U.S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-QSB
(Mark One)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 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: 10,108,587 shares of common stock, no
par value per share, as of November 10, 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 September 30, 2004................... 3
Statements of Operations for the three months
ended September 30, 2004 and 2003 ................... 4
Statements of Cash Flows for the three months
ended September 30, 2004 and 2003 ................... 5
Notes to Financial Statements............................ 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations ................. 12
Factors Affecting Future Performance .................... 24
Item 3. Controls and Procedures ................................. 28
Part II Other Information
Item 6. Exhibits ................................................ 28
Exhibit Index ......................................................... 28
Signatures ......................................................... 29
Exhibits ......................................................... 30
Item 1. Unaudited Financial Statements
eGames, Inc.
Balance Sheet
(Unaudited)
As of
September 30,
2004
-------------
ASSETS
- ------
Current assets:
Cash and cash equivalents $ 1,553,840
Accounts receivable, net of allowances of $849,849 1,121,740
Inventory, net 842,114
Prepaid and other expenses 473,896
-----------
Total current assets 3,991,590
Furniture and equipment, net 74,969
Intangible assets 24,089
-----------
Total assets $ 4,090,648
===========
LIABILITIES AND STOCKHOLDERS' EQUITY
- ------------------------------------
Current liabilities:
Accounts payable $ 359,575
Accrued expenses 312,952
-----------
Total current liabilities 672,527
-----------
Commitments and contingencies
Stockholders' equity:
Common stock, no par value (40,000,000 shares authorized;
10,340,487 issued and 10,108,587 outstanding) 9,179,827
Additional paid-in capital 1,359,970
Accumulated deficit (6,620,259)
Treasury stock, at cost - 231,900 shares (501,417)
-----------
Total stockholders' equity 3,418,121
-----------
Total liabilities and stockholders' equity $ 4,090,648
===========
See accompanying notes to financial statements.
eGames, Inc.
Statements of Operations
(Unaudited)
Three Months ended
September 30,
---------------------------
2004 2003
----------- -----------
Net sales $ 1,177,829 $ 2,052,472
Cost of sales 571,158 818,185
----------- -----------
Gross profit 606,671 1,234,287
Operating expenses:
Product development 239,115 126,390
Selling, general and administrative 571,132 602,284
----------- -----------
Total operating expenses 810,247 728,674
----------- -----------
Operating income (loss) (203,576) 505,613
Interest (income) expense, net (1,230) 4,983
----------- -----------
Income (loss) before income taxes (202,346) 500,630
Provision (benefit) for income taxes (18,024) 22,284
----------- -----------
Net income (loss) ($ 184,322) $ 478,346
=========== ===========
Net income (loss) per common share:
- Basic ($ 0.02) $ 0.05
=========== ===========
- Diluted ($ 0.02) $ 0.05
=========== ===========
Weighted average common shares outstanding - Basic 10,102,673 9,989,337
Dilutive effect of common share equivalents - 0 - 483,761
---------- ----------
Weighted average common shares
and common share equivalents outstanding - Diluted 10,102,673 10,473,098
========== ==========
See accompanying notes to financial statements.
eGames, Inc.
Statements of Cash Flows
(Unaudited)
Three Months ended
September 30,
-------------------------
2004 2003
---------- ----------
Cash flows from operating activities:
Net income (loss) ($ 184,322) $ 478,346
Adjustment to reconcile net income (loss) to net
cash used in operating activities:
Stock-based compensation 18,306 8,058
Depreciation and amortization 8,686 4,152
Changes in operating assets and liabilities:
Accounts receivable, net 412,119 (511,416)
Inventory, net (27,828) (110,437)
Prepaid and other expenses (33,766) (72,109)
Accounts payable (81,441) 11,001
Accrued expenses (303,842) (66,534)
---------- ----------
Net cash used in operating activities (192,088) (258,939)
---------- ----------
Cash flows from investing activities:
Purchases of furniture and equipment (8,796) (7,774)
---------- ----------
Net cash used in investing activities (8,796) (7,774)
---------- ----------
Cash flows from financing activities:
Proceeds from exercise of stock options 12,500 - 0 -
---------- ----------
Net cash provided by financing activities 12,500 - 0 -
---------- ----------
Net decrease in cash and cash equivalents (188,384) (266,713)
Cash and cash equivalents:
Beginning of period 1,742,224 1,024,237
---------- ----------
End of period $1,553,840 $ 757,524
========== ==========
Supplemental cash flow information:
Cash paid during the period for interest $ - 0 - $ 5,475
========== ==========
Cash paid (refunds received) for income taxes $ 23,550 ($ 253)
========== ==========
See accompanying notes to financial statements.
eGames, Inc.
Notes to Financial Statements
(Unaudited)
1. Summary of Significant Accounting Policies
Description of Business
eGames, Inc. ("eGames", "our" or "we") is a Pennsylvania corporation
incorporated in July 1992 that publishes, markets and sells affordable PC
software games. We focus on publishing software games for the PC platform, and
while we are preliminarily exploring possible opportunities in the mobile phone
game market, we currently do not plan to publish products for any other game
platform, such as console devices, hand held game devices, mobile phones and
personal digital assistants. Our product line enables us to satisfy consumers
who are seeking a broad range of high-quality, affordable PC gaming software,
which are sold on CDs or online through the Internet. In North America, our PC
games are distributed primarily through third-party software distributors who
service the mass-merchant and major retailers. In territories outside North
America, we license our PC games to third-party software distributors who are
responsible for the manufacture and distribution of our PC games within specific
geographic territories.
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, 2004 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 cash, accounts payable and accrued liabilities at
September 30, 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, net is reflected at the amount we expect to ultimately
collect from outstanding customer balances, and is shown on our balance sheet
net of the 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 reflected within
the current period's 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 consists primarily of finished goods and 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 is 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
At September 30, 2004, we had intangible assets of approximately $24,000, which
related to the Company's trademark registration activities with the United
States Patent and Trademark Office. As of September 30, 2004, we had not
recorded any amortization expense relating to these assets 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 North American 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 sales agreements, most 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, we perform sales cut-off tests,
in which 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 these 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 and are deferred until the subsequent
reporting period.
We recognize product sales to 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 support to
consumers who purchase our products as a means of improving consumer
satisfaction and brand loyalty. Costs associated with our customer support
efforts 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 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.
We have also 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, revenues
from product shipments pursuant to these arrangements are only recognized to the
extent that the third-party software distributor has reported to us that the
actual product sell-through to end consumers has occurred.
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 and price markdown
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 quantities of new products with higher retail price points
or unproven genres remain in the retail channel. The adequacy of our allowance
for product returns and price markdowns is reviewed throughout each reporting
period and any necessary adjustment to this allowance 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.
Historically, the allowance for product returns and price markdowns has
represented a substantial percentage of our gross accounts receivable. As of
September 30, 2004, the allowance for product returns and price markdowns was
42% of our gross accounts receivable, compared to 34% of our gross accounts
receivable at September 30, 2003. This allowance represents a high percentage of
our gross accounts receivable because we have product return and price markdown
exposure relating to paid receivables while the physical software 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 product sell-through results and remaining unit
levels in the retail channel for our titles that help us estimate our exposure
for future product returns and price markdowns.
During the quarters ended September 30, 2004 and 2003, our provisions for
product returns and price markdowns for customers that have traditionally sold
consumer entertainment PC software products were $228,000 and $308,000,
respectively, or 17% and 14%, respectively, of related gross sales.
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, estimated tax payments, 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 usually expensed in cost of sales at contractual rates based on the net
sales of the related software titles at retail (see Notes 4 and 7), and income
tax payments reflected as income tax provisions when appropriate.
We continually evaluate the recoverability of our advance licensing and royalty
payments by evaluating all available information about each title, and in
particular the expected volume of future sales. For titles that have achieved a
successful launch into their intended retail channels, we charge to cost of
sales any amount we determine to be non-recoverable in future periods. For
titles that have not yet achieved a successful launch into their intended retail
channels, we charge all non-recoverable costs to product development expense.
Write-off amounts are recognized in the reporting period in which the
determination is reached by management that recoverability in future periods is
unlikely.
Marketing Costs
Marketing costs reflected as operating expenses, such as advertising and
merchandising fees, are expensed as incurred. These costs were $20,000 and
$23,000, respectively, for the quarters ended September 30, 2004 and 2003.
Sales Incentives and Promotional Costs
Sales incentives and promotional costs we incur with distributors and retailers,
such as rebates and slotting fees, are recorded as reductions to gross sales as
incurred or on a straight-line basis over contractual periods. For the quarters
ended September 30, 2004 and 2003, our sales incentives and promotional costs
were $88,000 and $58,000, respectively, or 7% and 3%, respectively, of related
gross sales.
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 (Loss) per Common Share
Net income (loss) per common share is computed in accordance with SFAS No. 128,
"Earnings per Share". Basic earnings (loss) per share is computed by dividing
net earnings 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 9).
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 $ 1,972,000
Allowance for product returns and price markdowns (836,000)
Allowance for bad debts (14,000)
------------
Accounts receivable, net $ 1,122,000
============
3. Inventory, net
Inventory, net consists of the following:
Raw materials - warehouse $ 153,000
Finished goods - warehouse 751,000
Product returns - retailer and distributor locations 107,000
------------
1,011,000
Allowance for obsolescence (169,000)
------------
Inventory, net $ 842,000
============
4. Prepaid and Other Expenses
Prepaid and other expenses consists of the following:
Royalties $ 247,000
Insurances 103,000
Federal tax 61,000
Retailer slotting fees 33,000
Other expenses 30,000
------------
Prepaid and other expenses $ 474,000
============
5. Furniture and Equipment, net
Furniture and equipment consists of the following:
Furniture and equipment $ 355,000
Accumulated depreciation (280,000)
------------
Furniture and equipment, net $ 75,000
============
6. Accrued Expenses
Accrued expenses consists of the following:
Accrued payroll and vacation $ 84,000
Accrued state income taxes 62,000
Customers with credit balances 57,000
Accrued professional fees 41,000
Other accrued expenses 37,000
Marketing promotions 32,000
------------
Accrued expenses $ 313,000
============
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. Total rent expense amounted to $22,000 and $21,000 for the quarters
ended September 30, 2004 and 2003, respectively. As of September 30, 2004, we
had future operating lease commitments of $206,000 that are scheduled to be paid
as follows: $64,000 in less than one year; $138,000 in one to three years; and
$4,000 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 September 30, 2004, assuming
performance by certain third-party software developers under such agreements, we
had future commitments to pay $92,000 in advance royalty payments to various
software developers scheduled to be paid as follows: $80,000 in less than one
year; and $12,000 in one to three years.
8. 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. We expect to
renew this facility before its expiration date. Amounts outstanding under this
credit facility are 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 September 30, 2004, we were in compliance with each of those covenants.
This credit facility was established to provide working capital for our
operations. As September 30, 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.
9. Accounting for Stock-Based Compensation
As of September 30, 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. The 1995 Plan allows for such granting of options
to purchase shares of our common stock through July 1, 2005, after which date
any previously granted options will remain in effect throughout their respective
contractual terms.
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. 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. As of January
1, 2003, we adopted the provisions of SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure".
During the quarters ended September 30, 2004 and 2003, we recognized stock-based
compensation expense of $18,000 and $8,000, respectively, within our financial
statements. All stock options that vested during these quarters had been
previously valued under the fair value method, and accordingly no reconciliation
of stock-based compensation expense between the valuation methods for APB
Opinion No. 25 and SFAS No. 123 is necessary.
10. Dependence on One Large Software Distributor - Atari
Atari is our primary software distributor servicing the North American
mass-merchants and other major retailers, such as Wal-Mart, Target, and Best
Buy, among others. During the quarter ended September 30, 2004, Atari accounted
for $514,000 of our net sales, or 44% of net sales, compared to the quarter
ended September 30, 2003, when Atari accounted for $1,569,000 in net sales, or
76% of net sales.
Throughout fiscal 2004 we increased our product distribution through Atari to
the major North American mass-merchant retailers by increasing the number of our
individual titles carried by these retailers and the number of stores within
these retailers' store chains that offer our titles to consumers. During the
quarter ended September 30, 2004, one of the largest North American mass
- -merchant retailers serviced by Atari indicated that it was reducing the number
of $9.99 retail priced titles within their PC software departments, in order to
expand its offering of higher priced ($19.99 and above) game and productivity
titles. This change in this retailer's marketing emphasis had a negative impact
on our net sales during the quarter as a result of lower replenishment and
initial product orders from Atari due to its changing inventory requirements
from this decision.
Our financial condition and ability to continue as a going concern would be
significantly affected in the event that we would lose our distribution
capability through Atari, or if they would not be able to or willing to make
timely receivable payments in the normal course of business. 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, Atari was unable or unwilling to make
timely receivable payments in the normal course of business, or if any of these
retailers decided to discontinue its 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, or if such
distributors would be acceptable to these retailers.
11. Operations by Reportable Segment and Geographic Area
SFAS No. 131, "Disclosure about Segments of an Enterprise and Related
Information," establishes standards for reporting information about an
enterprise's operating segments and related disclosures about our products,
geographic areas and major customers.
Based on our organizational structure, we operate in only one geographic area,
which is North America, and only one reportable segment, which is publishing
consumer entertainment software for PCs.
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:
- Possible opportunities in the mobile phone game market;
- Our anticipation that during fiscal 2005 the majority of our net
sales, accounts receivable and related cash receipts will continue
to be attributable to Atari;
- Our expectation that the recent decision by one of North America's
largest mass-merchant retailers to decrease the size of its ($9.99
retail priced) jewel case PC game software department chain-wide
will continue to impact our financial results for the foreseeable
future;
- The likely increase in product distribution at the retailers and
through the distributors that charge sales incentive and
promotional fees during the remainder of fiscal 2005, and that
these types of costs will continue having a negative impact on our
net sales, gross profit and gross profit margin;
- Our expectation that our gross profit margin will continue to be
impacted by higher royalty rates associated with new titles during
the remainder of fiscal 2005;
- Our goal to increase the distribution of our products offered at
retail locations to provide us with sufficient profitability and
cash flows, as well as continued access to these retail markets;
- Our launch of a new online games website to complement our existing
e-commerce website and the increase in profitability of our overall
Internet sales;
- The increase in our receipt of additional quantities of
discontinued titles back from the retail channel for liquidation,
along with the liquidation of any remaining quantities of these
titles still in our warehouse; and
- Our intention to ultimately meet the listing standards for the
American Stock Exchange and to apply for listing on the American
Stock Exchange, or an equivalent exchange.
The following important factors, as well as those factors discussed under
"Factors Affecting Future Performance" beginning on page 24 in this report,
could cause our actual results to differ materially from those indicated by the
forward-looking statements contained in this report:
- The market acceptance and successful sell-through results for our
products at retail stores, particularly at North American
mass-merchant retailers where consumer entertainment PC software
has traditionally been sold;
- The continued successful business relationship between us and
Atari, as our largest customer and our distributor to Wal-Mart,
Target, and Best Buy, among others;
- The amount of shelf space Wal-Mart, Target and Best Buy allocate
to ($9.99 retail priced) jewel case PC game software;
- The amount of unsold product that is returned to us by retail
stores and distributors;
- The amount of price markdowns we grant 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 continued success of our current business model of selling,
primarily through third-party distributors, to a concentrated
number of select mass-merchant and major retailers;
- Our ability to control the manufacturing and distribution costs
of our software titles;
- The success of our distribution strategy, including the ability to
continue to distribute our products into key North American
mass-merchant retailers and to enter into new distribution and
direct sales relationships on commercially acceptable terms;
- Our ability to collect outstanding accounts receivable and
establish an adequate allowance for bad debts;
- Downward pricing pressure;
- Fluctuating costs of developing, producing and marketing our
products;
- Our ability to license or develop quality content for our products;
- The success of our efforts to increase website traffic and product
sales over the Internet;
- Consumers' continued demand for affordable consumer entertainment PC
software;
- Increased competition in the affordable PC software category;
and various other factors set forth in our Annual Report on Form 10-KSB for the
fiscal year ended June 30, 2004 as filed with the Securities and Exchange
Commission on September 27, 2004.
Overview
The following overview is a summary of our operating results as well as some
identified trends in our business. We believe that an understanding of these
trends is important in order to understand our results for the quarter ended
September 30, 2004, as well as our future results. This summary is not intended
to be exhaustive, nor is it intended to be a substitute for the detailed
discussion and analysis provided elsewhere in this Form 10-QSB, including in
this Item 2 "Management's Discussion and Analysis of Financial Condition and
Results of Operations" and under "Factors Affecting Future Performance" or the
financial statements and the related notes.
About eGames
We publish, market and sell consumer entertainment PC software games to
consumers seeking a broad range of high-quality, affordably priced PC games,
either on CDs or online at www.egames.com. We focus on publishing software games
for the PC platform, and while we are preliminarily exploring possible
opportunities in the mobile phone game market, we currently do not plan to
publish products for any other game platform, such as console devices, hand held
game devices, mobile phones and personal digital assistants. In North America,
our PC games are distributed primarily through third-party software distributors
who service the mass-merchant and major retailers. In territories outside North
America, we license our PC games to third-party software distributors who are
responsible for the manufacture and distribution of our PC games within specific
geographic territories.
We promote the eGames(TM) and Home Office Help(TM) brands in order to generate
customer loyalty, encourage repeat purchases and differentiate eGames software
products to retailers and consumers. We also publish and market RealAge(R) Games
& Skills, a collection of PC software activities and games designed to help
build and maintain mental sharpness.
Summary of First Quarter Fiscal 2005 Financial Results
Net sales decreased by $874,000, or 43%, to $1,178,000 for the three months
ended September 30, 2004, compared to $2,052,000 in net sales for the three
months ended September 30, 2003. The $874,000 decrease in net sales was caused
by a $927,000 decrease in net sales to software distributors that serve the
major North American mass-merchant retailers, which was partially offset by
increases in Internet and inventory liquidation net sales.
For the quarter ended September 30, 2004, we experienced a net loss of $184,000,
or $0.02 per diluted share, compared to net income of $478,000, or $0.05 per
diluted share, for the quarter ended September 30, 2003. This $662,000 decline
in profitability for the quarter ended September 30, 2004 compared to the year
ago quarter was caused primarily by a decrease in gross profit resulting from
lower net sales, combined with a lower gross profit margin and higher operating
expenses associated with the write-off of costs related to the RealAge Games &
Skills project.
During the quarter ended September 30, 2004, we experienced a decrease in cash
of $188,000, compared to the year ago quarter when cash decreased by $267,000.
The $188,000 decrease in cash during the current quarter resulted from $192,000
in cash used in operating activities (as a result of the $184,000 net loss) and
$9,000 in cash used in investing activities (for computer network upgrades),
which were partially offset by $13,000 in cash provided by financing activities
(in proceeds from stock option exercises).
Primary Trends in our Business
Dependence on One Large Software Distributor - Atari
----------------------------------------------------
We continue to have a highly concentrated customer base of a few large software
distributors and retailers. 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 September 30,
2004, Wal-Mart accounted for about half of our business with Atari, while Best
Buy and Target accounted for most of our remaining units sold through Atari.
During the quarter ended September 30, 2004, we recognized net sales to Atari of
$514,000, which represented 44% of our total net sales, compared to the quarter
ended September 30, 2003, when we had $1,569,000 in net sales to Atari, which
represented 76% of our total net sales. As of September 30, 2004, Atari
represented 57% of our total net accounts receivable, compared to September 30,
2003 when Atari represented 82% of our total net accounts receivable.
Additionally, during the quarters ended September 30, 2004 and 2003, we
collected receivable payments of $1.1 million and $1.0 million, respectively,
from Atari, which represented 69% and 72%, respectively, of our total customer
receipts during those quarters.
We anticipate that during fiscal 2005 the majority of our net sales, accounts
receivable and related cash receipts will continue to be attributable to Atari.
Our financial condition and ability to continue as a going concern would be
significantly affected if we lost our distribution capability through Atari, if
the amount of net sales to Atari were to substantially decrease, or if Atari
would not be able or willing to make timely receivable payments to us in the
normal course of business.
The Affordable Jewel Case PC Game Software Market is Shrinking
--------------------------------------------------------------
The affordable ($9.99 retail priced) jewel case PC game software market is not
growing and is in fact decreasing in size. An indication of this trend was the
recent decision by one of North America's largest mass-merchant retailers to
decrease the size of its ($9.99 retail priced) jewel case PC game software
department chain-wide, which has more than halved the number of our titles that
are now being sold in that retailer's stores. This event negatively affected our
net sales and operating results for the quarter ended September 30, 2004 and we
expect that it will continue to impact our results for the foreseeable future.
We have begun launching titles in the productivity software market, and are also
exploring different PC game genres that have recently performed well. In
addition to these strategies, we have launched a new online game website, with
free online game play and chat rooms, in an effort to tap into potential revenue
streams from the growing online game market. We cannot predict whether these new
opportunities and strategies will be effective in increasing net sales and
offsetting the decreases in net sales caused by recent reductions in the
affordable PC game software market at retail.
Product Returns and Price Markdowns
-----------------------------------
During the quarter ended September 30, 2004, our provision for product returns
and price markdowns for customers that have traditionally sold PC software
increased to 17% of related gross sales, compared to 14% of related gross sales
for the year ago quarter.
Sales Incentives and Promotional Costs
--------------------------------------
During the quarters ended September 30, 2004 and 2003, these types of fees
(recognized as reductions to gross sales) were $88,000 and $58,000,
respectively, or 7% and 3%, respectively, of related gross sales. For the
remainder of fiscal 2005, our product distribution will likely increase at the
retailers and through the distributors that charge such fees, and so we expect
these types of costs to continue having a negative impact on our net sales,
gross profit and gross profit margin.
Gross Profit Margin
-------------------
During the quarter ended September 30, 2004, our gross profit margin declined to
51.5%, compared to 60.1% for the quarter ended September 30, 2003. This 8.6%
decrease in the gross profit margin was due to increases, as a percentage of net
sales, of: 4.1% in royalty costs related to product mix and the write-off of
advanced royalties related to titles discontinued at retail; 2.3% in freight
costs due to lower sales to software distributors within the United States, and
2.2% in other cost of sales traceable to inventory liquidation sales. For the
remainder of fiscal 2005, we expect that our gross profit margin will continue
to be impacted by higher royalty rates associated with new titles, combined with
continued pricing pressures from software distributors and retailers.
Employee Incentive Compensation Expense
---------------------------------------
During the quarter ended September 30, 2004, we did not accrue any expense
relating to the fiscal 2005 employee incentive compensation plan due to the net
loss we experienced, and our uncertainty that we would achieve the operating
income threshold required for bonus payments to be made pursuant to that plan.
This is in contrast to the quarter ended September 30, 2003, which included
approximately $75,000 in compensation expense ($13,000 in product development
expense and $62,000 in selling, general and administrative expense) relating to
accruals for anticipated bonus payments under the fiscal 2004 employee incentive
compensation plan.
Critical Accounting Policies and Estimates
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, the cost of sales we
expense, and the values of our inventory and accounts receivable. 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 for 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 factors and
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, all of which have traditionally sold consumer entertainment
PC software products. The distribution of our products is governed by purchase
orders, distribution agreements or direct sale agreements, most 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 the title of our product
passes to these distributors or retailers.
Key Assumptions
Our provision for anticipated product returns and price markdowns is based on
the assumptions we make after evaluating various 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 and price markdown authorizations; and the
extent to which units of new products with higher price points or unproven
genres remain in the retail channel.
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 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 at the end of any
reporting period and cost of sales during 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.
Key Assumptions
Our provision for inventory obsolescence is based on the assumptions we make
after evaluating various factors related to the remaining value of existing
warehouse and field inventory units, including: estimating the remaining product
life of existing titles based on how long the titles have been out at retail;
analyzing the trend of current product sell-through results to consumers for
existing titles; identification of competitors' new products with capabilities
or technologies that could replace or shorten the lifecycles of our existing
titles; assessing the potential for litigation that may terminate our ability to
sell existing titles containing certain product content; monitoring of
expiration dates of licensing agreements with software developers related to
content within existing titles that could stop our further distribution of
certain titles; and tracking the current market value for remaining units of
discontinued titles based on recent liquidation sales of similar products.
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 remaining inventory value to zero. The adequacy of our allowance for
inventory obsolescence is reviewed throughout each reporting period, and any
adjustments 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.
Quarter Ended September 30, 2004 Compared to the Quarter Ended
September 30, 2003
Net Sales
Net sales decreased by $874,000, or 43%, to $1,178,000 for the three months
ended September 30, 2004, compared to $2,052,000 in net sales for the three
months ended September 30, 2003. The $874,000 decrease in net sales was caused
by a $927,000 decrease in net sales to software distributors that service the
major North American mass-merchant retailers due to the effects of less retail
shelf space being allocated to $9.99 retail priced PC software products,
combined with less promotional box titles being sold in the current quarter
compared to the year ago quarter. Additionally, direct sales to various
retailers decreased by $10,000, while Internet sales and inventory liquidation
sales increased by $25,000 and $38,000, respectively, during the same period.
The following table represents our net sales by distribution channel for the
quarters ended September 30, 2004 and 2003:
Net Sales by Distribution Channel
---------------------------------
Quarters ended
September 30,
-----------------------------------------
Increase %
Distribution Channel 2004 % 2003 % (Decrease) Change
- ----------------------------------------------------------------------------------------------
Software Distributors $ 815,000 69% $ 1,742,000 85% ($ 927,000) (53%)
Software Retailers 160,000 14% 170,000 8% (10,000) (6%)
Licensing 101,000 9% 101,000 5% - 0 - n/m
Internet 64,000 5% 39,000 2% 25,000 64%
Inventory Liquidators 38,000 3% - 0 - n/m 38,000 n/m
- ----------------------------------------------------------------------------------------------
Totals $ 1,178,000 100% $ 2,052,000 100% ($ 874,000) (43%)
=========== ==== =========== ==== ========= ===
The overall decrease in net sales was primarily driven by decreased sales of our
products to our largest software distributor, Atari, which services many of the
larger North American mass-merchant and major retailers (such as Wal-Mart,
Target and Best Buy). Partially offsetting this net sales decrease were net
sales increases resulting from expanded distribution of our products to major
office superstores within the United States, such as Office Max, through Take
Two Interactive's software distribution division, along with increased product
distribution to various Canadian retailers, such as EB Games, Future Shop, Radio
Shack and Business Depot through software distributors such as Jack of All Games
and Softek.
Retailers that have historically been successful in merchandising PC game
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.
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 sufficient profitability and cash flows,
as well as continued access to these retail markets.
Software Distributors
---------------------
For the quarter ended September 30, 2004, net sales to software distributors
amounted to $815,000, which represented a decrease of $927,000 or 53% from the
quarter ended September 30, 2003. For the quarter ended September 30, 2004, net
sales to software distributors decreased to 69% of total net sales, compared to
85% of total net sales for the quarter ended September 30, 2003.
For the quarter ended September 30, 2004, the $927,000 decrease in net sales to
software distributors was predominantly driven by the $1,055,000 decrease in net
sales to Atari that resulted from:
o The impact on replenishment and initial product orders related to the
recent decision by one of North America's largest mass-merchant
retailers to change its marketing emphasis to feature higher retail
price point ($19.99 and above) game and productivity titles, thereby
reducing the retail shelf space allocated to PC game software titles at
the $9.99 retail price point;
o No sales during the quarter ended September 30, 2004 of certain
promotional box titles retail priced at $19.99, which in the year ago
quarter had represented approximately $280,000 in net sales; combined
with
o Decreased demand for value priced game software, in general, which we
believe has been caused in part by increased competition in the overall
consumer entertainment marketplace from a growing number of alternative
game-playing technologies available to consumers, including game
consoles, hand-held game devices, mobile phones and online game
websites.
Partially offsetting this decrease in net sales to Atari were net sales
increases of:
o $51,000 to Take Two Interactive,
o $44,000 to Softek, and
o $26,000 to Jack of All Games.
Dependence on One Large Software Distributor - Atari
----------------------------------------------------
Atari is our primary software distributor serving the mass-merchants and major
retailers in North America, such as Wal-Mart, Target, and Best Buy, among
others. During the quarter ended September 30, 2004, Atari accounted for
$514,000, or 44%, of our net sales, compared to the quarter ended September 30,
2003 when Atari accounted for $1,569,000, or 76%, of our net sales.
During the quarter ended September 30, 2004, we continued to rely heavily on our
product distribution through Atari to the major North American mass-merchant
retailers, although Atari's percentage of our total business declined to 44% of
net sales. Our financial condition and ability to continue as a going concern
would be significantly affected in the event that we would lose our distribution
capability through Atari, or if the amount of net sales to Atari were to
substantially decrease over a short period of time. The distribution of PC
software to these retailers is a competitive business within itself, and there
are several alternative distributors that could potentially distribute our
products to these retailers if, for example, Atari chose to discontinue
distributing our titles, Atari was not able or willing to make timely receivable
payments in the normal course of business or if any of these retailers decided
to discontinue its relationship with Atari. We can provide no assurance,
however, that we would be able to secure agreements with alternative
distributors on commercially reasonable terms or at all, or if such distributors
would be acceptable to these retailers.
Software Retailers
------------------
For the quarter ended September 30, 2004, net sales made directly to software
retailers were $160,000, which represented a $10,000 decrease compared to the
quarter ended September 30, 2003. This $10,000 decrease in net sales made
directly to software retailers resulted primarily from a $29,000 decrease in net
sales to CompUSA due to a reduced number of our titles being offered at CompUSA
stores, which was partially offset by various net sales increases to other
retailers.
Licensing
---------
During the quarter ended September 30, 2004, licensing revenues were 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,
the United Kingdom, and Brazil. For the quarters ended September 30, 2004 and
2003, licensing revenues amounted to $101,000 for both periods, and represented
9% and 5%, respectively, of net sales during these quarters.
Internet
--------
Internet sales were $64,000 and $39,000 for the quarters ended September 30,
2004 and 2003, respectively, and represented 5% and 2%, respectively, of net
sales during these quarters. This $25,000 increase in Internet sales during the
quarter ended September 30, 2004 represented a 64% rise from the year ago
quarter, and resulted from our decision to manage our Internet sales internally
in order to more effectively market our titles on the Internet.
In October 2004, we launched a new online games website, www.egamesonline.com,
which is intended to complement our existing e-commerce website and increase the
profitability of our overall Internet sales, through additional advertising
revenues, and downloadable demos that are designed to generate incremental sales
on the main eGames website by cross-promoting the full game versions of those
eGames titles.
Inventory Liquidators
---------------------
For the quarter ended September 30, 2004, net sales to inventory liquidators
were $38,000 and represented 3% of total net sales, compared to no such sales
during the year ago quarter. 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 product lifecycles. As retailers continue
to routinely change the mix of software titles displayed 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 still 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 to return products or to receive price
markdowns.
Product Returns and Price Markdowns
-----------------------------------
During the quarters ended September 30, 2004 and 2003, our provisions for
product returns and price markdowns for customers that have traditionally sold
consumer entertainment PC software products were $228,000 and $308,000,
respectively, or 17% and 14%, respectively, of related gross sales. This $80,000
decrease in the provisions for product returns and price markdowns resulted from
a 38% decrease in gross sales compared to the year ago quarter, that was
partially offset by a higher provision rate needed against the current quarter's
gross sales to maintain an adequate allowance for product returns and price
markdowns based upon our evaluation of the salability of the titles remaining in
the retail channel as of September 30, 2004.
Sales Incentives and Promotional Costs
--------------------------------------
In order to gain or maintain retail shelf space for our titles, we incur sales
incentives and promotional costs from distributors and retailers, such as
rebates and slotting fees, and recognize them as reductions to gross sales.
During the quarters ended September 30, 2004 and 2003, our sales incentives and
promotional costs were $88,000 and $58,000, respectively, or 7% and 3%,
respectively, of related gross sales. For the remainder of fiscal 2005, we plan
to increase our product distribution at the retailers and through the
distributors that charge such fees, and so we expect these types of costs to
continue impacting our net sales, gross profit and gross profit margin.
Cost of Sales
Cost of sales consists of the following costs that are associated with the
publishing of our PC games for retail distribution: actual product costs;
royalty costs incurred with third-party software developers for licensing
product content; freight and handling costs; inventory obsolescence provisions
and other costs.
The following table represents our cost of sales for the quarters ended
September 30, 2004 and 2003:
September 30, % of September 30, % of Increase %
2004 net sales 2003 net sales (Decrease) Change
- -------------------------------------------------------------------------------
$ 571,000 48.5% $ 818,000 39.9% ($ 247,000) (30.2%)
During the quarter ended September 30, 2004, cost of sales decreased by
$247,000, or 30.2%, to $571,000, due to the 43% decrease in overall net sales,
which was partially offset by a higher cost of sales percentage on those reduced
sales.
For the quarter ended September 30, 2004, cost of sales, as a percentage of net
sales, increased to 48.5% from 39.9% for the quarter ended September 30, 2003.
This 8.6% increase in cost of sales, as a percentage of net sales, was due to:
o a 4.1% increase in royalty costs resulting from product mix changes and
the write-off of advance royalty payments related to various game
titles removed from retail distribution;
o a 2.3% increase in freight costs due to a smaller proportion of sales
to software distributors within the United States, combined with a
greater percentage of higher costing product deliveries made to
Canadian distributors and to North American retailers; and
o a 2.2% increase in other costs related primarily to increased inventory
liquidation sales.
For the remainder of fiscal 2005, we expect our gross profit margin to continue
to be impacted by higher average royalty rates associated with our new titles,
combined with continued pricing pressures from our distributors and retailers
(such as sales incentives and promotional costs reflected as selling price
adjustments), as we attempt to maintain or increase our share of retail shelf
space.
Product Development
Product Development expenses consist of personnel costs related to product
management, quality assurance testing, packaging design and website
administration, along with outside services for product ratings and website
maintenance, in addition to non-recoverable project costs related to products
prior to achieving a successful launch into their intended retail channels.
The following table represents our product development expenses for the quarters
ended September 30, 2004 and 2003:
September 30, % of September 30, % of Increase %
2004 net sales 2003 net sales (Decrease) Change
- -------------------------------------------------------------------------------
$ 239,000 20.3% $ 126,000 6.2% $ 113,000 89.7%
For the quarter ended September 30, 2004, product development expenses increased
by $113,000, or 89.7%, to $239,000, compared to the quarter ended September 30,
2003. This expense increase resulted from the write-off of $122,000 in
capitalized licensing and inventory costs related to the RealAge Games & Skills
title due to our determination during the quarter that the recovery of these
costs in future periods was unlikely, based upon our consideration of all
available information, and in particular on the expected amount of any future
sales.
The write-off of these costs was charged to product development expense, rather
than to cost of sales, because we determined that these costs were related to a
business development project that had not yet achieved a successful launch into
its intended retail channels. This project was not designed for traditional
retail distribution through our normal business operations, but rather through
alternative retail distribution channels such as direct response TV and direct
to consumer marketing campaigns. To date, all of our efforts to launch this
title and brand into its intended retail channels have been unsuccessful, and we
are currently evaluating its future commercial viability. The RealAge Games &
Skills brand was developed during fiscal 2004, in an attempt to attract new
consumers to the PC game category by providing consumers with a compelling
reason to play PC games because they can help maintain mental sharpness.
Selling, General and Administrative
Selling, General and Administrative expenses consist of personnel related costs,
insurance costs, stock-based compensation expense, professional service fees for
legal, accounting and public relations, along with occupancy costs including
rent, utilities and phones.
The following table represents our selling, general and administrative expenses
for the quarters ended September 30, 2004 and 2003:
September 30, % of September 30, % of Increase %
2004 net sales 2003 net sales (Decrease) Change
- -------------------------------------------------------------------------------
$ 571,000 48.5% $ 602,000 29.3% ($ 31,000) (5.1%)
For the quarter ended September 30, 2004, selling, general and administrative
expenses decreased by $31,000 to $571,000 compared to the quarter ended
September 30, 2003. This $31,000 expense decrease was caused by a $40,000
decrease in public relations costs associated with the RealAge Games & Skills
brand, which was partially offset by a $10,000 increase in stock-based
compensation expense relating to the vesting of stock options. During the
remainder of fiscal 2005, we anticipate incurring additional expenses relating
to our compliance efforts associated with the requirements under Section 404 of
the Sarbanes-Oxley Act of 2002.
Interest (Income) Expense, net
The following table represents our net interest income for the quarter ended
September 30, 2004 and our net interest expense for the quarter ended September
30, 2003:
September 30, % of September 30, % of Increase %
2004 net sales 2003 net sales (Decrease) Change
- -------------------------------------------------------------------------------
($ 1,000) (0.1%) $ 5,000 0.2% ($ 6,000) (120.0%)
For the quarter ended September 30, 2004, we earned net interest income of
$1,000 compared to recognizing $5,000 in net interest expense in the quarter
ended September 30, 2003.
Provision (Benefit) for Income Taxes
The following table represents our income tax benefit for the quarter ended
September 30, 2004 and our income tax provision for the quarter ended September
30, 2003:
September 30, % of September 30, % of Increase %
2004 net sales 2003 net sales (Decrease) Change
- -------------------------------------------------------------------------------
($ 18,000) (1.5%) $ 22,000 1.1% ($ 40,000) (181.8%)
For the quarter ended September 30, 2004, our benefit for income taxes was
$18,000 compared to the year ago quarter's provision for income taxes of
$22,000. This $40,000 decrease in the provision for income taxes related to the
estimated taxable loss for state income purposes during the current quarter
compared to the estimated taxable income for state income tax purposes for the
year ago quarter. As of the beginning of fiscal 2005, we had approximately $2.3
million in net operating loss carry-forwards ("NOL's") available to offset
future taxable income for federal income tax purposes.
Net Income (Loss)
The following table represents our net loss for the quarter ended September 30,
2004 and our net income for the quarter ended September 30, 2003:
September 30, % of September 30, % of Increase %
2004 net sales 2003 net sales (Decrease) Change
- -------------------------------------------------------------------------------
($ 184,000) (15.6%) $ 478,000 23.3% ($ 662,000) (138.5%)
Weighted Average Common Shares
The weighted average common shares outstanding on a diluted basis decreased by
370,425 for the quarter ended September 30, 2004 to 10,102,673 from 10,473,098
for the quarter ended September 30, 2003. The current quarter's decrease in the
diluted basis calculation of weighted average common shares resulted from this
quarter's amount not including any common share equivalents due to the quarter's
net loss, compared to the year ago quarter's amount that did include common
share equivalents.
Liquidity and Capital Resources
As of
September 30,
------------------------
2004 2003 Change
-------------------------------------
Cash and cash equivalents $ 1,554,000 $ 758,000 $ 796,000
=========== ========= =========
Percent of total assets 38% 23%
=== ===
Quarters
September 30,
-----------------------
2004 2003 Change
-----------------------------------
Cash used in operating activities ($ 192,000) ($259,000) $ 67,000
Cash used in investing activities (9,000) (8,000) (1,000)
Cash provided by financing activities 13,000 - 0 - 13,000
-----------------------------------
Net decrease in cash and cash equivalents ($ 188,000) ($ 267,000) $ 79,000
========= ========= ========
Changes in Cash Flow, Operating Activities
During the quarter ended September 30, 2004, we had $192,000 of cash used in
operating activities compared to $259,000 of cash used in operating activities
for the quarter ended September 30, 2003. The $192,000 of cash used in operating
activities for the quarter ended September 30, 2004 resulted primarily from the
$184,000 net loss we experienced, combined with reductions in:
o Accrued expenses traceable to employee bonus payments made pursuant to
the fiscal 2004 employee incentive compensation plan; and
o Accounts payable resulting from accelerated vendor payments in exchange
for obtaining cash discounts, combined with lower purchasing
requirements traceable to lower sales volumes.
Partially offsetting these cash uses, was the cash provided from additional
customer receivable payments received during the quarter ended September 30,
2004.
Accounts Receivable, net
------------------------
During the quarter ended September 30, 2004, net accounts receivable decreased
by $412,000, which reflected a $732,000 decrease in gross accounts receivable
and a $320,000 decrease in our allowances for product returns, price markdowns
and bad debts. The $412,000 decrease in net accounts receivable for the current
quarter resulted directly from receiving $1.6 million in cash from our
customers, which exceeded the $1.2 million in net sales during the quarter.
Generally, we have been able to collect our net accounts receivable in the
ordinary course of business, but have from time to time experienced periods of
slowness in customer payments. Accordingly, we continually monitor our
receivable balances and communicate with our customers in order to expedite
their payments of past due amounts or to process authorized credits for product
returns and price markdowns. 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 in the normal
course of business.
We continue to have a highly concentrated customer base consisting of a few
large software distributors and retailers. In particular, as of September 30,
2004, our largest software distributor, Atari, represented 57% of our net
accounts receivable, compared to September 30, 2003, when Atari represented 82%
of our net accounts receivable. Additionally, during the quarters ended
September 30, 2004 and 2003, we collected receivable payments of $1.1 million
and $1.0 million, respectively, from Atari, which represented 69% and 72%,
respectively, of our total customer receipts during those quarters. Our ability
to collect, in a timely manner, the net receivable amount owed by Atari remains
critical for us to be able to meet our financial obligations and to fund normal
operations. If at any time Atari would become unable or unwilling to make its
receivable payments to us in a timely manner, our ability to continue ongoing
operations would be significantly impaired.
Inventory, net
--------------
During the quarter ended September 30, 2004, we experienced a $28,000 increase
in net inventory, which resulted from a $76,000 increase in our gross inventory
that was partially offset by a $48,000 increase in the allowance for inventory
obsolescence. The increase in our gross inventory was largely due to many of our
newly manufactured titles not being shipped to Atari within the current quarter,
as a result of the recent decision by one of North America's largest
mass-merchant retailers to reduce the size of its ($9.99 retail priced) jewel
case PC software department, which had a negative impact on both replenishment
and initial product orders from Atari during the quarter ended September 30,
2004. We anticipate that this change at retail will continue to negatively
impact our net sales and inventory levels for the remainder of fiscal 2005.
Prepaid and Other Expenses
--------------------------
During the quarter ended September 30, 2004, prepaid and other expenses
increased by $34,000 due to payments related to insurances and federal taxes,
which were partially offset by a decrease in advanced royalties due to amounts
written off that related to certain discontinued titles.
Accounts Payable
----------------
During the quarter ended September 30, 2004, our accounts payable decreased by
$81,000, which resulted from our continued acceleration of payments to certain
trade vendors in exchange for receiving cash discounts, combined with decreased
purchasing requirements traceable to reduced sales activity. During the quarter
ended September 30, 2004, our vendor cash discounts amounted to $20,000.
Accrued Expenses
----------------
During the quarter ended September 30, 2004, our accrued expenses decreased by
$304,000 as a result of employee bonus payments made pursuant to the fiscal 2004
employee incentive compensation plan. There was no such expense accrual made
during the current quarter relating to the fiscal 2005 employee incentive
compensation plan due to the net loss we experienced, and our uncertainty that
we would achieve the operating income threshold required for bonus payments to
be made pursuant to that plan.
Changes in Cash Flow, Non-Operating Activities
For the quarter ended September 30, 2004, we had net cash used from investing
activities of $9,000 for equipment upgrades to our computer network. For the
quarter ended September 30, 2004, we had $13,000 in net cash provided by
financing activities from the proceeds related to the exercise of options to
purchase shares of our common stock.
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. We expect to
renew this facility before its expiration date. Amounts outstanding under this
credit facility are 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 November 10,
2004, we were in compliance with each of those covenants. This credit facility
was established to provide working capital for our operations. As of November
10, 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
We occupy our 5,000 square foot office facility located in Langhorne,
Pennsylvania 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 September 30, 2004, we had future
operating lease commitments of $206,000, 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. 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 content. As of September 30, 2004,
assuming performance by certain third-party software developers under such
agreements, we had commitments to pay $92,000 in future 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 1 year years years 5 years
- ---------------------------------------------------------------------------------------------
Operating leases $ 206,000 $ 64,000 $ 138,000 $ 4,000 $ - 0 -
Advanced royalties 92,000 80,000 12,000 - 0 - - 0 -
- ---------------------------------------------------------------------------------------------
Totals $ 298,000 $ 144,000 $ 150,000 $ 4,000 $ - 0 -
========= ========= ========= ======= ========
Liquidity Risk
Our ability to 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. In
particular, our ability to 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, marketing and promoting of our PC software titles.
There are significant challenges that we will need to successfully manage in
order to fund our operations in the future. These challenges include, but are
not limited to, maintaining our relationships with our principal distributors
and retailers, maintaining timely receivable payments from our concentrated
group of distributors and retailers, in addition to maintaining acceptable
payment terms with our trade vendors. For example, our liquidity would be
severely impacted if Atari, and to a lesser extent Take Two Interactive, Softek
or EB Carlson, did not make receivable payments to us on a timely basis, or if
other business conditions caused them to fail to pay us at all.
Additionally, there are market factors beyond our control that could also
significantly affect our operating cash flow. The most significant market
factors are the market acceptance and sell-through rates of our products to
consumers, and the shelf space allocated to our products at retail. If any of
our software titles do not sell through to consumers at a rate acceptable to
retailers, then we could be exposed to unanticipated product return and price
markdown credit authorizations that could then be used by distributors and
retailers to reduce their upcoming receivable payments to us, along with a
reduction in retailer and/or distributor 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 flow 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 potential
stockholder dilution it may cause or other costs associated with such financing
that we could not accept.
Listing of Our Common Stock
Our common stock trades on the OTC Bulletin Board under the symbol EGAM. It is
our intention to ultimately meet the listing standards for the American Stock
Exchange. If we are able to achieve these standards, we plan to apply for
listing on the American Stock Exchange, or an equivalent exchange, at that time.
FACTORS AFFECTING FUTURE PERFORMANCE
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.
A significant part of our sales come from a limited number of customers, and if
we are unable to continue viable business relationships with key distributors
and retailers, this could materially harm our business. The majority of our
current sales are to software distributors that service the mass-market and
major retailers in North America, and therefore our business relies on a
concentrated group of these large customers. 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. During fiscal 2004, Wal-Mart
accounted for about half of our unit sales to Atari, while Best Buy and Target
accounted for most of our remaining business with Atari. During the first
quarter of fiscal 2005, the decision by one of North America's largest
mass-merchant retailers to decrease the size of its PC game software department
(allocated to $9.99 jewel case titles) chain-wide more than halved the number of
our titles that are now being sold in that retailer's stores. This event
negatively affected our net sales and operating results for the quarter ended
September 30, 2004, and we expect that it will continue to impact our results
for the foreseeable future.
Our net sales to Atari during the fiscal year ended June 30, 2004 were $5.5
million and represented 69% of our total net sales. We anticipate that net sales
to Atari may represent approximately 70% of our total net sales during fiscal
2005. Accordingly, we expect to continue depending upon a limited number of
significant distributors and retailers, and in particular Atari, for the
foreseeable future.
We do not have long-term agreements with the primary distributors of our
products (Atari, Take Two Interactive, Jack of All Games, Softek and E.B.
Carlson), and the terms of our business relationships with these distributors do
not require them to purchase our products. If these distributors were to stop
distributing our products, our sales would decline substantially and in a brief
period of time. In addition, if distributors of our products were only willing
to distribute our products on terms that were commercially unacceptable to us,
our financial condition would be materially harmed. We also might not be
successful in distributing our products directly to key retailers. Even if we
were successful in selling our products directly to these retailers, it might be
on terms that are not 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.
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 limited amount of shelf
space, which has diminished over time. Retailers have a finite amount of shelf
space on which to display consumer entertainment PC software products, and
changes to shelf space allocations, such as the ones that recently occurred at a
major retailer, will negatively affect our future sales and operating results.
There is intense competition among consumer entertainment PC software publishers
for retail shelf space and promotional support from retailers. The competition
for retail shelf space continues to intensify and we are seeing shifts in the
retail marketing of PC software games that are likely to continue to affect our
operating results. Competition for retail shelf space also results in greater
leverage for retailers and distributors in negotiating terms of sale, including
price markdowns and product return policies, and 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.
We depend on the market acceptance of our products, and these products typically
have relatively short product life cycles. Our profitability is dependent on our
ability to publish and get into retail stores successful new PC software titles.
Consumer preferences for entertainment PC software products are difficult to
predict and few products achieve sustained market acceptance. The market for
consumer entertainment PC software is also subject to shifts in consumer
preferences and typical product life cycles of no more than six to fifteen
months. 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 royalty, inventory, development, marketing and 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 significant 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 to the retailers. Failure of new products to achieve or
sustain market acceptance would adversely impact our business, operating results
and financial condition.
We may need additional funds, and we may not be able to obtain such funding if
we need it. In September 2003, we entered into a $500,000 credit facility
agreement with Hudson United Bank ("HUB"), which matures on December 1, 2004.
We expect to renew this facility before its expiration date. Our capital
requirements are currently funded from the cash flow generated from product
sales and our $500,000 credit facility with Hudson United Bank. 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 in the future.
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, small size, and our historical fluctuating financial
results could make it difficult for us 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.
If our major distributors or retailers are not able to or are unwilling to pay
us at all or within the normal course of business, this would materially harm
our financial condition. 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
companies 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 distribution or retail
customers failed to pay an outstanding receivable, particularly Atari, which as
of September 30, 2004 represented 57% of our total net accounts receivable
balance, our business, operating results and financial condition would be
significantly harmed.
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
retailers and distributors servicing such retailers. These allowances are 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
and price markdown 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 quantities of new products with higher
retail price points or unproven genres remain in the retail channel. Our sales
to these customers are reported net of product return and price markdown
provisions. Actual product returns and price markdowns could exceed our
allowances for 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.
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. Comparative sequential and year-to-year quarterly
operating results may provide little meaningful information or guidance because
of our relatively small size and the impact on our net sales resulting from the
timing of purchase orders from retailers and distributors and other changes in
market forces. Fluctuations in quarterly operating results will depend upon
many factors including:
o Seasonality of consumer entertainment PC software purchases;
o Shelf space allocations by major retailers;
o Timing of major distributor and retailer purchase orders;
o Amount and timing of product returns and price markdowns; and
o Timing of our new product introductions, product enhancements
and those of our competitors.
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 each reporting period.
We are exposed to seasonality in the purchases of our products. The PC game
software industry is highly seasonal, with sales tending to be higher during the
quarter ending December 31st. 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 out on key selling periods - typically referred to
as merchandising "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 these
key selling periods, our financial results for the entire fiscal year would be
adversely affected.
We rely entirely on third party independent software developers for our product
content, and therefore our success depends on our ability to secure commercially
viable licensing agreements with these developers. Independent software
developers develop all of the content for our software titles. Our success in
introducing new high quality PC software titles depends on our ability to
maintain relationships and obtain licensing agreements on favorable terms with
skilled independent software developers. Increased competition for the licensing
rights to quality consumer entertainment PC software content has compelled us to
agree to 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 advance and minimum payments do not
generate sufficient sales volumes to recover these costs, this would have a
negative impact on our financial results. Additionally, if we are not able to
obtain quality content on commercially viable terms from independent software
developers, this would also adversely affect our business.
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, sales incentives, 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.
Our common stock has experienced low trading volumes and other risks on the OTC
Bulletin Board. Our shares of Common Stock are currently traded on the OTC
Bulletin Board under the symbol EGAM. 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 online 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 past 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 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, primarily consisting of licensing revenues,
represented 9% of our net sales for the quarter ended September 30, 2004. We
anticipate that in fiscal 2005 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 the related outstanding
licensing receivable, 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 September 30, 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 September 30, 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
Exhibit No. Description of Exhibit
- ----------- ----------------------
10.1 1995 Amended and Restated Stock Option Plan
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.
SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
eGames, Inc.
(Registrant)
Date: November 12, 2004 /s/ Gerald W. Klein
----------------- --------------------
Gerald W. Klein, President, Chief
Executive Officer and Director
Date: November 12, 2004 /s/ Thomas W. Murphy
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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: November 12, 2004
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/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: November 12, 2004
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/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 September 30, 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
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Gerald W. Klein
President and Chief Executive Officer
November 12, 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 September 30, 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
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Thomas W. Murphy
Chief Financial Officer
November 12, 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.