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 March 31, 2002
|_| 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 (X) No ( )
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 May 3, 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 March 31, 2002....................... 3
Statements of Operations for the three and nine months
ended March 31, 2002 and 2001 ....................... 4
Statements of Cash Flows for the nine months
ended March 31, 2002 and 2001....................... 5
Notes to Financial Statements............................ 6-10
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations ................. 11-24
Risk Factors............................................. 24-29
Part II Other Information
Item 4. Submission of Matters to a Vote of Security Holders...... 30
Item 6. Exhibits and Reports on Form 8-K......................... 30-32
Exhibit Index ......................................................... 30-32
Signatures ......................................................... 33
Exhibits ......................................................... 34-35
Item 1. Financial Statements
eGames, Inc.
Balance Sheet
(Unaudited)
As of
March 31,
ASSETS 2002
- ------ -------------
Current assets:
Cash and cash equivalents $ 292,523
Accounts receivable, net of allowances totaling $1,227,508 1,030,843
Inventory 1,000,729
Prepaid royalties and other expenses 179,802
Note receivable 20,000
------------
Total current assets 2,523,897
Furniture and equipment, net 89,009
Intangibles and other assets, net 12,011
------------
Total assets $ 2,624,917
============
LIABILITIES AND STOCKHOLDERS' DEFICIT
- -------------------------------------
Current liabilities:
Note payable $ 67,126
Accounts payable 220,598
Customer advance payments 806,168
Bank debt 820,000
Accrued expenses 1,555,311
Trade note payable 15,301
------------
Total current liabilities 3,484,504
Bank debt, net of current portion 240,000
Note payable, net of current portion 5,774
------------
Total liabilities 3,730,278
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 (10,939,250)
Treasury stock, at cost - 231,900 shares (501,417)
------------
Total stockholders' deficit (1,105,361)
------------
Total liabilities and stockholders' deficit $ 2,624,917
============
See accompanying notes to the financial statements.
eGames, Inc.
Statements of Operations
(Unaudited)
Three Months ended Nine Months ended
March 31, March 31,
------------------------- -------------------------
2002 2001 2002 2001
------------------------- -------------------------
Net sales $ 3,626,289 $ 2,691,479 $ 7,929,936 $ 6,426,806
Cost of sales 1,910,678 1,721,775 4,244,652 3,885,967
------------------------- -------------------------
Gross profit 1,715,611 969,704 3,685,284 2,540,839
Operating expenses:
Product development 91,987 194,973 312,559 552,445
Selling, general and administrative 680,806 1,435,967 2,258,282 4,424,350
------------------------- -------------------------
Total operating expenses 772,793 1,630,940 2,570,841 4,976,795
------------------------- -------------------------
Operating income (loss) 942,818 (661,236) 1,114,443 (2,435,956)
Interest expense, net 31,416 33,376 104,159 64,099
------------------------- -------------------------
Income (loss) from continuing operations before
income taxes 911,402 (694,612) 1,010,284 (2,500,055)
Provision (benefit) for income taxes - 0 - (27,307) 800 (39,099)
------------------------- -------------------------
Income (loss) from continuing operations 911,402 (667,305) 1,009,484 (2,460,956)
Loss from discontinued operation (Note 4) - 0 - (100,822) - 0 - (33,166)
------------------------- -------------------------
Net income (loss) $ 911,402 ($ 768,127) $ 1,009,484 ($2,494,122)
=========== =========== =========== ===========
Net income (loss) per common share:
- Basic $ 0.09 ($ 0.08) $ 0.10 ($ 0.26)
=========== =========== =========== ===========
- Diluted $ 0.09 ($ 0.08) $ 0.10 ($ 0.26)
=========== =========== =========== ===========
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)
Nine months ended
March 31,
--------------------------
2002 2001
----------- -----------
Cash flows from operating activities:
Net income (loss) $ 1,009,484 ($2,494,122)
Adjustment to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Depreciation, amortization and other non-cash items 111,639 176,912
Provision for sales returns, price markdowns and bad debt 811,936 1,984,618
Provision for inventory obsolescence 248,238 225,917
Sell-through of prior year customer advance payments (1,636,503) - 0 -
Loss from discontinued operation - 0 - 33,166
Changes in items affecting operations:
Restricted cash 30,000 - 0 -
Accounts receivable (297,902) (2,238,484)
Prepaid royalties and other expenses 80,381 (318,070)
Inventory 2,318,887 (1,590,097)
Accounts payable (1,528,177) 378,863
Customer advance payments (1,042,742) 1,576,670
Accrued expenses 846,025 339,469
----------- -----------
Net cash provided by (used in) operating activities 951,266 (1,925,158)
----------- -----------
Cash flows from investing activities:
Purchase of furniture and equipment (27,341) (37,916)
Purchase of software rights and other assets (1,375) (4,980)
----------- -----------
Net cash (used in) investing activities (28,716) (42,896)
----------- -----------
Cash flows from financing activities:
Proceeds from credit facility/bank debt 280,000 3,650,000
Repayments of credit facility/bank debt (420,000) (2,650,000)
Proceeds from note receivable 90,000 - 0 -
Repayments of trade notes payable (468,779) - 0 -
Repayments of convertible subordinated debt - 0 - (150,000)
Repayments of note payable (46,801) (40,641)
Repayments of capital lease obligations (90,184) (82,324)
----------- -----------
Net cash (used in) provided by financing activities (655,764) 727,035
Effect of exchange rate changes on cash and cash equivalents - 0 - (12,099)
Net cash provided by discontinued operation - 0 - 229,921
----------- -----------
Net increase (decrease) in cash and cash equivalents 266,786 (1,023,197)
Cash and cash equivalents:
Beginning of period 25,737 1,139,178
----------- -----------
End of period $ 292,523 $ 115,981
=========== ===========
Supplemental cash flow information:
Cash paid for interest $ 108,321 $ 76,458
=========== ===========
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 - $ 294,921
=========== ===========
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. Dollar amounts discussed
within the Company's "Notes to Financial Statements" have been rounded to the
nearest thousand ('000).
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 determined that it does not have the ability to make reliable
estimates of product returns for shipments to drug store 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". This determination was made based
upon receipt of delayed reporting of sell-through results from its drug store
retailers, which have not historically sold consumer entertainment PC software
products. Accordingly, the Company's revenues associated with product shipments
to drug store 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 drug store 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 provision for
anticipated product returns based upon, among other factors: historical product
return results, analysis of customer provided product sell-through and field
inventory data when available to the Company, and review of outstanding return
material authorizations ("RMA's"). 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 that have
traditionally 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
entertainment PC software products, the Company records an allowance for product
returns and price markdowns as a reduction of gross sales at the time title of
the products passes to the customer. At the end of each reporting period, the
remaining balance of this allowance is reflected as a reduction of accounts
receivable balance within the Company's Balance Sheet.
During the quarters ended March 31, 2002 and 2001, the Company's provisions for
product returns and price markdowns for customers that have traditionally sold
consumer PC software products were $132,000 and $382,000, or 9% and 24% of
related gross product shipments, respectively. During the nine months ended
March 31, 2002 and 2001, the Company's provisions for product returns and price
markdowns for customers that have traditionally sold consumer PC software
products were $657,000 and $1,469,000 or 15% and 30% of related gross product
shipments, respectively. During fiscal 2002, the Company has experienced
improved sell-through of its products being distributed to a more concentrated
group of retail customers that have historically sold the Company's consumer
entertainment PC software products successfully, while increasing the number of
retail placement slots for the Company's products at these retail locations.
Customer Advance Payments
Although the Company recognizes revenue from drug store 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 drug store retailers in advance of
such products being sold to the end consumer. As of March 31, 2002, the Company
had received $806,000 in net customer payments from certain drug store 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 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.
During the Company's fiscal 2002 third quarter, the customer advance payments
balance was significantly reduced as a result of the Company's agreement with
one of its drug store retailers, as discussed in the Management's Discussion and
Analysis of Financial Condition and Results of Operations. Additionally, the
agreement discussed in Note 8 "Subsequent Event" will impact the customer
advance account during the Company's fiscal 2002 fourth quarter.
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.
Notes to Financial Statements (continued)
Marketing and Sales Incentive Costs
Marketing costs the Company pays its resellers, such as advertising fees, are
charged to expense as incurred and were $29,000 and $295,000 for the quarters
ended March 31, 2002 and 2001, respectively and were $305,000 and $1,067,000 for
the nine months ended March 31, 2002 and 2001, 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 $13,000 and $172,000 for the quarters March 31, 2002 and 2001, respectively
and were $187,000 and $485,000 for the nine months ended March 31, 2002 and
2001, respectively.
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 Nine Months Ended
March 31, March 31,
--------------------- -------------------------
2002 2001 2002 2001
--------- ---------- ----------- ------------
Net income (loss) $ 911,000 ($ 768,000) $ 1,009,000 ($ 2,494,000)
Other comprehensive income (loss):
Foreign currency translation adjustment - 0 - (19,000) - 0 - (5,000)
--------- ---------- ----------- ------------
Comprehensive income (loss) $ 911,000 ($ 787,000) $ 1,009,000 ($ 2,499,000)
========= ========== =========== ============
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 "1934 Act"). Effective
April 19, 2002, the Company's common stock listed again on the OTC BB,
after the Company became current with its 1934 Act filings.
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 March 31, 2001
were $373,000 and for the nine months ended March 31, 2001 were $1,732,000. Loss
from the discontinued operation was ($101,000) for the quarter ended March 31,
2001. Loss from the discontinued operation for the nine months ended March 31,
2001 was ($33,000), which was net of an income tax benefit of $19,000.
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 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 May 3, 2002, the Company had made 7 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. As of March 31, 2002 and May 3, 2002, the
Company was in compliance with the terms of this agreement. 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 March 31, 2002, the principal balance
outstanding on this term loan was $1,060,000, and as of May 3, 2002, the
principal balance outstanding on this term loan was $960,000.
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 consumer entertainment 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 assurance 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 April 2002, the Company entered into an agreement with one of its drug store
retail customers, which among other things modified the terms of sale to this
retailer. This agreement made all prior sales between the Company and this
retailer final and eliminated any further right of product return. As a result
of this agreement, the Company will recognize net sales of approximately
$1,100,000, which had been deferred in accordance with the Company's revenue
recognition policy requiring the Company to recognize sales relating to product
shipments to drug store retailers based on reported product sell-through. These
net sales will result in approximately $1,000,000 in net income after
recognizing the product costs and royalty expenses associated with these sales,
and the favorable impact attributable to the reversal of certain accruals for
reclamation costs and marketing promotional expenses associated with sales to
this retailer. The impact from this agreement will be recognized during the
Company's fiscal fourth quarter ending June 30, 2002.
9. Dependence on Large Customer
The Company now relies primarily on a concentrated group of large customers, due
to the decision, during fiscal 2002, to cease distributing its products directly
to drug store retailers and refocus its efforts on distributing its products to
mass-merchant retailers that have traditionally sold value-priced consumer
entertainment PC software. The majority of the Company's current sales are to
mass-merchant retailers, and distributors serving such retailers, and in
particular to Infogrames, Inc., ("Infogrames"). Infogrames is 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. In the event
that the Company loses its distribution capability through Infogrames, it would
significantly harm the Company's financial condition and its ability to continue
as a going concern.
Excluding all net sales to drug store retailers for the quarters ended March 31,
2002 and 2001, the Company would have reported net sales of $1,301,000 and
$1,427,000, respectively. Infogrames accounted for $599,000 and $167,000,
respectively, in net sales during those periods, or 46% and 12% of the Company's
net sales, respectively. Excluding all net sales to drug store retailers for the
nine months ended March 31, 2002 and 2001, the Company would have reported net
sales of $3,844,000 and $3,681,000, respectively. Infogrames accounted for
$1,814,000 and $714,000, respectively, in net sales during those periods, or 47%
and 19% of the Company's net sales, respectively.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The accompanying financial statements as of March 31, 2002 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 ability to
maintain the increased number of its consumer entertainment PC software titles
carried by Wal-Mart, K-Mart and Best Buy; the Company's potential to improve its
operational profitability by focusing its sales efforts on the North American
traditional software retail channel rather than the drug store retail channel;
the Company's determination during fiscal 2002 to cease distributing its
consumer entertainment PC software titles directly to drug store retailers; the
level of the Company's international net sales remaining at between 1% and 3% of
the Company's net sales for the remainder of fiscal 2002; the ability of the
Company's international product distribution to earn a royalty for the Company;
the success of the Company's efforts to increase sales of its products via the
Internet; the Company's ability to continue to achieve cost reductions in its
operations; the sufficiency of the Company's cash and working capital balances
to fund the Company's operations for the foreseeable future; the anticipated
financial effects of the agreement the Company entered into with one of its drug
store retail customers in April 2002; 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 mass-merchant retailers where
consumer entertainment PC software has traditionally been sold; the continued
successful business relationship between the Company and Infogrames, Inc., as
one of the Company's largest customers and the exclusive distributor to
Wal-Mart, K-Mart and Best Buy; 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 consumer entertainment 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 and price markdowns that
will occur and the adequacy of the reserves established for such product returns
and price markdowns; 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 for the
remainder of fiscal 2002; 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 heading "Risk Factors" in the Company's Form 10-KSB
for the fiscal year ended June 30, 2001 and Forms 10-QSB for the quarters ended
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
September 30, 2001 and December 31, 2001, as filed with the Securities and
Exchange Commission.
Critical Accounting Policies
The Company's significant accounting policies and methods used in the
preparation of the Financial Statements are discussed in Note 1 of the Notes to
Financial Statements. The Company considers its accounting policies with respect
to revenue recognition and the valuation of inventory to be critical.
Revenue Recognition
In accordance with Generally Accepted Accounting Principles, significant
management judgments and estimates must be made and used in connection with the
Company's revenue that is recognized in any reporting period. Material
differences may result in the amount and timing of the Company's revenue for any
period if management made different judgments or utilized different estimates
for product returns, price markdowns and product sell-through rates. These
differences, if material, would significantly affect the Company's operating
results and financial condition.
The Company distributes the majority of its consumer entertainment PC software
products to customers that traditionally have sold consumer entertainment PC
software products (i.e., mass merchant retailers and distributors serving such
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. The Company recognizes revenues for product
shipments to these customers at the time title to the inventory passes to these
customers, by reducing gross sales by a provision for anticipated product
returns and price markdowns. This provision is based upon, among other factors:
historical product return and price markdown results, analysis of customer
provided product sell-through and field inventory data when available to the
Company, and review of outstanding return material authorizations. The adequacy
of the Company's provision for product returns and price markdowns is reviewed
at the close of each reporting period and any adjustments (positive or negative)
are recorded when deemed necessary.
The Company recognizes revenues from product shipments to its customers that
have traditionally sold consumer entertainment PC software products, in
accordance with the criteria of SFAS No. 48, "Revenue Recognition When the Right
of Return Exists", 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. 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.
The Company has determined that it does not have the ability to make reliable
estimates of product returns for shipments to drug store retailers in accordance
with SFAS No. 48, and the additional guidance provided in the SEC's Staff
Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements". This
determination was made based upon receipt of delayed reporting of sell-through
results from its drug store retailers, which have not historically sold consumer
entertainment PC software products. Accordingly, the Company's revenues
associated with product shipments to drug store 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
drug store retailer. During fiscal 2002, the Company ceased granting terms of
sale to drug store retailers allowing for product returns. Additionally, during
fiscal 2002, the Company has entered into agreements with two of its drug store
retailers, which amoung other things, modified the terms of previous product
shipments. These agreements made all prior sales to these retailers final and
eliminated any further right of product return (see discussion below of the
Company's fiscal 2002 third quarter agreement with one of its drug store retail
customers and the "Subsequent Event" discussed in Note 8 to the Financial
Statements in Part I, Item 1).
Inventory Valuation
The Company's accounting policy for inventory valuation requires the Company's
management to make estimates and assumptions that affect the reported amounts of
inventory and cost of sales for any reporting period. Material differences may
result in the Company's valuation of its inventory at the close of any reporting
period or the amount reflected as cost of sales during any reporting period, if
management made different judgments or utilized different estimates with respect
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
to provisions for the potential impairment of its inventory value for any
reporting period. These differences, if material, would significantly affect the
Company's operating results and financial condition.
The Company is exposed to product obsolescence due to the relatively short
product life cycles (averaging six to twenty-four months) of its consumer
entertainment PC software products. From time to time, the Company or its
competitors may introduce new products, capabilities or technologies that have
the potential to replace or shorten the life cycles of the Company's existing
products, which would require the Company to write-down the value of such
inventory. Additionally, from time to time, the Company has been subject to
litigation or threatened litigation involving product content, which has caused
certain products to no longer be saleable. License agreements for product
content may also expire before such inventory has been sold. The Company may
also from time to time produce an amount of inventory of a product that exceeds
the eventual consumer demand for such product, causing the Company to liquidate
these excess quantities of remaining inventory at close out prices below the
Company's carrying costs and in excess of the Company's provision for
obsolescence. The adequacy of the Company's provision for inventory obsolescence
is reviewed, by product, at the close of each reporting period and any
adjustments (positive or negative) are recorded when deemed necessary.
Results of Operations
Three Months Ended March 31, 2002 and 2001
Net Sales
Net sales for the quarter ended March 31, 2002 were $3,626,000 compared to
$2,691,000 for the quarter ended March 31, 2001, representing an increase of
$935,000 or 35%. The $935,000 increase in net sales was due primarily to an
increase in net sales of $1,061,000 recognized from product shipments to drug
store retailers (see discussion below of the Company's fiscal 2002 third quarter
agreement with one of its drug store retail customers) and an increase in net
sales of $130,000 to North American traditional software distributors and
retailers. These increases were partially offset by decreases in net sales to
promotional customers of $225,000 and net sales to international customers of
$31,000.
During fiscal 2001, the Company had established its first "Store-in-a-Store"
entertainment software display sections in approximately 4,000 drug store
retailers. The establishment of these Store-In-A-Store software display sections
within certain national and regional drug store retailers 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.
During the quarter ended March 31, 2002, the Company decided to cease
distributing PC software titles directly to these retailers, due to:
o increasing demand on available working capital resources caused
largely by the costs of expensive disposable merchandising
displays;
o increased inventory levels that resulted from more product returns
from under-performing promotional programs at these retailers;
o the costs and resources required to continually revamp the
Company's product offering to support these repeated promotional
programs; and
o 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 increase in net sales recognized from product shipments to drug store
retailers for the three months ended March 31, 2002 was due primarily to an
agreement entered into between the Company and one of its drug store retail
customers during the Company's fiscal 2002 third quarter which, among other
things, modified the terms of previous product shipments. The agreement made all
prior sales to this retailer final and eliminated any further right of product
return. Based upon the terms of the agreement, the Company recognized net sales
of approximately $2,115,000 during the three months ended March 31, 2002. These
net sales had been deferred in accordance with the Company's revenue recognition
policy requiring the Company to recognize sales relating to product shipments to
drug store retailers based on the timing of the actual sell-through of the
Company's products to the end consumer as reported to the Company from the
respective drug store retailer.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
Excluding the impact from this agreement, the Company would have reported
approximately $1,511,000 in net sales for the quarter ended March 31, 2002,
representing a net sales decrease of $1,180,000 compared to the same period a
year earlier. This decrease in net sales is a direct result of the Company's
decision to cease distributing its products directly to drug store 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, including Wal-Mart, K-Mart and Best
Buy. Improved sell-through of the Company's products at these retail stores also
contributed to the net sales increase and was a contributing factor in the
retailers' decision to increase the number of retail placement slots for the
Company's products at these retail stores.
Compared to the quarter ended March 31, 2001, 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 a selection of the
Company's software titles. These mass-merchant retailers - Wal-Mart, K-Mart and
Best Buy - 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 drug store retail channel, the Company's operational
profitability may improve due to improved product sell-through and fewer product
returns in the traditional retail sector compared to the drug store retail
channel.
Due to the Company's decision during fiscal 2002 to cease distributing its
consumer entertainment PC software products directly to drug store retailers and
to focus instead on distributing its products to mass-merchant retailers that
have traditionally sold value-priced consumer entertainment PC software, the
Company now relies primarily on a concentrated group of large customers. The
majority of the Company's current sales are to mass-merchant retailers, and
distributors serving such retailers, and in particular to Infogrames, Inc.,
("Infogrames"). Infogrames is 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. In the event that the Company loses its
distribution capability through Infogrames, it would significantly harm the
Company's financial condition and its ability to continue as a going concern.
Excluding all net sales to drug store retailers for the quarters ended March 31,
2002 and 2001, the Company would have reported net sales of $1,301,000 and
$1,427,000, respectively. Infogrames accounted for $599,000 and $167,000,
respectively, in net sales during those periods, or 46% and 12% of the Company's
net sales, respectively.
The Company liquidated certain inventory stock at closeout selling prices,
yielding minimal to no profit margin, during the quarters ended March 31, 2002
and 2001 in net sales amounts of $350,000 and $514,000, respectively, in order
to raise cash to address liquidity requirements during those time periods. These
amounts are included in the net sales to North American traditional software
distributors and retailers. 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 promotional customers for the quarter ended March 31,
2001 were $225,000 compared to no such sales for the same quarter during the
current fiscal year.
The Company's international net revenues, including both product net sales and
royalty revenues, for the quarter ended March 31, 2002, decreased by $31,000
compared to the prior year period. The primary cause for this decrease was the
softening retail demand for consumer entertainment PC software experienced by
European retailers during this period. As a percentage of net sales, the
Company's international net revenues represented approximately 1% and 3% of the
Company's net sales for the quarters ended March 31, 2002 and 2001,
respectively. The Company anticipates that international net revenues will range
from 1% to 3% 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, under which 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 March 31, 2001 was $373,000.
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 consumer entertainment 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 March 31, 2002 and 2001 were $60,000 and
$43,000, respectively, or approximately 2% of the Company's net sales for each
of these periods.
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 March 31, 2002 and 2001, the Company's provision for product
returns and price markdowns relating to product shipments to its traditional
software customers totaled approximately $132,000 and $382,000, or 9% and 24% of
related gross product shipments, respectively. This $250,000 decrease in the
provision for product returns and price markdowns largely related to decreased
distribution to certain office superstore customers that returned the Company's
product or required price markdowns of the Company's products during the period
a year ago in connection with these retailers' transition away from value-priced
casual gaming software titles. The decrease in the provision for product returns
and price markdowns was also due to improved product sell-through at
mass-merchant retail stores, combined with the Company's analysis of historical
product returns from these customers.
Cost of Sales
Cost of sales for the quarter ended March 31, 2002 were $1,911,000 compared to
$1,722,000 for the quarter ended March 31, 2001, representing an increase of
$189,000 or 11%. The primary reasons for this $189,000 increase in cost of sales
was a $387,000 increase in product costs largely associated with the increase in
product sales and a $149,000 increase in the provision for inventory
obsolescence caused primarily by discontinuance of various end of lifecycle PC
software products and retail drug store display units, and the scrapping of
unsold, date-sensitive brand name licensed products that the Company no longer
had the right to distribute. These cost of sales increases were partially offset
by a $311,000 decrease in reclamation and other costs primarily because the
Company no longer distributes its products to drug store retailers, and
specifically due to the agreement reached with one of these drug store retailers
that enabled the Company to reverse $105,000 in prior reclamation expense
accruals. Additionally, freight expense decreased by $75,000 due largely to
reduced product shipments to drug store 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 quarter ended March 31, 2002 increased
to 47.3% of net sales from 36.0% of net sales for the quarter ended March 31,
2001. This 11.3% increase in gross profit margin was caused primarily by
decreases, as a percentage of net sales, of:
o 11.0% in reclamation and other related costs;
o 3.6% in freight costs;
o 1.8% in developer royalty costs;
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
which were partially offset by increases, as a percentage of net sales, of:
o 4.5% in provision for inventory obsolescence; and
o 0.6% in product costs.
The 11.0% and 3.6% decreases in reclamation and other related costs and in
freight costs were almost entirely attributable to the cost savings achieved by
the fiscal 2002 third quarter agreement the Company entered into with one of its
drug store retailers . This agreement enabled the Company to reverse $105,000 in
prior reclamation expense accruals and to currently recognize revenue on product
shipments made during prior reporting periods, where freight costs associated
with such product shipments had already been recognized.
The 1.8% decrease in developer royalty costs was largely due to the increase in
revenue recognized from non-royalty sensitive third-party publisher products
that were not returned to the Company in accordance with the Company's fiscal
2002 third quarter agreement with one of its drug store retailers.
The 4.5% increase in the provision for inventory obsolescence was caused
primarily by the discontinuance of various end of lifecycle PC software products
and retail drug store display units, and the scrapping of unsold, date-sensitive
brand name licensed products that the Company no longer had the right to
distribute.
The 0.6% increase in product costs resulted primarily from non-recurring
promotional sales to drug store retailers, which had discounted pricing.
Operating Expenses
Product development expenses for the quarter ended March 31, 2002 were $92,000
compared to $195,000 for the quarter ended March 31, 2001, a decrease of
$103,000 or 53%. This 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.
Selling, general and administrative expenses for the quarter ended March 31,
2002 were $681,000 compared to $1,436,000 for the quarter ended March 31, 2001,
a decrease of $755,000 or 53%. Most of this $755,000 decrease was caused by
decreases of:
o $266,000 in marketing promotional expenses primarily as a result of
decreased product shipments to drug store retailers and office
super store retailers;
o $170,000 in salary related costs primarily from the employee
layoffs effected by the Company in January, July and August 2001;
o $110,000 in litigation costs related to the non-recurrence of
litigation and related expenses incurred in fiscal 2001;
o $47,000 in bad debt expense due to improved strength in customers'
receivables;
o $42,000 in trade show and travel costs due to the concentration of
the Company's customer base; and
o $23,000 in depreciation and amortization expenses related to
expiring assets.
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.
Interest Expense, Net
Net interest expense for the quarter ended March 31, 2002 was approximately
$31,000 compared to approximately $33,000 for the quarter ended March 31, 2001,
a decrease of $2,000.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
Provision (Benefit) for Income Taxes
Provision for income taxes for the quarter ended March 31, 2002 was zero
compared to a benefit for income taxes of ($27,000) for the quarter ended March
31, 2001, a decrease in benefit for income taxes of $27,000. This $27,000
decrease in the benefit for income taxes was primarily due to the $1,606,000
increase in the Company's income from continuing operations before income taxes
for the quarter ended March 31, 2002, 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, and in particular the
Company's fiscal 2002 third quarter agreement with one of its drug store
retailers to make all prior sales final, the Company recognized $911,000 in
income from continuing operations for the quarter ended March 31, 2002, compared
to a ($667,000) loss from continuing operations for the quarter ended March 31,
2001, an increase of $1,578,000 in income from continuing operations. Excluding
the impact from this agreement, which the Company is not likely to experience
during the same period next year, the Company would have reported a loss from
continuing operations of approximately ($211,000) for the quarter ended March
31, 2002, representing a decrease in loss from continuing operations of $456,000
compared to the same period a year earlier.
Loss from Discontinued Operation
Loss from discontinued operation for the quarter ended March 31, 2001 was
($101,000). This ($101,000) loss from discontinued operation was caused
primarily by $195,000 in gross profit, less $294,000 in selling, general and
administrative expenses and $2,000 in interest expense.
Net Income (Loss)
As a result of the factors discussed above and in particular the Company's
fiscal 2002 third quarter agreement with one of its drug store retailers to make
all prior sales final, net income increased to $911,000 for the quarter ended
March 31, 2002 from a net loss of ($768,000) for the quarter ended March 31,
2001, an increase in net income of $1,679,000. Excluding the impact from this
agreement, which the Company is not likely to experience during the same period
next year, the Company would have reported a net loss of approximately
($211,000) or ($0.02) per diluted share, for the quarter ended March 31, 2002,
representing a decrease in the net loss of $557,000 compared to the same period
a year earlier.
Weighted Average Common Shares
The weighted average common shares outstanding on a diluted basis increased by
239,362 for the quarter ended March 31, 2002 to 9,989,337 from 9,749,975 for the
quarter ended March 31, 2001. 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 March 31, 2002, 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 been an
anti-dilutive.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
Results of Operations
Nine Months Ended March 31, 2002 and 2001
Net Sales
Net sales for the nine months ended March 31, 2002 were $7,930,000 compared to
$6,427,000 for the nine months ended March 31, 2001, representing an increase of
$1,503,000 or 23%. The $1,503,000 increase in net sales was due primarily to an
increase in net sales of $1,340,000 recognized from product shipments to drug
store retailers (see discussion below of the Company's fiscal 2002 third quarter
agreement with one of its drug store retail customers), and an increase in net
sales of $426,000 to North American traditional software distributors and
retailers. These increases were partially offset by a $225,000 decrease in net
sales to promotional customers and a $38,000 decrease in net sales to
international customers.
Based upon the terms of an agreement the Company reached with one of its drug
store retail customers during the Company's fiscal 2002 third quarter, the
Company recognized net sales of approximately $2,115,000 during the nine months
ended March 31, 2002, which had been deferred in accordance with the Company's
revenue recognition policy requiring the Company to recognize sales relating to
product shipments to drug store retailers based on the timing of the actual
sell-through of the Company's products to the end consumer as reported to the
Company from the respective drug store retailer. Excluding the impact from this
agreement, the Company would have reported approximately $5,815,000 in net sales
for the nine months ended March 31, 2002, representing a net sales decrease of
$612,000 compared to the same period a year earlier.
The $426,000 net sales increase to North American traditional software
distributors and retailers resulted largely from increased distribution through
Infogrames, Inc., ("Infogrames"). Infogrames is 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. During fiscal 2002, the Company
decided to cease distributing its consumer entertainment PC software products
directly to drug store retailers and to focus instead on distributing its
products to mass-merchant retailers that have traditionally sold value-priced
consumer entertainment PC software. The Company now relies primarily on a
concentrated group of large customers, and particularly on Infogrames for
distributing its products to these mass-merchant retailers. Excluding all net
sales to drug store retailers for the nine months ended March 31, 2002 and 2001,
the Company would have reported net sales of $3,844,000 and $3,681,000,
respectively. Infogrames accounted for $1,814,000 and $714,000, respectively, in
net sales during those periods, or 47% and 19% of the Company's net sales,
respectively.
The Company liquidated certain inventory stock at closeout selling prices,
yielding minimal to no profit margin, during the nine months ended March 31,
2002 and 2001 in net sales amounts of $696,000 and $606,000, respectively, in
order to raise cash to address liquidity requirements during those periods.
These amounts are included in the net sales to North American traditional
software distributors and retailers. 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 promotional customers for the nine months ended March
31, 2001 were $225,000 compared to no such sales during the same period for the
current fiscal year.
The Company's international net revenues, inclusive of both product net sales
and royalty revenues, for the nine months ended March 31, 2002 decreased by
$38,000 compared to the prior year period. As a percentage of net sales, the
Company's international net revenues represented approximately 4% and 5% of the
Company's net sales for the nine months ended March 31, 2002 and 2001,
respectively. The Company anticipates that international net revenues will range
from 1% to 3% 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. 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 nine
months ended March 31, 2001 was $1,732,000.
Net sales of the Company's products via the Internet for the nine months ended
March 31, 2002 and 2001 were $167,000 and $118,000, respectively, or
approximately 2% of the Company's net sales for each of these periods.
During the nine months ended March 31, 2002 and 2001, the Company's provision
for product returns and price markdowns relating to product shipments to its
traditional software customers totaled approximately $657,000 and $1,469,000, or
15% and 30% of related gross product shipments, respectively. This $812,000
decrease in the provision for product returns and price markdowns largely
related to decreased distribution to certain office superstore customers that
returned the Company's product or required price markdowns of the Company's
products during the period a year ago in connection with these retailers'
transition away from value-priced casual gaming software titles. The decrease in
the provision for product returns and price markdowns was also due to improved
product sell-through of the Company's products at mass-merchant retail stores,
combined with the Company's analysis of historical product returns from these
customers.
Cost of Sales
Cost of sales for the nine months ended March 31, 2002 were $4,245,000 compared
to $3,886,000 for the quarter ended March 31, 2001, representing an increase of
$359,000 or 9%. The primary reasons for this $359,000 increase in cost of sales
were increases of $529,000 in product costs and $245,000 in royalty costs, which
were both largely associated with the increase in product sales of the Company
published software titles. These cost of sales increases were partially offset
by a $240,000 decrease in reclamation and other costs primarily because the
Company no longer distributes its products to drug store retailers, and
specifically due to the agreement reached with one of these retailers that
enabled the Company to reverse $105,000 in prior reclamation expense accruals.
Additionally, freight expense decreased by $197,000 primarily because of the
reduced product shipments to drug store 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 nine months ended March 31, 2002
increased to 46.5% of net sales from 39.5% of net sales for the nine months
ended March 31, 2001. This 7.0% increase in gross profit margin was caused
primarily by decreases, as a percentage of net sales, of:
o 4.3% in reclamation and other related costs;
o 3.8% in freight costs;
o 0.4% in provision for inventory obsolescence;
which were partially offset by an increase, as a percentage of net sales, of:
o 1.5% in developer royalty costs.
The 4.3% and 3.8% decreases in reclamation and other related costs and in
freight costs were almost entirely attributable to the cost savings achieved by
the fiscal 2002 third quarter agreement the Company entered into with one of its
drug store retailers. This agreement enabled the Company to reverse $105,000 in
prior reclamation expense accruals and to currently recognize revenue on product
shipments made during prior reporting periods, where freight costs associated
with such product shipments had already been recognized.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
The 0.4% decrease in the provision for inventory obsolescence was caused
primarily by the reduction in the discontinuance of various end-of- lifecycle PC
software products.
The 1.5% increase in developer royalty costs was primarily due from the
continued increase in the cost for the Company to acquire software content as
the competition to obtain higher quality consumer entertainment PC software has
caused these costs to increase.
Operating Expenses
Product development expenses for the nine months ended March 31, 2002 were
$313,000 compared to $552,000 for the nine months ended March 31, 2001, a
decrease of $239,000 or 43%. This $239,000 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.
Selling, general and administrative expenses for the nine months ended March 31,
2002 were $2,258,000 compared to $4,424,000 for the nine months ended March 31,
2001, a decrease of $2,166,000 or 49%. This $2,166,000 decrease was caused
primarily by decreases of:
o $762,000 in marketing promotional expenses primarily as a result of
decreased product shipments to drug store retailers and office
super store retailers;
o $600,000 in salary related costs primarily from employee layoffs
effected by the Company in January, July and August 2001;
o $168,000 in litigation and related costs;
o $125,000 in professional services;
o $105,000 in travel costs due to head count reductions and the
increase concentration of the Company's customer base;
o $82,000 in bad debt expense;
o $76,000 in marketing trade-show costs; and
o $73,000 in public corporation expense.
Interest Expense, Net
Net interest expense for the nine months ended March 31, 2002 was $104,000
compared to $64,000 for the nine months ended March 31, 2001, an increase of
$40,000. The $40,000 increase was primarily due to the increase in bank debt
outstanding during the nine months ended March 31, 2002 and the time period that
such bank debt was outstanding during that period compared to the prior year.
Provision (Benefit) for Income Taxes
Provision for income taxes for the nine months ended March 31, 2002 was $1,000
compared to a benefit for income taxes of ($39,000) for the nine months ended
March 31, 2001, a decrease in the benefit for income taxes of $40,000.
Income (Loss) from Continuing Operations
As a result of the various factors discussed above and in particular the
Company's fiscal 2002 third quarter agreement with one of its drug store
retailers to make all prior sales final, the Company recognized $1,009,000 in
income from continuing operations for the nine months ended March 31, 2002,
compared to a ($2,461,000) loss from continuing operations for the nine months
ended March 31, 2001, an increase of $3,470,000 in income from continuing
operations. Excluding the impact from this agreement, which the Company is not
likely to experience during the same period next year, the Company would have
reported a loss from continuing operations of approximately ($113,000) for the
nine months ended March 31, 2002, representing a decrease in loss from
continuing operations of $2,348,000 compared to the same period a year earlier.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
Loss from Discontinued Operation
Loss from discontinued operation for the nine months ended March 31, 2001 was
($33,000) and resulted from $890,000 in gross profit and $19,000 in income tax
benefit, less $942,000 in selling, general and administrative expenses.
Net Income (Loss)
As a result of the factors discussed above and in particular the Company's
fiscal 2002 third quarter agreement with one of its drug store retailers to make
all prior sales final, net income increased to $1,009,000 for the nine months
ended March 31, 2002 from a net loss of ($2,494,000) for the nine months ended
March 31, 2001, an increase of $3,503,000 in net income. Excluding the impact
from this agreement, which the Company is not likely to experience during the
same period next year, the Company would have reported a net loss of
approximately ($113,000) or ($0.01) per diluted share for the nine months ended
March 31, 2002, representing a net loss decrease of $2,381,000 compared to the
same period a year earlier.
Weighted Average Common Shares
The weighted average common shares outstanding on a diluted basis increased by
239,362 for the nine months ended March 31, 2002 to 9,989,337 from 9,749,975 for
the nine months ended March 31, 2001. 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 nine months ended March 31, 2002, 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 April 2002, the Company entered into an agreement with another drug store
retailer, which among other things modified the terms of sale to this retailer.
This agreement made all prior sales between the Company and this retailer final
and eliminated any further right of product return. As a result of this
agreement, the Company will recognize net sales of approximately $1,100,000,
which had been deferred in accordance with the Company's revenue recognition
policy requiring the Company to recognize sales relating to product shipments to
drug store retailers based on the timing of the actual sell-through of the
Company's products to the end consumer as reported to the Company from the
respective drug store retailer. These net sales will result in approximately
$1,000,000 in net income after recognizing the product costs and royalty
expenses associated with these sales, and the favorable impact attributable to
the reversal of certain accruals for reclamation costs and marketing promotional
expenses associated with sales to this retailer. The impact from this agreement
will be recognized during the Company's fiscal fourth quarter ending June 30,
2002.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
Liquidity and Capital Resources
As of March 31, 2002, the Company's cash and working capital deficit balances
were $293,000 and $961,000, respectively, and the Company's total stockholders'
deficit balance at March 31, 2002 was $1,105,000. The fiscal 2002 third quarter
agreement the Company entered into with one of its drug store retail customers
improved the Company's working capital deficiency and stockholders' deficit
balances by more than $1.1 million at March 31, 2002, but did not affect the
Company's cash balance at March 31, 2002. Additionally, as a result of the
Company's April 2002 agreement with another drug store retailer, discussed
herein as a "Subsequent Event", the Company anticipates its June 30, 2002
working capital deficit and stockholders' deficit balances benefiting by
approximately $1,000,000.
Net cash provided by (used in) operating activities was $951,000 and
($1,925,000) for the nine months ended March 31, 2002 and 2001, respectively.
The $951,000 in net cash provided by operating activities resulted from
decreases of:
o $2,319,000 in inventory;
o $30,000 in restricted cash; and
o $80,000 in prepaid royalties and other expenses, combined
with an $846,000 increase in accrued expenses.
These sources of cash were partially offset by decreases of:
o $1,528,000 in accounts payable; and
o $1,043,000 in customer advance payments, in addition to a $298,000
increase in accounts receivable.
Additionally, the Company recorded approximately ($464,000) in non-cash
adjustments to its $1,009,000 in net income for the nine months ended March 31,
2002.
Net cash (used in) investing activities for the nine months ended March 31, 2002
and 2001 were ($29,000) and ($43,000), respectively. The ($29,000) in net cash
(used in) investing activities resulted from purchases of $28,000 in furniture
and equipment and $1,000 in other assets.
Net cash (used in) provided by financing activities for the nine months ended
March 31, 2002 and 2001 were ($656,000) and $727,000, respectively. The
($656,000) in net cash used in financing activities reflects net proceeds from
the Company's borrowing of $280,000 of bank debt and $90,000 in proceeds from a
note receivable, which were partially offset by repayments of:
o $420,000 in the borrowing of bank debt;
o $469,000 in trade notes payable;
o $47,000 in note payable; and
o $90,000 in capital lease obligations.
Net cash provided by the Company's discontinued operation for the nine months
ended March 31, 2001 was $230,000. The $230,000 in net cash provided by the
Company's discontinued operation resulted from $242,000 in net cash provided by
operating activities and $13,000 in net cash provided by investing activities,
which cash sources were partially offset by ($25,000) in net cash (used in)
financing activities.
As of March 31, 2002, the Company had received $806,000 in net customer payments
from certain drug store 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.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
During the Company's fiscal 2002 third quarter, the customer advance payments
balance was significantly reduced as a result of the Company's agreement with
one of its drug store retailers discussed above. Additionally, as a result of
the Company's agreement reached in April 2002, discussed above under "Subsequent
Event" and in Note 8 to the financial statements in Part I, Item 1, the Company
anticipates that the customer advance payment account will be approximately zero
at June 30, 2002.
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, 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 May 3, 2002, the Company
had made 7 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. As of March
31, 2002 and May 3, 2002, the Company was in compliance with the terms of this
agreement. 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 March
31, 2002 and May 3, 2002, the principal balances outstanding on this term loan
were $1,060,000 and $960,000, respectively.
The Company's ability to achieve and maintain positive cash flow depends upon a
variety of factors, including but not limited to, 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 consumer entertainment PC game
software, the development and sell-through of the Company's products, the costs
of developing, producing, distributing 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 assurance 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.
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 "1934 Act"). Effective
April 19, 2002, the Company's common stock listed again on the OTC BB,
following the Company becoming current with its 1934 Act filings, which occurred
following its March 29, 2002 filing of its Form 10-QSB for the period ended
December 31, 2001.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (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.
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
- ------------
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 in November 1996 and in January and April 1997, in addition to the
proceeds from the exercise of various common stock warrants and common stock
options. 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.
Risk Factors (continued)
- ------------------------
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 was 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 whether
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 March 31, 2002, the
principal balance outstanding on this term loan was $1,060,000.
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. 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, the first lien that the bank has with respect to all of
the Company's assets, and the Company's recent poor financial performance, 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 PC 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. Due to the Company's decision during fiscal 2002 to cease
distributing its consumer entertainment PC software products directly to drug
store retailers and to focus instead on distributing its products to
mass-merchant retailers that have traditionally sold value-priced PC
entertainment software, the Company now relies primarily on a concentrated group
of large customers. The majority of the Company's current sales are to
mass-merchant retailers, and distributors serving such retailers, and in
particular to Infogrames, Inc., ("Infogrames"). Infogrames is 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. The Company's
net sales to Infogrames during the three and nine months ended March 31, 2002,
were $599,000 and $1,814,000, respectively, and represented 46% and 47%,
respectively, of the Company's net sales, excluding net sales to drug store
retailers. The Company expects to continue depending upon a limited number of
significant customers for the foreseeable future.
Risk Factors (continued)
- ------------------------
These customers may terminate their relationship with the Company at any time.
In the event that the Company loses its distribution capability through
Infogrames or any of its other large customers, it would significantly harm the
Company's financial condition and its ability to continue as a going concern.
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.
Adverse Effect of Product Returns and Price Markdown Allowances. The Company is
exposed to product returns and price markdown allowances with respect to the
Company's customers. The Company establishes allowances for future product
returns and price markdowns at the time of sale for its traditional software
retail customers and distributors servicing such retailers, based on historical
product return and price markdown rates in the retail channels in which the
Company's products are sold, and the Company's sales are reported net of product
returns and price markdowns provisions. 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 price markdowns could exceed
the Company's anticipated amounts, which would negatively impact the Company's
results of operations.
Fluctuations in Quarterly Results; Uncertainty of Future Operating Results. 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 drug store retailers.
Risk Factors (continued)
- ------------------------
Seasonality. 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.
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 PC 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.
Risk Factors (continued)
- ------------------------
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.
Risks Associated With Stock 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 "1934 Act"). Effective
April 19, 2002, the Company's common stock listed again on the OTC BB,
following the Company becoming current with its 1934 Act filings, which occurred
following its March 29, 2002 filing of its Form 10-QSB for the period ended
December 31, 2001. There can be no assurance that the Company will be successful
in maintaining the trading of its stock 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 common stocks traded on the OTC Bulletin Board are thinly
traded, such as the Company's common stock, 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,
Risk Factors (continued)
- ------------------------
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.
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.
Risks Associated With International Sales. International net revenues, inclusive
of both product net sales and royalty revenues, represented 1% and 4%,
respectively, of the Company's net sales for the quarter and nine months ended
March 31, 2002. The Company anticipates that international net revenues may
account for approximately 3% 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; difficulties in managing
foreign distributors; potentially adverse tax consequences; fluctuating currency
valuations; and difficulties in collecting delinquent accounts receivable.
Additionally, because the Company's international business is concentrated among
a small number of third-party distributors, the business failure of any one of
these distributors, and the resulting inability to collect royalties due, could
have a material adverse affect on the Company's financial condition.
Part II. Other Information
Item 4. Submission of Matters to a Vote of Security Holders
The Company held its Annual Meeting of Shareholders on March 12, 2002. At that
meeting, the following matter was acted upon, together with the number of votes
cast for, against or withheld as to such matter:
The election of the following directors:
Votes Cast
----------
For Against Abstain
----------------------------------
Robert M. Aiken, Jr. 8,726,695 - 0 - 231,825
Gerald W. Klein 8,739,195 - 0 - 219,325
Thomas D. Parente 8,734,495 - 0 - 224,025
Lambert C. Thom 8,740,895 - 0 - 217,625
Item 6. Exhibits and Reports on Form 8-K
The following is a list of exhibits filed as part of this
quarterly report on Form 10-QSB. Where so indicated, exhibits
which were previously filed are incorporated by reference.
(a) Exhibits
Exhibit No. Description of Exhibit
- ----------- ----------------------
(1) 2.1 Share Purchase Agreement dated May 11, 2001 by and between the
Registrant and Greenstreet Software Limited.
(2) 2.2 Sale and Purchase Agreement between the Registrant and the
stockholders of Software Partners Publishing and Distribution
Ltd. Dated August 14, 1998.
(3) 3.1 Amended and Restated Articles of Incorporation of the
Registrant.
(4) 3.2 By-Laws of the Registrant.
(5) 4.1 Rights Agreement, dated as of June 1, 1999, between the
Registrant and StockTrans, Inc.
(6) 4.2 Promissory Note in the amount of $350,000 from Virtual Reality
Laboratories, Inc. to Heller First Capital Corporation dated
March 25, 1996; Commercial Security Agreement dated
March 25, 1996 between Virtual Reality Laboratories, Inc. and
Heller First Capital Corporation; and U.S. Small Business
Administration Guaranty dated March 25, 1996.
(7) 10.1 Form of Redeemable Warrant for the Purchase of the Registrant's
Common Shares (Exhibit A to Form of Amended and Restated
Agreement and Plan of Merger between and among Applied
Optical Media Corporation and the Registrant).
(8) 10.2 Form of Underwriter's Warrant Agreement.
(3) 10.3 Amended and Restated 1995 Stock Option Plan.
(9) 10.4 Form of Purchase Agreement for the Class Two Convertible
Preferred Stock (the "Class Two Preferred") dated as of
November 15, 1996.
(9) 10.5 Form of Warrant Agreement for the Warrants (the "Warrants")
issued to the holders of the Class Two Preferred dated as of
November 15, 1996.
(9) 10.6 Form of Registration Rights Agreement for the Common Stock
underlying the Class Two Preferred and the Warrants dated as of
November 15, 1996.
(9) 10.7 Form of Agreement amending certain terms of the Class Two
Preferred Certificate of Designation, Warrants and Registration
Rights Agreement dated as of November 15, 1996.
(10) 10.8 Purchase Agreement dated January 30, 1997 between the
Registrant and Odyssey Capital Group, L.P.
(10) 10.9 Agreement dated January 30, 1997 between the Registrant and
Odyssey Capital Group, L.P.
(10) 10.10 Registration Rights Agreement dated January 30, 1997 between
the Registrant and Odyssey Capital Group, L.P.
(11) 10.11 Warrant Agreement dated January 30, 1997 by and between
Registrant and PJM Trading Company, Inc.
(12) 10.12 Loan Agreement dated August 9, 2000 by and between Summit Bank
(now Fleet Bank) and the Registrant.
(12) 10.13 Security Agreement dated August 9, 2000 by and between Summit
Bank (now Fleet Bank) and the Registrant.
(12) 10.14 $2,000,000 Secured Line of Credit Note.
(13) 10.15 Stipulation and Consent Judgment by and between plaintiffs
Hasbro Interactive, Inc., Atari Interactive, Inc., ZAO Elorg,
d/b/a Elorg Corporation and defendants MVP Software Inc.,
Webfoot Technologies, Inc. and the Registrant, dated
August 16, 2000.
(14) 10.16 Description of Registrant's Fiscal 2001 Employee Incentive
Compensation Plan
(15) 10.17 Forbearance Agreement by and between Fleet National Bank and
the Registrant dated October 31, 2001.
(15) 10.18 Common Stock Purchase Warrant of the Registrant dated
October 31, 2001.
(15) 10.19 Registration Rights Agreement by and between Fleet National
Bank and the Registrant dated October 31, 2001.
10.20 Release Agreement between Walgreen Company and the Registrant
dated January 24, 2002.
- --------- ---------------------------------
(1) Incorporated herein by reference from the Registrant's Form 8-K as
filed with the Securities and Exchange Commission on May 25, 2001.
(2) Incorporated herein by reference from the Registrant's Form 10-KSB
for the year ended June 30, 1998 as filed with the Securities and
Exchange Commission on September 10, 1998.
(3) Incorporated by reference herein from the Registrant's Form SB-2 as
filed with the Securities and Exchange Commission on July 28, 1995.
(4) Incorporated by reference herein from the Registrant's Form 10-QSB
for the quarter ended September 30, 1998 as filed with the Securities
and Exchange Commission on November 16, 1998
(5) Incorporated by reference herein from the Registrant's Form 8-K as
filed with the Securities and Exchange Commission on June 10, 1999.
(6) Incorporated by reference herein from the Registrant's Form 10-QSB
for the quarter ended March 31, 1996 as filed with the Securities and
Exchange Commission on May 14, 1996.
(7) Incorporated by reference herein from Amendment No. 3 of the
Registrant's Form SB-2 as filed with the Securities and Exchange
Commission on October 4, 1995.
(8) Incorporated by reference herein from the Registrant's Form SB-2 as
filed with the Securities and Exchange Commission on July 28, 1995.
(9) Incorporated by reference herein from the Registrant's Form 8-K as
filed with the Securities and Exchange Commission on November 27,
1996.
(10) Incorporated by reference herein from the Registrant's Form 8-K as
filed with the Securities and Exchange Commission on February 4,
1997.
(11) Incorporated herein by reference from the Registrant's Form 10-KSB
for the year ended June 30, 1997 as filed with the Securities and
Exchange Commission on September 29, 1997.
(12) Incorporated by reference herein from the Registrant's Form 8-K as
filed with the Securities and Exchange Commission on August 17, 2000.
(13) Incorporated herein by reference from the Registrant's Form 10-KSB
for the year ended June 30, 2000 as filed with the Securities and
Exchange Commission on September 28, 2000.
(14) Incorporated herein by reference from the Registrant's Form 10-QSB
for the quarter ended September 30, 2000 as filed with the Securities
and Exchange Commission on November 14, 2000.
(15) Incorporated herein by reference with the Registrant's Form 8-K as
filed with the Securities and Exchange Commission on November 13,
2001.
(b) Reports on Form 8-K
On April 19, 2002, the Company filed a report on Form 8-K regarding a press
release announcing the Company's financial results for the third fiscal quarter
and nine months ended March 31, 2002, and disclosing the impact of recent
agreements entered into with two of the Company's drug store retail customers
which, among other things, modified the terms relating to the Company's previous
product shipments to these retailers.
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: May 9, 2002 /s/ Gerald W. Klein
----------- --------------------
Gerald W. Klein, President, Chief
Executive Officer and Director
Date: May 9, 2002 /s/ Thomas W. Murphy
----------- --------------------
Thomas W. Murphy, Chief Financial
Officer and Chief Accounting Officer
Exhibit 10.20
RELEASE AGREEMENT
Agreement dated as of January 24, 2002 by and between Walgreen Company
("Walgreens"), a corporation organized under the laws of the State of Illinois,
with its principal place of business at 200 Wilmot Road Deerfield, IL
60015-4616, and eGames, Inc. ("eGames"), a Pennsylvania corporation with its
principal place of business at 2000 Cabot Boulevard West, Suite 110, Langhorne,
Pennsylvania 19047-1811.
WHEREAS, eGames has sold certain software products to Walgreens, which
Walgreens has sold in its retail stores; and
WHEREAS, Walgreen's has alleged that as of the date hereof, based upon
the value of product returns received at eGames' third-party warehouses and
Walgreen's payments to eGames prior to the date hereof, eGames owes to
Walgreen's approximately $530,747.93 per Walgreen's open activity statement
dated January 23, 2002; and
WHEREAS, eGames is currently insolvent, owes its sole secured lender
$1.3 million, and its current financial condition precludes eGames from
refunding to Walgreens any amounts paid to eGames for eGames products, whether
such products have been returned to eGames or are anticipated to be returned to
eGames; and
WHEREAS, eGames can no longer accept any further product returns from
Walgreens as a result of its inability to pay for returns processing, nor can
eGames refund to Walgreens previous amounts paid to eGames for such products;
and
WHEREAS, Walgreens and eGames have agreed to settle these and any other
outstanding obligations between the parties, including without limitation any
amounts that Walgreens alleges that eGames owes now or may owe in the future to
Walgreens, under the terms and conditions set forth in this Agreement;
NOW THEREFORE, in consideration of the mutual promises and covenants
contained herein, and intending to be legally bound hereby, the parties agree as
follows:
1. Recitals: The parties hereto agree that the recitals set forth
hereinabove are incorporated by reference as if fully set forth herein and are
hereby made a part of this Release Agreement.
2. Product Shipment: Simultaneously with the execution by each of the
parties hereto of this Release Agreement, eGames agrees to authorize the
shipment to Walgreens of eGames software product reflecting a Walgreens invoice
value of no less than $530,747.93 (comprised of no less than $513,110 in product
value together with related shipping, reclamation and other costs of
approximately $17,641). Walgreens shall own full right and title to any such
eGames products, free and clear of any liens, and shall not be permitted to
return any such eGames products to eGames for credit.
3. Release: In consideration of the product shipment described in
paragraph 2 above, Walgreens hereby releases and forever discharges eGames and
its principals, officers, directors, shareholders, employees, affiliates,
agents, representatives, successors or assigns from any and all claims, causes
of action, suits, and demands of any kind, whether in law or equity, that it
previously had or now has, by reason of any matter whatsoever existing as of the
date hereof, including without limitation:
(a) any and all claims, causes of action, suits and demands of
any kind, whether in law or equity, that it previously had
or now has, by reason of any matter whatsoever existing as
of the date hereof, with respect to any payments made to
eGames by Walgreens prior to the date hereof;
(b) any and all claims, causes of action, suits and demands of
any kind, whether in law or equity, that it previously had
or now has, by reason of any matter whatsoever existing as
of the date hereof, relating to Walgreens' ability or
right to return any eGames product to eGames or its
third-party warehouses, whether such eGames products
remain in Walgreens stores, are located in Walgreens
warehouses, reclamation centers or are in transit;
(c) any and all claims, causes of action, suits and demands of
any kind, whether in law or equity, that it previously had
or now has, by reason of any matter whatsoever existing as
of the date hereof, with respect to the eGames products
shipped to Walgreens pursuant to paragraph 2 above.
Walgreens agrees and acknowledges that Walgreens accepts the product shipment
described in paragraph 2 as a full, complete, final and binding settlement of
any and all outstanding obligations that eGames has or may have to Walgreens.
4. No Fault: The execution of this Release Agreement shall not be deemed
or construed to be an admission of liability or wrongdoing on the part of either
party.
5. Costs and Expenses: Except as otherwise expressly stated herein, each
party shall bear its own costs, fees and expenses in any way connected with the
matters which are referenced or covered herein.
6. Arbitration: Any controversy arising out of or relating to this Release
Agreement or the breach hereof shall be settled by binding arbitration in
Philadelphia, Pennsylvania pursuant to the then-applicable rules of the American
Arbitration Association. The parties consent to any court of competent
jurisdiction in the Commonwealth of Pennsylvania solely for the purpose of
enforcing the arbitrators' decision. The parties further agree that any Demand
for Arbitration or application to the Court in connection with said arbitration
may be served by Certified Mail, return receipt requested to the addresses set
forth above.
7. Applicable Law: This Release Agreement shall be construed in
accordance with the law of the Commonwealth of Pennsylvania applicable to
contracts executed and wholly performed within such state.
8. Entire Agreement: This Release Agreement constitutes the entire
agreement between the parties hereto regarding the subject matter hereof, shall
inure to the benefit of the parties and their respective assignees and
successors; and no amendment or modification of any provision herein shall be
binding unless in writing and signed by the party against whom any such
amendment or modification is sought.
IN WITNESS WHEREOF, the parties have caused this Release Agreement to
be executed as of the day and year first above written.
WALGREEN COMPANY eGAMES, Inc.
By: /s/ Gary Platek By: /s/ Richard Siporin
Name: Gary Platek Name: Richard Siporin
Title: Divisional Merchandise Mgr. Title: Vice President - Sales &
Purchasing Electronics Marketing