U.S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-QSB
(Mark One)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2004
|_| 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 CORPORATE ISSUERS
State the number of shares outstanding of each of the issuer's classes of common
equity, as of the latest practicable date: 10,014,337 shares of common stock, no
par value per share, as of May 12, 2004.
Transitional Small Business Disclosure Format (check one): Yes ( ) No ( X )
INDEX
Page
----
Part I. Financial Information
Item 1. Unaudited Financial Statements:
Balance Sheet as of March 31, 2004........................ 3
Statements of Operations for the three and nine months
ended March 31, 2004 and 2003 ........................ 4
Statements of Cash Flows for the nine months
ended March 31, 2004 and 2003 ........................ 5
Notes to Financial Statements............................. 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations .................. 12
Risk Factors.............................................. 26
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
Exhibits .......................................................... 33
Item 1. Unaudited Financial Statements
eGames, Inc.
Balance Sheet
(Unaudited)
March 31, 2004
ASSETS
Current assets:
Cash and cash equivalents $ 1,552,279
Accounts receivable, net of allowances of $1,283,887 1,515,069
Inventory, net 791,943
Prepaid and other expenses 354,927
-----------
Total current assets 4,214,218
Furniture and equipment, net 61,330
Intangible assets 19,300
-----------
Total assets $ 4,294,848
===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 406,344
Accrued expenses 617,878
-----------
Total current liabilities 1,024,222
Commitments and contingencies
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 1,290,228
Accumulated deficit (6,698,012)
Treasury stock, at cost - 231,900 shares (501,417)
-----------
Total stockholders' equity 3,270,626
-----------
Total liabilities and stockholders' equity $ 4,294,848
===========
See accompanying notes to financial statements.
eGames, Inc.
Statements of Operations
(Unaudited)
Three Months Ended Nine Months Ended
March 31, March 31,
------------------------- -------------------------
2004 2003 2004 2003
---- ---- ---- ----
Net sales $ 2,152,859 $ 1,530,983 $ 6,320,892 $ 5,335,956
Cost of sales 874,230 579,817 2,585,045 2,200,911
----------- ----------- ----------- -----------
Gross profit 1,278,629 951,166 3,735,847 3,135,045
Operating expenses:
Product development 119,344 108,240 386,431 312,987
Selling, general and
administrative 608,454 591,483 1,800,271 1,885,585
----------- ----------- ----------- -----------
Total operating expenses 727,798 699,723 2,186,702 2,198,572
----------- ----------- ----------- -----------
Operating income 550,831 251,443 1,549,145 936,473
Interest (income) expense, net (2,430) 6,330 1,087 36,493
----------- ----------- ----------- -----------
Income before income taxes 553,261 245,113 1,548,058 899,980
Provision (benefit) for income taxes 25,137 (51,007) 70,335 (51,007)
----------- ----------- ----------- -----------
Net income $ 528,124 $ 296,120 $ 1,477,723 $ 950,987
=========== =========== =========== ===========
Net income per common share:
- Basic $ 0.05 $ 0.03 $ 0.15 $ 0.10
====== ====== ====== ======
- Diluted $ 0.05 $ 0.03 $ 0.14 $ 0.10
====== ====== ====== ======
Weighted average common shares
outstanding - Basic 9,989,337 9,989,337 9,989,337 9,989,337
Dilutive effect of common share
equivalents 1,380,022 10,309 886,948 9,720
---------- --------- ---------- ---------
Weighted average common shares
outstanding - Diluted 11,369,359 9,999,646 10,876,285 9,999,057
========== ========= ========== =========
See accompanying notes to financial statements.
eGames, Inc.
Statements of Cash Flows
(Unaudited)
Nine Months Ended
March 31,
--------------------------
2004 2003
---- ----
Cash flows from operating activities:
Net income $ 1,477,723 $ 950,987
Adjustment to reconcile net income to net cash
provided by operating activities:
Stock-based compensation 47,091 87,278
Depreciation and amortization 15,358 32,763
Provisions for product returns, price markdowns,
bad debts and inventory obsolescence 1,574,147 939,579
Changes in items affecting operations:
Accounts receivable (1,796,481) (1,125,363)
Prepaid and other expenses (117,691) (41,296)
Inventory (436,628) (4,318)
Accounts payable (166,753) (108,991)
Accrued expenses 8,009 (114,751)
----------- ----------
Net cash provided by operating activities 604,775 615,888
----------- ----------
Cash flows from investing activities:
Purchases of furniture and equipment (57,433) (7,685)
Expenditures related to intangible assets (19,300) - 0 -
----------- ----------
Net cash used in investing activities (76,733) (7,685)
----------- ----------
Cash flows from financing activities:
Repayments of bank debt - 0 - (840,000)
Redemption of common stock warrant - 0 - (50,000)
Repayments of note payable - 0 - (56,550)
----------- ----------
Net cash used in financing activities - 0 - (946,550)
----------- ----------
Net increase (decrease) in cash and cash equivalents 528,042 (338,347)
Cash and cash equivalents:
Beginning of period 1,024,237 700,109
----------- ----------
End of period $ 1,552,279 $ 361,762
=========== ==========
Supplemental cash flow information:
Cash paid during the period for interest $ 5,475 $ 38,211
======== ==========
Cash paid (refunds received) for income taxes $ 43,646 ($ 51,007)
======== ==========
See accompanying notes to financial statements.
eGames, Inc.
Notes to Financial Statements
(Unaudited)
1. Summary of Significant Accounting Policies
Description of Business
eGames, Inc. is a Pennsylvania corporation incorporated in July 1992 that
publishes, markets and sells affordable consumer entertainment PC software
games. PC software games today are sold in most mass-merchant and major
retailers. Our product line enables us to serve consumers who are seeking a
broad range of high-quality, affordable PC software, distributed on CD-ROM media
and also electronically via the Internet. In North America, our products are
distributed primarily through third-party software distributors on a
non-exclusive basis who service mass-merchant and major retailers. We also sell
our products directly to certain PC software retailers. In territories outside
North America, our products are distributed through third-party software
distributors that license our PC software content for their own manufacture and
distribution within specific geographic territories. The word "customer " as
used in this document refers to third-party distributors and retailers, as
compared to the word "consumer," which refers to the end consumer shopping at
retail stores or over the Internet.
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, 2003 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. Amounts discussed within the "Notes to Financial Statements"
have been rounded to the nearest thousand dollars.
Fair Value of Financial Instruments
The recorded amounts of accounts receivable and accounts payable at March 31,
2004 approximate fair value due to the relatively short period of time between
origination of the instruments and their expected realization. All liabilities
are carried at cost, which approximate fair value 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.
Accounts Receivable, net
Accounts receivable is reflected at the amount we expect to ultimately collect
from outstanding customer balances, and is shown on our balance sheet net of
allowances for product returns, price markdowns and customer bad debts. The
adequacy of these allowances is reviewed throughout each reporting period and
any necessary adjustments to these allowances are made through additional
provisions for: product returns and price markdowns (reflected as a reduction to
gross sales); and customer bad debts (reflected as an operating expense). Actual
product returns, price markdowns and customer bad debts are recorded as
reductions to these allowances as well as reductions to the customers'
individual accounts receivable balances (see Note 2).
Inventory, net
Inventory, net 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) (see
Note 3).
Furniture and Equipment, net
Furniture and equipment, net are stated at cost and net of accumulated
depreciation. Depreciation is calculated on the straight-line method over the
estimated useful lives of the assets ranging from three to five years
(see Note 5).
Long-Lived Assets, net
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 March 31, 2004, we had intangible assets of approximately $19,000, which
related to the Company's trademark activities with the United States Patent and
Trademark Office. As of March 31, 2004, we had not recorded any amortization
expense on these costs based upon our evaluation that no impairment has
occurred.
Revenue Recognition
Product Sales:
- --------------
We distribute the majority of our products through third-party software
distributors to mass-merchant and major retailers and directly to certain PC
software retailers. These retailers have traditionally sold consumer
entertainment PC software products. The distribution of our products is governed
by purchase orders, distribution agreements, or direct sale agreements, many of
which allow for product returns and price markdowns. We recognize sales revenues
from product shipments to these software distributors and retailers that
traditionally have sold consumer entertainment PC software products at the time
title to our inventory passes to these distributors or retailers, less a
provision for anticipated product returns and price markdowns. Title passes to
most of these distributors and retailers upon receipt of the product by these
customers, because most of these customers require shipping terms of FOB
destination. In order to recognize sales revenues associated with customer
purchase orders having terms of FOB destination, as part of our sales cut-off
tests, we obtain proof of deliveries from the freight companies that deliver our
products to our retail and distribution customers for product shipments made
during the last two weeks of a reporting period. The results of the sales
cut-off tests are reviewed by our Controller, Chief Financial Officer and
independent auditors before the reporting period's earnings release is
distributed. Based on the results of the sales cut-off tests, any sales revenue
and cost of sales associated with product shipments received by our customers
after the reporting period and having FOB destination terms are excluded from
the current period's operating results.
We recognize product sales to the customers that traditionally have sold
consumer entertainment PC software products in accordance with the criteria of
SFAS No. 48 at the time title to our inventory passes to these distributors or
retailers, 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.
After deliveries to our distribution and retail customers are made, we do not
provide any further services or materials that are essential to our products'
functionality. However, we do provide basic telephone and web-based customer
support to consumers who purchase our products as a means of fostering consumer
satisfaction and brand loyalty. Costs associated with our customer support
effort usually occur within one year from the period we recognize revenue and
these costs have continued to be minimal (averaging about 1% of net sales).
These costs to render our customer support services, which are comprised of the
salary and related costs of our one customer support representative, are
recorded as operating expenses in the period incurred.
During fiscal 2004, we entered into relationships with certain software
distributors that expanded our product distribution into various office
superstores, which distribution is governed by consignment sales agreements.
Accordingly, sales revenues from product shipments pursuant to these
arrangements are only recognized to the extent that one of these third-party
software distributors has reported to us the actual product sell-through to end
consumers at these office superstore retailers.
Provision for Product Returns and Price Markdowns:
- --------------------------------------------------
Our provision for anticipated product returns and price markdowns (reflected as
a reduction to gross sales) is based upon, among other factors, our analysis of:
historical product return and price markdown results; current product
sell-through results at retail store locations; current field inventory
quantities at distributors' warehouses and at retail store locations; the length
of time that products have been out at retail along with their estimated
remaining retail life; outstanding return material authorizations; the
introduction of new and/or competing software products that could negatively
impact the sales of one or more of our current products; and the extent to which
new products with higher price points or unproven genres have been launched. The
adequacy of our allowance for product returns and price markdowns is reviewed
throughout each reporting period and any necessary adjustment to this allowance
(positive or negative) is reflected within the current period's provision. At
the end of each reporting period, the allowance for product returns and price
markdowns is recorded as a reduction to our gross accounts receivable balance.
Historically, the allowance for product returns and price markdowns has
represented a substantial percentage of our gross accounts receivable. As of
March 31, 2004, the allowance for product returns and price markdowns was 46% of
related gross accounts receivable, compared to 41% of related gross accounts
receivable at June 30, 2003. This large percentage occurs because we continue to
have product return exposure relating to paid receivables while the physical
product units relating to these receivables remain in the retailers' stores or
in the retailers' or distributors' warehouses. Until the physical products are
actually returned to us, or sell through to end consumers, we continue to
evaluate our product return or price markdown exposure for these units remaining
in the retail channel. During these time periods, through customer-provided
reports, we have regular and timely visibility of the sell-through results for
our titles to help us estimate our exposure for future product returns or price
markdowns.
During the three months ended March 31, 2004 and 2003, our provisions for
product returns and price markdowns for customers that have traditionally sold
consumer entertainment PC software products were $398,000 and $222,000,
respectively, or 16% and 13% of related gross sales, respectively.
During the nine months ended March 31, 2004 and 2003, our provisions for product
returns and price markdowns for customers that have traditionally sold consumer
entertainment PC software products were $1,432,000 and $892,000, respectively,
or 19% and 15% of related gross sales, respectively.
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, certain insurance coverage and various service
contracts. Prepaid and other expenses are usually expensed as operating expenses
on a straight-line basis over the period of time covered by a contract, except
for advance licensing and royalty payments, which are expensed in cost of sales
at contractual rates based on the net sales of the related software titles (see
Notes 4 and 7). We continually evaluate the recoverability of advance licensing
and royalty payments and charge to cost of sales (in the reporting period in
which such determination is made) the amount we determine will likely not be
recouped at the contractual rate based on anticipated sales for a title.
Marketing Costs, Sales Incentives and Promotional Costs
Marketing costs reflected as operating expenses, such as advertising fees, are
expensed as incurred. These costs were $4,000 and $9,000 for the three months
ended March 31, 2004 and 2003, respectively and were $49,000 and $46,000 for the
nine months ended March 31, 2004 and 2003, respectively.
Sales incentives and promotional costs, such as rebates and slotting fees, we
incur with distributors or retailers are recorded as reductions to gross sales
as incurred or on a straight-line basis over a contractual period. These costs
were $141,000 and $38,000 for the three months ended March 31, 2004 and 2003,
respectively, and were $383,000 and $200,000 for the nine months ended March 31,
2004 and 2003, 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 Net Income per Common Share
Net income per common share is computed in accordance with SFAS No. 128,
"Earnings per Share". Basic earnings per share is computed by dividing net
earnings by the weighted average number of common shares outstanding during each
period. Diluted earnings per share is computed by dividing net earnings by the
weighted average number of common shares and common share equivalents ("CSE's")
outstanding during each period that we report net income. CSE's may 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). As of
January 1, 2003, we adopted the provisions of SFAS No. 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure" (see Note 8).
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 customer bad debts, in addition to 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 also recognize that actual results
could differ from any of our estimates and such differences could have either a
negative or positive impact on future financial results.
2. Accounts Receivable, net
Accounts receivable, net consists of the following:
Accounts receivable, gross $ 2,799,000
Allowance for product returns (1,027,000)
Allowance for price markdowns (247,000)
Allowance for bad debts (10,000)
-----------
Accounts Receivable, net $ 1,515,000
===========
3. Inventory, net
Inventory, net consists of the following:
Raw materials $ 184,000
Finished goods 502,000
Product returns 215,000
---------
901,000
Allowance for inventory obsolescence (109,000)
---------
Inventory, net $ 792,000
=========
4. Prepaid and Other Expenses
Prepaid and other expenses consists of the following:
Advanced royalties $ 261,000
Prepaid insurance expenses 47,000
Prepaid federal income taxes 20,000
Other expenses 16,000
Prepaid retail market analysis 11,000
---------
Prepaid and Other Expenses $ 355,000
=========
5. Furniture and Equipment, net
Furniture and equipment, net consists of the following:
Furniture and equipment $ 478,000
Accumulated depreciation (417,000)
---------
Furniture and Equipment, net $ 61,000
=========
During the nine months ended March 31, 2004, the Company removed $638,000 of
fully depreciated assets from its furniture and equipment records based on these
assets no longer being in service.
6. Accrued Expenses
Accrued expenses consist of the following:
Accrued compensation $ 276,000
Accrued royalties 76,000
State income taxes 68,000
Accrued marketing promotion costs 61,000
Customers with net credit balances 53,000
Accrued legal and accounting fees 44,000
Other accrued expenses 40,000
---------
Accrued Expenses $ 618,000
=========
7. Commitments and Contingencies
Our 5,000 square foot office facility located in Langhorne, Pennsylvania is
occupied under an operating lease through September 30, 2007. Additionally, we
currently rent certain office equipment through various operating lease
agreements. As of March 31, 2004, we had future operating lease commitments of
$215,000 that are scheduled to be paid as follows: $61,000 in less than one
year; $119,000 in one to three years; and $35,000 in three to five years.
Under various licensing agreements with third-party software developers, we are
required to pay royalties for the use of licensed content in our products. Most
of these licensing agreements require us to make advance royalty payments to
these developers prior to the time we recognize any net sales of software titles
containing this licensed software content. As of March 31, 2004, assuming
performance by certain third-party software developers under such agreements, we
had future commitments to pay $165,000 in advance royalty payments to various
software developers scheduled to be paid as follows: $153,000 in less than one
year and $12,000 in one to three years.
8. Accounting for Stock-based Compensation - Transition and Disclosure, per
SFAS No. 148
As of March 31, 2004, we had one existing stock-based employee compensation
plan, which was adopted, amended and restated during 1995. This Plan, known as
our 1995 Amended and Restated Stock Option Plan (the "1995 Plan"), is
administered by the Board of Directors and provides for the grant of incentive
stock options and non-qualified stock options to employees and eligible
independent contractors and non-qualified stock options to non-employee
directors at prices not less than the fair market value of a share of common
stock on the date of grant.
Prior to July 1, 2002, we accounted for all stock option grants under the
recognition and measurement provisions of APB Opinion No. 25, "Accounting for
Stock Issued to Employees", and related Interpretations. No stock-based employee
compensation cost relating to stock option grants is reflected in net income
before fiscal 2003, as all stock option grants had an exercise price equal to or
greater than the market value of the underlying common stock on the date of
grant. Effective 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 prospectively for stock option grants made on or
after that date. Therefore, the cost related to stock-based employee
compensation included in the determination of net income for the three and nine
months ended March 31, 2003, respectively, is less than that which would have
been recognized if the fair value based method had been applied to all stock
option grants since the original effective date of SFAS No. 123. Additionally,
the stock-based employee compensation included in the table below for the nine
months ended March 31, 2003 does not include $16,250 in stock-based compensation
expense reflected in that period's net income, due to being related to a common
stock warrant issued to a non-employee third-party (Fleet Bank).
As of January 1, 2003, we adopted the provisions of SFAS No. 148, "Accounting
for Stock-Based Compensation - Transition and Disclosure". Accordingly, the
following table illustrates the effect on net income and net income per share
for the three and nine months ended March 31, 2004 and 2003, respectively, if
the fair value method had been applied to all outstanding stock option grants
during those periods.
Three Months Ended Nine Months Ended
March 31, March 31,
--------------------- -----------------------
2004 2003 2004 2003
---- ---- ---- ----
Net income, as reported $ 528,000 $ 296,000 $ 1,478,000 $ 951,000
Add: Stock-based employee compensation expense
included in reported net income 22,000 25,000 47,000 71,000
Deduct: Total stock-based employee compensation
expense determined under fair value based
method for stock option grants (22,000) (36,000) (47,000) (191,000)
--------- --------- ----------- ---------
Pro forma net income $ 528,000 $ 285,000 $ 1,478,000 $ 831,000
========= ========= =========== =========
Net income per common share:
- - Basic, as reported $ 0.05 $ 0.03 $ 0.15 $ 0.10
====== ====== ====== ======
- - Basic, pro forma $ 0.05 $ 0.03 $ 0.15 $ 0.08
====== ====== ====== ======
- - Diluted, as reported $ 0.05 $ 0.03 $ 0.14 $ 0.10
====== ====== ====== ======
- - Diluted, pro forma $ 0.05 $ 0.03 $ 0.14 $ 0.08
====== ====== ====== ======
9. Credit Facility
In September 2003, we entered into a $500,000 credit facility agreement with
Hudson United Bank ("HUB"), which matures on December 1, 2004. Amounts
outstanding under this new credit facility will be charged interest at one-half
of one percent above HUB's current prime rate and such interest is due monthly.
Our access to these funds is limited to the lesser of $500,000 or seventy-five
percent of qualified accounts receivable, which are defined as invoices less
than ninety days old and net of any allowances for product returns, price
markdowns or customer bad debts. The credit facility is secured by all of the
Company's assets and requires us, among other things, to maintain the following
financial covenants to be tested quarterly: a total liabilities to tangible net
worth ratio of 1.25 to 1.00 and a tangible net worth requirement of $1.5
million. As of March 31, 2004, we were in compliance with each of those
covenants. This credit facility was established to provide working capital for
our operations. As of March 31, 2004, we had not utilized any of this credit
facility, although we were eligible to draw up to $500,000 under this credit
facility, based upon qualified accounts receivable as of that date.
10. 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 its products,
geographic areas and major customers.
Based on our organizational structure, we operate in only one geographic area,
which is North America, and one reportable segment, which is publishing consumer
entertainment software for personal computers.
11. Recent Accounting Pronouncements
In January 2003, the Financial Accounting Standards Board ("FASB") issued
Interpretation No. 46 ("FIN") No. 46, "Consolidation of Variable Interest
Entities". In December 2003, the FASB issued FIN No. 46 (Revised) ("FIN 46-R")
to address certain FIN 46 implementation issues. This interpretation requires
that the assets, liabilities, and results of operations of a Variable Interest
Entity ("VIE") be consolidated into the financial statements of the enterprise
that has a controlling interest in the VIE. The provisions of this
interpretation were effective immediately for all arrangements entered into with
new VIEs created after January 31, 2003, and became effective during the period
ended March 31, 2004 for any VIE created on or before January 31, 2003. Based
upon our review, we do not believe we have any such entities or arrangements
that would require disclosure or consolidation.
In March 2003, the Emerging Issues Task Force published Issue No. 00-21
"Accounting for Revenue Arrangements with Multiple Deliverables" (EITF 00-21).
EITF 00-21 addresses certain aspects of the accounting by a vendor for
arrangements under which it performs multiple revenue generating activities and
how to determine whether such an arrangement involving multiple deliverables
contains more than one unit of accounting for purposes of revenue recognition.
The guidance in this Issue is effective for revenue arrangements entered in
fiscal periods beginning after June 15, 2003. The adoption of EITF 00-21 on July
1, 2003 did not have any impact on our financial statements.
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
This Quarterly Report on Form 10-QSB contains forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934. All statements made in this Quarterly Report on
Form 10-QSB, other than statements of historical fact, including statements
regarding industry prospects and future results of operations or financial
position, are forward looking. We use the words "believe", "expect",
"anticipate", "intend", "will", "should", "may" and similar expressions to
identify forward-looking statements. These forward-looking statements are
subject to business volatility, economic risk, and world events, which are
inherently uncertain and difficult to predict. Our actual results could differ
materially from management's expectations due to such risks. We will not
necessarily update information if any forward-looking statement later turns out
to be inaccurate. In particular, these forward-looking statements include, among
others, statements about:
- our objective in fiscal 2004 and beyond of continuing to expand
distribution of our products at current retail customers and
pursuing new distribution channels;
- our expectation that our gross profit margin may continue to
decrease;
- our financial results being affected in the event of a future drop
in our sell-through results;
- our goal to increase the distribution of our products offered at
retail locations;
- the impact on our financial condition and ability to continue as a
going concern in the event that we lost our distribution through
Atari, or if Atari were unwilling or unable to make its receivable
payments to us;
- anticipated licensing revenues for the remainder of fiscal 2004;
- our continued efforts to improve our websites in order to drive
web traffic and sales and expand on-line registration programs of
our retail products in order to more effectively conduct promotional
product offerings;
- our expectation regarding the receipt of discontinued titles from
the retail channel for liquidation;
- our expectation for our overall fiscal 2004 provision for product
returns and price markdowns;
- our expectation regarding the negative impact of sales incentives
and promotional costs on our net sales, gross profit and gross
profit margin;
- our expectation regarding the reduction of costs for security
sensor tags in our products for the remainder of fiscal 2004;
- our expectations regarding future product development expenses;
- our expectation regarding public relations expenditures for the
remainder of fiscal 2004;
- our expectation regarding the increase of our provision for income
taxes;
- our expectation regarding the continued increase of our inventory
purchasing costs;
- our belief that we will continue to experience increases in advanced
royalty and licensing payments;
- our expectation regarding accelerated vendor payments;
- our expectation regarding financing activities for the remainder of
fiscal 2004;
- our expectation that guaranteed royalty and licensing commitments
are expected to be funded by cash flows from operating income;
- our exposure to additional product returns and a lack of
replenishment orders if any of our software titles do not sell
through to consumers at anticipated rates;
- our expectation that we will meet the stockholders equity
requirement for listing on the American Stock Exchange by the first
quarter of fiscal 2005, and our plans to apply for listing as soon
as practicable after we achieve the standards for listing;
- our expectation that recent adoption of accounting pronouncements
will not have an impact on our financial statements; and
- our ability to fund our operations based on our projected cash and
working capital balances.
The following important factors, as well as those factors discussed under "Risk
Factors" at pages 26 to 30 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;
- our continued successful business relationship with Atari, our
distributor to Wal-Mart, Target, and Best Buy, among other
retailers;
- the amount of unsold product that is returned to us by retail stores
and distributors;
- the amount of price markdowns and sales incentives granted to
retailers 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 to consumers of our new higher price
point products, in all retail channels through which they are sold;
- the continued success of our current business model of selling,
primarily through third-party distributors, to a concentrated
number of major mass-merchant and PC software retailers;
- our ability to control the manufacturing and distribution costs of
our software products;
- our 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 (retail facings) for our products in
major retail chain stores;
- the ability to earn royalties through our international product
distribution under licensing agreements and the ability of our
licensees to pay us such royalties within agreed upon terms;
- our ability to collect outstanding accounts receivable, especially
from Atari, and to establish an adequate allowance for bad debts;
- the continued increase in the number of computers in homes in North
America and worldwide;
- our ability to deliver products in response to customer orders
within a commercially acceptable time frame;
- downward pricing pressure and increased competition in the
value-priced software category;
- our ability to control the costs of producing and marketing our
products on commercially reasonable terms or at all;
- our ability to license 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;
and various other factors, many of which are beyond our control.
Product, Industry and Market Data
eGames publishes and markets a diversified line of Family Friendly(TM),
affordable consumer entertainment PC software games to consumers, mostly through
third-party software distributors to mass-merchant and major retailers, and
directly to certain PC software retailers. We obtain the rights to publish PC
software games through licensing agreements with third-party PC software
developers. We do not develop PC software games internally, but rather we make
royalty payments to third-party software game developers based on a percentage
of net sales for each licensed PC game in order to minimize the risks associated
with developing game content. Our titles have historically had a product
lifecycle of six to fifteen months. After a software title's life cycle has
ended, some of the software games from the discontinued title are often included
in subsequent game collection titles that have the potential to extend the
original product content life by as much as an additional twelve to twenty-four
months.
The core game genres we focus on within the PC software market include Mahjongg,
game collections, card & board games, Solitaire, puzzles and word games. We use
industry market data from sources such as NPD Techworld to evaluate current
trends in the PC market place, such as specific game genres realizing increased
or decreased consumer demand, sales trends for the overall PC software market,
our market position relative to other publishers, and how our titles are selling
to consumers compared to our competitors' products. According to NPD Techworld
data for the month of March 2004, while the overall PC game software industry
decreased by 20% in unit sales compared to March 2003, our unit sales increased
by 42% compared to March 2003. NPD Techworld reported that six eGames titles
were in the overall top 50 of PC games sold at retail during March 2004,
including DROP! at number 8, 251 Games Collectors' Edition at number 14,
Solitaire Master 4 at number 38, Card & Board 2 at number 39, Mahjongg Master 5
at number 44 and Mahjongg Variety Pack at number 48.
Unit sales data provided to us by Atari, our largest software distributor, has
indicated that sell-through of our products to consumers at North American
mass-merchant and major retailers through Atari during March 2004 increased by
more than 37% compared to the sell-through of our products during March 2003. We
view this increase in product sell-through to consumers as a positive reflection
on the market acceptance of our current product offerings, and it also reflects
the broader distribution of our titles at retail stores. There is, however, no
way to predict with any certainty whether this increased product sell-through
trend to consumers will continue.
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 revenue recognition and inventory valuation
accounting policies require us to make significant judgments and estimates that
could materially affect the amount of revenue we recognize and the value of our
inventory. 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 judgments and
estimates that affect the reported amounts of assets, liabilities, revenues and
expenses, and related disclosure of contingent assets and liabilities. On an
ongoing basis, we evaluate our estimates, including estimated product returns,
price markdowns, customer bad debts, inventory obsolescence, income taxes,
contingencies and litigation risks. 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)
- --------------------------------------------------------------------
We distribute the majority of our products through third-party software
distributors to mass-merchant and major retailers and directly to certain PC
software retailers. These retailers have traditionally sold consumer
entertainment PC software products. The distribution of our products is governed
by purchase orders, distribution agreements or direct sale agreements, many of
which allow for product returns and price markdowns. For product shipments to
these software distributors or retailers, 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 these distributors or retailers.
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; current product sell-through results at retail store
locations; current field inventory quantities at distributors' warehouses and at
retail store locations; the length of time that products have been out at retail
along with their estimated remaining retail life; the introduction of new and/or
competing software products that could negatively impact the sales of one or
more of our current products; outstanding return material authorizations; and
the extent to which new products with higher price points or unproven genres
have been launched. The adequacy of our allowance for product returns and price
markdowns is continually reviewed throughout each reporting period and any
necessary adjustment to this allowance (positive or negative) is reflected
within the current period's provision. At the end of each reporting period, the
allowance for product returns and price markdowns is reflected as a reduction to
our gross accounts receivable balance.
Significant management judgments and estimates must be made and used in order to
determine how much sales revenue 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 or excessive compared to actual results.
These differences, if material, would significantly affect our operating results
and financial condition in any given period.
Inventory Valuation
- -------------------
Our accounting policy for inventory valuation requires management to make
estimates and assumptions about the recoverability of the carrying value of
inventory that affect the reported value of inventory and cost of sales for any
reporting period. Our inventory could be valued differently at the close of any
reporting period and the amount recorded as cost of sales during any reporting
period could differ, if management's judgments or estimates of provisions for
the potential impairment of inventory value are insufficient or excessive when
compared to actual results. These differences, if material, would significantly
affect our operating results and financial condition.
We are exposed to inventory obsolescence because of our products' relatively
short product life cycles, which average six to fifteen months. If our products
do not sell-through to consumers during that life cycle, or if we or our
competitors introduce new products with capabilities or technologies that can
replace or shorten the life cycles of our existing products, then we may need to
write-down the value of such inventory below its previous carrying value.
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. Although we attempt to accurately match production requirements of our
products to forecasted consumer demand, we may from time to time produce an
amount of inventory of a product that exceeds the eventual consumer demand for
such product. When this occurs, we attempt to liquidate these excess quantities
of remaining inventory, frequently at closeout prices below their original
manufactured costs. If we cannot liquidate such inventory, or if we are unable
to sell any remaining units due to legal or other reasons, we would then write
down the related inventory value to zero. The adequacy of our allowance for
inventory obsolescence is reviewed throughout each reporting period, and any
adjustments (positive or negative) are reflected in the current period's
inventory obsolescence provision.
Results of Operations
The following discussion should be read together with our Financial Statements
and Notes beginning on page 3. The word "customer" as used in this document
refers to third-party distributors and retailers, as compared to the word
"consumer", which refers to the end consumer purchasing our PC software products
at retail stores or over the Internet. Amounts discussed below have been rounded
to the nearest thousand dollars.
Three and Nine Months Ended March 31, 2004 Compared to the Three and Nine
Months Ended March 31, 2003
Net Sales
The following tables represent our net sales by distribution channel for the
three and nine months ended March 31, 2004 and 2003, respectively:
Net Sales by Distribution Channel
---------------------------------
Three Months Ended
March 31,
--------------------------
Increase %
Distribution Channel 2004 2003 (Decrease) Change
- -------------------------------------------------------------------------------
Software distributors $ 1,769,000 $ 1,236,000 $ 533,000 43%
Software retailers 166,000 111,000 55,000 50%
Licensing 97,000 62,000 35,000 56%
Internet 64,000 51,000 13,000 25%
Inventory liquidators 57,000 27,000 30,000 111%
Other sales - 0 - 44,000 (44,000) (100%)
- -------------------------------------------------------------------------------
Total Net Sales $ 2,153,000 $ 1,531,000 $ 622,000 41%
=========== =========== ========= =====
Nine Months Ended
March 31,
--------------------------
Increase %
Distribution Channel 2004 2003 (Decrease) Change
- --------------------------------------------------------------------------------
Software distributors $ 5,169,000 $ 3,577,000 $ 1,592,000 45%
Software retailers 532,000 841,000 (309,000) (37%)
Licensing 319,000 313,000 6,000 2%
Internet 190,000 155,000 35,000 23%
Inventory liquidators 111,000 328,000 (217,000) (66%)
Other sales - 0 - 122,000 (122,000) (100%)
- -------------------------------------------------------------------------------
Total Net Sales $ 6,321,000 $ 5,336,000 $ 985,000 18%
=========== =========== =========== =====
Net sales for the three and nine months ended March 31, 2004 increased by 41%
and 18%, respectively, compared to the three and nine months ended March 31,
2003. The overall increase in net sales has been primarily driven by increased
distribution of our products to many of the major North American mass-merchant
and major retailers (such as Wal-Mart, Target and Best Buy) through our largest
software distributor, Atari, Inc. ("Atari"). In addition, net sales benefited
from new distribution of our products to major office superstores and warehouse
clubs, such as Office Max, Staples, Circuit City, Sam's Club and BJ's, primarily
through other software distributors, such as Take Two Interactive ("Take Two")
and E.B. Carlson. One of our most important objectives in fiscal 2004 and beyond
is the continued expansion of product distribution at current retail customers,
as well as our continued pursuit of new channels of distribution on terms
profitable to eGames. As we have continued to expand our product distribution
into more retail channels, our gross profit margin has decreased because of
downward pricing pressures resulting from the increasingly competitive retail
environment. Although some of this increased product distribution has negatively
affected our gross profit margin, as a percentage of net sales, it has
contributed favorably to the growth in our overall gross profit and operating
income. We anticipate that downward pricing pressures may continue to negatively
impact our gross profit margin as our product distribution expands further into
new and existing retail markets.
Distribution of our products to retailers that have historically been successful
in merchandising consumer entertainment PC software has increased as a result of
our products' strong sell through rates to consumers at these retailers' stores.
In particular, one of our products, DROP!, experienced very strong sell through
to consumers during the three months ended March 31, 2004, and when combined
with the robust sell-through performance of several other core titles, such as
251 Games Collector's Edition and Mahjongg Master 5, drove customer
replenishment orders and helped to increase our net sales during the quarter. In
future periods, if our products do not achieve similarly strong sell-through
results as we experienced during the three months ended March 31, 2004, our
financial results for those periods will be correspondingly affected.
Retailers that have historically been successful in merchandising consumer
entertainment PC software typically designate the distributor that they want to
use for the distribution of our products to their stores, and in certain
instances retailers have decided that we should distribute our software products
directly to them. Distribution to these retailers is a competitive business
within itself and there typically are several distributors who distribute PC
software products to these leading national retail chains. Our goal is to
increase the distribution of our products offered at retail locations, by
whatever means - third party distribution or direct shipments to retailers -
that will provide us with an adequate gross profit as well as steady and
continued access to these retail markets.
Software distributors
- ---------------------
For the three and nine months ended March 31, 2004, net sales to software
distributors increased by $533,000 and $1,592,000, respectively, or 43% and 45%,
respectively, compared to the three and nine months ended March 31, 2003. For
the three and nine months ended March 31, 2004, net sales to software
distributors represented 82% of net sales for both periods, compared to 81% and
67%, respectively, for the three and nine months ended March 31, 2003.
For the three months ended March 31, 2004, the $533,000 increase in net sales to
software distributors was driven by increases in net sales to Atari, Take Two
and E.B. Carlson of $339,000, $136,000 and $23,000, respectively.
For the nine months ended March 31, 2004, the $1,592,000 increase in net sales
to software distributors was similarly driven by increases in net sales to
Atari, Take Two and E.B. Carlson of $1,235,000, $217,000 and $198,000,
respectively. Strong sell-through results for our products during the current
year's periods continued to drive replenishment order volume from these software
distributors, which was the primary reason for the overall net sales increases
through this distribution channel.
Dependence on one major software distributor
- --------------------------------------------
Atari is our primary software distributor serving the mass-merchant and major
retailers in North America, such as Wal-Mart, Target, and Best Buy, among
others. During the three months ended March 31, 2004 and 2003, Atari accounted
for $1,454,000 and $1,115,000 of our net sales, or 68% and 73% of net sales,
respectively. During the nine months ended March 31, 2004 and 2003, Atari
accounted for $4,408,000 and $3,173,000 in net sales, or 70% and 59% of net
sales, respectively.
We have continued to increase our product distribution through Atari to the
major mass-merchant retailers by increasing the number of our titles carried by
these retailers and the number of stores within these retailers' store chains
that offer our titles to consumers. Our financial condition and ability to
continue as a going concern could be significantly affected in the event that we
would lose our distribution capability through Atari. However, because the
distribution of PC software to these retailers is a competitive business within
itself, there are several alternative distributors that could potentially
distribute our products to these retailers if, for example, Atari chose to
discontinue distributing our titles or if any of these retailers decided to
discontinue their relationship with Atari. We can provide no assurance, however,
that we would be able to secure agreements with such alternative distributors on
commercially reasonable terms or at all.
Software retailers
- ------------------
For the three months ended March 31, 2004, net sales directly to software
retailers increased by $55,000 or 50%, compared to the same period a year
earlier, while net sales to software retailers for the nine months ended March
31, 2004 declined by $309,000, or 37%, compared to the same year ago period. For
the three and nine months ended March 31, 2004, net sales to software retailers
represented 8% of net sales during both periods, compared to 7% and 16%,
respectively, for the three and nine months ended March 31, 2003.
The $55,000 increase in net sales directly to software retailers for the three
months ended March 31, 2004 was largely attributable to a $45,000 increase in
net sales to Fry's Electronics due to increased product distribution of the
Company's titles at this retailer that was driven by increased consumer demand.
The $309,000 decrease in net sales directly to software retailers for the nine
months ended March 31, 2004 was caused by our decision to stop directly
distributing PC software to certain retailers, such as Office Depot, and
transitioning these direct sales through one of our software distributors under
more profitable terms. In addition, during fiscal 2004 we have reduced the
number of eGames titles offered at certain PC software retailers, such as
CompUSA, EB Games and GameStop, to improve the profitability generated by our
remaining titles. As a result of these changes, during the nine months ended
March 31, 2004, net sales to Office Depot, EB Games, CompUSA, and GameStop
decreased by $124,000, $105,000, $84,000 and $27,000, respectively, compared to
the same period a year ago.
Licensing
- ---------
Licensing revenues are generated primarily from sales made by our international
software distributors under a series of licensing agreements covering various
territories outside of North America, with the majority of our licensing
revenues originating from Germany, United Kingdom, Australia and Brazil. For the
three and nine months ended March 31, 2004, licensing revenues increased by
$35,000 and $6,000, respectively, or 56% and 2%, respectively, compared to the
three and nine months ended March 31, 2003. For the three and nine months ended
March 31, 2004, licensing revenues represented 5% of net sales during both
periods, compared to 4% and 6%, respectively, for the three and nine months
ended March 31, 2003.
The $35,000 increase in licensing revenues for the three months ended March 31,
2004 was principally driven by increases in licensing revenues from our
licensees responsible for the retail markets in Australia of $18,000 and the
United Kingdom of $15,000.
The $6,000 increase in licensing revenues for the nine months ended March 31,
2004 resulted mainly from increases in licensing revenues from our licensees
responsible for the retail markets in the United Kingdom of $30,000 and
Australia of $23,000, which increases were partially offset by decreases in
licensing revenues generated in the United States of $31,000, Brazil of $10,000
and Germany of $6,000.
For the remainder of fiscal 2004, we anticipate licensing revenues to remain
flat to slightly below last year's amounts due to some indications of weakening
within certain international markets for PC software games. We continue to look
for ways to increase our licensing revenues by working with our existing
licensing partners, in addition to searching for new licensees to help expand
our worldwide retail presence.
Internet
- --------
For the three and nine months ended March 31, 2004, Internet sales increased by
$13,000 and $35,000, respectively, or 25% and 23%, respectively, compared to the
three and nine months ended March 31, 2003. For the three and nine months ended
March 31, 2004 and 2003, Internet sales continued to represent 3% of net sales
during all of these periods.
During fiscal 2004, we launched a new e-commerce system, which was intended to
increase the profitability of our Internet sales. In conjunction with the launch
of this new system, we have revamped the look of our websites and will continue
to improve the more popular features of our websites, including a free online
game arcade, in order to drive web traffic and sales on our websites. We plan to
continue expanding on-line registration programs of our retail products in order
to increase our database of registered users and their related demographic
information, so that we can more effectively conduct targeted promotional
product offerings to these existing consumers.
Inventory liquidators
- ---------------------
For the three months ended March 31, 2004, net sales to inventory liquidators
increased by $30,000 or 111%, compared to the year ago quarter, while net sales
to inventory liquidators declined by $217,000, or 66%, compared to the nine
months ended March 31, 2003. For the three and nine months ended March 31, 2004,
net sales to inventory liquidators represented 2% of net sales during both
periods compared to 2% and 6%, respectively, of net sales for the three and nine
months ended March 31, 2003.
Net sales to inventory liquidators consist of sales of residual inventory titles
that have been discontinued at retail because these titles have reached the end
of their lifecycles. As retailers periodically reset the mix of software titles
on their store shelves - usually on a quarterly basis - we expect to receive
additional quantities of discontinued titles back from the retail channel that
will then need to be liquidated, along with any remaining quantities of these
titles in our warehouse. Inventory liquidation sales are usually made at
discount prices, below a product's previous wholesale price point, and are
usually sold to these inventory liquidators with no right of product return.
Other sales
- -----------
For the three and nine months ended March 31, 2004, other sales declined by
$44,000 and $122,000, respectively, compared to the same periods a year earlier.
These net sales decreases resulted from our decision to stop distributing
software titles to retailers that have not traditionally sold PC software
successfully (such as food and drug retailers).
Product Returns and Price Markdowns
- -----------------------------------
During the three months ended March 31, 2004 and 2003, our provisions for
product returns and price markdowns for customers that have traditionally sold
consumer entertainment PC software products were $398,000 and $222,000,
respectively, or 16% and 13% of related gross sales, respectively.
During the nine months ended March 31, 2004 and 2003, our provisions for product
returns and price markdowns for customers that have traditionally sold consumer
entertainment PC software products were $1,432,000 and $892,000, respectively,
or 19% and 15% of related gross sales, respectively.
During fiscal 2004, we have increased our provision for product returns and
price markdowns because of unsatisfactory sell-through results of certain higher
priced ($19.99 retail priced) box titles that did not achieve the product sell
through results to end consumers that we had expected. We began distributing
titles with a $19.99 retail price point in fiscal 2003, which represented a
departure from our typical value-priced product offering to the casual gamer
with a retail price of $9.99. These higher priced titles represented a greater
risk of price markdown exposure if they did not sell through to consumers at
estimated rates. As a result of these factors, we have reduced the number of
$19.99 products that we currently offer. Based upon historical and recent trends
in our product sell-through rates to consumers of our core titles retail priced
at $9.99, and the reduction in our distribution of higher priced box titles, our
overall fiscal 2004 provision for product returns and price markdowns is
anticipated to be approximately 18% of related gross sales.
Sales Incentives and Promotional Costs
- --------------------------------------
Sales incentives and promotional costs, such as rebates and slotting fees, are
charged to us by distributors or retailers and are recorded as reductions to
gross sales as incurred or on a straight-line basis over a contractual period.
These costs were $141,000 and $38,000 for the three months ended March 31, 2004
and 2003, respectively, and were $383,000 and $200,000 for the nine months ended
March 31, 2004 and 2003, respectively
These fees have continued to increase during fiscal 2004 compared to prior
periods as a result of increased sales of our software titles to retailers and
distributors who make these fees a requirement for gaining and then maintaining
retail shelf space for products supplied by their vendors. These fees are
recognized as price reductions to gross sales. Because we currently plan to
increase our distribution at these retailers and through these distributors, we
expect these types of fees to continue to have a negative affect on our net
sales, gross profit and gross profit margin.
Cost of Sales
Cost of sales consists of actual product costs, royalty costs incurred with
third-party software developers, freight costs, inventory obsolescence
provisions and other costs.
March 31, % of March 31, % of Increase %
2004 net sales 2003 net sales (Decrease) Change
- ----------------------------------------------------------------------------------------------------
Three months ended $ 874,000 41% $ 580,000 38% $ 294,000 51%
Nine months ended $ 2,585,000 41% $ 2,201,000 41% $ 384,000 17%
For the three months ended March 31, 2004, cost of sales, as a percentage of net
sales increased by 3% to 41% from 38% for the quarter ended March 31, 2003. This
3% increase in cost of sales, as a percentage of net sales, was driven by a 4%
increase in product costs due to:
o Additional costs associated with the recent requirement of certain
retailers to have security sensor tags included in software packages;
o Increased sales of lower margin box titles containing multiple
compact disks (CD's); and
o Increased low margin inventory liquidation sales.
This product cost increase was partially offset by minimal reductions, as a
percentage of net sales, in royalty costs due to product mix and the inventory
obsolescence provision due to improved quality of inventory. However, due to the
trend of rising royalty rates associated with some of our future titles, we
expect royalty rates in upcoming periods to begin increasing and negatively
affecting our gross profit margin.
For the nine months ended March 31, 2004, cost of sales, as a percentage of net
sales, remained flat at 41% compared to last year's similar nine-month period.
Similar to the three months ended March 31, 2004, product costs increased due to
the additional costs associated with including security sensor tags in our
software packaging and the increased sales of multiple disk box titles, but
during this fiscal year's nine-month period, these cost increases were offset by
product costs savings, as a percentage of net sales, due to a decrease in
inventory liquidation sales that have a higher product cost percentage compared
to most other sales. For the remainder of fiscal 2004, we expect the additional
product costs relating to security sensor tags to be reduced due to achieving
improved pricing and discount terms with certain key vendors.
Operating Expenses
Product development expenses consist of personnel costs related to product
management, quality assurance testing and packaging design, along with outside
services for product ratings and website design.
March 31, % of March 31, % of Increase %
2004 net sales 2003 net sales (Decrease) Change
- --------------------------------------------------------------------------------------------------
Three months ended $ 119,000 6% $ 108,000 7% $ 11,000 10%
Nine months ended $ 386,000 6% $ 313,000 6% $ 73,000 23%
For the three and nine months ended March 31, 2004, product development expenses
increased by 10% and 23%, respectively, compared to the same periods in the
prior fiscal year.
For the three months ended March 31, 2004, product development expenses
increased by $11,000 to $119,000 compared to the three months ended March 31,
2003. This cost increase was driven by higher personnel costs related to wage
increases for employees involved in the product management and quality assurance
testing of our PC software titles, and increases in the attractiveness of our
products by developing higher quality packaging designs and treatments.
For the nine months ended March 31, 2004, product development expenses increased
by $73,000 to $386,000 compared to the nine months ended March 31, 2003. In
addition to higher personnel costs, the cost increase for the current year's
nine month period was increased by costs incurred to upgrade our website's
functionality and in higher per title fees to obtain industry ratings for our
software products. We believe that we have now completed upgrading the majority
of our website's capabilities and so these types of costs should now begin to
decrease, but we do expect the industry rating fees to continue to escalate as a
result of expected price increases from this vendor.
Selling, general and administrative expenses consist of personnel related costs,
insurance costs, stock compensation expense, professional service fees for
legal, accounting and public relations, along with occupancy costs including
rent, utilities and phones.
March 31, % of March 31, % of Increase %
2004 net sales 2003 net sales (Decrease) Change
- ----------------------------------------------------------------------------------------------------
Three months ended $ 609,000 28% $ 592,000 39% $ 17,000 3%
Nine months ended $ 1,800,000 29% $ 1,886,000 35% ($ 86,000) (5%)
Selling, general and administrative expenses increased by 3% for the three
months ended March 31, 2004 compared to the same period a year ago, while
decreasing by 5% for the nine months ended March 31, 2004 compared to the nine
months ended March 31, 2003.
For the three months ended March 31, 2004, selling, general and administrative
expenses increased by $17,000 to $609,000 compared to the three months ended
March 31, 2003. This $17,000 cost increase was primarily due to increases of:
o $10,000 in legal fees related to trademark activities and higher fees
to review regulatory filings; and
o $9,000 in personnel related costs due to employee wage increases.
For the nine months ended March 31, 2004, selling, general and administrative
expenses decreased by $86,000 to $1,800,000 compared to the nine months ended
March 31, 2003. This $86,000 cost decrease was affected by reductions of:
o $54,000 in bad debt expense related to improved quality of customer
account balances;
o $40,000 in stock compensation expense related to the vesting of
employee stock options and non-recurring common stock warrant
expense; and
o $49,000 in professional service fees related to the non-recurrence of
various matters including the prior year's income tax compliance
efforts associated with a previously owned foreign subsidiary and
consulting services to support our EDI system.
These costs decreases were partially offset by a $62,000 increase in public
relations costs associated with a product launch earlier this fiscal year. We do
not anticipate any further such public relations expenditures for the remainder
of fiscal 2004.
Operating Income
March 31, % of March 31, % of Increase %
2004 net sales 2003 net sales (Decrease) Change
- --------------------------------------------------------------------------------------------------
Three months ended $ 551,000 25% $ 251,000 16% $ 300,000 119%
Nine months ended $ 1,549,000 24% $ 936,000 18% $ 613,000 65%
For the three months ended March 31, 2004, operating income increased by
$300,000, or 119%, compared to the same period last year due to a $328,000
increase in gross profit that was partially offset by a $28,000 increase in
operating expenses.
For the nine months ended March 31, 2004, operating income increased by
$613,000, or 65%, compared to the nine months ended March 31, 2003 due to a
$601,000 increase in gross profit, combined with a $12,000 decrease in operating
expenses.
Interest (Income) Expense, Net
March 31, % of March 31, % of Increase %
2004 net sales 2003 net sales (Decrease) Change
- --------------------------------------------------------------------------------------------------
Three months ended ($ 2,000) 0% $ 6,000 0% ($ 8,000) (133%)
Nine months ended $ 1,000 0% $ 36,000 1% ($ 35,000) (97%)
For the three months ended March 31, 2004, we earned $2,000 in net interest
income compared to the $6,000 in net interest expense we incurred during the
three months ended March 31, 2003. For the nine months ended March 31, 2004, we
incurred net interest expense of $1,000 compared to $36,000 for the similar
nine-month period in fiscal 2003. These reductions in net interest expense
resulted from the elimination of the prior year's bank debt, combined with the
interest income we earned on higher average cash balances we maintained
throughout the three and nine month periods ended March 31, 2004, compared to
the same periods a year earlier.
Provision (Benefit) for Income Taxes
March 31, % of March 31, % of Increase %
2004 net sales 2003 net sales (Decrease) Change
- --------------------------------------------------------------------------------------------------
Three months ended $ 25,000 1% ($ 51,000) (3%) $ 76,000 149%
Nine months ended $ 70,000 1% ($ 51,000) (1%) $ 121,000 237%
For the three and nine months ended March 31, 2004, our provisions for income
taxes increased by $76,000 and $121,000, respectively. These provisions related
to the estimated taxable income from various states net of available state
operating loss carry-forwards, and no estimated taxable income calculated for
federal income tax purposes because of our remaining federal net operating loss
carry-forwards ("NOL's"), which were sufficient to offset estimated taxable
income for federal income tax purposes for the three and nine months ended March
31, 2004.
The benefit for income taxes realized during the three and nine months ended
March 31, 2003 resulted from income tax refunds received during these periods
wherein there was no previously recorded deferred income tax asset. Going
forward, we expect that our provision for income taxes will continue to increase
due to our expectation of fully utilizing any remaining federal and state NOL's
that had been previously available to offset taxable income in prior periods.
Net Income
March 31, % of March 31, % of Increase %
2004 net sales 2003 net sales (Decrease) Change
- --------------------------------------------------------------------------------------------------
Three months ended $ 528,000 24% $ 296,000 19% $ 232,000 78%
Nine months ended $ 1,478,000 23% $ 951,000 18% $ 527,000 55%
As a result of the factors discussed above, our net income for the three and
nine months ended March 31, 2004 increased by $232,000 and $527,000,
respectively, or 78% and 55%, respectively.
Weighted Average Common Shares
The weighted average common shares outstanding on a diluted basis increased by
1,369,713 for the three months ended March 31, 2004 to 11,369,359 from 9,999,646
for the three months ended March 31, 2003. The weighted average common shares
outstanding on a diluted basis increased by 877,228 for the nine months ended
March 31, 2004 to 10,876,285 from 9,999,057 for the nine months ended March 31,
2003.
The current periods' increases in the diluted basis calculation of weighted
average common shares resulted from including additional common share
equivalents, compared to the prior year's periods, due to more common share
equivalents being "in the money" or having an exercise price less than the
average market price of our common shares during these periods.
Liquidity and Capital Resources
Nine Months Ended
March 31, March 31,
2004 2003 Change
---------------------------------------
Cash and cash equivalents $ 1,552,000 $ 362,000 $ 1,190,000
=========== ========= ===========
Percent of total assets 36% 18%
---------------------------------------
Cash provided by operating activities $ 605,000 $ 616,000 ($ 11,000)
Cash used in investing activities ( 77,000) ( 8,000) ( 69,000)
Cash used in financing activities - 0 - ( 946,000) 946,000
---------------------------------------
Net increase (decrease) in cash and cash equivalents $ 528,000 ($ 338,000) $ 866,000
=========== ========= ===========
Changes in Cash Flow, Operating Activities:
- -------------------------------------------
During the nine months ended March 31, 2004, we generated $605,000 of cash from
operating activities compared to $616,000 for the nine months ended March 31,
2003. The $605,000 in cash provided by operating activities for the nine months
ended March 31, 2004 resulted primarily from $1,478,000 in net income, which was
partially offset by increases in:
o accounts receivable due to increased net sales;
o inventory purchases of higher costing products (multiple disk box
titles and jewel case titles including security sensor tags);
o advanced royalty and licensing payments with software developers and
licensors for upcoming titles; and
o accelerated vendor payments in exchange for cash discounts.
Accounts receivable
- -------------------
During the nine months ended March 31, 2004, our accounts receivable balance
increased primarily due to the increase in net sales to our primary software
distributors that was driven by additional distribution of our PC software
titles at mass-merchant and major retailers, office superstores and warehouse
clubs. Although this receivable growth negatively impacted our cash flows during
this nine-month period, we do not believe it represents a reduction in the
quality of our customer balances, or a change in credit policy. Generally, we
have been able to collect our accounts receivable in the ordinary course of
business. However, since we do not hold any collateral to secure payment from
any of our customers and because most of our customers have the right to return
products and receive price markdowns that can be used to reduce their payments
to us, the valuation of our accounts receivable is continually reviewed and
analyzed in order to help anticipate any liquidity issues that could result from
our inability to collect a receivable balance when due.
We continue to have a highly concentrated customer base of a few large software
distributors and retailers. In particular as of March 31, 2004, our largest
software distributor, Atari, represented 74% of our net accounts receivable,
which compared to 77% of our net accounts receivable at June 30, 2003.
Additionally, during the nine months ended March 31, 2004, we collected
receivable payments from Atari of $4.1 million, which represented 70% of all of
our customer receipts during that period. Our ability to ultimately collect the
net amount owed by Atari remains critical for us being able to meet our
financial obligations and fund normal operations. If at any time Atari would
become unable to or unwilling to make its receivable payments to us when due,
our ability to continue ongoing operations could be significantly impaired.
Inventory
- ---------
During the nine months ended March 31, 2004, we experienced an increase in
inventory purchases due to: increased distribution of our products at new and
existing retail locations; higher costs of certain box titles; and the
additional costs of security sensor tags for PC software recently required by
mass-merchant retailers. As we attempt to continue increasing our product
distribution to new and existing customers, we expect our inventory purchasing
costs to continue rising but at a reduced rate due to achieving more favorable
pricing with certain key vendors and the reduced distribution of higher costing
box titles.
Advanced royalty and licensing payments
- ---------------------------------------
In order to try to gain a competitive advantage in the retail PC software
marketplace, we continually seek to obtain higher quality software content and
more recognizable brand licenses. During the nine months ended March 31, 2004,
we experienced an increase in advanced royalty and licensing payments that were
related to obtaining the software content and certain brand licenses for
upcoming titles. We anticipate that this trend will continue, as the competition
for quality software content and well-known brand licenses is likely to continue
to increase.
Accelerated vendor payments
- ---------------------------
During the nine months ended March 31, 2004, we accelerated payments to various
trade vendors in exchange for receiving cash discounts. We expect to continue
leveraging any excess cash by making accelerated vendor payments in exchange for
receiving vendor cash discounts.
Changes in Cash Flow, Non-operating activities:
- -----------------------------------------------
For the nine months ended March 31, 2004, our primary uses of cash from
non-operating activities were $58,000 in purchases of furniture and equipment
relating to hardware and software upgrades to our computer network, combined
with $19,000 in expenditures relating to trademark activities. For the nine
months ended March 31, 2004, we did not have any financing activities. For the
remainder of fiscal 2004, we expect the upgrading of our computer network to
continue at a reduced rate and we do not anticipate any financing activities
other than possibly receiving cash proceeds from stock option exercises.
Credit Facility
- ---------------
In September 2003, we entered into a $500,000 credit facility agreement with
Hudson United Bank ("HUB"), which matures on December 1, 2004. Amounts
outstanding under this new credit facility will be charged interest at one-half
of one percent above HUB's current prime rate and such interest is due monthly.
Our access to these funds is limited to the lesser of $500,000 or seventy-five
percent of qualified accounts receivable, which are defined as invoices less
than ninety days old and net of any allowances for product returns, price
markdowns and customer bad debts. This credit facility is secured by all of the
Company's assets and requires us, among other things, to maintain the following
financial covenants to be tested quarterly: a total liabilities to tangible net
worth ratio of 1.25 to 1.00 and a tangible net worth requirement of $1.5
million. As of May 12, 2004, we were in compliance with each of those covenants.
This new credit facility was established to provide working capital for our
operations. As of May 12, 2004, we had not utilized any of this credit
facility, although we were eligible to draw up to $500,000 under this credit
facility, based upon qualified accounts receivable as of that date.
Contractual Obligations and Commitments
- ---------------------------------------
Our 5,000 square foot office facility located in Langhorne, Pennsylvania is
occupied under an operating lease that is scheduled to expire on September 30,
2007. Additionally, we currently rent certain office equipment through various
operating lease agreements. As of March 31, 2004, we had future operating lease
commitments of $215,000 as reflected in the table below.
Under various licensing agreements with third-party software developers, we are
required to pay royalties for the use of licensed content in our products.
Additionally, most of these licensing agreements require us to make advance
royalty payments to these software developers prior to the time we recognize any
net sales of software titles containing this licensed software content. As of
March 31, 2004, assuming performance by certain third-party software developers
under such agreements, we had commitments to pay $165,000 in advance royalty
payments to various software developers as reflected in the table below. These
commitments are expected to be funded by cash flows generated through
anticipated income from operations.
The following table represents a summary of our off-balance sheet contractual
obligations and commitments.
Payments Due by Period
------------------------------------------
Less than 1-3 3-5 More than
Contractual Obligations Total 1year years years 5 years
- ---------------------------------------------------------------------------------------
Operating leases $ 215,000 $ 61,000 $ 119,000 $ 35,000 $ - 0 -
Advanced royalties 165,000 153,000 12,000 - 0 - - 0 -
- ---------------------------------------------------------------------------------------
Total $ 380,000 $ 214,000 $ 131,000 $ 35,000 $ - 0 -
========= ========= ========= ======== ========
Liquidity Risk
- --------------
From the first quarter of fiscal 2002 until we entered into our new credit
facility agreement in September 2003, we did not have access to a credit
facility and had been dependent entirely on cash flow from operations to meet
our financial obligations. Our ability to achieve and maintain positive cash
flow remains essential to our survival as a going concern because our access to
our existing credit facility is limited to the lesser of $500,000 or 75% of our
qualified accounts receivable. Our ability to achieve and maintain positive cash
flow depends upon a variety of factors, including the timing of the collection
of outstanding accounts receivable, the creditworthiness of our primary software
distributors and retailers, sell-through of our products to consumers, and the
costs of developing, producing and marketing such products.
There are significant challenges that we will need to successfully manage in
order to be able to fund our operations in the future. These challenges include,
but are not limited to maintaining timely receivable payments from our
concentrated group of customers and agreeing to and maintaining acceptable
payment terms with our vendors. For example, our liquidity would be severely
impacted if Atari, and to a lesser extent Take Two Interactive or Jack of All
Games, did not make payments to us on a timely basis, or if other business
conditions caused them to fail to pay us.
Additionally, there are market factors beyond our control that could also
significantly affect our operating cash flow. The most significant of these
market factors is the market acceptance and sell-through rates of our products
to consumers. If any of our software titles do not sell through to consumers at
the rate anticipated, then we could be exposed to additional product returns and
a lack of customer replenishment orders for these products. If we experienced a
negative trend in any of these factors, we may not be able to maintain positive
cash flow. Additional 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 stockholder dilution it may cause or other
costs associated with such financing.
Listing of Our Common Stock
Our common stock trades on the OTC Bulletin Board under the symbol EGAM. We now
meet all of the listing standards for the American Stock Exchange except for
stockholders equity ($4 million) and the minimum bid share price ($3.00). We
anticipate meeting the stockholders equity requirement by the first quarter of
fiscal 2005, and we continue to implement business strategies and plans that are
designed to achieve financial results that could justify a higher share price
for our stock. We plan to apply for listing on the American Stock Exchange, or
an equivalent exchange, as soon as practicable after we achieve the standards
for listing.
Recent Accounting Pronouncements
In January 2003, the Financial Accounting Standards Board ("FASB") issued
Interpretation No. 46 ("FIN") No. 46, "Consolidation of Variable Interest
Entities". In December 2003, the FASB issued FIN No. 46 (Revised) ("FIN 46-R")
to address certain FIN 46 implementation issues. This interpretation requires
that the assets, liabilities, and results of operations of a Variable Interest
Entity ("VIE") be consolidated into the financial statements of the enterprise
that has a controlling interest in the VIE. The provisions of this
interpretation were effective immediately for all arrangements entered into with
new VIEs created after January 31, 2003, and became effective during the period
ended March 31, 2004 for any VIE created on or before January 31, 2003. Based
upon our review, we do not believe we have any such entities or arrangements
that would require disclosure or consolidation.
In March 2003, the Emerging Issues Task Force published Issue No. 00-21
"Accounting for Revenue Arrangements with Multiple Deliverables" (EITF 00-21).
EITF 00-21 addresses certain aspects of the accounting by a vendor for
arrangements under which it performs multiple revenue generating activities and
how to determine whether such an arrangement involving multiple deliverables
contains more than one unit of accounting for purposes of revenue recognition.
The guidance in this Issue is effective for revenue arrangements entered in
fiscal periods beginning after June 15, 2003. The adoption of EITF 00-21 on July
1, 2003 did not have any impact on our financial statements.
FACTORS AFFECTING FUTURE PERFORMANCE
Risk Factors
- ------------
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 our future performance.
During our recent history, we have experienced significant volatility in our
financial results, making it difficult to evaluate our future financial
prospects. Although during fiscal 2003 and 2002, we were able to earn net income
of $1,592,000 and $2,181,000, respectively, those results were preceded with our
$5,933,000 loss in fiscal 2001. Prior to those periods, our earnings had
continued to decline for three years in a row when we earned $1,253,000,
$463,000 and $253,000 in fiscal 1998, 1999 and 2000, respectively. We began
operations in July 1992, and experienced significant losses from inception
through the end of fiscal 1997. 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 have access only to a $500,000 credit facility with
Hudson United Bank ("HUB") that is subject to borrowing restrictions based on
the value of our accounts receivable.
Our accumulated deficit at June 30, 2003 was $8,176,000. Even though we achieved
profitability in fiscal 2002 and 2003, given current economic conditions in the
United States in general, and the intensely competitive nature of the retail PC
software business, we cannot predict whether we will continue to be profitable
in future periods. Our operations today continue to be subject to all of the
risks inherent in the operation of a small business, which has suffered
liquidity problems in a highly competitive industry dominated by larger and
financially stronger competitors. These risks include difficulties obtaining
quality content for our products, distributing and marketing our products on
terms that are profitable and commercially reasonable to us, competition from
other products in the genres and at the price points that we sell our products,
and unanticipated costs and expenses associated with product development,
distribution, or marketing. 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. While we currently have access to
a $500,000 credit facility with our current commercial lender, Hudson United
Bank ("HUB"), this credit facility is subject to limitations based on the value
of our accounts receivable, and therefore working capital may not be available
to us when we need it. Our ability to continue operations essentially 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 and our $500,000 credit facility with
HUB. 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.
Our current financial condition and our poor financial performance in fiscal
2001 could adversely affect our ability to obtain additional financing, which
makes 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, to access
funds from our credit facility 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. Our products are currently sold at some of the
largest mass-market retailers in the United States - including Wal-Mart, Best
Buy and Target - and the success of our business depends on our continued
ability to sell our products at these and other major retail stores. While we
currently have distribution relationships with some of the major distributors
who sell our products to these retailers, such as Atari and Take-Two
Interactive, if these distributors were unwilling to distribute our products or
were only willing to distribute our products on terms that were commercially
unacceptable to us, our financial condition would be materially harmed. We also
may not be able to distribute our products directly to key retailers on terms
that we consider commercially acceptable. Our inability to negotiate
commercially viable distribution relationships with major software 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. Our
business relies on a concentrated group of large software distributors and
retailers. The majority of our current sales are to major mass merchant and PC
software retailers, and software distributors serving such retailers, and in
particular to Atari. Atari is our primary North American distributor servicing
the major mass-merchant retailers in North America, such as Wal-Mart, Target,
and Best Buy, among others. Our net sales to Atari during the fiscal year ended
June 30, 2003 were $4,370,000 and represented 61% of our total net sales. We
anticipate that net sales to Atari may represent greater than 70% of our total
net sales during fiscal 2004. Accordingly, we expect to continue depending upon
a limited number of significant distributors and retailers, and in particular
Atari, for the foreseeable future.
Our current retailers and distributors, including Atari, may terminate their
relationship with us at any time. If Atari terminated their distribution
relationship with us, it may affect our ability to collect the outstanding
receivable balance from Atari, which as of March 31, 2004 represented 74% of our
total net accounts receivable balance. If we lose our distribution capability
through Atari or any of our other large distributors or retailers, this would
significantly harm our financial condition and our ability to continue as a
going concern.
Our distributors or retailers may not be able to pay us at all or on time if
their 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 some of these businesses have failed. If any significant retailer
or distributor of our products experienced financial difficulties, became
insolvent, or went out of business, this 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 uncollectible 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. If any of our major distributors
or retail customers failed to pay an outstanding receivable, this would
significantly harm our business, operating results and financial condition.
Our distributors and retailers 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 revenue is recognized for sales to 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 products that have higher
price points than our typical $9.99 jewel case products, or are in genres that
have not been proven to be successful for us, which would negatively impact our
future results of operations.
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 typical
product life cycles of no more than six to fifteen months. 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 retailers or distributors, we could be forced to
accept substantial product returns or be required to issue 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 would adversely impact our business, operating results and financial
condition.
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 the seasonality of computer entertainment PC software purchases;
o the size and rate of growth or contraction of the consumer
entertainment PC software market;
o the demand for our typical affordable and 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 distributor or retailer orders;
o product shipment delays;
o access to distribution channels;
o product defects and other quality problems;
o product life cycles;
o ability to accurately forecast inventory production requirements;
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 somewhat seasonal, with sales tending to
be higher during the third and fourth calendar quarters (our first and second
fiscal quarters). This is due to increased demand for PC software games during
the back-to-school and holiday selling seasons primarily because retailers
experience greater store traffic during these periods. Delays in product
development or manufacturing can affect the timing of the release of our
products, causing us to miss key selling periods - sometimes called retail
product "resets" - such as the year-end holiday buying season. Our ability to
maintain adequate liquidity to satisfy critical software developers with
required advance royalty payments and paying our manufacturing vendors within
acceptable timeframes are critical to avoiding any delays in having product
available for sale throughout the year, but especially during seasonal peaks in
demand. If we miss product deliveries during these key selling periods, or if
our products are not ready for shipment to meet these critical selling periods,
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 back-to-school or
holiday selling seasons, our financial results for the entire fiscal year would
be adversely affected.
The consumer entertainment PC 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 a finite 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. 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 we do to negotiate more and
better-positioned shelf space than we do. 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 operating
results and financial condition would be negatively impacted.
Increased competition for 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, this would have a negative impact on our financial
results.
Our present or future competitors may develop products that are comparable or
superior to ours. Our competitors may offer higher quality products, lower
priced products or adapt more quickly than we do 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 has continued to intensify as our industry has
consolidated, since we have remained a small software publisher and some of our
competitors have grown larger. 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 adversely affect our operating results
and financial condition.
We are moderately vulnerable to periodic technological changes that could make
our products obsolete or not to function as expected. Over time, 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 allowance, and the related 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.
If we do not remain current with our reporting requirements under the Securities
Exchange Act of 1934, as amended, we would not be able to maintain the trading
of our stock on the OTC Bulletin Board. Even if we are successful in maintaining
trading of our stock on the OTC Bulletin Board, 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 can make it difficult to sell our stock. If our stock is not
eligible to be traded on the OTC Bulletin Board, 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.
Regulation of our product content and features could affect the marketability of
our products. 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 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. 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 for our product content,
trademarks and trade names and other marketing 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 top-selling 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 and on the overall value of our company.
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. A
significant amount of unauthorized copying of our products would adversely
affect our business, operating results and financial condition.
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 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
initiation 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 can be 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 years ended
June 30, 2003 and 2002. We anticipate that in fiscal 2004 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 licensees, the business failure
of any one of these licensees, and the resulting inability for us to collect
outstanding licensing receivables, could have a material adverse effect on our
financial condition.
Item 3. Controls and Procedures
(a) Disclosure Controls and Procedures. Under the supervision and with the
participation of our Chief Executive Officer and Chief Financial Officer, we
carried out an evaluation of the effectiveness of our disclosure controls and
procedures, as such term is defined in Rules 13a-15(e) and 15d-15(e) under the
Securities Exchange Act of 1934, as of March 31, 2004 (the "Evaluation Date").
Based on that evaluation, our Chief Executive Officer and Chief Financial
Officer have concluded that as of the Evaluation Date, our disclosure controls
and procedures were effective to provide reasonable assurance that the
information required to be disclosed in our reports filed or furnished under the
Exchange Act are recorded, processed, summarized and reported, within the
periods specified in the SEC's rules and forms. We believe that a controls
system, no matter how well designed and operated, cannot provide absolute
assurance that the objectives of the controls system are met, and no evaluation
of controls can provide absolute assurance that all control issues and instances
of fraud, if any, within a company have been detected.
(b) Changes in Internal Control Over Financial Reporting. There have not been
any changes in our internal control over financial reporting during the fiscal
quarter ended March 31, 2004 that have materially affected, or are reasonably
likely to materially affect, our internal control over financial reporting.
Part II. Other Information
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit No. Description of Exhibit
- ----------- ----------------------
31.1 Certification of Gerald W. Klein as President and Chief Executive
Officer of eGames, Inc. pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002.
31.2 Certification of Thomas W. Murphy as Vice President and Chief
Financial Officer of eGames, Inc. pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
32.1 Certification of Gerald W. Klein as President and Chief Executive
Officer of eGames, Inc. pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002.
32.2 Certification of Thomas W. Murphy as Vice President and Chief
Financial Officer of eGames, Inc. pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
(b) Reports on Form 8-K
On February 2, 2004, the Company furnished a report on Form 8-K under Item 12
regarding a press release announcing the Company's financial results for the
three and six months ended December 31, 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: May 14, 2004 /s/ Gerald W. Klein
------------ --------------------
Gerald W. Klein, President, Chief
Executive Officer and Director
Date: May 14, 2004 /s/ Thomas W. Murphy
------------ --------------------
Thomas W. Murphy, Chief Financial
Officer and Chief Accounting Officer
Exhibit 31.1
Certification
I, Gerald W. Klein, certify that:
1. I have reviewed this quarterly report on Form 10-QSB of eGames, Inc.;
2. Based on my knowledge, this report does not contain any untrue statement of a
material fact or omit to state a material fact necessary to make the statements
made, in light of the circumstances under which such statements were made, not
misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial
information included in this 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 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-15(e) and 15d-15(e)) for the registrant and have:
a) Designed such disclosure controls and procedures, or caused such
disclosure controls and procedures to be designed under our
supervision, 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 report is being prepared;
b) Evaluated the effectiveness of the registrant's disclosure controls
and procedures and presented in this report our conclusions about the
effectiveness of the disclosure controls and procedures, as of the end
of the period covered by this report based on such evaluation; and
c) Disclosed in this report any change in the registrant's internal
control over financial reporting that occurred during the registrant's
most recent fiscal quarter that has materially affected, or is
reasonably likely to materially affect, the registrant's internal
control over financial reporting;
5. The registrant's other certifying officer and I have disclosed, based on our
most recent evaluation of internal control over financial reporting, to the
registrant's auditors and the audit committee of the registrant's board of
directors (or persons performing the equivalent functions):
a) all significant deficiencies and material weaknesses in the design
or operation of internal control over financial reporting which are
reasonably likely to adversely affect the registrant's ability to
record, process, summarize and report financial information; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal control over financial reporting.
Date: May 14, 2004
- ------------------
/s/ Gerald W. Klein
------------------
Gerald W. Klein
President and Chief Executive Officer
(Principal Executive Officer)
Exhibit 31.2
Certification
I, Thomas W. Murphy, certify that:
1. I have reviewed this quarterly report on Form 10-QSB of eGames, Inc.;
2. Based on my knowledge, this report does not contain any untrue statement of a
material fact or omit to state a material fact necessary to make the statements
made, in light of the circumstances under which such statements were made, not
misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial
information included in this 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 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-15(e) and 15d-15(e)) for the registrant and have:
a) Designed such disclosure controls and procedures, or caused such
disclosure controls and procedures to be designed under our
supervision, 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 report is being prepared;
b) Evaluated the effectiveness of the registrant's disclosure controls
and procedures and presented in this report our conclusions about the
effectiveness of the disclosure controls and procedures, as of the end
of the period covered by this report based on such evaluation; and
c) Disclosed in this report any change in the registrant's internal
control over financial reporting that occurred during the registrant's
most recent fiscal quarter that has materially affected, or is
reasonably likely to materially affect, the registrant's internal
control over financial reporting;
5. The registrant's other certifying officer and I have disclosed, based on our
most recent evaluation of internal control over financial reporting, to the
registrant's auditors and the audit committee of the registrant's board of
directors (or persons performing the equivalent functions):
a) all significant deficiencies and material weaknesses in the design
or operation of internal control over financial reporting which are
reasonably likely to adversely affect the registrant's ability to
record, process, summarize and report financial information; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal control over financial reporting.
Date: May 14, 2004
- ------------------
/s/ Thomas W. Murphy
--------------------
Thomas W. Murphy
Chief Financial Officer
(Principal Financial Officer)
Exhibit 32.1
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 fiscal quarter ended March 31, 2004 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, based on my knowledge, 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
May 14, 2004
The foregoing certification is being furnished to the Securities and Exchange
Commission pursuant to 18 U.S.C. Section 1350 as an exhibit to the Report and is
not being filed as part of the Report or as a separate disclosure document.
Exhibit 32.2
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 fiscal quarter ended March 31, 2004 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, based on my knowledge, 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
May 14, 2004
The foregoing certification is being furnished to the Securities and Exchange
Commission pursuant to 18 U.S.C. Section 1350 as an exhibit to the Report and is
not being filed as part of the Report or as a separate disclosure document.