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 September 30, 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 November 13, 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 September 30, 2002.................. 3
Statements of Operations for the three months
ended September 30, 2002 and 2001 .................. 4
Statements of Cash Flows for the three months
ended September 30, 2002 and 2001................... 5
Notes to Financial Statements........................... 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations ................ 14
Risk Factors............................................ 24
Item 3. Controls and Procedures................................. 30
Part II Other Information
Item 6. Exhibits and Reports on Form 8-K........................ 31
Exhibit Index ........................................................ 31
Signatures ........................................................ 32
Certifications ........................................................ 33
Exhibits ........................................................ 35
Item 1. Financial Statements
eGames, Inc.
Balance Sheet
(Unaudited)
As of
September 30,
ASSETS 2002
-------------
Current assets:
Cash and cash equivalents $ 271,141
Accounts receivable, net of allowances totaling $872,503 1,404,326
Inventory 415,743
Prepaid and other expenses 83,402
------------
Total current assets 2,174,612
Furniture and equipment, net 44,973
------------
Total assets $ 2,219,585
============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Note payable $ 39,958
Accounts payable 590,764
Bank debt 630,000
Accrued expenses 612,395
------------
Total current liabilities 1,873,117
------------
Total liabilities 1,873,117
Stockholders' equity:
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 1,223,489
Accumulated deficit (9,555,431)
Treasury stock, at cost - 231,900 shares (501,417)
-----------
Total stockholders' equity 346,468
-----------
Total liabilities and stockholders' equity $ 2,219,585
============
See accompanying notes to financial statements.
eGames, Inc.
Statements of Operations
(Unaudited)
Three months ended
September 30,
------------- ------------
2002 2001
----------- -----------
Net sales $ 1,859,156 $ 1,556,168
Cost of sales 879,803 957,819
----------- -----------
Gross profit 979,353 598,349
Operating expenses:
Product development 102,806 130,097
Selling, general and administrative 645,292 819,943
----------- -----------
Total operating expenses 748,098 950,040
----------- -----------
Operating income (loss) 231,255 (351,691)
Interest expense, net 18,475 30,351
----------- -----------
Income (loss) before income taxes 212,780 (382,042)
Provision for income taxes - 0 - 800
----------- -----------
Net income (loss) $ 212,780 ($ 382,842)
=========== ===========
Net income (loss) per common share:
- Basic $ 0.02 ($ 0.04)
=========== ===========
- Diluted $ 0.02 ($ 0.04)
=========== ===========
Weighted average common shares outstanding - Basic 9,989,337 9,989,337
Dilutive effect of common stock equivalents 303,344 - 0 -
----------- -----------
Weighted average common shares outstanding - Diluted 10,292,681 9,989,337
=========== ===========
See accompanying notes to financial statements.
eGames, Inc.
Statements of Cash Flows
(Unaudited)
Three months ended
September 30,
----------------------
2002 2001
--------- ---------
Cash flows from operating activities:
Net income (loss) $ 212,780 ($382,842)
Adjustment to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Depreciation, amortization and other non-cash items 44,964 35,534
Provisions for sales returns, price markdowns,
bad debts and inventory obsolescence 355,730 358,863
Sell-through of prior year's customer advance payments - 0 - (126,586)
Changes in items affecting operations:
Accounts receivable (903,891) 462,382
Prepaid and other expenses 27,663 (198,567)
Inventory 14,555 441,620
Accounts payable 257,681 (838,259)
Customer advance payments - 0 - (484,979)
Accrued expenses (211,858) 912,865
--------- ---------
Net cash provided by (used in) operating activities (202,376) 180,031
--------- ---------
Cash flows from investing activities:
Purchases of furniture and equipment - 0 - (10,260)
--------- ---------
Net cash used in investing activities - 0 - (10,260)
--------- ---------
Cash flows from financing activities:
Proceeds from credit facility/bank debt - 0 - 280,000
Repayments of credit facility/bank debt (210,000) (80,000)
Proceeds from note receivable - 0 - 30,000
Repayments of trade notes payable - 0 - (50,629)
Repayments of note payable (16,592) (15,132)
Repayments of capital lease obligations - 0 - (49,604)
--------- ---------
Net cash provided by (used in) financing activities (226,592) 114,635
--------- ---------
Net increase (decrease) in cash and cash equivalents (428,968) 284,406
Cash and cash equivalents:
Beginning of period 700,109 25,737
--------- ---------
End of period $ 271,141 $ 310,143
========= =========
Supplemental cash flow information:
Cash paid for interest $ 18,475 $ 32,372
========= =========
Non cash investing and financing activities:
Conversion of selected accounts payable to trade notes payable $ - 0 - $ 484,080
========= =========
See accompanying notes to financial statements.
eGames, Inc.
Notes to Financial Statements
1. Summary of Significant Accounting Policies
Description of Business
eGames, Inc. is a Pennsylvania corporation incorporated in July 1992 that
develops, publishes, markets and sells primarily value-priced consumer
entertainment PC software games. Our product line enables us to serve customers
who are seeking a broad range of high-quality, value-priced PC software,
distributed on CD-ROM media and also electronically via the Internet. In North
America, our products are usually distributed through third-party distributors
on a non-exclusive basis who service mass-merchant retailers, in addition to
direct relationships that we have with certain specialty and PC software
retailers. In territories outside North America our products are typically
distributed through third-party distributors that license our PC software
content for their own manufacture and distribution within specific geographic
territories.
Liquidity
As of September 30, 2002, we had stockholders' equity of $346,000 and working
capital of $301,000. For the three months ended September 30, 2002, we earned
$213,000 in net income and experienced $429,000 in negative cash flow. Since the
first quarter of fiscal 2002, we have not had access to a credit facility, and
have been dependent entirely on cash flow from operations to meet our financial
obligations. Our ability to continue meeting our financial obligations in the
ordinary course of business depends on our ability to maintain profitable
operations or obtain additional financing through public or private equity
financing, bank financing, or other sources of capital. We believe that our
projected cash and working capital may be sufficient to fund our operations
through June 30, 2003, but there are significant challenges that we will need to
successfully manage in order to be able to fund our operations through that
period of time. These challenges include, but are not limited to: agreeing to
and maintaining acceptable payment terms with our vendors; increasing the speed
of receivable collections from our customers; and maintaining compliance under
the covenants set forth in the forbearance agreement negotiated with Fleet Bank.
Basis of Presentation
The accompanying unaudited interim financial statements were prepared in
accordance with generally accepted accounting principles for interim financial
information as promulgated in the United States of America. 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 our Form 10-KSB for
the fiscal year ended June 30, 2002 should be read in conjunction with the
accompanying statements. These statements include all adjustments that
management believes are necessary for a fair presentation of the statements.
These interim operating results are not necessarily indicative of the results
for a full year. Certain dollar amounts discussed within the "Notes to Financial
Statements" have been rounded to the nearest thousand ('000").
Fair Value of Financial Instruments
The recorded amounts of accounts receivable and accounts payable at September
30, 2002 approximate fair value due to the relatively short period of time
between origination of the instruments and their expected realization. Our debt
is carried at cost, which approximates fair value, as the debt bears interest at
rates approximating current market rates for similar instruments.
Cash and Cash Equivalents
For purposes of the statements of cash flows, we consider all highly liquid
instruments purchased with an original maturity of three months or less to be
cash equivalents.
Inventory
Inventory, consisting primarily of finished goods, is valued at the lower of
cost or market. Cost is determined by the first-in, first-out method (FIFO).
Furniture and Equipment
Furniture and equipment are stated at cost. Depreciation is calculated on the
straight-line method over the estimated useful lives of the assets ranging from
three to five years.
Leasehold improvements have been fully amortized on the straight-line method
over the shorter of the lease term or estimated useful life of the assets.
Maintenance and repair costs are expensed as incurred.
Long-Lived Assets
In accordance with Statement of Financial Accounting Standards ("SFAS") No. 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets," we record
impairment losses on long-lived assets, including intangible assets, used in
operations when the fair value of those assets, less the cost to sell, is lower
than our carrying value for those assets.
Intangible Assets
As of September 30, 2002, we had intangible assets totaling $741,000, which
costs were fully amortized as of the beginning of fiscal 2003. These assets
resulted primarily from the purchase of software rights. We previously amortized
intangible assets using the straight-line method over three years, and we had
recorded amortization expense of $5,000 for the three months ended September 30,
2001, respectively.
Revenue Recognition
Product Sales:
- --------------
We distribute the majority of our products through third-party distributors to
mass-merchant retailers and directly to certain specialty and PC software
retailers. These retailers have traditionally sold consumer entertainment PC
software products. The distribution of our products is governed by distribution
agreements, direct sale agreements or purchase orders, which generally allow for
product returns and price markdowns. We recognize revenues from product
shipments to these types of customers that traditionally have sold consumer
entertainment PC software products at the time title to the inventory passes to
these customers, less a provision for anticipated product returns and price
markdowns. The provision for anticipated product returns and price markdowns 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 us, and review of outstanding return material
authorizations. 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
sales transaction. Most of our customers require shipping terms of FOB
destination, which results in the title to our product passing at the time when
the customer actually receives our product.
We recognize product sales to our customers who traditionally have sold consumer
entertainment 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 us, title of the product
transfers to the buyer, the buyer has economic substance apart from us, we do
not have further obligations to assist the buyer in the resale of the product
and the product returns and price markdowns can be reasonably estimated at the
time of sale. While we have no other obligations to perform future services
subsequent to shipment, we provide telephone customer support as an
accommodation to purchasers of our products and as a means of fostering customer
loyalty. Costs associated with this effort are insignificant and, accordingly,
are expensed as incurred.
We recognize revenues for product shipments directly to drug store retailers and
distributors when our products actually sell through to the end consumer at
these retail locations and not at the time we ship our products to these drug
store retailers or distributors, or when the right of return no longer exists
for product shipments to a drug store retailer or distributor. During fiscal
2002, we transitioned our prior direct distribution relationships with drug
store retailers to a licensing model with a third-party distributor, United
American Video ("UAV"), which assumes the responsibilities and costs of: order
processing and receivable collections, inventory production, distribution,
promotion and merchandising of our products to these drug store retailers. We
recognize licensing revenues, which are reflected in net sales, based upon
notification from our various licensees, including UAV, of the licensing
revenues that we earned from their net sales during the reporting period, based
upon contractual royalty rates.
Allowance for Product Returns and Price Markdowns:
- --------------------------------------------------
We distribute the majority of our products through third-party distributors to
mass-merchant retailers and directly to certain specialty and PC software
retailers. These retailers traditionally have sold consumer entertainment PC
software products. The distribution of our products is governed by distribution
agreements, direct sale agreements or purchase orders, which generally allow for
product returns and price markdowns. For product shipments to our customers that
have traditionally sold consumer entertainment PC software products, we record a
provision for product returns and price markdowns as a reduction of gross sales
at the time title of the product passes to the customer.
The provision for anticipated product returns and price markdowns is based upon,
among other factors, our analysis of: historical product return and price
markdown results, product sell-through results at retail store locations,
current field inventory quantities at distributors' warehouses and at retail
store locations, introduction of new and/or competing software products that
could negatively impact the sales of one or more of our current products, and
outstanding return material authorizations. The adequacy of our allowance for
product returns and price markdowns is reviewed at the end of each reporting
period and any adjustments (positive or negative) are recorded when deemed
necessary. At the end of each reporting period, the allowance for product
returns and price markdowns is reflected as a reduction to the accounts
receivable balance reflected within our balance sheet.
During the three months ended September 30, 2002 and 2001, our provision for
product returns and price markdowns for customers that have traditionally sold
consumer entertainment PC software products were $316,000 and $175,000,
respectively, or 15% of related gross product shipments during both periods.
Customer Advance Payments
Prior to our fiscal 2002 agreements with two drug store retailers and our
decision to stop distributing our products directly to drug store retailers and
distributors, we had recognized revenue from drug store retailers and
distributors based on the timing of the actual sell-through of our products to
end consumers. Additionally, we previously received payments from these drug
store retailers or distributors in advance of our products being sold to the end
consumer at drug store retail locations. These payments had been recorded as
customer advance payments in our balance sheet until such time as the products
were actually sold through to end consumers. After the products had sold through
to end consumers, or agreements were reached with a drug store retailer or
distributor that eliminated all further right of return, the customer advance
payment amount was recorded as revenue.
Prepaid and Other Expenses
Prepaid and other expenses represent advance payments made to third parties for,
among other things, items such as: licensing of software and intellectual
properties used in our products, maintenance contracts, and retailers' slotting
fees. Prepaid and other expenses are expensed at contractual rates or on a
straight-line basis over the period of time covered by a contract.
Marketing, Sales Incentive and Promotional Costs
Marketing costs reflected as operating expenses, such as advertising fees and
display costs, are charged to expense as incurred or when shipped to a customer
and were $19,000 and $87,000 for the three months ended September 30, 2002 and
2001, respectively.
Sales incentives, such as rebates and coupons, that we experience with retailers
or consumers are recorded as reductions to net sales as incurred and were
$10,000 and $97,000 for the three months ended September 30, 2002 and 2001,
respectively.
Promotional costs, such as slotting fees required by certain retailers, are
recorded as reductions to net sales on a straight-line basis over the
contractual period and were $52,000 and $31,000 for the three months ended
September 30, 2002 and 2001, respectively.
Income Taxes
We use the asset and liability method of accounting for income taxes. Under the
asset and liability method, deferred tax assets and liabilities are recognized
for the estimated future tax consequences attributable to differences between
the financial statement carrying amounts of existing assets and liabilities and
their respective tax bases and for net operating loss and credit carry-forwards.
Deferred tax assets and liabilities are measured using enacted tax rates in
effect for the year in which those temporary differences are expected to be
recovered or settled.
Computation of Earnings (Loss) per Common Share
Net earnings (loss) per common share is computed in accordance with SFAS No.
128, "Earnings per Share". Basic earnings (loss) per share is computed by
dividing net earnings (loss) by the weighted average number of common shares
outstanding during each period. Diluted earnings (loss) per share is computed by
dividing net earnings (loss) by the weighted average number of common and common
share equivalents ("CSE's") outstanding during each period that we report net
income. CSE's include stock options and warrants using the treasury stock
method.
Accounting for Stock-Based Compensation
As of July 1, 2002, we adopted within our financial statements the provisions of
SFAS No. 123, "Accounting for Stock-Based Compensation" by applying the fair
value method for stock option grants made on or after that date. For stock
option grants made prior to July 1, 2002, we recognized stock-based compensation
using the intrinsic value method in accordance with Accounting Principles Board
Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25). We also
applied the provisions of SFAS No. 123 for purposes of valuing and recording the
effects of the common stock warrants issued to Fleet Bank during October 2001.
For the three months ended September 30, 2002, we recorded $34,000 of
stock-based compensation expense relating to both stock option grants and common
stock warrants within the operating expense section of the Statements of
Operations under "Selling, general and administrative".
Management's Estimates
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities, including allowances for inventory obsolescence, product returns,
price markdowns and bad debts (from un-collectible accounts receivable), and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. We recognize the critical nature and potential impact from
making these and any other estimates and attempt to make reliable estimates,
based upon the information available to us as of any reporting period. However,
we recognize that actual results could differ from any of our estimates and such
differences could have a negative impact on future financial results.
New Accounting Pronouncements
During fiscal 2002, we adopted Emerging Issues Task Force ("EITF") Issue 00-25,
"Vendor Income Statement Characterization of Consideration Paid to a Reseller of
the Vendor's Products", which requires that certain promotional costs, such as
slotting fees charged by retailers, be reclassified as reductions to net sales,
as opposed to being reflected as operating expenses. Accordingly, net sales
amounts for current and prior periods reflect the reclassification of expenses,
such as slotting fees, from selling, general and administrative expenses to a
reduction of net sales. For the three months ended September 30, 2002 and 2001,
these amounts were $52,000 and $31,000, respectively.
EITF Issue 00-25 was subsequently codified by EITF Issue 01-9, "Accounting for
Consideration Given by a Vendor to a Customer (Including a Reseller of the
Vendor's Products)". We do not expect any other recently issued accounting
pronouncements to have a significant impact on our results of operations,
financial position or cash flows.
2. Accounts Receivable, net
Accounts receivable consists of the following:
Accounts receivable, gross $2,276,829
Allowance for product returns (586,011)
Allowance for price markdowns (207,409)
Allowance for bad debts (79,083)
----------
Accounts receivable, net $1,404,326
==========
3. Inventory
Inventory consists of the following:
Raw materials in warehouse $ 113,541
Finished goods in warehouse 379,716
Finished goods at customer locations 119,486
----------
612,743
Allowance for inventory obsolescence (197,000)
----------
Inventory $ 415,743
==========
4. Prepaid and Other Expenses
Prepaid and other expenses consists of the following:
Retailer slotting fees $ 30,998
Maintenance contracts 7,579
Other expenses 44,825
----------
Prepaid and other expenses $ 83,402
==========
5. Furniture and Equipment, net
Furniture and equipment consists of the following:
Equipment $ 492,165
Furniture 404,657
----------
896,822
Accumulated depreciation (851,849)
----------
Furniture and equipment, net $ 44,973
==========
6. Note Payable
Note payable to bank, bearing interest at the prime
rate plus 2.75% (7.50% at September 30, 2002). Matures
on March 24, 2003, principal and interest payable monthly.
The note is guaranteed by a former officer of eGames, Inc.
and the Small Business Administration. $ 39,958
Less current portion (39,958)
----------
Long term portion $ - 0 -
==========
7. Bank Debt
Bank debt consists of the following:
Principal amount owed to Fleet Bank at September 30, 2002
under term loan bearing interest at the prime rate plus
3.00% (7.75% at September 30, 2002). Matures on
July 31, 2003, principal and interest payable monthly.
$ 630,000
Less current portion (630,000)
----------
Long term portion $ - 0 -
==========
On July 23, 2001, Fleet Bank (the "Bank") notified us that due to our violation
of the financial covenants under our credit facility as of June 30, 2001, and
the material adverse changes in our financial condition at that time, the Bank
would no longer continue to fund the $2,000,000 credit facility.
On November 2, 2001, we entered into an agreement with the Bank to pay off the
credit facility's outstanding balance of $1,400,000 over a twenty-two month
period. The agreement also provides that, despite our defaults under the loan
documents, the Bank would not enforce their rights and remedies under the loan
documents as long as we remain in compliance with the terms of the agreement.
Our shareholders would face a total loss of their investment if we were to
default under the agreement and the Bank enforced its right to liquidate the
company. The agreement provides that the remaining outstanding balance owed
under the credit facility is to be repaid in monthly installments, with interest
at the prime rate plus three percent. The final monthly payment under this
agreement is due and payable on July 31, 2003. Additionally, the terms of the
agreement require us to achieve certain earnings benchmarks and to provide the
Bank with periodic financial and cash flow reporting.
8. Accrued Expenses
Accrued expenses consist of the following:
Customers with credit balances $ 187,267
Accrued marketing promotion costs 106,488
Accrued royalty fees 58,384
Accrued payroll, bonus and vacation expenses 98,185
Accrued professional fees 42,671
Other accrued expenses 119,400
----------
Accrued expenses $ 612,395
==========
9. Lease Obligations
As of June 30, 2002, we leased 11,000 square feet of office, development and
warehouse space in Langhorne, Pennsylvania under an operating lease scheduled to
expire on September 30, 2002. During December 2001, we executed a sublease
agreement with a third-party for approximately 6,000 square feet of our
operating facility space, in order to help improve cash flow and to more
effectively realign resources. In conjunction with this sublease, we extended
our operating lease for the remaining 5,000 square feet of office space through
September 2004. During the three months ended September 30, 2002, $17,000 was
recorded as a reduction to rent expense that related to this sublease agreement.
Of this amount, $13,000 was from sublease payments received during the three
months ended September 30, 2002 and $4,000 was reclassified from a deposit
amount that had been previously received and recorded within accrued expenses in
the balance sheet. Additionally, we currently rent office equipment through
various operating lease agreements and do not have any capital lease obligations
outstanding. Net rent expense incurred under our operating leases was $18,000
and $34,000 for the three months ended September 30, 2002 and 2001,
respectively.
Our future payments for operating leases are as follows:
Period Amount
- ------------------------------------------------------------------------------
Remaining nine months of fiscal 2003 $ 47,000
Fiscal 2004 63,000
Fiscal 2005 29,000
Fiscal 2006 19,000
Fiscal 2007 and thereafter 28,000
----------
$ 186,000
==========
10. Dependence on Large Customer
We now rely primarily on a concentrated group of large customers, due to the
decision, during fiscal 2002, to cease distributing our products directly to
drug store retailers and refocus our efforts on distributing products to
mass-merchant retailers that have traditionally sold value-priced consumer
entertainment PC software. The majority of our current sales are to
mass-merchant retailers, and distributors serving such retailers, and in
particular to Infogrames, Inc. ("Infogrames"). Infogrames is our primary North
American distributor that services the major mass-merchant retailers in North
America, such as Wal-Mart, K-Mart, Target and Best Buy, among others. In the
event that we lose our distribution capability through Infogrames, it would
significantly harm eGames' financial condition and our ability to continue as a
going concern. During the three months ended September 30, 2002 and 2001,
Infogrames accounted for $992,000 and $356,000, respectively, in net sales
during those periods, or 53% and 23% of net sales, respectively.
11. Commitments and Contingencies
Under various licensing agreements with third-party software developers, we are
required to pay royalties for the use of licensed content in our products.
Royalty expense under such agreements, which is recorded in cost of sales, was
approximately $224,000 and $143,000 for the three months ended September 30,
2002 and 2001, respectively.
We finance our Directors and Officers Liability and Employment Practice
Liability insurance policies with a third-party financing company. We record
this expense monthly on a straight-line basis over the period covered by the
relevant insurance policies. During the three months ended September 30, 2002
and 2001, we recorded $33,000 and $22,000 in related insurance expense and made
related payments of $86,000 and $30,000, respectively. As of August 1, 2002, we
had obtained one-year replacement policies for this insurance coverage for a
total cost of $145,000 (premium cost of $143,000 plus interest cost of $2,000).
The financing terms require us to pay this full amount by February 1, 2003. As
of September 30, 2002, our remaining obligation under this financing arrangement
was $59,000.
We have a retirement plan covering substantially all of our eligible employees.
The retirement plan is qualified in accordance with Section 401(k) of the
Internal Revenue Code. Under the plan, employees may defer up to 15% of their
pre-tax salary, but not more than statutory limits. We match 50% of each dollar
contributed by a participant. Our matching contribution to the plan was $13,000
and $15,000 during the three months ended September 30, 2002 and 2001,
respectively. Our matching contributions vest in fifty percent increments over a
two-year period, beginning on the first day of an individual's employment.
As a result of an agreement with the third-party to which we sold our United
Kingdom subsidiary in May 2001, we are obligated to purchase 50,000 units of
consumer entertainment PC software from this third-party during fiscal 2003 and
2004, at a delivered cost of $1.50 per unit, for a total annual commitment of
$75,000 during each of those fiscal years. As of September 30, 2002, we had not
yet purchased any of this fiscal year's annual commitment.
12. Major Customers, International Sales and Internet Sales
During the three months ended September 30, 2002, one major customer,
Infogrames, accounted for 53% of net sales, compared to the three months ended
September 30, 2001, when two major customers, Walgreen Company and Infogrames,
accounted for 24% and 23% of net sales, respectively.
International net sales, including both licensing revenues and product net
sales, represented 3% of net sales for the three months ended September 30,
2002, compared to 6% of net sales for the three months ended September 30, 2001.
For the three months ended September 30, 2002, licensing revenues comprised 95%
of international net sales compared to 55% of international net sales during the
same period a year ago.
Internet sales accounted for 2% of net sales for the three months ended
September 30, 2002 and 2001.
13. Operations by Reportable Segment and Geographic Area
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 our products,
geographic areas and major customers.
Based on our organizational structure, we operate in only one geographic and one
reportable segment, which is publishing interactive entertainment software for
personal computers.
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
Forward-Looking Statements
This Quarterly Report on Form 10-QSB contains forward-looking statements about
circumstances that have not yet occurred, including, without limitation,
statements regarding:
- our anticipated sell-through rates for new higher price point
products;
- our expected provision for product returns and price markdowns for
customers that have traditionally sold consumer PC software products;
- the expectation that the majority of our product sales for the
foreseeable future will be through third-party distributors,
as opposed to direct-to-store retail distribution;
- the expected percentage of net sales to Infogrames for the remainder of
fiscal 2003;
- the expected net sales to North American OEM and licensing customers
for the remainder of fiscal 2003;
- the belief that the transition from direct distribution relationships
with drug store retailers to a licensing agreement with United American
Video (UAV) will result in higher gross profit margins;
- the expectation that we will earn licensing revenues from the UAV
agreement;
- the belief that for the remainder of fiscal 2003, the majority of
our net sales generated at North American non-traditional software
retail locations will be through the licensing agreement with UAV,
which should cause net sales to North American non-traditional
software customers to decrease significantly, on a comparative
basis to prior year periods, but enable us to earn higher profit
margins;
- expected international sales for the remainder of fiscal 2003;
- the creation of programs designed to increase sales of our products via
the Internet;
- expected Internet sales for the remainder of fiscal 2003;
- the belief that reclamation costs will remain at the reduced levels
experienced to date in fiscal 2003 for the foreseeable future;
- the expectation that royalty rates required by software developers will
continue to increase for the foreseeable future;
- the belief that our fiscal 2003 gross profit margin may range between
50% to 55%;
- the expectation that, for the remainder of fiscal 2003, our marketing
promotional expenses will primarily increase or decrease
proportionately based on corresponding increases and decreases in net
sales;
- the expectation that we will not need to undertake any large decrease
or increase in the number of employees during the remainder of fiscal
2003;
- our anticipated investing activities for the remainder of fiscal 2003;
- our belief that projected cash and working capital balances may be
sufficient to fund our operations through June 30, 2003;
- the expectation that certain new accounting pronouncements will not
have a significant impact on our results of operations, financial
position or cash flows;
- and 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 our actual future results could differ materially from those
set forth in the forward-looking statements due to such risks and uncertainties.
We will not necessarily update information if any forward looking statement
later turns out to be inaccurate.
The following important factors, as well as those factors discussed under "Risk
Factors" at pages 24 to 29 in this report, could cause our 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 our
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 us and
Infogrames, as one of our largest customers and the distributor to
Wal-Mart, K-Mart, Target, Shopko, and Best Buy, among others;
- our ability to accurately estimate sell-through volume when
products are shipped to, or received by, a customer that has
traditionally sold consumer entertainment PC software;
- the amount of unsold product that is returned to us by retail stores
and distributors;
- our ability to accurately estimate the amount of product returns
and price markdowns that will occur and the adequacy of the
allowances established for such product returns and price
markdowns;
- the successful sell-through of our new higher price point products, in
all retail channels where it has been sold;
- the continued success of our current business model of selling,
primarily through third-party distributors, to a concentrated number of
select mass-merchant, specialty and PC software retailers;
- the success of our distribution strategy, including the ability to
continue to increase the distribution of our 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 our products in major retail chain
stores;
- the ability of our international product distribution to earn a royalty
and the ability of licensors to pay us such royalties;
- our success in achieving additional cost savings and avoiding
unforeseeable expenses for the remainder of fiscal 2003;
- our ability to collect outstanding accounts receivable and establish an
adequate allowance for bad debts;
- 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 our products;
- our ability to license or develop quality content for our products;
- the success of our efforts to increase website traffic and product
sales over the Internet;
- consumers' continued demand for value-priced consumer entertainment PC
software;
- increased competition in the value-priced software category;
- and various other factors, many of which are beyond our control.
Risks and uncertainties that may affect our 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, 2002,
as filed with the Securities and Exchange Commission and also posted on the
Company's website, www.egames.com.
Critical Accounting Policies
- ----------------------------
Our significant accounting policies and methods used in the preparation of the
Financial Statements are discussed in Note 1 of the Notes to Financial
Statements. We believe our accounting policies with respect to revenue
recognition and the valuation of inventory involve the most significant
management judgments and estimates. Our discussion and analysis of our financial
condition and results of operations are based upon our financial statements,
which have been prepared in accordance with accounting principles generally
accepted in the United States. The preparation of these financial statements
requires us to make estimates and judgments that affect the reported amounts of
assets, liabilities, revenues and expenses, and related disclosure of contingent
assets and liabilities. On an on-going basis, we evaluate our estimates,
including those related to product returns, price markdowns, bad debts,
inventory obsolescence, income taxes, contingencies and litigation. We base our
estimates on historical experience and on various other assumptions that we
believe are reasonable under the circumstances. Actual results may differ from
these estimates under different assumptions or conditions.
Revenue Recognition (Net Sales, Product Returns and Price Markdowns)
Significant management judgments and estimates must be made and used in order to
determine when revenues can be recognized in any reporting period. Material
differences may result in the amount and timing of our revenue for any period if
management's judgments or estimates for product returns or price markdowns prove
to be insufficient based upon actual results. These differences, if material,
would significantly affect our operating results and financial condition.
We distribute the majority of our products through third-party distributors to
mass-merchant retailers and directly to certain specialty and PC software
retailers. These retailers have traditionally sold consumer entertainment PC
software products. The distribution of our products is governed by distribution
agreements, direct sale agreements or purchase orders, which generally allow for
product returns and price markdowns. For product shipments to our customers that
have traditionally sold consumer entertainment PC software products, we record a
provision for product returns and price markdowns as a reduction of gross sales
at the time title of the product passes to the customer.
The provision for anticipated product returns and price markdowns is based upon
many factors, including our analysis of: historical product return and price
markdown results, product sell-through results at retail store locations,
current field inventory quantities at distributors' warehouses and at retail
store locations, introduction of new and/or competing software products that
could negatively impact the sales of one or more of our current products, and
outstanding return material authorizations. The adequacy of our allowance for
product returns and price markdowns is reviewed at the end of each reporting
period and any adjustments (positive or negative) are recorded when deemed
necessary. At the end of each reporting period, the allowance for product
returns and price markdowns is reflected as a reduction to the accounts
receivable balance reflected within our balance sheet.
During the three months ended September 30, 2002 and 2001, our provision for
product returns and price markdowns for customers that have traditionally sold
consumer entertainment PC software products were $316,000 and $175,000,
respectively, or 15% of related gross product shipments during both periods.
During the three months ended September 30, 2002, available sell-through
information, including information provided directly by retailers and by NPD
Group (a global market information firm), suggested that at traditional software
retailers, our products continued to generally sell through to consumers at
historically comparable rates. Additionally, compared to this same quarter a
year ago, we have increased the number of retail placement slots for our
products at many of these retail locations. A factor that we will continue to
closely monitor in establishing our provision for anticipated product returns
and price markdowns will be the sell-through results of our higher price point
products that were first introduced during the quarter ended September 30, 2002.
The sale of such products, ranging in retail price points from $19.99 to $29.99,
represents a departure from our typical value-priced product offering to the
casual gamer that have historically been retail priced from $9.99 to $14.99, and
accordingly represent a greater risk of requiring additional price markdowns if
these products do not sell-through to consumers at anticipated rates. If both
our new higher price point products and our typical value-priced products sell
through to consumers at anticipated rates, we expect our provision for product
returns and price markdowns for customers that have traditionally sold consumer
PC software products to range from 15% to 20%, as a percentage of related gross
product shipments, for the remainder of fiscal 2003.
We recognize revenues from product shipments to 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 us, title of the
product transfers to the buyer, the buyer has economic substance apart from us,
we do 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. Most of
our customers require shipping terms of FOB destination, which results in the
title to our product passing at the time when the customer actually receives our
product.
We recognize revenues for product shipments to drug store retailers and
distributors when our products actually sell through to the end consumer at
these retail locations and not at the time we ship our products to these drug
store retailers or distributors, or when the right of return no longer exists
for product shipments to a drug store retailer or distributor. During fiscal
2002, we transitioned our prior direct distribution relationships with drug
store retailers to a licensing model with a third-party distributor, United
American Video ("UAV"), which assumes the responsibilities and costs of: order
processing and receivable collections, inventory production, distribution,
promotion and merchandising of our products to these drug store retailers. We
recognize licensing revenues, which are reflected in net sales, based upon
notification from our various licensees, including UAV, of the licensing
revenues that we earned from their net sales during the reporting period, based
upon contractual royalty rates.
Inventory Valuation
Our accounting policy for inventory valuation requires management to make
estimates and assumptions as to the recoverability of the carrying value of our
inventory that affect the reported value of inventory and cost of sales for any
reporting period. Differences may result in the valuation of our inventory at
the close of any reporting period and the amount reflected as cost of sales
during any reporting period, if management's judgments or estimates with respect
to provisions for the potential impairment of inventory value prove to be
insufficient based upon actual results. These differences, if material, would
significantly affect our operating results and financial condition.
We are exposed to product obsolescence due to the relatively short product life
cycles (averaging six to twenty-four months) of our consumer entertainment PC
software products. From time to time, we or our competitors may introduce new
products, capabilities or technologies that have the potential to replace or
shorten the life cycles of our existing products, which would require us to
write-down the value of such inventory. Additionally, from time to time, we have
been subject to litigation or threatened litigation involving product content,
which has caused certain products to no longer be saleable. License agreements
with third-party software developers for product content may also expire before
such inventory has been sold. We may also from time to time produce an amount of
inventory of a product that exceeds the eventual consumer demand for such
product, causing us to liquidate these excess quantities of remaining inventory
at close out prices below our carrying costs net our provision for obsolescence.
The adequacy of our provision for inventory obsolescence is reviewed at the
close of each reporting period, and any adjustments (positive or negative) are
recorded when deemed necessary.
Results of Operations
Three Months ended September 30, 2002 and 2001
Net Sales
- ---------
For the three months ended September 30, 2002, net sales increased by $303,000,
or 20%, to $1,859,000 compared to $1,556,000 for the same quarter a year
earlier. This $303,000 increase in net sales resulted from a $782,000 increase
in net sales to North American traditional software customers and a $51,000
increase in net sales to North American OEM and licensing customers, which
increases were partially offset by net sales decreases to North American
non-traditional software customers and international customers of $489,000 and
$41,000, respectively. Additionally, net sales benefited by $81,000 from
agreements entered into during the quarter with two customers to finalize their
respective sales return allowances. The following tables represent our net sales
by distribution channel and by major customer for the three months ended
September 30, 2002 and 2001, respectively:
Net Sales by Distribution Channel
Three Months ended
----------------------------
September 30, September 30, Increase
Channel 2002 2001 (Decrease)
- --------------------------------------------------------------------------------------------------
North American traditional software customers $1,678,000 $ 896,000 $ 782,000
North American OEM and licensing customers 51,000 - 0 - 51,000
North American non-traditional software customers 72,000 561,000 (489,000)
International customers 58,000 99,000 (41,000)
- --------------------------------------------------------------------------------------------------
Totals $1,859,000 $1,556,000 $ 303,000
========== ========== =========
Net Sales by Major Customer
Three Months ended
----------------------------
September 30, September 30, Increase
Customer 2002 2001 (Decrease)
- --------------------------------------------------------------------------------------------------
Infogrames, Inc. $ 992,000 $ 356,000 $ 636,000
Walgreen Company - 0- 372,000 (372,000)
Various inventory liquidation customers 233,000 330,000 (97,000)
All other customers 634,000 498,000 136,000
- ---------------------------------------------------------------------------------------- ---------
Totals $1,859,000 $1,556,000 $ 303,000
========== ========== =========
The $782,000 net sales increase to traditional software customers resulted
primarily from the $636,000 increase in net sales to Infogrames, which
represented a 179% increase in net sales to Infogrames, compared to same period
last year. During the three months ended September 30 2002, we were able to
increase, compared to the same period a year ago, the number of retail facings
(designated positions for our software titles within a retailer's shelf space)
at mass-merchant and specialty retailers such as Wal-Mart, K-Mart, Target and
Best Buy, as well as PC software retailers like CompUSA and Office Depot.
Product distribution to these customers (which have historically been successful
in merchandising consumer entertainment PC software) improved as a result of our
increased sales efforts to these retailers combined with previous product
sell-through results. Partially offsetting the net sales increase to traditional
software customers was a $97,000 decrease in net sales of end-of-lifecycle
products to various inventory liquidation customers. Although negatively
impacting our gross profit margin for the current quarter, these inventory
liquidation sales continued to support our liquidity needs.
For the three months ended September 30, 2002, net sales to third-party
distributors represented 71% of net sales, compared to 55% of net sales during
the same period a year ago. For the foreseeable future, we expect to continue
selling the majority of our products through third-party distributors, such as
Infogrames, as opposed to direct-to-store distribution to retailers, which
usually include higher fulfillment costs related to EDI order processing and
other additional costs associated with direct-to-store shipments. In addition,
many mass-market retailers such as Wal-Mart will not purchase PC software
products directly from us, and require us to distribute our products through one
of their approved distributors (such as Infogrames).
During the three months ended September 30, 2002, one major customer,
Infogrames, accounted for 53% of net sales, compared to the three months ended
September 30, 2001, when two major customers, Walgreen Company and Infogrames,
accounted for 24% and 23% of net sales, respectively. For the remainder of
fiscal 2003, we anticipate that net sales to Infogrames may continue to
represent greater than 50% of net sales.
The $489,000 net sales decrease to North American non-traditional software
customers resulted primarily from net sales decreases to the Walgreen Company
and Rite Aid Corporation of $372,000 and $100,000, respectively. During the
three months ended September 30, 2002, we did not recognize any revenue
attributable to either of these two drug store retailers, due to our decision in
fiscal 2002 to stop distributing products directly to these retailers. During
the three months ended September 30, 2001, we recognized revenue attributable to
these two drug store retailers after receiving notification from them of eGames
products having been sold through to end consumers at their retail locations.
The $51,000 net sales increase (or 3% of net sales) to North American OEM and
licensing customers was comprised of $35,000 in licensing revenues from United
American Video ("UAV") and $16,000 through two OEM relationships, compared to no
such revenues for the same period last year. For the remainder of fiscal 2003,
we expect net sales to North American OEM and licensing customers to represent
approximately 3% to 5% of net sales.
During the fourth quarter of fiscal 2002, we transitioned our prior direct
distribution relationships with drug store retailers to a higher-margin
licensing agreement with UAV. Through this agreement, we earn licensing revenues
based on contractual royalty rates applied to UAV's net sales during a reporting
period from product shipments of eGames software titles that UAV has
manufactured. UAV incurs all production, sales, distribution and fulfillment
costs related to the sales of eGames software titles to these retailers. During
the three months ended September 30, 2001, we recognized $68,000 in net sales
relating to shipments of physical products to UAV, which is reflected within net
sales to North American non-traditional software customers for that prior year
period. During fiscal 2003, we believe that the majority of our net sales
generated at North American non-traditional software retail locations will be
through our licensing agreement with UAV. This arrangement should continue to
cause our net sales to North American non-traditional software customers to
decrease significantly, on a comparative basis to prior year periods, but should
enable us to earn higher profit margins on these licensing revenues compared to
our historical margins on product sales to drug store retailers.
International net sales, including both licensing revenues and product net
sales, represented 3% of net sales for the three months ended September 30,
2002, compared to 6% of net sales for the three months ended September 30, 2001.
For the three months ended September 30, 2002, licensing revenues comprised 95%
of international net sales compared to 55% of international net sales during the
same period a year ago. For the remainder of fiscal 2003, we anticipate that
international net sales may range from 3% to 5% of net sales, and will continue
to be primarily generated from licensing revenues.
During fiscal 2003, we have continued initiating various programs designed to
increase the net sales of our products over the Internet, including: adding an
on-line registration feature to our retail products, which is designed to
increase our database of registered users who are interested in receiving
promotional offers about our products and drive traffic to our website;
continuously updating and improving our websites; improving our electronic
distribution capabilities by further developing and expanding our affiliation
with Digital River, a leading distributor of digital software over the Internet
and certain of their promotional customers; and further incorporating
user-friendly on-line functionality into our products. Internet sales accounted
for 2% of net sales for the three months ended September 30, 2002 and 2001 and
we anticipate this percentage remaining relatively constant for the remainder of
fiscal 2003.
Cost of Sales
- -------------
Cost of sales for the three months ended September 30, 2002 were $880,000
compared to $958,000 for the three months ended September 30, 2001, representing
a decrease of $78,000 or 8%. This cost of sales decrease was caused by decreases
of:
o $69,000 in product costs,
o $59,000 in provision for inventory obsolescence,
o $40,000 in reclamation costs associated with product returns, and
o $13,000 in freight costs.
These cost of sales decreases were partially offset by cost of sales increases
of:
o $81,000 in royalty costs, and
o $22,000 in other cost of sales.
The $69,000 decrease in product costs was caused by the non-recurrence of low
margin third-party publisher software titles sales and a decrease in inventory
liquidation sales comprised of low margin end-of-lifecycle products. During
fiscal 2002, we stopped distributing software products directly to drug store
retailers, which retailers had sometimes required us to provide third-party
software products along with our PC game titles within short-term promotional
displays.
The $59,000 decrease in provision for inventory obsolescence also resulted from
our decision to discontinue distributing software products to drug store
retailers. During fiscal 2002, our products did not sell through to consumers
at drug store retailers at the rates we had anticipated. Much of the product
costs associated with products returned from these drug store retailers had to
be scrapped due to the short product life cycle of this inventory combined with
the long length of time it took these retailers to return products to us.
During fiscal 2003, we have not experienced the same high level of inventory
obsolescence that occurred in fiscal 2002. We believe the primary reason for
this cost improvement is our focus on increasing product distribution to
traditional software retailers and distributors servicing such retailers, where
our products remain on the retailers' store shelves longer and product
sell-through results to consumers have historically been better than we
experienced with drug store retailers.
The $40,000 decrease in reclamation costs (processing costs charged by drug
store retailers and third-party warehouse vendors when products are returned to
us) was the result of the non-recurrence of the high product return rates we
experienced during fiscal 2002 from drug store retailers. We believe that
reclamation costs will remain at these reduced levels for the foreseeable future
as we continue to focus on distributing our products to traditional software
retailers and distributors.
The $13,000 decrease in freight costs was due to reduced product shipments to
and product returns from multiple drug store warehouses. Additionally, freight
costs have decreased, in part, due to the increase in cost efficient product
shipments to a more concentrated group of third-party distributor warehouses.
The $81,000 increase in royalty costs was caused by the current period's
increase in net sales, combined with an increase in the average royalty rate
associated with those net sales. We anticipate royalty rates required by
software developers to continue increasing for the foreseeable future.
The $22,000 increase in other costs of sales related primarily to the increased
warehousing, handling, and packaging costs incurred in the distribution of our
products to CompUSA and Office Depot. These customers require us to deliver our
products directly to their individual retail stores, resulting in these types of
costs being higher than the amounts we incur on the majority of our customer
orders that are delivered to third-party distributors' warehouses.
Gross Profit Margin
- -------------------
Our gross profit margin for three months ended September 30, 2002 increased to
52.7% of net sales from 38.5% of net sales for three months ended September 30,
2001. Reflected within the percentages discussed below, our gross profit margin
benefited by 2.2%, as a percentage of net sales, from agreements entered into
during the current quarter with two previous customers to finalize their
respective sales return allowances.
This 14.2% increase in gross profit margin was caused by cost decreases, as a
percentage of net sales, of:
o 9.7% in product costs,
o 4.2% in provision for inventory obsolescence,
o 2.6% in reclamation costs associated with product returns, and
o 1.5% in freight costs.
These costs decreases were partially offset by cost increases, as a percentage
of net sales, of:
o 2.9% in royalty costs, and
o 0.9% in other costs of sales.
In particular, the 9.7% decrease in product costs, as a percentage of net sales,
was caused by:
o Increased distribution of higher-priced consumer entertainment PC gaming
software titles,
o Discontinuation of low margin sales of third-party publisher software
titles to drug store customers,
o Agreements with two customers to finalize their respective sales return
allowances, and
o Decreased low margin inventory liquidation sales of end-of-lifecycle
software products.
The reasons for the percentage of net sales decreases in the provision for
inventory obsolescence and in reclamation and freight costs, along with the
increases in royalty costs and other costs of sales are discussed under "Cost of
Sales," above. Our gross profit margin for the first three months of fiscal 2003
benefited from our decision to stop distributing products directly to drug store
retailers. Based on our current business model of servicing, primarily through
third-party distributors, a concentrated number of select mass-merchant,
specialty and PC software retailers, and assuming that our existing overall
product sell-through to consumers and product return rates from customers remain
at current levels, we believe that our fiscal 2003 gross profit margin may range
between 50% to 55%. Factors having potential impact on our fiscal 2003 gross
profit margin are, among other things:
o Controlling the manufacturing and distribution costs of our titles,
o Consumer acceptance of newly released higher-priced consumer
entertainment PC gaming software titles,
o Third-party licensees' success in distributing our titles to
international customers and drug store retailers,
o Establishing successful titles at higher retail price points to
compensate for developer royalty rate increases,
o Possible inventory liquidation sales yielding below normal profit margins
to address liquidity needs, and
o Price markdowns and other consumer and retailer incentives to support
product sell-through to consumers.
Operating Expenses
- ------------------
Product development expenses for the three months ended September 30, 2002 were
$103,000 compared to $130,000 for the three months ended September 30, 2001, a
decrease of $27,000 or 21%. The liquidity crisis we encountered during fiscal
2002 required us to undertake several cost saving initiatives, which among other
things, included substantial reductions in our internal staffing levels. As a
result of these initiatives, we achieved $37,000 in cost reductions in salary
related costs, which was partially offset by this period's employee bonus
accrual. This cost reduction was also partially offset by a $9,000 increase in
outside services associated with obtaining additional consumer entertainment PC
software content including the standard industry ratings required by most
retailers.
Selling, general and administrative expenses for the three months ended
September 30, 2002 were $645,000 compared to $820,000 for three months ended
September 30, 2001, a decrease of $175,000 or 21%. As a result of various cost
saving initiatives we undertook throughout fiscal 2002, which among other
things, included substantial reductions in marketing promotional expenses and in
our internal staffing levels, we achieved the following cost reductions:
o $68,000 in marketing promotional expenses,
o $48,000 in bad debt expense,
o $34,000 in cash discounts,
o $28,000 in salary related costs and travel expenses, and
o $31,000 in other selling, general and administrative expenses.
These cost savings were partially offset by $34,000 in stock compensation
expense recorded during the three months ended September 30, 2002 compared to no
similar expense for the same period last year. This stock compensation expense
related to the monthly straight-line expensing over the vesting periods of the
value assigned to both the warrants issued to Fleet Bank during October 2001 and
to the stock options granted to employees during the first quarter of fiscal
2003. As of July 1, 2002, we adopted within our financial statements the
provisions of SFAS No. 123, "Accounting for Stock-Based Compensation," by
applying the fair value method for stock option grants made on or after that
date.
The $68,000 decrease in marketing promotional expenses contributed significantly
to the 21% decrease in selling, general and administrative expenses. This
decrease was caused primarily by our decision to discontinue distributing our
products directly to drug store retailers. Previously, we had incurred
significant merchandising, display and other promotional costs in order to
support our Store-in-a-Store distribution strategy with drug store retailers.
For the remainder of fiscal 2003, we anticipate that our marketing promotional
expenses will primarily increase or decrease proportionately based on
corresponding increases and decreases in net sales.
The $48,000 decrease in bad debt expense was primarily attributable to an
improvement in the relative credit quality of our more concentrated group of
customers.
The $34,000 decrease in cash discounts was caused by a decrease in cash receipts
from drug store retailers that required approximately a 3% discount to be
deducted from their receivable payments.
The $28,000 decrease in salary related costs and travel expenses resulted from
our reduced staff levels, which was partially offset by this period's employee
bonus accrual. We believe that we have reduced our employee workforce to a level
that most effectively supports our projected operations for the foreseeable
future, and we do not anticipate any large decrease or increase in our number of
employees during the remainder of fiscal 2003.
The $31,000 decrease in other selling, general and administrative expenses was
achieved through various cost reductions, and in particular a $25,000 decrease
in depreciation and amortization expense related to older assets becoming fully
depreciated at rates greater than we are purchasing new assets.
Interest Expense, Net
- ---------------------
Net interest expense for the three months ended September 30, 2002 was $18,000
compared to $30,000 for the three months ended September 30, 2001, a decrease of
$12,000. This $12,000 decrease was primarily due to the decrease in the average
outstanding balance of our bank debt, which bears a floating interest rate of
prime plus 3%.
Provision for Income Taxes
- --------------------------
We had no provision for income taxes for the three months ended September 30,
2002 compared to a $1,000 provision for income taxes for the three months ended
September 30, 2001. We did not record any provision for income taxes due to the
expected utilization of certain net operating loss carry-forwards from prior
periods.
Net Income (Loss)
- -----------------
As a result of the factors discussed above, and in particular our agreements
with two customers that benefited the current period's financial results by
$81,000, our net income for the three months ended September 30, 2002 was
$213,000 compared to a ($383,000) net loss for the same period a year earlier,
an increase in net income of $596,000.
Weighted Average Common Shares
The weighted average common shares outstanding on a diluted basis increased by
303,344 for the three months ended September 30, 2002 to 10,292,681 from
9,989,337 for the three months ended September 30, 2001. The current period's
increase in the diluted basis calculation of weighted average common shares
resulted from additional common stock equivalents ("CSE's"), compared to the
same period last year that did not include any CSE's. The diluted basis
calculation for the three months ended September 30, 2001, excluded common stock
equivalents due to their anti-dilutive impact caused by the net loss incurred
during that period.
Liquidity and Capital Resources
At September 30, 2002, we had working capital of $301,000 and total
stockholders' equity of $346,000, compared to a working capital deficiency of
($1,986,000) and a total stockholders' deficit balance of ($2,498,000) at
September 30, 2001. As of September 30, 2002, we had $271,000 in cash compared
to $700,000 as of June 30, 2002. This $429,000 decrease in cash resulted from
net cash used in operating activities of $202,000 and by net cash used in
financing activities of $227,000. We did not have investing activities during
the three months ended September 30, 2002.
For the three months ended September 30, 2002, net cash used in operating
activities was $202,000 compared to net cash provided by operating activities of
$180,000 for the three months ended September 30, 2001. The $202,000 net cash
used in operating activities during the current period was caused by a $904,000
increase in accounts receivable combined with a $212,000 decrease in accrued
expenses largely related to software developer royalty payments. Partially
offsetting these cash uses were cash sources of:
o $356,000 in provision for product returns, price markdowns, bad debts
and inventory obsolescence,
o $258,000 from an increase in accounts payable,
o $213,000 in net income,
o $45,000 in depreciation, amortization and other non-cash items,
o $28,000 from a decrease in prepaid and other expenses, and
o $14,000 from a decrease in inventory.
For the three months ended September 30, 2002, we did not have investing
activities compared to $10,000 in net cash used in investing activities for the
three months ended September 30, 2001. Other than potential additions and
upgrades to our existing computer network's hardware and software, we do not
anticipate a material amount of investing activities for the remainder of fiscal
2003.
For the three months ended September 30, 2002, net cash used in financing
activities was $227,000 compared to net cash provided by financing activities of
$115,000 for the three months ended September 30, 2001. The $227,000 net cash
used in financing activities for the current period resulted from $210,000 in
repayments of bank debt and $17,000 in repayments of a note payable.
On July 23, 2001, Fleet Bank (the "Bank") notified us that due to our violation
of the financial covenants under our credit facility as of June 30, 2001, and
the material adverse changes in our financial condition at that time, the Bank
would no longer continue to fund the $2,000,000 credit facility.
On November 2, 2001, we entered into an agreement with the Bank to pay off the
credit facility's outstanding balance of $1,400,000 over a twenty-two month
period. The agreement also provides that, despite our defaults under the loan
documents, the Bank would not enforce their rights and remedies under the loan
documents as long as we remain in compliance with the terms of the agreement.
Our shareholders would face a total loss of their investment if we were to
default under the agreement and the Bank enforced its right to liquidate the
company. The agreement provides that the remaining outstanding balance owed
under the credit facility is to be repaid in monthly installments, with interest
at the prime rate plus three percent. The final monthly payment under this
agreement is due and payable on July 31, 2003. As of November 13, 2002, the
principal balance outstanding on this term loan was $560,000. The terms of the
agreement also require us to achieve certain earnings benchmarks and to provide
the Bank with periodic financial and cash flow reporting, and as of November 13,
2002, we were in compliance with the covenants of this agreement.
As part of the agreement, we issued warrants to the Bank for the purchase of
750,000 shares of our 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 has demand registration rights that
began on November 1, 2002. The value of these warrants was determined by using
the Black-Scholes valuation model and was expensed at a monthly rate of $3,750
on a straight-line basis over the warrants' one-year vesting period from October
1, 2001 through September 30, 2002.
During the three months ended September 30, 2002 and 2001, we financed our
Directors and Officers Liability and Employment Practice Liability insurance
policies with a third-party financing company, and recorded $33,000 and $22,000
in related insurance expense and made related payments of $86,000 and $30,000
for the same periods, respectively. As of August 1, 2002, we had obtained
one-year replacement policies for this insurance coverage for a total cost of
$145,000 (premium cost of $143,000 plus interest cost of $2,000). The financing
terms require us to pay this full amount by February 1, 2003. As of November 13,
2002, our outstanding balance under this financing arrangement was $44,000.
Liquidity Risk
- --------------
Since we no longer have a credit facility available to us, our ability to
achieve and maintain positive cash flow is essential to our survival as a going
concern. Our ability to do this depends upon a variety of factors, including the
timeliness and success of the collection of outstanding accounts receivable, the
creditworthiness of the primary distributors and retail customers of our
products, the development and sell-through of our products to consumers, and the
costs of developing, producing and marketing such products. We believe that our
projected cash and working capital balances may be sufficient to fund our
operations through June 30, 2003, but there are significant challenges that we
will need to successfully manage in order to be able to fund our operations
through that period of time. These challenges include, but are not limited to:
agreeing to and maintaining acceptable payment terms with our vendors;
increasing the speed of our receivable collections from customers; and
maintaining compliance under the covenants set forth in the forbearance
agreement with the Bank. Additionally, there are market factors beyond our
control that could also significantly affect our operating cash flow. The most
significant of these market factors are the market acceptance and sell-through
rates of our current products to consumers, and the continued growth of the
consumer entertainment PC software market. If any of our software titles do not
sell through to consumers at the rate anticipated, we could be exposed to
additional product returns and a lack of customer replenishment orders for these
products, which could severely reduce the accounts receivable that we would be
able to collect from such retailers or distributors of our products. As a result
of these factors, we may not be able to achieve or maintain positive cash flow.
Outside financing to supplement our cash flows from operations may not be
available if and when we need it. Even if such financing were available from a
bank or other financing source, it may not be on terms satisfactory to us
because of the dilution it may cause or other costs associated with such
financing.
New Accounting Pronouncements
During fiscal 2002, we adopted Emerging Issues Task Force ("EITF") Issue 00-25,
"Vendor Income Statement Characterization of Consideration Paid to a Reseller of
the Vendor's Products", which requires that certain promotional costs, such as
slotting fees charged by retailers, be reclassified as reductions to net sales,
as opposed to being reflected as operating expenses. Accordingly, net sales
amounts for current and prior periods reflect the reclassification of expenses,
such as slotting fees, from selling, general and administrative expenses to a
reduction of net sales. For the three months ended September 30, 2002 and 2001,
these amounts were $52,000 and $31,000, respectively.
EITF Issue 00-25 was subsequently codified by EITF Issue 01-9, "Accounting for
Consideration Given by a Vendor to a Customer (Including a Reseller of the
Vendor's Products)". We do not expect any other recently issued accounting
pronouncements to have a significant impact on our results of operations,
financial position or cash flows.
FACTORS AFFECTING FUTURE PERFORMANCE
Risk Factors
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Our business is subject to many risks and uncertainties that could affect our
future financial performance. The following discussion highlights some of the
more important risks we have identified, but they may not be the only factors
that could affect future performance.
We sustained a significant loss during fiscal 2001, and achieved only minimal
net income in fiscal 2002 exclusive of the non-cash impact from fiscal 2002
agreements with two national drug store retailers. We began operations in July
1992, and experienced significant losses from inception through the end of
fiscal 1997. We earned approximately $253,000, $463,000 and $1,253,000 in fiscal
2000, 1999 and 1998, respectively, and in fiscal 2001, we sustained a net loss
of $5,933,000. Prior to fiscal 1998, we funded our operations mostly through
proceeds from our initial public offering of common stock in October 1995 and
through the sale of preferred stock in private offerings in November 1996, and
January and April 1997, in addition to proceeds from the exercise of various
common stock warrants and stock options. We have since funded our business
activities from cash generated from operations and bank borrowings. Currently,
we do not have access to any further bank borrowings.
Our net income in fiscal 2002 was $2,181,000. Excluding the non-cash impact from
our fiscal 2002 agreements with two national drug store retailers, our net
income in fiscal 2002 was only $76,000. Our accumulated deficit at June 30, 2002
was $9,768,000. Even though we achieved modest profitability in fiscal 2002,
given current market conditions in the United States in general, and the effects
from the significant loss we sustained in fiscal 2001, there can be no assurance
that we will be profitable in fiscal 2003. Our 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. These risks include, but are not limited to, development,
distribution and marketing difficulties, competition, and unanticipated costs
and expenses. Our future success will depend on our ability to be profitable in
the development, marketing and distribution of our current and future software
products.
We have experienced severe liquidity problems. On July 23, 2001, our commercial
lender, Fleet Bank, notified us that because of our default of the financial
covenants under our $2,000,000 credit facility as of June 30, 2001, and due to
material adverse changes in our financial condition, the bank would no longer
continue to fund our credit facility. On November 2, 2001, we entered into an
agreement with Fleet Bank to pay off the credit facility's outstanding balance
at that time of $1,400,000 owed to Fleet Bank over a twenty-two month period.
The agreement also provides that, despite our defaults under the loan documents,
Fleet Bank would not enforce its rights and remedies under those loan documents
as long as we remain in compliance with the terms of the agreement. As of
November 13, 2002, we were in compliance with the covenants of this agreement.
Our shareholders would lose their entire investment if we defaulted under the
agreement and Fleet Bank enforced its right to liquidate our company. The terms
of the agreement provide, among other things, for us to repay the remaining
outstanding balance owed under the credit facility in 22 monthly installments,
with interest at the prime rate plus three percent. Additionally, the terms of
the agreement require us to achieve certain earnings benchmarks and to provide
Fleet Bank with periodic financial and cash flow reporting. There can be no
assurance we will be able to meet this agreement's covenants through June 30,
2003. As part of the agreement, we issued warrants to Fleet Bank for the
purchase of 750,000 shares of our 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 has demand registration
rights that began on November 1, 2002. As of November 13, 2002, the principal
balance outstanding on this term loan was $560,000.
Since we do not currently have access to a credit facility, our ability to
continue operations requires us to generate sufficient cash flow from operations
to fund our business activities. In the past we have experienced dramatic
fluctuations in cash flows, so we cannot be sure we will be able to continue
achieving sufficient cash flows to fund our operations.
We may need additional funds. Our capital requirements are currently funded from
the cash flow generated from product sales. If we are not able to achieve cash
flow from operations at a level sufficient to support our business activities,
we may require additional funds. The degree to which we are indebted to our
commercial lender, the first lien that the bank has on all of our assets, and
our poor financial performance in fiscal 2001, could adversely affect our
ability to obtain additional financing and could make us more vulnerable to
industry downturns and competitive pressures. Additionally, we may only be able
to raise needed funds on terms that would result in significant dilution or
otherwise be unfavorable to existing shareholders. Our inability to secure
additional funding when needed, or generate adequate funds from operations,
would adversely impact our long-term viability.
Our success depends on continued viable business relationships with key
distributors and retailers. Many of the largest mass-market retailers have
buying relationships with certain distributors, and these retailers often will
only buy consumer entertainment PC software from such distributors. It would
pose a significant challenge to us if these distributors were unwilling to
distribute our products. Additionally, even if the distributors are willing to
purchase our products, distributors are frequently able to dictate the price,
timing and other terms on which we can distribute our products to such
retailers. We also may not be able to distribute our products to such retailers
on terms that we consider commercially acceptable. If we cannot negotiate sales
terms with these retailers that are commercially acceptable, we may then choose
to distribute our products to such retailers through a large distributor, such
as Infogrames, which would further concentrate our sales to only a few large
customers. Our inability to negotiate commercially viable distribution
relationships with significant retailers and distributors, or the loss of, or
significant reduction in sales to, any of our key distributors or retailers,
would adversely affect our business, operating results and financial condition.
A significant part of our sales come from a limited number of customers. Due to
our decision during fiscal 2002 to discontinue selling our consumer
entertainment PC software products directly to drug store retailers and
distributors and to focus instead on selling our products to mass-merchant,
specialty and PC software retailers that have traditionally sold value-priced
consumer entertainment PC software, we now rely primarily on a concentrated
group of large customers. The majority of our current sales are to
mass-merchant, specialty and PC software retailers, and distributors serving
such retailers, and in particular to Infogrames. Infogrames is our primary North
American distributor that services the major mass-merchant retailers in North
America, such as Wal-Mart, K-Mart, Target, Best Buy, Shopko, among others. Our
net sales to Infogrames during the fiscal year ended June 30, 2002 were
$2,311,000 and represented 21% of our total net sales. Excluding net sales to
drug store retailers and distributors, this $2,311,000 in net sales to
Infogrames represented 46% of our net sales. We anticipate that net sales to
Infogrames may represent greater than 50% of our total net sales during fiscal
2003. Accordingly, we expect to continue depending upon a limited number of
significant customers, and in particular Infogrames, for the foreseeable future.
Most of our customers, including Infogrames, may terminate their relationship
with us at any time. In the event that we lose our distribution capability
through Infogrames or any of our other large customers, it would significantly
harm our financial condition and our ability to continue as a going concern.
We may experience customer payment defaults and un-collectible accounts
receivable if our distributors' or retailers' businesses fail or if they
otherwise cannot pay us. Distributors and retailers in the consumer
entertainment PC software industry and in mass-market retail channels can and
have experienced significant fluctuations in their businesses and many of these
businesses have failed. These business failures have increased and may continue
to increase as a result of economic conditions in the United States. The
insolvency or business failure of any significant retailer or distributor of our
products would significantly harm our business, operating results and financial
condition. Our sales are typically made on credit, with terms that vary
depending upon the customer and the nature of the product. We do not hold
collateral to secure payment. We maintain an allowance for bad debts for
anticipated un-collectible accounts receivable which we believe to be adequate.
The actual allowance required for any one customer's account or on all of the
accounts receivable in total, may ultimately be greater than our allowance for
bad debts at any point in time. The failure to pay an outstanding receivable by
a significant customer would significantly harm our business, operating results
and financial condition.
Our customers have the right to return our products and to take price markdowns,
which could reduce our net sales and results of operations. Most of our customer
relationships allow for product returns and price markdowns. We establish
allowances for future product returns and price markdowns at the time of sale
for traditional software retail customers and distributors servicing such
retailers. These allowances are based on historical product return and price
markdown results with these types of customers, product sell-through information
and channel inventory reports supplied by these retailers and the distributors
that serve them, among other factors. Our sales to these customers are reported
net of product return and price markdown provisions. Actual product returns and
price markdowns could exceed these anticipated amounts, particularly for new
products released during the quarter ended September 30, 2002 that have higher
price points than our typical $9.99 jewel case products, which would negatively
impact our future results of operations.
Our operating results fluctuate from quarter to quarter, which makes our future
operating results uncertain and difficult to predict. Our 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 our
control. Fluctuations in quarterly operating results will depend upon many
factors including:
o seasonality of customer buying patterns;
o the size and rate of growth of the consumer entertainment PC software
market;
o the demand for our typical value-priced and new higher-priced PC software
products;
o product and price competition;
o the amount of product returns and price markdowns;
o the timing of our new product introductions and product enhancements and
those of our competitors;
o the timing of major customer orders;
o product shipment delays;
o access to distribution channels;
o product defects and other quality problems;
o product life cycles;
o international royalty rates and licensing revenues; and
o our ability to develop and market new products and control costs.
Products are usually shipped within days following the receipt of customer
orders so we typically operate with little or no backlog. Therefore, net sales
in any reporting period are usually dependent on orders booked, shipped and
received by our customers during that period.
We are exposed to seasonality in the purchases of our products. The consumer
entertainment PC software industry is highly seasonal, with sales typically
higher during the first and last calendar quarters (our second and third fiscal
quarters). This is due to increased demand for PC software games during and
immediately following the holiday buying season. Delays in product development
or manufacturing can affect the timing of the release of our products, causing
us to miss key selling periods such as the year-end holiday buying season. If we
miss product deliveries during these key selling periods, or if our products are
not ready for shipment to meet the holiday buying season, our net sales and
operating results would be adversely affected. Additionally, if our products do
not adequately sell-in to our customers' retail locations or sell-through to
consumers at these retail locations during the holiday buying season, our
financial results for the entire fiscal year would be adversely affected.
The consumer entertainment software market is highly competitive and changes
rapidly. The market for consumer entertainment PC 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 PC software products. There is intense competition among
consumer entertainment PC software publishers for shelf space and promotional
support from retailers. As the number of PC 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. Also, our larger
competitors may have more leverage than us to negotiate more and
better-positioned shelf space than us. Our retail and distribution customers
have no long-term obligations to purchase our products, and may discontinue
purchasing our products at any time. If any of our large customers stopped
buying our products or significantly reduced their purchases, our sales would
significantly decrease.
Increased competition for acquiring the licensing rights to quality consumer
entertainment PC software content has compelled us to agree to make increasingly
higher advance royalty payments and, in some cases, to guarantee minimum royalty
payments to content licensors and PC software game developers. If the products
subject to these advances and minimums do not generate sufficient sales volumes
to recover these costs, our financial results would be negatively impacted.
Our present or future competitors may also develop products that are comparable
or superior to ours. Our competitors may offer higher quality products, lower
priced products or adapt more quickly than us to new technologies or evolving
customer requirements. Our competitors typically have more financial resources
to spend on marketing promotions, licensing recognizable brands, and advertising
efforts. Competition is expected to intensify. In order to be successful in the
future, we must be able to respond to technological changes, customer
requirements and competitors' current products and innovations. We may not be
able to compete effectively in this market, which would have an adverse effect
on our operating results and financial condition.
We depend on the market acceptance of our products, and these products typically
have relatively 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 PC software products
are difficult to predict and few products achieve sustained market acceptance.
New products we introduce may not achieve any significant degree of market
acceptance, or the product life cycles may not be long enough for us to recover
advance royalties, development, marketing and other promotional costs. Also, if
a product does not sell-through to consumers at a rate satisfactory to our
retail or distribution customers, we could be forced to accept substantial
product returns or be required to issue additional price markdowns to maintain
our relationships with these distributors and retailers. We may also lose retail
shelf space if our products do not sell-through to consumers at satisfactory
rates. Failure of new products to achieve or sustain market acceptance or
product returns or price markdowns results in excess of our expectations would
adversely impact our business, operating results and financial condition.
We are vulnerable to rapid technological change that could make our products
less marketable. Frequent new product introductions and enhancements, rapid
technological developments, evolving industry standards and swift changes in
customer requirements characterize the market for our products. Our future
success depends on our 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 our
competitors introduce products more quickly than us, or if they introduce better
products than ours, then our business could be adversely affected. We may also
not be successful in developing and marketing new products or enhancements to
our existing products on a timely basis. Our new or enhanced products may not
adequately address the changing needs of the marketplace. From time to time, our
competitors may announce new products, capabilities or technologies that have
the potential to replace or shorten the life cycles of our existing products.
Announcements of currently planned or other new products by competitors may
cause customers to delay their purchasing decisions in anticipation of such
products, which could adversely affect our business, liquidity and operating
results. Additionally, technological advancements in computer operating systems
that cause our products to be obsolete or not to function as expected would
adversely affect our financial results if product returns exceeded our reserves,
and inventory was deemed valueless (and exceeded our allowance for inventory
obsolescence).
Our common stock has experienced low trading volumes and other risks on the OTC
Bulletin Board. In April 2001, our common stock was delisted from the Nasdaq
SmallCap Market as a result of our failure to maintain a minimum bid price of
$1.00 over a period of 30 consecutive trading days. Our stock then began trading
on the OTC Bulletin Board under the existing symbol EGAM. In March 2002, our
common stock was not eligible to be traded on the OTC Bulletin Board because we
were not current with our reporting requirements under the Securities Exchange
Act of 1934, as amended (the "1934 Act"). In April 2002, our common stock was
again traded on the OTC Bulletin Board, when we became current with our 1934 Act
filings.
We may not be able to continue to maintain the trading of our stock on the OTC
Bulletin Board, which in calendar 2003 will implement listing standards and an
application approval requirement to transition to the new Bulletin Board
Exchange (BBX) trading system. The BBX trading system will also require listing
fees. Even if we are successful in maintaining trading of our stock on the OTC
Bulletin Board or the BBX, many stocks traded on the OTC Bulletin Board have
experienced extreme price and trading volume fluctuations. These fluctuations
are often unrelated or disproportionate to the operating performance of
individual companies. Our stock price may be adversely affected by such
fluctuations, regardless of our operating results. Additionally, many common
stocks traded on the OTC Bulletin Board are thinly traded, such as our common
stock, which would make it difficult to sell our stock. If we are not eligible
to list our common stock for trading on the BBX, our stock will then be traded
on the Pink Sheets, which may have even less trading volume potential and more
price fluctuations than the OTC Bulletin Board.
We have experienced increased regulation of our product content and features.
Due to the competitive environment in the consumer entertainment software
industry, we have and will continue to incorporate features into our products,
such as an Internet browser-like interface, advertising technology and on-line
consumer registration capabilities, to differentiate our products to retailers,
provide value-added features to consumers, and to potentially increase website
traffic and create new revenue streams based on advertising and promotional
opportunities. These features may not 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.
We may have difficulty protecting our intellectual property rights. We either
own or have licensed the rights to copyrights on our products, manuals,
advertising and other materials. We also hold trademark rights in our corporate
logo, and the names of the products owned or licensed by us. Our success depends
in part on our ability to protect our proprietary rights to the trademarks,
trade names and content used in our principal products. We rely on a combination
of copyrights, trademarks, trade secrets, confidentiality procedures and
contractual provisions to protect our proprietary rights. These initiatives to
protect our proprietary rights require us to use internal resources as well as
outside legal counsel. We may not have sufficient resources to adequately
protect our intellectual property rights, and our existing or future copyrights,
trademarks, trade secrets or other intellectual property rights may not be of
sufficient scope or strength to provide meaningful protection or commercial
advantage to us. Also, in selling our products, we rely on "click-through"
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 our proprietary rights, as do the laws of the United
States. Our inability to sufficiently protect our intellectual property rights
would have an adverse effect on our business and operating results.
Policing unauthorized use of an easily duplicated and broadly disseminated
product such as computer software is very difficult. Software piracy is expected
to be a persistent problem for the software industry for the foreseeable future.
Software piracy is a much greater problem in certain international markets. If a
significant amount of unauthorized copying of our products were to occur, our
business, operating results and financial condition could be adversely affected.
We may incur substantial expenses and be required to use our internal resources
to defend infringement claims, and settlements may not be favorable or
attainable. We may from time to time be notified that we are infringing on the
intellectual property rights of others. Combinations of content acquired through
past or future acquisitions and content licensed from third-party software
developers will create new products and technology that may give rise to claims
of infringement. In recent years, we have incurred significant defense costs and
utilized internal resources in defending trademark and copyright claims and
lawsuits. Other third parties may initiate infringement actions against us in
the future. Any future claims could result in substantial costs to us, and
diversion of our limited resources. If we are found to be infringing on the
rights of others, we may not be able to obtain licenses on acceptable terms or
at all, and significant damages for past infringement may be assessed, or
further litigation relating to any such licenses or usage may occur. Our failure
to obtain necessary licenses or other rights, or the commencement of litigation
arising from any such claims, could materially and adversely affect our
operating results.
We are exposed to the risk of product defects. Products we offer 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
our 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 or widespread product recalls, which would adversely affect
our business, operating results and financial condition.
We depend on key management and technical personnel. Our success depends to a
significant degree on the continued efforts of our key management, marketing,
sales, product development and operational personnel. The loss of one or more
key employees could adversely affect our operating results. We also believe our
future success will depend in large part on our ability to attract and retain
highly skilled management, technical, marketing, sales, product development and
operational personnel. Competition for such personnel is intense, and, due to
our limited resources and size, we may not be successful in attracting and
retaining such personnel.
We may experience unique risks with our international revenues and distribution
efforts. International net revenues, including both product net sales and
licensing revenues, represented 4% of our net sales for the fiscal year ended
June 30, 2002, compared to 6% of our net sales for the fiscal year ended June
30, 2001. We anticipate that in fiscal 2003 our international business will
continue to be transacted primarily through third-party licensees, which is
subject to some risks that our domestic business is not, including: varying
regulatory requirements; difficulties in managing foreign distributors;
potentially adverse tax consequences; and difficulties in collecting delinquent
accounts receivable. Additionally, because our 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
outstanding licensing receivables, could have a material adverse effect on our
financial condition.
Item 3. Controls and Procedures
(a) Evaluation of disclosure controls and procedures. Our Chief Executive
Officer and Chief Financial Officer (together, the "Certifying Officers"), after
evaluating the effectiveness of our disclosure controls and procedures (as
defined in the Securities Exchange Act of 1934 Rules 13a-14(c) and 15-d-14(c))
as of a date within 90 days before the filing date of this quarterly report,
have concluded that as of the date of the evaluation, our disclosure controls
and procedures were:
(i) effective to ensure that the information required to be
disclosed in the reports that we file or submit under the
Securities Exchange Act of 1934 is recorded, processed,
summarized and reported within the time periods specified in the
SEC's rules and forms, and
(ii) designed to ensure that material information relating to us
that is required to be disclosed by us in such reports is
accumulated and communicated to the Certifying Officers by
others within our company to allow timely decisions
regarding disclosure.
(b) Changes in internal controls. There were no significant changes in our
internal controls or, to our knowledge, in other factors, that could
significantly affect our disclosure controls and procedures subsequent to their
evaluation.
Part II. Other Information
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit No. Description of Exhibit
- ----------- ----------------------
99.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002
99.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002
(b) Reports on Form 8-K
On July 30, 2002, the Company filed a report on Form 8-K regarding a press
release announcing its financial results for the fiscal year ended June 30,
2002.
On October 24, 2002, the Company filed a report on Form 8-K regarding a press
release announcing its financial results for the first quarter of fiscal 2003.
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: November 14, 2002 /s/ Gerald W. Klein
----------------- --------------------
Gerald W. Klein, President, Chief
Executive Officer and Director
Date: November 14, 2002 /s/ Thomas W. Murphy
----------------- --------------------
Thomas W. Murphy, Chief Financial
Officer and Chief Accounting Officer
CERTIFICATIONS
I, Gerald W. Klein, President and Chief Executive Officer, certify that:
1. I have reviewed this quarterly report on Form 10-QSB of eGames,
Inc.;
2. Based on my knowledge, this quarterly report does not contain
any untrue statement of a material fact or omit to state a
material fact necessary to make the statements made, in light
of the circumstances under which such statements were made, not
misleading with respect of the period covered by this
quarterly report;
3. Based on my knowledge, the financial statements, and other
financial information included in this quarterly report,
fairly present in all material respects the financial
condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other Certifying Officer and I are
responsible for establishing and maintaining disclosure
controls and procedures (as defined in Exchange Act Rules
13a-14 and 15d-14) for the registrant and have:
a) Designed such disclosure controls and procedures to
ensure that material information relating to the
registrant, including its consolidated subsidiaries,
is made known to us by others within those entities,
particularly during the period in which this
quarterly report is being prepared;
b) Evaluated the effectiveness of the registrant's
disclosure controls and procedures as of a date
within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) Presented in this quarterly report our conclusions about
the effectiveness of the disclosure controls and procedures
based on our evaluation as of the Evaluation Date;
5. The registrant's other Certifying Officer and I have
disclosed, based on our most recent evaluation, to the
registrant's auditors and the audit committee of registrant's
board of directors (or persons performing the equivalent
functions):
a) All significant deficiencies in the design or
operation of internal controls which could adversely
affect the registrant's ability to record, process,
summarize and report financial data and have
identified for the registrant's auditors any material
weaknesses in internal controls; and
b) Any fraud, whether or not material, that involves
management or other employees who have a significant role
in the registrant's internal controls; and
6. The registrant's other Certifying Officer and I have
indicated in this quarterly report whether there were
significant changes in internal controls or in other factors
that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and
material weaknesses.
Date: November 14, 2002
/s/ Gerald W. Klein
Gerald W. Klein
President and Chief Executive Officer
CERTIFICATIONS
I, Thomas W. Murphy, Chief Financial Officer and Chief Accounting Officer,
certify that:
1. I have reviewed this quarterly report on Form 10-QSB of eGames,
Inc.;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material
fact necessary to make the statements made, in light of the
circumstances under which such statements were made, not
misleading with respect of the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other
financial information included in this quarterly report, fairly
present in all material respects the financial condition, results
of operations and cash flows of the registrant as of, and for,
the periods presented in this quarterly report;
4. The registrant's other Certifying Officer and I are responsible
for establishing and maintaining disclosure controls and
procedures (as defined in Exchange Act Rules 13a-14 and 15d-14)
for the registrant and have:
a) Designed such disclosure controls and procedures to ensure
that material information relating to the registrant,
including its consolidated subsidiaries, is made known to
us by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b) Evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior
to the filing date of this quarterly report (the
"Evaluation Date"); and
c) Presented in this quarterly report our conclusions about
the effectiveness of the disclosure controls and procedures
based on our evaluation as of the Evaluation Date;
5. The registrant's other Certifying Officer and I have disclosed,
based on our most recent evaluation, to the registrant's auditors
and the audit committee of registrant's board of directors (or
persons performing the equivalent functions):
a) All significant deficiencies in the design or operation of
internal controls which could adversely affect the
registrant's ability to record, process, summarize and
report financial data and have identified for the
registrant's auditors any material weaknesses in internal
controls; and
b) Any fraud, whether or not material, that involves
management or other employees who have a significant role
in the registrant's internal controls; and
6. The registrant's other Certifying Officer and I have indicated
in this quarterly report whether there were significant changes
in internal controls or in other factors that could significantly
affect internal controls subsequent to the date of our most
recent evaluation, including any corrective actions with regard
to significant deficiencies and material weaknesses.
Date: November 14, 2002
/s/ Thomas W. Murphy
Thomas W. Murphy
Chief Financial Officer and Chief
Accounting Officer
Exhibit 99.1
CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the Quarterly Report of eGames, Inc. (the "Company") on Form
10-QSB for the three months ended September 30, 2002 as filed with the
Securities and Exchange Commission on the date hereof (the "Report"), I, Gerald
W. Klein, President and Chief Executive Officer of the Company, certify,
pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the
Sarbanes-Oxley Act of 2002, that:
1. The Report fully complies with the requirements of section 13(a) or
15(d) of the Securities Exchange Act of 1934; and
2. The information contained in the Report fairly presents, in all
material respects, the financial condition and results of operations
of the Company.
/s/ Gerald W. Klein
Gerald W. Klein
President and Chief Executive Officer
November 14, 2002
Exhibit 99.2
CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the Quarterly Report of eGames, Inc. (the "Company") on Form
10-QSB for the three months ended September 30, 2002 as filed with the
Securities and Exchange Commission on the date hereof (the "Report"), I, Thomas
W. Murphy, Vice President and Chief Financial Officer of the Company, certify,
pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the
Sarbanes-Oxley Act of 2002, that:
1. The Report fully complies with the requirements of section 13(a) or
15(d) of the Securities Exchange Act of 1934; and
2. The information contained in the Report fairly presents, in all
material respects, the financial condition and results of operations
of the Company.
/s/ Thomas W. Murphy
Thomas W. Murphy
Chief Financial Officer and Chief Accounting Officer
November 14, 2002