U.S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-QSB
(Mark One)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended December 31, 2001
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR
15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission File Number 0-27102
eGames, Inc.
(Exact name of registrant as specified in its charter)
PENNSYLVANIA 23-2694937
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification Number)
2000 Cabot Boulevard West, Suite 110
Langhorne, PA 19047-1811
(address of Principal executive offices)
Issuer's Telephone Number, Including Area Code: 215-750-6606
Not Applicable
(Former name, former address and former
fiscal year, if changed since last report.)
Check whether the issuer (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 ( ) No (X)
APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY
PROCEEDINGS DURING THE PRECEDING FIVE YEARS:
Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Sections 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court.
Yes ( ) No ( )
APPLICABLE ONLY TO CORPORATE ISSUERS
State the number of shares outstanding of each of the issuer's classes of common
equity, as of the latest practicable date: 9,989,337 shares of common stock, no
par value per share, as of March 22, 2002.
Transitional Small Business Disclosure Format (check one): Yes ( ) No ( X )
INDEX
Page
Part I. Financial Information
Item 1. Financial Statements:
Balance Sheet as of December 31, 2001.................... 3
Statements of Operations for the three and six months
ended December 31, 2001 and 2000 .................... 4
Statements of Cash Flows for the six months
ended December 31, 2001 and 2000 ................... 5
Notes to Financial Statements............................ 6-10
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations ................. 11-20
Risk Factors............................................. 21-26
Part II Other Information
Item 6. Exhibits and Reports on Form 8-K......................... 27
Exhibit Index ......................................................... 27
Exhibits ......................................................... 27
Signatures ......................................................... 28
Item 1. Financial Statements
eGames, Inc.
Balance Sheet
(Unaudited)
As of
December 31,
ASSETS 2001
- ------ ------------
Current assets:
Cash and cash equivalents $ 635,084
Accounts receivable, net of allowances totaling $1,509,774 1,701,779
Inventory 2,289,044
Prepaid royalties and other expenses 342,555
Note receivable 50,000
------------
Total current assets 5,018,462
Furniture and equipment, net 114,656
Intangibles and other assets, net 17,143
------------
Total assets $ 5,150,261
============
LIABILITIES AND STOCKHOLDERS' DEFICIT
- ------------------------------------
Current liabilities:
Note payable $ 65,780
Accounts payable 724,811
Customer advance payments 3,021,012
Bank debt 820,000
Accrued expenses 1,806,137
Trade notes payable 286,100
------------
Total current liabilities 6,723,840
Bank debt, net of current portion 420,000
Note payable, net of current portion 23,184
------------
Total liabilities 7,167,024
Stockholders' deficit:
Common stock, no par value (40,000,000 shares authorized;
10,221,237 issued and 9,989,337 outstanding) 9,179,827
Additional paid-in capital 1,155,479
Accumulated deficit (11,850,652)
Treasury stock, at cost - 231,900 shares (501,417)
------------
Total stockholders' deficit (2,016,763)
------------
Total liabilities and stockholders' deficit $ 5,150,261
============
See accompanying notes to the financial statements.
eGames, Inc.
Statements of Operations
(Unaudited)
Three months ended Six months ended
December 31, December 31,
------------------------- -------------------------
2001 2000 2001 2000
------------------------- -------------------------
Net sales $ 2,716,093 $ 2,590,453 $ 4,303,647 $ 3,735,327
Cost of sales 1,376,155 1,413,188 2,333,974 2,164,192
----------- ----------- ----------- -----------
Gross profit 1,339,938 1,177,265 1,969,673 1,571,135
Operating expenses:
Product development 90,475 176,325 220,572 357,472
Selling, general and administrative 726,147 1,548,259 1,577,476 2,988,385
----------- ----------- ----------- -----------
Total operating expenses 816,622 1,724,584 1,798,048 3,345,857
----------- ----------- ----------- -----------
Operating income (loss) 523,316 (547,319) 171,625 (1,774,722)
Interest expense, net 42,392 23,370 72,743 30,723
----------- ----------- ----------- -----------
Income (loss) from continuing operations
before income taxes 480,924 (570,689) 98,882 (1,805,445)
Provision (benefit) for income taxes - 0 - (39,638) 800 (11,792)
----------- ----------- ----------- -----------
Income (loss) from continuing operations 480,924 (531,051) 98,082 (1,793,653)
Discontinued operation (Note 4):
Income from discontinued operation, net of
income tax provision (benefit) for three
months ended December 31, 2000 of $5,357,
and for the six months ended December 31,
2000 of ($19,668) - 0 - 89,072 - 0 - 67,656
----------- ----------- ----------- -----------
Net income (loss) $ 480,924 ($ 441,979) $ 98,082 ($1,725,997)
=========== =========== =========== ===========
Net income (loss) per common share:
- Basic $ 0.05 ($ 0.05) $ 0.01 ($ 0.18)
=========== =========== =========== ===========
- Diluted $ 0.05 ($ 0.05) $ 0.01 ($ 0.18)
=========== =========== =========== ===========
Weighted average common shares
outstanding - Basic 9,989,337 9,749,975 9,989,337 9,749,975
Dilutive effect of common stock equivalents - 0 - - 0 - - 0 - - 0 -
----------- ----------- ----------- -----------
Weighted average common shares
outstanding - Diluted 9,989,337 9,749,975 9,989,337 9,749,975
=========== =========== =========== ===========
See accompanying notes to the financial statements.
eGames, Inc.
Statements of Cash Flows
(Unaudited)
Six months ended
December 31,
--------------------------
2001 2000
----------- -----------
Cash flows from operating activities:
Net Income (loss) $ 98,082 ($1,725,997)
Adjustment to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Depreciation, amortization and other non-cash items 73,527 118,012
Provision for sales returns, price markdowns and bad debt 664,557 1,568,689
Provision for inventory obsolescence 137,032 264,079
Sell-through of prior year customer advance payments (339,913) - 0 -
Income from discontinued operation - 0 - (67,656)
Changes in items affecting operations:
Restricted cash 30,000 - 0 -
Accounts receivable (821,459) (2,031,708)
Prepaid royalties and other expenses (82,372) (317,439)
Inventory 1,141,778 (2,088,642)
Accounts payable (1,023,964) 1,003,555
Customer advance payments (124,488) 926,766
Accrued expenses 1,096,851 499,284
Deferred revenues - 0 - 45,000
----------- -----------
Net cash provided by (used in) operating activities 849,631 (1,806,057)
----------- -----------
Cash flows from investing activities:
Purchase of furniture and equipment (20,009) (37,248)
Purchase of software rights and other assets (1,375) (4,980)
----------- -----------
Net cash used in investing activities (21,384) (42,228)
----------- -----------
Cash flows from financing activities:
Proceeds from credit facility/bank debt 280,000 2,250,000
Repayments of credit facility/bank debt (240,000) (1,200,000)
Proceeds from note receivable 60,000 - 0 -
Repayments of trade notes payable (197,980) - 0 -
Repayments of convertible subordinated debt - 0 - (150,000)
Repayments of note payable (30,736) (26,500)
Repayments of capital lease obligations (90,184) (6,342)
----------- -----------
Net cash (used in) provided by financing activities (218,900) 867,158
Effect of exchange rate changes on cash and cash equivalents - 0 - (3,630)
Net cash used in discontinued operation - 0 - (91,714)
----------- -----------
Net decrease in cash and cash equivalents 609,347 (1,076,471)
Cash and cash equivalents:
Beginning of period 25,737 1,139,178
----------- -----------
End of period $ 635,084 $ 62,707
=========== ===========
Supplemental cash flow information:
Cash paid for interest $ 74,702 $ 39,411
=========== ===========
Non cash investing and financing activities:
Conversion of selected accounts payable to trade notes payable $ 484,080 $ - 0 -
=========== ===========
Acquisition of furniture, equipment through capital leases $ - 0 - $ 294,070
=========== ===========
See accompanying notes to the financial statements.
eGames, Inc.
Notes to Financial Statements
1. Summary of Significant Accounting Policies
Basis of Presentation
The accompanying unaudited interim financial statements were prepared in
accordance with generally accepted accounting principles for interim financial
information. Accordingly, they do not include all of the information and
footnotes required by accounting principles generally accepted in the United
States for complete financial statements. The Notes to Financial Statements
included in the Company's Form 10-KSB for the fiscal year ended June 30, 2001
should be read in conjunction with the accompanying statements. These statements
include all adjustments the Company believes are necessary for a fair
presentation of the statements. The interim operating results are not
necessarily indicative of the results for a full year.
Description of Business
eGames, Inc. (the "Company"), a Pennsylvania corporation incorporated in July
1992, develops, publishes, markets and sells a diversified line of personal
computer software primarily for consumer entertainment. The Company targets the
growing market of home personal computer ("PC") users who value full-featured,
value-priced and easy-to-use entertainment software. The Company's sales are
made through various national distributors on a non-exclusive basis in addition
to direct relationships with certain national and regional retailers. The
Company's products generally sell at retail for under $15, a price point that is
intended to generate impulse purchases in mass market shopping environments.
Consolidation
The financial statements include the accounts of the Company and its previously
wholly-owned subsidiary, which due to the sale of this operation in May 2001,
the relevant transactions have been presented as a discontinued operation for
the comparative prior periods. All inter-company transactions have been
eliminated for those periods.
Revenue Recognition
Product Sales:
- --------------
The Company has concluded, based upon receipt of delayed reporting of
sell-through results from its food and drug retailers, which have not
historically sold consumer PC software products, that it does not have the
ability to make reliable estimates of product returns for shipments to food and
drug retailers in accordance with SFAS No. 48, "Revenue Recognition When the
Right of Return Exists" and the additional guidance provided in the SEC's Staff
Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements".
Accordingly, the Company's revenues associated with product shipments to food
and drug retailers are recognized based on the timing of the actual sell-through
of the Company's products to the end consumer at the retail location as reported
to the Company from the respective food and drug retailer.
Revenues associated with the Company's product shipments to its customers that
traditionally have sold consumer PC software products (i.e., mass merchant
retailers or distributors serving such retailers) are recognized at the time
title to the inventory passes to these customers, less a historically based
provision for anticipated product returns. Title passes to these customers
either upon shipment of the product or receipt of the product by these customers
based on the terms of the sale transaction.
Notes to Financial Statements (continued)
Customers generally have the right to return products purchased from the
Company. The Company recognizes product sales to its customers who traditionally
have sold consumer PC software products, in accordance with the criteria of SFAS
No. 48, at the time of the sale based on the following: the selling price is
fixed at the date of sale, the buyer is obligated to pay the Company, title of
the product transfers to the buyer, the buyer has economic substance apart from
the Company, the Company does not have further obligations to assist the buyer
in the resale of the product and the returns can be reasonably estimated at the
time of sale. While the Company has no other obligations to perform future
services subsequent to shipment, the Company provides telephone customer support
as an accommodation to purchasers of its products and as a means of fostering
customer loyalty. Costs associated with this effort are insignificant and,
accordingly, are expensed as incurred.
Allowance For Product Returns and Price Markdowns:
- --------------------------------------------------
The Company distributes the majority of its products through several third-party
distributors and directly to national and regional retailers. The distribution
of these products is governed by distribution agreements, direct sale agreements
or purchase orders, which generally allow for product returns and price
markdowns. For shipments to its customers that have traditionally sold consumer
PC software products, the Company records an allowance for returns and markdowns
as a reduction of gross sales at the time title of the products pass to the
customer. This allowance, which is reflected as a reduction of accounts
receivable, is estimated based primarily upon historical experience.
During the quarters ended December 31, 2001 and 2000, the Company's provisions
for product returns and price markdowns for customers that have traditionally
sold consumer PC software products were approximately $350,000 and $862,000 or
20% and 42% of related gross shipments, respectively. During the six months
ended December 31, 2001 and 2000, the Company's provisions for product returns
and price markdowns for customers that have traditionally sold consumer PC
software products were approximately $525,000 and $1,087,000 or 18% and 33% of
related gross shipments, respectively.
Customer Advance Payments
Although the Company recognizes revenue from food and drug retailers based on
the timing of the actual sell-through of the Company's products to the end
consumer, the Company may receive payments from these food and drug retailers in
advance of such products being sold to the end consumer. These payments are
recorded as customer advance payments in the Company's Balance Sheet until such
time as the products are actually sold through to the end consumer. After the
products are sold through to the end consumer, the customer advance payment
amount is recorded as revenue. In the event that the Company receives customer
advance payments that ultimately exceed the actual product sell-through of the
Company's products to the end consumer at such retailers, the Company would owe
these retailers such excess amounts.
Prepaid Royalties
Prepaid royalties represent advance payments made to licensors of software and
intellectual properties used in the Company's products. Prepaid royalties are
expensed at contractual royalty rates based on net product sales.
Marketing and Sales Incentive Costs
Marketing costs for which the Company pays its resellers, such as slotting and
advertising fees, are charged to expense as incurred and were approximately
$158,000 and $402,000 for the quarters ended December 31, 2001 and 2000,
respectively and were approximately $276,000 and $772,000 for the six months
ended December 31, 2001 and 2000, respectively.
Sales incentive costs, such as rebates and coupons, that the Company offers to
the retail consumer are recorded as reductions to net sales as incurred and were
approximately $77,000 and $205,000 for the quarters December 31, 2001 and 2000,
respectively and were approximately $174,000 and $313,000 for the six months
ended December 31, 2001 and 2000, respectively.
Notes to Financial Statements (continued)
New Accounting Pronouncements
The Company does not expect any recently issued accounting pronouncements to
have a significant impact on its results of operations, financial position or
cash flows.
2. Comprehensive Income (Loss)
On July 1, 1998, the Company adopted SFAS 130, "Reporting Comprehensive Income".
This Statement requires that all items that are required to be recognized under
accounting standards as components of comprehensive income be reported in a
financial statement that is displayed with the same prominence as other
financial statements. Comprehensive income (loss) is computed as follows:
Three Months Ended Six Months Ended
December 31, December 31,
----------------------- --------------------------
2001 2000 2001 2000
----------- ---------- ------------ ------------
Net income (loss) $ 480,924 ($ 441,979) $ 98,082 ($ 1,725,997)
Other comprehensive income (loss):
Foreign currency translation adjustment - 0 - 75,185 - 0 - 14,065
----------- ---------- ------------ ------------
Comprehensive income (loss) $ 480,924 ($ 366,794) $ 98,082 ($ 1,711,932)
=========== ========== ============ ============
3. Common Stock Trading
Effective April 2, 2001, the Company's common stock began trading on the OTC
Bulletin Board ("OTC BB") under the symbol EGAM. The Company's common stock had
previously traded on the Nasdaq SmallCap Market under the symbol EGAM. On March
15, 2002, the Company's common stock was no longer eligible to be traded on the
OTC BB because the Company was not current with its reporting requirements under
the Securities Exchange Act of 1934, as amended (the "'34 Act"). The Company is
currently working towards becoming current with its '34 Act filings by the end
of March 2002, upon filing its Form 10-QSB for the period ended December 31,
2001, and once current, will seek to have its common stock sponsored for trading
on the OTC BB.
4. Discontinued Operation
On May 11, 2001, the Company sold eGames Europe Limited, its wholly-owned
subsidiary located in the United Kingdom, to a non-related third-party. The
Company has reflected the relevant activity and account balances for this
operation as a discontinued operation within each of the respective financial
statements included in this report. In connection with the sale of this
operation, the Company received $300,000 in net proceeds, which approximated the
discontinued operation's net book value. The net proceeds consisted of: $150,000
in cash provided at closing, $120,000 in a note receivable to be payable in
twelve monthly payments of $10,000 each, and $30,000 in cash held in escrow
which was subsequently released in its entirety to the Company during the
quarter ended December 31, 2001. The amounts in the accompanying financial
statements and footnotes have been reclassified for the comparative prior
periods presented to give effect to the discontinued operation.
Net sales for the discontinued operation for the quarter ended December 31, 2000
were approximately $768,000 and for the six months ended December 31, 2000 were
$1,359,000. For the quarter ended December 31, 2000, the income from the
discontinued operation was approximately $89,000, and resulted from gross profit
of $397,000, less operating expenses and income tax provision of $303,000 and
$5,000, respectively. For the six months ended December 31, 2000, the income
from the discontinued operation was approximately $68,000, and resulted from
gross profit of $695,000 and income tax benefit of $20,000, less operating
expenses of $647,000.
Notes to Financial Statements (continued)
5. Operations by Reportable Segments
SFAS No. 131, "Disclosure about Segments of an Enterprise and Related
Information" establishes standards for reporting information about an
enterprise's operating segments and related disclosures about its products,
geographic areas and major customers.
Based on the Company's organizational structure and its prior period
presentation of the discontinued operation, the Company operates in only one
reportable segment, which is publishing interactive entertainment software for
personal computers.
6. Bank Debt
On August 9, 2000, the Company entered into a $2,000,000 revolving credit
facility with Fleet Bank (formerly Summit Bank). The credit facility was
established to provide, among other things, working capital to support the
Company's operations. Amounts outstanding under this credit facility were
charged interest at one-half of one percent above the bank's current prime rate,
with interest due monthly, and was collateralized by substantially all of the
Company's assets. The credit facility required the Company, among other things,
to maintain certain financial ratios, such as: a minimum working capital balance
of $1,500,000 and a maximum senior debt to effective net worth ratio of 1.50 to
1.00. Additionally, this credit facility had a minimum effective net worth
covenant that started at $3,100,000 at June 30, 2000 and increased by $150,000
quarterly to a $3,700,000 requirement at June 30, 2001. As of June 30, 2001, the
Company was not in compliance with those covenants.
On July 23, 2001, Fleet Bank notified the Company that due to the Company's
default of the financial covenants under its credit facility as of June 30,
2001, and material adverse changes in the Company's financial condition, the
bank would no longer continue to fund the Company's $2,000,000 credit facility.
On November 2, 2001 the Company and Fleet Bank, entered into an agreement to pay
off the then outstanding balance of $1,400,000 owed to Fleet Bank over a
twenty-two month period. The agreement also provides that, despite the Company's
defaults under the loan documents, Fleet Bank will not enforce its rights and
remedies under those loan documents as long as the Company remains in compliance
with the terms of the agreement. The Company's shareholders would face a total
loss of their investment if such an asset-liquidation were to occur. The terms
of the agreement provide, among other things, that the remaining outstanding
balance owed under the credit facility will be repaid in 22 monthly
installments, with interest at the prime rate plus three percent. As of March
28, 2002, the Company had made 6 of these 22 monthly payments to Fleet Bank. The
terms of the agreement also require the Company to achieve certain earnings
benchmarks and to provide Fleet Bank with periodic financial and cash flow
reporting. This loan has been classified as "bank debt", within the Company's
Balance Sheet. As part of the agreement, the Company issued warrants to Fleet
Bank for the purchase of 750,000 shares of the Company's Common Stock. The
warrants are exercisable until October 31, 2006 at an exercise price of $0.09
per share, and a separate registration rights agreement provides that the bank
will have demand registration rights beginning on November 1, 2002. As of
December 31, 2001 and March 28, 2002, the principal balances outstanding on this
term loan were $1,240,000 and $1,060,000, respectively.
7. Liquidity
The Company's ability to achieve and maintain positive cash flow depends upon a
variety of factors, including the timeliness and success of the collection of
outstanding accounts receivable; the timeliness of product returns and the
Company's ability to resell such products after return; the creditworthiness of
the primary distributors and retail customers of the Company's products; the
continuing retail demand for value-priced PC game software; the development and
sell-through of the Company's products, the costs of developing, producing and
marketing such products; and various other factors, many of which are beyond the
Company's control. In the future, the Company expects its cash and working
capital requirements to be affected by each of these factors. There can be no
assurances that the Company will be able to achieve and maintain a positive cash
flow or that additional financing will be available if and when required or, if
available, will be on terms satisfactory to the Company.
Notes to Financial Statements (continued)
8. Subsequent Event
In February 2002, the Company entered into an agreement with one of its major
drug store retailers that provided for a mutual release of each party's past
obligations relating to any and all prior business transactions. This agreement
eliminates this retailer's right to make any further product returns of the
Company's products that had not yet been reported by this retailer as being sold
through to the end customer, thereby releasing the Company from any future
obligation as it relates to the portion of the Customer Advance Payments (see
Note 1) associated with this retailer. As a result, the Company will now be able
to recognize the gross profit of approximately $1,000,000 on the Customer
Advance Payments for product shipments not previously recognized as revenue,
since such products had not been reported by this retailer as being sold through
to the end consumer. This transaction will be recognized in the third quarter
ending March 31,2002.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The accompanying financial statements as of December 31, 2001 include the
accounts of eGames, Inc. (the "Company") and its previously wholly-owned
subsidiary that is presented as a discontinued operation. Dollar amounts
discussed within the Company's "Management's Discussion and Analysis of
Financial Condition and Results of Operations" have been rounded to the nearest
thousand ('000).
Forward-Looking Statements
This Quarterly Report on Form 10-QSB and in particular Management's Discussion
and Analysis of Financial Condition and Results of Operations contains
forward-looking statements about circumstances that have not yet occurred,
including, without limitation, statements regarding the Company's potential to
improve its operational profitability by focusing its sales efforts on the North
American traditional software retail channel; the Company's determination that
it will cease distributing PC software titles directly to food and drug
retailers during the second half of fiscal 2002; the level of the Company's
international net sales remaining at between 5% and 10% of the Company's net
sales for the remainder of fiscal 2002; the transition of the Company's
international product distribution to a licensing model, and the ability of this
new model to earn a royalty for the Company; the Company's efforts to increase
distribution of its products via the Internet; the Company's plans to continue
to look for additional cost improvement opportunities throughout fiscal 2002;
the possibility of customer advance payments exceeding the actual product
sell-through at retail stores, and the resulting requirement that the Company
repay these retailers; the likelihood that product sell-through at such
retailers will be less than the advance customer payments; the sufficiency of
the Company's cash and working capital balances to fund the Company's operations
for the foreseeable future; the Company's plans to become current in its filings
pursuant to the Securities Exchange Act of 1934, as amended, and to seek to have
its common stock sponsored for trading on the OTC Bulletin Board; the
expectation that certain new accounting pronouncements will not have a
significant impact on the Company's results of operations, financial position or
cash flows; as well as other statements including words such as "anticipate",
"believe" or "expect" and statements in the future tense. These forward-looking
statements are subject to business and economic risks, and actual events or the
Company's actual future results could differ materially from those set forth in
the forward-looking statements due to such risks and uncertainties. The Company
will not necessarily update information if any forward looking statement later
turns out to be inaccurate.
The following important factors, among others discussed elsewhere in this
report, could cause the Company's actual results to differ materially from those
indicated by the forward-looking statements contained in this report: the market
acceptance and successful sell-through results for the Company's products at
retail stores, particularly at North American retailers where PC software has
traditionally been sold; the ability of the Company to accurately estimate
sell-through volume when an order is shipped to, or received by, a customer that
has traditionally sold PC software; the amount of unsold product that is
returned to the Company by retail stores; the Company's ability to accurately
predict the amount of product returns that will occur and the adequacy of the
reserves established for such returns; the success of the Company's distribution
strategy, including its ability to continue to increase the distribution of its
products into key North American mass-merchant retailers and to enter into new
distribution and direct sales relationships on commercially acceptable terms;
the allocation of shelf space for the Company's products in major retail chain
stores; the Company's ability to negotiate lower product promotional costs in
its distribution and retail relationships; the ability of the Company's
international product distribution to earn a royalty for the Company and the
ability of licensors to pay the Company such royalties; the Company's success in
achieving additional cost savings and avoiding unforeseeable expenses in fiscal
2002; the Company's ability to obtain sponsorship from an eligible OTC Bulletin
Board market maker for trading of the Company's common stock on the OTC Bulletin
Board; the Company's ability to collect outstanding accounts receivable and
establish adequate reserves for un-collectible receivables; increased selling,
general and administrative costs, including increased legal expenses; the
continued increase in the number of computers in homes in North America and the
world; the ability to deliver products in response to orders within a
commercially acceptable time frame; downward pricing pressure; fluctuating costs
of developing, producing and marketing the Company's products; the Company's
ability to license or develop quality content for its products; the Company's
ability to access alternative distribution channels and the success of the
Company's efforts to develop its Internet sales; consumers' continued demand for
value-priced software; increased competition in the value-priced software
category; and various other factors, many of which are beyond the Company's
control. Risks and uncertainties that may affect the Company's future results
and performance also include, but are not limited to, those discussed under the
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
heading "Risk Factors" in the Company's Annual Report on Form 10-KSB for the
fiscal year ended June 30, 2001 as filed with the Securities and Exchange
Commission and other documents filed with the Commission.
Results of Operations
Three Months Ended December 31, 2001 and 2000
Net Sales
Net sales for the quarter ended December 31, 2001 were $2,716,000 compared to
$2,590,000 for the quarter ended December 31, 2000, representing an increase of
$126,000 or 5%. The $126,000 increase in net sales was primarily attributable to
the Company's increase in net sales to North American traditional software
distributors and retailers of $331,000 and its increase in net sales to
international customers of $15,000, which increases were partially offset by a
$220,000 decrease in net sales to North American food and drug retailers.
The net sales increase to North American traditional software distributors and
retailers resulted largely from increased distribution through Infogrames, Inc.,
the Company's primary North American distributor that services the major
mass-merchant retailers in North America, such as Wal-Mart, K-Mart and Best Buy.
Compared to the prior year period, the Company has been able to increase both
the number of its individual software titles carried by these retail stores and
the number of total stores distributing certain Company software titles. These
mass-merchant retailers have developed a history of successfully merchandising
consumer entertainment PC software and cost effectively managing consumer
entertainment PC software inventory levels. The Company's management believes
that by focusing its sales efforts on the North American traditional software
retail channel, rather than on the food and drug retail channel, the Company's
operational profitability may improve due to the steadier sell-through and
return rates experienced in the traditional retail sector compared to the food
and drug retail channels. Included in the net sales to North American
traditional software distributors and retailers for the quarter ended December
31, 2001 was approximately $39,000 in net sales at customer selling prices equal
to or less than the Company's carrying cost, which were related to the Company's
inventory liquidation efforts implemented during fiscal 2002 in order to
address its liquidity issues. These product sales had no right-of-return
associated with them and the Company required the customer's payment at the time
of shipment, or shortly thereafter.
The Company's net sales to North American food and drug retailers decreased by
$220,000 compared to the prior year period. During fiscal 2001, the Company had
established its first "Store-in-a-Store" entertainment software display sections
in approximately 4,000 food and drug retail stores. The establishment of these
Store-In-A-Store software display sections within certain national and regional
food and drug retail stores was intended to help secure longer-term placement of
the Company's products in this retail channel, with the goal of increasing
product sell through volume, while decreasing the rate of product returns due to
longer product exposure on these retailers' product shelves. The Company has
determined that it will cease distributing PC software titles directly to these
retailers during the second half of fiscal 2002, due to increasing demand on
available working capital resources caused largely by the costs of expensive
disposable merchandising displays; increased inventory levels that resulted from
more product returns from under-performing promotional programs at these
retailers; the need to continually revamp the Company's product offering to
support these repeated promotional programs; and the increased demand for
consumer and retailer incentives such as rebates and instant price markdowns to
help support the eventual product sell-through to the end consumer.
The Company's international net revenues, inclusive of both product net sales
and royalty revenues, for the quarter ended December 31, 2001 increased by
$15,000 compared to the prior year period. As a percentage of net sales, the
Company's international net revenues represented approximately 6% of the
Company's net sales for both of the quarters ended December 31, 2001 and 2000,
respectively. The Company anticipates that international net revenues will range
from 5% to 10% of the Company's net sales for the remainder of fiscal 2002.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
On May 11, 2001, the Company sold its wholly-owned subsidiary "eGames Europe
Limited", located in the United Kingdom, to a non-related third-party. By
effecting this sale, the Company transitioned the majority of its international
product distribution efforts to a licensing revenue model, whereby the Company
no longer bears the working capital risk of supporting these multi-country
product sales efforts, but anticipates earning a royalty fee based upon net
product sales covered under various licensing arrangements with third-party
developers. The Company has reflected the net sales activity for this operation
as a discontinued operation for the comparable prior year period within the
Company's Statements of Operations. Net sales for the discontinued operation for
the quarter ended December 31, 2000 was $768,000.
The Company has continued to implement programs designed to increase sales of
its products over the Internet, including: entering into agreements with larger,
high-profile companies that offer the Company's PC software titles as "value
added" additions to their own consumer promotional offerings; continual
improvements and updates to its website and electronic distribution
capabilities; and incorporation of optional, user-friendly on-line functionality
into its products. Net sales of the Company's products via the Internet for the
quarters ended December 31, 2001 and 2000 were $78,000 and $43,000,
respectively, or approximately 3% and 2% of the Company's net sales,
respectively.
Most of the Company's non-exclusive arrangements with its traditional software
distributors and retailers allow for product returns or price markdowns. During
the quarters ended December 31, 2001 and 2000, the Company's provisions for
product returns and price markdowns relating to product shipments to its
traditional software customers totaled approximately $350,000 and $862,000, or
20% and 42% of related gross shipments, respectively. This $512,000 decrease in
the provision for product returns and price markdowns largely related to
decreased distribution to certain office superstore customers that returned or
required price markdowns of the Company's products during the period a year ago
in connection with their transition away from value-priced casual gaming
software titles.
Cost of Sales
Cost of sales for the quarter ended December 31, 2001 were $1,376,000 compared
to $1,413,000 for the quarter ended December 31, 2000, representing a decrease
of $37,000 or 3%. The primary reason for this $37,000 decrease in cost of sales
was a $196,000 decrease in the provision for inventory obsolescence caused by a
non-recurring discontinuance of various end of lifecycle products and the
scrapping of unsold, date-sensitive consumer income tax software that had
occurred in the same period a year earlier. This cost of sales decrease was
partially offset by increases in royalty expense of $130,000 due to increasing
developer royalty rates for recently acquired PC software titles, product costs
of $21,000 associated with increased product sales and distribution, packaging
and reclamation costs of $8,000. Product costs consist mainly of replicated
compact discs, printed materials, protective jewel cases and boxes for certain
products.
Gross Profit Margin
The Company's gross profit margin for the quarter ended December 31, 2001
increased to 49.3% of net sales from 45.4% of net sales for the quarter ended
December 31, 2000. This 3.9% increase in gross profit margin was caused
primarily by a decrease in provision for inventory obsolescence of 7.6%, as a
percentage of net sales, caused by a non-recurring discontinuance of various end
of lifecycle products and the scrapping of unsold date-sensitive consumer income
tax that had occurred in the same period a year earlier. This increase to gross
profit margin was partially offset by a cost of sales increase, as a percentage
of net sales, of 4.5% in royalty costs because of increased developer royalty
rates for recently acquired PC software titles. In general, the Company's cost
to acquire PC software content has continued to increase as the competition to
obtain higher quality consumer entertainment PC software has driven these costs
up.
Operating Expenses
Product development expenses for the quarter ended December 31, 2001 were
$90,000 compared to $176,000 for the quarter ended December 31, 2000, a decrease
of $86,000 or 49%. This decrease was caused primarily by a decrease in salary
and related costs due employee layoffs effected by the Company in July and
August 2001.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
Selling, general and administrative expenses for the quarter ended December 31,
2001 were approximately $726,000 compared to approximately $1,548,000 for the
quarter ended December 31, 2000, a decrease of $822,000 or 53%. Most of this
$822,000 decrease was caused by decreases in:
o salary related costs of $266,000 primarily from the employee layoffs
affected by the Company in January, July and August 2001;
o marketing promotional expenses of $244,000 primarily as a result of
decreased product shipments to food and drug retailers and office super
store retailers;
o bad debt expense of $97,000 due to the Company's determination of
improved strength in its customers' receivables;
o travel costs of $50,000 due to head count reductions and the increase
concentration of the Company's customer base;
o public corporation expense of $46,000; and
o professional services of $39,000.
As a result of the Company's recent liquidity issues, during fiscal 2002 the
Company has attempted to achieve cost reductions in all aspects of its
operations, in order to improve its ongoing viability as a going concern. The
Company plans to continue to look for additional cost reduction opportunities
throughout fiscal 2002.
Interest Expense, Net
Net interest expense for the quarter ended December 31, 2001 was approximately
$42,000 compared to approximately $23,000 for the quarter ended December 31,
2000, an increase of approximately $19,000. The $19,000 increase was primarily
due to the increase in bank debt outstanding during the quarter ended December
31, 2001 compared to the same period a year earlier.
Benefit for Income Taxes
Benefit for income taxes for the quarter ended December 31, 2001 was zero
compared to a benefit for income taxes of $40,000 for the quarter ended December
31, 2000, a decrease in benefit for income taxes of $40,000. This $40,000
decrease in the benefit for income taxes was primarily due to the $1,052,000
increase in the Company's income from continuing operations before income taxes
for the quarter ended December 31, 2001, which was offset by the benefit from
the utilization of the Company's net operating loss carry-forward.
Income (Loss) from Continuing Operations
As a result of the various factors discussed above, the Company recognized
$481,000 in income from continuing operations for the quarter ended December 31,
2001, compared to a ($531,000) loss from continuing operations for the quarter
ended December 31, 2000, an increase of $1,012,000 in income from continuing
operations.
Income from Discontinued Operation
Income from discontinued operation for the quarter ended December 31, 2000 was
$89,000 and resulted from gross profit of $397,000, less operating expenses and
income tax provision of $303,000 and $5,000, respectively.
Net Income (Loss)
As a result of the factors discussed above, net income increased to $481,000 for
the quarter ended December 31, 2001 from a net loss of ($442,000) for the
quarter ended December 31, 2000, an increase in net income of $923,000.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
Weighted Average Common Shares
The weighted average common shares outstanding on a diluted basis decreased by
239,362 for the quarter ended December 31, 2001 to 9,989,337 from 9,749,975 for
the quarter ended December 31, 2000. This 239,362 increase in weighted average
common shares outstanding was caused primarily by an increase in the number of
common stock shares outstanding. Although the Company recognized net income for
the quarter ended December 31, 2001, no common stock equivalents were used in
this weighted average common shares calculation, since none of these instruments
were "in-the-money" and so their inclusion in the calculation would have had an
anti-dilutive effect.
Results of Operations
Six Months Ended December 31, 2001 and 2000
Net Sales
Net sales for the six months ended December 31, 2001 were $4,304,000 compared to
$3,735,000 for the six months ended December 31, 2000, representing an increase
of $569,000 or 15%. The $569,000 increase in net sales was primarily
attributable to increases in the Company's net sales to North American
traditional software distributors and retailers of $297,000 and net sales to
North American food and drug retailers of $279,000, which net sales increases
were partially offset by a $7,000 decrease in net sales to international
customers.
The net sales increase to North American traditional software distributors and
retailers resulted largely from increased distribution through Infogrames, Inc.,
the Company's primary North American distributor that services the major
mass-merchant retailers in North America, such as Wal-Mart, K-Mart and Best Buy.
Compared to the prior year period, the Company has been able to increase both
the number of its individual software titles carried by these retail stores and
the number of total stores distributing certain Company's software titles. The
Company's management believes that by focusing its sales efforts on the North
American traditional software retail channel, rather than on the food and drug
retail channel, the Company's operational profitability may improve due to the
steadier sell-through and return rates experienced in the traditional retail
sector compared to the food and drug retail channels. Included in the net sales
to North American traditional software distributors and retailers for the six
months ended December 31, 2001 was approximately $346,000 in net sales at
customer selling prices equal to or less than the Company's carrying cost, which
were related to the Company's inventory liquidation efforts implemented during
fiscal 2002 in order to address its liquidity issues. These product sales had no
right-of-return associated with them and the Company required the customer's
payment at the time of shipment, or shortly thereafter.
The Company's net sales to North American food and drug retailers increased by
$279,000 compared to the prior year period. Although the Company has experienced
some improvement in product sell-through to the end consumer at these food and
drug retail locations, the Company has determined that it will cease
distributing PC software titles directly to these retailers during the second
half of fiscal 2002, due to the increasing demand on available working capital
resources caused largely by the costs of expensive disposable merchandising
displays; increased inventory levels that resulted from more product returns
from under-performing promotional programs at these retailers; the need to
continually revamp the Company's product offering to support these repeated
promotional programs; and the increased demand for consumer and retailer
incentives such as rebates and instant price markdowns to help support the
eventual product sell-through to the end consumer.
The Company's international net revenues, inclusive of both product net sales
and royalty revenues, for the six months ended December 31, 2001 decreased by
$7,000 compared to the prior year period. As a percentage of net sales, the
Company's international net revenues represented approximately 6% and 7% of the
Company's net sales for the six months ended December 31, 2001 and 2000,
respectively. The Company anticipates that international net revenues will range
from 5% to 10% of the Company's net sales for the remainder of fiscal 2002.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
On May 11, 2001, the Company sold its wholly-owned subsidiary "eGames Europe
Limited", located in the United Kingdom, to a non-related third-party. By
effecting this sale, the Company transitioned the majority of its international
product distribution efforts to a licensing revenue model, whereby the Company
no longer bears the working capital risk of supporting these multi-country
product sales efforts, but anticipates earning a royalty fee based upon net
product sales covered under various licensing arrangements with third-party
developers. The Company has reflected the net sales activity for this operation
as a discontinued operation for the comparable prior year period within the
Company's Statements of Operations. Net sales for the discontinued operation for
the six months ended December 31, 2000 was $1,359,000.
Net sales of the Company's products via the Internet for the six months ended
December 31, 2001 and 2000 were $107,000 and $95,000, respectively, or
approximately 2% and 3% of the Company's net sales, respectively.
Most of the Company's non-exclusive arrangements with its traditional software
distributors and retailers allow for product returns or price markdowns. During
the six months ended December 31, 2001 and 2000, the Company's provision for
product returns and price markdowns relating to product shipments to its
traditional software customers totaled approximately $525,000 and $1,087,000, or
18% and 33% of related gross shipments, respectively. This $562,000 decrease in
the provision for product returns and price markdowns largely related to
decreased distribution to certain office superstore customers that returned or
required price markdowns of the Company's products during the period a year ago
in connection with their transition away from value-priced casual gaming
software titles.
Cost of Sales
Cost of sales for the six months ended December 31, 2001 were $2,334,000
compared to $2,164,000 for the six months ended December 31, 2000, representing
an increase of $170,000 or 8%. This $170,000 increase in cost of sales was
caused primarily by increases in product costs and royalty costs of $143,000 and
$206,000, respectively, caused mostly by the increase in the Company's net sales
for the six months ended December 31, 2001 and increased developer royalty rates
for recently acquired PC software titles. These cost of sales increases were
partially offset by a $127,000 decrease in the provision for inventory
obsolescence primarily associated with a non-recurring discontinuance of various
end of lifecycle products and the scrapping of unsold, date-sensitive consumer
income tax software that had occurred in the same period a year earlier, and a
$52,000 decrease in the Company's distribution, packaging and reclamation costs
primarily associated with the Company's decreased product shipments to food and
drug retailers. Product costs consist mainly of replicated compact discs,
printed materials, protective jewel cases and boxes for certain products.
Gross Profit Margin
The Company's gross profit margin for the six months ended December 31, 2001
increased to 45.8% of net sales from 42.1% of net sales for the six months ended
December 31, 2000. This 3.7% increase in gross profit margin was caused
primarily by decreases, as a percentage of net sales, in:
o provision for inventory obsolescence of 3.9%, as a percentage of
net sales, primarily caused by a non-recurring discontinuance of
various end of lifecycle products and the scrapping of unsold
date-sensitive consumer income tax that had occurred in the same
period a year earlier;
o distribution, packaging and reclamation costs of 2.8%; and
o product costs of 0.9%.
These cost of sales decreases, as a percentage of net sales, were partially
offset by an increase, as a percentage of net sales, in developer royalty fees
for recently acquired PC software titles of 3.9%.
Operating Expenses
Product development expenses for the six months ended December 31, 2001 were
$221,000 compared to $358,000 for the six months ended December 31, 2000, a
decrease of $137,000 or 38%. This $137,000 decrease was caused primarily by a
decrease in salary and related costs due to employee layoffs effected by the
Company in July and August 2001.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
Selling, general and administrative expenses for the six months ended December
31, 2001 were $1,577,000 compared to $2,988,000 for the six months ended
December 31, 2000, a decrease of $1,411,000 or 47%. This $1,411,000 decrease was
caused primarily by decreases in:
o salary related costs of $431,000 primarily from the employee layoffs
affected by the Company in January, July and August 2001;
o marketing promotional expenses of $496,000 primarily as a result of
decreased product shipments to food and drug retailers and office
super store retailers;
o professional services costs of $105,000;
o travel costs of $86,000 due to head count reductions and the increase
concentration of the Company's customer base;
o public corporation expense of $58,000;
o litigation costs of $58,000; and
o marketing trade show costs of $52,000.
As a result of the Company's recent liquidity issues, during fiscal 2002 the
Company has attempted to achieve cost reductions in all aspects of its
operations, in order to improve its ongoing viability as a going concern. The
Company plans to continue to look for additional cost reduction opportunities
throughout fiscal 2002.
Interest Expense, Net
Net interest expense for the six months ended December 31, 2001 was $73,000
compared to $31,000 for the six months ended December 31, 2000, an increase of
$42,000. The $42,000 increase was primarily due to the increase in bank debt
outstanding during the six months ended December 31, 2001 compared to the same
period a year earlier.
Provision (Benefit) for Income Taxes
Provision for income taxes for the six months ended December 31, 2001 was $1,000
compared to a benefit for income taxes of $12,000 for the six months ended
December 31, 2000, a decrease in the benefit for income taxes of $13,000.
Income (Loss) from Continuing Operations
As a result of the various factors discussed above, the Company recognized
$98,000 in income from continuing operations for the six months ended December
31, 2001, compared to a ($1,794,000) loss from continuing operations for the six
months ended December 31, 2000, an increase of $1,892,000 in income from
continuing operations.
Income from Discontinued Operation
Income from discontinued operation for the six months ended December 31, 2000
was $68,000 and resulted from $695,000 in gross profit and $20,000 in income tax
benefit, which were reduced by $647,000 in operating expenses.
Net Income (Loss)
As a result of the factors discussed above, net income increased to $98,000 for
the six months ended December 31, 2001 from a net loss of ($1,726,000) for the
six months ended December 31, 2000, an increase of $1,824,000 in net income.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
Weighted Average Common Shares
The weighted average common shares outstanding on a diluted basis decreased by
239,362 for the six months ended December 31, 2001 to 9,989,337 from 9,749,975
for the six months ended December 31, 2000. This 239,362 increase in weighted
average common shares outstanding was caused primarily by an increase in the
number of common stock shares outstanding. Although the Company recognized net
income for the six months ended December 31, 2001, no common stock equivalents
were used in this weighted average common shares calculation, since none of
these instruments were "in-the-money" and so their inclusion in the calculation
would have had an anti-dilutive effect.
Subsequent Event
In February 2002, the Company entered into an agreement with one of its major
drug store retailers that provided for a mutual release of each party's past
obligations relating to any and all prior business transactions. This agreement
eliminates this retailer's right to make any further product returns of the
Company's products that had not yet been reported by this retailer as being sold
through to the end customer, thereby releasing the Company from any future
obligation as it relates to the portion of the Customer Advance Payments (see
Note 1) associated with this retailer. As a result, the Company will now be able
to recognize the gross profit of approximately $1,000,000 on the Customer
Advance Payments for product shipments not previously recognized as revenue,
since such products had not been reported by this retailer as being sold through
to the end consumer. This transaction will be recognized in the third quarter
ending March 31,2002.
Liquidity and Capital Resources
As of December 31, 2001, the Company's cash and working capital deficit balances
were $635,000 and $1,705,000, respectively, and the Company's total
stockholders' deficit balance at December 31, 2001 was $2,017,000.
Net cash provided by (used in) operating activities was $850,000 and
($1,806,000) for the six months ended December 31, 2001 and 2000, respectively.
The $850,000 in net cash provided by operating activities resulted primarily
from cash sources of: decreases in inventory and restricted cash of $1,142,000
and $30,000, respectively, and an increase in accrued expenses of $1,097,000,
which cash sources were partially offset by cash uses of: decreases in accounts
payable and customer advance payments of $1,024,000 and $124,000, respectively,
in addition to increases in accounts receivable and prepaid expenses of $821,000
and $82,000, respectively. Additionally, the Company recorded approximately
$534,000 in non-cash adjustments to its $98,000 in net income for the six months
ended December 31, 2001.
Net cash used in investing activities for the six months ended December 31, 2001
and 2000 were $21,000 and $42,000, respectively. The $21,000 in net cash used in
investing activities resulted from purchases of $20,000 in furniture and
equipment and $1,000 in other assets.
Net cash (used in) provided by financing activities for the six months ended
December 31, 2001 and 2000 were ($219,000) and $867,000, respectively. The
($219,000) in net cash used in financing activities reflects net proceeds from
the Company's borrowing of $280,000 of bank debt and $60,000 in proceeds from a
note receivable, which were partially offset by repayments of the borrowing of
bank debt, trade notes payable, note payable and capital lease obligations of
$240,000, $198,000, $31,000 and $90,000, respectively.
Net cash used in the Company's discontinued operation for the six months ended
December 31, 2000 was $92,000. The $92,000 in net cash used in the Company's
discontinued operation resulted primarily from $90,000 in net cash used in
operating activities.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
As December 31, 2001, the Company had received $3,021,000 in customer payments
from certain food and drug retailers for products shipped to such retailers
prior to the sale of such products to the end consumer being reported to the
Company by these retailers. These payments are recorded as customer advance
payments in the Company's Balance Sheet until such time that these retailers
report to the Company that the products are actually sold to the end consumer.
After the products are sold through to the end consumer, the customer advance
payment amount is recorded as product revenue. In the event that the Company
receives customer advance payments that ultimately exceed the actual product
sell-through of the Company's products to the end consumer at such retailers,
the Company would owe these retailers such excess amounts. The Company's
management believes that it is highly likely that the ultimate product
sell-through of the Company's products will be substantially less than the
customer advance payment balances for these food and drug retailers. If these
retailers request that the Company repay this liability, it would likely result
in a serious liquidity issue for the Company.
On August 9, 2000, the Company entered into a $2,000,000 revolving credit
facility with Fleet Bank (formerly Summit Bank). The credit facility was
established to provide, among other things, working capital to support the
Company's operations. Amounts outstanding under this credit facility were
charged interest at one-half of one percent above the bank's current prime rate,
with interest due monthly, and was collateralized by substantially all of the
Company's assets. The credit facility required the Company, among other things,
to maintain certain financial ratios, such as: a minimum working capital balance
of $1,500,000 and a maximum senior debt to effective net worth ratio of 1.50 to
1.00. Additionally, this credit facility had a minimum effective net worth
covenant that started at $3,100,000 at June 30, 2000 and increased by $150,000
quarterly to a $3,700,000 requirement at June 30, 2001. As of June 30, 2001, the
Company was not in compliance with those covenants.
On July 23, 2001, Fleet Bank notified the Company that due to the Company's
default of the financial covenants under its credit facility as of June 30,
2001, and material adverse changes in the Company's financial condition, the
bank would no longer continue to fund the Company's $2,000,000 credit facility.
On November 2, 2001 the Company and Fleet Bank, entered into an agreement to pay
off the outstanding balance of $1,400,000 owed to Fleet Bank over a twenty-two
month period. The agreement also provides that, despite the Company's defaults
under the loan documents, Fleet Bank will not enforce its rights and remedies
under those loan documents as long as the Company remains in compliance with the
terms of the agreement. The Company's shareholders would face a total loss of
their investment if such an asset liquidation were to occur. The terms of the
agreement include, among other things, that the remaining outstanding balance
owed under the credit facility will be repaid in 22 monthly installments, with
interest at the prime rate plus three percent. As of March 28, 2002, the Company
had made 6 of these 22 monthly payments to Fleet Bank. The terms of the
agreement also require the Company to achieve certain earnings benchmarks and to
provide Fleet Bank with periodic financial and cash flow reporting. This loan
has been classified "bank debt" within the Company's Balance Sheet. As part of
the agreement, the Company issued warrants to Fleet Bank for the purchase of
750,000 shares of the Company's Common Stock. The warrants are exercisable until
October 31, 2006 at an exercise price of $0.09 per share, and a separate
registration rights agreement provides that the bank will have demand
registration rights beginning on November 1, 2002. As of December 31, 2001 and
March 28, 2002, the principal balances outstanding on this term loan
were $1,240,000 and $1,060,000, respectively.
The Company's ability to achieve and maintain positive cash flow depends upon a
variety of factors, including the timeliness and success of the collection of
outstanding accounts receivable, the creditworthiness of the primary
distributors and retail customers of the Company's products, the continuing
retail demand for value-priced PC game software, the development and
sell-through of the Company's products, the costs of developing, producing and
marketing such products, and various other factors, some of which are beyond the
Company's control. In the future, the Company expects its cash and working
capital requirements to be affected by each of these factors. There can be no
assurances that the Company will be able to achieve and maintain a positive cash
flow or that additional financing will be available if and when required or, if
available, will be on terms satisfactory to the Company.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
Effective April 2, 2001, the Company's common stock began trading on the OTC
Bulletin Board ("OTC BB") under the symbol EGAM. The Company's common stock had
previously traded on the Nasdaq SmallCap Market under the symbol EGAM. On March
15, 2002, the Company's common stock was no longer eligible to be traded on the
OTC BB because the Company was not current with its reporting requirements under
the Securities Exchange Act of 1934, as amended (the "'34 Act"). The Company is
currently working towards becoming current with its '34 Act filings by the end
of March 2002, and once current, will seek to have its common stock sponsored
for trading on the OTC BB.
New Accounting Pronouncements
The Company does not expect any recently issued accounting pronouncements to
have a significant impact on its results of operations, financial position or
cash flows.
FACTORS AFFECTING FUTURE PERFORMANCE
This report contains certain forward-looking statements involving risks and
uncertainties that could cause actual results to differ materially from those
anticipated, including, but without limitation: economic and competitive
conditions in the software business affecting the demand for the Company's
products; the rate of return of the Company's products from its customers; the
Company's need for additional funds; the ability to hire and retain key
management personnel to manage anticipated growth; the development, market
acceptance and timing of new products; access to distribution channels; and the
renewal of licenses for key software products. Investors in the Company should
consider those factors and the factors discussed below. All forward-looking
statements are necessarily speculative and there are numerous risks and
uncertainties that could cause actual events or results to differ materially
from those referred to in such forward-looking statements. The discussion below
highlights some of the more important risks identified by management, but should
not be assumed to be the only factors that could affect future performance.
Risk Factors
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The Company Sustained Significant Losses During Fiscal 2001. The Company
commenced operations in July 1992. The Company experienced significant losses
from inception through the end of fiscal 1997. Fiscal year 1998 was the first
year that the Company earned a profit. The Company earned approximately
$253,000, $463,000 and $1,253,000 in fiscal 2000, 1999 and 1998, respectively,
and in fiscal 2001 the Company sustained a net loss of approximately $5,933,000.
The accumulated deficit for the Company at June 30, 2001 was approximately
$11,949,000. Prior to fiscal 1998, the Company's operations were funded
primarily through proceeds from the Company's initial public offering of Common
Stock in October 1995 and through the sale in private offerings of preferred
stock and Common Stock warrants in November 1996 and in January and April 1997.
Subsequently, the Company has funded its activities mainly through operations
and bank borrowings. Given current market conditions in the entertainment
software industry and the economy in general, and the Company's financial
performance in fiscal 2001, there can be no assurance that the Company will be
able to return to a sustainable profitability in fiscal 2002. The Company's
operations today continue to be subject to all of the risks inherent in the
operation of a small business which has liquidity problems in a highly
competitive industry dominated by larger competitors, including, but not limited
to, development, distribution and marketing difficulties, competition and
unanticipated costs and expenses. The Company's future success will depend upon
its ability to return to profitability in the development, marketing and
distribution of its current and future software products.
The Company May Not Be Able to Maintain Liquidity. On July 23, 2001, the Company
was notified by its commercial lender, Fleet Bank, that due to the Company's
default of the financial covenants under its $2,000,000 credit facility as of
June 30, 2001, and due to material adverse changes in the Company's financial
condition, the bank had determined that it would no longer continue to fund the
Company's credit facility. Subsequently, the Company worked with Fleet Bank and
its advisors on an analysis of Fleet Bank's collateral position, management's
restructuring and cost reduction plans, and the results of an independent
business assessment of the Company and its business plan. These actions provided
the basis for a turnaround plan that was presented to Fleet Bank culminating in
an agreement providing for an amortizing term loan of the existing balance owed
to Fleet Bank.
On November 2, 2001, the Company and Fleet Bank entered into an agreement to pay
off the outstanding balance of $1,400,000 owed to Fleet Bank over a twenty-two
month period. The agreement also provides that, despite the Company's defaults
under the loan documents, Fleet Bank will not enforce its rights and remedies
under those loan documents as long as the Company remains in compliance with the
terms of the agreement. The Company's shareholders would face a total loss of
their investment if the Company were to default under the agreement and Fleet
Bank enforced its right to liquidate the Company. The terms of the agreement
provide, among other things, that the remaining outstanding balance owed under
the credit facility will be repaid in 22 monthly installments, with interest at
the prime rate plus three percent. Additionally, the terms of the agreement
require the Company to achieve certain earnings benchmarks and to provide Fleet
Bank with periodic financial and cash flow reporting. It is uncertain that the
Company will be able to meet this agreement's covenants through June 30, 2002.
As part of the agreement, the Company issued warrants to Fleet Bank for the
purchase of 750,000 shares of the Company's Common Stock. The warrants are
exercisable until October 31, 2006 at an exercise price of $0.09 per share, and
a separate registration rights agreement provides that the bank will have demand
registration rights beginning on November 1, 2002. As of December 31, 2001, the
principal balance outstanding on this term loan was $1,240,000.
Risk Factors (continued)
- ------------------------
Since the Company no longer has access to a credit facility, its ability to
continue operations requires the Company to generate sufficient cash from
operations to fund itself. Given fluctuations in cash flows historically
experienced by the Company, as well as the $5,933,000 net loss sustained by the
Company in fiscal 2001, there can be no assurance that the Company will be able
to do this.
The Company May Need Additional Funds. The Company's future capital requirements
will depend on many factors, but particularly on cash flow from sales of the
Company's products and access to capital in lieu of the $2,000,000 credit
facility that is no longer available. If the Company is not able to achieve cash
flow from operations at a level sufficient to support its business, the Company
may require additional funds to sustain its product development, marketing and
sales activities. The degree to which the Company is indebted to its commercial
lender, and the first lien that the bank has with respect to all of the
Company's assets, could adversely affect the Company's ability to obtain
additional financing and could make the Company more vulnerable to industry
downturns and competitive pressures. Additionally, the Company may only be able
to raise needed funds on terms that would result in significant dilution or
otherwise be unfavorable to existing shareholders. If the Company is unable to
secure additional funding, or if the Company is unable to obtain adequate funds
from operations or other external sources when required, the Company's inability
to do so would have a material adverse effect on the long-term viability of the
Company.
Dependence On Distributors And Retailers. Many of the largest mass-market
retailers have established exclusive buying relationships under which such
retailers will buy consumer entertainment software only from certain
distributors. In such instances, the Company will not be able to sell its
products to such mass-market retailers if these distributors are unwilling to
distribute the Company's products. Additionally, even if the distributors are
willing to purchase the Company's products, the distributor is frequently able
to dictate the price, timing and other terms on which the Company sells to such
retailers, or the Company may be unable to sell to such retailers on terms that
the Company deems acceptable. The inability of the Company to negotiate
commercially viable distribution relationships with these and other
distributors, or the loss of, or significant reduction in sales attributable to,
any of the Company's principal distributors or retailers would adversely affect
the Company's business, operating results and financial condition.
A Significant Part of the Company's Sales Come From a Limited Number of
Customers. Net sales to the Company's three largest customers accounted for
approximately 63% of the Company's net sales for the quarter ended December 31,
2001, or 31%, 21% and 11% respectively. Net sales to the Company's three largest
customers accounted for approximately 59% of the Company's net sales for the six
months ended December 31, 2001, or 28%, 22% and 9% respectively.
These customers may terminate their relationship with the Company at any time.
The loss of the Company's relationships with its principal customers or a
decline in sales to its principal customers would harm the Company's operating
results.
Risk of Customer Business Failure. Distributors and retailers in the computer
industry and in mass-market retail channels have from time to time experienced
significant fluctuations in their businesses and there have been a number of
business failures among these entities. These business failures have increased
and may continue to increase as a result of recent economic conditions in the
United States. The insolvency or business failure of any significant retailer or
distributor of the Company's products would have a material adverse effect on
the Company's business, operating results and financial condition. Sales are
typically made on credit, with terms that vary depending upon the customer and
the nature of the product. The Company does not hold collateral to secure
payment. The Company maintains allowances for uncollected receivables that it
believes to be adequate, but the actual allowance maintained may not be
sufficient. The failure to pay an outstanding receivable by a significant
customer or distributor would have a material adverse effect on the Company's
business, operating results and financial condition.
Risk Factors (continued)
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Adverse Effect of Product Returns and Markdown Allowances. The Company is
exposed to product returns and markdown allowances with respect to the Company's
customers. The Company establishes allowances for future product returns at the
time of sale for its traditional software retail customers and distributors
servicing such retailers, based on historical return rates in the retail
channels in which the Company's products are sold, and the Company's sales are
reported net of returns. The Company may also accept product returns in order to
maintain its relationships with retailers and its access to distribution
channels. Actual product returns and pricing concessions could exceed the
Company's anticipated amounts, which could impact the Company's results of
operations.
Customer Advance Payments. Payments received primarily from certain food and
drug retailers for products shipped to such retailers prior to the sale of the
Company's products to the end customer may exceed the actual product
sell-through of the Company's products at such retailers. The Company's
management believes that it is highly likely that the ultimate product
sell-through of the Company's products will be substantially less than the
customer advance payment balances for these food and drug retailers. In such
event, the Company would owe these retailers such excess amounts, and such
obligation would likely result in a serious liquidity issue for the Company.
Fluctuations in Quarterly Results; Uncertainty of Future Operating Results;
Seasonality. The Company's quarterly operating results have varied significantly
in the past and will likely vary significantly in the future depending on
numerous factors, many of which are not under the Company's control. Future
operating results will depend upon many factors including:
o the size and rate of growth of the consumer entertainment software
market;
o the demand for the Company's products, particularly value-priced,
casual PC games;
o the level of product and price competition;
o the level of product returns;
o seasonality of customer buying patterns;
o the timing of new product introductions and product enhancements by the
Company and its competitors;
o the timing of orders from major customers;
o delays in shipment of products;
o access to distribution channels;
o product defects and other quality problems;
o product life cycles;
o levels of international royalty and licensing net revenues; and
o the ability of the Company to develop and market new products and
control costs.
Products are usually shipped within days following the receipt of customer
orders so the Company typically operates with little or no backlog. Therefore,
net sales in any quarter are usually dependent on orders booked, shipped and
received by the Company's customers during that quarter for most traditional
software customers and on actual product sell-through to end consumers relating
to product shipments to food and drug retailers.
The consumer entertainment software industry is highly seasonal, with sales
typically higher during the fourth and first calendar quarters (second and third
fiscal quarters for the Company), due primarily to increased demand for games
during and immediately following the holiday buying season. Therefore, net sales
and operating results for any future quarter are not predictable with any
significant degree of accuracy. Consequently, the Company believes that
period-to-period comparisons of its operating results are not necessarily
meaningful and should not be relied upon as indications of future performance.
Risk Factors (continued)
- ------------------------
The Consumer Entertainment Software Market is Highly Competitive and Changes
Rapidly. The market for consumer entertainment software is highly competitive,
particularly at the retail shelf level where a constantly increasing number of
software titles are competing for the same amount of shelf space. Retailers have
a limited amount of shelf space on which to display consumer entertainment
software products. Therefore, there is intense competition among consumer
entertainment software publishers for adequate levels of shelf space and
promotional support from retailers. As the number of software titles continues
to increase, the competition for shelf space continues to intensify, resulting
in greater leverage for retailers and distributors in negotiating terms of sale,
including price discounts and product return policies. The Company's products
represent a relatively small percentage of any retailer's sales volume, and
there can be no assurance that retailers will continue to purchase the Company's
products or promote the Company's products with adequate levels of shelf space
and promotional support. Most of the Company's competitors have substantially
greater sales, marketing, development and financial resources.
Increased competition for quality third-party software content has compelled the
Company to agree to make advance royalty payments and, in some cases, to
guarantee minimum royalty payments to content licensors and game developers. If
the products subject to these advances and minimums do not generate sufficient
sales volumes to recover these costs, this could cause material harm to the
Company's business and financial results.
Moreover, the Company's present or future competitors may be able to develop
products, which are comparable or superior to those offered by the Company,
offer lower priced products or adapt more quickly than the Company to new
technologies or evolving customer requirements. The Company's competitors also
have more financial resources to spend on marketing promotions and advertising
efforts. Competition is expected to intensify. In order to be successful in the
future, the Company must be able to respond to technological change, customer
requirements and competitors' current products and innovations. There can be no
assurance that the Company will be able to compete effectively in its market or
that future competition will not have a material adverse effect on its business
operating results and financial condition.
Uncertainty of Market Acceptance; Short Product Life Cycles. The market for
consumer entertainment software has been characterized by shifts in consumer
preferences and short product life cycles. Consumer preferences for
entertainment software products are difficult to predict and few products
achieve sustained market acceptance. There can be no assurance that new products
introduced by the Company will achieve any significant degree of market
acceptance, that such acceptance will be sustained for any significant period,
or that product life cycles will be sufficient to permit the Company to recover
development, marketing and other associated costs. In addition, if market
acceptance is not achieved, the Company could be forced to accept substantial
product returns to maintain its relationships with distributors and retailers
and its access to distribution channels. Failure of new products to achieve or
sustain market acceptance or product returns in excess of the Company's
expectations would have a material adverse effect on the Company's business,
operating results and financial condition.
Rapid Technological Change; Product Development. Frequent new product
introductions and enhancements, rapid technological developments, evolving
industry standards and swift changes in customer requirements characterize the
market for the Company's products. The Company's continued success depends upon
its ability to continue to quickly and efficiently develop and introduce new
products and enhance existing products to incorporate technological advances and
responses to customer requirements. If any of the Company's competitors
introduce products more quickly than the Company, or if they introduce better
products, the Company's business could be adversely affected. There is also no
assurance that the Company will be successful in developing and marketing new
products or enhancements to its existing products on a timely basis or that any
new or enhanced products will adequately address the changing needs of the
marketplace. From time to time, the Company or its competitors may announce new
products, capabilities or technologies that have the potential to replace or
shorten the life cycles of the Company's existing products. There can be no
assurance that announcements of currently planned or other new products by
competitors will not cause customers to delay their purchasing decisions in
anticipation of such products, which could have a material adverse effect on the
Company's business, liquidity and operating results.
Risk Factors (continued)
- ------------------------
The Company's Stock is Currently Not Eligible to be Traded on the OTC Bulletin
Board. On April 2, 2001, the Company's common stock was de-listed from the
Nasdaq SmallCap Market as a result of the Company's failure to maintain a
minimum bid price of $1.00 over a period of 30 consecutive trading days, and its
stock then began trading on the OTC Bulletin Board under its existing symbol
EGAM. On March 15, 2002, the Company's common stock was no longer eligible to be
traded on the OTC Bulletin Board because the Company was not current with its
reporting requirements under the Securities Exchange Act of 1934, as amended
(the "'34 Act"). The Company is currently working towards becoming current with
its '34 Act filings by the end of March 2002, and once current, would seek to
have its common stock sponsored for trading on the OTC BB. However, there can be
no assurance that the Company will be successful in having its stock traded on
the OTC Bulletin Board. Even if the Company is successful in doing so, the OTC
Bulletin Board has experienced extreme price and trading volume fluctuations.
These fluctuations have often been unrelated or disproportionate to the
operating performance of individual companies. These broad market fluctuations
may materially adversely affect the Company's stock price, regardless of the
Company's operating results. Additionally, many stocks traded on the OTC
Bulletin Board are thinly traded, which would make it difficult to sell the
Company's stock.
Risks Related to Added Product Features and Increased Regulation of the Internet
and Advertising. Due to the competitive environment in the consumer
entertainment software industry, the Company has and will continue to seek to
incorporate features into its products, such as an Internet browser interface
and advertising technology, in order to differentiate its products to retailers,
provide value-added features to consumers, and to potentially create new revenue
streams based on advertising and promotional opportunities. There can be no
assurance that such features will enhance the product's value, and in fact such
features may detract from a product's value if they are not accepted in the
marketplace or if new regulations governing the Internet and related
technologies are enacted which impact these features.
Difficulty in Protecting the Company's Intellectual Property Rights. The Company
either owns or has obtained licenses to the rights to copyrights on the
products, manuals, advertising and other materials owned by it. The Company also
holds trademark rights in the Company's name and logo, and the names of the
products owned or licensed by the Company. The Company's success depends in part
on its ability to protect its proprietary rights to the trademarks, trade names
and content used in its principal products. The Company relies on a combination
of copyrights, trademarks, trade secrets, confidentiality procedures and
contractual provisions to protect its proprietary rights. These initiatives to
protect the Company's proprietary rights require the Company to utilize internal
resources as well as outside legal counsel. There can be no assurance that the
Company will have sufficient resources to adequately protect its intellectual
property rights, nor can there be any assurance that the Company's existing or
future copyrights, trademarks, trade secrets or other intellectual property
rights will be of sufficient scope or strength to provide meaningful protection
or commercial advantage to the Company. Also, in selling certain of its
products, the Company relies on "shrink wrap" licenses that are not signed by
licensees and, therefore, may be unenforceable under the laws of certain
jurisdictions. In addition, the laws of some foreign countries do not protect
the Company's proprietary rights, as do the laws of the United States. If the
Company is not able to sufficiently protect its intellectual property rights,
this would have a material adverse effect on the Company's business and
operating results.
Substantial Expenses and Resources Can Be Used to Defend Infringement Claims;
Effects of Settlements are Uncertain. The Company may from time to time be
notified that it is infringing on the intellectual property rights of others.
Combinations of content acquired through past or future acquisitions and content
licensed from third party developers will create new products and technology
that may give rise to claims of infringement. In recent years, the Company has
incurred significant defense costs and utilized internal resources in defending
trademark and copyright claims and lawsuits. There can be no assurance that
other third parties will not initiate infringement actions against the Company
in the future. Any future claims could result in substantial cost to and
diversion of resources of the Company. If the Company is found to be infringing
the rights of others, no assurance can be given that licenses would be
obtainable on acceptable terms or at all, that significant damages for past
infringement would not be assessed, or that further litigation relative to any
such licenses or usage would not occur. The failure to obtain necessary licenses
or other rights, or the commencement of litigation arising out of any such
claims, could have a material adverse effect on the Company's operating results.
Risk Factors (continued)
- ------------------------
Risks Inherent in the Consumer Entertainment Software Business. The development
of multimedia software products, which can combine text, sound, high quality
graphics, images and video, is difficult and time consuming, requiring the
coordinated participation of various technical and marketing personnel and
outside developers. Some of the factors that could affect the Company's future
success include, but are not limited to, the ability of the Company to generate
sufficient funds from operations or find other financing sources to obtain
quality product content; to overcome problems and delays in product development;
and to successfully implement the Company's sales, distribution and marketing
strategy. There can be no assurance the Company will be successful in
maintaining and expanding a sustainable consumer entertainment software
business.
Risk of Defects. Products offered by the Company can contain errors or defects.
The PC hardware environment is characterized by a wide variety of non-standard
peripherals, such as sound and graphics cards, and configurations that make
pre-release testing for programming or compatibility errors difficult and
time-consuming. Despite the extensive testing performed by the Company's quality
assurance personnel, new products or releases may contain errors discovered
after shipments have commenced, resulting in a loss of or delay in market
acceptance, which could have a material adverse effect on the Company's
business, operating results and financial condition.
Dependence on Key Management and Technical Personnel. The Company's success
depends to a significant degree upon the continued contributions of its key
management, marketing, technical and operational personnel, including members of
senior management. The loss of the services of one or more key employees could
have a material adverse effect on the Company's operating results. The Company
also believes its future success will depend in large part upon its ability to
attract and retain highly skilled management, technical, marketing, product
development and operational personnel. Competition for such personnel is
intense, and there can be no assurance that the Company will be successful in
attracting and retaining such personnel.
International Sales. International net revenues, inclusive of both product net
sales and royalty revenues, represented 6% of the Company's net sales for the
quarter and six months ended December 31, 2001. The Company anticipates that
international net revenues may account for approximately 5% to 10% of the
Company's net sales for the year ending June 30, 2002. For fiscal 2002, the
Company's international business will be transacted primarily through
third-party licensees and will continue to be subject to risks that its domestic
business is not, including: varying regulatory requirements; tariffs and trade
barriers; political and economic instability; reduced protection for
intellectual property rights in certain countries; difficulties in supporting
foreign customers; difficulties in managing foreign distributors; potentially
adverse tax consequences; the burden of complying with a wide variety of complex
operations; customs, foreign laws, regulations and treaties; fluctuating
currency valuations; and the possibility of difficulties in collecting accounts
receivable.
Part II. Other Information
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit No. Description of Exhibit
----------- ----------------------
None.
(b) Reports on Form 8-K
On February 28, 2002, the Company filed a report on Form 8-K regarding the
Company having received notice from its independent auditor, KPMG LLP ("KPMG"),
of its resignation as the Company's certifying accountant.
On March 8, 2002, the Company filed a report on Form 8-K regarding it's Audit
Committee approval of Stockton Bates, LLP ("Stockton Bates") as the Company's
principal accountant to audit the Company's financial statements for the fiscal
year ending June 30, 2002 and to review the Company's interim financial
statements.
On March 12, 2002, the Company filed a report on Form 8-K regarding a press
release announcing the anticipated dates by which the Company would file amended
Forms 10-QSB for the quarters ended September 30, 2000, December 31, 2000 and
March 31, 2001, as well as Forms 10-QSB for the quarters ended September 30,
2001 and December 31, 2001.
SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
eGames, Inc.
(Registrant)
Date: March 29, 2002 /s/ Gerald W. Klein
-------------- --------------------
Gerald W. Klein, President, Chief
Executive Officer and Director
Date: March 29, 2002 /s/ Thomas W. Murphy
-------------- --------------------
Thomas W. Murphy, Chief Financial
Officer and Chief Accounting Officer