U.S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-QSB
(Mark One)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended December 31, 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: 10,871,754 shares of common stock, no
par value per share, as of February 8, 2005.
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 December 31, 2004....................... 3
Statements of Operations for the three and six months
ended December 31, 2004 and 2003 ....................... 4
Statements of Cash Flows for the six months
ended December 31, 2004 and 2003 ....................... 5
Notes to Financial Statements............................... 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations .................... 13
Factors Affecting Future Performance ....................... 27
Item 3. Controls and Procedures .................................... 31
Part II Other Information
Item 4. Submission of Matters to a Vote of Security Holders ........ 31
Item 6. Exhibit Listing ............................................ 32
Exhibit Index ............................................................ 32
Signatures ............................................................ 33
Exhibits ............................................................ 34
Item 1. Unaudited Financial Statements
eGames, Inc.
Balance Sheet
(Unaudited)
As of
December 31,
2004
-----------
ASSETS
- ------
Current assets:
Cash and cash equivalents $ 1,691,909
Accounts receivable, net of allowances of $1,037,860 1,287,316
Inventory, net 916,742
Prepaid and other expenses 436,319
-----------
Total current assets 4,332,286
Furniture and equipment, net 67,438
Intangible assets 24,089
-----------
Total assets $ 4,423,813
===========
LIABILITIES AND STOCKHOLDERS' EQUITY
- ------------------------------------
Current liabilities:
Accounts payable $ 375,615
Accrued expenses 309,763
-----------
Total current liabilities 685,378
-----------
Commitments and contingencies
Stockholders' equity:
Common stock, no par value (40,000,000 shares authorized;
10,370,487 issued and 10,138,587 outstanding) 9,179,827
Additional paid-in capital 1,385,026
Accumulated deficit (6,325,001)
Treasury stock, at cost - 231,900 shares (501,417)
-----------
Total stockholders' equity 3,738,435
-----------
Total liabilities and stockholders' equity $ 4,423,813
===========
See accompanying notes to financial statements.
eGames, Inc.
Statements of Operations
(Unaudited)
Three Months Ended Six Months Ended
December 31, December 31,
---------------------------- ----------------------------
2004 2003 2004 2003
------------ ------------ ------------ ------------
Net sales $ 1,912,630 $ 2,115,561 $ 3,090,459 $ 4,168,033
Cost of sales 839,234 892,630 1,410,392 1,710,815
------------ ------------ ------------ ------------
Gross profit 1,073,396 1,222,931 1,680,067 2,457,218
Operating expenses:
Product development 103,878 140,696 342,993 267,086
Selling, general and
administrative 647,533 589,534 1,218,665 1,191,818
------------ ------------ ------------ ------------
Total operating expenses 751,411 730,230 1,561,658 1,458,904
------------ ------------ ------------ ------------
Operating income 321,985 492,701 118,409 998,314
Interest (income) expense, net (1,597) (1,466) (2,827) 3,517
------------ ------------ ------------ ------------
Income before income taxes 323,582 494,167 121,236 994,797
Provision for income taxes 28,324 22,913 10,301 45,197
------------ ------------ ------------ ------------
Net income $ 295,258 $ 471,254 $ 110,935 $ 949,600
============ ============ ============ ============
Net income per common
share:
- Basic $ 0.03 $ 0.05 $ 0.01 $ 0.10
============ ============ ============ ============
- Diluted $ 0.03 $ 0.04 $ 0.01 $ 0.09
============ ============ ============ ============
Weighted average common shares
outstanding - Basic 10,116,329 9,989,337 10,109,501 9,989,337
Dilutive effect of common share
equivalents 502,459 831,090 869,972 684,845
------------ ------------ ------------ ------------
Weighted average common shares
outstanding - Diluted 10,618,788 10,820,427 10,979,473 10,674,182
============ ============ ============ ============
See accompanying notes to financial statements.
eGames, Inc.
Statements of Cash Flows
(Unaudited)
Six Months ended
December 31,
--------------------------
2004 2003
----------- -----------
Cash flows from operating activities:
Net income $ 110,935 $ 949,600
Adjustment to reconcile net income to net cash
used in operating activities:
Stock-based compensation 36,612 25,332
Depreciation 17,712 8,993
Changes in operating assets and liabilities:
Accounts receivable, net 246,543 40,728
Inventory, net (102,456) (238,837)
Prepaid and other expenses 3,812 (97,983)
Accounts payable (65,401) 181,729
Accrued expenses (307,031) (80,612)
----------- -----------
Net cash (used in) provided by operating activities (59,274) 788,950
----------- -----------
Cash flows from investing activities:
Purchases of furniture and equipment (10,291) (25,909)
----------- -----------
Net cash used in investing activities (10,291) (25,909)
----------- -----------
Cash flows from financing activities:
Proceeds from exercise of stock options 19,250 - 0 -
----------- -----------
Net cash provided by financing activities 19,250 - 0 -
----------- -----------
Net (decrease) increase in cash and cash equivalents (50,315) 763,041
Cash and cash equivalents:
Beginning of period 1,742,224 1,024,237
----------- -----------
End of period $ 1,691,909 $ 1,787,278
=========== ===========
Supplemental cash flow information:
Cash paid during the period for interest $ - 0 - $ 5,475
=========== ===========
Cash paid during the period for income taxes $ 127,620 $ 29,986
=========== ===========
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
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
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 and net accounts receivable at December 31, 2004
approximate fair value due to the relatively short period of time between
origination of the instruments and their expected realization. All liabilities
are carried at cost, which approximate fair value for similar instruments.
Cash and Cash Equivalents
For purposes of the statements of cash flows, we consider all highly liquid
instruments purchased with an original maturity of three months or less to be
cash equivalents.
Accounts Receivable, net
Accounts receivable, net is reflected 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 December 31, 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 December 31, 2004, we had not recorded
any 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 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 their receipt of our products,
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 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
December 31, 2004, the allowance for product returns and price markdowns was 45%
of our gross accounts receivable. This allowance usually 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 December 31, 2004 and 2003, our provisions for product
returns and price markdowns for customers that have traditionally sold consumer
entertainment PC software products were $412,000 and $726,000, respectively, or
18% and 26%, respectively, of related gross sales.
During the six months ended December 31, 2004 and 2003, our provisions for
product returns and price markdowns for customers that have traditionally sold
consumer entertainment PC software products were $640,000 and $1,034,000,
respectively, or 18% and 20%, 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 reviewing the information available about each title and the
underlying licensed content. In particular, we evaluate the expected future
sales of a title or potential subsequent titles containing the same licensed
content based on current and potential sales programs, along with historical
sell-through results to end consumers of similar titles. For titles that have
achieved distribution into their intended retail channels, we charge to cost of
sales the remaining costs we determine to be non-recoverable in future periods.
In the rare circumstance that a title does not achieve distribution into its
intended retail channels, we charge to product development expense the remaining
costs we determine to be non-recoverable in future periods. These charges are
expensed in the reporting period in which the determination is reached by
management that recoverability of these costs in future periods is unlikely.
Marketing Costs
Marketing costs reflected as operating expenses, such as advertising and
merchandising fees, are expensed as incurred, and were $20,000 and $21,000,
respectively, for the quarters ended December 31, 2004 and 2003. For the six
months ended December 31, 2004 and 2003, these types of marketing related costs
were $40,000 and $44,000, respectively.
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 December 31, 2004 and 2003, our sales incentives and promotional costs
were $152,000 and $184,000, respectively, or 7% of related gross sales for both
periods. For the six months ended December 31, 2004 and 2003, our sales
incentives and promotional costs were $240,000 and $242,000, respectively, or 7%
and 5%, 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 per Common Share
Net income per common share is computed in accordance with SFAS No. 128,
"Earnings per Share". Basic earnings per share is computed by dividing net
earnings by the weighted average number of common shares outstanding during each
period. Diluted earnings per share is computed by dividing net earnings by the
weighted average number of common shares and common share equivalents ("CSE's")
outstanding during each period that we report net income. CSE's may include
stock options and warrants using the treasury stock method.
Accounting for Stock-Based Compensation
As of July 1, 2002, we adopted within our financial statements the provisions of
SFAS No. 123, "Accounting for Stock-Based Compensation," by applying the fair
value method for stock option grants made on or after that date. For stock
option grants made prior to July 1, 2002, we recognized stock-based compensation
using the intrinsic value method in accordance with Accounting Principles Board
Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25). As of
January 1, 2003, we adopted the provisions of SFAS No. 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure" (see Note 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. Estimates and assumptions are made in determining allowances for
inventory obsolescence, product returns, price markdowns and customer bad debts,
disclosure of contingent assets and liabilities at the date of the financial
statements, the recoverable value of advance licensing and royalty payments, 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 that
such differences could have either a negative or positive impact on future
financial results.
2. Accounts Receivable, net
Accounts receivable, net consists of the following:
Accounts receivable, gross $ 2,325,000
Allowance for product returns and price markdowns (1,021,000)
Allowance for bad debts (17,000)
------------
Accounts receivable, net $ 1,287,000
============
3. Inventory, net
Inventory, net consists of the following:
Raw materials - warehouse $ 235,000
Finished goods - warehouse 681,000
Product returns - retailer and distributor locations 142,000
------------
1,058,000
Allowance for obsolescence (141,000)
------------
Inventory, net $ 917,000
============
4. Prepaid and Other Expenses
Prepaid and other expenses consists of the following:
Royalties $ 237,000
Insurances 76,000
Federal tax 66,000
Other expenses 37,000
Retailer slotting fees 20,000
------------
Prepaid and other expenses $ 436,000
============
5. Furniture and Equipment, net
Furniture and equipment consists of the following:
Furniture and equipment $ 356,000
Accumulated depreciation (289,000)
------------
Furniture and equipment, net $ 67,000
============
6. Accrued Expenses
Accrued expenses consists of the following:
Royalties $ 70,000
Vacation and payroll 61,000
Customers with credit balances 60,000
Marketing promotions 48,000
Professional fees 45,000
Other 26,000
------------
Accrued expenses $ 310,000
============
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 $21,000 for both quarters ended
December 31, 2004 and 2003, and total rent expense was $43,000 and $42,000,
respectively, for the six months ended December 31, 2004 and 2003. At December
31, 2004, we had future operating lease commitments of $190,000 that are
scheduled to be paid as follows: $64,000 in less than one year; $124,000 in one
to three years; and $2,000 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 December 31, 2004, we had
future commitments to pay $39,000 in advance licensing and royalty payments to
various third-party licensors and software developers, which are scheduled to be
paid as follows: $27,000 in less than one year; and $12,000 in one to three
years.
8. Credit Facility
In November 2004, we renewed our credit facility agreement with Hudson United
Bank ("HUB"), which matures on December 1, 2005. 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 $750,000 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. 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 $2.0 million.
At December 31, 2004, we were in compliance with each of those covenants. This
credit facility was established to provide working capital for our operations.
As of December 31, 2004, we had not utilized any of this credit facility,
although we were eligible to draw up to $750,000 under this credit facility,
based upon qualified accounts receivable as of that date.
9. Accounting for Stock-Based Compensation
At December 31, 2004, we had one existing stock-based employee compensation
plan, which was adopted, amended and restated during 1995. This Plan, known as
our 1995 Amended and Restated Stock Option Plan (the "1995 Plan"), is
administered by the Board of Directors and provides for the grant of incentive
stock options and non-qualified stock options to employees and eligible
independent contractors and non-qualified stock options to non-employee
directors at prices not less than the fair market value of a share of common
stock on the date of grant. 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 for the remainder of 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".
We recognized stock-based compensation expense within our financial statements
of $18,000 and $17,000, respectively, during the quarters ended December 31,
2004 and 2003, and $37,000 and $25,000, respectively, during the six months
ended December 31, 2004 and 2003. All stock options that vested during these
periods 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 presented.
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 December 31, 2004, Atari accounted
for $963,000 of our net sales, or 50% of net sales, compared to the quarter
ended December 31, 2003, when Atari accounted for $1,385,000 in net sales, or
65% of net sales. During the six months ended December 31, 2004, Atari accounted
for $1,477,000 of our net sales, or 48% of net sales, compared to the six months
ended December 31, 2003, when Atari accounted for $2,954,000 in net sales, or
71% of net sales.
During the six months ended December 31, 2004, one of the largest North American
mass-merchant retailers serviced by Atari reduced its retail shelf space
allotment for PC software games at the $9.99 retail price point. This reduction
in available retail shelf space for $9.99 retail priced PC software games had a
negative impact on our net sales during this period due to Atari's reduced
purchasing requirements needed to support the decreased amount of retail shelf
space.
If we were to lose our distribution capability through Atari, or if one of the
largest North American mass-merchant retailers continues to reduce its shelf
space allocated to $9.99 retail priced PC software games, our financial
condition and ability to continue as a going concern would be significantly
affected. Also, if Atari were not able or willing to make timely receivable
payments to us in the normal course of business, our financial condition would
be negatively impacted. Since the distribution of PC software to most retailers
is a competitive business within itself, there may be 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.
12. Subsequent Event - Quarterly Cash Dividend
Our Board of Directors has authorized the payment of a quarterly cash dividend
of $0.015 per common share, payable on February 22, 2005 to shareholders of
record on February 15, 2005. The quarterly cash dividend program is being
implemented in lieu of our previously announced stock repurchase program. It is
our intention to continue paying a comparable quarterly cash dividend to
shareholders of our common stock. However, the payment of any further cash
dividends depends entirely upon the discretion of our Board of Directors and may
be discontinued at any time, for any reason.
13. Recent Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 123 (revised 2004),
"Share-Based Payment" which revised Statement of Financial Accounting Standards
No. 123, "Accounting for Stock-Based Compensation". This statement supercedes
APB Opinion No. 25, "Accounting for Stock Issued to Employees". The revised
statement addresses the accounting for share-based payment transactions with
employees and other third parties, eliminates the ability to account for
share-based compensation transactions using APB 25 and requires that the
compensation expense relating to such transactions be recognized in the
statement of operations. The revised statement is effective as of the first
interim period beginning after June 15, 2005. Since we had adopted within our
financial statements the provisions of SFAS No. 123 as of July 1, 2002, we do
not expect the adoption of SFAS No. 123 (revised 2004) to have an impact on our
financial statements.
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
This Quarterly Report on Form 10-QSB contains forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934. All statements made in this Quarterly Report on
Form 10-QSB, other than statements of historical fact, including statements
regarding industry prospects and future results of operations or financial
position, are forward looking. We use the words "believe", "expect",
"anticipate", "intend", "will", "should", "may" and similar expressions to
identify forward-looking statements. These forward-looking statements are
subject to business volatility, economic risk, and world events, which are
inherently uncertain and difficult to predict. Our actual results could differ
materially from management's expectations due to such risks. We will not
necessarily update information if any forward-looking statement later turns out
to be inaccurate. In particular, these forward-looking statements include, among
others, statements about:
- The platforms for which we currently intend to publish products;
- Our belief that the largest single source of our net sales,
accounts receivable and related cash receipts will continue to be
attributable to Atari during fiscal 2005;
- Our expectation that reductions in the retail PC market that we
serve will continue to negatively impact our financial results and
inventory levels in the future;
- The strategies and new opportunities that we are exploring in order
to offset recent reductions in the affordable PC game software
market at retail;
- Our expectation that, during the remainder of fiscal 2005, we will
continue to sell our products at the retailers and through the
distributors that charge sales incentive and promotional fees,
which 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 and freight costs during the
remainder of fiscal 2005;
- Our plans to continue to add content to our websites, including our
new online games website, in order to attract visitors to our
websites;
- Increased quantities of discontinued titles being returned to us
from retail channels that need to be sold in liquidation, along
with any remaining quantities of these titles still in our
warehouse;
- Our expectation that during the remainder of fiscal 2005, we will
incur additional professional fees related to fulfilling the
requirements of the Sarbanes-Oxley Act of 2002;
- Our expectation that the adoption of SFAS No. 123 (revised 2004)
will not have an impact on our financial statements; and
- Our current intention not to seek listing on a stock exchange even
if we meet the standards for listing.
The following important factors, as well as those factors discussed under
"Factors Affecting Future Performance" beginning on page 27 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.
Overview
The following overview summarizes our business and some identified trends in our
business. We believe that this overview is helpful in understanding our results
for the quarter ended December 31, 2004, as well as our future results. This
overview 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 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.
Primary Trends in our Business
The Decrease in Shelf Space for Value-Priced PC Software Has Reduced Our Sales
- ------------------------------------------------------------------------------
The reduced amount of shelf space allocated to our products in retail stores
during the past three and six-month periods has contributed to our declining net
sales for those periods. Sometimes referred to as retail "facings," we have
consistently experienced higher sales with more retail facings, especially at
the large mass-merchant retailers in North America, and lower sales with less
retail facings. We continue to see indications that the traditional retail PC
software market is shrinking, and an indication of this trend was the recent
change by a major North American mass-merchant retailer to reduce its retail
shelf space allotment for PC software games at the $9.99 retail price point. Due
to the resulting reduction in the purchasing requirements of our software
distributor that services this retailer, this event negatively impacted our net
sales during the three and six months ended December 31, 2004. We expect that
reductions in the retail PC market that we serve will continue to impact our
results for the foreseeable future. We are attempting to offset this reduction
in product distribution by establishing "out of department" displays at
retailers currently selling our titles, exploring opportunities with titles in
the productivity software market, launching a new online game website to drive
Internet sales, as well as investigating alternative retail channels, packaging,
displays and price points that may help develop currently untapped markets for
value-priced PC software. 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.
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 and six months ended
December 31, 2004, Wal-Mart accounted for the majority of our business with
Atari, while Best Buy and Target accounted for most of our remaining units sold
through Atari. Atari continues to represent the largest percentage of our total
net accounts receivable and is the customer from which we collect the largest
percentage of receivable payments.
As of December 31, 2004, Atari represented 47% of our total net accounts
receivable, compared to December 31, 2003, when Atari represented 66% of our
total net accounts receivable. During the three and six months ended December
31, 2004, we collected receivable payments of $985,000 and $2,118,000,
respectively, from Atari, which represented 56% and 63%, respectively, of our
total customer receipts. This compares to the three and six months ended
December 31, 2003, when we collected receivable payments from Atari of
$2,017,000 and $3,055,000, respectively, which represented 76% and 74%,
respectively, of our total customer receipts.
We anticipate that during the remainder of fiscal 2005 the largest single source
of our net sales, accounts receivable and related cash receipts will continue to
be 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.
Gross Profit Margin
-------------------
During the three and six months ended December 31, 2004, our gross profit margin
was 56.1% and 54.4%, respectively, compared to 57.8% and 59.0% for the three and
six months ended December 31, 2003. The 1.7% and 4.6% reductions in the gross
profit margins for the three and six month periods, respectively, were both
attributable to: increased royalty expense (due to accelerating the expensing of
advanced royalties and to changes in product mix); and higher freight expense
(related to increased product deliveries to Canadian software distributors). For
the remainder of fiscal 2005, we expect that our gross profit margin will
continue to be impacted by higher royalty rates and freight costs.
Employee Incentive Compensation Expense
---------------------------------------
During the three and six months ended December 31, 2004, we did not accrue any
expense relating to the fiscal 2005 employee incentive compensation plan due to
our uncertainty that we will be able to achieve the operating income threshold
required for bonus payments to be made pursuant to that plan. This is in
contrast to the three and six months ended December 31, 2003 which included
approximately $75,000 and $150,000 in operating expenses that were related to
fiscal 2004 employee incentive compensation plan accruals.
Inventory Costs
---------------
During the six months ended December 31, 2004, we experienced a $102,000 (or
13%) increase in net inventory. This increase was due to the combination of many
of our newly manufactured titles not achieving the level of retail distribution
we had anticipated, along with an increase in inventory units shipped to
software distributors under consignment agreements that had not yet sold through
to end consumers. The decreased level of distribution was related to a large
mass-merchant retailer reducing its retail shelf space allotment for $9.99
retail priced PC software games. We are currently evaluating the future retail
and consumer demand for these newly manufactured products, but we anticipate
that the reduction of product distribution to this retailer will continue to
negatively impact our inventory levels for the remainder of fiscal 2005.
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, recoverability of advanced licensing and royalty
payments, 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 software 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 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 the remaining value of existing warehouse and field inventory
units, which involves: 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 affect our ability to sell existing titles
containing certain product content; monitoring expiration dates of licensing
agreements with software developers for content within existing 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. We attempt to liquidate 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.
Advanced Licensing and Royalty Payments
---------------------------------------
We make advance licensing and royalty payments to third party software
developers and other licensors for the licensing of software content and
intellectual properties for use within our PC software titles. These advanced
payments are initially classified on our balance sheet under the caption
"Prepaid and other expenses", and are then usually expensed within the "Cost of
sales" category of our Statements of Operations based upon contractual rates
applied against our net sales of the related software titles to third party
software distributors and retailers.
Key Assumptions
We continually evaluate the recoverability of our advance licensing and royalty
payments by reviewing the information available about each title and the
underlying licensed content. In particular, we evaluate the expected future
sales of a title or potential subsequent titles containing the same licensed
content based on current and potential sales programs, along with historical
sell-through results to end consumers of similar titles. For titles that have
achieved distribution into their intended retail channels, we charge to cost of
sales the remaining costs we determine to be non-recoverable in future periods.
In the rare circumstance that a title does not achieve distribution into its
intended retail channels, we charge to product development expense the remaining
costs we determine to be non-recoverable in future periods. These charges are
expensed in the reporting period in which the determination is reached by
management that recoverability of these costs in future periods is unlikely.
Results of Operations
The following discussion should be read together with our Financial Statements
and Notes beginning on page 3.
Three and Six Months Ended December 31, 2004 and 2003
Net Sales
For the three months ended December 31, 2004, net sales decreased by $203,000,
or 10%, to $1,913,000, compared to $2,116,000 in net sales for the three months
ended December 31, 2003. The $203,000 decrease in overall net sales was driven
by a $214,000 decline in net sales to software distributors that serve North
American mass-merchants and other major retailers.
For the six months ended December 31, 2004, net sales decreased by $1,078,000,
or 26%, to $3,090,000 compared to $4,168,000 for the same year ago period. The
$1,078,000 decrease in overall net sales was impacted by a $1,143,000 decline in
net sales to software distributors that serve North American mass-merchants and
other major retailers.
The following table represents our net sales by distribution channel for the
three and six months ended December 31, 2004 and 2003, respectively:
Net Sales by Distribution Channel
---------------------------------
(rounded to the nearest thousand)
---------------------------------
Three Months Ended
December 31,
-----------------------------------------
Increase %
Distribution Channel 2004 % 2003 % (Decrease) Change
- ------------------------------------------------------------------------------------------
Software Distributors $ 1,443,000 76% $ 1,657,000 78% ($ 214,000) (13%)
Software Retailers 138,000 7% 196,000 9% (58,000) (30%)
Licensing 156,000 8% 120,000 6% 36,000 30%
Internet 72,000 4% 89,000 4% (17,000) (19%)
Inventory Liquidators 104,000 5% 54,000 3% 50,000 93%
- ------------------------------------------------------------------------------------------
Totals $ 1,913,000 100% $ 2,116,000 100% ($ 203,000) (10%)
=========== ==== =========== ==== ========= ===
Six Months Ended
December 31,
-----------------------------------------
Increase %
Distribution Channel 2004 % 2003 % (Decrease) Change
- ------------------------------------------------------------------------------------------
Software Distributors $ 2,257,000 73% $ 3,400,000 82% ($ 1,143,000) (34%)
Software Retailers 298,000 10% 366,000 9% (68,000) (19%)
Licensing 249,000 8% 217,000 5% 32,000 15%
Internet 144,000 5% 131,000 3% 13,000 10%
Inventory Liquidators 142,000 4% 54,000 1% 88,000 163%
- ------------------------------------------------------------------------------------------
Totals $ 3,090,000 100% $ 4,168,000 100% ($ 1,078,000) (26%)
=========== ==== =========== ==== =========== ===
Software Distributors
---------------------
For the three months ended December 31, 2004, net sales to software distributors
that serve North American mass-merchants and other major retailers amounted to
$1,443,000, which represented a decrease of $214,000 or 13% compared to
$1,657,000 for the three months ended December 31, 2003. For the quarter ended
December 31, 2004, net sales to these software distributors decreased to 76% of
total net sales, compared to 78% of total net sales for the three months ended
December 31, 2003.
The $214,000 decline in net sales to software distributors was driven by a
$422,000 decrease in net sales to Atari, our primary software distributor in the
United States servicing many of the larger mass-merchant and major retailers
(such as Wal-Mart, Target and Best Buy, among others). This decrease in net
sales was partially offset by a $194,000 increase in net sales to Canadian
software distributors due to increased product distribution of our PC software
games at various Canadian retailers.
Atari's reduced purchasing requirements during the current quarter were impacted
by a large mass-merchant retailer's reduction in its retail shelf space
allotment for PC software games at the $9.99 retail price point, along with
another major retailer's decision to replenish $9.99 retail priced PC software
titles at lower than historical rates due to uncertainty regarding the level of
its future commitment to this segment of the PC software market. This retailer
has now decided to continue participating in the value-priced PC software
market, but will be serviced through a single-source software supplier. We will
continue to closely monitor the impact that this new arrangement will have on
our net sales, gross profit margin and overall financial results. During our
third fiscal quarter we anticipate earning licensing revenues from this software
supplier for their manufacture and distribution of our products to this
retailer, compared to prior periods, when we sold finished goods to Atari for
distribution there.
For the six months ended December 31, 2004, net sales to software distributors
that serve North American mass-merchants and other major retailers amounted to
$2,257,000, which represented a decrease of $1,143,000 or 34% compared to
$3,400,000 for the six months ended December 31, 2003. For the six months ended
December 31, 2004, net sales to North American software distributors decreased
to 73% of total net sales, compared to 82% of total net sales for the six months
ended December 31, 2003.
The $1,143,000 decline in net sales to North American software distributors was
impacted by a $1,477,000 decrease in net sales to Atari due to similar factors
that affected the three month period, which net sales decrease was partially
offset by a $264,000 increase in net sales to Canadian software distributors.
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 December 31, 2004, Atari accounted
for $963,000 of our net sales, or 50% of net sales, compared to the quarter
ended December 31, 2003, when Atari accounted for $1,385,000 in net sales, or
65% of net sales. During the six months ended December 31, 2004, Atari accounted
for $1,477,000 of our net sales, or 48% of net sales, compared to the six months
ended December 31, 2003, when Atari accounted for $2,954,000 in net sales, or
71% of net sales. While the percentage of our business that is driven by sales
to Atari is declining, we expect that during the remainder of fiscal 2005, the
largest single source of our net sales, accounts receivable and related cash
receipts will continue to be Atari.
Software Retailers
------------------
For the three months ended December 31, 2004, net sales made directly to
software retailers were $138,000, which represented a $58,000 decrease compared
to the three months ended December 31, 2003. This $58,000 decrease in net sales
made directly to software retailers resulted from decreases in net sales to
various retailers, including EB Games, Microcenter and CompUSA.
For the six months ended December 31, 2004, net sales made directly to software
retailers were $298,000, which represented a $68,000 decrease compared to the
six months ended December 31, 2003. This $68,000 decrease in net sales made
directly to software retailers resulted from decreases in net sales to the same
retailers that negatively impacted the three month period.
Licensing
---------
Licensing revenues continued to be primarily generated by 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 December 31, 2004 and 2003, licensing revenues amounted
to $156,000 and $120,000, respectively, and represented 8% and 6%, respectively,
of net sales. For the six months ended December 31, 2004 and 2003, licensing
revenues amounted to $249,000 and $217,000, respectively, and represented 8% and
5%, respectively, of net sales.
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
by promoting the sale of eGames software titles. We are currently evaluating the
initial results from this new design and will continue to add content in order
to attract visitors to our websites.
For the three months ended December 31, 2004 and 2003, Internet sales were
$72,000 and $89,000, respectively, and represented 4% of net sales during both
periods. For the six months ended December 31, 2004 and 2003, Internet sales
were $144,000 and $131,000, respectively, and represented 5% and 3%,
respectively, of net sales.
Inventory Liquidators
---------------------
Net sales to inventory liquidators consist of sales of residual inventory titles
that have been discontinued at traditional software retail stores because these
titles have approached the end of their product lifecycles. As these 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 discounted
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.
For the three months ended December 31, 2004 and 2003, net sales to inventory
liquidators were $104,000 and $54,000, respectively, and for the six months
ended December 31, 2004 and 2003, net sales to inventory liquidators amounted to
$142,000 and $54,000, respectively.
Product Returns and Price Markdowns
-----------------------------------
Until physical units of our products are returned to us from our software
distributors or retailers, or until they 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 the three months ended December 31, 2004 and 2003, our provisions for
product returns and price markdowns for customers that have traditionally sold
consumer entertainment PC software products amounted $412,000 and $726,000,
respectively, or 18% and 26%, respectively, of related gross sales. The
decreases in the amount and percentage of the provisions for product returns and
price markdowns resulted from the year ago period impact from an unsuccessful
promotional box program (retail priced at $19.99) that required a greater
provision due to lack of consumer demand.
During the six months ended December 31, 2004 and 2003, our provisions for
product returns and price markdowns for customers that have traditionally sold
consumer entertainment PC software products were $640,000 and $1,034,000,
respectively, or 18% and 20%, respectively, of related gross sales. The
decreases in the amount and percentage of the provisions for product returns and
price markdowns resulted from the combination of lower sales in the current
period and the year ago impact from an unsuccessful promotional box program at
the higher $19.99 retail price point.
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. For
the remainder of fiscal 2005, we will continue to sell our products to 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.
For the quarters ended December 31, 2004 and 2003, our sales incentives and
promotional costs were $152,000 and $184,000, respectively, or 7% of related
gross sales for both periods. For the six months ended December 31, 2004 and
2003, our sales incentives and promotional costs were $240,000 and $242,000,
respectively, or 7% and 5%, respectively, of related gross sales.
Cost of Sales
Cost of sales consists of the following costs that are associated with the
publishing of our PC games for retail distribution: product costs; royalty costs
incurred with third-party software developers for licensing product content or
with other third-parties related to licensing various intellectual properties;
freight and handling costs; inventory obsolescence provisions and other costs.
The following table represents our cost of sales for the three and six months
ended December 31, 2004 and 2003:
December 31, % of December 31, % of Increase %
2004 net sales 2003 net sales (Decrease) Change
- -----------------------------------------------------------------------------------------------------
Three months ended $ 839,000 43.9% $ 893,000 42.2% ($ 54,000) (6.0%)
Six months ended $ 1,410,000 45.6% $ 1,711,000 41.0% ($ 301,000) (17.6%)
During the three months ended December 31, 2004, cost of sales decreased by
$54,000, or 6.0%, to $839,000, compared to cost of sales of $893,000 for the
three months ended December 31, 2003. This $54,000 cost of sales decrease was
due to a 10% decrease in net sales, which was partially offset by a 1.7% higher
cost of sales percentage on those reduced sales. The 1.7% increase in cost of
sales, as a percentage of net sales, was primarily due to cost increases, as a
percentage of net sales of:
o 1.3% in royalty expense due to the accelerated expensing of
advance royalty payments related to various game and productivity
titles, in addition to changes in product mix; and
o 0.9% in freight expense resulting from increased product shipments
to Canadian distributors, combined with reduced product deliveries
to Atari that are typically more cost effective.
During the six months ended December 31, 2004, cost of sales decreased by
$301,000, or 17.6%, to $1,410,000, compared to cost of sales of $1,711,000 for
the six months ended December 31, 2003. This $301,000 cost of sales decrease was
due to a 26% decrease in net sales, which was partially offset by a 4.6%
increase in the cost of sales percentage on those lower sales. The 4.6% increase
in cost of sales, as a percentage of net sales, was primarily due to cost
increases, as a percentage of net sales of:
o 2.4% in royalty expense due to the accelerated expensing of
advance royalty payments related to various game and productivity
titles, in addition to product mix changes;
o 1.4% in freight expense resulting from increased product shipments
to Canadian distributors, combined with reduced product deliveries
to Atari; and
o 0.9% in product costs related to increased sales of lower margin
inventory liquidation titles.
For the remainder of fiscal 2005, we expect our gross profit margin to continue
to be impacted by higher average royalty rates (due to product mix changes and
the potential need to further accelerate the expensing of various advanced
royalties based upon future sell-through results of certain titles) and freight
costs (due to the potential that our product shipments to Atari may continue to
decline as a percentage of our overall product deliveries).
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, website
maintenance and non-recoverable project costs related to products prior to
achieving distribution into their intended retail channels.
The following table represents our product development expenses for the three
and six months ended December 31, 2004 and 2003:
December 31, % of December 31, % of Increase %
2004 net sales 2003 net sales (Decrease) Change
- ---------------------------------------------------------------------------------------------------
Three months ended $ 104,000 5.4% $ 141,000 6.7% ($ 37,000) (26.2%)
Six months ended $ 343,000 11.1% $ 267,000 6.4% $ 76,000 28.5%
For the three months ended December 31, 2004, product development expenses
decreased by $37,000, or 26.2%, to $104,000, compared to $141,000 for the same
period a year ago. This expense decrease resulted from the non-recurrence of
costs incurred during the year ago period for redesigning and internalizing the
administration of our website, in addition to no current period bonus expense
related to the fiscal 2005 employee incentive compensation plan.
For the six months ended December 31, 2004, product development expenses
increased by $76,000, or 28.5%, to $343,000, compared to $267,000 for the six
months ended December 31, 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 prior
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. This expense increase was partially offset
by the non recurrence of the year ago period's costs that related to the
maintenance of our website and to the fiscal 2004 employee incentive
compensation plan.
The write-off of the costs related to the RealAge Games & Skills title were
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 achieved distribution 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. 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 three and six months ended December 31, 2004 and 2003:
December 31, % of December 31, % of Increase %
2004 net sales 2003 net sales (Decrease) Change
- --------------------------------------------------------------------------------------------------
Three months ended $ 648,000 33.9% $ 590,000 27.9% $ 58,000 9.8%
Six months ended $ 1,219,000 39.4% $ 1,192,000 28.6% $ 27,000 2.2%
For the three months ended December 31, 2004, selling, general and
administrative expenses increased by $58,000 to $648,000, compared $590,000 for
the three months ended December 31, 2003. This $58,000 expense increase was
driven by an increase in legal expenses incurred in enforcing our intellectual
property rights, in addition to small cost increases in accounting fees, outside
service fees, charitable contributions and depreciation expense. These cost
increases were partially offset by decreases in public relations costs
associated with the RealAge Games & Skills brand and in salary related costs due
to no current period expense related to the fiscal 2005 employee incentive
compensation plan.
For the six months ended December 31, 2004, selling, general and administrative
expenses increased by $27,000 to $1,219,000 compared to $1,192,000 during the
six months ended December 31, 2003. This $27,000 expense increase was caused by
the same factors impacting the three month period, with the addition of an
increase in stock-based compensation expense traceable to the vesting of
previously granted stock options.
During the remainder of fiscal 2005, we anticipate incurring additional
professional fees related to fulfilling the requirements of Section 404 of the
Sarbanes-Oxley Act of 2002.
Interest (Income) Expense, net
The following table represents our net interest (income) expense for the three
and six months ended December 31, 2004 and 2003:
December 31, % of December 31, % of Increase %
2004 net sales 2003 net sales (Decrease) Change
- ----------------------------------------------------------------------------------------------------------
Three months ended ($ 2,000) (0.1%) ($ 1,000) (0.1%) $ 1,000 100%
Six months ended ($ 3,000) (0.1%) $ 4,000 0.1% $ 7,000 175%
Provision for Income Taxes
The following table represents our provision for income taxes for the three and
six months ended December 31, 2004 and 2003:
December 31, % of December 31, % of Increase %
2004 net sales 2003 net sales (Decrease) Change
- ----------------------------------------------------------------------------------------------------------
Three months ended $ 28,000 1.5% $ 23,000 1.1% $ 5,000 21.7%
Six months ended $ 10,000 0.3% $ 45,000 1.1% ($ 35,000) (77.8%)
For the three months ended December 31, 2004, our provision for income taxes
increased by $5,000 to $28,000, compared to $23,000 for the same period a year
earlier. This $5,000 increase was due to a higher effective state income tax
rate for fiscal 2005, which was partially offset by a decrease in the current
period's estimated taxable income for state income tax purposes. At 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.
For the six months ended December 31, 2004, our provision for income taxes
decreased by $35,000 to $10,000, compared to $45,000 during the six months ended
December 31, 2003. This $35,000 decrease was due to the reduction in the current
period's estimated taxable income for state income tax purposes, which was
partially offset by a higher effective state income tax rate for fiscal 2005.
Net Income
The following table represents our net income for the three and six months ended
December 31, 2004 and 2003:
December 31, % of December 31, % of Increase %
2004 net sales 2003 net sales (Decrease) Change
- ----------------------------------------------------------------------------------------------------------
Three months ended $ 295,000 15.4% $ 471,000 22.3% ($ 176,000) (37.4%)
Six months ended $ 111,000 3.6% $ 950,000 22.8% ($ 839,000) (88.3%)
Weighted Average Common Shares
The weighted average common shares outstanding on a diluted basis decreased by
201,639 for the quarter ended December 31, 2004 to 10,618,788 from 10,820,427
for the quarter ended December 31, 2003. This 201,639 decrease in the diluted
basis calculation of weighted average common shares resulted from the
combination of a decrease in common share equivalents (due to a lower average
share price for eGames stock during the current three month period), which was
partially offset by an increase in outstanding shares due to the exercise of
common stock options.
The weighted average common shares outstanding on a diluted basis increased by
305,291 for the six months ended December 31, 2004 to 10,979,473 from 10,674,182
for the six months ended December 31, 2003. This 305,291 increase in the diluted
basis calculation of weighted average common shares resulted from the
combination of an increase in outstanding shares due to the exercise of common
stock options, along with an increase in common share equivalents (due to a
higher average share price for eGames stock during the current six month
period).
Recent Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 123 (revised 2004),
"Share-Based Payment" which revised Statement of Financial Accounting Standards
No. 123, "Accounting for Stock-Based Compensation". This statement supercedes
APB Opinion No. 25, "Accounting for Stock Issued to Employees". The revised
statement addresses the accounting for share-based payment transactions with
employees and other third parties, eliminates the ability to account for
share-based compensation transactions using APB 25 and requires that the
compensation expense relating to such transactions be recognized in the
statement of operations. The revised statement is effective as of the first
interim period beginning after June 15, 2005. Since we had adopted within our
financial statements the provisions of SFAS No. 123 as of July 1, 2002, we do
not expect the adoption of SFAS No. 123 (revised 2004) to have an impact on our
financial statements.
Liquidity and Capital Resources
As of
December 31,
------------------------
2004 2003 Change
-------------------------------------
Cash and cash equivalents $ 1,692,000 $ 1,787,000 ($ 95,000)
=========== =========== ========
Percent of total assets 38.2% 44.6%
===== =====
Six Months Ended
December 31,
-------------------------
2004 2003 Change
--------------------------------------
Cash (used in) provided by operating activities ($ 59,000) $ 789,000 ($ 848,000)
Cash used in investing activities (10,000) (26,000) 16,000
Cash provided by financing activities 19,000 - 0 - 19,000
--------------------------------------
Net (decrease) increase in cash and cash equivalents ($ 50,000) $ 763,000 ($ 813,000)
=========== ========= =========
Changes in Cash Flow, Operating Activities
During the six months ended December 31, 2004, we had $59,000 of cash used in
operating activities compared to $789,000 of cash provided by operating
activities for the six months ended December 31, 2003. The $59,000 of cash used
in operating activities for the six months ended December 31, 2004 resulted
primarily from:
o Employee bonus payments traceable to the fiscal 2004 employee
incentive compensation plan that were accrued as of June 30, 2004,
and paid during the first quarter of fiscal 2005;
o Accelerated accounts payable vendor payments made in exchange for
obtaining cash discounts, in addition to increased vendor payments
related to higher levels of inventory; and
o Income tax payments associated with estimated federal alternative
minimum tax and various state income tax estimates.
Partially offsetting these cash uses was the cash provided from customer
receivable collections and net income we earned during the six months ended
December 31, 2004.
Accounts Receivable, net
------------------------
Our gross accounts receivable totaled $2.3 million and $2.7 million at December
31, 2004 and June 30, 2004, respectively. This $0.4 million decrease in gross
accounts receivable resulted from our accounts receivable collections exceeding
the slower pace of sales during the six months ended December 31, 2004. At
December 31, 2004, the allowances for product returns, price markdowns and bad
debts totaled $1.0 million, compared to $1.2 million at June 30, 2004. This $0.2
million decrease in these allowances resulted from actual product returns and
price markdowns from software distributors and retailers exceeding the current
period's provisions to these allowances (based on declining sales). However, at
December 31, 2004, our allowances for product returns, price markdowns and bad
debts had increased to 45% of gross accounts receivable, compared to 43% of
gross accounts receivable at June 30, 2004.
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 December 31,
2004, our largest software distributor, Atari, represented 47% of our net
accounts receivable. Additionally, during the six months ended December 31,
2004, we collected receivable payments of $2.1 million from Atari, which
represented 63% of our total customer receipts. 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 six months ended December 31, 2004, we experienced a $102,000 (or
13%) increase in net inventory, which resulted primarily from an increase in our
gross inventory, which was partially offset by a small increase in our allowance
for inventory obsolescence. The increase in gross inventory was due to the
combination of many of our newly manufactured titles not achieving the level of
retail distribution we had anticipated, along with an increase in inventory
units shipped to software distributors under consignment agreements that had not
yet sold through to end consumers. The decreased level of distribution was
related to a large mass-merchant retailer reducing its retail shelf space
allotment for $9.99 retail priced PC software games. We are currently evaluating
the future retail and consumer demand for these newly manufactured products, but
we anticipate that this reduction of product distribution at this retailer will
continue to negatively impact our inventory levels for the remainder of fiscal
2005.
Accounts Payable
----------------
During the six months ended December 31, 2004, our accounts payable decreased by
$65,000, which resulted from our continued acceleration of payments to our
primary trade vendors in exchange for receiving cash discounts, combined with
increased payments relating to higher inventory levels.
Accrued Expenses
----------------
During the six months ended December 31, 2004, our accrued expenses decreased by
$307,000 as a result of employee bonus payments made pursuant to the fiscal 2004
employee incentive compensation plan. There was no such expense recorded during
the six months ended December 31, 2004 relating to the fiscal 2005 employee
incentive compensation plan due to our uncertainty of achieving the operating
income threshold required for bonus payments pursuant to that plan.
Changes in Cash Flow, Non-Operating Activities
For the six months ended December 31, 2004, we had net cash used in investing
activities of $10,000 for equipment upgrades to our computer network, compared
to $26,000 in cash used in investing activities during the year ago period for
similar expenditures. For the six months ended December 31, 2004, we had $19,000
in net cash provided by financing activities from the proceeds related to the
exercise of options to purchase shares of our common stock, compared to no
financing activities for the same period last year.
Credit Facility
In November 2004, we renewed our credit facility agreement with Hudson United
Bank ("HUB"), which matures on December 1, 2005. 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 $750,000 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 $2.0 million.
As of February 8, 2005, we were in compliance with each of those covenants. This
credit facility was established to provide working capital for our operations.
As of February 8, 2005, we had not utilized any of this credit facility,
although we were eligible to draw up to $750,000 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 December 31, 2004, we had future
operating lease commitments of $190,000, 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 December 31, 2004, we
had future commitments to pay $39,000 in advance licensing and royalty payments
to various third-party licensors and 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 $ 190,000 $ 64,000 $ 124,000 $ 2,000 $ - 0 -
Advanced royalties 39,000 27,000 12,000 - 0 - - 0 -
- --------------------------------------------------------------------------------------
Totals $ 229,000 $ 91,000 $ 136,000 $ 2,000 $ - 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 $750,000 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 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 Jack of All Games, Softek,
Take Two Interactive, 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 shelf space allocated to our products at retail and the market
acceptance and sell-through rates of our products to consumers. If one of the
major retailers where our products are sold were to further reduce or eliminate
entirely the shelf space allocated to $9.99 PC software games, our cash flow and
future financial prospects could be significantly impacted. Also, 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 requests that could then be used by distributors and retailers
to reduce their future receivable payments to us. This could also cause 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. We have
considered applying for listing on an exchange, such as the American Stock
Exchange, but at this time we do not meet the standards for listing. Even if we
did meet these standards, however, we do not believe at this time that the
benefits of listing are substantial enough to justify the fees, costs and
additional regulatory requirements imposed by such listing.
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 implement a chain-wide decrease in the size of its PC
game software department allocated to $9.99 jewel case titles 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 three and six
months ended December 31, 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 will continue representing the largest percentage of our 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 market for PC software games that are likely to continue to affect our
operating results, including the recent decision by a major retailer to continue
participating in value-priced PC software market, but through a single-source
software supplier that will now control the manufacture, distribution and
merchandising of this category of products at this retailer. 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 new PC software titles that get into retail stores and
successfully sell through to consumers. 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. For example, certain newly manufactured titles did not
achieve the level of retail distribution we had anticipated during the quarter
ended December 31, 2004, and if these products never achieve full retail
distribution at the largest mass-merchant retailers, this would significantly
affect the success of these products. 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 rates that satisfy retailers. The 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 November 2004, we renewed our $750,000 credit facility
agreement with Hudson United Bank ("HUB"), which matures on December 1, 2005.
Our capital requirements are currently funded from the cash flow generated from
product sales and our $750,000 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 December 31, 2004 represented 47% 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 prices 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:
- Seasonality of consumer entertainment PC software purchases;
- Shelf space allocations by major retailers;
- Timing of major distributor and retailer purchase orders;
- Amount and timing of product returns and price markdown requests; and
- 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 7% and 8%, respectively, of our net sales for the three and six
months ended December 31, 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 December 31, 2004 (the "Evaluation
Date"). Based on that evaluation, our Chief Executive Officer and Chief
Financial Officer have concluded that as of the Evaluation Date, our disclosure
controls and procedures were effective to provide reasonable assurance that the
information required to be disclosed in our reports filed or furnished under the
Exchange Act are recorded, processed, summarized and reported, within the
periods specified in the SEC's rules and forms. We believe that a controls
system, no matter how well designed and operated, cannot provide absolute
assurance that the objectives of the controls system are met, and no evaluation
of controls can provide absolute assurance that all control issues and instances
of fraud, if any, within a company have been detected.
(b) Changes in Internal Control Over Financial Reporting. There have not been
any changes in our internal control over financial reporting during the second
quarter ended December 31, 2004 that have materially affected, or are reasonably
likely to materially affect, our internal control over financial reporting.
Part II. Other Information
Item 4. Submission of Matters to a Vote of Security Holders
The Annual Meeting of Shareholders of the Company was held on December 8, 2004,
where the following actions were taken:
The shareholders voted to elect Robert M. Aiken, Jr., Gerald W. Klein, Thomas D.
Parente and Lambert C. Thom to the Board of Directors. The votes cast for each
Director were as follows:
Number of Shares
----------------
For Withheld
--- --------
Robert M. Aiken, Jr. 9,313,149 389,057
Gerald W. Klein 9,319,724 382,482
Thomas D. Parente 9,313,049 389,157
Lambert C. Thom 9,313,349 388,857
The shareholders voted to ratify the selection of Stockton Bates, LLP as the
Company's independent registered public accounting firm for the fiscal year
ending June 30, 2005. The votes cast in this matter were as follows:
Number of Shares
----------------
For Against Abstain
--- ------- -------
9,483,246 182,850 36,110
Item 6. Exhibit Listing
The following exhibits are being filed or furnished as part of this Quarterly
Report on Form 10-QSB:
Exhibit Number Description of Exhibit
- -------------- ----------------------
(1) 10.1 Business Loan Agreement between Hudson United Bank
and eGames, Inc. dated November 23, 2004
(1) 10.2 Commercial Security Agreement between Hudson United
Bank and eGames, Inc. dated November 23, 2004
(1) 10.3 Promissory Note of eGames, Inc. dated November 23,
2004
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.
(1) Incorporated herein by reference from the Registrant's Form 8-K as filed
with the Securities and Exchange Commission on November 24, 2004.
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: February 10, 2005 /s/ Gerald W. Klein
----------------- -------------------
Gerald W. Klein, President, Chief
Executive Officer and Director
Date: February 10, 2005 /s/ Thomas W. Murphy
----------------- --------------------
Thomas W. Murphy, Chief Financial
Officer and Chief Accounting Officer
Exhibit 31.1
Certification
-------------
I, Gerald W. Klein, certify that:
1. I have reviewed this quarterly report on Form 10-QSB of eGames, Inc.;
2. Based on my knowledge, this report does not contain any untrue statement of a
material fact or omit to state a material fact necessary to make the statements
made, in light of the circumstances under which such statements were made, not
misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material respects the
financial condition, results of operations and cash flows of the registrant as
of, and for, the periods presented in this report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:
a) Designed such disclosure controls and procedures, or caused such
disclosure controls and procedures to be designed under our
supervision, to ensure that material information relating to the
registrant, including its consolidated subsidiaries, is made known to
us by others within those entities, particularly during the period in
which this report is being prepared;
b) Evaluated the effectiveness of the registrant's disclosure controls
and procedures and presented in this report our conclusions about the
effectiveness of the disclosure controls and procedures, as of the end
of the period covered by this report based on such evaluation; and
c) Disclosed in this report any change in the registrant's internal
control over financial reporting that occurred during the registrant's
most recent fiscal quarter that has materially affected, or is
reasonably likely to materially affect, the registrant's internal
control over financial reporting;
5. The registrant's other certifying officer and I have disclosed, based on our
most recent evaluation of internal control over financial reporting, to the
registrant's auditors and the audit committee of the registrant's board of
directors (or persons performing the equivalent functions):
a) all significant deficiencies and material weaknesses in the design
or operation of internal control over financial reporting which are
reasonably likely to adversely affect the registrant's ability to
record, process, summarize and report financial information; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal control over financial reporting.
Date: February 10, 2005
- ------------------------
/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: February 10, 2005
- ------------------------
/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 second quarter ended December 31, 2004 as filed with the
Securities and Exchange Commission on the date hereof (the "Report"), I, Gerald
W. Klein, President and Chief Executive Officer of the Company, certify,
pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the
Sarbanes-Oxley Act of 2002, based on my knowledge, that:
1. The Report fully complies with the requirements of section 13(a)
or 15(d) of the Securities Exchange Act of 1934; and
2. The information contained in the Report fairly presents, in all
material respects, the financial condition and results of operations
of the Company.
/s/ Gerald W. Klein
- -------------------
Gerald W. Klein
President and Chief Executive Officer
February 10, 2005
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 second quarter ended December 31, 2004 as filed with the
Securities and Exchange Commission on the date hereof (the "Report"), I, Thomas
W. Murphy, Vice President and Chief Financial Officer of the Company, certify,
pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the
Sarbanes-Oxley Act of 2002, based on my knowledge, that:
1. The Report fully complies with the requirements of section 13(a)
or 15(d) of the Securities Exchange Act of 1934; and
2. The information contained in the Report fairly presents, in all
material respects, the financial condition and results of operations
of the Company.
/s/ Thomas W. Murphy
- --------------------
Thomas W. Murphy
Chief Financial Officer
February 10, 2005
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.