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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------------
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2001
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER 0-23137
REALNETWORKS, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
WASHINGTON 91-1628146
(STATE OF INCORPORATION) (I.R.S. EMPLOYER
IDENTIFICATION NUMBER)
2601 ELLIOTT AVENUE, SUITE 1000 98121
SEATTLE, WASHINGTON (ZIP CODE)
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
(206) 674-2700
(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
----- -----
The number of shares of the registrant's Common Stock outstanding as of
April 30, 2001 was 160,247,148.
2
REALNETWORKS, INC.
FORM 10-Q
FOR THE QUARTER ENDED MARCH 31, 2001
TABLE OF CONTENTS
PAGE
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements...........................................................................3
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations........13
Item 3. Quantitative and Qualitative Disclosures About Market Risk....................................38
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.............................................................................39
Item 6. Exhibits and Reports on Form 8-K..............................................................39
3
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
REALNETWORKS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)
March 31, December 31,
2001 2000
--------- ------------
ASSETS
Current assets:
Cash, cash equivalents and short-term investments $ 350,476 364,710
Trade accounts receivable, net of allowances for doubtful
accounts and sales returns 7,210 8,647
Prepaid expenses and other current assets 4,272 3,989
Deferred income taxes 9,201 10,777
--------- ---------
Total current assets 371,159 388,123
Equipment and leasehold improvements, at cost:
Equipment and software 30,783 28,979
Leasehold improvements 32,667 25,670
--------- ---------
Total equipment and leasehold improvements 63,450 54,649
Less accumulated depreciation and amortization 15,241 12,376
--------- ---------
Net equipment and leasehold improvements 48,209 42,273
--------- ---------
Goodwill, net 95,672 104,861
Restricted cash equivalents 17,300 18,800
Deferred income taxes 3,758 3,365
Other 19,539 20,986
--------- ---------
TOTAL ASSETS $ 555,637 578,408
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 7,476 7,727
Accrued and other liabilities 32,473 36,552
Deferred revenue, excluding non-current portion 31,605 38,522
--------- ---------
Total current liabilities 71,554 82,801
--------- ---------
Deferred revenue, excluding current portion 13,098 12,747
Deferred rent 2,237 2,048
Shareholders' equity:
Preferred stock, $0.001 par value per share, no shares issued and outstanding:
Series A: authorized 200 shares -- --
Undesignated series: authorized 59,800 shares -- --
Common stock, $0.001 par value per share,
Authorized 1,000,000 shares; issued and outstanding 160,697
shares at March 31, 2001 and 159,214 shares at December 31, 2000 161 159
Additional paid-in capital 689,990 692,245
Deferred stock compensation (34,960) (53,222)
Accumulated other comprehensive loss (17,084) (13,384)
Accumulated deficit (169,359) (144,986)
--------- ---------
Total shareholders' equity 468,748 480,812
--------- ---------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 555,637 578,408
========= =========
See accompanying notes to condensed consolidated financial statements
4
REALNETWORKS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE INCOME (LOSS)
(in thousands, except per share data)
Quarter Ended
March 31,
------------------------
2001 2000
--------- ---------
Net revenues:
Software license fees $ 29,571 34,103
Service revenues 15,286 11,018
Advertising 5,522 8,407
--------- ---------
Total net revenues 50,379 53,528
--------- ---------
Cost of revenues:
Software license fees 1,927 4,348
Service revenues 5,152 2,585
Advertising 1,849 1,591
--------- ---------
Total cost of revenues 8,928 8,524
--------- ---------
Gross profit 41,451 45,004
--------- ---------
Operating expenses:
Research and development (excluding non-cash
stock based compensation of $14,045 for the
quarter ended March 31, 2001, and $17,755 for
the comparable period in 2000, included below) 16,621 11,620
Sales and marketing (excluding non-cash stock
based compensation of $715 for the quarter
ended March 31, 2001, and $866 for the
comparable period in 2000, included below) 20,246 22,600
General and administrative 5,453 6,933
Goodwill amortization, acquisitions charges,
and stock based compensation 27,466 27,572
--------- ---------
Total operating expenses 69,786 68,725
--------- ---------
Operating loss (28,335) (23,721)
Other income, net 5,196 4,900
--------- ---------
Loss before income taxes (23,139) (18,821)
Income taxes 1,234 --
--------- ---------
Net loss $ (24,373) (18,821)
========= =========
Basic and diluted net loss per share $ (0.15) (0.12)
========= =========
Shares used to compute basic and diluted
net loss per share 158,719 151,589
Comprehensive loss:
Net loss $ (24,373) (18,821)
Unrealized gain (loss) on investments (3,209) 381
Foreign currency translation adjustment (491) (60)
--------- ---------
Comprehensive loss $ (28,073) (18,500)
========= =========
See accompanying notes to condensed consolidated financial statements
5
REALNETWORKS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
QUARTER ENDED MARCH 31,
------------------------
2001 2000
--------- ---------
Cash flows from operating activities:
Net loss $ (24,373) (18,821)
Adjustments to reconcile net loss to net cash
provided by operating activities:
Depreciation and amortization of equipment and
leasehold improvements 2,954 1,894
Amortization of goodwill, related stock based
compensation and acquisition charges 27,466 27,572
Deferred income taxes 1,183 --
Net change in certain assets and liabilities (8,121) 12,487
--------- ---------
Net cash provided by (used in) operating activities (891) 23,132
Cash flows from investing activities:
Purchases of equipment and leasehold improvements (9,120) (4,417)
Purchases of short-term investments (108,791) (85,376)
Proceeds from sales and maturities of short-term investments 140,805 103,859
Purchases of long-term equity investments (5,022) (17,997)
Decrease in restricted cash equivalents 1,500 --
Cost of businesses acquired, net of cash acquired (1,949) (2,945)
--------- ---------
Net cash provided by (used in) investing activities 17,423 (6,876)
--------- ---------
Cash flows from financing activities:
Net proceeds from sale of common stock and
exercise of stock options 1,790 6,299
--------- ---------
Net cash provided by financing activities 1,790 6,299
--------- ---------
Effect of exchange rate changes on cash (770) (395)
--------- ---------
Net increase in cash and cash equivalents 17,552 22,160
Cash and cash equivalents at beginning of period 147,885 160,955
--------- ---------
Cash and cash equivalents at end of period 165,437 183,115
Short-term investments at end of period 185,039 165,570
--------- ---------
Total cash, cash equivalents and short-term
investments at end of period $ 350,476 348,685
========= =========
See accompanying notes to condensed consolidated financial statements
6
REALNETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(in thousands, except per share data)
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(a) Description of Business
RealNetworks, Inc. and subsidiaries (RealNetworks or Company) is a
leading global provider of software products and services for Internet media
delivery. The Company pioneered the development of "streaming media" systems
that enable the creation, real-time delivery and playback of audio, video and
multimedia content on the Web. In 1999, the Company extended its media delivery
platform to include a digital music management system that allows consumers to
acquire, record, store, organize and play their personal music collections on
personal computers and digital playback devices and is extending it further to
allow consumers to enjoy streaming and digital media content via mobile networks
and devices.
Inherent in the Company's business are various risks and uncertainties,
including its limited operating history and the limited history of commerce on
the Internet. The Company's success may depend in part upon the emergence of the
Internet and corporate intranets as a communications medium, the acceptance of
the Company's technology by the marketplace and the Company's ability to
generate license, service and advertising revenues from the use of its
technology on the Internet.
(b) Basis of Presentation
The accompanying unaudited condensed consolidated financial statements
include the accounts of the Company and its wholly-owned subsidiaries. All
significant intercompany balances and transactions have been eliminated in
consolidation.
These financial statements reflect all adjustments, consisting only of
normal, recurring adjustments that, in the opinion of the Company's management,
are necessary for a fair presentation of the results of operations for the
periods presented. Operating results for the quarter ended March 31, 2001 are
not necessarily indicative of the results that may be expected for any
subsequent quarter or for the year ending December 31, 2001. Certain information
and footnote disclosures normally included in financial statements prepared in
conformity with generally accepted accounting principles have been condensed or
omitted pursuant to the rules and regulations of the Securities and Exchange
Commission.
These condensed consolidated financial statements should be read in
conjunction with the consolidated financial statements and related notes
included in the Company's Annual Report on Form 10-K for the year ended December
31, 2000.
(c) Cash, Cash Equivalents and Short-Term Investments
Cash, cash equivalents and short-term investments are comprised of the
following:
March 31, 2001 December 31, 2000
-------------- -----------------
Cash and cash equivalents $165,437 147,885
Short-term investments 185,039 216,825
-------- -------
Total cash, cash equivalents and
short-term investments $350,476 364,710
======== =======
Restricted cash equivalents $ 17,300 18,800
======== =======
7
Restricted cash equivalents represent (a) a restricted escrow account of
$10,000 established in connection with a lease agreement for the Company's
corporate headquarters that will be maintained for the term of the lease, and
(b) cash equivalents held as collateral against a $7,300 line of credit with a
bank which represents collateral on the lease of a building located near the
Company's corporate headquarters.
The majority of short-term investments mature within twelve months from
the date of purchase.
(d) Revenue Recognition
The Company recognizes revenue using the residual method pursuant to the
requirements of Statement of Position No. 97-2, "Software Revenue Recognition"
(SOP 97-2), as amended by Statement of Position No. 98-9, "Software Revenue
Recognition with Respect to Certain Arrangements."
Under the residual method, revenue is recognized in a multiple element
arrangement when Company-specific objective evidence of fair value exists for
all of the undelivered elements in the arrangement, but does not exist for one
or more of the delivered elements in the arrangement. At the outset of the
arrangement with a customer, the Company defers revenue for the fair value of
its undelivered elements such as consulting services and product support and
upgrades, and recognizes the revenue for the remainder of the arrangement fee
attributable to the elements initially delivered, such as software licenses,
when the criteria in SOP 97-2 have been met. If specific objective evidence does
not exist for an undelivered element in a software arrangement, which, for the
Company, relates to the development of complex content delivery networks which
include software licenses, consulting services and product support, revenue is
recognized over the term of the support period commencing upon deployment of the
Company's technology in the customer's network.
Under SOP 97-2, revenue attributable to an element in a customer
arrangement is recognized when persuasive evidence of an arrangement exists and
delivery has occurred, provided the fee is fixed or determinable, collectibility
is probable, and the arrangement does not require significant customization of
the software. If, at the outset of the customer arrangement, the Company
determines that the arrangement fee is not fixed or determinable or that
collectibility is not probable, the Company defers the revenue and recognizes
the revenue when the arrangement fee becomes due and payable.
Revenue from software license agreements with original equipment
manufacturers (OEM) is recognized when the OEM delivers its product
incorporating the Company's software to the end user. In the case of prepayments
received from an OEM, the Company recognizes revenue based on the actual
products sold by the OEM. If the Company provides ongoing support to the OEM in
the form of future upgrades, enhancements or other services over the term of the
contract, revenue is recognized over the term of the contract.
Service revenues include payments under support and upgrade contracts,
RealPlayer GoldPass media subscription services, and fees from consulting
services and streaming media content hosting. Support and upgrade revenues are
recognized ratably over the term of the contract, which typically is twelve
months. Media subscription service revenues are recognized over the period that
services are provided. Other service revenues are recognized when the services
are performed.
Fees generated from advertising appearing on the Company's Web sites,
and from advertising included in the Company's products, such as fees for
distribution of RealChannels, LiveStations, and e-commerce and other links in
the RealPlayer and RealJukebox, are recognized as revenue over the terms of the
contracts. The Company may guarantee a minimum number of advertising
impressions, click-throughs or other specified criteria on the Company's Web
sites or products for a specified period. To the extent these guarantees are not
met, the Company defers recognition of the corresponding revenues until
guaranteed delivery levels are achieved.
(e) Net Loss Per Share
Basic net loss per share is computed by dividing net loss by the
weighted average number of common shares outstanding during the period. Diluted
net loss per share is computed by dividing net loss by the weighted
8
average number of common and dilutive common equivalent shares outstanding
during the period. As the Company had a net loss for the quarters ended March
31, 2001 and 2000, basic and diluted net loss per share are the same for those
periods.
Excluded from the computation of diluted net loss per share for the
quarter ended March 31, 2001 are options and warrants to acquire approximately
21,353 shares of common stock with a weighted-average exercise price of $9.40.
Also excluded are approximately 1,366 shares of common stock issued in
acquisitions that are subject to repurchase by the Company at a nominal price in
certain circumstances. Excluded from the computation of diluted net loss per
share for the quarter ended March 31, 2000 are options and warrants to acquire
39,392 shares of common stock with a weighted-average exercise price of $23.53.
Also excluded are approximately 1,820 shares of common stock issued in
acquisitions that are subject to repurchase by the Company at a nominal price in
certain circumstances. Such potentially dilutive securities are excluded, as
their effects are anti-dilutive.
(f) Derivative Financial Instruments
Effective January 1, 2001, the Company adopted Statement of Financial
Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging
Activities" (SFAS 133). The adoption of SFAS 133 did not impact the Company's
consolidated financial statements as of January 1, 2001.
SFAS 133, as amended, requires that all derivative instruments be
recorded on the balance sheet at fair value. Changes in the fair value of
derivatives are recorded each period in current results of operations or other
comprehensive income (loss) depending on whether a derivative is designated as
part of a hedge transaction, and if so, the type of risk being hedged.
For a derivative designated as a fair value hedge, the gain or loss of
the derivative in the period of change and the offsetting loss or gain of the
hedged item attributed to the hedged risk are recognized in results of
operations. For a derivative designated as a cash flow hedge, the effective
portion of the derivative's gain or loss is initially reported as a component of
other comprehensive income (loss) and subsequently reclassified into results of
operations when the hedged exposure affects results of operations. The
ineffective portion of the gain or loss of a cash flow hedge is recognized
immediately in results of operations. For a derivative not designated as a
hedging instrument, the gain or loss is recognized in results of operations in
the period of change.
During the quarter ended March 31, 2001, the Company entered into a
foreign currency forward contract to manage the foreign currency risk of certain
intercompany payables denominated in a foreign currency. Although this
instrument is effective as a hedge from an economic perspective, it did not
qualify for hedge accounting under SFAS No. 133, as amended. The net gain on
this contract was not significant at March 31, 2001, and is recorded in other
assets.
(g) Impairment of Long-Lived Assets and Goodwill
The Company reviews its long-lived assets, including goodwill, for
impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. Recoverability of assets
held and used, including goodwill, is measured by a comparison of the carrying
amount of an asset to future net cash flows expected to be generated by the
asset. If such assets are considered to be impaired, the impairment to be
recognized is measured by the amount by which the carrying amount of the assets
exceeds the fair value of the assets. Assets to be disposed of are reported at
the lower of their carrying amount or fair value less costs to sell.
NOTE 2 - SEGMENT INFORMATION
The Company operates in one business segment, media delivery, for which
the Company receives revenues from its customers. The Company's Chief Operating
Decision Maker is considered to be the Company's Operating Committee (COC),
which is comprised of the Company's Chief Executive Officer, President and Chief
Operating Officer, and Senior Vice Presidents. The COC reviews financial
information presented on a consolidated basis accompanied by disaggregated
information about products and services and geographical regions for purposes of
making decisions and assessing financial performance. The COC does not review
discrete financial information regarding profitability of the Company's
different products or services and, therefore, the Company does not have
operating segments as defined by Statement of Financial Accounting Standards No.
131, "Disclosure About Segments of an Enterprise and Related Information."
The Company's customers consist primarily of end users located in the
United States and various foreign countries. Revenues by geographic region are
as follows:
9
Quarter Ended
March 31,
---------------------
2001 2000
------- ------
United States $34,990 38,555
Europe 8,953 6,353
Asia 4,670 4,852
Rest of the world 1,766 1,151
------- ------
Subtotal 50,379 50,911
Microsoft license revenue -- 2,617
------- ------
Total $50,379 53,528
======= ======
Revenue from external customers by product type is as follows:
Quarter Ended
March 31,
----------------------
2001 2000
------- ------
Media delivery license revenue $29,571 31,486
Media delivery service revenue 15,286 11,018
Microsoft license revenue -- 2,617
Advertising revenue 5,522 8,407
------- ------
Total net revenues $50,379 53,528
======= ======
Long-lived assets by geographic location are as follows:
March 31, December 31,
2001 2000
--------- ------------
United States $143,089 146,280
Japan/Rest of the world 578 594
Europe 214 260
-------- -------
Total $143,881 147,134
======== =======
NOTE 3 - ACQUISITIONS
In December 2000, the Company acquired all of the outstanding
securities of Aegisoft, Inc. (Aegisoft), a developer of secure digital media
software, for approximately 1,212 shares (including options to purchase shares)
of its common stock. Approximately 274 of those shares are subject to repurchase
by the Company at a nominal price in certain circumstances. The acquisition was
accounted for under the purchase method of accounting and, accordingly, the
results of Aegisoft's operations are included in the Company's consolidated
financial statements since the date of acquisition. The Company incurred
approximately $1,287 in acquisition-related expenditures, including $562 of
relocation payments for Aegisoft employees which are dependent upon the related
individuals remaining employed by the Company, and are expensed over the related
employment term, and $725 in professional fees and other costs. As of March 31,
2001, approximately $747 of these costs have been paid. The remaining costs are
expected to be paid during 2001.
In July 2000, the Company acquired a privately held company accounted
for under the purchase method of accounting for total consideration of $5.6
million including common shares valued at $3.5 million which are subject
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to repurchase by the Company under certain circumstances. Goodwill of $2.1
million was recorded and represents the excess of the purchase price over the
fair value of identifiable tangible and intangible assets acquired and
liabilities assumed.
In January 2000, the Company acquired all of the outstanding securities
of NetZip, Inc. (NetZip), a developer and provider of Internet download
management and utility software for 3,418 shares (including options to purchase
shares) of its common stock. Approximately 1,820 of those shares are subject to
repurchase by the Company at a nominal price in certain circumstances. The
acquisition was accounted for under the purchase method of accounting and,
accordingly, the results of NetZip's operations are included in the Company's
consolidated financial statements since the date of acquisition. The Company
incurred approximately $5.0 million in acquisition-related expenditures,
including $3.2 million of relocation payments and stay bonuses for NetZip
employees which are dependent upon the related individuals remaining employed by
the Company, and are expensed over the related employment term, and $1.8 million
in professional fees and other costs. As of March 31, 2001, approximately $4.8
million of these costs have been paid.
Summaries of the purchase price for Aegisoft and NetZip are as follows:
Aegisoft NetZip
-------- -------
Stock and stock options $10,303 125,913
Direct acquisition costs 725 1,771
Accrued liabilities assumed 89 809
Other liabilities assumed - 281
------- -------
Total purchase price 11,117 128,774
Stock based compensation not
included in purchase price 2,327 143,973
------- -------
Total acquisition cost and value of
common stock to be issued under
compensation agreements $13,444 272,747
======= =======
The purchase price was allocated as follows:
Aegisoft NetZip
-------- -------
Cash $ -- 73
Other current assets acquired 33 440
Equipment 51 324
Non-current assets acquired 26 15
Goodwill 11,007 127,922
------- -------
Total $11,117 128,774
======= =======
No elements of in-process research and development were identified as
part of the acquisitions.
The following table presents unaudited pro forma results of operations
for the quarter ended March 31, 2000 as if the acquisitions of Aegisoft and
NetZip had occurred on January 1, 2000. The unaudited pro forma information is
not necessarily indicative of the combined results that would have occurred had
the acquisitions taken place at the beginning of the periods presented, nor is
it necessarily indicative of results that may occur in the future.
Total net revenue 54,624
Net loss (30,424)
Net loss per share - basic and diluted (0.20)
11
Goodwill amortization, acquisition charges and stock based compensation for
these and other acquisitions are as follows:
Quarter Ended
March 31,
-------------------
2001 2000
------- ------
Stock based compensation $14,760 18,621
Goodwill amortization and
acquisition charges 12,706 8,951
------- ------
Total $27,466 27,572
======= ======
NOTE 4 - OTHER INVESTMENTS
RealNetworks has made investments through the purchase of voting capital
stock of companies that are engaged in businesses that are complimentary to
those of the Company. The Company's investments in publicly traded companies are
available for sale and are carried at current market value and are classified as
long term as they are strategic in nature and the Company has no plans to sell
them in the near term. Based upon an evaluation of the facts and circumstances
at March 31, 2001, an other than temporary impairment had not occurred.
NOTE 5 - STOCK OPTIONS
In February 2001, the Company offered a voluntary stock option
cancellation and regrant program to its employees. The plan allowed employees,
at their option, to cancel a portion or all of their unexercised stock options
effective February 22, 2001, provided that, should an employee participate, any
option granted to that employee within the six month period preceding February
22, 2001 is automatically cancelled. In exchange, the employee will be granted
on August 31, 2001 a new option to purchase a number of shares equal to the
number of shares underlying the cancelled option. The exercise price of the new
options will be the fair market price of the Company's common stock as listed on
the Nasdaq National Market at the close of business on August 31, 2001 and the
vesting period will remain consistent with the original option grant. Members of
the Company's Board of Directors, including the chairman and CEO as well as the
CFO, were not eligible for this program, and participation by other named
executive officers was limited.
NOTE 6 - LITIGATION
In August 1998, Venson M. Shaw and Steven M. Shaw filed a lawsuit
against the Company and co-defendant Broadcast.com in the United States District
Court for the Northern District of Texas -- Dallas Division. The plaintiffs
allege that the Company, individually and in combination with Broadcast.com,
infringes on a certain patent by making, using, selling and/or offering to sell
software products and services directed to media delivery systems for the
Internet and corporate intranets. The plaintiffs seek to enjoin the Company from
the alleged infringing activity and to recover damages in an amount no less than
a reasonable royalty. The Company may be required to indemnify Broadcast.com
under the terms of its license agreement. The plaintiffs filed a similar claim
based on the same patent and seeking similar remedies as a separate lawsuit
against Microsoft and Broadcast.com in the same court. The court has
consolidated the lawsuit against Microsoft and Broadcast.com with the lawsuit
against the Company and Broadcast.com. If the plaintiffs prevail in their
claims, the Company could be required to pay damages or other royalties, in
addition to complying with injunctive relief, which could have a material
adverse effect on the Company's operating results. Although no assurance can be
given as to the outcome of this lawsuit, the Company believes that the
allegations in this action are without merit, and intends to vigorously defend
itself against these claims. The Company believes the ultimate outcome will not
have a material adverse effect on its financial position or results of
operations.
Between November 1999 and March 2000, fourteen lawsuits were filed
against the Company in federal and/or state courts in California, Illinois,
Pennsylvania, Washington and Texas. The plaintiffs have voluntarily dismissed
all of the state court cases with the exception of the case pending in
California. The remaining actions,
12
which seek to certify classes of plaintiffs, allege breach of contract, invasion
of privacy, deceptive trade practices, negligence, fraud and violation of
certain federal and state laws in connection with various communications
features of our RealPlayer and RealJukebox products. Plaintiffs are seeking both
damages and injunctive relief. The Company has filed answers denying the claims
and has filed suit in Washington State Court to compel the state court
plaintiffs to arbitrate the claims as required by the Company's End User License
Agreements. The Washington State Court has granted the Company's motion to
compel arbitration. On February 10, 2000, the federal Judicial Panel on
Multidistrict Litigation transferred all pending federal cases to the federal
district court for the Northern District of Illinois. On the same day, that
court granted RealNetworks' motion to stay the court proceedings because the
claims are subject to arbitration under RealNetworks' End User License
Agreement. Although no assurance can be given as to the outcome of these
lawsuits, the Company believes that the allegations in these actions are without
merit, and intends to vigorously defend itself. The Company believes the
ultimate outcome will not have a material adverse effect on its financial
position or results of operations. If the plaintiffs prevail in their claims,
the Company could be required to pay damages or other penalties in addition to
complying with injunctive relief, which could harm the Company's business and
its operating results.
From time to time RealNetworks is, and expects to continue to be,
subject to legal proceedings and claims in the ordinary course of its business,
including employment claims, contract-related claims and claims of alleged
infringement of third-party patents, trademarks and other intellectual property
rights. These claims, even if not meritorious, could force the Company to spend
significant financial and managerial resources. The Company currently has a
number of such claims threatened against it relating to intellectual property
infringement or employment, though it believes these claims are without merit.
The Company is not aware of any legal proceedings or claims that the Company
believes will have, individually or taken together, a material adverse effect on
the Company's business, prospects, financial condition or results of operations.
However, the Company may incur substantial expenses in defending against third
party claims. In the event of a determination adverse to the Company, the
Company may incur substantial monetary liability, and/or be required to change
its business practices. Either of these could have a material adverse effect on
the Company's financial position and results of operations.
NOTE 7 - SUBSEQUENT EVENTS
In April 2001, the Company announced the formation of Musicnet.com, Inc.
(MusicNet), a joint venture with three media companies to create a platform for
online music subscription services. MusicNet, which previously was a subsidiary
of the Company, issued additional shares of capital stock reducing the Company's
ownership interest in MusicNet to 40%. The Company's investment in MusicNet will
be accounted for under the equity method of accounting from the transaction
date.
13
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The discussion in this report contains forward-looking statements that
involve risks and uncertainties. We have identified a number of these
forward-looking statements in the section below entitled "Special Note Regarding
Forward-Looking Statements." RealNetworks' actual results could differ
materially from those discussed below. Factors that could cause or contribute to
such differences include, but are not limited to, those identified below, and
those discussed in the section titled "Factors that May Affect Our Business,
Future Operating Results and Financial Condition", included elsewhere in this
Report. You should also carefully review the risk factors set forth in other
reports or documents that RealNetworks files from time to time with the
Securities and Exchange Commission, particularly Quarterly Reports on Form 10-Q
and any Current Reports on Form 8-K.
OVERVIEW
RealNetworks is a leading global provider of software products and
services for Internet media delivery. We pioneered the development of streaming
media systems that enable the creation, real-time delivery and playback of
audio, video and multimedia content on the Web. In 1999, we extended our media
delivery platform to include a digital music management system that allows
consumers to acquire, record, store, organize and play their personal music
collections on PCs and digital playback devices and are extending it further to
allow consumers to enjoy streaming and digital media content via mobile networks
and devices.
We were incorporated in February 1994 and were in the development stage
until July 1995, when we released the commercial version of RealAudio Version
1.0, the first version of our RealPlayer products. In August 1996, we began
selling RealPlayer Plus, a premium version of our RealPlayer product. RealPlayer
has always been available for download free of charge from our Web sites. In
December 1997, we released the commercial version of RealSystem Version 5.0, a
streaming media solution that included RealAudio and RealVideo technology. In
May 1999, we released RealSystem MP as well as a beta version of RealJukebox, a
personal music management system. In September 1999, we released the commercial
versions of RealJukebox and RealJukebox Plus. In November 1999, we introduced
the new Real.com Network, which gives consumers the ability to find, organize
and play audio and video on the Internet, and Take 5, Real.com's media
programming guide. In March 2000, we introduced Real.com Games, which offers a
new online, digital distribution model for high quality downloadable computer
games. In May 2000, we released a beta version of RealVideo 8, an Internet media
system that we believe delivers a high clarity, full-motion video experience to
consumers using dial-up modems, full-screen VHS quality at mainstream broadband
rates, and near DVD-quality video to those using high capacity networks or
downloadable media. In August 2000, we released the gold version of RealPlayer
8, RealJukebox 2, RealDownload 4 and launched RealPlayer GoldPass, a for-pay
media subscription service available to RealPlayer Plus customers. RealPlayer
GoldPass gives subscribers access to a combination of premium software, services
and content updated monthly. In December 2000, we released RealSystem iQ, a new
foundational architecture for digital media delivery which greatly increases the
reliability of Internet broadcasts, scales to large audiences, and provides
greatly enhanced flexibility and cost-effectiveness for media delivery network
deployments. In March 2001, we introduced RealArcade, a new end-to-end platform
for the digital distribution of PC games benefiting both developers and
consumers. The RealArcade developer service will provide game creators with the
tools and services they need to build, package, distribute and sell PC games
online.
We report revenues in three categories:
- Software license fees, which include revenues from sales of our
RealPlayer Plus, RealJukebox Plus, RealEntertainment Center Plus,
RealServers and related authoring and publishing tools, both directly to
customers and indirectly through OEM channels, and sales of third-party
products.
- Service revenues, which include revenues from support and maintenance
services that we sell to customers who purchase our RealPlayer Plus,
RealJukebox Plus, RealEntertainment Center Plus, RealServers and related
authoring and publishing tools, RealPlayer GoldPass subscription
services, broadcast hosting services we provide through our Real
Broadcast Network, and consulting services we offer to our customers.
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- Advertising revenues, which are derived from the sale of advertising
on our Web sites and the placement and distribution of RealChannels,
LiveStations and advertising and promotional buttons and links included
in the RealPlayer and the RealJukebox products.
In January 2000, we acquired NetZip, Inc. (NetZip), a privately-held
developer and provider of Internet download management and utility software. In
December 2000, we acquired Aegisoft Corp. (Aegisoft), a developer of secure
digital media software. Both transactions were accounted for using the purchase
method of accounting.
RESULTS OF OPERATIONS
REVENUES
Software License Fees. Software license fees were $29.6 million for the
quarter ended March 31, 2001, a decrease of 13% from $34.1 million for the
quarter ended March 31, 2000. We believe the decrease was due primarily to a
significant reduction in equity funding of new and Internet-related businesses
in the second half of 2000 and the first quarter of 2001. We believe that this
reduced funding impacted, either directly or indirectly, Internet-related
businesses, which thereby directly impacted both our customers and potential
customers. The reduced availability of funding has contributed to certain of our
customers and potential customers going out of business and others experiencing
difficult financial situations. We believe that this environment has also
resulted in current and potential customers delaying or foregoing purchases and
has caused sales cycles for some customers to take longer than in the past.
These factors negatively impacted our revenues for the first quarter of 2001. In
August 2000, we began our transition to selling GoldPass, and we focused our
promotional activities to feature GoldPass, which has characteristics of
longer-term, recurring subscription revenue, rather than product offerings that
generate short-term, non-recurring revenue. Additionally, software license fees
for the quarter ended March 31, 2000 included $2.6 million related to a
three-year license agreement we entered into with Microsoft which expired in
the quarter ended June 30, 2000.
Service Revenues. Service revenues were $15.3 million for the quarter
ended March 31, 2001, an increase of 39% from $11.0 million for the quarter
ended March 31, 2000. The increase in service revenues was primarily
attributable to our GoldPass subscription services, which we introduced in
August 2000. GoldPass accounted for approximately $4.3 million of revenue for
the quarter ended March 31, 2001.
Advertising. Advertising revenues were $5.5 million for the quarter
ended March 31, 2001, a decrease of 34% from $8.4 million for the quarter ended
March 31, 2000. The decrease in advertising revenues for the quarter ended March
31, 2001 was due to a decline in the demand for Internet advertising, which
resulted in lower average advertising rates, and caused certain promotional
contracts not to be renewed.
GEOGRAPHIC REVENUES
International revenues represented 31% of total net revenues for the
quarter ended March 31, 2001, compared to 24% for the quarter ended March 31,
2000 (excluding revenues from the Microsoft license agreement). Revenues
generated in Europe were 18% of total net revenues for the quarter ended March
31, 2001, and 12% of total net revenues for the quarter ended March 31, 2000
(excluding revenues from the Microsoft license agreement), and revenues
generated in Asia and the rest of the world were 13% of total net revenues for
the quarter ended March 31, 2001 and 12% of total net revenues for the quarter
ended March 31, 2000 (excluding revenues from the Microsoft license agreement).
At March 31, 2001, accounts receivable due from European and Asian customers
represented approximately 47% of total accounts receivable. The functional
currency of our foreign subsidiaries is the local currency of the country in
which the subsidiary operates. Results of operations of our foreign subsidiaries
are translated from local currency into U.S. dollars based on average monthly
exchange rates. We currently do not hedge the majority of our foreign currency
exposures and therefore are subject to the risk of changes in exchange rates. We
expect that international revenues will increase over time in both absolute
dollars and as a percentage of total net revenues. The costs of both domestic
and international revenues are substantially the same.
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DEFERRED REVENUES
Deferred revenue is comprised of the unrecognized revenue related to
support contracts, prepayments under OEM arrangements, and other prepayments for
which the earnings process has not been completed. Revenue from contracts with
customers developing content delivery networks was generally recognized over the
term of the arrangement commencing upon the customer's deployment of our
technology in their network build-out. Because many of the agreements related to
the content delivery networks have been with companies that have had limited
operating histories, we have historically required prepayments from such
customers to manage our credit risk. Cash prepayments associated with these
contracts are recorded as deferred revenue and amounted to $23.7 million and
$26.9 million at March 31, 2001 and December 31, 2000, respectively. If, in the
future, we enter into agreements with more established companies, we may not
require these prepayments and as such, we anticipate our deferred revenue
balances may decline as a result.
COST OF REVENUES
Cost of Software License Fees. Cost of software license fees includes
costs of product media, duplication, manuals, packaging materials, amounts paid
for licensed technology, and fees paid to third-party vendors for order
fulfillment. Cost of software license fees was $1.9 million for the quarter
ended March 31, 2001, a decrease of 56% from $4.3 million for the quarter ended
March 31, 2000, and decreased as a percentage of software license fees to 7% for
the quarter ended March 31, 2001 from 13% for the quarter ended March 31, 2000.
The decrease in costs was due primarily to lower sales volumes and the
expiration of certain royalty agreements. The decrease in percentage of
software license fees was due to shifts in product mix.
Cost of Service Revenues. Cost of service revenues includes the cost of
in-house and contract personnel providing support and consulting services,
expenses incurred in providing our streaming media hosting services and cost of
content included in our GoldPass subscription service offering. Cost of service
revenues was $5.2 million for the quarter ended March 31, 2001, an increase of
99% from $2.6 million for the quarter ended March 31, 2000, and increased as a
percentage of service revenues to 34% for the quarter ended March 31, 2001 from
23% for the quarter ended March 31, 2000. The increase in costs was primarily
due to increased staff and contract personnel employed to provide services to a
greater number of customers, including consulting and streaming media hosting
customers, increased bandwidth costs, the introduction of our GoldPass
subscription service in August 2000 and related costs of content included in
GoldPass. The increase in percentage of service revenues was due to shifts in
product mix.
Cost of Advertising. Cost of advertising includes the cost of personnel
associated with maintenance of programming services, content creation and
maintenance and fees paid to third parties for content included in our Web sites
and ad delivery services. Cost of advertising was $1.8 million for the quarter
ended March 31, 2001, an increase of 16% from $1.6 million for the quarter ended
March 31, 2000, and increased as a percentage of advertising revenues to 34% for
the quarter ended March 31, 2001 from 19% for the quarter ended March 31, 2000.
The increase in costs was primarily due to increases in the quality and quantity
of content available on our Web sites. The increase in percentage of advertising
revenues was due to cost of advertising decreasing at a lower rate than the
decrease in advertising revenues, due to certain fixed expense components of
cost of advertising.
OPERATING EXPENSES
Research and Development
Research and development expenses consist primarily of salaries and
related personnel costs, consulting fees associated with product development and
costs of technology acquired from third parties to incorporate into products
currently under development. To date, all research and development costs have
been expensed as incurred because technological feasibility is generally not
established until substantially all development is complete. We believe that
significant investment in research and development is a critical factor in
attaining our strategic objectives and, as a result, we expect research and
development expenses to continue to increase in future periods. Research and
development expenses, excluding non-cash stock compensation expenses, were $16.6
million for the quarter ended March 31, 2001, an increase of 43% from $11.6
million for the quarter ended March 31, 2000, and increased as a percentage of
total net revenues to 33% for the quarter ended March 31, 2001 from 22% for the
quarter ended March
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31, 2000. The increase in expenses was primarily due to increases in internal
development personnel and related costs, consulting expenses and contract labor
related to the development of new technology and products and enhancements made
to existing products. New product developments in the first quarter of 2001
include RealArcade and live ad insertion technology. The increase in percentage
of total net revenues was primarily a result of the decrease in net revenues in
the first quarter of 2001 while expenses were increasing.
Sales and Marketing
Sales and marketing expenses consist primarily of salaries and related
personnel costs, sales commissions, consulting fees, trade show expenses,
advertising costs and costs of marketing collateral. Sales and marketing
expenses, excluding non-cash stock compensation expenses, were $20.2 million for
the quarter ended March 31, 2001, a decrease of 10% from $22.6 million for the
quarter ended March 31, 2000, and decreased as a percentage of total net
revenues to 40% for the quarter ended March 31, 2001 from 42% for the quarter
ended March 31, 2000. The decrease in expenses was due to decreased trade show
attendance, a decrease in advertising and marketing expenses and decreased
advertising, promotions and expenses related to our overall corporate branding
and marketing. The decrease in percentage of total net revenues was primarily a
result of cost saving measures that reduced sales and marketing expenses faster
than the rate of the decline in net revenues.
General and Administrative
General and administrative expenses consist primarily of salaries and
related personnel costs, and fees for professional and temporary services.
General and administrative expenses were $5.5 million for the quarter ended
March 31, 2001, a decrease of 21% from $6.9 million for the quarter ended March
31, 2000, and decreased as a percentage of total net revenues to 11% for the
quarter ended March 31, 2001 from 13% for the quarter ended March 31, 2000. The
decrease in expenses was primarily due to decreased litigation defense costs.
The decrease in percentage of total net revenues was primarily due to cost
saving measures that reduced general and administrative expenses faster than the
rate of the decline in net revenues.
Goodwill Amortization, Acquisition Charges and Stock-Based Compensation
Stock-based compensation expense for the quarters ended March 31, 2001
and 2000 was $14.8 million and $18.6 million, respectively. Goodwill
amortization and acquisition charges for the quarters ended March 31, 2001 and
2000 were $12.7 million and $9.0 million, respectively. The changes between
periods are due to the timing of acquisitions.
OTHER INCOME, NET
Other income, net consists primarily of interest earnings on our cash,
cash equivalents and short-term investments. The increase was primarily due to
higher returns on invested cash balances.
INCOME TAXES
For the quarter ended March 31, 2001, we recorded an income tax
provision, although we do not expect to pay federal income taxes in the near
future, due primarily to tax deductions related to the exercise of employee
stock options, the benefit of which is recorded directly to shareholders'
equity. During the quarter ended March 31, 2001, our effective income tax rate
differed from the amount computed by applying the statutory federal rate
principally due to nondeductible amortization of goodwill and stock compensation
charges related to acquisitions. Excluding these nondeductible charges, our
effective tax rate was approximately 31%. For the quarter ended March 31, 2000,
we did not recognize income tax expense as a result of reductions in our
valuation allowance for deferred tax assets. As of March 31, 2001, we had net
operating loss carryforwards of approximately $501 million, substantially all of
which result from employee stock options, the realization of which would
increase shareholders' equity.
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LIQUIDITY AND CAPITAL RESOURCES
Net cash used in operating activities was $0.9 million for the quarter
ended March 31, 2001 and net cash provided by operating activities was $23.1
million for the quarter ended March 31, 2000. Net cash used in operating
activities for the quarter ended March 31, 2001 resulted primarily from net
income of $3.1 million (excluding non-cash charges of $27.5 million for goodwill
amortization, acquisition charges, and stock- based compensation), non-cash
depreciation expense of $3.0 million and a reduction of accounts receivable of
$1.7 million, offset by decreases in deferred revenue of $6.7 million and
accrued and other liabilities of $2.2 million. Net cash provided by operating
activities for the quarter ended March 31, 2000 resulted primarily from net
income of $8.8 million (excluding non-cash charges of $27.6 million for goodwill
amortization, acquisition charges, and stock-based compensation) and increases
in deferred revenue of $11.6 million, and accrued and other liabilities of $3.5
million, and non-cash depreciation expense of $1.9 million. This was partially
offset by an increase in accounts receivable of $2.7 million.
Net cash provided by investing activities was $17.4 million for the
quarter ended March 31, 2001. This was primarily the result of the sales and
maturities of short-term investments, offset in large part by purchases of
short-term investments and equipment and leasehold improvements. Net cash used
in investing activities was $6.9 million for the quarter ended March 31, 2000.
This was primarily a result of purchases of short-term investments, purchases of
long-term equity investments and purchases of equipment and leasehold
improvements, offset in large part by sales and maturities of short-term
investments.
Net cash provided by financing activities was $1.8 million and $6.3
million for the quarters ended March 31, 2001 and 2000, respectively. In both
periods, net cash provided by financing activities was a result of net proceeds
from the exercise of stock options.
At March 31, 2001, we had $368 million in cash, cash equivalents,
short-term investments and restricted cash equivalents and our principal
commitments consisted of obligations under operating leases. Since our
inception, we have experienced and expect to continue to experience a
substantial increase in our capital expenditures to support expansion of our
operations and information systems.
In January 1998, we entered into a lease agreement for a new location
for our corporate headquarters. The lease commenced on April 1, 1999 and expires
on April 1, 2011, with an option to renew the lease for either a three-or
ten-year period. In October 2000, we entered into a 10-year lease agreement for
additional office space for our corporate headquarters.
We do not hold derivative financial instruments or equity securities in
our short-term investment portfolio. Our cash equivalents and short-term
investments consist of high quality securities, as specified in our investment
policy guidelines. The policy limits the amount of credit exposure to any one
issue or issuer to a maximum of 5% of the total portfolio and requires that all
investments mature in two years or less, with the average maturity being one
year or less. These securities are subject to interest rate risk and will
decrease in value if interest rates increase. Because we have historically had
the ability to hold our fixed income investments until maturity, we would not
expect our operating results or cash flows to be significantly affected by a
sudden change in market interest rates on our securities portfolio.
We conduct our operations in ten primary functional currencies: the
United States dollar, the Japanese yen, the British pound, the French franc, the
euro, the Mexican peso, the Brazilian real, the Australian dollar, the Hong Kong
dollar and the German mark. Historically, neither fluctuations in foreign
exchange rates nor changes in foreign economic conditions have had a significant
impact on our financial condition or results of operations. We currently do not
hedge the majority of our foreign currency exposures and are therefore subject
to the risk of exchange rate fluctuations. We invoice our international
customers primarily in U.S. dollars, except in Japan, France, Germany and the
United Kingdom, where we invoice our customers primarily in yen, euros and
pounds, respectively. We are exposed to foreign exchange rate fluctuations as
the financial results of foreign subsidiaries are translated into U.S. dollars
in consolidation. Our exposure to foreign exchange rate fluctuations also arises
from intercompany payables and receivables to and from our foreign subsidiaries.
Foreign exchange rate fluctuations did not have a material impact on our
financial results for the quarters ended March 31, 2001 and 2000.
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On January 1, 1999, the participating member countries of the European
Union converted to a common currency, the euro. On that same date they
established fixed conversion rates between their existing sovereign currencies
and the euro. Even though legacy currencies are scheduled to remain legal tender
in the participating countries as denominations of the euro until January 1,
2002, the participating countries will no longer be able to direct independent
interest rates for the legacy currencies. The authority to set monetary policy
will now reside with the new European Central Bank. We do not anticipate any
material impact from the euro conversion on our financial information systems,
which currently accommodate multiple currencies. Due to numerous uncertainties,
we cannot reasonably estimate the effect that the euro conversion issue will
have on our pricing or market strategies or the impact, if any, it will have on
our financial condition and results of operations.
We believe that our current cash, cash equivalents and short-term
investments will be sufficient to meet our anticipated cash needs for working
capital and capital expenditures for at least the next 12 months.
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FACTORS THAT MAY AFFECT OUR BUSINESS, FUTURE OPERATING RESULTS AND FINANCIAL
CONDITION
You should carefully consider the risks described below together with
all of the other information included in this quarterly report on Form 10-Q. The
risks and uncertainties described below are not the only ones facing our
company. If any of the following risks actually occurs, our business, financial
condition or operating results could be harmed. In such case, the trading price
of our common stock could decline, and you could lose all or part of your
investment.
WE HAVE A LIMITED OPERATING HISTORY, WHICH MAKES IT DIFFICULT TO EVALUATE OUR
BUSINESS
We were incorporated in February 1994 and have a limited operating history. We
have limited financial results on which you can assess our future success. Our
prospects must be considered in light of the risks, expenses and difficulties
frequently encountered by growing companies in new and rapidly evolving markets,
such as streaming media software, media delivery systems and electronic
commerce.
To address the risks and uncertainties faced by our business, we must:
- establish and maintain broad market acceptance of our products and
services and convert that acceptance into direct and indirect sources of
revenues;
- maintain and enhance our brand name;
- continue to timely and successfully develop new products, product
features and services and increase the functionality and features of
existing products;
- successfully respond to competition from Microsoft and others, including
competition from emerging technologies and solutions; and
- develop and maintain strategic relationships to enhance the distribution,
features and utility of our products and services.
Our business strategy may be unsuccessful and we may be unable to address
the risks we face in a cost-effective manner, if at all. If we are unable to
successfully address these risks our business will be harmed.
WE HAVE A HISTORY OF LOSSES
We have incurred significant losses since our inception. As of March 31,
2001, we had an accumulated deficit of approximately $169 million. While we had
net income in 1999, we had a net loss for the year ended December 31, 2000 and
the quarter ended March 31, 2001, and we may not continue our historical growth
or generate sufficient revenues to be profitable on a quarterly or annual basis
in the future. We devote significant resources to developing, enhancing, selling
and marketing our products and services. As a result, we will need to generate
significant revenues to be profitable in the future.
OUR OPERATING RESULTS ARE LIKELY TO FLUCTUATE SIGNIFICANTLY, WHICH WOULD LIKELY
CAUSE OUR STOCK PRICE TO FLUCTUATE
As a result of our limited operating history and the rapidly changing and
uncertain nature of the markets in which we compete, our quarterly and annual
revenues and operating results are likely to fluctuate from period-to-period,
and period-to-period comparisons are not likely to be meaningful. These
fluctuations are caused by a number of factors, many of which are beyond our
control. Our future operating results could fall below the
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expectations of public market analysts or investors, which would likely
significantly reduce the market price of our common stock. Fluctuations in our
operating results will likely increase the volatility of our stock price.
Our research and development and sales and marketing efforts, and other
business expenditures generally, are partially based on predictions regarding
certain developments for media delivery and digital media distribution. To the
extent that these predictions prove inaccurate, our revenues may not be
sufficient to offset these expenditures, and our operating results may be
harmed.
In recent periods, many Internet-related companies have experienced
financial difficulties, in part as a result of their inability to access capital
from financial markets. This has directly or indirectly impacted our current and
prospective customers. The result is that some of these companies have ceased
operations, some are continuing to experience financial difficulty, and sales
cycles for some of our customers and potential customers have taken longer to
close than in the past. In the event that a substantial number of our current or
potential customers experience financial difficulties in the future, our ability
to increase or maintain sales to such customers will be adversely affected and
our ability to generate revenues from these companies will also be adversely
impacted.
WE MAY BE UNABLE TO SUCCESSFULLY COMPETE WITH MICROSOFT AND OTHER COMPANIES IN
THE MEDIA DELIVERY MARKET
The market for software and services for media delivery over the Internet
is relatively new, constantly changing and intensely and increasingly
competitive. As media delivery evolves into a central component of the Internet
experience, more companies are entering the market for, and expending increasing
resources to develop, media delivery software and services. We expect that
competition will continue to intensify. Increased competition could hurt our
business and the trading price of our stock.
Many of our current and potential competitors have longer operating
histories, greater name recognition, more employees and significantly greater
financial, technical, marketing, public relations and distribution resources
than we do. In addition, new competitors with potentially unique or more
desirable products or services are entering the market all the time. The
competitive environment may require us to make changes in our products, pricing,
licensing, services or marketing to maintain and extend our current brand and
technology franchise. Price concessions or the emergence of other pricing or
distribution strategies or technology solutions of competitors may diminish our
revenues, impact our margins or lead to a reduction in our market share, any of
which will harm our business. Other changes we have to make in response to
competition could cause us to expend significant financial and other resources,
disrupt our operations, strain relationships with partners, or release products
and enhancements before they are thoroughly tested, any of which could harm our
operating results and stock price.
We believe that the primary factors on which we compete in the media
delivery market include:
- the quality, reliability, price and licensing terms of the overall media
delivery solution;
- access to distribution channels necessary to achieve broad distribution
and use of products;
- the availability of content for delivery over the Internet;
- the ability to license or develop and support secure formats and digital
rights management systems for digital media delivery, particularly music
and video;
- the ability to license and support popular and emerging media formats for
digital media delivery in a market where competitors may control the
intellectual property rights for these formats;
- the size of the active audience for streaming and digital media and its
appeal to content providers and advertisers;
- features for creating, editing and adapting content for the Internet;
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- ease of use and interactive user features in products;
- scalability of streaming media and media delivery technology and cost per
user;
- the ability to obtain any necessary intellectual property rights
underlying important streaming media and digital distribution technologies
that gain market acceptance;
- compatibility with new and existing media formats and with the user's
existing network components and software systems;
- the build-out and deployment of broadband infrastructures and
technologies; and
- challenges caused by bandwidth constraints and other limitations of the
Internet infrastructure.
Our failure to adequately address any of the above factors could harm our
business and operating results.
Microsoft Corporation is a principal competitor in the development and
distribution of streaming media and media distribution technology. Microsoft
currently competes with us in the market for streaming media servers, players
and digital distribution of media. Microsoft's commitment to and presence in the
media delivery industry has increased and we expect that Microsoft will continue
to increase competitive pressure in the overall market for streaming media and
media distribution.
Microsoft distributes its competing streaming media server and tools
products by bundling them with its Windows operating systems at no additional
charge and by making them available for download from its Web site for free.
While we also provide free downloads of certain of our products, including
players, servers and tools, Microsoft's practices have caused, and may continue
to cause, pricing pressure on our products. These practices have led in some
cases, and could continue to lead to, longer sales cycles, decreased sales, loss
of existing and potential customers and reduced market share. In addition, we
believe that Microsoft has used and may continue to use its monopoly position in
the computer industry and its financial resources to secure preferential or
exclusive distribution and bundling contracts for its streaming media products
with third parties such as Internet Service Providers ("ISPs"), content delivery
networks, online service providers, content providers, entertainment companies,
media companies, broadcasters, value-added resellers and original equipment
manufacturers, including third parties with whom we have relationships.
Microsoft has also invested significant sums of money in or has provided
substantial financial incentives to certain of our current and potential
customers and content suppliers, and we expect this trend to continue, which may
cause such customers to stop using or reduce their use of our products and
services, or to withhold desirable media content from us or end users of our
products. Such arrangements, together with Microsoft's aggressive marketing of
Windows operating systems and of its streaming media products, may reduce our
share of the streaming media market.
Microsoft's Windows Media Player competes with our RealPlayer products. The
Windows Media Player is available for download from Microsoft's Web site for
free, and is integrated into features of Microsoft's Internet Explorer Web
browser, the Windows 98, Windows 2000 and Windows ME operating systems and the
upcoming new version of Windows (Windows XP), which is scheduled to be released
later this year and a significant focus of which is media delivery. We expect
that by leveraging its monopoly position in operating systems and tying
streaming or digital media into its operating systems and its Web browser,
Microsoft will distribute substantially more copies of the Windows Media Player
in the future than it has in the past and may be able to attract more users to
its streaming or digital media products. In light of Microsoft's efforts and
dominant position in operating systems, our market position may be difficult to
sustain.
Microsoft's Windows Media Player also competes with our RealJukebox
products, and Microsoft has invested in other digital distribution technologies
that compete with RealJukebox, like the MusicMatch Jukebox. The Windows Media
Player and MusicMatch Jukebox support the Windows Media format, but not
RealNetworks' media formats. Microsoft also licenses Windows Media Technologies
7, a platform for authoring, delivering and playing digital media intended to
compete with RealSystem and supports and promotes other third party products
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competitive to our products. We expect Microsoft and other competitors to devote
significantly greater resources to product development in the jukebox and
digital media categories.
Microsoft also competes with us to attract broadcasters of high quality or
popular content to promote and deliver such content in Microsoft's formats, in
some cases on an exclusive or preferential basis. While we have rights to play
back certain content in Microsoft formats through our RealPlayer and RealJukebox
products, we may not secure necessary rights from Microsoft to enable our
products to play back all such content or content in Microsoft's newest formats.
RealJukebox and/or RealPlayer may be disadvantaged if they cannot play content
in Windows Media formats or secured by the Windows Media Digital Rights
Management technology, or if such content providers do not also make their
content available in RealNetworks' media formats using digital rights management
systems supported by us. In some cases, we believe Microsoft uses its financial
resources and monopoly leverage to obtain rights to such content. We believe
that Microsoft's commitment to and presence in the media delivery industry has
increased and that Microsoft will continue to increase competitive pressure in
the overall market for streaming media and media distribution.
In addition to Microsoft, we face increasing competition from other
companies that are developing and marketing streaming media products. For
example, Apple Computer offers the QuickTime streaming media technology,
including a free media player and a free streaming media server, and licenses
for free source code to the server under the conditions of Apple Computer's end
user license agreement. We expect that Apple Computer will devote more resources
to developing and marketing streaming media systems, and will seek to compete
more vigorously with us in the marketplace. Apple Computer has enlisted the open
source code development community to assist its development of competitive
products. Companies such as AOL Time Warner and Yahoo! and many smaller
competitors also offer various products that compete with our RealPlayer and
RealJukebox products. In connection with the deployment of RealSystem iQ in
AOL's Internet service, we also licensed our RealPlayer technology to AOL for
use with its own Internet service application. Such licensing may impact the
number of RealPlayer end users if AOL users only use their AOL applications. As
more companies enter the market with products that compete with our servers,
players and tools, the competitive landscape could change rapidly to our
disadvantage.
Our streaming media and media delivery products also face competition from
"fast download" media delivery technologies such as AVI, QuickTime and MP3. We
also face competition from recently emergent and rapidly accepted peer-to-peer
file sharing services, which allow computer users to connect with each other and
directly access and copy many types of program files, including music and other
media, from one another's hard drives, such as Napster and Gnutella. Such
services allow consumers to directly access content without relying on content
providers to make the content available for streaming or digital download, and
without relying on products such as the RealPlayer or RealJukebox to be able to
play, record and store such content. Other fast download or non-streaming
IP-based content distribution methods are likely to emerge and could compete
with our products and services, which could harm our business.
WE MAY BE UNABLE TO SUCCESSFULLY COMPETE IN OTHER PARTS OF OUR BUSINESS
Media Hosting. Our media hosting service, the Real Broadcast Network,
competes with a variety of companies that provide streaming media hosting and
broadcast services. These companies include Yahoo! Broadcast Services (formerly
Broadcast.com), Akamai/Intervu and other emerging broadcast networks. Some of
these competitors offer other services which Real Broadcast Network does not
offer, such as Web page hosting or broadcast hosting in media formats not
supported by Real Broadcast Network. We may not establish or sustain our
competitive position in this market segment. Some media hosting competitors are
also customers on whom we rely to help drive product download traffic to our Web
sites through their broadcast events. We also sell servers and tools to
companies that compete with Real Broadcast Network. If our relationship with
these companies becomes more competitive, such companies may reduce their level
of usage and purchases of our products or services.
Web Site Destinations, Content and Advertising. Our Web sites and the
Real.com Network compete for user traffic and Internet advertising revenues with
a wide variety of Web sites, Internet portals and ISPs. In particular,
aggregators of audio, video and other media, such as Yahoo! Broadcast Services
and Microsoft's Windows Media Guide, compete with our Real.com Guide. We also
compete with traditional media such as television, radio and
23
print for a share of advertisers' total advertising budgets. Our advertising
sales force and infrastructure are still in early stages of development relative
to those of many of our competitors. We cannot be certain that advertisers will
place advertising with us or that revenues derived from such advertising will be
meaningful. Certain recent slowdowns in funding for Internet-related companies
have had a negative effect on Internet advertising markets. Internet advertising
revenues across the industry decreased substantially in 2000 and the first
quarter of 2001 and our advertising revenues declined sequentially in the first
quarter of 2001 from the previous quarter. If we lose advertising customers,
fail to attract new customers, are forced to reduce advertising rates or
otherwise modify our rate structure to retain or attract customers, or if we
lose Web site traffic, our business could be harmed.
GoldPass. We recently introduced the RealPlayer GoldPass subscription
service, which provides customers access to a combination of premium software,
services and content, updated monthly, in exchange for a monthly fee. The
GoldPass subscription service is a relatively unproven business model for
delivering media over the Internet and is a new business model for us.
Accordingly it is too early to predict whether GoldPass will be accepted by
consumers. GoldPass competes with both traditional and online entertainment
service providers. Many of these providers have significantly more resources and
experience in providing such services to customers. In order to increase our
subscription service revenues, we must continue to obtain premium digital
content in order to increase subscriptions and overall customer satisfaction.
Failure to obtain such content or to successfully market our GoldPass services
to our end users could harm our business.
Electronic Commerce. To compete successfully in the electronic commerce
market, we must attract sufficient traffic to our Web sites by offering
high-quality, competitively priced, desirable merchandise in a compelling,
easy-to-purchase format. In addition, we must successfully leverage our existing
user base to develop the market for our products and services. We may not
compete successfully in the growing and rapidly changing market for electronic
commerce. Our failure to do so could harm our business.
Increased competition may result in price reductions, reduced margins, loss
of customers, and a change in our business and marketing strategies, any of
which could harm our business.
OUR INDUSTRY IS EXPERIENCING CONSOLIDATION THAT MAY INTENSIFY COMPETITION
The Internet and media distribution industries have recently experienced
substantial consolidation and a proliferation of strategic transactions. We
expect this consolidation and strategic partnering to continue. Acquisitions or
strategic relationships could harm us in a number of ways. For example:
- competitors could acquire or enter into relationships with companies with
which we have strategic relationships and discontinue our relationship,
resulting in the loss of distribution opportunities for our products and
services or the loss of certain enhancements or value-added features to our
products and services;
- competitors could obtain exclusive access to desirable multimedia content
and prevent that content from being available in our formats, thus
decreasing the use of our products and services to distribute and
experience the content that audiences most desire, and hurting our ability
to attract advertisers to our Web sites and product offerings;
- suppliers of important or emerging technologies could be acquired by a
competitor or other company which could prevent us from being able to
utilize such technologies in our offerings, and disadvantage our offerings
relative to those of competitors;
- a competitor could be acquired by a party with significant resources and
experience that could increase the ability of the competitor to compete
with our products and services; and
- other companies with related interests could combine to form new,
formidable competition, which could preclude us from obtaining access to
certain markets or content, or which could dramatically change the market
for our products and services.
24
Any of these results could put us at a competitive disadvantage which could
cause us to lose customers, revenue and market share. They could also force us
to expend greater resources to meet the competitive threat, which could also
harm our operating results.
WE MAY NOT BE SUCCESSFUL IN THE MARKET FOR DOWNLOADABLE MEDIA AND LOCAL MEDIA
DELIVERY
The market for products such as RealJukebox is new and still evolving. We
may be unable to develop a revenue model or sufficient demand to take advantage
of the market opportunity. While over 50 million copies of RealJukebox have been
downloaded since its beta release in May of 1999, it is too soon to determine
whether consumers will adopt RealJukebox as their primary application to play,
record, download and manage their digital music. Even if RealJukebox achieves a
high degree of market acceptance, it may not achieve a high level of use, which
would lead to a low rate of upgrade sales and electronic commerce opportunities.
There are a number of competitive products on the market that offer certain of
the features offered by RealJukebox. These products include WinAmp Player,
MusicMatch Jukebox, Sonique Player, Liquid Audio Player, AOL 6.0 and Windows
Media Player. Because free versions are available for all of these competing
products, our ability to sell RealJukebox upgrades, and the prices we charge,
may be affected. Given the size and importance of the general market for music
distribution, competitors will likely release additional products that directly
compete with RealJukebox, which could harm our business. Our competitors may
develop new features and technology not available in RealJukebox, including
advanced codecs and digital rights management technology, which could harm our
business.
RealJukebox also faces competition from the emergence of widespread
peer-to-peer file sharing services and programs like Napster and Gnutella. Our
inability to achieve widespread acceptance for our digital music architecture
and RealJukebox or to create new revenue streams from the new market segments,
including digital music content, could harm the prospects for our business.
We have announced that RealJukebox supports or will support a variety of
audio formats, including RealAudio G2, MP3, Liquid Audio, Mjuice, Windows Media
Audio, IBM's EMMS, and a2b. However, technical formats and consumer preferences
evolve very rapidly, and we may be unable to adequately address consumer
preferences or fulfill the market demand to the extent it exists. In addition,
we must provide digital rights management solutions and other security
mechanisms in order to address concerns of content providers, and we cannot be
certain that we can develop, license or acquire such solutions, or that content
licensors or consumers will accept them.
We have had long-term relationships with recording companies, including
major record labels, many of which offer their streaming content in our formats.
However, recording companies, including those with whom we have a relationship,
may not make their desirable content available for download or playback in
formats supported by RealJukebox or may make the cost of licensing such content
prohibitive, may impose technical restrictions designed to secure intellectual
property rights that may impact the user experience or demand for RealJukebox,
or may refrain from or delay participating in promotional opportunities with
respect to RealJukebox.
In addition, we have recently announced the formation of a joint venture
called MusicNet with three leading media companies to create a platform for
online music subscription services. The business models and market for online
music subscription services are new and unproven. If these new online music
subscription services do not achieve market acceptance our business prospects
could be harmed.
WE RELY ON CONTENT PROVIDED BY THIRD PARTIES TO INCREASE MARKET ACCEPTANCE OF
OUR PRODUCTS AND SERVICES
If third parties do not develop or offer compelling content to be delivered
over the Internet, or grant necessary licenses to us or our customers to
distribute or perform such content, our business will be harmed and our products
and services may not achieve or sustain broad market acceptance. We rely on
third-party content providers, such as radio and television stations, record
labels, media companies, Web sites and other companies,
25
to develop and offer content in our formats that can be delivered using our
server products and played back using our player products. We also rely on
third-party content for our GoldPass subscription service. We cannot guarantee
that third-party content providers will continue to rely on our technology or
offer compelling content in our formats to encourage and sustain broad market
acceptance of our products. Their failure to do so would harm our business.
While we have a number of short-term agreements with third parties to
provide content from their Web sites in our formats, most third parties are not
obligated to develop or offer content using our technology. In addition, some
third parties have entered into and may in the future enter into agreements with
our competitors, principally Microsoft, to develop or offer all or a substantial
portion of their content in our competitors' formats. Microsoft has
substantially more resources than us that may enable it to secure preferential
and even exclusive relationships with content providers. There could be less
demand for and use of our products if Microsoft or another competitor were to
secure preferential or exclusive relationships with the leading content
providers, Web sites or broadcasters. We cannot guarantee that third-party
content providers will continue to rely on our technology or offer compelling
content in our formats to encourage and sustain broad market acceptance of our
products. Their failure to do so would harm our business.
Our success depends on the availability of third-party content, especially
music, that users of our RealJukebox product can lawfully and easily access,
record and play back. Our products may not achieve or sustain market acceptance
if third parties are unwilling to offer their content for free download or
purchase by users of RealJukebox. Current concerns regarding the secure
distribution of music over the Internet are causing content owners to delay or
refuse to make content available for distribution.
WE MAY NOT SUCCESSFULLY DEVELOP NEW PRODUCTS AND SERVICES
Our growth depends on our ability to continue to develop leading edge media
delivery and digital distribution products and services. Our business and
operating results would be harmed if we fail to develop products and services
that achieve widespread market acceptance or that fail to generate significant
revenues to offset development costs. We may not timely and successfully
identify, develop and market new product and service opportunities. If we
introduce new products and services, they may not attain broad market acceptance
or contribute meaningfully to our revenues or profitability.
Because the markets for our products and services are changing rapidly, we
must develop new offerings quickly. We have experienced development delays and
cost overruns in our development efforts in the past and we may encounter such
problems in the future. Delays and cost overruns could affect our ability to
respond to technological changes, evolving industry standards, competitive
developments or customer requirements. Our products also may contain undetected
errors that could cause increased development costs, loss of revenues, adverse
publicity, reduced market acceptance of the products or lawsuits by customers.
THE RATE STRUCTURE OF SOME OF OUR ADVERTISING AND SPONSORSHIP ARRANGEMENTS
SUBJECTS US TO FINANCIAL RISK
We generate advertising revenues in part through sponsored services and
placements by third parties in our products and on our Web sites, in addition to
banner advertising. We may receive sponsorship fees or a portion of transaction
revenues in return for minimum levels of user impressions to be provided by us.
These arrangements expose us to potentially significant financial risks in the
event our usage levels decrease, including the following:
- the fees we are entitled to receive may be adjusted downwards;
- we may be required to "make good" on our obligations by providing
alternative services;
- the sponsors may not renew the agreements or may renew at lower rates;
and
- the arrangements may not generate anticipated levels of shared
transaction revenues, or sponsors may default on the payment commitments in
such agreements.
26
Accordingly, any leveling off or decrease of our user base or the failure
to generate anticipated levels of shared transaction revenues could result in a
meaningful decrease in our revenue levels. To the extent that our advertisers
are experiencing slow-downs in their businesses or tighter resources to fund
advertising, our anticipated revenue results could be harmed. Certain recent
slowdowns in funding for Internet-related companies have had a negative effect
on Internet advertising markets. Internet advertising revenues across the
industry decreased substantially in 2000 and the first quarter of 2001 and our
advertising revenues declined sequentially in the first quarter of 2001 from the
previous quarter.
WE DEPEND ON KEY PERSONNEL WHO MAY NOT CONTINUE TO WORK FOR US
Our success substantially depends on the continued employment of our
executive officers and key employees, particularly Robert Glaser, our founder,
chairman of the board and chief executive officer. The loss of the services of
Mr. Glaser or any of our other executive officers or key employees could harm
our business. If any of these individuals were to leave RealNetworks, we could
face substantial difficulty in hiring qualified successors and could experience
a loss in productivity while any such successor obtains the necessary training
and experience. A number of our key employees have reached or will soon reach
the five-year anniversary of their RealNetworks hiring date and, as a result,
will have become or will shortly become fully vested in their initial stock
option grants. While most personnel are typically granted additional five-year
stock options subsequent to their hire date to provide additional incentive to
remain at RealNetworks, the initial option grant is typically the largest and an
employee may be more likely to leave our employ upon completion of the vesting
period for the initial option grant. None of our executive officers has a
contract that guarantees employment. Other than a $2 million insurance policy on
the life of Mr. Glaser, we do not maintain "key person" life insurance policies.
If we do not succeed in retaining and motivating existing personnel, our
business could be harmed.
OUR FAILURE TO ATTRACT, TRAIN OR RETAIN HIGHLY QUALIFIED PERSONNEL COULD HARM
OUR BUSINESS
Our success also depends on our ability to attract, train and retain
qualified personnel in all areas, especially those with management and product
development skills. In particular, we must hire additional experienced
management personnel to help us continue to grow and manage our business, and
skilled software engineers to further our research and development efforts. At
times, we have experienced difficulties in hiring personnel with the proper
training or experience, particularly in technical areas. Competition for
qualified personnel is intense, particularly in high-technology centers such as
the Pacific Northwest, where our corporate headquarters are located. If we do
not succeed in attracting new personnel or retaining and motivating our current
personnel, our business could be harmed.
In making employment decisions, particularly in the Internet and
high-technology industries, job candidates and even our current personnel often
consider the value of stock options they may receive in connection with their
employment. As a result of recent volatility in our stock price, we may be
disadvantaged in competing with companies that have not experienced similar
volatility or that have not yet sold their stock publicly.
WE MAY NOT SUCCESSFULLY MANAGE OUR GROWTH
We cannot successfully implement our business model if we fail to manage
our growth. We have rapidly and significantly increased our number of employees
and expanded our operations domestically and internationally and anticipate
further expansion to take advantage of market opportunities. Managing this
substantial expansion has placed a significant strain on our management,
operational and financial resources. If our growth continues, we will need to
continue to improve our financial and managerial control and reporting systems
and procedures. If we do not successfully manage this growth, our business could
be harmed.
POTENTIAL ACQUISITIONS INVOLVE RISKS WE MAY NOT ADEQUATELY ADDRESS
As part of our business strategy, we have acquired technologies and
businesses in the past, and intend to continue to do so in the future. The
failure to adequately address the financial, legal and operational risks raised
27
by acquisitions of technology and businesses could harm our business.
Acquisition or business combination transactions are accompanied by a number of
significant risks. Financial risks related to acquisitions may harm our
financial position, reported operating results or stock price, and include:
- potentially dilutive issuances of equity securities;
- use of cash resources;
- the incurrence of additional debt and contingent liabilities;
- large write-offs and difficulties in assessment of the relative
percentages of in-process research and development expense that can be
immediately written off as compared to the amount which must be amortized
over the appropriate life of the asset; and
- amortization expenses related to goodwill and other intangible assets.
Acquisitions also involve operational risks that could harm our existing
operations or prevent realization of anticipated benefits from an acquisition.
These operational risks include:
- difficulties in assimilating the operations, products, technology,
information systems and personnel of the acquired company;
- diversion of management's attention from other business concerns and the
potential disruption of our ongoing business;
- the difficulty of incorporating acquired technology or content and rights
into our products and services and unanticipated expenses related to such
integrations;
- impairment of relationships with our employees, affiliates, advertisers
and content providers;
- inability to maintain uniform standards, controls, procedures and
policies;
- the assumption of known and unknown liabilities of the acquired company;
- entrance into markets in which we have no direct prior experience; and
- loss of key employees of the acquired company.
THE GROWTH OF OUR BUSINESS DEPENDS ON THE INCREASED USE OF THE INTERNET FOR
COMMUNICATIONS, ELECTRONIC COMMERCE AND ADVERTISING
The growth of our business depends on the continued growth of the Internet
as a medium for communications, electronic commerce and advertising. Our
business will be harmed if Internet usage does not continue to grow,
particularly as a source of media information and entertainment and as a vehicle
for commerce in goods and services. Our success also depends on the efforts of
third parties to develop the infrastructure and complementary products and
services necessary to maintain and expand the Internet as a viable commercial
medium. We believe that other Internet-related issues, such as security,
privacy, reliability, cost, speed, ease of use and access, quality of service
and necessary increases in bandwidth availability, remain largely unresolved and
may affect the amount and type of business that is conducted over the Internet,
and impact our ability to sell our products and services and ultimately impact
our business results.
If Internet usage grows, the Internet infrastructure may not be able to
support the demands placed on it by such growth, specifically the demands of
delivering high-quality media content. As a result, its performance and
reliability may decline. In addition, Web sites have experienced interruptions
in service as a result of outages, system attacks and other delays occurring
throughout the Internet network infrastructure. If these outages, attacks
28
or delays occur frequently or on a broad scale in the future, Internet usage, as
well as the usage of our products, services and Web sites, could grow more
slowly or decline.
CHANGES IN NETWORK INFRASTRUCTURE, TRANSMISSION METHODS AND BROADBAND
TECHNOLOGIES POSE RISKS TO OUR BUSINESS
We believe that increased Internet use and especially the use of media over
the Internet may depend on the availability of greater bandwidth or data
transmission speeds (also known as broadband transmission). If broadband access
becomes widely available, we believe it presents both a substantial opportunity
and significant business challenges for us. Internet access through cable
television set-top boxes, digital subscriber lines or wireless connections could
dramatically reduce the demand for our products and services by utilizing
alternate technology that more efficiently transmits data and media. This could
harm our business as currently conducted.
Also, our products and services may not achieve market acceptance or
generate sufficient revenues to offset our costs of developing products and
services compatible with broadband transmission formats and infrastructure.
Development of products and services for a broadband transmission infrastructure
involves a number of additional risks, including:
- changes in content delivery methods and protocols;
- the emergence of new competitors, such as traditional broadcast and cable
television companies, which have significant control over access to
content, substantial resources and established relationships with media
providers;
- the development of relationships by our current competitors with
companies that have significant access to or control over the broadband
transmission infrastructure or content; and
- the need to establish new relationships with non-PC based providers of
broadband access, such as providers of television set-top boxes and cable
television, some of which may compete with us.
MORE INDIVIDUALS ARE UTILIZING NON-PC DEVICES TO ACCESS THE INTERNET AND WE MAY
NOT BE SUCCESSFUL IN DEVELOPING A VERSION OF OUR SERVICE THAT WILL GAIN
WIDESPREAD ADOPTION BY USERS OF SUCH DEVICES
In the coming years, the number of individuals who access the Internet
through devices other than a personal computer, such as personal digital
assistants, cellular telephones and television set-top devices, game consoles
and Internet appliances, is expected to increase dramatically. If we are unable
to attract and retain substantial number of alternative device manufacturers to
license and incorporate our technology into their devices, we may fail to
capture a sufficient share of an increasingly important portion of the market
for digital media delivery. Further, a failure to develop revenue-generating
relationships with a sufficient number of device manufacturers would harm our
business and operating results.
Our most popular products and services are primarily designed for rich,
graphical environments such as those available on personal and laptop computers.
The lower resolution, functionality and memory associated with alternative
devices could make the use of our products and services difficult. We have
limited experience to date in creating and shipping versions of our products and
services optimized for users of alternative devices, it is difficult to predict
the problems we may encounter in doing so and we may need to devote significant
resources to create, support and maintain such versions.
We do not believe that clear standards have emerged with respect to non-PC
wireless and cable-based systems. Likewise, no single company has yet gained a
dominant position in the mobile device market. However, certain products and
services in these markets support our technology, and certain support our
competitors' technology, especially that of Microsoft, which can use its
monopoly position in the operating system business and other financial resources
to gain access to these markets, potentially to our exclusion. Other companies'
products and
29
services or new standards may emerge in any of these areas, and differing
standards may emerge among different global markets, which could reduce demand
for our technology and products or render them obsolete.
WE COULD LOSE STRATEGIC RELATIONSHIPS THAT ARE ESSENTIAL TO OUR BUSINESS
The loss of certain current strategic relationships or key licensing
arrangements, the inability to find other strategic partners or the failure of
our existing relationships to achieve meaningful positive results for us could
harm our business. We rely in part on strategic relationships to help us:
- increase adoption of our products through distribution arrangements;
- increase the amount and availability of compelling media content on the
Internet to help boost demand for our products and services;
- acquire desirable or necessary technology components and intellectual
property rights;
- enhance our brand;
- expand the range of commercial activities based on our technology;
- expand the distribution of our streaming media content without a
degradation in fidelity; and
- increase the performance and utility of our products and services.
We would be unable to accomplish many of these goals without the assistance
of third parties. For example, we may become more reliant on strategic partners
to provide multimedia content and technology, to provide more secure and
easy-to-use electronic commerce solutions and to build out the necessary
infrastructure for media delivery. We may not be successful in forming or
managing strategic relationships.
OUR BUSINESS WILL SUFFER IF OUR SYSTEMS FAIL OR BECOME UNAVAILABLE
A reduction in the performance, reliability and availability of our Web
sites and network infrastructure may harm our ability to distribute our products
and services to our users, as well as our reputation and ability to attract and
retain users, customers, advertisers and content providers. Our revenues depend
in large part on the number of users that download our products from our Web
sites and access the content services on our Web sites. Our systems and
operations are susceptible to, and could be damaged or interrupted by, outages
caused by fire, flood, power loss, telecommunications failure, Internet
breakdown, earthquake and similar events. Our systems are also subject to human
error, security breaches, power losses, computer viruses, break-ins, "denial of
service" attacks, sabotage, intentional acts of vandalism and tampering designed
to disrupt our computer systems, Web sites and network communications. A sudden
and significant increase in traffic on our Web sites could strain the capacity
of the software, hardware and telecommunications systems that we deploy or use.
This could lead to slower response times or system failures.
Our operations also depend on receipt of timely feeds from our content
providers, and any failure or delay in the transmission or receipt of such feeds
could disrupt our operations. We also depend on Web browsers, ISPs and online
service providers to provide Internet users access to our Web sites. Many of
these providers have experienced significant outages in the past, and could
experience outages, delays and other difficulties due to system failures
unrelated to our systems. In addition, certain ISPs have temporarily interrupted
our Web site operations and ability to communicate with certain customers in
response to the heavy volume of email transmissions we generate and send to our
large user base. These types of interruptions could continue or increase in the
future.
Our electronic commerce and digital distribution activities are managed by
sophisticated software and computer systems. We continually develop and update
these systems over time as our business and business needs grow and change, and
these systems may not adequately reflect the current needs of our business. We
may
30
encounter delays in developing these systems, and the systems may contain
undetected errors that could cause system failures. Any system error or failure
that causes interruption in availability of products or content or an increase
in response time could result in a loss of potential or existing business
services customers, users, advertisers or content providers. If we suffer
sustained or repeated interruptions, our products, services and Web sites could
be less attractive to such entities or individuals and our business could be
harmed.
Real Broadcast Network's business is dependent on providing customers with
efficient and reliable services to enable such customers to broadcast content to
large audiences on an as-needed basis. Real Broadcast Network's operations are
also dependent in part upon transmission capacity provided by third-party
telecommunications network providers. Any failure of such network providers to
provide the capacity we require may result in a reduction in, or interruption
of, service to our customers. If we do not have access to third-party
transmission capacity, we could lose customers and if we are unable to obtain
such capacity on terms commercially acceptable to us, our business and operating
results could suffer.
Our computer and communications infrastructure is located at a single
leased facility in Seattle, Washington, an area that is at heightened risk of
earthquake and volcanic events. We do not have fully redundant systems or a
formal disaster recovery plan, and we may not have adequate business
interruption insurance to compensate us for losses that may occur from a system
outage. Despite our efforts, our network infrastructure and systems could be
subject to service interruptions or damage and any resulting interruption of
services could harm our business, operating results and reputation.
OUR NETWORK IS SUBJECT TO SECURITY RISKS THAT COULD HARM OUR BUSINESS AND
REPUTATION AND EXPOSE US TO LITIGATION OR LIABILITY
Online commerce and communications depend on the ability to transmit
confidential information securely over public networks. Any compromise of our
ability to transmit confidential information securely, and costs associated with
preventing or eliminating any problems, could harm our business. Online
transmissions are subject to a number of security risks, including:
- our own or licensed encryption and authentication technology may be
compromised, breached or otherwise be insufficient to ensure the security
of customer information;
- we could experience unauthorized access, computer viruses, system
interference or destruction, "denial of service" attacks and other
disruptive problems, whether intentional or accidental, that may inhibit or
prevent access to our Web sites or use of our products and services; and
- a third party could circumvent our security measures and misappropriate
our, our partners' and our customer's proprietary information or interrupt
operations.
The occurrence of any of these or similar events could damage our business,
hurt our ability to distribute products and services and collect revenue,
threaten the proprietary or confidential nature of our technology, harm our
reputation, and expose us to litigation or liability. We may be required to
expend significant capital or other resources to protect against the threat of
security breaches or hacker attacks or to alleviate problems caused by such
breaches or attacks.
OUR INTERNATIONAL OPERATIONS INVOLVE OPERATIONAL AND FINANCIAL RISKS
We operate subsidiaries in Australia, England, France, Germany, Japan,
Mexico, Brazil and Hong Kong, and market and sell products in a number of other
countries. We have also entered into joint ventures internationally. For the
quarter ended March 31, 2001, approximately 31% of our revenues were derived
from international operations.
A key part of our strategy is to develop localized products and services in
international markets through joint ventures, subsidiaries and branch offices.
If we do not successfully implement this strategy, we may not recoup our
international investments and we may lose worldwide market share. To date, we
have only limited experience
31
in developing localized versions of our products and services and marketing and
operating our products and services internationally, and we rely on the efforts
and abilities of our foreign business partners in such activities. We believe
that in light of the potential size of the customer base and the audience for
content, and the substantial anticipated competition, we need to continue to
expand quickly into international markets in order to effectively obtain and
maintain market share. International markets we have selected may not develop at
a rate that supports our level of investment. In particular, international
markets typically have been slower in adoption of the Internet as an advertising
and commerce medium.
In addition to uncertainty about our ability to continue to generate
revenues from our foreign operations and expand our international presence,
there are certain risks inherent in doing business on an international level,
including difficulties in managing operations due to distance, language and
cultural differences, including issues associated with establishing management
systems infrastructures in individual markets and exchange rate fluctuations.
Any of these factors could harm our future international operations, and
consequently our business, operating results and financial condition. We do not
currently hedge the majority of our foreign currency exposures.
WE MAY BE UNABLE TO ADEQUATELY PROTECT OUR PROPRIETARY RIGHTS AND MAY BE SUBJECT
TO INTELLECTUAL PROPERTY INFRINGEMENT CLAIMS, WHICH ARE COSTLY TO DEFEND AND
COULD LIMIT OUR ABILITY TO USE CERTAIN TECHNOLOGIES IN THE FUTURE
Our inability to protect our proprietary rights, and the costs of doing so,
could harm our business. Our success and ability to compete partly depend on the
superiority, uniqueness or value of our technology, including both internally
developed technology and technology licensed from third parties. To protect our
proprietary rights, we rely on a combination of patent, trademark, copyright and
trade secret laws, confidentiality agreements with our employees and third
parties, and protective contractual provisions. These efforts to protect our
intellectual property rights may not be effective in preventing misappropriation
of our technology. These efforts also may not prevent the development and design
by others of products or technologies similar to or competitive with, or
superior to those we develop. Any of these results could reduce the value of our
intellectual property.
As of March 31, 2001, we had 40 registered U.S. trademarks or service
marks, and had applications pending for an additional 31 U.S. trademarks. We
also have several unregistered trademarks. In addition, RealNetworks has several
foreign trademark registrations and pending applications. Many of our marks
begin with the word "Real" (such as RealSystem, RealAudio and RealVideo). We are
aware of other companies that use "Real" in their marks alone or in combination
with other words, and we do not expect to be able to prevent all third-party
uses of the word "Real" for all goods and services.
As of March 31, 2001, we had 17 U.S. patents and numerous patent
applications on file relating to various aspects of our technology. We are
preparing additional patent applications on other features of our technology.
Patents with respect to our technology may not be granted and, if granted, may
be challenged or invalidated. Issued patents may not provide us with any
competitive advantages and may be challenged by third parties.
Many of our current and potential competitors dedicate substantially
greater resources to protection and enforcement of their intellectual property
rights, especially patents. Many parties are actively developing streaming media
and digital distribution-related technologies, e-commerce and other Web-related
technologies, as well as a variety of online business methods and models. We
believe that these parties will continue to take steps to protect these
technologies, including, but not limited to seeking patent protection. As a
result, disputes regarding the ownership of these technologies and rights
associated with streaming media and digital distribution, and online businesses,
are likely to arise in the future. In addition to existing patents and
intellectual property rights, we anticipate that additional third-party patents
related to our products and services will be issued in the future. If a blocking
patent has issued or issues in the future, we would need to either obtain a
license or design around the patent. We may not be able to obtain such a license
on acceptable terms, if at all, or design around the patent, which could harm
our business.
32
Companies in the technology and content-related industries have frequently
resorted to litigation regarding intellectual property rights. We may be forced
to litigate to enforce or defend our intellectual property rights, to protect
our trade secrets or to determine the validity and scope of other parties'
proprietary rights. Any such litigation could be very costly and could distract
our management from focusing on operating our business. In addition, we believe
these industries are experiencing an increased level of litigation to determine
the applicability of current laws to, and impact of new technologies on, the use
and distribution of content over the Internet and through new devices. The
existence and/or outcome of such litigation could harm our business.
From time to time we receive claims and inquiries from third parties
alleging that our internally developed technology or technology we license from
third parties may infringe the third parties' proprietary rights, especially
patents. Third parties have also asserted and most likely will continue to
assert claims against us alleging infringement of copyrights, trademark rights,
trade secret rights or other proprietary rights, or alleging unfair competition
or violations of privacy rights. We are now investigating several of such
pending claims. We could be required to spend significant amounts of time and
money to defend ourselves against such claims. If any of these claims were to
prevail, we could be forced to pay damages, comply with injunctions, or stop
distributing our products and services while we re-engineer them or seek
licenses to necessary technology, which might not be available on reasonable
terms. We could also be subject to claims for indemnification resulting from
infringement claims made against our customers and strategic partners, which
could increase our defense costs and potential damages. Any of these events
could require us to change our business practices and harm our business.
In August 1998, Venson M. Shaw and Steven M. Shaw filed a lawsuit against
us and co-defendant Broadcast.com in the United States District Court for the
Northern District of Texas -- Dallas Division. The plaintiffs allege that we,
individually and in combination with Broadcast.com, infringe on a certain patent
by making, using, selling and/or offering to sell software products and services
directed to media delivery systems for the Internet and corporate intranets. The
plaintiffs seek to enjoin us from the alleged infringing activity and to recover
damages in an amount no less than a reasonable royalty. We believe the
allegations are without merit and intend to vigorously defend ourselves against
these claims. However, litigation is inherently uncertain, and we may be unable
to successfully defend ourselves against this claim.
WE ARE SUBJECT TO RISKS ASSOCIATED WITH GOVERNMENTAL REGULATION AND LEGAL
UNCERTAINTIES
Few existing laws or regulations specifically apply to the Internet, other
than laws and regulations generally applicable to businesses. Certain U.S.
export controls and import controls of other countries, including controls on
the use of encryption technologies, may apply to our products. Many laws and
regulations, however, are pending and may be adopted in the United States,
individual states and local jurisdictions and other countries with respect to
the Internet. These laws may relate to many areas that impact our business,
including content issues (such as obscenity, indecency and defamation),
copyright and other intellectual property rights, encryption, caching of content
by server products, personal privacy, taxation, e-mail, sweepstakes, promotions,
network and information security and the convergence of traditional
communication services with Internet communications, including the future
availability of broadband transmission capability and wireless networks. These
types of regulations are likely to differ between countries and other political
and geographic divisions. Other countries and political organizations are likely
to impose or favor more and different regulation than that which has been
proposed in the United States, thus furthering the complexity of regulation. In
addition, state and local governments may impose regulations in addition to,
inconsistent with, or stricter than federal regulations. The adoption of such
laws or regulations, and uncertainties associated with their validity,
interpretation, applicability and enforcement, may affect the available
distribution channels for and costs associated with our products and services,
and may affect the growth of the Internet. Such laws or regulations may harm our
business.
We do not know for certain how existing laws governing issues such as
property ownership, copyright and other intellectual property issues, taxation,
illegal or obscene content, retransmission of media, and personal privacy and
data protection apply to the Internet. The vast majority of such laws were
adopted before the advent of the Internet and related technologies and do not
address the unique issues associated with the Internet and related technologies.
Most of the laws that relate to the Internet have not yet been interpreted.
Changes to or the interpretation of these laws could:
33
- limit the growth of the Internet;
- create uncertainty in the marketplace that could reduce demand for our
products and services;
- increase our cost of doing business;
- expose us to significant liabilities associated with content available on
our Web sites or distributed or accessed through our products or services,
with our provision of products and services, and with the features or
performance of our products and Web sites;
- lead to increased product development costs or otherwise harm our
business; or
- decrease the rate of growth of our user base and limit our ability to
effectively communicate with and market to our user base.
The Digital Millennium Copyright Act (DMCA) includes statutory licenses for
the performance of sound recordings and for the making of recordings to
facilitate transmissions. Under these statutory licenses, we and our broadcast
customers may be required to pay licensing fees for digital sound recordings we
deliver in original and archived programming and through retransmissions of
radio broadcasts. The DMCA does not specify the rate and terms of the licenses,
which will be determined either through voluntary inter-industry negotiations or
arbitration. We plan to engage in arbitration before a tribunal of the United
States Copyright Office with the Recording Industry Association of America
during 2001 to determine what, if any, licensee fee should be paid. Depending on
the rates and terms adopted for the statutory licenses, our business could be
harmed both by increasing our own cost of doing business, as well as by
increasing the cost of doing business for our customers.
The Child Online Protection Act and the Child Online Privacy Protection Act
impose civil and criminal penalties on persons distributing material harmful to
minors (e.g., obscene material) over the Internet to persons under the age of
17, or collecting personal information from children under the age of 13. We do
not knowingly collect and disclose personal information from such minors. The
manner in which these Acts may be interpreted and enforced cannot be fully
determined, and future legislation similar to these Acts could subject us to
potential liability, which in turn could harm our business.
There are a large number of legislative proposals before the United States
Congress and various state legislatures regarding privacy issues related to our
business. It is not possible to predict whether or when such legislation may be
adopted, and certain proposals, if adopted, could materially and adversely
affect our business through a decrease in user registration and revenue, and
influence how and whether we can communicate with our customers.
WE MAY BE SUBJECT TO MARKET RISK AND LEGAL LIABILITY IN CONNECTION WITH THE DATA
COLLECTION CAPABILITIES OF OUR PRODUCTS AND SERVICES
Many of our products are interactive Internet applications that by their
very nature require communication between a client and server to operate. To
provide better consumer experiences and to operate effectively, our products
occasionally send information to servers at RealNetworks. Many of the services
we provide also require that a user provide certain information to us. We post
privacy policies concerning the use, collection and disclosure of our user data.
Any failure by us to comply with our posted privacy policies and existing or new
legislation regarding privacy issues could impact the market for our products
and services, subject us to litigation and harm our business.
Between November 1999 and March 2000, fourteen lawsuits were filed against
us in federal and/or state courts in California, Illinois, Pennsylvania,
Washington and Texas. The plaintiffs have voluntarily dismissed all of the state
court cases with the exception of the case pending in California. The remaining
actions, which seek to certify classes of plaintiffs, allege breach of contract,
invasion of privacy, deceptive trade practices, negligence, fraud and violation
of certain federal and state laws in connection with various communications
features of our
34
RealPlayer and RealJukebox products. Plaintiffs are seeking both damages and
injunctive relief. We have filed answers denying the claims and have filed suit
in Washington state court to compel the state court plaintiffs to arbitrate the
claims as required by our End User License Agreements. The Washington State
Court has granted our motion to compel arbitration. On February 10, 2000, the
federal Judicial Panel on Multidistrict Litigation transferred all pending
federal cases to the federal district court for the Northern District of
Illinois. On the same day, that court granted RealNetworks' motion to stay the
court proceedings because the claims are subject to arbitration under our End
User License Agreement. Although no assurance can be given as to the outcome of
these lawsuits, we believe that the allegations in these actions are without
merit, and intend to vigorously defend ourselves. If the plaintiffs prevail in
their claims, we could be required to pay damages or other penalties, in
addition to complying with injunctive relief, which could harm our business and
our operating results.
WE MAY BE SUBJECT TO LEGAL LIABILITY FOR THE PROVISION OF THIRD-PARTY PRODUCTS,
SERVICES OR CONTENT
We periodically enter into arrangements to offer third-party products,
services or content under the RealNetworks brand or via distribution on our Web
sites, in products or service offerings. We may be subject to claims concerning
these products, services or content by virtue of our involvement in marketing,
branding, broadcasting or providing access to them, even if we do not ourselves
host, operate, provide, or provide access to these products, services or
content. While our agreements with these parties often provide that we will be
indemnified against such liabilities, such indemnification may not be adequate.
It is also possible that, if any information provided directly by us contains
errors or is otherwise negligently provided to users, third parties could make
claims against us, including, for example, claims for intellectual property
infringement. Investigating and defending any of these types of claims is
expensive, even if the claims do not result in liability. If any of these claims
do result in liability, we could be required to pay damages or other penalties,
which could harm our business and our operating results.
OUR DIRECTORS AND EXECUTIVE OFFICERS BENEFICIALLY OWN APPROXIMATELY 43.7% OF OUR
STOCK; THEIR INTERESTS COULD CONFLICT WITH YOURS; SIGNIFICANT SALES OF STOCK
HELD BY THEM COULD HAVE A NEGATIVE EFFECT ON OUR STOCK PRICE; SHAREHOLDERS MAY
BE UNABLE TO EXERCISE CONTROL
As of March 31, 2001, our executive officers, directors and affiliated
persons beneficially own approximately 43.7% of our common stock. Robert Glaser,
our chief executive officer and chairman of the board, beneficially owns
approximately 33.3% of our common stock. As a result, our executive officers,
directors and affiliated persons will have significant influence to:
- elect or defeat the election of our directors;
- amend or prevent amendment of our articles of incorporation or bylaws;
- effect or prevent a merger, sale of assets or other corporate
transaction; and
- control the outcome of any other matter submitted to the shareholders for
vote.
Management's stock ownership may discourage a potential acquirer from
making a tender offer or otherwise attempting to obtain control of RealNetworks,
which in turn could reduce our stock price or prevent our shareholders from
realizing a premium over our stock price.
PROVISIONS OF OUR CHARTER DOCUMENTS, SHAREHOLDER RIGHTS PLAN AND WASHINGTON LAW
COULD DISCOURAGE OUR ACQUISITION BY A THIRD PARTY
Our articles of incorporation provide for a strategic transaction committee
of the board of directors. Without the prior approval of this committee, and
subject to certain limited exceptions, the board of directors does not have the
authority to:
35
- adopt a plan of merger;
- authorize the sale, lease, exchange or mortgage of:
(A) assets representing more than 50% of the book value of our assets
prior to the transaction; or
(B) any other asset or assets on which our long-term business strategy
is substantially dependent;
- authorize our voluntary dissolution; or
- take any action that has the effect of any of the above.
RealNetworks also entered into an agreement providing Mr. Glaser with
certain contractual rights relating to the enforcement of our charter documents
and Mr. Glaser's roles and authority within RealNetworks.
We have adopted a shareholder rights plan that provides that shares of our
common stock have associated preferred stock purchase rights. The exercise of
these rights would make the acquisition of RealNetworks by a third party more
expensive to that party and has the effect of discouraging third parties from
acquiring our company without the approval of our board of directors, which has
the power to redeem these rights and prevent their exercise.
Washington law imposes restrictions on some transactions between a
corporation and certain significant shareholders. The foregoing provisions of
our charter documents, shareholder rights plan, our agreement with Mr. Glaser
and Washington law, as well as those relating to a classified board of directors
and the availability of "blank check" preferred stock, could have the effect of
making it more difficult or more expensive for a third party to acquire, or of
discouraging a third party from attempting to acquire, control of us. These
provisions may therefore have the effect of limiting the price that investors
might be willing to pay in the future for our common stock.
OUR STOCK PRICE HAS BEEN AND MAY CONTINUE TO BE VOLATILE
The trading price of our common stock has been and is likely to continue to
be highly volatile. For example, during the 52-week period ended March 31,
2001, the price of our common stock ranged from $5.00 to $59.50 per share. Our
stock price could be subject to wide fluctuations in response to factors such
as:
- actual or anticipated variations in quarterly operating results;
- announcements of technological innovations, new products or services by
us or our competitors;
- changes in financial estimates or recommendations by securities analysts;
- the addition or loss of strategic relationships or relationships with our
key customers;
- conditions or trends in the Internet, streaming media, media delivery and
online commerce markets;
- changes in the market valuations of other Internet, online service or
software companies;
- announcements by us or our competitors of significant acquisitions,
strategic partnerships, joint ventures or capital commitments;
- legal, regulatory or political developments;
- additions or departures of key personnel;
- sales of our common stock; and
36
- general market conditions.
In addition, the stock market in general, and the Nasdaq National Market
and the market for Internet and technology companies in particular, have
experienced extreme price and volume fluctuations that have often been unrelated
or disproportionate to the operating performance of these companies. These broad
market and industry factors has and may in the future reduce our stock price,
regardless of our operating performance.
WE MAY BE SUBJECT TO ASSESSMENT OF SALES AND OTHER TAXES FOR THE SALE OF OUR
PRODUCTS, LICENSE OF TECHNOLOGY OR PROVISION OF SERVICES
We may have to pay past sales or other taxes that we have not collected
from our customers. We do not currently collect sales or other taxes on the sale
of our products, license of technology or provision of services in states and
countries other than those in which we have offices or employees.
In October 1998, the Internet Tax Freedom Act (ITFA) was signed into law.
Among other things, the ITFA imposed a three-year moratorium on discriminatory
taxes on electronic commerce. Nonetheless, foreign countries or, following the
moratorium, one or more states, may seek to impose sales or other tax
obligations on companies that engage in such activities within their
jurisdictions. Our business would be harmed if one or more states or any foreign
country were able to require us to collect sales or other taxes from current or
past sales of products, licenses of technology or provision of services,
particularly because we would be unable to go back to customers to collect sales
taxes for past sales and may have to pay such taxes out of our own funds.
WE DONATE A PORTION OF NET INCOME TO CHARITY
For the quarter ended March 31, 2001, we set aside 5% of our pre-tax net
income (before goodwill amortization, acquisition charges and stock-based
compensation) for donations to charity. If we sustain pro forma profitability,
we intend to donate such 5% of our annual pre-tax net income (before goodwill
amortization, acquisition charges, and stock-based compensation) to charitable
organizations. This will reduce our net income. We have recently incorporated
the non-profit RealNetworks Foundation to manage our charitable giving efforts.
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
We have made forward-looking statements in this document, all of which are
subject to risks and uncertainties. When we use words such as "believe,"
"intend," "plan," "expect" and "anticipate" or similar words, we are making
forward-looking statements. Forward-looking statements include information
concerning our possible or assumed future business success or financial results.
Such forward-looking statements include, but are not limited to, statements as
to our expectations regarding:
- the future development and growth of, and opportunities for, the Internet
and the online media delivery market;
- the features and functionality of our future products, services and
technologies;
- the future adoption of our current and future products, services and
technologies, including the extension of our media delivery platform to
mobile networks and devices;
- future revenue opportunities;
- the future growth of our customer base;
- our ability to successfully develop and introduce future products and
services;
- future international revenues;
37
- future expense levels (including cost of revenues, research and
development, capital expenditures, sales and marketing, general and
administrative and income tax expenses);
- future sales and marketing efforts;
- future capital needs and whether our current cash, cash equivalents and
short-term investments will be sufficient to meet our cash needs for the
next twelve months;
- the future levels of competition with Microsoft and other competitors;
- the effect of past and future acquisitions and the levels of future
acquisitions by us;
- the future effectiveness of our intellectual property rights; and
- the effect of current litigation in which we are involved.
You should note that an investment in our common stock involves certain
risks and uncertainties that could affect our future business success or
financial results. Our actual results could differ materially from those
anticipated in these forward-looking statements as a result of certain factors,
including those set forth in "Factors That May Affect Our Business, Future
Operating Results and Financial Condition" and elsewhere in this Quarterly
Report on Form 10-Q.
We believe that it is important to communicate our expectations to our
investors. However, there may be events in the future that we are not able to
predict accurately or over which we have no control. Before you invest in our
common stock, you should be aware that the occurrence of the events described in
the "Factors That May Affect Our Business, Future Operating Results and
Financial Condition" and elsewhere in this Quarterly Report on Form 10-Q could
materially and adversely affect our business, financial condition and operating
results. We undertake no obligation to publicly update any forward-looking
statements for any reason, even if new information becomes available or other
events occur in the future.
38
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The following discussion about our market risk involves forward-looking
statements. Actual results could differ materially from those projected in the
forward-looking statements.
Interest Rate Risk. Our exposure to market rate risk for changes in
interest rates relates primarily to our short-term investment portfolio. We
do not hold derivative financial instruments or equity investments in our
short-term investment portfolio. Our cash equivalents and short-term investments
consist of high quality securities, as specified in our investment policy
guidelines. Investments in both fixed rate and floating rate interest-earning
instruments carry a degree of interest rate risk. The fair value of fixed rate
securities may be adversely affected by a rise in interest rates, while floating
rate securities may produce less income than expected if interest rates fall.
Due in part to these factors, our future interest income may be adversely
affected by changes in interest rates. In addition, we may incur losses in
principal if we sell securities that have declined in market value due to
changes in interest rates. Because we have historically held our short-term
investments until maturity and the substantial majority of our investments
mature within one year of purchase, we do not expect our operating results or
cash flows to be significantly impacted by a sudden change in market interest
rates. There have been no material changes in the Company's investment
methodology regarding our cash equivalents and short-term investments, and as
such, the descriptions under the captions "Interest Rate Risk" remain unchanged
from those included in the Company's Form 10-K for the year ended December 31,
2000
Investment Risk. As of March 31, 2001, we had investments in voting
capital stock of privately-held, technology companies for business and strategic
purposes. These investments are included in other assets and are accounted for
under the cost method since ownership is less than 20% and we do not have
significant influence. Some of these securities do not have a quoted market
price. Our policy is to regularly review the operating performance in assessing
the carrying value of these investments. Our investments in publicly traded
companies are carried at current market value and are classified as long term as
they are strategic in nature, we have no plans to sell them in the near term.
Equity price fluctuations of plus or minus 10% of prices at March 31, 2001 would
have had an approximate $143,000 impact on the value of our investments in
publicly traded companies at March 31, 2001.
Foreign Currency Risk. International revenues accounted for
approximately 31% of total net revenues in the quarter ended March 31, 2001. Our
international subsidiaries incur most of their expenses in the local currency.
Accordingly, all foreign subsidiaries use the local currency as their functional
currency.
Our international business is subject to risks typical of an
international business, including, but not limited to differing economic
conditions, changes in political climate, differing tax structures, other
regulations and restrictions, foreign exchange rate volatility, and other
factors discussed in this document. Accordingly, our future results could be
materially adversely impacted by changes in these or other factors.
Our exposure to foreign exchange rate fluctuations arises in part from
intercompany payables and receivables to and from our foreign subsidiaries.
These intercompany accounts are denominated in the functional currency of the
foreign subsidiary in order to centralize foreign exchange risk with the parent
company in the United States. During the quarter ended March 31, 2001, the
Company entered into a foreign currency forward contract to manage the foreign
currency risk of certain intercompany payables denominated in a foreign currency
(contract amount to purchase British Pound Sterling was GBP576,000, contract
amount in United States Dollars was $825,000, fair value at March 31, 2001 in
United States Dollars was $3,000). Although this instrument is effective as a
hedge from an economic perspective, it did not qualify for hedge accounting
under SFAS No. 133, as amended.
We are also exposed to foreign exchange rate fluctuations as the
financial results of foreign subsidiaries are translated into U.S. dollars in
consolidation. As exchange rates vary, these results, when translated, may vary
from expectations and adversely impact overall expected profitability. The
effect of foreign exchange rate fluctuations for the quarter ended March 31,
2001 was not material.
39
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
In August 1998, Venson M. Shaw and Steven M. Shaw filed a lawsuit
against the Company and co-defendant Broadcast.com in the United States District
Court for the Northern District of Texas -- Dallas Division. The plaintiffs
allege that the Company, individually and in combination with Broadcast.com,
infringes on a certain patent by making, using, selling and/or offering to sell
software products and services directed to media delivery systems for the
Internet and corporate intranets. The plaintiffs seek to enjoin the Company from
the alleged infringing activity and to recover damages in an amount no less than
a reasonable royalty. Although no assurance can be given as to the outcome of
this lawsuit, the Company believes that the allegations in this action are
without merit, and intends to vigorously defend itself against these claims. The
Company may be required to indemnify Broadcast.com under the terms of its
license agreement. The plaintiffs filed a similar claim based on the same patent
and seeking similar remedies as a separate lawsuit against Microsoft and
Broadcast.com in the same court. The court has consolidated the lawsuit against
Microsoft and Broadcast.com with the lawsuit against the Company and
Broadcast.com. If the plaintiffs prevail in their claims, the Company could be
required to pay damages or other royalties, in addition to complying with
injunctive relief, which could have a material adverse effect on the Company's
operating results.
Between November 1999 and March 2000, fourteen lawsuits were filed
against the Company in federal and/or state courts in California, Illinois,
Pennsylvania, Washington and Texas. The plaintiffs have voluntarily dismissed
all of the state court cases with the exception of the case pending in
California. The remaining actions, which seek to certify classes of plaintiffs,
allege breach of contract, invasion of privacy, deceptive trade practices,
negligence, fraud and violation of certain federal and state laws in connection
with various communications features of our RealPlayer and RealJukebox products.
Plaintiffs are seeking both damages and injunctive relief. We have filed answers
denying the claims and have filed suit in Washington State Court to compel the
state court plaintiffs to arbitrate the claims as required by our End User
License Agreements. The Washington State Court has granted our motion to compel
arbitration. On February 10, 2000, the federal Judicial Panel on Multidistrict
Litigation transferred all pending federal cases to the federal district court
for the Northern District of Illinois. On the same day, that court granted
RealNetworks' motion to stay the court proceedings because the claims are
subject to arbitration under RealNetworks' End User License Agreement. Although
no assurance can be given as to the outcome of these lawsuits, the Company
believes that the allegations in these actions are without merit, and intends to
vigorously defend itself. If the plaintiffs prevail in their claims, the Company
could be required to pay damages or other penalties in addition to complying
with injunctive relief, which could harm our business and our operating results.
From time to time RealNetworks is, and expects to continue to be,
subject to legal proceedings and claims in the ordinary course of its business,
including employment claims, contract-related claims and claims of alleged
infringement of third-party patents, trademarks and other intellectual property
rights. These claims, even if not meritorious, could force the Company to spend
significant financial and managerial resources. The Company currently has a
number of such claims threatened against it relating to intellectual property
infringement or employment, though it believes these claims are without merit.
The Company is not aware of any legal proceedings or claims that the Company
believes will have, individually or taken together, a material adverse effect on
the Company's business, prospects, financial condition or results of operations.
However, the Company may incur substantial expenses in defending against third
party claims. In the event of a determination adverse to the Company, the
Company may incur substantial monetary liability, and/or be required to change
its business practices. Either of these could have a material adverse effect on
the Company's financial position and results of operations.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(b) Reports on Form 8-K:
40
On January 12, 2001, RealNetworks filed a report on Form 8-K in
connection with its acquisition of all of the outstanding capital
stock of Aegisoft Corp.
On February 7, 2001, RealNetworks filed a report on Form 8-K/A
amending the Form 8-K filed on January 12, 2001 in connection
with its acquisition of Aegisoft Corp. to include financial
statements, pro forma financial information and exhibits.
41
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this Report to be signed on its behalf by the
undersigned, thereunto duly authorized, on May 14, 2001.
REALNETWORKS, INC.
By /s/ Paul Bialek
----------------------------------------------
Paul Bialek
Senior Vice President, Finance and Operations,
Chief Financial Officer, and Treasurer