UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
(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, 1998.
or
[_] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 for the transition period from ____________ to ____________.
Commission File No. _______
DIVA SYSTEMS CORPORATION
(Exact name of Registrant as specified in its charter)
Delaware 94-3226532
(State or other jurisdiction of (IRS Employer
Incorporation or organization) Identification Number)
333 Ravenswood Avenue, Building 205
Menlo Park, California 94025
(Address of principal executive offices)
(650) 859-6400
(Registrant's telephone number, including area code)
Indicate by check mark whether the Registrant (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 the number of shares outstanding of each of the issuer's classes
of common stock, as of February 28, 1999.
Title of each class Outstanding at February 28, 1999
------------------- --------------------------------
Common Stock, $.001 par value 16,568,524
Class C Common Stock, $.001 par value 857,370
DIVA SYSTEMS CORPORATION
Quarterly Report on Form 10-Q
Table of Contents
Quarter Ended December 31, 1998
Page No.
--------
PART I - FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements (Unaudited)
Consolidated Balance Sheet at December 31, 1998 and June 30, 1998
Consolidated Statement of Operations for the three and six months
Ended December 31, 1998 and 1997
Consolidated Statement of Cash Flows for the six months ended
December 31, 1998 and 1997
Notes to Consolidated Financial Statements
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
PART II - OTHER INFORMATION
Item 2. Changes in Securities and Use of Proceeds
Item 6. Exhibits and Reports on Form 8-K
Signatures
PART I
ITEM 1. FINANCIAL STATEMENTS
DIVA SYSTEMS CORPORATION
(A Development Stage Company)
CONSOLIDATED BALANCE SHEET
(In thousands, except share data)
(Unaudited)
Assets December 31, 1998 June 30, 1998
------ ----------------- -------------
Current assets:
Cash and equivalents $ 112,045 $ 167,549
Short-term investments 56,311 30,015
Prepaid expenses 1,137 694
--------- ---------
Total current assets 169,493 198,258
Property and equipment, net 21,408 19,349
Debt issuance costs, net 8,843 9,524
Prepaid licenses 219 230
Deposits and other assets 358 354
Intangible asset, net 401 490
--------- ---------
Total assets $ 200,722 $ 228,205
========= =========
Liabilities, Redeemable warrants and Stockholders' Deficit
----------------------------------------------------------
Current liabilities:
Accounts payable $ 4,423 $ 3,047
Other current liabilities 904 1,300
--------- ---------
Total current liabilities 5,327 4,347
Notes payable 258,744 243,031
--------- ---------
Total liabilities 264,071 247,378
--------- ---------
Redeemable warrants 1,661 1,139
--------- ---------
Stockholders' equity (deficit):
Preferred stock, $.001 par value; 30,000,000 shares authorized;
21,382,932 and 21,372,287 shares issued and outstanding
at December 31, 1998 and June 30, 1998, respectively. 21 21
Common stock, $.001 par value; 60,000,000 shares authorized;
17,379,669 and 17,200,178 shares issued and outstanding
at December 31, 1998 and June 30, 1998, respectively. 17 17
Additional paid-in capital 117,405 115,759
Deferred compensation (1,668) --
Deficit accumulated during the development stage (180,785) (136,109)
--------- ---------
Total stockholders' equity (deficit) (65,010) (20,312)
--------- ---------
Total liabilities and stockholders' deficit $ 200,722 $ 228,205
========= =========
The accompanying notes are an integral part of these consolidated financial
statements.
1
DIVA SYSTEMS CORPORATION
(A Development Stage Company)
CONSOLIDATED STATEMENT OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)
Three Months Ended December 31, Six Months Ended December 31,
--------------------------------- -------------------------------
1998 1997 1998 1997
------------- ------------ ------------- ------------
Revenue $ 57 $ 5 $ 120 $ 5
Operating expenses:
Programming 2,068 1,428 3,939 2,454
Operations 1,936 1,077 4,102 1,783
Engineering and development 6,185 2,776 11,159 7,527
Sales and marketing 1,381 951 2,606 1,610
General and administrative 3,819 2,245 6,792 3,517
Depreciation and amortization 2,446 1,071 4,692 2,094
Amortization of intangible assets 45 -- 89 --
Acquired in-process research & -- -- -- --
development
-------- -------- ------------- ------------
Total operating expenses 17,880 9,548 33,379 18,985
-------- -------- -------- --------
Net operating loss (17,823) (9,543) (33,259) (18,980)
-------- -------- -------- --------
Other (income) expense, net:
Equity in loss of investee -- (444) -- (1,273)
Interest income 2,317 632 4,991 1,405
Interest expense (8,387) (958) (16,408) (1,703)
-------- -------- -------- --------
Total other (income) expense, net (6,070) (770) (11,417) (1,571)
-------- -------- -------- --------
Net loss before extraordinary item (23,893) (10,313) (44,676) (20,551)
Extraordinary item:
Loss on early extinguishment of debt -- -- -- --
-------- -------- -------- --------
Net loss $(23,893) $(10,313) $(44,676) $(20,551)
Accretion of redeemable warrants (137) (978) (522) (1,148)
-------- -------- -------- --------
Net loss attributable to common stockholders $(24,030) $(11,291) $(45,198) $(21,699)
======== ======== ======== ========
Basic and diluted net loss per share:
Loss before extraordinary item $1.40 $0.70 $2.65 $1.34
Extraordinary loss-early extinguishment
of debt -- -- -- --
-------- -------- -------- --------
Net loss per share $1.40 $0.70 $2.65 $1.34
======== ======== ======== ========
Shares used in per share computation 17,116 16,255 17,063 16,171
======== ======== ======== ========
Period from
July 1, 1995
(Inception)
to
December 31, 1998
-----------------
Revenue $ 202
Operating expenses:
Programming 13,610
Operations 9,984
Engineering and development 49,427
Sales and marketing 11,021
General and administrative 20,499
Depreciation and amortization 10,875
Amortization of intangible assets 134
Acquired in-process research & 28,382
development ---------
Total operating expenses 143,932
---------
Net operating loss (143,730)
---------
Other (income) expense, net:
Equity in loss of investee (3,354)
Interest income 11,098
Interest expense (34,123)
---------
Total other (income) expense, net (26,379)
---------
Net loss before extraordinary item (170,109)
Extraordinary item:
Loss on early extinguishment of debt 10,676
---------
Net loss $(180,785)
---------
Accretion of redeemable warrants (1,377)
---------
Net loss attributable to common stockholders $(182,162)
=========
Basic and diluted net loss per share:
Loss before extraordinary item $11.73
Extraordinary loss-early extinguishment
of debt 0.73
---------
Net loss per share $12.46
=========
Shares used in per share computation 14,626
=========
The accompanying notes are an integral part of these consolidated financial
statements.
2
DIVA SYSTEMS CORPORATION
(A Development Stage Company)
CONSOLIDATED STATEMENT OF CASH FLOWS
(In thousands)
(Unaudited)
Six Months Ended December 31, Inception to date
------------------------------- ------------------
1998 1997 December 31, 1998
------------- ------------ -----------------
Cash flows from operating activities
Net loss $(44,676) $(20,551) $(180,785)
Adjustments to reconcile net loss to net cash used in
operating activities:
Acquired in-process research and development -- -- 28,382
Depreciation 4,692 2,094 10,875
Amortization of intangible assets 89 -- 134
Equity in loss of investee -- 1,273 3,354
Write off of fixed asset, net 1,161 -- 1,161
Amortization of debt issuance costs and accretion
of discount on notes payable 16,404 1,870 34,064
Amortization of deferred stock compensation 318 -- 318
Issuance of stock for research and development -- -- 240
Extraordinary loss -- -- 10,676
Changes in operating assets and liabilities:
Prepaid expenses and other current assets (432) (354) (1,292)
Accounts payable 1,376 (756) 1,796
Payable to related party -- 372 --
Other current liabilities (396) -- 904
-------- -------- ---------
Net cash used in operating activities (21,464) (16,052) (90,173)
-------- -------- ---------
Cash flows from investing activities
Purchases of property and equipment (7,912) (6,877) (29,888)
Deposits on property and equipment (4) -- (6,611)
Purchases of short-term investments (26,296) (2,267) (56,311)
Cash acquired in business combination -- -- 402
Purchase of Norstar -- -- (3,358)
Restricted cash released -- 3,230 18,230
-------- -------- ---------
Net cash used in investing activities (34,212) (5,914) (77,536)
-------- -------- ---------
Cash flows from financing activities
Issuance of preferred stock -- 45,980 73,860
Exercise of stock options 182 153 565
Issuance of common stock -- -- 56
Proceeds from notes payable, net of issuance costs -- -- 205,302
Payments on notes payable (10) -- (29)
-------- -------- ---------
Net cash provided by financing activities 172 46,133 279,754
-------- -------- ---------
Net increase (decrease) in cash and cash equivalents (55,504) 24,167 112,045
Cash and cash equivalents at beginning of period 167,549 234 --
-------- -------- ---------
Cash and cash equivalents at end of period $112,045 $ 24,401 $ 112,045
======== ======== =========
The accompanying notes are an integral part of these consolidated
financial statements.
3
DIVA SYSTEMS CORPORATION
(A Development State Company)
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 1-The Company And Basis Of Presentation
DIVA Systems Corporation (the "Company"), a Delaware corporation, was
formed in July 1995 to design, develop, and market a proprietary video-on-demand
service for the cable television industry. The Company is in the development
stage, and its primary activities to date have included performing research and
development, licensing program content, manufacturing the necessary equipment,
developing a service offering, establishing strategic alliances, deploying
service trials and limited commercial launches with cable operators and raising
capital.
The interim unaudited financial statements as of December 31, 1998, and for
the six months ended December 31, 1997 and 1998, and for the period from July 1,
1995 (inception) to December 31, 1998, have been prepared on substantially the
same basis as the Company's audited financial statements and include all
adjustments, consisting only of normal recurring accruals, that, in the opinion
of management, are necessary for a fair presentation of the financial
information set forth herein. The results of operations for current interim
periods are not necessarily indicative of results to be expected for the current
year or any other period.
These interim unaudited financial statements should be read in conjunction
with the Company's annual financial statements for the year ended June 30, 1998.
Note 2-Basis and Diluted Net Loss Per Share
Basic and diluted net loss per share is computed using net loss adjusted
for the accretion of the redeemable warrants and the weighted-average number of
outstanding shares of common stock. Potentially dilutive securities, including
options, warrants, restricted common stock, and preferred stock, have been
excluded from the computation of diluted net loss per share because the effect
of the inclusion would be antidilutive.
Note 3-Acquisition of SRTC
On January 15, 1998, the Company and Sarnoff Real Time Corporation ("SRTC")
executed an Agreement and Plan of Reorganization setting forth their agreement
to merge SRTC into the Company, with the Company as the surviving corporation
(the "SRTC Transaction"). On that date, the Company held approximately 40% of
the outstanding capital stock of SRTC. In exchange for the remaining
approximately 60% of the issued and outstanding stock of SRTC, the Company
issued 3,277,539 shares of Series AA preferred stock valued at $6.50 per share.
The fair value was determined by the Company's Board of Directors based on the
most recent sales of preferred securities and the then current financial
condition of the Company, as well as other business considerations. In
addition, the Company reserved 276,792 shares of its Series AA preferred stock
for issuance upon exercise of options assumed by the Company in the transaction.
These options
4
were valued at $1,744,000 using the Black-Scholes option pricing model and were
included in the purchase price. Assumptions used were as follows: Expected life
of 3 years; Volatility of 90%; Dividend yield of 0%; Risk-free rate of 5.62%.
The Company also reserved 380,767 shares of its common stock for use in
connection with the future issuance of options to SRTC employees. The purchase
price of $23,049,000 is comprised of the fair value of the preferred stock
issued ($21,305,000) and the fair value of options assumed ($1,744,000).
The Company completed the SRTC Transaction in April 1998. The Company
accounted for the merger as a purchase, and, accordingly, the operating results
of SRTC have been included in the Company's consolidated financial statements
since the date of acquisition. The Company initially allocated the purchase
price based on an appraisal by an independent third party using the cost
approach, which is the approach often used to value an early stage technology.
The purchase price of $23,049,000 was allocated as follows: $2,886,000 to the
fair value of acquired assets; $4,693,000 to assumed liabilities; $535,000 to
assumed work force; and $24,321,000 to acquired in-process research and
development. The acquired in-process research and development has not yet
reached technological feasibility and has no future alternative use until it is
further developed. The Company believes it will have to incur a significant
amount of research and development to develop the in-process technology into a
commercially viable product. There were no contingent payments, options, or
commitments included in the purchase.
The following unaudited pro forma consolidated results of operations have
been prepared as if the acquisition of SRTC had occurred as of the beginning of
fiscal 1998:
Three months ended Six months ended
(in thousands, except per share data) December 31, 1997 December 31, 1997
------------------ -----------------
Net loss.................................................... $ 37,390 $ 48,878
Basic and diluted net loss per share........................ $ 2.30 $ 3.02
The pro forma results include amortization of the assumed work force of
$45,000 and $89,000 for the three months ended December 31, 1997 and the six
months ended December 31, 1997, respectively. The pro forma results are not
necessarily indicative of what actually would have occurred if the acquisition
had been completed as of the beginning of each of the fiscal periods presented,
nor are they necessarily indicative of future consolidated results.
5
Item 2. Management's Discussion And Analysis Of Financial Condition And
Results Of Operations
The following discussion of the financial condition and results of
operations of DIVA Systems Corporation ("DIVA" or the "Company") should be read
in conjunction with the Company's Consolidated Interim Financial Statements for
the six months ended December 31, 1998. This discussion contains forward-
looking statements that involve risks and uncertainties, including but not
limited to, certain assumptions regarding increases in customers, revenues and
certain expenses. Forward-looking statements are identified with an asterisk
(*) and reflect the Company's current expectations. Although the Company
believes that its plans, intentions and expectations reflected in such forward-
looking statements are reasonable, it can give no assurance that such plans,
intentions or expectations will be achieved. Actual results will differ and
such differences may be material. All forward-looking statements attributable to
the Company or persons acting on its behalf are expressly qualified in their
entirety by the cautionary statements set forth below and in "-Factors Affecting
Operating Results."
Overview
DIVA provides a true video-on-demand ("VOD") service over the cable
television infrastructure. The Company's VOD service offers immediate in-home
access to a diverse and continuously available selection of hundreds of movies
with VCR functionality (i.e., pause, play, fast forward and rewind) and high
quality digital picture and sound. DIVA's proprietary technology is designed to
provide an economically viable turnkey digital VOD system that offers movies at
prices comparable to those charged for videotape rentals, pay-per-view and near
video-on-demand movies, but with greater convenience and functionality.
The Company was founded July 1, 1995 and is still in the development stage.
Since inception, the Company has devoted substantially all of its resources to
developing its VOD system, establishing strategic relationships, negotiating
deployment agreements, carrying out initial marketing activities and
establishing the operations necessary to support the commercial launch of the
Company's VOD service. Through December 31, 1998, the Company has generated
minimal revenues, has incurred significant losses and has substantial negative
cash flow, primarily due to the engineering and development and start-up costs
required to develop its VOD service. Since inception through December 31, 1998,
the Company had an accumulated deficit of $180.8 million. The Company currently
intends to increase its operating expenses and its capital expenditures in order
to continue to deploy, develop and market its VOD service.* As a result, the
Company expects to incur substantial additional net losses and negative cash
flow for at least the next several years.*
Results of Operations
Since its inception, the Company has engaged principally in technology
development and activities related to the startup of business operations.
Accordingly, the Company's historical revenues and expenditures are not
necessarily indicative of, and should not be relied upon as an indicator of,
revenues that may be attained or expenditures that may be incurred by the
Company in future periods.
6
Revenues
Revenues consist of per-movie viewing fees, monthly service fees and the
sale of monthly subscription packages. The majority of revenues consists of
per-movie viewing fees paid by customers to view movies on demand. The Company
initiated the commercial launch of its VOD service on September 29, 1997. As of
December 31, 1998, the Company's VOD service was deployed commercially at four
multiple system operator ("MSO") locations. Revenue for the six months ended
December 31, 1997 and 1998 was $5,000 and $120,000, respectively.
DIVA realizes monthly revenue pursuant to long-term revenue sharing
agreements with MSOs. Generally, the timing and extent of deployment under each
agreement is conditioned on a successful initial deployment phase, followed by a
staged rollout in the applicable MSO system based on an agreed upon schedule.
DIVA incurs the capital expenditures necessary to deploy its VOD system a
substantial period of time prior to realizing any significant revenue.
The Company recognizes revenues under its MSO agreements only when its VOD
system is successfully integrated and operating and customer billing commences.
Accordingly, the recognition of revenues will lag the announcement of a new
cable operator agreement by at least the time necessary to install the service
and to achieve meaningful penetration and movie buy rates. In addition, the
Company believes the extent and timing of such revenues may fluctuate based on a
number of factors including the success and timing of deployment and the
Company's success in obtaining and retaining customers. Revenues are expected
to increase as the Company successfully deploys additional VOD systems and
achieves higher DIVA customer penetration.* The Company has a limited number of
customers and does not expect this number to increase substantially until the
Company deploys its VOD service utilizing industry standard set-top boxes.*
Operating Expenses
Programming expense. Programming expense includes license fees payable to
content providers, costs for the acquisition and production of digitally encoded
programming content (i.e. movies, videos, previews, promotions, etc.) and
content duplication and distribution expenses. Programming expense was $1.4
million and $2.1 million for the three months ended December 31, 1997 and 1998,
respectively, and $2.5 million and $3.9 million for the six months ended
December 31, 1997 and 1998, respectively. The increase in programming expenses
was primarily attributable to the Company's recent multiple commercial
deployments and an increase in the overall volume of programming content in the
Company's library as well as increased personnel costs in the area of program
acquisition and program production services. To date, license fees payable to
content providers have been minimal.
Operations expense. Operations expense includes the cost of field
operations, both for initial launches and for the ongoing operations of the
Company's VOD service. These costs include technical support, customer service
training and support, maintenance costs for headend equipment and other field
support costs. In addition, operations expense includes personnel and other
costs which support the Company's ongoing manufacturing relationships with
third-party manufacturers
7
for the Company's Sarnoff Server, DIVA converter units ("DCUs") and other
related hardware. Operations expense was $1.1 million and $1.9 million for the
three months ended December 31, 1997 and 1998, respectively. Operations expense
was $1.8 million and $4.1 million for the six months ended December 31, 1997 and
1998, respectively. The increase in operations expense is primarily attributable
to increased costs, including significant increases in personnel, to support the
Company's existing and future commercial deployments and to increased
manufacturing support costs, primarily in connection with manufacturing DCUs.
Engineering and Development Expense. Engineering and development expense
consists of salaries, consulting fees and other costs to support product
development, prototype hardware costs, ongoing system software and integration
and new services technology. To date, the most substantial portion of the
Company's operating expenses has been engineering and development expense.
Engineering and development expense was $2.8 million and $ 6.2 million for the
three months ended December 31, 1997 and December 31, 1998, respectively, and
$7.5 million and $11.2 million for the six months ended December 31, 1997 and
1998, respectively. Included in engineering and development expense for the six
months ended December 31, 1997 was approximately $2.8 million in one-time
prototype set-top box costs related to costs for materials and components
incurred by a third-party manufacturer which were expensed because the Company
has no future alternative use for the components. There was no comparable
expense for the six months ended December 31, 1998. The increase in engineering
and development expense between the six months ended December 31, 1997 and
December 31, 1998, net of the aforementioned one-time prototype costs, was
primarily due to the hiring of additional engineering personnel in connection
with the Company's further development and refinement of its VOD service
technology, including activities directed toward reducing the cost of its
technology. In addition, the Company has dedicated significant engineering and
development resources toward the integration of its VOD technology with various
industry adopted two-way digital platforms, including digital set-top boxes.
Included in engineering and development expense for the six months ended
December 31, 1998 was $3.0 million attributable to the Company's SRTD division
and $1.2 million in server prototype expenses. (The SRTD division was created as
result of the Company's acquisition of SRTC on April 1, 1998. The SRTD division
is responsible for the development and manufacture of the Company's VOD server.)
There were no comparable expenses for the six months ending December 31, 1997.
The Company intends to increase engineering and development expenses to fund
continued development and enhancements of its VOD service.* The Company believes
significant investments in engineering and development will be necessary to
remain competitive and to respond to market pressures.
Sales and Marketing Expense. Sales and marketing expense consists of the
costs of marketing DIVA's VOD system to MSOs and their customers, and include
business development and marketing personnel, travel expenses, trade shows,
consulting fees and promotional costs. In addition, sales and marketing expense
includes costs related to acquiring customers, such as telemarketing, direct
mailings, targeted advertising and promotional campaigns. Sales and marketing
expense was $951,000 and $1.4 million for the three months ended December 31,
1997 and 1998, respectively. Sales and marketing expense was $1.6 million and
$2.6 million for the six months ended December 31, 1997 and 1998, respectively.
The increase in sales and marketing expense was primarily the result of expanded
business development activity, increased promotional and product awareness
expenditures and increased consumer marketing and branding expenses in
8
connection with the Company's existing commercial deployments. The Company
expects sales and marketing expense to continue to increase as the Company
pursues and enters into new agreements.*
General and Administrative Expense. General and administrative expense
consists primarily of salaries and related expenses of management and
administrative personnel, professional fees and general corporate and
administrative expenses. General and administrative expense covers a broad range
of the Company's infrastructure including corporate functions such as executive
administration, finance, legal, human resources and facilities. In addition,
general and administrative expense includes costs associated with the
development, support and growth of the Company's complex information system
infrastructure.
General and administrative expense was $2.2 million and $3.8 million for
the three months ended December 31, 1997 and 1998, respectively. General and
administrative expense was $3.5 million and $6.8 million for the six months
ended December 31, 1997 and 1998, respectively. The increase in general and
administrative expense was primarily the result of increased personnel necessary
to support the growth of the Company in all phases of its operations, including
existing and future commercial deployments. General and administrative expenses
are expected to increase due to the addition of personnel required to support
expansion of the Company's business operations.*
Depreciation and Amortization. Depreciation and amortization expense
includes depreciation of property and equipment, including Sarnoff Servers and
other headend hardware. Generally, depreciation is calculated using the
straight-line method over the estimated useful lives of the assets, which range
from three to five years. Depreciation and amortization expense was $1.1
million and $2.4 million for the three months ended December 31, 1997 and 1998,
respectively, and $2.1 million and $4.7 million for the six months ended
December 31, 1997 and 1998, respectively. The increase is primarily due to the
increased number of servers and related hardware operating commercially at MSO
headends for the Company's VOD service. Depreciation and amortization expenses
are expected to continue to increase substantially due to planned expenditures
for capital equipment and other capital costs associated with the deployment and
expansion of the Company's business.*
Amortization of Intangible Assets. Amortization of intangible assets
represents the amortization expense related to the intangible assets, consisting
of the assumed and assembled workforce, which were recorded as a result of the
Company's acquisition of SRTC on April 1, 1998. Intangible assets are amortized
on a straight-line basis over three years. Amortization of intangible assets
was $89,000 for the six months ended December 31, 1998. There was no comparable
expense for the six months ended December 31, 1997.
Other Income and Expense
Other income and expense primarily consists of interest income and interest
expense. Interest income consists of earnings on cash, cash equivalents and
short-term investments. Interest income was $632,000 and $2.3 million for the
three months ended December 31, 1997 and 1998, respectively and $1.4 million and
$5.0 million for the six months ended December 31, 1997 and
9
1998, respectively. The increase in interest income is the result of increased
cash and cash equivalents balances, which are invested in short-term interest
bearing accounts, and an increase in short-term investments over the comparable
prior period. Interest expense consists of accreted interest on the Company's
indebtedness. Interest expense increased substantially from $958,000 for the
three months ended December 31, 1997 to $8.4 million for the three months ended
December 31, 1998. Interest expense increased from $1.7 million for the six
months ended December 31, 1997 to $16.4 million for the six months ended
December 31, 1998. The increase in interest expense was due to the significant
increase in the Company's debt as a result of the offering of the Company's 12-
5/8% Senior Discount Notes due 2008 (the "1998 Notes") which was completed on
February 19, 1998. The 1998 Notes were issued at a substantial discount from
their aggregate principal amount at maturity of $463.0 million. Although cash
interest is not payable on the 1998 Notes prior to September 1, 2003, the
Company's interest expense includes the accretion of such interest expense. The
carrying amount of the 1998 Notes will accrete to its face value by March 1,
2003. Beginning September 1, 2003, cash interest will be payable on the notes
semi-annually in arrears on each March 1/st/ and September 1/st/ at the rate of
12 5/8% per annum.
Liquidity and Capital Resources
From inception through December 31, 1998, the Company has financed its
operations primarily through the gross proceeds of private placements totaling
approximately $76.3 million of equity and $250.0 million of high yield debt
securities, net of repayments. As of December 31, 1998, the Company had cash
and cash equivalents and short-term investments totaling $168.4 million.
In May 1996, the Company received $25.0 million in gross proceeds from the
sale of 47,000 units, consisting of subordinated discount notes due 2006 (the
"1996 Notes") with an aggregate principal amount at maturity of $47.0 million
and warrants to purchase an aggregate of 1,898,800 shares of common stock.
Aggregate proceeds of $285,000 were attributed to these warrants. In connection
with the new offering of units described below, the Company subsequently retired
all of the 1996 Notes in a debt exchange.
In July and August 1996, the Company completed the sale of Series C
Preferred Stock for approximately $25.9 million in gross proceeds.
In August and September 1997, the Company completed the sale of Series D
Preferred Stock for approximately $47.4 million in gross proceeds.
On February 19, 1998, the Company received $250.0 million in gross proceeds
from an offering of 463,000 units consisting of the 1998 Notes with an aggregate
principal amount at maturity of $463.0 million and warrants to purchase an
aggregate of 2,778,000 shares of common stock. Of these units, a total of
404,998 units were offered for sale and an additional 58,002 units were
exchanged for all the 1996 Notes. Each unit consists of one 1998 Note and three
warrants, each to purchase two shares of the Company's common stock at $0.005
per share. The 1998 Notes are senior unsecured indebtedness of the Company and
rank pari passu with any future unsubordinated unsecured indebtedness. The 1998
Notes will be senior to any future subordinated
10
indebtedness of the Company, but effectively will be subordinated to any secured
indebtedness of the Company.
The 1998 Notes were issued at a substantial discount from their aggregate
principal amount at maturity of $463.0 million. Although cash interest is not
payable on the 1998 Notes prior to September 1, 2003, the Company's interest
expense includes the accretion of such interest expense and the carrying amount
of the 1998 Notes will accrete to face value by March 1, 2003. Beginning
September 1, 2003, cash interest will be payable on the notes semi-annually in
arrears on each March 1 and September 1 at the rate of 12 5/8% per annum. There
are no principal payments due on the 1998 Notes prior to maturity on March 1,
2008.
The gross proceeds to the Company from the issuance of the 1998 Notes were
approximately $250.0 million. In connection with the offering, the Company
recorded approximately $18.1 million in additional paid-in capital representing
the fair value of the warrants calculated using the Black-Scholes option pricing
model. In addition, the Company recorded an extraordinary loss of approximately
$10.7 million resulting from the early extinguishment of the 1996 Notes. The
net proceeds from the offering of the 1998 Notes were approximately $200.0
million, after deducting placement fees and other offering costs and the early
extinguishment of the 1996 Notes.
In connection with the SRTC Transaction, $24.3 million of the purchase
price was allocated to acquired in-process research and development. At this
time, there have been no changes in assumptions used in the valuation of the
acquired in-process research and development. For the six-month period and
three-month period ended December 31, 1998, the Company has spent approximately
$5.5 million and $2.8 million, respectively, on further server development.
The Company expects to incur significant capital expenditures and operating
expenses in the future.* Capital expenditures include the Sarnoff Servers and
related headend equipment, and general capital expenditures associated with the
anticipated growth of the Company. The amount of capital expenditures will, in
part, be driven by the rate at which cable operators introduce the Company's VOD
service and the rate at which customers subscribe to the VOD service. In
addition to capital expenditures, the Company anticipates expending a
significant portion of its resources for sales and marketing, continued
development and enhancement of existing technology, development of new consumer
services and other expenses associated with the delivery of the Company's VOD
service to customers.* Actual capital requirements may vary from expectations
and will depend on numerous future factors and conditions, many of which are
outside of the Company's control, including, but not limited to (i) the ability
of the Company to meet its development and deployment schedules; (ii) the
accuracy of the Company's assumptions regarding the rate and extent of
commercial deployment and market acceptance by cable operators and customers;
(iii) the extent that cable operators choose to deploy industry standard, DIVA-
compatible set-top boxes; (iv) the number of customers choosing DIVA's VOD
service and their buying patterns; (v) the nature and penetration of new
services to be offered by the Company; (vi) unanticipated costs; and (vii) the
need to respond to competitive pressures and technological changes. The Company
believes that its cash, cash equivalents and short-term investments at December
31, 1998 will be sufficient to satisfy the Company's liquidity at least through
the end of its fiscal year.* Thereafter, the Company will need to raise
significant additional funds to support its operations. However, the Company may
need to raise additional funds earlier if its estimates of working capital
and/or capital expenditure requirements change or prove to be inaccurate. The
Company may also need to raise significant additional funds in order to respond
to unforeseen technological or marketing hurdles or to take advantage of
unanticipated opportunities. The Company has no present commitments or
arrangements assuring it of any future equity or debt financing, and there can
be no assurance that the Company will be able to obtain any such equity or debt
financing on favorable terms or at all. In the event that the
11
Company is unable to obtain such additional capital, the Company will be
required to delay the expansion of its business or take other actions that could
have a material adverse effect on the Company's business, operating results and
financial condition and its ability to achieve sufficient cash flow to service
its indebtedness. To the extent the Company raises additional cash by issuing
equity securities, existing stockholders of the Company will be diluted.
Financial Market Risks
The Company is exposed to financial market risks, including changes in
interest rates and marketable equity security prices. The Company typically does
not attempt to reduce or eliminate its market exposures on its investment
securities because the majority of the Company's investments are short-term.
The fair value of the company's investment portfolio or related income would
not be significantly impacted by either a 100 basis point increase or decrease
in interest rates due mainly to the short-term nature of the major portion of
the Company's investment portfolio.
All of the potential changes noted above are based on sensitivity analysis
performed on the Company's balances as of June 30, 1998.
Year 2000 Compliance
Many computer systems and software and electronic products are coded to accept
only two-digit entries in the date code field. These date code fields will need
to accept four digit entries to distinguish 21st century dates from 20th century
dates. As a result, computer systems and software ("IT Systems") and other
property and equipment not directly associated with information and billing
systems ("Non-IT Systems"), such as phones, other office equipment used by many
companies, including the Company and MSOs, may need to be upgraded, repaired or
replaced to comply with such "Year 2000" requirements.
The Company has conducted an internal review of most of its internal corporate
headquarters IT Systems, including finance, human resources, Intranet
applications and payroll systems. DIVA has contacted most of the vendors of its
internal corporate headquarters IT Systems to determine potential exposure to
Year 2000 issues and has obtained certificates from such vendors assuring Year
2000 compliance. Although the Company has determined that most of its principal
internal corporate headquarters IT Systems are Year 2000 compliant, certain of
such internal systems, including its Windows NT operating system and internal
networking systems is not Year 2000 compliant or has not been evaluated by the
Company. In addition, the Company has tested and analyzed its proprietary VOD
hardware and software for Year 2000 compliance. As a result of such testing and
analysis, the Company has verified that it does not expect to encounter Year
2000 compliance issues with respect to such proprietary VOD hardware and
software. To date, costs to the Company of Year 2000 compliance related to its
proprietary VOD hardware and software have been included with the Company's
overall engineering and development activities as a component of the overall
design of the Company's VOD service. Such costs have not been material to the
Company's financial position or results of operations.
12
The Company has appointed a task force (the "Task Force") to oversee Year
2000 issues. The Task Force is expected to review all IT Systems and Non-IT
Systems that have not been determined to be Year 2000 compliant and will attempt
to identify and implement solutions to ensure such compliance.* To date, the
Company has spent an immaterial amount to remediate its Year 2000 issues. The
Company presently estimates that the total cost of addressing its Year 2000
issues will be immaterial.* These estimates were derived utilizing numerous
assumptions, including the assumption that it has already identified its most
significant Year 2000 issues and that the plans of its third-party suppliers and
MSOs which currently deploy the Company's VOD service will be fulfilled in a
timely manner without cost to the Company. However, these assumptions may not be
accurate, and actual results could differ materially from those anticipated.
The Company has been informed by most of its suppliers and MSOs that
currently deploy its VOD service that such suppliers and MSOs will be Year 2000
compliant by the Year 2000. The Company has been informed that the companies
that perform billing services for MSOs may not be fully Year 2000 compliant. The
Company understands that these companies have devoted resources to becoming Year
2000 compliant. Any failure of these third parties systems to timely achieve
Year 2000 compliance could have a material adverse effect on the Company's
business operating results and financial condition and its ability to achieve
sufficient cash flow to service its indebtedness.
The Company has not determined the state of compliance of certain third-
party suppliers of services such as phone companies, long distance carriers,
financial institutions and electric companies, the failure of any one of which
could severely disrupt the Company's ability to carry on its business as well as
disrupt the business of the Company's customers.
Failure to provide Year 2000 compliant business solutions to MSOs or to
receive such business solutions from its suppliers could result in liability to
the Company or otherwise have a material adverse effect on the Company's
business, results of operations, financial condition and prospects. The Company
could be affected through disruptions in the operation of the enterprises with
which it interacts or from general widespread problems or an economic crisis
resulting from noncompliant Year 2000 systems. Despite the Company's efforts to
address the Year 2000 effect on its internal systems and business operations,
such effect could result in a material disruption of its business or have a
material adverse effect on its business, operating results and financial
condition and its ability to achieve sufficient cash flow to service its
indebtedness. The Company has not developed a contingency plan to respond to any
of the foregoing consequences of internal and external failures to be Year 2000,
but expects the Task Force to develop such a plan.
Recent Accounting Pronouncements
The Financial Accounting Standards Board (FASB) recently issued Statement
of Financial Accounting Standards (SFAS) No. 130, Reporting Comprehensive
Income. SFAS No. 130 establishes standards for reporting and displaying
comprehensive income and its components in financial statements. It does not,
however, require a specific format, but requires the Company to display an
amount representing total comprehensive income for the period in its
consolidated financial statements. For all periods presented, comprehensive loss
equals net loss.
13
The FASB also recently issued SFAS No. 131, Disclosures about Segments of
an Enterprise and Related Information. SFAS No. 131 establishes standards for
the way public business enterprises are to report information about operating
segments in annual financial statements and requires those enterprises to report
selected information about operating segments in interim financial reports. SFAS
No. 131 is effective for financial statements for fiscal years beginning after
December 15, 1997. The Company has determined that it does not have any
separately reportable business segments.
In March 1998, the American Institute of Certified Public Accountants
(AICPA) issued Statement of Position ("SOP") No. 98-1, "Software for Internal
Use," which provides guidance on accounting for the cost of computer software
developed or obtained for internal use. SOP No. 98-1 is effective for financial
statements for fiscal years beginning after December 15, 1998. The Company does
not expect that the adoption of SOP No. 98-1 will have a material impact on its
consolidated financial statements.
In April 1998, the AICPA issued SOP No. 98-5, "Reporting on the Costs of
Start-Up Activities," which provides guidance on the financial reporting of
start-up costs and organization costs. It requires costs of start-up activities
and organization costs to be expensed as incurred. SOP No. 98-5 is effective for
financial statements for fiscal years beginning after December 15, 1998. The
Company does not expect that the adoption of SOP 98-5 will have a material
impact on its consolidated financial statements.
Factors Affecting Operating Results
Substantial Leverage; Ability to Service Indebtedness; Restrictive
Covenants
As a result of the issuance of the 1998 Notes, the Company is highly
leveraged. As of December 31, 1998, the Company had total debt of approximately
$258.7 million, accreting to $463.0 million in 2003. The Company believes its
existing cash and cash equivalents will be sufficient to meet its cash
requirements at least through the end of its fiscal year.* Thereafter, the
Company will require substantial additional indebtedness primarily to fund
operating deficits and to finance the continued development and enhancement of
its VOD system and to fund capital expenditures in connection with commercial
deployment of its system. See "-- Substantial Future Capital Requirements." As a
result, the Company expects that it will continue to have substantial
indebtedness.* The degree to which the Company is leveraged could have important
consequences to the holders of the 1998 Notes, including, but not limited to,
the following: (i) the Company's ability to obtain additional financing in the
future for working capital, system deployments, development and enhancement of
its VOD system, capital expenditures, acquisitions and other general corporate
purposes may be materially limited or impaired; (ii) the Company's cash flow, if
any, will not be available for the Company's business because a substantial
portion of the Company's cash flow must be dedicated to the payment of principal
and interest on its indebtedness; (iii) the terms of future permitted
indebtedness may limit the Company's ability to redeem the 1998 Notes in the
event of a Change of Control (as defined); and (iv) the Company's high degree of
leverage may make it more
14
vulnerable to economic downturns, may limit its ability to withstand competitive
pressures and may reduce its flexibility in responding to changing business and
economic conditions.
The ability of the Company to make scheduled debt service payments
(including with respect to the 1998 Notes) will depend upon the Company's
ability to achieve significant and sustained growth in its cash from operations
and to complete necessary additional financings. The Company's ability to
generate sufficient cash from operations is dependent upon, among other things,
the market acceptance and customer demand for its VOD service, the Company's
ability to successfully continue the development and enhancement of its system
including the Sarnoff Server, set-top box and network, including compatibility
with evolving industry standards as they are defined, the future operating
performance of the Company, integration of its digital platform with those
provided by major cable industry suppliers, the Company's ability to obtain
long-term contracts with MSOs and the rate of and success of commercial
deployment of its VOD system. The Company expects that it will continue to
generate operating losses and negative cash flow for at least the next several
years.* No assurance can be given that the Company will be successful in
achieving and maintaining a level of cash from operations sufficient to permit
it to pay the principal, premium, if any, and interest on its indebtedness. If
the Company is unable to generate sufficient cash from operations to service its
indebtedness, it may have to forego or delay development and enhancement of its
VOD system and service, reduce or delay system deployments, restructure or
refinance its indebtedness or seek additional equity capital or debt financing.
There can be no assurance that (i) any such strategy could be effected on
satisfactory terms, if at all, in light of the Company's high leverage or (ii)
any such strategy would yield sufficient proceeds to service the Company's
indebtedness, including the 1998 Notes. Any failure by the Company to satisfy
its obligations with respect to the 1998 Notes or any other indebtedness could
result in a default under the Indenture and could cause a default under
agreements governing other indebtedness of the Company. In the event of such a
default, the holders of such indebtedness would have enforcement rights,
including the right to accelerate such debt and the right to commence an
involuntary bankruptcy proceeding against the Company. Absent a certain level of
successful commercial deployment of its VOD service, ongoing technical
development and enhancement of its VOD system and significant growth of its cash
flow, the Company will not be able to service its indebtedness.
The indenture governing the 1998 Notes (the "Indenture") imposes operating
and financial restrictions on the Company and its subsidiaries. These
restrictions will affect, and in certain cases significantly limit or prohibit,
among other things, the ability of the Company and its subsidiaries to incur
additional indebtedness, create liens upon assets, apply the proceeds from the
disposal of assets, make investments, make dividend payments and other
distributions on capital stock and redeem capital stock. There can be no
assurance that such covenants will not adversely affect the Company's ability to
finance its future operations or capital needs or to engage in other business
activities that may be in the interest of the Company. However, the limitations
in the Indenture will be subject to a number of important qualifications and
exceptions. In particular, while the Indenture will restrict the Company's
ability to incur indebtedness by requiring that specified leverage ratios are
met, it will permit the Company and its subsidiaries to incur substantial
indebtedness (which may be secured indebtedness), without regard to such ratios,
to finance the acquisition of equipment, inventory or network assets or to
finance or support working capital and capital expenditures for its business.
15
Substantial Future Capital Requirements
The Company will require substantial additional funds for the continued
development and commercial deployment of its VOD service. As of December 31,
1998, the Company had approximately $168.4 million in cash, cash equivalents and
short-term investments. From inception until December 31, 1998, the Company had
an accumulated deficit of $180.8 million. The Company has made and expects to
continue to make significant investments in working capital and capital
expenditures in order to continue required development activities, continue to
commercially deploy its VOD service and fund operations until such time, if at
all, as the Company begins to generate positive cash flows from operations.* The
Company expects that its cash flow from operating and investing activities will
be increasingly negative over at least the next several years.* The Company
believes that its existing cash, cash equivalents and short-term investments
will be sufficient to meet its working capital and capital expenditure
requirements at least through the end of its fiscal year.* Thereafter, the
Company will need to raise significant additional funds to support its
operations. However, the Company may need to raise additional funds earlier if
its estimates of working capital and/or capital expenditure requirements change
or prove to be inaccurate. The Company may also need to raise significant
additional funds in order to respond to unforeseen technological or marketing
hurdles or to take advantage of unanticipated opportunities. Actual capital
requirements may vary from expectations and will depend on numerous future
factors and conditions, many of which are outside of the Company's control,
including, but not limited to (i) the ability of the Company to meet its
development and deployment schedules; (ii) the accuracy of the Company's
assumptions regarding the rate and extent of commercial deployment and market
acceptance by cable operators and customers; (iii) the extent that cable
operators choose to deploy DIVA Converter Units ("DCUs") as opposed to set-top
boxes manufactured by cable industry suppliers that are DIVA-compatible; (iv)
the number of customers choosing the Company's VOD service and their buying
patterns; (v) the nature and penetration of new services to be offered by the
Company; (vi) unanticipated costs; and (vii) the need to respond to competitive
pressures and technological changes. The Company has no present commitments or
arrangements assuring it of any future equity or debt financing, and there can
be no assurance that the Company will be able to obtain any such equity or debt
financing on favorable terms or at all. In the event that the Company is unable
to obtain such additional capital, the Company will be required to delay the
expansion of its business or take other actions that could have a material
adverse effect on the Company's business, operating results and financial
condition and its ability to achieve sufficient cash flow to service its
indebtedness.
Development Stage Company; Limited Revenues; History of Losses
The Company is a development stage company with limited commercial
operating history, having commercially deployed its VOD service on a limited
basis beginning in September 1997. The Company has incurred substantial net
losses in the period since inception through December 31, 1998 of approximately
$180.8 million. The Company expects to continue to incur substantial losses and
experience substantial negative cash flow for at least the next several years as
it continues to develop and deploy its VOD service.* The Company's limited
operating history makes the prediction of future operating results difficult or
impossible. Through December 31, 1998, the
16
Company recognized revenues of approximately $202,000. The Company does not
expect to generate any substantial revenues unless and until its VOD service is
deployed at a significant number of additional headend locations and it has a
substantial number of customers.*
The Company's prospects should be considered in light of the risks,
expenses and difficulties frequently encountered by companies in their early
stage of development, particularly companies in new and rapidly evolving
markets. The Company's future success depends in part on its ability to
accomplish a number of objectives, including, but not limited to (i) further
technical development of and reduction of the cost of manufacturing the Sarnoff
Server and other system components and modification of the service software for
future advances, (ii) modification of its headend equipment and of headend
equipment provided by cable industry suppliers and further integration of all
such headend equipment and related systems in order to achieve cost reductions
and reduce physical space requirements for widespread VOD deployment in a large
number of headends, (iii) continued scaling of the entire end-to-end system and
its implementation for use with larger numbers of customers and an increased
number of movie titles, (iv) further development of the Sarnoff Server required
for large-scale deployment of its VOD service and for other interactive and
digital applications, (v) continued integration of its digital platform with
two-way digital platforms developed and to be developed by cable industry
equipment suppliers, including set-top boxes and headend equipment, (vi)
integrating its digital platform or software with other digital applications and
services selected by the cable operator, including joint or coordinated
integration of set-top box and headend components and software provided by the
Company and cable industry equipment suppliers to enable such other digital
applications, (vii) designing and accessing content packages and service
offerings that will attract ongoing consumer demand for the Company's VOD
service on competitive economic terms, (viii) enhancement of its system to offer
additional services, including music videos and time-shifting, (ix) completion
of initial deployments with acceptable system performance and consumer
acceptance, (x) integrating DIVA's VOD service with other digital services that
cable operators may offer, (xi) entering into long-term service contracts on
acceptable terms with MSOs and (xii) raising significant additional debt and/or
equity financing to fund the Company's cash requirements.
Uncertainty of Future Revenues; Fluctuating Operating Results
As a result of the Company's limited operating history and the emerging
nature of the market in which it competes, the Company is unable to accurately
forecast its revenues. The Company does not have historical financial data for a
significant number of periods on which to base planned operating expenses and
plans its operating expenses based on anticipated deployments, which require
significant investments before any revenues are generated. If deployments in a
particular period do not meet expectations, it is likely that the Company will
not be able to adjust significantly its level of expenditures for such period,
which could have a material adverse effect on the Company's business, operating
results and financial condition and its ability to achieve sufficient cash flow
to service its indebtedness. The Company expects to incur significant operating
expenses in order to continue development activities, secure initial
deployments, continue to commercially deploy its VOD service and expand its
operations.* The cost of deployments is highly variable and will depend upon a
wide variety of factors, including the cable system architecture, the size of
the service area served by a single Sarnoff Server, local labor rates and other
economic factors. In
17
particular, the Company must install Sarnoff Servers at a headend in advance of
generating any significant revenues from customers served by such headend. To
the extent that expenses are not subsequently followed by increased revenues,
the Company's business, operating results and financial condition and its
ability to achieve sufficient cash flow to service its indebtedness would be
materially adversely affected.
The timing and amount of future revenues will depend in large part upon the
Company's ability to obtain long-term contracts with cable companies and the
successful deployment of its VOD service pursuant to such agreements. New
deployment agreements are expected to be secured on an irregular basis, if at
all, and there may be prolonged periods of time during which the Company does
not enter into new agreements or expanded arrangements. Furthermore, actual
deployments under such agreements are expected to occur at irregular intervals,
and the Company will have little control over when such deployments will occur,
which will make revenues difficult to forecast. Factors that may affect the
Company's operating results included, but are not limited to: (i) the Company's
success in obtaining and retaining customers and the rate of customer churn,
(ii) customers' usage of the Company's VOD service and their buying patterns,
(iii) the rate of growth in customers, (iv) the cost of continued development of
the VOD system and other costs relating to the expansion of operations, (v)
pricing changes by the Company and its competitors, (vi) prices charged by and
the timing of payments to suppliers, (vii) the mix of the Company's service
offerings sold, (viii) the timing of payments from cable operators, (ix) the
introduction of new service offerings by the Company's competitors, (x) the
evolution of alternative forms of in-home entertainment systems, (xi) economic
conditions in the cable television industry, (xii) the market for home video
entertainment services and (xiii) general economic conditions. Any one of these
factors, most of which are outside of the Company's control, could cause the
Company's operating results to fluctuate significantly in the future. In
response to a changing competitive environment and in order to respond to local
viewing patterns, the Company may choose or may be required from time to time to
make certain pricing, service or marketing decisions or enter into strategic
alliances or investments or be required to develop upgrades or enhancements to
its system that could have a material adverse effect on the Company's business,
operating results and financial condition and its ability to achieve sufficient
cash flow to service its indebtedness.
Due to the foregoing factors, the Company's revenues and operating results
are difficult to forecast. The Company believes that its quarterly revenues,
expenses and operating results will vary significantly in the future and that
period-to-period comparisons are not meaningful and are not indicative of future
performance. As a result of the foregoing factors, it is likely that in some
future quarters or years the Company's operating results will fall below the
expectations of securities analysts or investors, which would have a material
adverse effect on the trading price of the 1998 Notes.
Dependence on Cable Operator Participation; Unproven Business Model
The Company's future success depends in large part on its ability to sign
long-term service contracts with cable operators to deploy its VOD service. The
Company's ability to enter into long-term commitments will depend upon, among
other things, successful commercial deployment of the Company's fully-integrated
VOD system and the Company's ability to demonstrate that its VOD
18
service is reliable and more attractive to customers than alternative
entertainment services such as PPV and NVOD. To date, the Company has entered
into long-term contracts with Lenfest and Chambers and contingent contracts,
subject to significant conditions, with Adelphia, Cablevision and Rifkin. The
Company is in discussions with various other cable operators regarding its VOD
service. There can be no assurance that the Company will be able to enter into
definitive agreements with any of these or any other cable operators or that the
ongoing viability of its VOD service will be successfully demonstrated. If cable
operators are not persuaded to deploy the Company's VOD service, there can be no
assurance that the Company's VOD system can be modified and successfully
marketed to other potential video providers, and such modifications would
require additional time and capital if pursued.
The Company must negotiate separate agreements with each cable operator.
The Company's business model is significantly different from those commonly
employed in the cable television industry and is based on assumptions regarding
consumer acceptance and buying patterns that are as yet unproven. Cable
operators generally enter into service agreements on a wholesale basis and own,
install and fund all customer and headend equipment. By contrast, the Company
owns, installs and funds all headend hardware and software components of its VOD
service and intends to generate earnings through long-term, revenue sharing
agreements with MSOs, involving "per view" and other content prices set by the
Company. Certain MSOs may desire to own the headend equipment and license the
related software components of the VOD system or to determine the type, number
or pricing of product offerings contained in the VOD service. The Company
believes that it may not be able to do business at all with such MSOs unless it
alters its business model. Even if MSOs generally accept the equipment/software
ownership and price setting concepts of the Company's existing business model,
different pricing models or revenue sharing concepts may be required in order to
establish business relationships with some MSOs. It is likely that MSOs will
find it difficult to determine the net effect on revenue of either adding the
Company's service to their product mix, or replacing elements of their service
offerings with the Company's VOD service. The Company's VOD service may provide
lower margins than competitive services such as NVOD and may also be viewed as
cannibalizing existing MSO offerings. Consequently, until the economics of
DIVA's business model are proven, cable operators may be reluctant to broadly
deploy its VOD service in their systems or may be unwilling to deploy it at all.
There can be no assurance that the Company will be able to successfully alter
its business model, that such an alteration would not produce a material adverse
change to the economics of its business model or that cable operators will be
willing to deploy the Company's VOD service on these or any other terms. VOD is
a new market, and the Company's VOD service is only one possible means available
to cable operators for providing movies in the home. Further, consumer
acceptance of the Company's VOD service and the intensity of subscriber buying
behavior are not established. See "-- Dependence on Single Service; Acceptance
by Subscribers." There can be no assurance of broad consumer acceptance of the
Company's service or that those consumers that do utilize the VOD service will
do so with a frequency and at prices that will not materially affect the
Company's business, operating results and financial condition and its ability to
generate sufficient cash flow to meet its obligations. Although the Company
believes that it has an economically viable turnkey solution, there can be no
assurance that the Company will be successful in achieving wider adoption of its
VOD service by the cable industry or that it will be able to attract and retain
customers on economic terms that do not materially adversely affect its ability
to generate cash flow. The inability of the Company to enter
19
into definitive agreements with cable operators or the lack of acceptance of its
VOD service by cable operators and their subscribers would have a material
adverse effect on the Company's business, operating results and financial
condition and its ability to achieve sufficient cash flow to service its
indebtedness.
Long-Term Cable Operator Agreements Dependent on Initial Commercial
Deployment
The Company's agreements with each of Adelphia, Cablevision and Rifkin are
conditioned upon the successful completion of an initial commercial deployment
phase, which is designed to allow both parties to verify the business viability
of the Company's VOD service, in accordance with certain criteria set forth in
the agreements. The Company is currently in the limited commercial deployment
phase with each of these cable operators. Following the initial commercial
deployment phase, if any such cable operator is satisfied that the Company's VOD
service meets its business and operational expectations, the Company will
continue and expand the existing deployment and commence further commercial
deployment in certain of such cable operators' systems or other cable systems on
an agreed-to schedule. If the Company's VOD service does not demonstrate
business viability or if the cable operator otherwise determines that such
service does not meet its business or operational expectations, none of
Adelphia, Cablevision nor Rifkin is obligated to deploy the Company's VOD
service. There can be no assurance that the Company will successfully complete
its initial commercial deployment phases or that its VOD system and service will
be deployed beyond the initial phases in any such cable operator's systems. In
the event the Company fails to successfully complete initial commercial
deployment in any such cable operator's systems in accordance with the
contracts, the Company will be unable to generate any cash flow from such
systems and other prospective cable companies may be reluctant to enter into
long-term commitments with the Company due to concerns about the viability of
its VOD system. The Company's long-term Lenfest contract follows the completion
of an initial commercial deployment phase, and the Company's long-term Chambers
contract is not contingent upon the successful completion of an initial
commercial deployment phase. The Company expects that contracts with some MSOs
in the future will require such a contingency.*
Limited Commercial Deployments to Date
The Company has commercially deployed its VOD service in a single headend
location in cable systems owned by Lenfest, Adelphia, Cablevision and Rifkin.
Prior to launch of the service to commercial subscribers, the Company (i)
installed a Sarnoff Server at each headend location with associated control and
management systems; (ii) installed DCUs in an agreed-to number of homes and
business locations and delivered the Company's VOD service without charge to
such locations; and (iii) completed technical testing designed to stress both
the MSO's two-way HFC plant and the Company's system and VOD service. During
these periods, the Company experienced delays due to set-top box development,
two-way cable plant readiness, and integration and related stability testing of
the Company's and the cable operator's operating platforms and systems. The
Company experienced both fewer causes of delay and delays of more limited
duration with each successive installation. While the Company anticipates
continued reduction in the duration of these periods that precede commercial
deployments,* there can be no assurance that the Company will not experience
other delays in the testing, rollout or delivery of its VOD service, that the
Company will not experience periods of increased delay in testing, rollout and
delivery as it migrates its total end-to-
20
end digital platform to one integrated with third party set top boxes and
headend equipment, or that the Company's VOD service can be delivered on the
scale anticipated by the Company. The existing commercial deployments, unless
expanded in scope, will not serve more than a limited number of customers. Until
the Company is able to deploy on a large scale in one cable system, the
scalability of the Company's VOD system will remain unproven. Further, there can
be no assurance that unforeseen problems will not develop as the Company evolves
its technology, products and services, or that the Company will be successful in
the continued development, cost reduction, integration and commercial
implementation of its technology, products and services on a wide scale.
Dependence on Single Service; Acceptance by Subscribers
The Company expects to derive a substantial portion of its future revenues
from providing its VOD service to cable operators and their subscribers.* The
Company's future financial performance will depend on the successful
introduction and broad customer acceptance of its VOD service, as to which there
can be no assurance. Numerous factors could have a material adverse effect on
the level of consumer acceptance, including, but not limited to, the degree of
consumer sensitivity to (i) the price of the service, (ii) the number and type
of product offerings contained in the service and (iii) the availability,
functions and cost of a single set-top box that both enables the Company's VOD
service and replaces the customer's existing set-top box. Since there is no
existing market for true VOD service, there can be no assurance that an
acceptable level of consumer demand will be achieved. If sufficient demand for
the Company's VOD service does not develop due to lack of market acceptance,
technological change, competition or other factors, the Company's business,
operating results and financial condition and its ability to generate sufficient
cash flow to service its indebtedness would be materially adversely affected.
Risks Associated with Anticipated Growth
The Company intends to aggressively expand its operations.* The growth in
size and scale of the Company's business has placed and is expected to continue
to place significant demands on its management, operating, development, third
party manufacturing and financial resources. The Company's ability to manage
growth effectively will require continued implementation of and improvements to
its operating, manufacturing, development and financial systems and will require
the Company to expand and continue to train and manage its employee base. These
demands likely will require the addition of new management personnel and the
development of additional expertise by existing management personnel. Although
the Company believes that it has made adequate allowances for the costs and
risks associated with future growth, there can be no assurance that the
Company's systems, procedures or controls or financial resources will be
adequate to support the Company's operations or that management will be able to
keep pace with such growth. If the Company is unable to manage its growth
effectively, the Company's business, operating results, financial condition and
ability to achieve sufficient cash flow to service its indebtedness will be
materially adversely affected.
21
Dependence on Advanced Cable Distribution Networks
The Company's VOD service requires deployment on cable systems upgraded to
HFC architecture linking headends with nodes serving not more than 2,000 homes,
with the return path from the customer to the headend activated to enable two-
way operation. According to the Cablevision Blue Book, approximately 60% of the
total U.S. homes passed by cable had been upgraded to HFC architecture with
return path capability at the end of 1997, and only a limited portion of the
upgraded plant is currently activated for two-way transmission. A number of
cable operators have announced and begun to implement major infrastructure
investments to deploy two-way capable HFC systems which require significant
financial, managerial, operating and other resources. HFC upgrades have been,
and likely will continue to be, subject to delay or cancellation. In addition,
the Company believes that the widespread deployment of VOD services will not
occur until MSOs decide to deploy digital services through this upgraded plant
and invest in new digital set-top boxes. There can be no assurance that these or
any other cable operators will continue to upgrade their cable plant or that
sufficient, suitable cable plant will be available in the future to support the
Company's VOD service. The failure of cable operators to complete planned
upgrades in a timely and satisfactory manner, or at all, and the lack of
suitable cable plant to support the Company's VOD service would have a material
adverse effect on the Company's business, operating results and financial
condition and its ability to achieve sufficient cash flow to service its
indebtedness. In addition, the Company will be highly dependent on cable
operators to continue to maintain their cable infrastructure in such a manner
that the Company will be able to provide consistently high performance and
reliable service. Therefore, the future success and growth of the Company's
business will also be subject to economic and other factors affecting the
ability of cable operators to finance substantial capital expenditures to
maintain and upgrade the cable infrastructure.
Risk of Technological Change and New Product Development
Rapid technological developments are expected to occur in the home video
entertainment industry. As a result, the Company has modified and expects to
continue to modify its research and development plan.* Such modifications,
including those related to the set-top box, have resulted in delays and
increased costs. Furthermore, the Company expects that it will be required to
continue to enhance its current VOD service and develop and introduce increased
functionality and performance to keep pace with technological developments and
consumer preferences.* In particular, the Company must (i) continue technical
development of and reduce the cost of manufacturing the Sarnoff Server and other
system components and modification of the service software for future advances,
(ii) modify its headend equipment and headend equipment provided by cable
industry suppliers and integrate all of such headend equipment and related
systems in order to achieve cost reductions and reduce physical space
requirements for widespread VOD deployment in a large number of headends, (iii)
complete a scalable turnkey system and test it for use with larger numbers of
customers and a large number of movie titles, (iv) continue further development
of the Sarnoff Server required for large-scale deployment of its VOD service and
for other interactive and digital applications, (v) in order to achieve broader
deployment, integrate its digital platform with two-way digital platforms
developed and to be developed by cable industry equipment suppliers, including
set top boxes and headend equipment, (vi) integrate its digital platform and/or
software with other digital applications and services selected by the cable
operator, including joint or coordinated
22
integration of set top box and headend components and software provided by the
Company and cable industry equipment suppliers to enable such other digital
applications, (vii) design content packages and service offerings that will
attract ongoing consumer demand and (viii) enhance its system to offer
additional services, including music videos and time-shifting.* There can be no
assurance that the Company will, on a satisfactory timetable, be able to
accomplish any of these tasks or do so while maintaining the same functionality.
There can be no assurance that the Company will be successful in developing and
marketing product and service enhancements or new services that respond to
technological and market changes or that the Company will not experience
difficulties that could delay or prevent the successful development,
introduction and marketing of such new services or enhancements. The Company has
encountered delays in product development, service integration and field tests
and other difficulties affecting both software and hardware components of its
system and its ability to operate successfully over HFC plant. In addition, many
of the Company's competitors have substantially greater resources than the
Company to devote to further technological and new product development. See "--
Competition for VOD Services." There can be no assurance that technological and
market changes or other significant developments in VOD technology by the
Company's competitors will not render its VOD service obsolete.
Compliance with Industry Standards; Need to Integrate with Set-Top Box
Manufacturers
The cable industry has launched an initiative called "open cable," which
will redefine the requirements and features of digital set top converters as
well as the requirements and features of their control systems located in the
boxes themselves and in cable headends. The open cable initiative is managed by
CableLabs on behalf of the cable MSOs and is supported by some of the cable
equipment manufacturers, including General Instrument Corporation ("General
Instrument") and Scientific-Atlanta, Inc. ("Scientific-Atlanta"). The open cable
initiative is defining future digital platform requirements as they relate to
set-top box requirements and control systems, which could affect DIVA's digital
platform and its efforts to integrate its digital platform and VOD application
with digital set top and headend equipment manufactured by third party cable
industry suppliers. There can be no assurance that the Company will be
successful in complying with the requirements of the open cable initiative as
they are finally adopted, or that compliance will not cause difficulties that
could delay or prevent successful development, introduction or broad deployment
of its VOD service.
For the initial deployments, the Company is using a separate proprietary
set-top box that is deployed in parallel with the customer's analog cable set-
top box. All of the MSOs with which the Company has contingent and long-term
contracts have indicated their strong preference for a single box solution that
both enables the Company's VOD service and replaces the subscriber's existing
set-top box. Although the Company is developing a single box that meets these
requirements, the Company has determined that it also needs to port its VOD
solution to other digital platforms that are or will be broadly deployed in the
cable industry, including those that may be offered by General Instrument,
Scientific-Atlanta and other companies. In this regard, the Company has signed a
non-binding letter of intent with General Instrument pursuant to which the
Company has agreed to cooperate with General Instrument to make the Company's
VOD system compatible with General Instrument's Digital Network System ("DNS").
Pursuant to the letter of intent, the Company and General Instrument have
demonstrated the successful port of the Company's VOD application to the
23
DNS, and the initial implementation of this integration is being tested on a
limited, non-commercial basis with Lenfest. The Company and General Instrument
are continuing joint development efforts to more closely integrate the VOD
service with DNS, including achieving cost reductions, reducing physical space
requirements of headend equipment and enabling delivery of the Company's VOD
service with encryption capability. There can be no assurance that the Company
will be successful in accomplishing the General Instrument integration on a
cost-effective basis or at all or that this letter of intent will lead to a
definitive agreement with General Instrument. Further, failure to complete the
joint development as contemplated by the General Instrument letter of intent
could result in delay in implementation of a one box solution, delay of rollout
of the Company's VOD service under existing and contemplated long-term
deployment agreements with MSOs, reluctance on the part of other MSOs to enter
into long-term agreements with the Company and reallocation of resources to
internal or other third party single box development efforts. The Company
previously entered into a non-binding letter of intent with Scientific-Atlanta
to achieve compatibility between the Company's VOD System and Scientific-
Atlanta's Digital Broadband Delivery System. This letter of intent has since
expired without resulting in a definitive agreement, and limited development or
integration activities have occurred.
If the Company is unable to pursue and complete a relationship with
Scientific-Atlanta to achieve compatibility between their respective systems,
the Company's ability to enter into relationships with MSOs that require a
single box solution and choose to deploy Scientific-Atlanta's Digital Broadband
Delivery System may be significantly impaired.
Although the Company has developed an on-screen interactive guide or
navigator that is closely integrated with its VOD service, MSO customers and
their subscribers are likely to expect a seamless link between the navigator and
industry standard electronic programming guides ("EPGs") that provide
information regarding programming schedules. The ability to create cross access
points between the navigator and various EPGs may be limited by the engineering
and memory characteristics of the digital platforms provided by major cable
industry suppliers. Further, positioning the navigator as the first or one of
the first screens viewed by a subscriber, which would create enhanced revenue
and promotional opportunities, may be limited by these third-party platform
characteristics or by existing or future agreements between EPG providers and
MSOs.
Reliance on Third-Party Manufacturers; Exposure To Component Shortages
The Company depends and will continue to depend on third parties to
manufacture the major elements of its VOD system. The Company subcontracts
manufacturing of its proprietary DCU to Jabil Circuit, Inc., components of its
Video Session Manager to Pioneer Standard and the Sarnoff Server to another
manufacturer. All of such subcontractors are bound by confidentiality
agreements. As a result of the complexity of the Company's hardware components,
manufacturing and quality control are time consuming processes. Consequently,
there can be no assurance that these manufacturers will be able to meet the
Company's requirements in a timely and satisfactory manner or the Company would
be able to find or maintain a suitable relationship with alternate qualified
manufacturers for any such elements. The Company's reliance on third-party
manufacturers involves a number of additional risks, including the absence of
guaranteed capacity and reduced control over delivery schedules, quality
assurance, production yields and costs. In the event the Company is
24
unable to obtain such manufacturing on commercially reasonable terms, its
business, operating results and financial condition and its ability to achieve
sufficient cash flow to service its indebtedness would be materially adversely
affected.
Certain of the Company's subassemblies and components used in the Sarnoff
Server, the Video Session Manager and the DCU are procured from single sources
and others are procured only from a limited number of sources. Consequently, the
Company may be adversely affected by worldwide shortages of certain components,
significant price increases, reduced control over delivery schedules, and
manufacturing capability, quality and cost. Although the Company believes
alternative suppliers of products, services, subassemblies and components are
available, the lack of alternative sources could materially impair the Company's
ability to deploy its VOD system. Manufacturing lead times can be as long as
nine months for certain critical components. Therefore, the Company may require
significant working capital to pay for such components well in advance of
revenues. Moreover, a prolonged inability to obtain certain components could
have a material adverse effect on the Company's business, operating results and
financial condition and its ability to achieve sufficient cash flow to service
its indebtedness and could result in damage to MSO or customer relationships.
Uncertainty of Protection of Patents and Proprietary Rights
The Company's future success depends, in part, on its ability to protect
its intellectual property and maintain the proprietary nature of its technology
through a combination of patents, licenses and other intellectual property
arrangements. The Company has licensed rights to the Sarnoff Server and the DCU
initially developed by Sarnoff. Sarnoff and the Company have filed applications
and intend to file additional applications for patents covering the Sarnoff
Server. Sarnoff and the Company have filed applications for patents covering the
DCU, and the Company has filed patent applications, and intends to file
additional and derivative patent applications covering the interactive service
and its technology. There can be no assurance, however, that any patents issued
to Sarnoff or the Company will not be challenged, invalidated or circumvented,
or that the rights granted thereunder will provide proprietary protection to the
Company. Despite the efforts of Sarnoff and the Company to safeguard and
maintain these proprietary rights, there can be no assurance that the Company
will be successful in doing so or that the Company's competitors will not
independently develop or patent technologies that are substantially equivalent
or superior to the Company's technologies. On August 18, 1998, the Company
received a notice from a third party licensing company stating that it has
acquired rights in two U.S. patents and that the Company's VOD system and
process are described in the claims of these patents. The Company responded to
the letter in late November 1998 stating that it does not infringe and will
consider the matter closed unless it hears back promptly. The Company has not
received a response. In early November 1998, the Company received a letter from
a company that represents a group of companies that hold MPEG-2 patents,
offering to make available a license to that group of patents. The Company and
outside patent counsel are preparing a response. The Company has filed trademark
applications on certain marks and logos. In July 1996, the Company received a
notice from a third party claiming that the Company's use of one of its
trademarks infringes a trademark right held by such party. The Company
responded to the letter in late July 1996, asserting that the use of the
trademark does not infringe on the trademark right that the party holds. The
Company has received no further response.
25
In August 1998, the Company received a notice from a third party, which provides
integrated circuits for digital multimedia applications, claiming that such
third party's trademark application gives it priority over the Company's use of
the "DIVA" mark. The Company sent a response to this letter in late November
1998 stating that it does not believe there is an infringement issue and
inviting further discussions. The Company has not received a response to this
letter. The Company could encounter similar challenges to its trademarks in the
future.
Since patent applications in the U.S. are not publicly disclosed until the
patent has been issued, applications may have been filed which, if issued as
patents, would relate to the Company's products. In addition, the Company has
not conducted a comprehensive patent search relating to the technology used in
the Sarnoff Server or the Company's VOD system. The Company is subject to the
risk of claims and litigation alleging infringement of the intellectual property
rights of others. There can be no assurance that third parties will not assert
infringement claims against the Company in the future based on patents or trade
secrets or that such claims will not be successful. Parties making such claims
may be able to obtain injunctive or other equitable relief which could
effectively block the Company's ability to provide its VOD service in the U.S.
and internationally, and could result in an award of substantial damages. In the
event of a successful claim of infringement, the Company, its MSOs and other end
users may be required to obtain one or more licenses from third parties. There
can be no assurance that the Company or its customers could obtain necessary
licenses from third parties at a reasonable cost or at all. The defense of any
lawsuit could result in time consuming and expensive litigation regardless of
the merits of such claims, and damages, license fees, royalty payments and
restrictions on the Company's ability to provide its VOD service, any of which
could have a material adverse effect on the Company's business, operating
results and financial condition and its ability to achieve sufficient cash flow
to service its indebtedness.
Risks Associated with Programming Content
The Company's success will depend, in part, on its ability to obtain access
to sufficient movies (including new releases and library titles), special
interest videos and other programming content on commercially acceptable terms.
Although the Company has entered into arrangements with most of the major movie
studios and a number of other content providers for its initial deployments,
there can be no assurance that the Company will be able to continue to obtain
the content, during the segment of time available to VOD providers and others
such as PPV, to support its VOD service beyond the geographic area of its
initial deployments. The Company could encounter increased competition for
access to movie titles from competitors with greater resources and stronger
relationships with major movie studios than the Company, including other VOD,
NVOD or DBS providers and providers of video rentals. Such competitors could
successfully negotiate with movie studios to obtain exclusive access to certain
titles. Furthermore, studios could delay the period of time before a title
becomes available to the Company, and reduce the period of time in which a title
may be available for the VOD market. In addition, studios may require the
Company to make prepayments prior to the time that customers pay for viewing a
title or require the Company to enter into long-term contracts with minimum
payments. Further, studios may increase the license fees currently charged to
the Company. The Company's failure to obtain timely access to such content on
commercially acceptable terms would have a material adverse effect on its
business,
26
operating results and financial condition and its ability to achieve sufficient
cash flow to service its indebtedness.
Competition for VOD Services
The market for in-home video entertainment services is intensely
competitive, rapidly evolving and subject to rapid technological change. The
Company expects competition in the market for VOD services to intensify and
increase in the future.* A number of companies have announced an intention to
introduce a VOD service or deliver VOD components that might be deployed by a
video service provider. Intertainer, a company owned in part by Comcast Cable
Communications ("Comcast"), Intel Corporation ("Intel"), Sony Corp. of America
and NBC, is currently conducting trials with Comcast and US West to provide VOD
and other services over high speed networks such as ADSL (Asymmetric Digital
Subscriber Line) and cable modems primarily to the personal computer, but plans
to provide services to television sets in the future. It is possible that
companies currently operating overseas will adapt their technology and offer it
through high-speed networks in the U.S. Elmsdale Media is currently conducting a
trial for its VOD system in Cardiff, Wales for NTL Inc. VideoNet is conducting a
trial in Britain over telephone wires offering VOD and other interactive
services to non-paying customers. Hongkong Telecom began offering commercial
interactive services, including VOD, in March 1998 and has gained over 100,000
paying subscribers. Other companies internationally and domestically have also
announced plans to provide VOD services which vary in degree of commercial
viability. There can be no assurance that these or other companies will not
provide equivalent or more attractive capabilities that could be more acceptable
to cable operators and their subscribers.
It is also possible that such competitors may form new alliances, develop a
competitive VOD service and rapidly acquire significant market share. Such
competition would materially and adversely affect the Company's business,
operating results and financial condition. Companies that are or may be capable
of delivering VOD components include Concurrent Computer Corp, Celerity Systems
Inc., Mitsubishi Electronics America, Nippon Electric Corp., nCube, Pioneer and
its affiliates, SeaChange International, Inc., Silicon Graphics Inc., Unisys,
General Instrument, Scientific-Atlanta, Sony Corporation, Vivid Technology Inc.
and FreeLinQ Communications Corporation. Some of these competitors have
developed VOD products that have undergone tests or trials and may succeed in
obtaining market acceptance of their products more rapidly than the Company. In
addition, Time Warner Inc. previously field tested an integrated system solution
utilizing components from a number of the aforementioned entities. This trial
has since been terminated. Notwithstanding termination of its field trial in
Orlando, Time Warner Inc. has reached agreements with certain industry suppliers
for elements that might be used in designing and integrating a next generation
VOD system solution for an initial deployment in 1999. Cablevision is operating
a limited trial of an in-house VOD solution. Certain of the Company's
competitors or potential competitors have developed affiliations with cable
operators or alternative distribution providers or develop services or
technologies that may be better or more cost effective than the Company's VOD
service. These services or technologies may be more attractive to cable
operators, particularly those that desire to own all hardware and software
components of the VOD service. In addition, certain of these potential
competitors are either directly or indirectly affiliated with content providers
and cable operators and could therefore materially impact the Company's ability
to sign
27
long-term services contracts with such cable operators and obtain content from
such providers. Although the Company is pursuing joint development efforts to
port its VOD service to digital platforms that are or will be broadly deployed
in the cable industry, these third party equipment manufacturers have the
financial and technical ability to develop and sustain deployment of their own
proprietary VOD platforms. There can be no assurance that the Company will not
face competition from these suppliers or their affiliates or that they will
support the integration of Company's VOD service with their own components. See
"--Compliance with Industry Standards; Need to Integrate with Set-Top Box
Manufacturers."
The Company may also face competition from cable operators or other
organizations, including but not limited to the telephone companies, providers
of DBS, PPV and NVOD, cable programmers and Internet service providers, who
could provide VOD-like services through cable and alternative delivery
platforms, including the Internet, telephone lines and satellite. For example,
the Company could encounter competition from companies such as Microsoft/WebTV
Plus, @Home or video streaming companies that in the future may be able to
deliver movies over the Internet to the television, or from consumer use of
purchased or rented digital video discs or variants thereof. In addition, the
competitive environment in which the Company will operate may inhibit its
ability to offer its VOD service to cable operators and other types of operators
that compete with one another in the same territory. A cable operator may
require the Company to provide its VOD service exclusively to such cable
operator in a particular territory. Further, cable operators themselves may
offer competing services, including increased NVOD offerings, or may be
unwilling to use the Company's VOD service exclusively. There can be no
assurance that any cable operator will commit exclusively to the Company's VOD
service. In particular, cable operators may trial a number of different
alternatives. The Company will also face competition for viewers from providers
of home video rentals, which are increasingly entering into revenue sharing
arrangements with content providers. These arrangements have resulted in a
significant increase in the number of copies available for rental and an
extension in the rental period at major video chains and, accordingly, have made
home video rentals more attractive to consumers.
Many of the Company's competitors and potential competitors have longer
operating histories, greater name recognition, and significantly greater
financial, technical, marketing and distribution resources than the Company. As
a result, they may be able to respond to new or emerging technologies and
changes in customer requirements or to devote greater resources to the
development, promotion and sale of their products and services more effectively
than the Company. There can be no assurance that the Company will be able to
compete successfully against current or future competitors or that competitive
pressures faced by the Company will not materially adversely affect its
business, operating results and financial condition and its ability to achieve
sufficient cash flow to service its indebtedness.
Dependence on Key Personnel
The Company's performance is substantially dependent on the performance of
its officers and key employees. Given the Company's early stage of development,
the Company is dependent on its ability to retain and motivate qualified
personnel, especially its management. The Company does not have "key person"
life insurance policies on any of its employees. There can be no assurance that
28
key personnel will continue to be employed by the Company or that the Company
will be able to attract and retain qualified personnel in the future. The
Company's future success also depends on its ability to identify, hire, train
and retain technical, sales, marketing and managerial personnel. Competition for
such personnel is intense, and there can be no assurance that the Company will
be able to attract, assimilate or retain such personnel in the future. The
inability to attract and retain its officers and key employees and the necessary
technical, sales, marketing and managerial personnel could have a material
adverse effect upon the Company's business, operating results and financial
condition and its ability to achieve sufficient cash flow to service its
indebtedness.
Government Regulation
The Federal Communications Commission ("FCC") has broad jurisdiction over
the telecommunications and cable industries. The majority of FCC regulations,
while not directly affecting the Company, do affect cable companies, upon which
the Company will significantly rely for the marketing and distribution of its
VOD service to customers. As such, the indirect effect of these regulations may
adversely affect the Company's business. The Communications Act of 1934, as
significantly amended by Congress in 1992 and more recently by the
Telecommunications Act of 1996 (as so amended, the "Act"), provides a
significant regulatory framework for the operation of cable systems. Rules
promulgated by the FCC under the Act impose restrictions and obligations that
could affect how the cable operator offers or prices the Company's VOD service;
examples include (i) regulation of rates for certain tiers or packages of
programming and for equipment (set-top boxes) used to deliver regulated tiers of
service, (ii) prohibition of bundling equipment and service charges together
into one charge to the customer, (iii) equipment rate averaging, (iv)
prohibition of forced tier buy-through, and (v) imposition of various consumer
protection, billing and disclosure requirements. None of these impose direct
rate or service restrictions on the Company.
In addition, certain FCC rules, and FCC rulemakings in process or required
in the future under the Act could directly affect the Company's DCU and related
development efforts, as well as the joint efforts of the Company and third-party
equipment manufacturers such as General Instrument to port the Company's VOD
solution to digital platforms that are broadly deployed in the cable industry,
by imposing requirements that the set-top boxes (i) be designed to be compatible
with other consumer electronics equipment that is used to deliver services
provided by cable companies, (ii) be commercially available to consumers from
vendors other than cable operators, and (iii) not defeat or interfere with the
national emergency alert system, closed captioning for the hearing impaired, or
any "V" chip requirements that may be imposed. FCC rules to date have focused on
analog equipment, rather than digital equipment such as the Company's. However,
it is anticipated that as digital equipment, transmission and services are
deployed by cable operators, the FCC will extend analog rules to digital
transmission, or craft rules specific to digital platforms. An example being
discussed is digital "must carry" which would require cable operators to
transmit on their systems not only the analog channels of local broadcast
television stations in all markets, but the newly authorized digital broadcast
channels as well. Digital "must carry" for local over-the-air broadcast
licensees could consume a significant amount of the increased channel capacity
being created by cable operators through their upgrades. There can be no
assurance that the Company's VOD service will be successful in competing with
other analog and digital services for access to
29
cable operator transmission capacity that remains after implementation of
digital "must carry" in any local market.
Local franchising authorities retain certain statutory and general
regulatory authority with respect to cable operators including the ability to
regulate or exclude content that they deem inappropriate under local community
standards. The Company's VOD service includes adult offerings and, because local
community standards will vary, the Company works closely with the local cable
operator to determine the extent of adult content, which in some communities may
be entirely excluded. The Company's VOD system also enables individual
subscribers to exclude entirely or restrict access to such content. The
Company's operating results could be impacted by the decisions of local
regulatory authorities and cable operators regarding such content.
Finally, the Act authorizes, but does not require, local franchising
authorities to impose a fee of up to 5% on the gross revenues derived by third
parties from the provision of cable service over a cable system. To the extent
that the Company provides its VOD service directly to cable subscribers (rather
than providing it to cable operators for resale to cable subscribers) and the
local franchise agreement has been amended or renewed and includes appropriate
language, the Company could be required to pay a franchise fee of up to 5% of
gross revenues derived from its VOD service in a specific franchise area to the
local franchising authority. At present, only the Lenfest deployment uses this
business model, and it will not be used in any other of the currently scheduled
deployments.
There are other rulemakings that have been and still are being undertaken
by the FCC which will interpret and implement provisions of the Act. It is
anticipated that the Act will stimulate increased competition generally in the
telecommunications and cable industries, which may adversely impact the Company.
No assurance can be given that changes in current or future laws or regulations,
including those limiting or abrogating exclusive MSO contracts, in whole or in
part, adopted by the FCC or other federal, state or local regulatory authorities
would not have a material adverse effect on the Company's business.
In addition, VOD services are licensed by the Canadian Radio and
Telecommunications Commission, and the Company is seeking to determine the basis
on which it may offer its service in Canada, the extent of regulatory controls
and the terms of any revenue arrangements that may be required as conditions to
the deployment of its VOD service in Canada. The Company may not be able to
obtain distribution rights to movie titles in Canada under regulatory and
financial arrangements acceptable to the Company.
Control by Insiders
The Company's executive officers and directors, together with entities
affiliated with such individuals, and Acorn Ventures, Inc. beneficially own
approximately 42.7% of the Common Stock (assuming conversion of all outstanding
Preferred Stock into Common Stock). Accordingly, these stockholders have
significant influence over the affairs of the Company. This concentration of
ownership could have the effect of delaying or preventing a change in control of
the Company.
30
Forward-Looking Statements
The statements contained in the "Factors Affecting Operating Results"
section that are not historical facts are "forward-looking statements," which
can be identified by the use of forward-looking terminology such as "estimates,"
"projects," "anticipates," "expects," "intends," "believes," or the negative
thereof or other variations thereon or comparable terminology, or by discussions
of strategy that involve risks and uncertainties. These forward-looking
statements, including statements regarding market opportunity, deployment plans,
market acceptance, the Company's business model of long-term revenue sharing
contracts, capital requirements, anticipated net losses and negative cash flow,
revenue growth, anticipated operating expenditures and product development plans
are only estimates or predictions and cannot be relied upon. No assurance can be
given that future results will be achieved; actual events or results may differ
materially as a result of risks facing the Company or actual results differing
from the assumptions underlying such statements. Such risks and assumptions
include, but are not limited to, those discussed in this "Factors Affecting
Operating Results" section, which could cause actual results to vary materially
from the future results indicated, expressed or implied in such forward-looking
statements. The Company disclaims any obligation to update information contained
in any forward-looking statement.
31
PART II OTHER INFORMATION
Item 1 and Items 3 through 5 are not applicable with respect to the
current reporting period.
Item 2. Changes in Securities and Use of Proceeds
During the three months ended December 31, 1998, the Company issued and
sold an aggregate of 117,160 shares of Common Stock to employees and
consultants for an aggregate purchase price of $133,360 pursuant to
exercises of options under its 1995 Stock Plan. These issuances were
deemed exempt from registration under the Securities Act of 1933, as
amended, in reliance upon Rule 701 promulgated thereunder.
Item 6. Exhibits and Reports on Form 8-K:
a. Exhibits.
10.1 Lease Agreement between Seaport Centre Associates, LLC
and Registrant, dated January 20, 1999
27.1 Financial Data Schedule
b. Reports on Form 8-K.
No reports on Form 8-K were filed with the Securities and
Exchange Commission during the quarter ended December 31,
1998.
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SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934,
the Registrant has duly caused this Report to be signed on its behalf by the
undersigned, thereunto duly authorized.
DIVA SYSTEMS CORPORATION
/s/ William M. Scharninghausen
By:______________________________
William M. Scharninghausen
Vice President, Finance and Administration,
and Chief Financial Officer
Dated: March 26, 1999
33