Sales of our products are primarily in the United States and to a
lesser extent in Asia and Europe.
Net sales were $78.4 million for the three months ended September 30, 2002,
an increase of 43% from $54.8 million for the three months ended September 30,
2001. Net sales were $205.1 million for the nine months ended September 30,
2002, an increase of 53% from $134.2 million for the nine months ended September
30, 2001. Net sales increased from 2001 to 2002 primarily due to the inclusion
of sales from our acquisitions of Sensory Science and the market growth of our
video products particularly our DVD/VCR combination product and to a lesser
extent, ReplayTV. Net sales for the first nine months of 2002 consisted
primarily of consumer electronics products, including our Rio branded digital
audio players, Sensory Science video products and to a lesser extent our Diamond
brand modems. Net sales for the first nine months of 2001 consisted primarily of
our Diamond brand modems, PDA and communications products, Rio digital audio
players, net sales from our S3-VIA joint venture and our Sensory Science video
products.
We expect that the percentage of our net sales represented by any one
product or type of product may change significantly from period to period as new
products are introduced and existing products reach the end of their life
cycles. We anticipate that the majority of our revenues will be generated from
our consumer electronics product lines and to a lesser extent our modem product
line. No further significant revenues are anticipated from chips, boards or
S3-VIA, Inc. Due to competitive price pressures, our products experience
declining average selling prices over time, which at times can be substantial.
18
International sales accounted for 3% and 10% of net sales for the three
months ended September 30, 2002 and 2001, respectively. International sales
accounted for 4% and 50% of net sales for the nine months ended September 30,
2002 and 2001, respectively, excluding the net sales of S3-VIA, Inc.
International sales decreased as a result of our shift in business and focus on
the converging Internet, digital media, entertainment and consumer electronics
markets which are predominantly domestic sales. There can be no assurances that
international sales as a percentage of net sales will remain at current levels.
All sales transactions are denominated in U.S. dollars.
Two retailers accounted for 35% and 21% of net sales in the three months
ended September 30, 2002. Two customers accounted for 16% and 10% of net sales
for the three months ended September 30, 2001, excluding the sales by S3-VIA,
Inc. Four retailers accounted for 21%, 20%, 12% and 11% of net sales in the nine
months ended September 30, 2002. Two customers accounted for 10% and 11% of net
sales in the nine months ended September 30, 2001. We expect a significant
portion of our future sales to remain concentrated within a limited number of
strategic customers. Sales to any particular customer may fluctuate
significantly from quarter to quarter.
GROSS MARGIN
We had a positive gross margin of 6.5% for the three months ended September
30, 2002, as compared with a positive gross margin of 15.0% for the three months
ended September 30, 2001. We had a positive gross margin of 14.6% for the nine
months ended September 30, 2002, as compared with a negative gross margin of
56.7% for the nine months ended September 30, 2001. The decrease in gross margin
for the three months ended September 30, 2002, was primarily the result of
declining average selling prices in our video product line, new product
introduction costs and related product transition costs. The increase in gross
margin for the nine months ended September 30, 2002, was primarily the result of
adding the Sensory Science product lines, supply chain management efficiencies,
and decreased liabilities for certain purchase commitments with one of our
contract manufacturers and was partially offset by declining average selling
prices within our video product line, increased costs from the introduction of
new products and related product transition costs. In the future, our gross
margins will be affected by increased competition and related decreases in the
unit average selling prices, particularly within the video product line, our
ability to reduce costs by negotiating with vendors for more favorable pricing,
the timing and volume of shipments of new products, our ability to effectively
transition production to new manufacturers and related costs, the availability
of products from our suppliers, the impact of the west coast dock actions and
related delays and resulting increased shipping costs, our ability to secure
reasonable transportation costs, changes in the mix of products sold and the
extent to which we incur or obtain additional licensing fees.
RESEARCH AND DEVELOPMENT EXPENSES
Research and development expenses consist primarily of salaries, related
benefits, and fees for consulting and outsourced services. We have made and
intend to continue to make significant investments in research and development
to remain competitive by developing new and enhanced products. Research and
development expenses were $3.9 million for the three months ended September 30,
2002, a decrease of $2.7 million from $6.6 million for the three months ended
September 30, 2001. Research and development expenses were $12.3 million for the
nine months ended September 30, 2002, a decrease of $11.4 million from $23.7
million for the nine months ended September 30, 2001. This decrease was
primarily due to a reduction in headcount and related personnel costs resulting
from the shutdown of our multimedia board business and the transfer of our
graphics chips business. We intend to continue to focus on core technology and
products while concentrating on efforts to reduce overhead, headcount and
related costs.
SELLING, MARKETING AND ADMINISTRATIVE EXPENSES
Selling, marketing and administrative expenses consist primarily of
salaries, related benefits, selling costs, facilities costs and fees for
professional services, such as legal and accounting services. Selling, marketing
and administrative expenses were $14.9 million for the three months ended
September 30, 2002, a decrease of $4.4 million from $19.2 million for the three
months ended September 30, 2001. Selling, marketing and
19
administrative expenses were $44.4 million for the nine months ended September
30, 2002, a decrease of $33.8 million from $78.2 million for the nine months
ended September 30, 2001. This decrease was primarily due to a reduction in
headcount and related personnel costs resulting from the shutdown of our
multimedia board business and the transfer of our graphics chips business and
restructuring activities in 2001.
RESTRUCTURING, IMPAIRMENT AND IN-PROCESS R&D
Restructuring and impairment charges were $7.6 million and $21.2 million
for the three and nine months ended September 30, 2002, respectively as compared
to $7.2 million and $129.4 million for the three and nine months ended September
30, 2001, respectively. In-process R&D charges were $0 for the three and nine
months ended September 30, 2002, as compared to $4.2 million and $5.1 million
for the three and nine months ended September 30, 2001. The in-process R&D
charges related to our acquisitions of Sensory Science and ReplayTV in the
second and third quarters of 2001. In accordance with the restructuring plan we
adopted in April 2001, we have taken specific actions to address changes in our
business strategy, changes in the market due to technology changes, customer
demands and methods of distribution to reflect our long-term strategy and focus.
Restructuring expenses consist primarily of the write-off of goodwill and
intangibles, facilities consolidation and closure expenses, personnel severance
compensation and related expenses and contract termination, and other costs. We
expect our restructuring activities to continue for the remainder of 2002.
AMORTIZATION OF GOODWILL, INTANGIBLES AND DEFERRED COMPENSATION
Amortization of goodwill and intangibles decreased to $3.4 million for the
three months ended September 30, 2002, down from $5.1 million for the three
months ended September 30, 2001. Amortization of goodwill and intangibles
decreased to $10.2 million for the nine months ended September 30, 2002, down
from $27.7 million for the nine months ended September 30, 2001. This decrease
is due to the write-off in 2001 of approximately $110 million of goodwill and
other intangibles, primarily related to the acquisition of Diamond Multimedia
Systems, Inc. and the implementation of Statement of Financial Accounting
Standards No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"). Deferred
compensation expense increased to $0.5 million for the three months ended
September 30, 2002, from $0.3 for the three months ended September 30, 2001, and
to $1.8 million for the nine months ended September 30, 2002, from $0.3 for the
nine months ended September 30, 2001. This increase resulted from the
acquisition of ReplayTV, Inc. in August 2001.
Amortization charges will continue to decrease in 2002 when compared to
prior years due to the impact of the 2001 write-off noted above and the
implementation of SFAS 142. SFAS 142 requires that goodwill and intangible
assets with indefinite useful lives no longer be amortized, but be reviewed at
least annually for impairment. Intangible assets with finite useful lives will
continue to be amortized over their respective useful lives.
Excluding the adoption of SFAS 142, goodwill amortization expense would
have been an incremental $4.2 million and $8.4 million for the three and nine
months ended September 30, 2002, respectively. Total amortization charges for
goodwill, intangibles and deferred compensation would have been $8.1 million and
$24.6 million for the three and nine months ended September 30, 2002,
respectively, compared to $5.1 million and $27.4 million for the three and nine
months ended September 30, 2001, respectively.
GAIN (LOSS) ON UMC INVESTMENT
In 1995, SONICblue entered into a joint foundry venture with United
Microelectronics Corporation, or UMC, to build United Semiconductor Corporation,
or USC, a semiconductor manufacturing facility in Taiwan, R.O.C. In January
2000, USC merged with UMC and, as a result of the merger SONICblue received 252
million UMC shares in exchange for 252 million USC shares. The Company also
received stock dividends of approximately 50, 32 and 15 million shares of UMC
stock, in April 2000, August 2001, and August 2002, respectively. The Company
sold 15 and 191 million shares of UMC stock in 2000 and 2001, respectively, and
23 million shares in the first nine months of 2002 on the Taiwan Stock Exchange.
Under the terms of the USC
20
merger with UMC, a portion of the original number of UMC shares received by
SONICblue are subject to restrictions on their sale that lapse over a three-year
period from the date of the merger. At September 30, 2002, approximately 25
million additional shares were subject to restrictions that will lapse in one
year or more and are recorded at adjusted cost as a long-term investment. The
unrestricted shares and shares where the restrictions will lapse in one year or
less are recorded as a current asset and are marked-to-market value through
other comprehensive income as required by SFAS 115.
At December 31, 2000, the market value of the investment in UMC had
declined to an amount significantly below its original basis. It was determined
at that point that this decline was related to the downturn in the semiconductor
industry as a whole and was temporary in nature due to the historically cyclical
nature of the industry. During the first half of 2001, the Company concluded
that the downturn in the semiconductor industry and the economy in general
appeared to be more severe than previously anticipated and that there was a
great deal of uncertainty regarding when the semiconductor industry would
recover from this down cycle. Because SONICblue concluded that the decline in
value of UMC was other than temporary, it reported an unrealized loss on the UMC
investment of $468 million based on the market value at June 30, 2001. For the
nine months ended September 30, 2002, the Company realized a gain of $5.1
million related to its sale of 23 million UMC shares.
As of September 30, 2002, SONICblue's 120 million UMC shares were worth
approximately $90 million, based on the closing price of UMC shares on the
Taiwan Stock Exchange and the prevailing U.S. dollar to New Taiwan Dollar
exchange rate on that date. The Company's available-for-sale portion of the
investment will be marked-to-market through other comprehensive income as
required by SFAS 115 for changes in market value subsequent to September 30,
2002 unless a further decline in market value is considered to be other than
temporary. If any further decline is considered to be other than temporary, the
decrease in value of both the available-for-sale and long-term portions of the
Company's UMC investment will be recorded as an expense in the statement of
operations.
GAIN (LOSS) ON OTHER INVESTMENTS
In the three months ended September 30, 2002, we recognized a loss of $2.9
million primarily related to the $5.0 million write-down of certain equity
investments, which were partially offset by the mark-to-market gain of $8.2
million related to the liability associated with the UMC options granted in
conjunction with our recent debt financing. Effective July 31, 2002, we
authorized the option to purchase UMC shares as a hedge transaction and in
accordance with SFAS 133 any future fluctuations in market value will be offset
as a perfect hedge against our underlying UMC holdings. In the three months
ended September 30, 2001, we recognized a loss of $3.1 million primarily related
to the write-down of certain equity investments. In the nine months ended
September 30, 2002, we recognized a loss of $6.6 million primarily related to
the write-down of certain equity investments, which were partially offset by the
mark-to-market gains on our UMC options and the gains from the sale of our UMC
derivative instruments. In the nine months ended September 30, 2001, we
recognized a loss of $24.9 million, primarily related to the write-down of
certain equity investments. The downturn in the economy, particularly in the
high technology sector, contributed to the decline in the market value of these
private securities. The remaining value of these cost based equity investments
totaled $0.5 million as of September 30, 2002.
INTEREST EXPENSE
Interest expense increased to $5.5 million for the three months ended
September 30, 2002 up from $2.7 million for the three months ended September 30,
2001. Interest expense increased to $12.2 million for the nine months ended
September 30, 2002, up from $8.8 million for the nine months ended September 30,
2001. This increase is primarily due to the increased principal and the
amortization of the discount, issuance costs and equity instruments granted in
association with our recently issued senior subordinated convertible debt. We
expect to continue to incur significant interest charges associated with our
convertible subordinated debt and, to a lesser extent, interest and fees
associated with our line of credit.
21
OTHER INCOME (EXPENSE), NET
Other income was $1.3 million for the three months ended September 30, 2002
and 2001. Other income was $1.3 million for the nine months ended September 30,
2002, compared to $1.7 million for the nine months ended September 30, 2001. The
decrease in other income was due primarily to our receipt of less cash from the
sale of our professional graphics division to ATI that was due according to the
agreement.
INCOME TAXES
Our effective tax rate for the three months ended September 30, 2002 and
2001 was 0.0%. Our effective tax rate for the nine months ended September 30,
2002 and 2001 was 0.0% and a benefit rate of 159.7%, respectively. The effective
tax rate reflects expected tax payments on the adjusted taxable income at the
federal, state and international statutory rates. Due to uncertainty associated
with our prospective ability to realize the benefits of our tax assets, we have
fully reserved the value of our deferred tax assets and do not expect to record
any tax benefit associated with any further operating losses during the
remainder of fiscal 2002.
CERTIFICATION BY CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER
The certification by the Company's chief executive officer and chief
financial officer of this report on Form 10-Q, as required by Section 906 of the
Sarbanes-Oxley Act of 2002 (18 U.S.C. Section 1350), have been submitted to the
Securities and Exchange Commission as additional correspondence accompanying
this report.
LIQUIDITY AND CAPITAL RESOURCES
Cash used for operating activities was $111.1 million for the nine months
ended September 30, 2002, and consisted primarily of our net loss of $72.4
million and working capital outlays associated with our growth in revenues and
the payment of certain outstanding liabilities. Cash used for operating
activities was $116.8 million for the nine months ended September 30, 2001, and
consisted primarily of our net loss of $703.6 million, which included a
non-operating loss on our UMC investment of $545.7 million, deferred income tax
benefit of $214.2 million and charges related to the impairment of long-term
assets of $109.1 million.
Investing activities provided cash of $36.4 million for the nine months
ended September 30, 2002, and consisted primarily of sales and maturities of
short-term investments including $38.9 million received from the sale of 23
million UMC shares on the Taiwan Stock Exchange, and the sale of all of our
remaining UMC derivatives. Investing activities provided cash of $143.3 million
for the nine months ended September 30, 2001, and consisted primarily of sales
and maturities of short-term investments including cash received from the sale
of 136 million UMC shares on the Taiwan Stock Exchange, offset by funding
provided to ReplayTV and Sensory Science, in connection with SONICblue's
acquisition of those companies.
Financing activities provided cash of $72.3 million for the nine months
ended September 30, 2002, and consisted primarily of the net proceeds from the
private placement of our senior subordinated convertible debentures and
increased borrowings from our line of credit. Financing activities used cash of
$50.0 million for the nine months ended September 30, 2001, and consisted of
repayments of notes payable offset by sales of common stock.
We had working capital of $8.5 million at September 30, 2002. This working
capital is primarily attributable to the net proceeds received from the sale of
our $75 million senior subordinated convertible debentures, offset by the
significant degradation in the value of our available-for-sale UMC holdings and
our continued operating losses. We funded our 2002 and 2001 operating losses and
investment activities primarily through the sale of a portion of our holdings in
UMC and expect to use these holdings to fund working capital needs in the
foreseeable future.
A portion of the UMC shares received by SONICblue are subject to
restrictions on their sale that lapse over a three-year period. At September 30,
2002, approximately 25 million shares were subject to restrictions that will
lapse in more than one year and are recorded at adjusted cost as a long-term
investment. Shares
22
where the restrictions will lapse in one year or less are recorded as a current
asset and are marked-to-market value through other comprehensive income.
Sensory Science has loans under a line of credit with Congress Financial
Corporation. The line of credit was amended on September 30, 2002 and October
29, 2002 to, among other things, change the maturity date, increase the maximum
amount of the line of credit, delete a borrowing limit and delete a collateral
requirement. The amended line of credit has a maturity date of March 1, 2003,
and the maximum line of credit is $40.0 million, limited by a borrowing base
determined by specific inventory and receivable balances of Sensory Science and
an availability block of $5.0 million. The line of credit is collateralized by
assets of Sensory Science and by a guarantee of SONICblue. Borrowings were $28.5
million under this facility at September 30, 2002.
During 2001, we sold a portion of our UMC holdings, aggregating
approximately 38.9 million shares, in a derivative transaction. In connection
with the sales of these UMC holdings, we purchased a series of call option
collars on UMC stock with an aggregate notional amount of 38.9 million shares.
These transactions provided us funds from the sale of the shares while allowing
us to participate in future increases in the value of UMC shares, if any,
through this series of call option collars. All such derivatives were sold in
the first nine months of 2002.
On April 22, 2002, we completed a private placement of $75.0 million in
aggregate principal amount of our 7 3/4% secured senior subordinated convertible
debentures due 2005 to three institutional investors. We also issued warrants to
purchase up to 7,500,000 shares of our common stock to the investors, and a
warrant to purchase 293,805 shares of our common stock to the placement agent
for the transaction. The private placement resulted in gross proceeds to us,
prior to the exercise of the warrants, of approximately $62.3 million. The
debentures are convertible into SONICblue common stock at a conversion price of
$19.22 per share subject to standard anti-dilution adjustments. The warrants are
fully vested and exercisable at any time until April 22, 2007 at an exercise
price of $3.39 per share subject to standard anti-dilution adjustments. Under
the terms of the debentures we may pay up to 50% of the interest payments on the
debentures in shares of our common stock. Our repayment obligation on the
debentures is secured by a pledge of 24,640,574 shares of UMC stock. The
institutional investors also have an option to purchase these UMC shares from us
at an exercise price of $1.78 per share. We expect to use the net proceeds from
the private placement for working capital and general corporate purposes.
We have incurred significant losses and expect such losses to continue for
at least the next three months. Our net loss for the nine months ended September
30, 2002 was $72.4 million and for the year ended December 31, 2001 was $756.2
million. As of September 30, 2002, we have an accumulated deficit of $559.9
million and cash, cash equivalents, and short-term investments of $77.5 million.
We expect to experience negative cash flow from operations for at least the next
three months and believe that additional funds will be necessary to support
planned operations through the next twelve months. Our future cash requirements
will depend on a number of factors including:
- the rate at which customers accept and purchase our existing and future
products;
- the rate at which we invest in engineering, development and intellectual
property with respect to existing and future products;
- the level of marketing required to acquire a competitive position in the
marketplace;
- our ability to reduce costs by negotiating with vendors for more
favorable pricing;
- the operational costs that we incur to continue to develop our business
as a whole;
- our ability to sell our UMC shares, when needed, and at reasonable
prices;
- use of financial instruments to allow us to monetize our long-term UMC
share holdings;
- the forbearance of the creditors of our legacy businesses to accept
extended payment terms; and
- pending litigation as discussed in Part II -- OTHER INFORMATION Item 1.
"Legal Proceedings."
23
We may wish to selectively pursue possible acquisitions of, or investments
in businesses, technologies or products complementary to ours in order to expand
our geographic presence, broaden our product offerings, and achieve operating
efficiencies. We may not have sufficient liquidity, or we may be unable to
obtain additional financing on favorable terms or at all, in order to finance
such an acquisition or investment.
Adverse business or legal developments, our current debt obligations, and
continued negative cash flow from operations may require us to raise additional
financing. We may be required to raise such additional capital, at times and in
amounts, which are uncertain, especially under the current capital market
conditions. If we are unable to acquire additional capital or are required to
raise it on terms that are less satisfactory than we desire, it may have a
material adverse effect on our financial condition, which could require us to
curtail our operations significantly, restructure all or a portion of our
existing debt, sell significant assets, seek arrangements with strategic
partners or other parties that may require us to relinquish significant rights
to products, technologies or markets, or explore other strategic alternatives
including a merger or sale of the company. The Company is currently a party to
certain legal proceedings. Litigation could result in substantial expense to the
Company. See "Part II -- OTHER INFORMATION -- Item 1. Legal Proceedings."
FACTORS THAT MAY AFFECT OUR RESULTS
BECAUSE SONICBLUE'S LARGEST FINANCIAL ASSET IS ITS SHARES OF UNITED
MICROELECTRONICS CORPORATION, THE VOLATILITY OF SONICBLUE COMMON STOCK AND
AVAILABLE CASH MAY BE INFLUENCED BY THE VOLATILITY OF UMC'S STOCK PRICE.
SONICBLUE'S ABILITY TO SELL ITS UMC SHARES IS SUBJECT TO LOCKUP AND PLEDGE
RESTRICTIONS.
SONICblue's largest financial asset is its UMC shares. The market price of
UMC's stock is subject to volatility due to general market conditions as well as
actual or anticipated changes in UMC's business prospects or quarterly or yearly
operating results. Because the UMC shares are SONICblue's largest asset, when
the price per share of UMC's stock increases or declines, the price of
SONICblue's common stock tends to follow changes in UMC's stock price.
Fluctuations in the price of SONICblue common stock caused by changes in UMC's
stock price may or may not reflect SONICblue's actual or anticipated business
prospects or quarterly results. Also, fluctuations in UMC's stock price may
cause fluctuations in SONICblue's stock price when there is no material news
regarding SONICblue or any change in its results.
Due to Taiwan governmental restrictions, as of September 30, 2002,
approximately 75 million of SONICblue's UMC shares are subject to lockup
restrictions, which are being released over a three-year period ending in
January 2004. SONICblue's repayment obligation on its 7 3/4% secured senior
subordinated convertible debentures due 2005 is secured by a pledge of
24,640,574 of its UMC shares. The institutional investors that purchased the
debentures also have an option to purchase these UMC shares from SONICblue. As a
result, SONICblue's ability to sell its UMC shares is limited.
SONICBLUE EXPERIENCED NET OPERATING LOSSES IN THE PAST AND MAY EXPERIENCE NET
OPERATING LOSSES AGAIN IN THE FUTURE.
SONICblue had a net loss of $72.3 million for the first nine months of 2002
and $756.2 million for the year ended December 31, 2001, the latter primarily
resulting from the recognition of a loss of $561.6 million related to the
decline in value of SONICblue's UMC shares. SONICblue had net income of $312.8
million for the year ended December 31, 2000, primarily from recognizing a gain
of $869.4 million on the UMC shares but not as a result of income from
operations. SONICblue had a net loss of $30.8 million for 1999. With the
completion of the transfer of SONICblue's graphics chips business, SONICblue's
ability to achieve operating profitability depends primarily on its success in
refocusing its business resources and in executing its business plan for its
refocused business. In addition, SONICblue must achieve positive gross margins
at a level sufficient to offset its operating expenses. SONICblue's ability to
maintain or increase positive gross margins is dependent upon SONICblue's
success in negotiating lower prices with its vendors. SONICblue experienced
negative gross margins in 2000 and in the first six months of 2001 and there can
be no assurance that it will not experience negative gross margins in the
future. SONICblue cannot assure you that it will be able to maintain the
positive gross margins it achieved in the last five quarters, nor can SONICblue
assure you that it will be able to achieve operating profitability. If SONICblue
is unable to achieve operating profitability or incurs
24
future losses and negative cash flow, its stock price would likely decline, and
additional financing and restructuring activities would be required.
SONICBLUE HAS A SIGNIFICANT LEVEL OF DEBT, WHICH MAY HARM ITS ABILITY TO
OBTAIN ADDITIONAL FINANCING OR ADVERSELY AFFECT ITS LIQUIDITY. IF THE COMPANY
IS UNABLE TO GENERATE OR OTHERWISE OBTAIN SUFFICIENT FUNDS, ITS FINANCIAL
CONDITION AND OPERATIONS MAY BE HARMED.
At September 30, 2002, SONICblue had total debt and other liabilities
outstanding of $335.5 million. The degree to which SONICblue is leveraged could
harm its ability to obtain additional financing for working capital or other
purposes and could make SONICblue more vulnerable to economic downturns and
competitive pressures. SONICblue's significant leverage could also adversely
affect its liquidity, as a substantial portion of available cash from operations
may have to be applied to meet debt service requirements. In the event of a cash
shortfall, SONICblue would likely be forced to reduce other expenditures to be
able to meet such debt service requirements. Certain events of default under the
terms of our debt could, in turn, cause defaults under our other existing and
future debt obligations.
If SONICblue is unable to raise sufficient funds for working capital needs,
it may not be able to fund product development and expansion, take advantage of
future opportunities, meet its existing debt obligations or respond to
competitive pressures or unanticipated events or needs. SONICblue may also be
required to curtail its operations significantly or to seek arrangements with
strategic partners or other parties that may require SONICblue to relinquish
significant rights to products, technologies or markets.
SONICBLUE HAS RECENTLY CHANGED THE FOCUS OF ITS BUSINESS AND MAY BE
UNSUCCESSFUL OR EXPERIENCE DIFFICULTIES IN IMPLEMENTING THIS CHANGE. IF THIS
OCCURS, SONICBLUE MAY NOT BE ABLE TO ACHIEVE OPERATING PROFITABILITY.
In January 2001, SONICblue completed the transfer of its graphics chips
business to S3 Graphics Co., Ltd., a joint venture between VIA Technologies,
Inc. and a wholly owned subsidiary of SONICblue. Concurrently, SONICblue
realigned its resources to focus on the converging Internet, digital media,
entertainment and consumer electronics markets. To that end, SONICblue completed
acquisitions of Sensory Science Corporation and ReplayTV, Inc. in 2001, both of
which are in the consumer electronics and digital media industries. SONICblue
has a limited operating history in these markets, and its shift in focus may
prove to be unsuccessful. In connection with this shift in focus, it may be
necessary to implement new business processes and internal controls. In
addition, the convergence of these industries is new and continually evolving.
SONICblue must compete with larger, more established competitors in these
markets, and SONICblue may be unable to achieve market success. SONICblue's
profitability depends on its ability to successfully implement its new business
strategy.
LABOR DISPUTES AT WEST COAST PORTS ARE ADVERSELY AFFECTING THE DISTRIBUTION
AND SALE OF SONICBLUE'S PRODUCTS, AND COULD IMPAIR ITS SALES, LIQUIDITY AND
MARGINS.
SONICblue's products are assembled overseas, shipped to the United States
and then trucked to various distributors and major retailers/mass merchants.
SONICblue has experienced delays in the delivery of its products to its
distributors and retailers as a result of a lock out of the longshoremen in
ports on the west coast of the United States and a subsequent work slow down.
The ports remain backed-up following the resumption of work. Prolonged
congestion, as well as any future lock out, strike or slow down, could further
delay or halt the delivery of SONICblue's products and materially affect
revenues. Alternate means of shipment are more costly and are difficult to
secure as many affected companies compete for available shipping channels.
Further, continuing delays or future work stoppages prior to the holiday season
could severely impact the sale of SONICblue's products and materially affect its
revenues and expenses in future quarters. In addition, SONICblue could be
subject to penalties for late shipments to retailers and may face increased
costs of freight and transportation in order to meet delivery deadlines, which
could adversely affect its liquidity and margins.
25
SONICBLUE DEVELOPS AUDIO PRODUCTS FOR A NEW MARKET, WHICH MAY NOT DEVELOP IF
CONSUMERS DO NOT ACCEPT DIGITAL AUDIO AS THEIR PREFERRED METHOD OF LISTENING
TO MUSIC. SIMILARLY, THE MARKET FOR REPLAYTV DIGITAL VIDEO RECORDERS MAY NOT
DEVELOP IF CONSUMERS DO NOT ACCEPT PERSONAL TELEVISION.
The market for digital audio products is new and evolving. SONICblue's
digital audio products play music that consumers download from the Internet or
CDs. The success of SONICblue's digital audio products depends in part on
consumers using the Internet, rather than using solely traditional sources, such
as record stores where they buy CDs or cassette tapes, as a source of music. If
consumers do not access music on the Internet, or from their CDs, and download
it for use on SONICblue's digital audio products, a market for SONICblue's
digital audio products may not develop or may be limited. ReplayTV digital video
recorders are part of a new and largely untested market for personal television.
If television viewers do not accept and demand ReplayTV products and services,
the market for ReplayTV products will be limited.
IF SONICBLUE IS UNABLE TO CONTINUE TO DEVELOP AND MARKET NEW AND ENHANCED
PRODUCTS, ITS AVERAGE SELLING PRICES AND GROSS MARGINS WILL LIKELY DECLINE.
SONICblue must continue to develop new products in order to maintain
average selling prices and gross margins. As the markets for its products
develop and competition increases, SONICblue anticipates that product life
cycles will shorten and average selling prices will decline. In particular,
average selling prices and, in some cases, gross margins, for each of its
products will decline as products mature. A decline in selling prices may cause
the net sales in a quarter to be lower than those of a preceding quarter or
corresponding quarter in a prior year, even if more units were sold during that
quarter than in the preceding or corresponding quarter of a prior year. To
minimize the effect of declining average selling prices, SONICblue must
successfully identify new product opportunities and develop and bring new
higher-end and higher-margin products to market in time to meet market demand.
The availability of new products is typically restricted in volume early in a
product's life cycle. If customers choose to wait for the new version of a
product instead of purchasing the current version, SONICblue's ability to secure
the manufacture of sufficient volumes of these new products to meet customer
demand will be limited. If this happens, SONICblue's revenues and operating
margins could be harmed.
SONICBLUE'S QUARTERLY AND ANNUAL OPERATING RESULTS ARE SUBJECT TO FLUCTUATIONS
CAUSED BY MANY FACTORS, ANY OF WHICH COULD RESULT IN SONICBLUE'S FAILURE TO
ACHIEVE ITS REVENUE OR PROFITABILITY EXPECTATIONS.
SONICblue's quarterly and annual results of operations have varied
significantly in the past and are likely to continue to vary in the future due
to a number of factors, many of which are beyond SONICblue's control. Any one or
more of the factors listed below or other factors could cause SONICblue to fail
to achieve its revenue or profitability expectations. The failure to meet market
expectations would likely cause a decline in SONICblue's stock price. These
factors include:
- SONICblue's ability to develop, introduce, produce in volume quantities
and market successfully new or enhanced products;
- SONICblue's ability to introduce and market products in accordance with
market demand and short design cycles;
- changes in the relative volume of sales of various products with
sometimes significantly different margins;
- market acceptance of and changes in demand for SONICblue's products;
- rapid changes in electronic commerce on which SONICblue or its customers
may not capitalize or which erode SONICblue's current business base;
- gains or losses of significant customers, distributors or strategic
relationships;
- unpredictable volume and timing of customer orders;
26
- the availability, pricing and timeliness of delivery of components for
SONICblue's products, including flash memory;
- substantial disruption in SONICblue's suppliers' operations, either as a
result of natural disaster, equipment failure or other cause;
- fluctuations in the availability of manufacturing capacity or
manufacturing yields and related manufacturing costs;
- the timing of new technological advances, product announcements or
introductions by SONICblue or by its competitors;
- product obsolescence and the management of product transitions and
inventory;
- production delays;
- decreases in the average selling prices of products;
- rates of product return in excess of those forecasted or expected;
- seasonal fluctuations in sales;
- general consumer electronics industry conditions, including changes in
demand and associated effects on inventory and inventory practices; and
- general economic conditions, including economic conditions in North
America, Europe and Asia in particular, that could affect the timing of
customer orders and capital spending and result in order cancellations or
rescheduling.
Some or all of these factors could adversely affect demand for SONICblue's
products and its future operating results. Most of SONICblue's operating
expenses are relatively fixed in the short-term. SONICblue may be unable to
rapidly adjust spending to compensate for any unexpected sales shortfall, which
could harm its quarterly operating results. Because the lead times of firm
orders are typically short in the consumer products industry, SONICblue does not
have the ability to predict future operating results with any certainty. Because
of the above factors, you should not rely on period-to-period comparisons of
results of operations as an indication of future performance.
GENERAL ECONOMIC CONDITIONS AND POLITICAL AND MILITARY CONDITIONS ASSOCIATED
WITH CURRENT WORLDWIDE CONFLICTS AND SIMILAR EVENTS MAY PREVENT CONSUMERS FROM
PURCHASING SONICBLUE'S PRODUCTS, WHICH WOULD HARM ITS REVENUES.
Sales of consumer electronic products have historically been dependent upon
discretionary spending by consumers, which may be adversely affected by general
economic conditions. The recent decline in consumer confidence and the
continuing slowdown in the United States economy may cause consumers to defer
decisions to purchase SONICblue's products. Some analysts have predicted a
further decline in the United States economy will result from recent volatility
in the financial markets and the threat of war with Iraq. If the economy
continues to decline as a result of recent economic, political and social
turmoil, consumers may reduce discretionary spending and may not purchase
SONICblue's products.
WE HAVE APPLIED TO TRANSFER THE LISTING OF OUR COMMON STOCK TO THE NASDAQ
SMALLCAP MARKET AND IF WE ARE UNABLE TO MAINTAIN OUR LISTING ON THE NASDAQ
SMALLCAP MARKET, THE PRICE AND LIQUIDITY OF OUR COMMON STOCK MAY DECLINE.
We did not meet the $1.00 minimum closing bid price per share requirement
for continued inclusion on the Nasdaq National Market and therefore have applied
to transfer the listing of our common stock to the Nasdaq SmallCap Market. The
transfer of our common stock to the Nasdaq SmallCap Market will likely result in
decreased liquidity of our common stock and may further decrease the price per
share of our common stock.
27
There can be no assurance that we will be able to satisfy all of the
quantitative maintenance criteria of the Nasdaq SmallCap Market including a
minimum of $2.5 million in stockholders' equity and a continued minimum bid
price of $1.00 per share. As of November 7, 2002, our stock continued to trade
at less than $1.00 per share. If we are unable to comply with the $1.00 per
share minimum bid price for at least 10 consecutive trading days before February
18, 2003, we may be delisted from the Nasdaq SmallCap Market, which might
further decrease the price per share and the liquidity of our common stock, and
make it more difficult for us to raise capital in the future.
SONICBLUE DEPENDS ON A LIMITED NUMBER OF SUPPLIERS FROM WHOM IT DOES NOT HAVE
A GUARANTEE OF ADEQUATE SUPPLIES, INCREASING THE RISK THAT A LOSS OF OR
PROBLEMS WITH A SINGLE SUPPLIER COULD RESULT IN IMPAIRED MARGINS, REDUCED
PRODUCTION VOLUMES, STRAINED CUSTOMER RELATIONS AND LOSS OF BUSINESS.
SONICblue obtains several of the components used in its products, including
flash memory for its Rio players and semiconductors, hard drives, program guide
data and set-top box compatibility information for its ReplayTV digital video
recorders and service from single or limited sources. If component manufacturers
do not allocate a sufficient supply of components to meet its needs or if
current suppliers do not provide components of adequate quality or
compatibility, SONICblue may have to obtain these components from distributors
or on the spot market at a higher cost. SONICblue rarely has guaranteed supply
arrangements with its suppliers, and suppliers may not be able to meet its
current or future component requirements. If SONICblue is forced to use
alternative suppliers of components, it may have to alter its product designs to
accommodate these components. Alteration of product designs to use alternative
components could cause significant delays and reduce production of the related
products. In addition, from time to time, SONICblue has experienced difficulty
meeting certain product shipment dates to customers for various reasons. These
reasons include component delivery delays, component shortages and component
quality deficiencies. Delays in the delivery of components, component shortages
and supplier product quality deficiencies will likely continue to occur in the
future. These delays or problems have in the past and could in the future result
in impaired margins, reduced production volumes, strained customer relations and
loss of business.
Also, in an effort to avoid actual or perceived component shortages,
SONICblue may purchase more of certain components than it may otherwise require.
Excess inventory resulting from over-purchases, obsolescence or a decline in the
market value of such inventory could result in inventory write-offs, which would
have a negative effect on SONICblue's financial results.
WE ARE DEPENDENT ON A SMALL NUMBER OF CUSTOMERS FOR A SIGNIFICANT PERCENTAGE
OF NET SALES. LOSS OF A SIGNIFICANT CUSTOMER, REDUCTION IN ORDER SIZE OR
DELAYS IN PLACING ORDERS BY A SIGNIFICANT CUSTOMER COULD HAVE A NEGATIVE
EFFECT ON OUR OPERATING RESULTS.
Our business has recently become dependent on an increasingly limited
number of customers. In the three months ended September 30, 2002, two customers
accounted for approximately 56% of our net sales, with one of these customers
accounting for 35% and the other customer accounting for 21% of our net sales
for that period. Four customers accounted for approximately 64% of our net sales
in the nine months ended September 30, 2002, with each of these customers
accounting for at least 10% of our net sales for that period.
We anticipate that we will continue to rely on a limited number of
customers for a substantial portion of our net sales in the future foreseeable.
The loss of any significant would harm our operating results. Customer purchase
deferrals, cancellations, reduced order volumes or non-renewals from any
particular customer could cause our quarterly operating results to fluctuate and
harm our business.
A REDUCTION IN THE AVAILABILITY OR EASE OF DOWNLOADING MUSIC FROM THE INTERNET
WILL HURT THE SALES OF SONICBLUE'S PRODUCTS.
SONICblue's digital audio products play music downloaded from the Internet
and CDs. Currently, a variety of litigation is pending that could decrease the
availability of downloadable music available on the Internet. The lawsuits
maintain that the swapping of music between different users free of charge is a
violation of the copyright laws in the United States. If the record companies
prevail in the litigation, and companies
28
offering these services are forced to limit the selection of music available for
download or are forced to go out of business, there would be a reduction in the
amount of music available to consumers on the Internet. For example,
Napster.com, an Internet service that allowed its users to swap songs free of
charge, was subject to an injunction that ordered it to prevent users from
trading copyrighted songs on its web site. Napster subsequently filed for
bankruptcy, and its assets are being sold. Members of the music and film
industries have filed lawsuits against other web sites that offer file transfer
services similar to those previously offered by Napster. Similarly, the
Recording Industry Association of America recently asked a federal judge to
force Verizon Communications, Inc. to identify a Verizon internet subscriber who
allegedly traded copyrighted songs. No ruling has been made in the case.
Some web sites and record companies are working to provide fee-based
downloading of copyright-protected music files. If these web sites are
unsuccessful in providing copyright-protected music files or if consumers find
the downloading too difficult or expensive, acceptance of the Internet as a
source of music would decline. In addition, the rate at which the major record
companies make their music available for digital purchases may discourage the
use of digital audio players and reduce sales of SONICblue's digital audio
products. Some record companies and Internet companies are distributing, or have
announced plans to create, CDs or digital music that cannot be copied or can
only be copied a limited number of times or only played on one machine, which
would also limit the ability of users to download music from their own CD
collections or share their music with others. New copyright protection measures,
such as these, increased fees associated with making multiple copies of music
from personal collections, or changes in copyright laws, could diminish the
ability of consumers to download music to SONICblue's digital audio products.
Reductions in the availability or ease of downloading music from the Internet,
or limitations on copying from personal CDs, could also impair the use and sale
of SONICblue's digital audio products.
SONICBLUE HISTORICALLY HAS HAD SIGNIFICANT PRODUCT CONCENTRATION AND CURRENTLY
DEPENDS ON THE HEALTH OF THE CONSUMER ELECTRONICS MARKET. THIS MEANS THAT A
DECLINE IN DEMAND FOR A SINGLE PRODUCT, OR IN THE CONSUMER ELECTRONICS MARKET
IN GENERAL, COULD SEVERELY AFFECT SONICBLUE'S OVERALL SALES AND FINANCIAL
RESULTS.
SONICblue's revenues have historically been dependent on the markets for
graphics/video chips for PCs and on its ability to compete in those markets.
With the completion of the transfer of the graphics chips assets to a joint
venture between VIA and a wholly owned subsidiary of SONICblue, SONICblue's
remaining businesses continue to have significant product concentration.
SONICblue is dependent on the markets for digital audio players, digital and
analog video products, modems, and other consumer electronics products.
SONICblue's business would be materially harmed if it were unsuccessful in
selling digital audio players, including its Rio players, its Go-Video VCRs and
DVD players or its ReplayTV digital video recorders. A decline in demand or
average selling prices for these products would have a material adverse effect
on SONICblue's sales and operating results.
SONICBLUE'S BUSINESS IS DEPENDENT ON THE INTERNET AND THE DEVELOPMENT OF THE
INTERNET INFRASTRUCTURE.
The acceptance and sale of SONICblue's products could decrease if the
infrastructure of the Internet, particularly the development of broadband
Internet access, does not continue to be developed and maintained. For example,
if consumers do not have the necessary speed and data capacity for downloading
music, rendering the Internet too slow of a method for obtaining music,
consumers may choose not to download music, which will decrease demand for
SONICblue's digital audio products. Similarly, SONICblue's ReplayTV 4000 digital
video recorders rely or will rely on high-speed access to the Internet to
provide compelling content or, to access television programming information and
send recorded programs to friends. In addition, SONICblue's success will depend
in large part on increased use of the Internet, which in turn can increase
demand for high-speed communications products and the products that benefit from
high-speed connections. SONICblue's success will also depend on businesses and
consumers using the Internet more frequently for applications that use
multimedia content and that require high bandwidth. Recent growth in Internet
use has caused frequent periods of performance degradation. Any perceived
degradation in the performance of the Internet as a whole could undermine the
benefits of SONICblue's connectivity and digital
29
media products, such as Rio digital audio players and ReplayTV products. The
performance of SONICblue's products depends on the speed and reliability of the
Internet infrastructure itself. As a result, the emergence and growth of the
market for SONICblue's products will depend on improvements being made to the
entire Internet infrastructure.
SONICBLUE MAY NOT BE ABLE TO SUCCESSFULLY MANAGE THE GROWTH AND EXPANSION OF
ITS BUSINESS.
In the past few years, particularly following its merger with Diamond in
1999, and with its acquisitions of Sensory Science and ReplayTV in 2001,
SONICblue experienced a significant expansion in the overall level of its
business and the scope and changed nature of its operations, including
manufacturing, research and development, marketing, technical support, customer
service, sales and logistics. This expansion resulted in significant challenges,
and a need for substantial investment in, infrastructure, process development
and information systems, including:
- attracting, integrating and retaining key employees;
- integration of management information, product data management, internal
control, accounting, telecommunications and networking systems;
- establishment of a significant worldwide web and e-commerce presence;
- consolidation of geographically dispersed manufacturing and distribution
facilities;
- coordination of suppliers, rationalization of distribution channels,
establishment and documentation of business processes and procedures; and
- integration of various functions and groups of employees.
SONICblue may not successfully address these challenges. SONICblue's future
operating results will depend in large measure on its ability to implement
operating, manufacturing and financial procedures and controls that not only
address the expansion of its operations but also the change in focus of its
business from graphics chips and boards to consumer electronic products, improve
communication and coordination among the different operating functions,
integrate functions such as sales, procurement and operations, strengthen
management information and telecommunications systems, and continue to hire
additional qualified personnel in key areas. SONICblue may be unable to manage
these activities and implement these additional procedures, controls and systems
successfully. Any failure to do so could cause SONICblue's short-term and
long-term operating results to suffer.
THE DEMAND FOR SONICBLUE'S PRODUCTS HAS HISTORICALLY BEEN WEAKER IN CERTAIN
QUARTERS, WHICH MAKES IT DIFFICULT TO COMPARE ITS QUARTERLY RESULTS.
Due to industry seasonality, demand for video, digital audio and other
consumer electronic products is strongest during the fourth quarter of each year
and is generally slower in the period from March through August. This
seasonality has become more pronounced and material as a greater proportion of
SONICblue's sales consist of sales into the retail/mass merchant channel, and
- SONICblue's net revenues have become increasingly based on
entertainment-related products, including products such as its Rio
digital audio players, Sensory Science dual-deck VCRs and combination
DVD/VCR units and ReplayTV digital video recorders.
In addition, SONICblue generally ships more products in the third month of
each quarter than in either of the first two months of the quarter, with levels
of shipment in the third month being higher towards the end of the month. This
pattern is likely to continue and makes future quarterly operating results less
predictable. Because the consumer products market experiences substantial
seasonal fluctuations, with more sales occurring toward the end of the year,
SONICblue's quarterly results will be difficult to compare.
30
THE MARKETS IN WHICH SONICBLUE OPERATES ARE INTENSELY AND INCREASINGLY
COMPETITIVE, AND IF IT IS UNABLE TO COMPETE SUCCESSFULLY, ITS REVENUES COULD
DECLINE.
The converging Internet, digital media, entertainment and consumer
electronics markets in which SONICblue competes are intensely competitive and
are likely to become more competitive in the future. Because of this
competition, SONICblue faces a constant and increasing risk of losing customers
to its competitors. The competitive environment also creates downward pressure
on prices and requires higher spending to address the competition, both of which
tend to keep gross margins lower. SONICblue believes that the principal
competitive factors for its products are:
- performance and quality;
- ability to conform and adapt to, or upgrade for, current and evolving
industry standards, including audio formats;
- access to customers and distribution channels;
- reputation for quality and strength of brand;
- manufacturing capabilities and cost of manufacturing;
- price;
- product support; and
- ability to bring new products to the market in a timely manner.
Many of SONICblue's current and potential competitors have substantially
greater financial, technical, manufacturing, marketing, distribution and other
resources. Some of these competitors may also have greater name recognition and
market presence, longer operating histories, greater market power and product
breadth, lower cost structures and larger customer bases. As a result, these
competitors may be able to adapt more quickly to new or emerging technologies
and changes in customer requirements. In addition, some of SONICblue's principal
competitors may have the advantage of producing their own component parts, and,
therefore, benefit from capacity, cost and technical advantages.
In some markets where SONICblue is a relatively new entrant, including
digital audio or Internet music players and digital video products, it faces
dominant competitors that include Apple (digital audio players), 3Com (modems),
Creative Technology under the name Creative Labs (modems and digital audio
players), Handspring (digital audio player add-ons to PDAs), Gateway (home
network digital audio players), HP (home digital audio players and digital audio
players), Kenwood (home digital audio players), Microsoft (digital video
recorders), Motorola (handheld consumer electronics), Panasonic (digital audio
players, digital video recorders and combination TV/DVD/VCR players), Philips
(digital audio players, home digital audio players, digital video recorders and
home theater-in-a-box solutions), Pioneer (home theater-in-a-box solutions), RCA
(digital video recorders), Samsung (digital audio players, digital audio player
mobile telephones and combination DVD/VCR players), Sony (home theater-in-a-box
solutions, consumer electronic music, digital audio players and digital video
recorders), Thompson Multimedia (digital audio players), TDK (CD MP3 players)
and TiVo (digital video recorders). Some of SONICblue's products face a variety
of competitive sources. For example, digital audio players compete against
traditional stereos and CD players. In addition, the markets in which SONICblue
competes are expected to become increasingly competitive as PC products support
increasingly more robust multimedia functions and companies that previously
supplied products providing distinct functions (for example, companies today
primarily in the sound, modem, microprocessor or motherboard markets) emerge as
competitors across broader or more integrated product categories.
SONICBLUE OPERATES IN MARKETS THAT ARE HIGHLY CYCLICAL AND VULNERABLE TO SHARP
DECLINES IN DEMAND AND AVERAGE SELLING PRICES.
SONICblue operates in the digital media and consumer electronics markets.
These markets have in the past experienced, and may in the future experience,
significant downturns. In the event of an extensive
31
downturn, SONICblue would likely experience significantly reduced demand for its
products and may be pressured to reduce average selling prices. During the
second and third quarters of 2002, SONICblue experienced price pressure in the
video product line, which resulted in lowered average selling prices in order to
retain market share. In the near term, SONICblue expects to derive most of its
revenues from the sale of digital audio products, such as Rio players, and video
products, such as Go-Video dual-deck VCRs and combination DVD/VCR units and
ReplayTV digital video recorders. Changes in demand in digital media and
consumer electronics markets could be large and sudden. Since retailers often
build inventories during periods of anticipated growth, they may be left with
excess inventories if market growth slows or if they have incorrectly forecasted
product transitions. In these cases, the retailers may abruptly stop purchasing
additional inventory from suppliers like SONICblue until the excess inventory
has been used. This suspension of purchases or any reduction in demand for
SONICblue's products would negatively impact its revenues and financial results.
SONICblue may experience substantial period-to-period fluctuations in results of
operations due to these general industry conditions.
IF SONICBLUE FAILS TO IDENTIFY NEW PRODUCT OPPORTUNITIES OR DEVELOP AND MARKET
NEW AND ENHANCED PRODUCTS, IT WILL NOT BE ABLE TO COMPETE SUCCESSFULLY.
The markets for which SONICblue's products are designed are intensely
competitive and are characterized by rapidly changing technology, evolving
industry standards and short product life cycles. For example, the life cycles
of the Rio audio players typically range from 9 to 12 months. If SONICblue fails
to introduce new products successfully within a given time frame, SONICblue
could lose revenues and market share. Further, continued failure to develop,
introduce and market competitive new products that meet customer demands on time
could also damage SONICblue's brand name, reputation and relationships with its
customers and cause longer-term harm to its financial condition. SONICblue may
not successfully enter the various product markets that it identifies. In
addition, the sale of new products may not become significant or profitable. To
succeed in this environment, SONICblue must anticipate the features and
functionality that customers will demand. SONICblue must then incorporate those
features and functionality into products that meet the design, performance,
quality and pricing requirements of the digital media and consumer electronics
markets in which it competes and the timing requirements of retail selling
seasons. SONICblue believes this will require continued significant expenditures
for research and development activities. SONICblue has in the past experienced
delays in completing the development and introduction of new products and may
experience similar delays in the future. In the past, SONICblue's business was
seriously harmed when it developed products that failed to achieve significant
market acceptance, and, therefore, was unable to compete successfully in its
markets. This type of failure could occur again in the future.
SONICBLUE MUST MANAGE PRODUCT TRANSITIONS SUCCESSFULLY IN ORDER TO REMAIN
COMPETITIVE.
The introduction of a new product or product line is a complex task,
involving significant expenditures in research and development, training,
promotion and channel development, and management of existing product
inventories to reduce the cost associated with returns and slow moving channel
inventory. As new products are introduced, SONICblue attempts to monitor closely
the inventory of products to be replaced, and to phase out their manufacture in
a controlled manner. There can be no assurance that product transitions will be
executed without harming SONICblue's operating results. Failure to develop
products with required features and performance levels or any delay in bringing
a new product to market could significantly reduce SONICblue's revenues and harm
SONICblue's competitive position.
IF SONICBLUE IS UNABLE TO PREDICT MARKET DEMAND FOR ITS INDIVIDUAL PRODUCTS,
AND FOCUS ITS INVENTORIES AND DEVELOPMENT EFFORTS TO MEET MARKET DEMAND, IT
COULD LOSE SALES OPPORTUNITIES AND EXPERIENCE DECLINES IN SALES.
SONICblue offers a variety of products within each product line or
division. In order to arrange for the manufacture of sufficient quantities of
products and avoid excess inventories, SONICblue needs to accurately predict
market demand for each product. For example, if SONICblue predicted that
consumers would purchase the Rio Volt and plans its manufacturing accordingly,
but instead consumer demand is for the Rio
32
800, SONICblue would have excess inventory of the Rio Volt and lost sales
opportunities for the Rio 800, as well as lost market share and brand
confidence. SONICblue expects that it will become even more difficult to
forecast demand as it introduces and supports multiple products and product
lines and as competition in the market for its products intensifies. Significant
unanticipated fluctuations in demand could cause problems in SONICblue's
operations. SONICblue may not be able to accurately predict market demand in
order to properly allocate its manufacturing and distribution resources among
its products. As a result, SONICblue may experience declines in its sales and
lose, or fail to gain, market share.
DEMAND FOR SONICBLUE'S DIGITAL AUDIO AND VIDEO PRODUCTS MAY DECREASE IF THE
SAME CAPABILITIES PROVIDED BY ITS PRODUCTS BECOME AVAILABLE IN OR AS ADD-ONS
TO OTHER PERSONAL ELECTRONICS PRODUCTS.
There is a trend within the personal electronics industry for functionality
from individual products to be integrated with other personal electronics
products. For example, Samsung, Fuji, Handspring and others have developed or
announced plans to develop personal electronic products, such as mobile
telephones, digital cameras or PDA plug-ins that integrate digital audio
functions; in the digital video market, Panasonic offers combination TV/DVD/VCR
players, DirectTV offers satellite receiver set-top boxes with TiVo software
installed, and Sony and Creative Labs have announced hardware and software
products that would give PCs some Digital Video Recorder functionality. These
products could significantly reduce the demand for SONICblue's products. As a
result of these trends of technology migration and product integration,
SONICblue's success largely depends on its ability to continue to develop
products that incorporate new and rapidly evolving technologies into its
products.
SONICblue must continue to expand the scope of its research and development
efforts to provide the latest in digital audio and video technology products,
which will require that it hire and retain engineers skilled in these areas and
promote additional coordination among its design and engineering groups.
Alternatively, SONICblue may find it necessary or desirable to license or
acquire technology to enable it to provide these functions. This technology may
not be available for license or purchase on terms acceptable to SONICblue, if at
all.
SONICBLUE DEPENDS ON THIRD PARTIES FOR THE MANUFACTURE OF ITS PRODUCTS.
SONICblue relies on independent subcontractors to manufacture, assemble
and/or test its products. SONICblue procures its components, assembly and test
services and assembled products through purchase orders, and it does not have
specific volume purchase agreements with each of its subcontractors. Most of its
subcontractors could cease supplying the services, products or components at any
time with limited or no penalty. SONICblue recently replaced a key
subcontractor, which resulted in significant manufacturing set-up costs and
delays in manufacture of SONICblue's products. If SONICblue replaces key
subcontractors in the future, the changes could result in further manufacturing
set-up costs and delays in manufacture of its products. Also, SONICblue may be
unable to find suitable replacement subcontractors. SONICblue's emphasis on
maintaining low internal and channel inventory levels may exacerbate the effects
of any shortage that may result from the use of sole-source subcontractors
during periods of tight supply or rapid order growth. Further, some of
SONICblue's subcontractors are located outside the United States, which may
present heightened process control, quality control, political, infrastructure,
transportation, tariff, regulatory, legal, import, export, economic or supply
chain management risks.
SONICblue faces competition for access to manufacturers and manufacturing
capacity. Many of the companies competing with SONICblue for this capacity have
longer operating histories and greater financial and market resources than
SONICblue. SONICblue may not be able to maintain access to adequate capacity of
high quality manufacturing if its subcontractors choose to offer their services
to other companies who can negotiate better terms due to their market presence,
pay higher prices, engage more manufacturing capacity or offer other incentives.
As SONICblue develops new products, it will require manufacturing capacity to
produce quantities to meet market demand. If SONICblue is unable to obtain and
maintain access to high quality manufacturing capacity for its existing and
future products, it will not be able to fill distributor or customer orders, and
its revenues will decline.
33
SONICBLUE'S PRODUCTS COULD HAVE DEFECTS OR COMPATIBILITY ISSUES, WHICH COULD
BE COSTLY TO CORRECT AND COULD RESULT IN THE REJECTION OF ITS PRODUCTS AND
DAMAGE TO ITS REPUTATION, AS WELL AS LOST REVENUES, DIVERTED DEVELOPMENT
RESOURCES AND INCREASED SERVICE COSTS AND WARRANTY CLAIMS.
SONICblue's products could have design defects that could cause them to
malfunction. Product components may contain undetected errors or "bugs" when
first supplied to SONICblue that, despite testing by SONICblue, are discovered
only after SONICblue's products have been installed and used by customers. From
time to time, SONICblue has become aware of problems with components, product
designs and other defects. Errors or defects in SONICblue's products may arise
in the future, and, if significant or perceived to be significant, could result
in rejection of SONICblue's products, product returns or recalls, damage to
SONICblue's reputation, lost revenues, diverted development resources and
increased customer service and support costs and warranty claims. Errors or
defects in SONICblue's products could also result in product liability claims.
SONICblue includes, or bundles, internally developed and third party software,
including operating systems, with its hardware products. For example, the
software included in its ReplayTV digital video recorders is responsible for the
products' user interface and directs certain product functions. Also, SONICblue
includes software with its Rio players that the purchaser may use to download
and store MP3 or WMA files on the player. The software products and SONICblue's
hardware products are complex and may contain undetected errors or failures when
first introduced or as new versions are released. SONICblue has distributed
updates to Rio players in the past when required to improve sound quality or to
correct minor audio problems and to its ReplayTV digital video recorders to
improve functionality. SONICblue generally provides warranties for its retail
products allowing the return or repair of defective products. Despite testing by
SONICblue, its suppliers or current or potential customers, errors may be found
in new products after commencement of commercial shipments. These errors could
result in loss of or delay in market acceptance or product acceptance or in
warranty returns. Losses, delays or damage to SONICblue's reputation due to
product defects would likely harm SONICblue's business, financial condition and
results of operations.
Additionally, new versions or upgrades to operating systems, independent
software vendor titles or applications may require upgrades to the personal
computer software products SONICblue bundles with its hardware products, or the
software products that purchasers of SONICblue's products may obtain from other
sources such as the Internet, to maintain compatibility with the new versions or
upgrades. The sources for the software SONICblue bundles, or the other sources
for purchasers of SONICblue's products to obtain software, may not be successful
in developing new versions, upgrades or enhancements to their software products.
If producers of software experience delays or are unable to maintain
compatibility with new audio formats, operating systems and independent software
vendor titles or applications, the demand for SONICblue's products and
SONICblue's reputation could suffer. Loss of sales and damaged reputation could
harm SONICblue's revenues and profitability.
SONICBLUE IS SUBJECT TO RISKS RELATING TO PRICE PROTECTION AND PRODUCT
RETURNS, WHICH COULD REDUCE SONICBLUE'S REVENUES.
SONICblue often grants price protection on unsold inventory, which allows
customers to receive a price adjustment on existing inventory when its published
price is reduced. In an environment of slower demand and abundant supply of
products, price declines and channel promotional expenses are more likely to
occur and, should they occur, are more likely to have a significant impact on
SONICblue's operating results. Further, in this environment, high channel
inventory levels may result in substantial price protection charges. These price
protection charges have the effect of reducing gross sales and gross margin.
Consequently, in taking steps to bring its channel inventory levels down to a
more desirable level, SONICblue may cause a shortfall in net sales during one or
more accounting periods. These efforts to reduce channel inventory might also
result in price protection charges if prices are decreased to move product out
to final consumers, having a further adverse impact on operating results.
SONICblue also often grants limited rights to customers and distributors to
return unsold inventories of its products in exchange for new products, also
known as "stock rotation." Also, some of SONICblue's retail customers may accept
returned products from their own retail customers. These products are then
returned to SONICblue for credit. SONICblue has in the past experienced a
significant percentage of returns of its Rio players. SONICblue estimates stock
rotation, warranty and other returns and
34
accrues reserves for such costs at the time of sale. Any estimates, reserves or
accruals may be insufficient and any future price reductions or product returns
may seriously harm SONICblue's operating results.
SONICBLUE DEPENDS ON SALES THROUGH DISTRIBUTORS AND RETAILERS. IF
RELATIONSHIPS WITH OR SALES THROUGH DISTRIBUTORS OR RETAILERS DECLINE, ITS
OPERATING RESULTS WILL BE HARMED.
SONICblue sells its products through a network of domestic and
international distributors, and directly to major retailers/mass merchants.
SONICblue's future success is dependent on the continued viability and financial
stability of its customer base. Retail channels historically have been
characterized by rapid change, including periods of widespread financial
difficulties and consolidation and the emergence of alternative sales channels,
such as direct mail order, telephone sales and electronic commerce on the
worldwide web. SONICblue may be unable to retain its retailers or distributors.
In addition, sales to any particular retailer or distributor may fluctuate
significantly from quarter to quarter. The loss of, or a reduction in, sales to
any of SONICblue's key retail or distribution customers as a result of changing
market conditions, competition or customer credit problems could materially and
adversely affect its operating results. Likewise, changes in distribution
channel patterns, such as increased electronic commerce via the Internet and
increased use of mail-order catalogues, could affect SONICblue in ways not yet
known.
SONICBLUE'S ABILITY TO MARKET AND DISTRIBUTE ITS PRODUCTS DEPENDS IN PART UPON
ITS CURRENT AND FUTURE RELATIONSHIPS WITH ORIGINAL EQUIPMENT MANUFACTURERS, OR
OEMS, AND OTHER STRATEGIC PARTNERS TO MARKET AND DISTRIBUTE SONICBLUE'S
PRODUCTS UNDER THEIR OWN BRAND NAMES.
In addition to direct distributors of SONICblue's products, SONICblue also
depends upon OEMs and other strategic partners to market and distribute its
products. For example, SONICblue has licensed the ReplayTV technology to
Panasonic, which has incorporated the technology into its ShowStopper DVRs. If
SONICblue is unable to obtain and maintain relationships with OEMs and strategic
partners, it may not be able to increase sales of its products and achieve
market acceptance, and its revenues may decline.
SONICBLUE RELIES ON INTELLECTUAL PROPERTY AND OTHER PROPRIETARY INFORMATION
THAT MAY NOT BE ADEQUATELY PROTECTED AND THAT MAY BE EXPENSIVE TO PROTECT.
The markets in which SONICblue competes are characterized by vigorous
protection and pursuit of intellectual property rights. SONICblue relies on a
combination of patent, trademark, copyright, and trade secret laws, employee and
third-party nondisclosure agreements and licensing arrangements to protect its
intellectual property. If SONICblue is unable to adequately protect its
intellectual property, its business may suffer from the piracy of its technology
and the associated loss of sales. Also, the protection provided to SONICblue's
proprietary technology by the laws of foreign jurisdictions, many of which offer
less protection than the United States, may not be sufficient to protect its
technology. It is common in the personal electronics and Internet device
industries for companies to assert intellectual property infringement claims
against other companies. Therefore, SONICblue's products may also become the
target of infringement claims. These infringement claims or any future claims
could cause SONICblue to spend significant time and money to defend its
products, redesign its products or develop or license a substitute technology.
SONICblue may be unsuccessful in acquiring or developing substitute technology
and any required license may be unavailable on commercially reasonable terms, if
at all. In addition, an adverse result in litigation could require SONICblue to
pay substantial damages, cease the manufacture, use, sale, offer for sale and
importation of infringing products, or discontinue the use of certain processes.
Any of these events could materially harm SONICblue's business.
Litigation by or against SONICblue could result in significant expense and
could divert the efforts of its technical and management personnel, regardless
of the outcome of such litigation. However, even if claims do not have merit,
SONICblue may be required to dedicate significant management time and expense to
defending itself if it is directly sued, or assisting its customers in their
defense of these or other infringement claims pursuant to indemnity agreements.
This could have a negative effect on SONICblue's financial results.
35
THE JOINT VENTURE WITH VIA WILL REQUIRE SONICBLUE TO PAY SPECIFIED LIQUIDATED
DAMAGES IF CERTAIN EVENTS OCCUR.
The investment agreement between SONICblue, VIA and S3 Graphics provides
that under certain circumstances, SONICblue may be required to pay VIA
significant liquidated damages if, unless as a result of certain acts or
omissions on the part of either VIA or S3 Graphics, S3 Graphics is prevented by
court order from utilizing SONICblue's patent cross-license with Intel
Corporation or if SONICblue enters into a settlement agreement with Intel such
that S3 Graphics can no longer operate under the patent cross-license. In
September 2001, Intel filed a patent infringement lawsuit against S3 Graphics
and VIA. SONICblue is not a party to the lawsuit. The lawsuit is in early
stages. Any liquidated damages that SONICblue might be required to pay to VIA
under the investment agreement may under certain circumstances be reduced by
amounts paid by SONICblue to Intel in connection with any lawsuit and amounts
owed to SONICblue by either VIA or S3 Graphics. An adverse result or settlement
with regard to these proceedings could have a material adverse effect on
SONICblue's financial condition or results of operations.
SONICBLUE HAS RECENTLY MADE CHANGES TO ITS MANAGEMENT AND MAY BE UNSUCCESSFUL
OR EXPERIENCE DIFFICULTIES IN INTEGRATING THE NEW MANAGEMENT.
SONICblue has recently undergone changes in several management positions,
most recently appointing L. Gregory Ballard as its Chief Executive Officer and
Marcus Smith as its Chief Financial Officer. Prior to his appointment, Mr.
Ballard served as SONICblue's Interim Chief Executive Officer since August 2002
and Vice President for Marketing and Product Management from April 2002 to
August 2002. Prior to serving as Chief Financial Officer, Mr. Smith served as
Interim Chief Financial Officer from April 2002 to October 2002 and as
SONICblue's Vice President of Finance from August 2001 to April 2002. Other
members of SONICblue's management team are relatively new to SONICblue, and
there can be no assurance that Messrs. Ballard and Smith, and the other
executive officers of SONICblue, will be able to collaborate successfully. If
the executive officers are unable to collaborate successfully, SONICblue's
business, financial condition and results of operations could suffer.
SONICBLUE MAY NOT BE ABLE TO ATTRACT, RETAIN OR INTEGRATE KEY PERSONNEL, WHICH
MAY PREVENT IT FROM SUCCEEDING.
SONICblue may not be able to retain its key personnel or attract other
qualified personnel in the future. SONICblue's success will depend upon the
continued service of key management personnel. The loss of services of any of
the key members of SONICblue's management team or its failure to attract and
retain other key personnel could disrupt operations and have a negative effect
on employee productivity and morale, decreasing production and harming its
financial results. In addition, the competition to attract, retain and motivate
qualified technical personnel, such as engineers, as well as qualified sales and
operations personnel is intense. SONICblue has at times experienced difficulty
recruiting qualified software and hardware development engineers.
SONICBLUE HAS EXPOSURE TO INTERNATIONAL MARKETS.
International sales accounted for 4% and 50% of SONICblue's net sales for
the nine months ended September 30, 2002, and 2001, respectively. In addition, a
substantial proportion of SONICblue's products are manufactured, assembled and
tested by independent third parties in Asia. As a result, SONICblue is subject
to the risks of conducting business internationally, including:
- unexpected changes in, or impositions of, legislative or regulatory
requirements;
- fluctuations in the U.S. dollar, which could increase the price in local
currencies of SONICblue's products in foreign markets or increase the
cost of components purchased by SONICblue;
- delays resulting from difficulty in obtaining export licenses for certain
technology;
- tariffs and other trade barriers and restrictions;
36
- potentially longer payment cycles;
- greater difficulty in accounts receivable collection;
- potentially adverse tax treatment; and
- the burdens of complying with a variety of foreign laws.
In the past, SONICblue has experienced an adverse impact associated with
the economic downturn in Asia that contributed to decreases in net sales. In
addition, SONICblue's international operations are subject to general
geopolitical risks, such as political and economic instability and changes in
diplomatic and trade relationships. The People's Republic of China and Taiwan
have in the past experienced and are currently experiencing strained relations,
and a worsening of relations or the development of hostilities between them
could disrupt operations at the manufacturing facilities of SONICblue's
subcontractors and affect its Asian customers.
SONICBLUE MAY PURSUE STRATEGIC ACQUISITIONS AND COULD FAIL TO SUCCESSFULLY
INTEGRATE ACQUIRED BUSINESSES.
SONICblue has engaged in acquisitions in the past, including its
acquisitions of Sensory Science and ReplayTV in 2001, and expects to evaluate
acquisition opportunities in the future that could provide additional product or
services offerings, technologies or additional industry expertise. Any proposed
or future acquisition could result in difficulties assimilating acquired
operations and products, diversion of capital and management's attention away
from other business issues and opportunities and amortization of acquired
intangible assets. Integration of acquired companies may result in problems
related to integration of technology and management teams. SONICblue could fail
to integrate the operations, personnel or products that it may acquire in the
future. If SONICblue fails to successfully integrate acquisitions or achieve any
anticipated benefits of an acquisition, its operations and business could be
harmed.
SYSTEM FAILURES, INTERRUPTIONS TO THE REPLAYTV SERVICE OR PRODUCT DEFECTS MAY
HAVE A NEGATIVE IMPACT ON SONICBLUE'S REVENUES, DAMAGE ITS REPUTATION AND
DECREASE ITS ABILITY TO ATTRACT NEW VIEWERS.
SONICblue's ability to provide high quality products, service and customer
support is critical to its success because consumers of television-related
products are not accustomed to, and may not accept, interruptions in their
television service. SONICblue's network, communications hardware and other
operating systems for the ReplayTV service are vulnerable to damage or
interruption from earthquakes, floods, fires, power loss, telecommunication
failures and similar events. They are also subject to break-ins, sabotage,
intentional acts of vandalism and similar misconduct. These types of
interruptions in the ReplayTV service may reduce SONICblue's sales. In addition
to placing increased burdens on SONICblue's engineering staff, service outages
will create numerous customer questions and complaints that must be responded to
by SONICblue's or its partners' customer support personnel. Any frequent or
persistent system failures could irreparably damage SONICblue's reputation and
brand.
In addition, any delivery by SONICblue of products or upgrades with
undetected material product defects or software errors could harm SONICblue's
credibility. For example, the hard disk used in the ReplayTV-enabled digital
video recorder was originally designed for use in personal computers, and as a
result exhibits behaviors that are viewed as typical and minimally disruptive
when using a personal computer, but may result in the viewer momentarily facing
a black television screen when using the ReplayTV service. Any errors and
product defects can result in delays in releasing new versions of ReplayTV
digital video recorders, affect system uptime, result in returns and significant
warranty and repair costs and cause customer relations problems. Correcting
errors in software and hardware design requires significant time and resources,
which could delay future product releases and affect market acceptance of
ReplayTV digital video recorders.
37
SONICBLUE NEEDS TO SAFEGUARD THE SECURITY AND PRIVACY OF REPLAYTV VIEWERS'
CONFIDENTIAL DATA, AND ITS INABILITY TO DO SO MAY HARM SONICBLUE'S REPUTATION
AND BRAND AND COULD RESULT IN LAWSUITS.
The ReplayTV digital video recorder collects and stores viewer preferences
and other data that viewers may consider confidential. Any compromise or breach
of the encryption and other security measures that SONICblue uses to protect
this data could harm SONICblue's reputation and expose it to potential
liability. Advances in computer capabilities, new discoveries in the field of
cryptography or other events or developments could compromise or breach the
systems SONICblue uses to protect its viewers' confidential information.
SONICblue may be required to make significant expenditures to protect against
security breaches or to remedy problems caused by any breaches.
Viewers may be concerned about the use of personal information gathered by
the ReplayTV digital video recorder. SONICblue does not currently archive this
data or release it to third parties, and SONICblue is committed to complying
with all privacy laws and to protecting the confidentiality of its viewers. The
motion picture studios and television networks seek anonymous user data but
privacy concerns could create uncertainty in the marketplace for personal
television and ReplayTV products. In addition, privacy concerns or breaches, or
consumers' dissatisfaction with any privacy policy SONICblue may adopt, could
reduce demand for ReplayTV products, increase the cost of doing business as a
result of litigation costs or increased service delivery costs, or otherwise
harm SONICblue's reputation and business.
ONE OF SONICBLUE'S PRODUCTS IS THE SUBJECT OF A COPYRIGHT INFRINGEMENT CLAIM.
IF THIS OR FUTURE CLAIMS AGAINST SONICBLUE'S PRODUCTS ARE DECIDED AGAINST
SONICBLUE, SALES OF SONICBLUE'S PRODUCTS AND ITS REVENUES COULD DECREASE.
In October and November, 2001, a group of 28 entertainment companies
including, among others, Paramount Pictures Corporation, Disney Enterprises,
Inc. and the three major television networks filed four lawsuits against
SONICblue and its ReplayTV, Inc. subsidiary in the U.S. District Court in Los
Angeles, California. The lawsuits allege that the Company's manufacture and sale
of the ReplayTV 4000 and subsequent iterations of digital recorders, which allow
users to skip commercials, delete recordings only when instructed to by users,
and enable use of the Internet to send recorded material to other ReplayTV
users, constitutes copyright infringement, among other claims. The plaintiffs in
the lawsuits are seeking an injunction prohibiting the Company from including
these features in its video products. The parties have commenced discovery. The
District Court has scheduled a trial for October 2003. SONICblue disputes the
plaintiffs' claims and intends to defend this action vigorously.
In June, 2002, a group of five individual ReplayTV 4000 owners filed a
lawsuit in the United States District Court in Los Angeles against the 28
entertainment companies described above, seeking a declaration that their use of
the ReplayTV 4000 device is fair use and does not infringe copyrights. Those
individuals named SONICblue and its ReplayTV, Inc. subsidiary as nominal
defendants, although those individuals' interests are substantially aligned with
the Company's position. This complaint does not demand any affirmative relief
against the Company, but purports to reserve the right to amend to seek an
injunction to prohibit the Company from discontinuing support for features that
were advertised or served as inducements for consumers' purchases, absent
restitution to such consumers. This lawsuit has been consolidated for discovery
with the Paramount Pictures and related lawsuits.
This litigation has been costly and can divert the efforts of management.
Furthermore, SONICblue may be forced to delay the release, or eliminate certain
features of, its digital video recorders, which could result in decreased sales
of the product and a negative impact on SONICblue's revenues.
Sensory Science, acquired by SONICblue in June 2001, has designed and
markets its dual-deck VCRs and combination DVD/VCRs for use as full-featured
videocassette recorders. The marketing literature and owner manuals caution
consumers that the dual-deck VCR should not be used in a manner that infringes
on the rights of owners of copyrighted material. However, SONICblue cannot
predict the likelihood that distribution of current or future dual-deck VCRs or
DVD/VCR models will be challenged. Federal legislation affecting all VCRs was
passed in October 1998, commonly referred to as The Digital Millennium Copyright
Act. As a result, Sensory Science modified the operations of its dual-deck VCRs
sold after April 2000, so that
38
the VCRs would recognize a type of anticopying signal to prevent consumers from
making a usable copy of videotapes with that type of signal. However, models
purchased prior to April 2000 continued to operate as originally designed for
the lifetime of the VCR. SONICblue is unable to determine what the effect of
this or future required modifications may be on future sales of dual-deck VCRs
or combination DVD/VCRs.
SONICBLUE IS A PARTY TO LEGAL PROCEEDINGS THAT COULD HAVE A NEGATIVE FINANCIAL
IMPACT ON SONICBLUE.
SONICblue has also been defending several putative class action lawsuits
naming Diamond, which were filed in June and July 1996 and June 1997 in the
California Superior Court for Santa Clara County and the U.S. District Court for
the Northern District of California. The plaintiffs alleged that Diamond and the
other defendants made various material misrepresentations and omissions during
the class period. The parties have agreed to settle this matter for a payment of
$15.0 million, and final court approval of that settlement was obtained, and the
cases dismissed, in April 2002. SONICblue funded $4.5 million of the settlement
in November 2000. SONICblue previously accrued this amount in connection with
the merger with Diamond. SONICblue believes that Diamond's insurance covers the
remaining $10.5 million of the settlement; Diamond's insurers have funded that
amount into the settlement, although one of these insurers has commenced
arbitration disputing its obligation to pay $3.0 million of the $10.5 million.
The contesting insurer maintains that indemnification of its share of the
settlement is barred by virtue of a recent California appellate decision. The
arbitration tribunal issued an order in April 2002, stating that the California
state law claim in the class action was uninsurable, but that factual questions
were presented as to the allocation of the settlement amount as between the
state law claim and other claims included in the settlement documents. Further
briefs have been submitted on the allocation issue and, on November 13, 2002,
the arbitration tribunal issued its order awarding the insurer $1,914,250 plus
interest from November 1, 2000.
In November 2001, four former holders of ReplayTV preferred shares filed a
petition for appraisal in the Chancery Court in the State of Delaware asserting
their dissenters rights of appraisal and seeking the fair value of their
ReplayTV shares in cash in lieu of the SONICblue shares to be issued to them as
provided in SONICblue's merger agreement with ReplayTV. In December 2001,
ReplayTV filed its response to plaintiffs' petition. In addition, in December
2001, the same four former holders of ReplayTV preferred shares filed a
complaint in the Chancery Court in the State of Delaware asserting that ReplayTV
and its former directors breached their fiduciary duties in connection with
Replay TV's merger by engaging in self-dealing, failing to make appropriate
disclosures to shareholders and failing to maximize the value for them in the
merger, resulting in an allocation of an insufficient amount of the merger
consideration to the ReplayTV preferred stockholders. The complaint seeks "at
least $7,249,990.50" in damages. In its merger agreement with ReplayTV,
SONICblue agreed to indemnify ReplayTV's former directors against this type of
lawsuit, among other things. In February 2002, ReplayTV and the former ReplayTV
directors filed their answer. SONICblue and ReplayTV intend to dispute the
plaintiffs' claims and vigorously defend these actions. The cases are currently
in the pretrial discovery stage.
On December 12, 2001, SONICblue filed a complaint for patent infringement
against TiVo Inc. in the United States District Court for the Northern District
of California. SONICblue's complaint generally alleges that TiVo is infringing
one of its patents by licensing and offering to license its DVR technology and
offering its program guide service. In response, TiVo filed an answer and
counterclaim against SONICblue that denies infringement of SONICblue's patent
and that alleges that the patent is invalid. On January 23, 2002, TiVo filed a
separate action in the same court, but assigned to a different judge, that
generally alleges that SONICblue is infringing one of TiVo's patents by making,
selling, offering to sell its ReplayTV DVRs. In response to TiVo's complaint,
SONICblue filed an answer and counterclaim denying infringement and alleging
that TiVo's patent is invalid. The parties have settled the cases, and each has
lodged stipulations for dismissal with the Court.
On November 28, 2001, TechSearch, LLC filed a complaint for patent
infringement against a number of consumer electronics companies, including
SONICblue, in the United States District Court for the Northern District of
Illinois. TechSearch's complaint generally alleges that SONICblue is infringing
one of its patents by making, selling, and offering to sell its Rio Volt CD
players that are capable of playing CDs encoded with audio tracks in the MP3
format. SONICblue intends to dispute the plaintiff's claims and vigorously
defend
39
itself against the allegations made in TechSearch's complaint. This action was
stayed by order of the Court on or about May 1, 2002, pending a reexamination of
the patent asserted by TechSearch by the U.S. Patent and Trademark Office. The
stay was extended by court order on or about September 10, 2002.
On February 14, 2000, Robert C. Price filed a purported class action
lawsuit in the Circuit Court of Monroe County, State of Indiana against the
Company and Diamond alleging violations of the California Business and
Professions Code section 17200 and the California Song-Beverly Act, which covers
consumer warranties. The lawsuit alleges that certain of the Company's Rio 300
MP3 player retail boxes, which were discontinued in approximately 1999, are
misleading because the boxes indicate that computer software included in the
package allows the purchaser to convert audio tracks on CDs to the MP3 audio
format, but the software included with the product permitted only 50
conversions. The Company answered the complaint on April 27, 2000, denying
plaintiff's allegations. Status conferences were conducted on July 26, 2000,
January 10, 2001, and April 17, 2002. Discovery has commenced. No class has been
certified, but the briefing on the plaintiff's motion for class certification is
expected to be completed by Winter 2002/03, with a hearing on class
certification issues to be scheduled thereafter. SONICblue intends to contest
the certification of the purported class, dispute the lawsuit's allegations and
defend this action vigorously.
In November 2001, Pac Tec, a division of La France Corporation, filed a
civil action against the Company and one of its suppliers, Manufacturers'
Services Limited, in the United States District Court for the Eastern District
of Pennsylvania, alleging claims against both defendants jointly for breach of
contract and promissory estoppel. The plaintiff seeks damages in excess of $2.5
million, plus prejudgment interest and costs of suit. In August 2002, the Court
granted the Company's motion to dismiss the plaintiff's claims for recovery of
consequential damages. The parties have propounded written discovery, and the
Court has set a tentative trial date in the case of March 10, 2003. SONICblue
intends to dispute the plaintiff's claims and vigorously defend itself against
this action.
On October 17, 2001, Skyline Capital Associates, LLC filed a lawsuit in the
San Mateo County Superior Court alleging that SONICblue breached an agreement
for tax consulting services and seeking payment of $3.2 million for consulting
fees and interest. In November 2001, SONICblue filed a counter claim against
Skyline for $750,000. In March 2002, SONICblue, Skyline and Skyline's principal
entered into a settlement agreement pursuant to which the parties would resolve
their dispute for $2.4 million. In June 2002, after SONICblue had paid
approximately $2.3 million under the settlement agreement, a dispute over the
settlement arose. SONICblue intends to dispute the plaintiff's claims and defend
this action vigorously.
By letter of counsel dated September 18, 2002, Kenneth Potashner initiated
proceedings under an employment agreement dated June 21, 2001, claiming that he
was terminated as chief executive officer without cause and in violation of
public policy. Mr. Potashner demanded payment of $1,984,000, plus the reasonable
value of benefits, and confirmation that his stock options will continue to vest
under the employment agreement. By letter dated September 30, 2002, the Company
denied that Mr. Potashner was terminated without cause, denied that his
termination violated public policy, and declined to furnish the relief
requested, but agreed to submit the dispute to private resolution procedures, in
accordance with the terms of the employment agreement. These proceedings are
expected to take place later this year.
On or about August 21, 2001, VIA Technologies, Inc. commenced an
arbitration proceeding against the Company that is currently pending before the
International Centre for Dispute Resolution (the international division of the
American Arbitration Association). In November 2001, the Company responded to
the demand for arbitration, denying liability and asserting various other
defenses. An arbitrator was appointed on July 24, 2002, and on or about
September 20, 2002, VIA, joined by S3 Graphics Co., Ltd. as a co-claimant, filed
a First Amended Demand for Arbitration, seeking, among other things, damages of
approximately $8.0 million and an order of specific performance to correct
alleged errors in the Closing Balance Sheet for the transactions contemplated by
the investment agreement between the parties in the amount of approximately $4.1
million as well as recovery of costs and attorneys' fees. The Company filed a
Statement of Defense to the First Amended Demand for Arbitration and
Counterclaim in which it, among other things, denied liability, alleged that the
tribunal lacked jurisdiction over certain of the claims included in the First
Amended Demand for Arbitration and conditionally asserted counterclaims for
breach of the investment agreement. The parties
40
are presently briefing the jurisdictional issues. There has been no discovery in
the proceeding, and a hearing date has not yet been set. SONICblue intends to
defend this action vigorously.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
INTEREST RATE RISK
The Company's exposure to market risk for changes in interest rates relates
primarily to its investment portfolio, its convertible subordinated notes and
its senior subordinated convertible debentures. The Company's investment
portfolio principally consists of short-term fixed income securities. The
primary objective of the Company's investment activities is to maintain the
safety of principal and preserve liquidity while maximizing yields without
significantly increasing risk. This is accomplished by investing in marketable
investment grade securities, and by limiting exposure to any one issue or
issuer. The Company does not use derivative financial instruments in its
investment portfolio and due to the nature of its investments, does not expect
its operating results or cash flows to be significantly affected by potential
changes in interest rates. At September 30, 2002, the market value of these
investments, which were classified as cash equivalents, approximated cost.
In September 1996, the Company completed a private placement of $103.5
million aggregate principal amount of convertible subordinated notes. The notes
mature in 2003. Interest is payable semi-annually at 5 3/4% per annum. The notes
are convertible at the option of the note holders into the Company's common
stock at an initial conversion price of $19.22 per share, subject to adjustment.
During 2000, $0.2 million in notes were converted into common stock. Beginning
in October 1999, the notes became redeemable at the option of the Company at an
initial redemption price of 102% of the principal amount. The market value of
the convertible subordinated notes at September 30, 2002 and 2001 was
approximately $14.5 million and $62.9 million, respectively.
In April 2002, the Company completed a private placement of $75.0 million
in aggregate principal amount of its 7 3/4% secured senior subordinated
convertible debentures due 2005 to three institutional investors. The debentures
are convertible into SONICblue common stock at a conversion price of $19.22 per
share subject to standard anti-dilution adjustments. Under the terms of the
debentures the Company may pay up to 50% of the interest payments on the
debentures in shares of SONICblue common stock.
EQUITY PRICE RISK
The Company's largest financial asset is its UMC shares, which are traded
on the Taiwan Stock Exchange. The market price of UMC's stock is subject to
volatility due to general market conditions, including changes in the
semiconductor industry and the Taiwanese market, as well as actual or
anticipated changes in UMC's business prospects or quarterly or yearly operating
results. Because the UMC shares are SONICblue's largest asset, when the price
per share of UMC's stock increases or declines, the price of SONICblue's common
stock tends to follow changes in UMC's stock price. Fluctuations in the price of
SONICblue common stock caused by changes in UMC's stock price may or may not
reflect SONICblue's actual or anticipated business prospects or quarterly
results. Also, fluctuations in UMC's stock price may cause fluctuations in
SONICblue's stock price when there is no material news regarding SONICblue or
any change in its results. Future fluctuations in the value of SONICblue's UMC
shares could negatively impact SONICblue's financial condition.
FOREIGN CURRENCY EXCHANGE RATE RISK
The Company invoices its customers in U.S. dollars for all products. The
Company is exposed to foreign exchange rate fluctuations as the financial
results of its foreign subsidiaries are translated into U.S. dollars in
consolidation. The foreign subsidiaries maintain their accounts in the local
currency of the foreign location in order to centralize the foreign exchange
risk with the parent company. To date this risk has not been material.
41
ITEM 4. CONTROLS AND PROCEDURES
(a) Evaluation of disclosure controls and procedures. Our Chief Executive
Officer and our Chief Financial Officer have concluded, based on their
evaluation as of a date within 90 days prior to the filing date of this
quarterly report, that SONICblue's disclosure controls and procedures (as
defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of
1934 (the "Exchange Act")) were effective.
(b) Changes in internal controls. There have not been any significant
changes in SONICblue's internal controls or in other factors that could
significantly affect these controls subsequent to the date of their evaluation.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Internet, digital media, entertainment and consumer electronics
industries are characterized by frequent litigation, including litigation
regarding patent and other intellectual property rights. SONICblue is party to
various legal proceedings that arise in the ordinary course of business. While
we currently believe that the ultimate outcome of these proceedings,
individually and in the aggregate, will not have a material adverse effect on
the Company's financial position or overall trends in results of operations,
litigation is subject to inherent uncertainties. There can be no assurance that
an adverse result or settlement with regard to these lawsuits would not have a
material adverse effect on SONICblue's financial condition or results of
operations.
SONICblue has been defending several putative class action lawsuits naming
Diamond, which were filed in June and July 1996 and June 1997 in the California
Superior Court for Santa Clara County and the U.S. District Court for the
Northern District of California. The plaintiffs alleged that Diamond and the
other defendants made various material misrepresentations and omissions during
the class period. The parties have agreed to settle this matter for a payment of
$15.0 million, and final court approval of that settlement was obtained, and the
cases dismissed, in April 2002. SONICblue funded $4.5 million of the settlement
in November 2000. SONICblue previously accrued this amount in connection with
the merger with Diamond. SONICblue believes that Diamond's insurance covers the
remaining $10.5 million of the settlement; Diamond's insurers have funded that
amount into the settlement, although one of these insurers has commenced
arbitration disputing its obligation to pay $3.0 million of the $10.5 million.
The contesting insurer maintains that indemnification of its share of the
settlement is barred by virtue of a recent California appellate decision. The
arbitration tribunal issued an order in April 2002, stating that the California
state law claim in the class action was uninsurable, but that factual questions
were presented as to the allocation of the settlement amount as between the
state law claim and other claims included in the settlement documents. Further
briefs have been submitted on the allocation issue and, on November 13, 2002,
the arbitration tribunal issued its order awarding the insurer $1,914,250 plus
interest from November 1, 2000.
In November 2001, four former holders of ReplayTV preferred shares filed a
petition for appraisal in the Chancery Court in the State of Delaware asserting
their dissenters rights of appraisal and seeking the fair value of their
ReplayTV shares in cash in lieu of the SONICblue shares to be issued to them as
provided in SONICblue's merger agreement with ReplayTV. In December 2001,
ReplayTV filed its response to plaintiffs' petition. In addition, in December
2001, the same four former holders of ReplayTV preferred shares filed a
complaint in the Chancery Court in the State of Delaware asserting that ReplayTV
and its former directors breached their fiduciary duties in connection with
Replay's merger by engaging in self-dealing, failing to make appropriate
disclosures to shareholders and failing to maximize the value for them in the
merger, resulting in an allocation of an insufficient amount of the merger
consideration to the ReplayTV preferred stockholders. The complaint seeks "at
least $7,249,990.50" in damages. In its merger agreement with ReplayTV,
SONICblue agreed to indemnify ReplayTV's former directors against this type of
lawsuit, among other things. In February 2002, ReplayTV and the former ReplayTV
directors filed their answer. SONICblue and ReplayTV intend to dispute the
plaintiffs' claims and vigorously defend these actions. The cases are currently
in the pretrial discovery stage.
42
In October and November, 2001, a group of 28 entertainment companies
including, among others, Paramount Pictures Corporation, Disney Enterprises,
Inc. and the three major television networks filed four lawsuits against
SONICblue and its ReplayTV, Inc. subsidiary in the U.S. District Court in Los
Angeles, California. The lawsuits allege that the Company's manufacture and sale
of the ReplayTV 4000 and subsequent iterations of digital recorders, which allow
users to skip commercials, delete recordings only when instructed to by users,
and enable use of the Internet to send recorded material to other ReplayTV
users, constitutes copyright infringement, among other claims. The plaintiffs in
the lawsuits are seeking an injunction prohibiting the Company from including
these features in its video products. The parties have commenced discovery. The
District Court has scheduled a trial for October 2003. SONICblue disputes the
plaintiffs' claims and intends to defend this action vigorously.
In June, 2002, a group of five individual ReplayTV 4000 owners filed a
lawsuit in the United States District Court in Los Angeles against the 28
entertainment companies described above, seeking a declaration that their use of
the ReplayTV 4000 device is fair use and does not infringe copyrights. Those
individuals named SONICblue and its ReplayTV, Inc. subsidiary as nominal
defendants, although those individuals' interests are substantially aligned with
the Company's position. This complaint does not demand any affirmative relief
against the Company, but purports to reserve the right to amend to seek an
injunction to prohibit the Company from discontinuing support for features that
were advertised or served as inducements for consumers' purchases, absent
restitution to such consumers. This lawsuit has been consolidated for discovery
with the Paramount Pictures and related lawsuits.
On December 12, 2001, SONICblue filed a complaint for patent infringement
against TiVo Inc. in the United States District Court for the Northern District
of California. SONICblue's complaint generally alleges that TiVo is infringing
one of its patents by licensing and offering to license its DVR technology and
offering its program guide service. In response, TiVo filed an answer and
counterclaim against SONICblue that denies infringement of SONICblue's patent
and that alleges that the patent is invalid. On January 23, 2002, TiVo filed a
separate action in the same court, but assigned to a different judge, that
generally alleges that SONICblue is infringing one of TiVo's patents by making,
selling, offering to sell its ReplayTV DVRs. In response to TiVo's complaint,
SONICblue filed an answer and counterclaim denying infringement and alleging
that TiVo's patent is invalid. The parties have settled the cases, and each has
lodged stipulations for dismissal with the Court.
On November 28, 2001, TechSearch, LLC filed a complaint for patent
infringement against a number of consumer electronics companies, including
SONICblue, in the United States District Court for the Northern District of
Illinois. TechSearch's complaint generally alleges that SONICblue is infringing
one of its patents by making, selling, and offering to sell its Rio Volt CD
players that are capable of playing CDs encoded with audio tracks in the MP3
format. SONICblue intends to dispute the plaintiff's claims and vigorously
defend itself against the allegations made in TechSearch's complaint. This
action was stayed by order of the Court on or about May 1, 2002, pending a
reexamination of the patent asserted by TechSearch by the U.S. Patent and
Trademark Office. The stay was extended by court order on or about September 10,
2002.
On February 14, 2000, Robert C. Price filed a purported class action
lawsuit in the Circuit Court of Monroe County, State of Indiana against the
Company and Diamond alleging violations of the California Business and
Professions Code section 17200 and the California Song-Beverly Act, which covers
consumer warranties. The lawsuit alleges that certain of the Company's Rio 300
MP3 player retail boxes, which were discontinued in approximately 1999, are
misleading because the boxes indicate that computer software included in the
package allows the purchaser to convert audio tracks on CDs to the MP3 audio
format, but the software included with the product permitted only 50
conversions. The Company answered the complaint on April 27, 2000, denying
plaintiff's allegations. Status conferences were conducted on July 26, 2000,
January 10, 2001, and April 17, 2002. Discovery has commenced. No class has been
certified, but the briefing on the plaintiff's motion for class certification is
expected to be completed by Winter 2002/03, with a hearing on class
certification issues to be scheduled thereafter. SONICblue intends to contest
the certification of the purported class, dispute the lawsuit's allegations and
defend this action vigorously.
43
In November 2001, Pac Tec, a division of La France Corporation, filed a
civil action against the Company and one of its suppliers, Manufacturers'
Services Limited, in the United States District Court for the Eastern District
of Pennsylvania, alleging claims against both defendants jointly for breach of
contract and promissory estoppel. The plaintiff seeks damages in excess of $2.5
million, plus prejudgment interest and costs of suit. In August 2002, the Court
granted the Company's motion to dismiss the plaintiff's claims for recovery of
consequential damages. The parties have propounded written discovery, and the
Court has set a tentative trial date in the case of March 10, 2003. SONICblue
intends to dispute the plaintiff's claims and vigorously defend itself against
this action.
On October 17, 2001, Skyline Capital Associates, LLC filed a lawsuit in the
San Mateo County Superior Court alleging that SONICblue breached an agreement
for tax consulting services and seeking payment of $3.2 million for consulting
fees and interest. In November 2001, SONICblue filed a counter claim against
Skyline for $750,000. In March 2002, SONICblue, Skyline and Skyline's principal
entered into a settlement agreement pursuant to which the parties would resolve
their dispute for $2.4 million. In June 2002, after SONICblue had paid
approximately $2.3 million under the settlement agreement, a dispute over the
settlement arose. SONICblue intends to dispute the plaintiff's claims and defend
this action vigorously.
By letter of counsel dated September 18, 2002, Kenneth Potashner initiated
proceedings under an employment agreement dated June 21, 2001, claiming that he
was terminated as chief executive officer without cause and in violation of
public policy. Mr. Potashner demanded payment of $1,984,000, plus the reasonable
value of benefits, and confirmation that his stock options will continue to vest
under the employment agreement. By letter dated September 30, 2002, the Company
denied that Mr. Potashner was terminated without cause, denied that his
termination violated public policy, and declined to furnish the relief
requested, but agreed to submit the dispute to private resolution procedures, in
accordance with the terms of the employment agreement. These proceedings are
expected to take place later this year.
On or about August 21, 2001, VIA Technologies, Inc. commenced an
arbitration proceeding against the Company that is currently pending before the
International Centre for Dispute Resolution (the international division of the
American Arbitration Association). In November 2001, the Company responded to
the demand for arbitration, denying liability and asserting various other
defenses. An arbitrator was appointed on July 24, 2002, and on or about
September 20, 2002, VIA, joined by S3 Graphics Co., Ltd. as a co-claimant, filed
a First Amended Demand for Arbitration, seeking, among other things, damages of
approximately $8.0 million and an order of specific performance to correct
alleged errors in the Closing Balance Sheet for the transactions contemplated by
the investment agreement between the parties in the amount of approximately $4.1
million as well as recovery of costs and attorney's fees. The Company filed a
Statement of Defense to the First Amended Demand for Arbitration and
Counterclaim in which it, among other things, denied liability, alleged that the
tribunal lacked jurisdiction over certain of the claims included in the First
Amended Demand for Arbitration and conditionally asserted counterclaims for
breach of the investment agreement. The parties are presently briefing the
jurisdictional issues. There has been no discovery in the proceeding, and a
hearing date has not yet been set. SONICblue intends to defend this action
vigorously.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
<Table>
<Caption>
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
10.1 Amendment Number Nine to Second Amended and Restated Loan
and Security Agreement, dated as of September 30, 2002, by
and among Congress Financial Corporation (Western), Sensory
Science Corporation and California Audio Labs, LLC.
10.2 Amendment Number Ten to Second Amended and Restated Loan and
Security Agreement, dated as of October 29, 2002, by and
among Congress Financial Corporation (Western), Sensory
Science Corporation and California Audio Labs, LLC.
</Table>
44
(b) Reports on Form 8-K:
On August 9, 2002, SONICblue filed a current report on Form 8-K reporting
under Item 5 that on August 8, 2002, L. Gregory Ballard was appointed as the
Company's interim chief executive officer following the Board of Director's
earlier action terminating its Chairman, President and CEO, Kenneth Potashner,
as an officer and employee of the Company.
On August 28, 2002, SONICblue filed a current report on Form 8-K under Item
5 reporting that on August 19, 2002, it received notification from Nasdaq that
for 30 consecutive trading days, the Company's common stock had closed below the
minimum $1.00 per share requirement for continued listing on the Nasdaq National
Market and that failure to achieve compliance with the $1.00 per share
requirement may result in the Company's common stock ceasing to be listed on the
Nasdaq National Market.
On September 9, 2002, SONICblue filed a current report on Form 8-K under
Item 5 reporting that on September 5, 2002 it announced that it would streamline
its business structure, including a 25 percent reduction in force beginning on
September 5, 2002 that will be implemented by year's end.
45
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.
SONICBLUE INCORPORATED
(Registrant)
/s/ MARCUS SMITH
--------------------------------------
Marcus Smith
Vice President and Chief Financial
Officer
(Duly Authorized Officer and
Principal Financial and Accounting
Officer)
Date: November 14, 2002
46
CERTIFICATIONS
I, L. Gregory Ballard, certify that:
1. I have reviewed this quarterly report on Form 10-Q of SONICblue
Incorporated;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances under
which such statements were made, not misleading with respect to the period
covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other
financial information included in this quarterly report, fairly present in
all material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible
for establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we
have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the filing
date of this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors and the
audit committee of the registrant's board of directors (or persons
performing the equivalent function):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's ability
to record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in
this quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant deficiencies
and material weaknesses.
Date: November 14, 2002
/s/ L. GREGORY BALLARD
--------------------------------------
L. Gregory Ballard
Chief Executive Officer
47
I, Marcus Smith, certify that:
1. I have reviewed this quarterly report on Form 10-Q of SONICblue
Incorporated;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances under
which such statements were made, not misleading with respect to the period
covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other
financial information included in this quarterly report, fairly present in
all material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible
for establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we
have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the filing
date of this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors and the
audit committee of the registrant's board of directors (or persons
performing the equivalent function):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's ability
to record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in
this quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant deficiencies
and material weaknesses.
Date: November 14, 2002
/s/ MARCUS SMITH
--------------------------------------
Marcus Smith
Vice President and Chief Financial
Officer
48
EXHIBIT INDEX
<Table>
<Caption>
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
10.1 Amendment Number Nine to Second Amended and Restated Loan
and Security Agreement, dated as of September 30, 2002, by
and among Congress Financial Corporation (Western), Sensory
Science Corporation and California Audio Labs, LLC.
10.2 Amendment Number Ten to Second Amended and Restated Loan and
Security Agreement, dated as of October 29, 2002, by and
among Congress Financial Corporation (Western), Sensory
Science Corporation and California Audio Labs, LLC.
</Table>
49