U.S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-QSB
(Mark One)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2005
|_| 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 ( )
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act)
Yes ( ) No (X)
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: 11,724,193 shares of common stock, no
par value per share, as of November 11, 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 September 30, 2005................... 3
Statements of Operations for the three months
ended September 30, 2005 and 2004 ................... 4
Statements of Cash Flows for the three months
ended September 30, 2005 and 2004 .................. 5
Notes to Financial Statements............................ 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations ................. 12
Item 3. Controls and Procedures ................................. 24
Part II Other Information
Item 6. Exhibit Listing ......................................... 24
Exhibit Index ......................................................... 24
Signatures ......................................................... 25
Exhibits ......................................................... 26
Item 1. Unaudited Financial Statements
eGames, Inc.
Balance Sheet
(Unaudited)
September 30,
2005
-------------
ASSETS
- ------
Current assets:
Cash and cash equivalents $ 2,181,206
Accounts receivable, net of allowances of $712,476 772,631
Inventory, net 811,492
Prepaid and other expenses 367,027
-----------
Total current assets 4,132,356
Furniture and equipment, net 44,099
Intangible assets 24,089
-----------
Total assets $ 4,200,544
===========
LIABILITIES AND STOCKHOLDERS' EQUITY
- ------------------------------------
Current liabilities:
Accounts payable $ 410,273
Accrued expenses 430,554
-----------
Total current liabilities 840,827
-----------
Commitments and contingencies
Stockholders' equity:
Common stock, no par value (40,000,000 shares authorized;
11,138,654 issued and 10,906,754 outstanding) 9,179,827
Additional paid-in capital 1,653,316
Accumulated deficit (6,972,009)
Treasury stock, at cost - 231,900 shares (501,417)
-----------
Total stockholders' equity 3,359,717
-----------
Total liabilities and stockholders' equity $ 4,200,544
===========
See accompanying notes to financial statements.
eGames, Inc.
Statements of Operations
(Unaudited)
Three Months Ended
September 30,
----------------------------
2005 2004
------------ ------------
Net sales $ 1,294,012 $ 1,177,829
Cost of sales 703,806 571,158
------------ ------------
Gross profit 590,206 606,671
Operating expenses:
Product development 84,028 239,115
Selling, general and
administrative 568,228 571,132
------------ ------------
Total operating expenses 652,256 810,247
------------ ------------
Operating loss (62,050) (203,576)
Interest income, net 8,077 1,230
------------ ------------
Loss before income taxes (53,973) (202,346)
Benefit for income taxes - 0 - 18,024
------------ ------------
Net loss ($ 53,973) ($ 184,322)
=========== ===========
Net loss per common share:
- Basic ($ 0.00) ($ 0.02)
=========== ===========
- Diluted ($ 0.00) ($ 0.02)
=========== ===========
Weighted average common shares
outstanding - Basic 10,906,754 10,102,673
Dilutive effect of common share
equivalents - 0 - - 0 -
---------- ----------
Weighted average common shares
outstanding - Diluted 10,906,754 10,102,673
========== ==========
See accompanying notes to financial statements.
eGames, Inc.
Statements of Cash Flows
(Unaudited)
Three Months Ended
September 30,
---------------------------
2005 2004
----------- ------------
OPERATING ACTIVITIES:
- ---------------------
Net loss ($ 53,973) ($ 184,322)
Adjustment to reconcile net loss to net cash
used in operating activities:
Stock-based compensation 17,172 18,306
Depreciation 7,967 8,686
Changes in operating assets and liabilities:
Accounts receivable, net (503,463) 412,119
Inventory, net 82,274 (27,828)
Prepaid and other expenses (53,342) (33,766)
Accounts payable 253,681 (81,441)
Accrued expenses 20,914 (303,842)
----------- ------------
Net cash used in operating activities (228,770) (192,088)
----------- ------------
INVESTING ACTIVITIES:
- ---------------------
Purchases of furniture and equipment (2,186) (8,796)
----------- ------------
Net cash used in investing activities (2,186) (8,796)
----------- ------------
FINANCING ACTIVITIES:
- ---------------------
Proceeds from exercise of stock options - 0 - 12,500
----------- ------------
Net cash provided by financing activities - 0 - 12,500
----------- ------------
Net decrease in cash and cash equivalents (230,956) (188,384)
Cash and cash equivalents:
Beginning of period 2,412,162 1,742,224
----------- ------------
End of period $ 2,181,206 $ 1,553,840
=========== ============
Supplemental cash flow information:
Cash paid (refunds received) for income taxes ($ 43,289) $ 23,550
========== ============
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", "us", or "we") is a Pennsylvania corporation
incorporated in July 1992 that publishes, markets and sells affordable PC
software games. Historically, we have focused on publishing software games for
the PC platform only. We are currently evaluating various opportunities to
publish quality content for other gaming platforms, such as console and handheld
game devices. We sell our software titles to consumers who are seeking a broad
range of high-quality, affordable PC gaming software, which are sold on CDs
through retail distribution or online via 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 the instructions to Form 10-QSB and Item 310(b) of Regulation
S-B. Accordingly, these financial statements do not include all information and
disclosures required by generally accepted accounting principles in the United
States for complete financial statements. These financial statements include all
adjustments that management believes are necessary for a fair presentation of
the financial statements. These interim operating results are not necessarily
indicative of the results for a full year. The accompanying financial statements
should be read in conjunction with the audited financial statements and notes
thereto contained in our Form 10-KSB for the fiscal year ended June 30, 2005.
Amounts discussed within the "Notes to Financial Statements" have been rounded
to the nearest thousand ("000") dollars.
Fair Value of Financial Instruments
The recorded amounts of cash and net accounts receivable at September 30, 2005
approximate fair value due to the relatively short period of time between
origination of the instruments and their expected realization. All liabilities
are carried at cost, which approximate fair value for similar instruments.
Cash and Cash Equivalents
For purposes of the statements of cash flows, we consider all highly liquid
instruments purchased with an original maturity of three months or less to be
cash equivalents.
Accounts Receivable, net
Accounts receivable is reflected 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).
Furniture and Equipment, net
Furniture and equipment, net is stated at cost and net of accumulated
depreciation. Depreciation is calculated on the straight-line method over the
estimated useful lives of the assets ranging from three to five years (see
Note 5).
Long-Lived Assets, net
In accordance with Statement of Financial Accounting Standards ("SFAS") No. 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets," we record
impairment losses on long-lived assets, including intangible assets, used in
operations when the fair value of those assets, less the cost to sell, is lower
than our carrying value for those assets.
Intangible assets
At September 30, 2005, we had intangible assets of approximately $24,000, which
related to the Company's trademark registration activities with the United
States Patent and Trademark Office. As of September 30, 2005, 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. 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 revenues from
product shipments to software distributors and retailers at the time title to
our inventory transfers to the distributor or retailer, less a provision for
anticipated product returns and price markdowns. Title to our products usually
transfers to software distributors and retailers upon their receipt of our
products, because retailer and distributor purchase orders typically reflect
shipping terms of FOB destination. In order to recognize revenues associated
with customer purchase orders having terms of FOB destination, we perform sales
cut-off tests, in which we obtain proof of deliveries for product shipments made
during the last two weeks of a reporting period from the freight companies that
deliver our products to our retail and distribution customers. All revenues and
costs associated with product shipments received by our customers after the end
of a 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 revenues in accordance with the criteria of SFAS No. 48 at the time
title to our inventory passes to software 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 product returns and price markdowns
can be reasonably estimated at the time of sale. After product 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 as a means of
improving consumer satisfaction and brand loyalty. Costs associated with our
customer support efforts usually occur within six months from the period we
recognize revenue and these costs have historically averaged about 1% of net
sales.
We also have relationships with certain software distributors for product
distribution to various retailers, which are based on consignment sales
agreements. Accordingly, revenues from product shipments pursuant to these
arrangements are only recognized to the extent that the distributor has reported
to us that our products have actually sold through to consumers.
Provision for Product Returns and Price Markdowns
-------------------------------------------------
Our provision for anticipated product returns and price markdowns (reflected as
a reduction to gross sales) is primarily based on our analysis of: historical
product return and price markdown results; current product sell-through activity
at retail store locations; current field inventory quantities at distributors'
warehouses and at retail store locations; the length of time that products have
been released 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
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.
At September 30, 2005, the allowance for product returns and price markdowns
amounted to 48% of our gross accounts receivable. Historically, the allowance
for product returns and price markdowns has represented a substantial percentage
of our gross accounts receivable because we continue to have product return and
price markdown exposure relating to paid receivables while the physical software
units relating to paid receivables remain in the retailers' stores or in the
retailers' or distributors' warehouses. Until physical software units are
actually returned to us, or sell through to consumers, we continue to evaluate
our product return or price markdown exposure for these previously sold units
that are still remaining in the retail channel. During reporting periods,
through retailer and distributor provided reports, we have regular and timely
visibility of product sell-through activity and remaining quantities of our
titles in the retail channel that help us assess our exposure for future product
returns and price markdowns.
Prepaid and Other Expenses
Prepaid and other expenses represent advance payments made to third parties for
items such as licensing of software and intellectual properties used in our
products, estimated tax payments, certain insurance coverage, retail market
reporting 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. Advance licensing and royalty payments are usually
expensed as cost of sales at the higher of contractual or effective rates based
on the net sales of the related software titles (see Notes 4 and 7). Income tax
payments are reflected as income tax expense 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 of similar titles to consumers. 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. Costs determined to
be non-recoverable are expensed in the reporting period in which the decision is
reached by management that recoverability of these costs in future periods is
unlikely.
Income Taxes
We use the asset and liability method of accounting for income taxes. Under the
asset and liability method, deferred tax assets and liabilities are recognized
for the estimated future tax consequences attributable to differences between
the financial statement carrying amounts of existing assets and liabilities and
their respective tax bases and for net operating loss and credit carry-forwards.
Deferred tax assets and liabilities are measured using enacted tax rates in
effect for the year in which those temporary differences are expected to be
recovered or settled.
Computation of Net Income (Loss) per Common Share
Net income (loss) per common share is computed in accordance with SFAS No. 128,
"Earnings per Share". Basic earnings per share is computed by dividing net
income (loss) 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.
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, and the recoverable value of
advance licensing and royalty payments at the end of the reporting period, 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 $ 1,485,000
Allowance for product returns and price markdowns (712,000)
------------
Accounts receivable, net $ 773,000
============
3. Inventory, net
Inventory, net consists of the following:
Raw materials - warehouse $ 257,000
Finished goods - warehouse 442,000
Finished goods - consignment 125,000
Product returns - retailer and distributor locations 127,000
------------
Inventory, gross 951,000
Allowance for obsolescence (140,000)
------------
Inventory, net $ 811,000
============
4. Prepaid and Other Expenses
Prepaid and other expenses consist of the following:
Royalties $ 135,000
Insurances 98,000
Federal tax 55,000
Retail market reporting 45,000
Retailer slotting fees 17,000
Other expenses 17,000
------------
Prepaid and other expenses $ 367,000
============
5. Furniture and Equipment, net
Furniture and equipment consists of the following:
Furniture and equipment, gross $ 360,000
Accumulated depreciation (316,000)
------------
Furniture and equipment, net $ 44,000
============
6. Accrued Expenses
Accrued expenses consist of the following:
Customer credit balances $ 98,000
Vacation accrual 95,000
Inventory receipts 65,000
Professional fees 61,000
Royalties 38,000
Other 30,000
Charities 16,000
Annual report 16,000
State taxes 12,000
------------
Accrued expenses $ 431,000
============
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. For the quarters ended September 30, 2005 and 2004, total rent
expense amounted to $22,000 during both periods. At September 30, 2005, we had
future operating lease commitments of $141,000 scheduled to be paid as follows:
$64,000 in less than one year; and $77,000 in one to three years.
Under various licensing agreements with third-party software developers, we are
required to pay royalties for the use of licensed content in our products. Most
of these licensing agreements require us to make advance royalty payments to
these developers prior to the time we recognize any net sales of software titles
containing this licensed software content. As of September 30, 2005, we had
future commitments to pay $53,000 in advance licensing and royalty payments to
various third-party licensors and software developers, which are scheduled to be
paid as follows: $40,000 in less than one year; and $13,000 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. This credit facility was
established to provide working capital for our operations. We expect to renew
this facility before its expiration date. Amounts outstanding under this credit
facility are charged interest at one-half of one percent above HUB's current
prime rate and such interest is due monthly. Our access to these funds is
limited to the lesser of $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. As
of September 30, 2005, we had not utilized any of this credit facility, and we
had access to approximately $580,000 under this credit facility, based on the
prescribed calculation of seventy-five percent of qualified accounts receivable
as of that date. The credit facility is secured by all of the Company's assets
and requires us, among other things, to maintain certain financial covenants to
be tested quarterly.
9. Dependence on One Large Software Distributor - Atari
Atari is our primary software distributor servicing the North American
mass-merchants and other major retailers. During the three months ended
September 30, 2005, Atari accounted for $563,000 of net sales, or 44% of net
sales, compared to the three months ended September 30, 2004, when Atari
accounted for $514,000 of net sales, or 44% of net sales. Historically, Atari
has represented the majority of our net accounts receivable, and as of September
30, 2005 Atari's net receivable balance amounted to $402,000, or 52% of our
total net accounts receivable.
If we were to lose our product distribution through Atari, or if they were not
able or willing to make timely receivable payments to us in the normal course of
business, our financial condition would be significantly impacted. Since the
retail distribution of PC software is a competitive business, there may be
alternative distributors that could distribute our products to retailers if, for
example, Atari chose to discontinue distributing our titles, we chose to
transition all or part of our business with Atari to one or more alternative
software distributors, or if any retailers decided to discontinue their software
distribution relationship with Atari.
10. Accounting for Stock-Based Compensation
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 options grants made on or
after that date. On January 1, 2003, we adopted the provisions of SFAS No. 148,
"Accounting for Stock-Based Compensation - Transition and Disclosure". During
the three months ended September 30, 2005 and 2004, we recognized stock-based
compensation expense within our financial statements of $17,000 and $18,000,
respectively. All stock options that vested during these periods had been
previously valued under the fair value method.
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 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 - Acquisition of Assets of Cinemaware, Inc.
On October 13, 2005, eGames completed the acquisition of substantially all of
the assets of Cinemaware, Inc. pursuant to an Asset Purchase Agreement. The
acquired assets consisted principally of intellectual property, contract rights
and goodwill. As part of the transaction, Cinemaware and its principal
shareholder, Lars Fuhrken-Batista, entered into non-competition agreements, and
Mr. Batista became Vice President of Development for eGames. We intend to use
the Cinemaware assets for the purpose of developing new higher-priced PC game
titles and console game titles.
In consideration for the Cinemaware assets, eGames issued to Cinemaware 817,439
shares of its common stock, a warrant to purchase 150,000 shares of eGames
common stock at an exercise price of $.50 per share, and a warrant to purchase
150,000 shares of eGames common stock at an exercise price of $.75 per share.
The warrants each have terms of five years. 272,480 shares of the 817,439 shares
of eGames common stock issued at closing are being held in an escrow account for
one year for eGames' potential indemnification claims. eGames did not assume any
of Cinemaware's liabilities, except for certain obligations relating to assumed
contracts.
Additionally, as part of Mr. Batista's employment, he received stock options to
purchase 150,000 shares of eGames common stock with an exercise price equal of
$.43 per share, which was based on the closing price for a share of eGames
common stock on the grant date. These options are not part of any stock option
plan, and vest over five years in equal annual installments. These options have
a term of six years.
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 supersedes
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 became effective during the first
interim period beginning after June 15, 2005. The adoption of SFAS No. 123
(revised 2004) did not have a material impact on our financial statements.
In November 2004, the FASB issued SFAS No. 151, "Inventory Costs - an amendment
of ARB No. 43, Chapter 4". SFAS No. 151 amends the guidance in Accounting
Research Bulletin ("ARB") No. 43, "Restatement and Revision of Accounting
Research Bulletins", Chapter 4, "Inventory Pricing", to clarify the accounting
for abnormal amounts of idle facility expense, freight, handling costs, and
wasted material (spoilage) and requires that those items be recognized as
current-period charges. SFAS No. 151 also requires that allocation of fixed
production overheads to the costs of conversion be based on the normal capacity
of the production facilities. SFAS No. 151 became effective for inventory costs
incurred during fiscal years beginning after June 15, 2005. The adoption of SFAS
No. 151 did not have a material 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 largest single source of our net sales, accounts receivable and
related cash receipts continuing to be attributable to Atari during
fiscal 2006;
- reductions in retail shelf space allocated to affordable PC game
software continuing to negatively impact our financial results and
inventory levels;
- the strategies and new opportunities that we are exploring to
offset reductions in the retail shelf space allocated to
affordable PC game software and increase consumer demand for our
products;
- evaluating opportunities to publish higher-priced software games
for the PC and other gaming platforms, such as console and
handheld game devices;
- our intent to use the Cinemaware assets we acquired to develop new
higher-priced PC game titles and console game titles;
- our provision for product returns and price markdowns, as a
percentage of related gross sales, trending higher for the
foreseeable future;
- product development expenses and advanced royalty payments
increasing as we begin to implement a strategy of publishing
higher quality, and higher-priced PC game titles, as well as
seeking to publish titles for other gaming platforms, such as
console and handheld game devices, which we intend to fund with
cash flows from operations;
- continued sales of our products to the retailers and distributors
that charge sales incentives and promotional fees, which will
continue to reduce our gross sales;
- our gross profit percentage continuing to be impacted by higher
royalty expense and freight costs in fiscal 2006;
- additional quantities of discontinued titles being returned to us
from retailers and distributors that need to be sold to inventory
liquidators at discounted prices, which could cause inventory
liquidation sales to vary from quarter to quarter;
- our liquidity being significantly impacted if Atari would become
unable or unwilling to make receivable payments to us in a timely
manner;
- our plan to market promotional programs to reduce excess inventory,
increase collectible accounts receivable and be a source of funds;
- our intent to renew our credit facility;
- the impact of reduced shelf space allocated to our products and
lack of product sell-through on our future financial results;
- future advance royalty commitments being funded by cash flows from
operations; 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" in our Form 10-KSB for the fiscal year
ended June 30, 2005, 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;
- the continued successful business relationship between us and Atari,
as our largest customer and our distributor to the major mass-market
retailers;
- the amount of shelf space the major mass-market retailers allocate
to affordable, jewel case PC game software;
- the amount of unsold product that is returned to us by retailers and
distributors;
- the amount of price markdowns granted to retailers and distributors;
- our ability to accurately estimate the amount of product returns
and price markdowns that will occur and the adequacy of the
allowances established for such product returns and price markdowns;
- the 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 increase the distribution of our products into key
North American mass-merchant retailers and to enter into new
distribution and direct sales relationships on commercially
acceptable terms;
- the allocation of shelf space (retail facings) for our products in
major retail chain stores;
- the ability of our international product distribution through
licensing agreements to earn a royalty and the ability of our
licensees to pay us such royalties within agreed upon terms;
- our ability to collect net outstanding accounts receivable and
establish an adequate allowance for customer bad debts;
- the ability to deliver products in response to customer orders
within a commercially acceptable time frame;
- downward pricing pressure;
- fluctuating costs of developing, producing, distributing 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 net sales
over the Internet;
- consumers' continued demand for affordable consumer entertainment
PC software;
- our ability to fund our strategy of publishing higher quality and
higher-priced game titles for the PC, console and handheld
devices; and
- increased competition in the affordable software category.
Overview
The following overview identifies certain recent trends and events in our
business. We believe that an understanding of these trends and events is
important in order to understand our results for the three months ended
September 30, 2005, 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 the
remainder of "Management's Discussion and Analysis of Financial Condition and
Results of Operations," or the financial statements and the related notes.
Amounts, other than percentages, discussed within the "Management's Discussion
and Analysis of Financial Condition and Results of Operations" have been rounded
to the nearest thousand ("000") dollars.
About eGames
eGames, Inc. ("eGames", "our", "us", or "we") is a Pennsylvania corporation
incorporated in July 1992 that publishes, markets and sells affordable PC
software games. Historically, we have focused on publishing software games for
the PC platform only. We are currently evaluating various opportunities to
publish higher-priced software games for the PC and other gaming platforms, such
as console and handheld game devices. We sell products to consumers who are
seeking a broad range of high-quality, affordable PC gaming software, which are
sold on CDs through retail distribution or online via 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. We promote the eGames(TM) and
Cinemaware(TM) brands in order to generate customer loyalty, encourage repeat
purchases and differentiate eGames software products to retailers and consumers.
Significant Trends and Events in our Business
Publishing of Higher Quality and Higher-Priced Games for PC, Console and
Handheld Game Devices
------------------------------------------------------------------------
In fiscal 2006, we hope to partially offset the impact from the decrease in
retail shelf space being allocated to value-priced PC software by implementing a
strategy of publishing higher quality, and higher-priced PC game titles, as well
as seeking to publish titles for other gaming platforms, such as console and
handheld game devices. Due to the increased complexity of game play and
additional quality control and other procedures that we anticipate will be
required to develop these more technically sophisticated games, we expect our
future product development costs to increase compared to prior periods.
Additionally, higher quality software content for these gaming platforms
generally requires higher licensing fees and advance royalty payments, and we
therefore expect our future licensing and advanced royalty payments to
significantly increase over prior periods and represent a greater use of
available cash as we bring such products to market. Also, to the extent that we
begin to publish games for console and handheld game devices we would be
required to make upfront payments to gaming platform manufacturers to preorder
production units, which would further consume available cash in future periods,
and at an accelerated timing before retail product release.
Decrease in Retail Shelf Space for Value-Priced PC Software Has
Impacted Our Sales
---------------------------------------------------------------
The reduced amount of shelf space allocated to our category of products in
retail stores throughout fiscal 2005 has continued to impact our net sales
during the early part of fiscal 2006. We continue to see indications that the
amount of retail shelf space being allocated to PC software games at the $9.99
retail price point is decreasing, and we expect this trend to continue
negatively impacting our results for the foreseeable future. We are attempting
to offset the reduction in our sales caused by this trend by offering high value
promotional packs which may be displayed in a secondary location within or
outside of the PC software department. Additionally, we continue to seek
incremental licensing opportunities and pursue increased sales at alternative
retail channels such as discount retailers and in-statement advertising
providers. We cannot predict whether these initiatives will be effective in
increasing net sales.
Decline in Consumer Demand for Titles Has Reduced Our Sales
-----------------------------------------------------------
During fiscal 2005, we experienced a decrease in consumer demand for our titles
as indicated by reduced product sell-through rates of our titles to consumers at
retail. We believe this decline was due in part to an increase in the number of
competitors' previously higher-priced titles transitioning down to the $9.99
retail price point more quickly than in the past, combined with more titles
within the core gaming genres in which we compete. Throughout fiscal 2006, we
will continue to evaluate various product and marketing strategies to increase
consumer demand for our products, such as offering more content per title to the
consumer, creating unique and compelling packaging, exploring different gaming
genres and price points, acquiring higher quality gaming content and licensing
higher-profile brands, and investigating different gaming platform opportunities
that could offer us incremental business growth.
Dependence on One Large Software Distributor - Atari
----------------------------------------------------
We continue to have a concentrated customer base consisting of a few large
software distributors and retailers. Atari is our primary software distributor
serving the mass-merchant and major retailers in North America. Although our
sales through Atari declined during fiscal 2005, Atari has continued to
represent the largest percentage of our business activity.
During the three months ended September 30, 2005, Atari accounted for $563,000
of net sales, or 44% of net sales, compared to the three months ended September
30, 2004, when Atari accounted for $514,000 of net sales, or 44% of net sales.
As of September 30, 2005, our net accounts receivable with Atari was $402,000
and represented 52% or our total net accounts receivable.
Our financial condition, financial results and ability to continue as a going
concern could be significantly affected if: we lost our distribution capability
through Atari; the amount of net sales to Atari were to substantially decrease;
we chose to transition all or part of our business with Atari to one or more
alternative software distributors; or Atari would not be able or willing to make
timely receivable payments to us in the normal course of business.
Inventory Costs
---------------
As of September 30, 2005, our net inventory value remained high relative to
historical levels and in relation to our net accounts receivable balance. We
anticipate the reduction of retail shelf space for $9.99 retail priced PC
software games that occurred during fiscal 2005 will continue to impact our
inventory levels throughout fiscal 2006. During the three months ended September
30, 2005, our net inventory decreased by $82,000, or 9%, and was a result of
increased sales of end of lifecycle titles to inventory liquidators and discount
retailers, combined with lower warehouse stock levels for most of our titles.
Acquisition of Assets of Cinemaware, Inc.
-----------------------------------------
On October 13, 2005, eGames completed the acquisition of substantially all of
the assets of Cinemaware, Inc. pursuant to an Asset Purchase Agreement. The
acquired assets consisted principally of intellectual property, contract rights
and goodwill. As part of the transaction, Cinemaware and its principal
shareholder, Lars Fuhrken-Batista, entered into non-competition agreements, and
Mr. Batista became Vice President of Development for eGames. We intend to use
the Cinemaware assets for the purpose of developing new higher-priced PC game
titles and console game titles.
In consideration for the Cinemaware assets, eGames issued to Cinemaware 817,439
shares of its common stock, a warrant to purchase 150,000 shares of eGames
common stock at an exercise price of $.50 per share, and a warrant to purchase
150,000 shares of eGames common stock at an exercise price of $.75 per share.
The warrants each have terms of five years. 272,480 of the 817,439 shares of
eGames common stock issued at closing are being held in an escrow account for
one year for eGames' potential indemnification claims. eGames did not assume any
of Cinemaware's liabilities, except for certain obligations relating to assumed
contracts.
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 policies for revenue recognition, inventory valuation
and recoverability of advanced licensing and royalty payments 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 reported net values
for inventory, accounts receivable, prepaid and other expenses. 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, recoverable values of advanced licensing and royalty
payments, income tax expense, contingencies and litigation risks. We base our
estimates on historical experience and on various other factors and assumptions
that we believe are appropriate. 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 North American mass-merchant and major retailers and directly to
certain PC software retailers, most 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 and have shipping terms of
FOB destination. For product shipments to these software distributors or
retailers, we record a provision for product returns and price markdowns as a
reduction to gross sales at the time the title of our product transfers to a
distributor or retailer.
We also have relationships with certain software distributors for product
distribution to various retailers based on consignment sales agreements.
Accordingly, revenues from product shipments pursuant to these arrangements are
only recognized to the extent that the distributor has reported to us that our
product has actually sold through to consumers.
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 activity at retail store locations; current field inventory
quantities at distributors' warehouses and at retail store locations; the length
of time that products have been released 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 our current products;
outstanding return material and price markdown authorizations; and the extent to
which units of 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
reviewed throughout each reporting period and any necessary adjustment to this
allowance is reflected within the current period's provision. Significant
management judgments and estimates must be made and used in order to determine
how much 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.
Inventory Valuation
-------------------
Our inventory valuation policy requires management to make estimates and
assumptions about the recoverability of the carrying value of inventory at the
end of each reporting period and cost of sales expensed during each reporting
period. Our inventory could be valued differently at the close of any reporting
period and the amount of expense 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.
Key Assumptions
Our provision for inventory obsolescence is based on the assumptions we make
after evaluating the remaining value of existing inventory units (consisting of
unsold units and estimated units of product returns), which involves: assessing
the remaining product life of existing titles based on how long the titles have
been released at retail; analyzing the trend of current product sell-through
activity to consumers for existing titles; identification of competitors' new
products with greater capabilities or more recognizable brands 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 sales of similar products to inventory liquidators and discount
retailers.
Although we attempt to accurately match production requirements of our products
to forecasted consumer demand, at the end of a product's lifecycle we usually
have some level of excess inventory units that need to be disposed of through
liquidation sales. 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 provision for inventory
obsolescence.
Advance 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 advance
payments are initially classified on our balance sheet as "Prepaid and other
expenses", and are then usually expensed within the "Cost of sales" category of
our Statements of Operations based upon the greater of the contractual or
effective royalty rate based on net sales.
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 existing titles. In particular, we evaluate the
potential future sales of a title or subsequent titles containing the same
licensed content based on current and potential sales programs, along with
historical sell-through results of a title and similar titles, if any, to
consumers. 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. Non-recoverable costs are expensed in the reporting period in
which management determines that it is not likely that we will be able to
recover these costs in future periods.
Results of Operations
The following discussion should be read together with our Financial Statements
and Notes beginning on page 3.
Three Months Ended September 30, 2005 Compared to the Three Months Ended
September 30, 2004
Net Sales
Net sales increased by $116,000, or 10%, to $1,294,000, for the quarter ended
September 30, 2005, compared to $1,178,000 for the same quarter a year earlier.
The $116,000 increase in net sales for the quarter ended September 30, 2005 was
driven by net sales increases to inventory liquidators and software retailers of
$73,000 and $21,000, respectively, in addition to a $66,000 increase in
licensing revenues. Partially offsetting these net sales increases was a $45,000
decrease in net sales to software distributors caused by a decline in net sales
to Canadian software distributors.
The following table represents the Company's net sales by distribution channel
for the quarters ended September 30, 2005 and 2004, respectively:
Net Sales by Distribution Channel
---------------------------------
(rounded to the nearest thousand)
-------------------------------
Quarters Ended
September 30,
----------------------------------------
Increase %
Distribution Channel 2005 % 2004 % (Decrease) Change
- ----------------------------------------------------------------------------------------
Software Distributors $ 770,000 59% $ 815,000 69% ($ 45,000) (6%)
Software Retailers 181,000 14% 160,000 14% 21,000 13%
Licensing 158,000 12% 92,000 8% 66,000 72%
Internet 74,000 6% 73,000 6% 1,000 1%
Inventory Liquidators 111,000 9% 38,000 3% 73,000 192%
- ----------------------------------------------------------------------------------------
Totals $ 1,294,000 100% $1,178,000 100% $ 116,000 10%
=========== ==== ========== ==== ========= ===
Software Distributors
---------------------
For the three months ended September 30, 2005, net sales to software
distributors that serve North American mass-merchants and other major retailers
amounted to $770,000, which represented a decrease of $45,000 or 6% compared to
the three months ended September 30, 2004. This $45,000 decline in net sales to
software distributors was caused by a decrease in net sales to Canadian software
distributors, which was traceable to $82,000 in the year ago quarter's net sales
to a major Canadian software distributor that went into liquidation during the
second half of fiscal 2005. Partially offsetting this net sales decrease was a
$49,000 net sales increase to Atari relating to net sales of higher-priced
promotional box titles.
Software Retailers
------------------
For the three months ended September 30, 2005, net sales direct to software
retailers totaled $181,000, representing a $21,000 increase compared to the
three months ended September 30, 2004. This increase resulted primarily from
sales of excess inventory of end of lifecycle titles to various discount
retailers that was partially offset by net sales decreases to various
traditional software retailers.
Licensing
---------
For the three months ended September 30, 2005 and 2004, we realized licensing
revenues of $158,000 and $92,000, respectively, which represented 12% and 8%,
respectively, of net sales. This $66,000, or 72%, increase in licensing revenues
was driven by revenue increases in the United States and the United Kingdom
markets, which were partially offset by a decrease in licensing revenues from
our German licensee.
Internet
--------
For the three months ended September 30, 2005 and 2004, Internet sales were
$74,000 and $73,000, respectively, and represented 6% of net sales during both
periods. Our Internet sales strategy remains focused on distributing our game
titles more broadly via affiliate programs and on popular Internet game websites
and other portals.
Inventory Liquidators
---------------------
For the three months ended September 30, 2005 and 2004, net sales to inventory
liquidators were $111,000 and $38,000, respectively, and represented 9% and 3%,
respectively, of net sales. Net sales to inventory liquidators consist of sales
of residual inventory units of titles that have been discontinued (in part or
entirely) at traditional software retail stores because these titles had reached
the end of their product lifecycles. As retailers continue to routinely change
the mix of software titles displayed on their store shelves - usually on a
quarterly basis - we expect to continue receiving quantities of discontinued
titles back from the retail channel that will then need to be liquidated, along
with any quantities of those titles remaining in our warehouse. Accordingly, the
amount of inventory liquidation sales will vary, period to period, and are
usually made at discounted prices with no right of return or price markdown.
Product Returns and Price Markdowns
-----------------------------------
Until physical units of our products are returned to us from software
distributors or retailers, or until these units sell through to consumers, we
continue to evaluate our product return and price markdown exposure for the
software units we previously sold to software distributors and retailers.
During the three months ended September 30, 2005 and 2004, our provisions for
product returns and price markdowns relating to gross product sales with
software distributors and retailers amounted to $244,000 and $228,000,
respectively, or 17.6% and 17.3%, respectively, of related gross sales. Based on
various assumptions, including shorter product lifecycles, more competitive
titles in our core game genres, and the continued reduction of retail shelf
space allocated to $9.99 retail priced PC games, we anticipate our provision for
product returns and price markdowns, as a percentage of related gross sales, to
trend higher for the foreseeable future.
Sales Incentives and Promotional Costs
--------------------------------------
For the three months ended September 30, 2005 and 2004, our sales incentives and
promotional costs were $80,000 and $88,000, respectively, or 5.8% and 6.7%,
respectively, of related gross sales. In order to maintain retail shelf space
for our titles, we incur sales incentives and promotional costs from software
distributors and retailers, such as pricing rebates and slotting fees, which are
recognized as reductions to gross sales. We intend to continue selling our
products to software retailers and distributors that charge such fees, and
accordingly we expect to continue incurring these types of reductions to gross
sales.
Cost of Sales
Cost of sales consists of the following costs that are associated with
publishing our PC games: product costs; royalty costs incurred with third
parties for licensing product content or other intellectual properties; freight
and handling costs; inventory obsolescence provision, reclamation fees and other
costs.
The following table represents our cost of sales for the quarters ended
September 30, 2005 and 2004:
September 30, % of September 30, % of Increase %
2005 net sales 2004 net sales (Decrease) Change
- ------------------------------------------------------------------------------
$ 704,000 54.4% $ 571,000 48.5% $ 133,000 23.3%
During the quarter ended September 30, 2005, cost of sales increased by $133,000
compared to the prior year's quarter and resulted from a 5.9% higher cost of
sales percentage on increased net sales. The 5.9% increase in cost of sales, as
a percentage of net sales, was due to an 11.3% increase in product costs, as a
percentage of net sales, traceable to increased sales of:
o End of lifecycle titles to inventory liquidators and discount retailers
at prices substantially below standard wholesale and distributor
prices; and
o Promotional titles consisting of higher costing units containing
multiple CD's and more expensive box packaging designed to promote
consumer demand.
Partially offsetting this increase in product costs, as a percentage of net
sales, were cost decreases, as a percentage of net sales, of:
o 2.7% in royalty expense due to the non-recurrence of the prior year
quarter's accelerated expensing of royalty costs associated with end of
lifecycle titles;
o 1.0% in freight expense traceable to decreased shipments to Canadian
distributors and to retailers that require direct product deliveries to
individual store locations; and
o 1.7% in other costs of sales related to a lower provision for inventory
obsolescence traceable to increased sales to discount retailers at
prices above traditional liquidation levels.
Product Development
Product development expenses consist of personnel costs related to product
management, content acquisition, quality assurance testing, packaging design and
website administration, along with outside services for product ratings, website
infrastructure maintenance and non-recoverable costs related to products not
achieving distribution into their intended retail channels.
The following table represents our product development expenses for the quarters
ended September 30, 2005 and 2004:
September 30, % of September 30, % of Increase %
2005 net sales 2004 net sales (Decrease) Change
- ------------------------------------------------------------------------------
$ 84,000 6.5% $ 239,000 20.3% ($ 155,000) (64.9%)
The $155,000 decrease in product development expenses for the quarter ended
September 30, 2005 resulted from the non-recurrence of the year ago quarter's
$122,000 write-off of capitalized costs related to the RealAge Games & Skills
title. Additionally, salary and related costs decreased by $25,000 due to
headcount reductions traceable to employee turnover at the end of fiscal 2005.
As we begin to implement our strategy of publishing higher quality, and
higher-priced PC game titles, as well as seeking to publish titles for other
gaming platforms, such as console and handheld game devices, we expect our
product development expenses to increase due to the increased complexity of game
play and additional quality control and other procedures that will be required
to develop these more technically sophisticated games.
Selling, General and Administrative
Selling, general and administrative expenses consist primarily 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, in addition to other administrative
expenses.
The following table represents our selling, general and administrative expenses
for the quarters ended September 30, 2005 and 2004:
September 30, % of September 30, % of Increase %
2005 net sales 2004 net sales (Decrease) Change
- ------------------------------------------------------------------------------
$ 568,000 43.9% $ 571,000 48.5% ($3,000) (0.5%)
The $3,000 decrease in selling, general and administrative expenses for the
quarter ended September 30, 2005 was primarily attributable to lower commission
expense incurred with independent sales representatives as a result of lower
product sales to certain retailers, which was partially offset by an increase in
legal expense associated with the acquisition of the assets of Cinemaware.
Interest Income, net
The following table represents our net interest income for the quarters ended
September 30, 2005 and 2004:
September 30, % of September 30, % of Increase %
2005 net sales 2004 net sales (Decrease) Change
- ------------------------------------------------------------------------------
$ 8,000 0.6% $ 1,000 0.1% $ 7,000 N/M
Benefit for Income Taxes
The following table represents our benefit for income taxes for the quarters
ended September 30, 2005 and 2004:
September 30, % of September 30, % of Increase %
2005 net sales 2004 net sales (Decrease) Change
- ------------------------------------------------------------------------------
$ - 0 - N/A $ 18,000 1.5% ($ 18,000) (100%)
Weighted Average Common Shares
For the quarter ended September 30, 2005, the weighted average common shares
outstanding on the basic and diluted basis increased to 10,906,754, compared to
10,102,673 for the quarter ended September, 2004. This 804,081 increase in the
basic and diluted basis calculations of weighted average common shares resulted
from the issuance of the Company's shares of common stock related to the
exercise of common stock options throughout fiscal 2005. Both quarterly periods'
calculation for the diluted basis excluded common share equivalents based on
their potential anti-dilutive impact on the periods' net losses.
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 supersedes
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 became effective during the first
interim period beginning after June 15, 2005. The adoption of SFAS No. 123
(revised 2004) did not have a material impact on our financial statements.
In November 2004, the FASB issued SFAS No. 151, "Inventory Costs - an amendment
of ARB No. 43, Chapter 4". SFAS No. 151 amends the guidance in Accounting
Research Bulletin ("ARB") No. 43, "Restatement and Revision of Accounting
Research Bulletins", Chapter 4, "Inventory Pricing", to clarify the accounting
for abnormal amounts of idle facility expense, freight, handling costs, and
wasted material (spoilage) and requires that those items be recognized as
current-period charges. SFAS No. 151 also requires that allocation of fixed
production overheads to the costs of conversion be based on the normal capacity
of the production facilities. SFAS No. 151 became effective for inventory costs
incurred during fiscal years beginning after June 15, 2005. The adoption of SFAS
No. 151 did not have a material impact on our financial statements.
Liquidity and Capital Resources
As of
September 30,
-------------------------
2005 2004 Change
------------------------------------
Cash and cash equivalents $ 2,181,000 $ 1,554,000 $ 627,000
=========== =========== =========
Percent of total assets 51.9% 38.0%
===== =====
Quarters Ended
September 30,
------------------------
2005 2004 Change
-----------------------------------
Cash used in operating activities ($ 229,000) ($ 192,000) ($ 37,000)
Cash used in investing activities (2,000) (9,000) 7,000
Cash provided by financing activities - 0 - 13,000 (13,000)
---------- --------- --------
Net decrease in cash and cash equivalents ($ 231,000) ($ 188,000) ($ 43,000)
========== ========= ========
Changes in Cash Flow, Operating Activities
During the quarter ended September 30, 2005, we had $229,000 in cash used in
operating activities compared to $192,000 in cash used in operating activities
for the quarter ended September 30, 2004. The $229,000 in cash used in operating
activities for the quarter ended September 30, 2005 resulted primarily from
increases in net accounts receivable and prepaid and other expenses, along with
the $54,000 net loss realized during this period, which cash uses were partially
offset by cash sources from an increase in accounts payable and a decrease in
net inventory.
Accounts Receivable, net
------------------------
At September 30, 2005, gross accounts receivable totaled $1.5 million, which was
an increase from $0.8 million at June 30, 2005. This $0.7 million increase in
gross accounts receivable was due to higher gross sales in the first quarter of
fiscal 2006 as compared to the fourth quarter of fiscal 2005, along with cash
collections from the June 30, 2005 receivable balance.
At September 30, 2005, the allowance for product returns and price markdowns
increased to $0.7 million, compared to $0.5 million at June 30, 2005. This $0.2
million increase in the allowance for product returns and price markdowns
resulted from the current quarter's product returns and price markdowns
provision, related to increased gross sales, exceeding the actual product
returns and price markdowns that were processed during this period.
Generally, we have been able to collect our net accounts receivable in the
ordinary course of business, but periodically we have experienced slowness in
distributor and retailer receivable collections. Throughout each reporting
period, we monitor our receivable accounts and communicate with our distributors
and retailers in order to expedite their payments of past due amounts or to
process receivable credits for authorized 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 receivable payments to us, the
realizable value of our net accounts receivable is continually reviewed in order
to help anticipate future liquidity issues that could result from our inability
to collect a net receivable balance in the normal course of business.
We continue to have a concentrated customer base consisting of a few large
software distributors and retailers, with Atari historically representing the
majority of our net accounts receivable. At September 30, 2005, Atari's net
accounts receivable balance totaled $402,000, or 52%, of our total net accounts
receivable. Additionally during the quarter ended September 30, 2005, we
collected $138,000 in receivable payments from Atari, which was approximately
twice the size of the next largest amount we collected from any other customer
during this period. We believe that our ability to collect, in a timely manner,
the net account receivable owed by Atari will remain critical for us to be able
to meet our financial obligations and to fund our operations. If at any time
Atari would become unable or unwilling to make receivable payments to us in a
timely manner, our ability to continue ongoing operations would be significantly
impaired.
Inventory, net
--------------
As of September 30, 2005, our net inventory value remained high relative to
historical levels and in relation to our net accounts receivable balance.
Throughout fiscal 2006, we plan to market various promotional programs designed
to reduce excess inventory stock levels, increase collectible net accounts
receivable, and be a source of funds to help support our operations. During the
three months ended September 30, 2005, our net inventory decreased by $82,000,
or 9%, and was a result of increased sales of end of lifecycle titles to
inventory liquidators and discount retailers, combined with lower warehouse
stock levels for most of our titles.
Prepaid and other expenses
--------------------------
During the quarter ended September 30, 2005, our prepaid and other expenses
increased by $53,000, which related to upfront annual payments for corporate
insurances, partially offset by a refund of prepaid federal taxes.
Accounts Payable
----------------
During the quarter ended September 30, 2005, our accounts payable increased by
$254,000, which resulted primarily from inventory purchases to support higher
sales volumes.
Accrued Expenses
----------------
During the quarter ended September 30, 2005, our accrued expenses increased by
$21,000 due to accruals for un-invoiced inventory deliveries from trade vendors
we received during this period, in addition to increased accrued royalties to
third-party software developers. Partially offsetting these increases in accrued
expenses was a decrease in the amount of customer credit balances reclassified
from our net accounts receivable.
Changes in Cash Flow, Non-Operating Activities
During the quarter ended September 30, 2005, we had net cash used in investing
activities of $2,000 for equipment purchases for our computer network, compared
to $9,000 in net cash used in investing activities during the prior year's
quarter for similar expenditures.
During the quarter ended September 30, 2005, we had no financing activities
compared to the quarter ended September 30, 2004, when we had $13,000 in cash
provided by financing activities that related to cash proceeds we received from
the exercise of options to purchase shares of the Company's common stock.
Credit Facility
In November 2004, we renewed our credit facility agreement with Hudson United
Bank ("HUB"), which matures on December 1, 2005. This credit facility was
established to provide working capital for our operations. We expect to renew
this facility before its expiration date. Amounts outstanding under this credit
facility are charged interest at one-half of one percent above HUB's current
prime rate and such interest is due monthly. Our access to these funds is
limited to the lesser of $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. At
September 30, 2005 we had access to approximately $580,000 under this credit
facility, based on the prescribed calculation of seventy-five percent of
qualified accounts receivable as of that date. This credit facility is secured
by all of the Company's assets and requires us, among other things, to maintain
certain financial covenants to be tested quarterly.
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. At September 30, 2005, we had future
operating lease commitments of $141,000, 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 we begin to implement our
strategy of publishing higher quality, and higher-priced game titles for the PC,
and seek opportunities to publish titles for console and handheld game devices,
we expect our advance royalty payments to significantly increase and represent a
greater use of available cash. As of September 30, 2005, we had future
commitments to pay $53,000 in advance licensing and royalty payments to
third-party licensors and software developers as reflected in the table below.
The following table represents a summary of our off-balance sheet contractual
obligations and commitments, which are expected to be funded by cash flows from
operations.
Payments Due by Period
----------------------------------------------------------
Less than 1-3 3-5 More than
Contractual Obligations Total 1 year years years 5 years
- -------------------------------------------------------------------------------------
Operating leases $ 141,000 $ 64,000 $ 77,000 $ - 0 - $ - 0 -
Advanced royalties 53,000 40,000 13,000 - 0 - - 0 -
- -------------------------------------------------------------------------------------
Totals $ 194,000 $ 104,000 $ 90,000 $ - 0 - $ - 0 -
========= ========= ======== ======= ========
Liquidity Risk
Our ability to achieve positive cash flow remains essential to our survival as a
going concern because access to our existing credit facility is limited to the
lesser of $750,000 or 75% of our qualified accounts receivable, which at
September 30, 2005 amounted to approximately $580,000, based on the prescribed
calculation as of that date. In particular, our ability to achieve positive cash
flow depends upon a variety of factors, including the timing of the collection
of net accounts receivable, the creditworthiness of our software distributors
and retailers, sell-through of our products to consumers, and the costs of
developing, producing, distributing, marketing and promoting our software
titles.
There are significant challenges that we will need to continue to successfully
manage in order to fund our operations in the future. These challenges include,
but are not limited to, maintaining commercially viable relationships with our
distributors and retailers, collecting timely receivable payments from our
concentrated group of distributors and retailers, and maintaining acceptable
payment terms with our trade vendors. For example, our liquidity would be
severely impacted if Atari, for any reason, did not make receivable payments to
us on a timely basis.
Additionally, there are market factors beyond our control that could
significantly affect our operating cash flow. The most significant of these
market factors are the shelf space allocated to our products at retail and the
market acceptance of our titles, as evidenced by actual sell-through results of
our titles to consumers. If major retailers where our products are sold further
reduce or eliminate entirely the shelf space allocated to $9.99 retail priced 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, we could then 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 distributor
replenishment orders for our products. If we experienced a negative trend in any
of these factors, we may not be able to achieve positive cash flow.
Also, as we implement our strategy of publishing higher quality, and
higher-priced game titles for the PC, console and handheld game devices, we may
need to seek additional funds to finance: increased advanced royalty payments or
substantial content acquisition costs needed to obtain higher quality games on
various gaming platforms; upfront payments required by console platform
manufacturers to order production units; greater product development costs to
finalize titles for retail release; and larger marketing expenditures to more
aggressively promote the retail release of key titles. Additional outside
financing to support our operations may not be available if and when we need it.
Even if such financing were available from a bank or other financing source,
such financing may cause significant stockholder dilution or may have other
costs associated with such financing that would not be commercially acceptable
to us.
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.
Item 3. Controls and Procedures
(a) Disclosure Controls and Procedures. Under the supervision and with the
participation of our Chief Executive Officer and Chief Financial Officer, we
carried out an evaluation of the effectiveness of our disclosure controls and
procedures, as such term is defined in Rules 13a-15(e) and 15d-15(e) under the
Securities Exchange Act of 1934, as of September 30, 2005 (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 first
quarter ended September 30, 2005 that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.
Part II. Other Information
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
- -------------- ----------------------
31.1 Certification of Gerald W. Klein as President and Chief
Executive Officer of eGames, Inc. pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002.
31.2 Certification of Thomas W. Murphy as Vice President and Chief
Financial Officer of eGames, Inc. pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002.
32.1 Certification of Gerald W. Klein as President and Chief
Executive Officer of eGames, Inc. pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002.
32.2 Certification of Thomas W. Murphy as Vice President and Chief
Financial Officer of eGames, Inc. pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002.
SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
eGames, Inc.
(Registrant)
Date: November 14, 2005 /s/ Gerald W. Klein
----------------- --------------------
Gerald W. Klein, President, Chief
Executive Officer and Director
Date: November 14, 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: November 14, 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: November 14, 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 first quarter ended September 30, 2005 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
Date: November 14, 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 first quarter ended September 30, 2005 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
Date: November 14, 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.