Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549FORM 10-Q
QUARTERLY REPORT
PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934For the quarterly period ended January 31, 2008
Commission File No. 000-51128
Majesco Entertainment Company
(Exact name of registrant as specified in its charter)
Incorporation or Organization)
Identification No.)160 Raritan Center Parkway, Edison, NJ 08837
(Address of principal executive offices)
REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE: (732) 225-8910
(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)
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
No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of ‘‘large accelerated filer’’, ‘‘accelerated filer’’ and ‘‘smaller reporting company’’ in Rule 12b-2 of the Exchange Act:
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Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes
As of March 14, 2008, there were 28,774,528 shares of the Registrant’s common stock outstanding.
MAJESCO ENTERTAINMENT COMPANY AND SUBSIDIARY
January 31, 2008 QUARTERLY REPORT ON FORM 10-QINDEX
SIGNATURES
CERTIFICATIONS
Table of ContentsPART I. FINANCIAL INFORMATION
Item 1. Financial Statements
MAJESCO ENTERTAINMENT COMPANY AND SUBSIDIARY
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share amounts)
2008
2007See accompanying notes
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Table of ContentsMAJESCO ENTERTAINMENT COMPANY AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited in thousands, except share amounts)
January 31,See accompanying notes
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Table of ContentsMAJESCO ENTERTAINMENT COMPANY AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited in thousands)
January 31,See accompanying notes
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Table of ContentsMAJESCO ENTERTAINMENT COMPANY AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(in thousands, except share amounts)1. PRINCIPAL BUSINESS ACTIVITY AND BASIS OF PRESENTATION
Majesco Entertainment Company, together with its wholly owned UK subsidiary (‘‘Majesco’’ or ‘‘Company’’), is a provider of interactive entertainment products. The Company’s offerings include video game software and other digital entertainment products.
The Company’s products provide it with opportunities to capitalize on the large and growing installed base of interactive entertainment platforms and an increasing number of interactive entertainment enthusiasts. The Company sells its products directly and through resellers primarily to U.S. retail chains, including Best Buy, GameStop/Electronics Boutique, Circuit City, Target, Toys ‘‘R’’ Us and Wal-Mart. Majesco also sells products internationally through partnerships with international publishers. The Company has developed retail and distribution network relationships over its more than 20-year history.
Majesco provides offerings for most major interactive entertainment hardware platforms, including Nintendo’s Game Boy Advance, or GBA, DS, Micro, GameCube and Wii, Sony’s PlayStation 2, or PS2, and PlayStation Portable, or PSP, Microsoft’s Xbox and Xbox 360, and the personal computer, or PC.
The Company’s offerings include video game software and other digital entertainment products. The Company’s operations involve similar products and customers worldwide. The products are developed and sold domestically and internationally. The Company is centrally managed and the chief operating decision makers, the chief executive and other officers, use consolidated and other financial information supplemented by sales information by product category, major product title and platform for making operational decisions and assessing financial performance. Accordingly, the Company operates in a single segment. Sales for the Company in the United States were $18.5 million or 99% and $12.5 million or 86% for the three month periods ended January 31, 2008 and 2007, respectively. Sales in Europe were $0.2 million or 1% and $2.0 million or 14% for the three month periods ended January 31, 2008 and 2007, respectively.
The accompanying interim consolidated financial statements of the Company are unaudited, but in the opinion of management, reflect all adjustments, consisting of normal recurring accruals, necessary for a fair presentation of the results for the interim period. Accordingly, they do not include all information and notes required by generally accepted accounting principles for complete financial statements. Our financial results are impacted by the seasonality of the retail selling season and the timing of the release of new titles. The results of operations for interim periods are not necessarily indicative of results to be expected for the entire fiscal year. The balance sheet at October 31, 2007 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. These interim consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements and notes for the year ended October 31, 2007 filed with the Securities and Exchange Commission on Form 10-K on January 29, 2008.
The statements contained in this Report on Form 10-Q, that are not purely historical, are forward-looking information and statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These include statements regarding our expectations, intentions, or strategies regarding future matters. All forward-looking statements included in this document are based on information available to us on the date hereof. It is important to note that our actual results could differ materially from those projected in such forward-looking statements contained in this Form 10-Q. The forward-looking statements contained herein are based on current expectations that involve numerous risks and uncertainties. Assumptions relating to the foregoing involve judgments regarding among other things, our ability to secure financing or investment for capital expenditures, future economic and competitive market conditions, and future
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Table of Contentsbusiness decisions. All these matters are difficult or impossible to predict accurately, many of which may be beyond our control. Although we believe that the assumptions underlying our forward-looking statements are reasonable, any of the assumptions could be inaccurate and, therefore, there can be no assurance that the forward-looking statements included in this Form 10-Q will prove to be accurate.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Estimates. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities or the disclosure of gain or loss contingencies at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Among the more significant estimates included in these financial statements are the estimated customer allowances, the valuation of inventory and the recoverability of advance payments for software development costs and intellectual property licenses. Actual results could differ from those estimates.
Earnings/(Loss) per share. Basic earnings/(loss) per common share is computed by dividing the net income (loss) by the weighted-average number of shares of common stock outstanding for the period. Diluted earnings per share for the three months ended January 31, 2008 includes the net addition of 24,884 shares representing the impact of 1,316,927 weighted average unvested shares of stock outstanding under the Company’s incentive stock compensation plan, after applying the treasury stock method, as is required by SFAS 128 Earnings per Share. Diluted earnings per share for the three months ended January 31, 2008 excludes the impact of 2,318,611 stock warrants and 1,167,191 stock options outstanding at January 31, 2008, which would have an antidilutive impact on earnings per share. Diluted and basic earnings/(loss) per common share for the three month period ended January 31, 2007, are the same because the impact of the conversion or exercise, as applicable, of the 2,220,687 warrants and 1,509,872 stock options at January 31, 2007 would be antidilutive.
Income Taxes. In June 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes — An Interpretation of FASB Statement No. 109 (‘‘FIN 48’’). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements. FIN 48 requires companies to determine whether it is ‘‘more likely than not’’ that a tax position will be sustained upon examination by the appropriate taxing authorities before any part of the benefit can be recorded in the financial statements. It also provides guidance on the recognition, measurement and classification of income tax uncertainties, along with any related interest and penalties. On November 1, 2007, we adopted the provisions of FIN 48 on a prospective basis.
3. INCOME TAXES
On November 1, 2007 the Company adopted FASB Interpretation No. 48, ‘‘Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109’’ (‘‘FIN 48’’). FIN 48 contains a two step approach to recognizing and measuring uncertain income tax positions. The first step is to evaluate the uncertain tax position for recognition. Each position is evaluated based on its technical merits and a determination is made whether it is ‘‘more likely than not’’ that the position would be sustained upon examination by a tax authority with full knowledge of the facts and circumstances. No benefit is recognized for a tax position that does not meet the ‘‘more likely than not’’ recognition threshold. The second step is to measure the tax benefit of each position. The tax benefit is the largest amount which is more than 50% likely to be realized upon ultimate settlement. FIN 48 is effective for fiscal years beginning after December 15, 2006. Our adoption of FIN 48 on November 1, 2007 had no impact on our beginning retained earnings balance.
We file income tax returns in the U.S. and various foreign jurisdictions.
As of January 31, 2008, we had $1.2 million in unrecognized tax benefits, of which $0.1 million would impact our tax rate if recognized.
We recognize accrued interest and penalties related to unrecognized tax benefits in our consolidated statement of operations. These items are classified as income tax expense in our
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Table of Contentsconsolidated statement of operations. As of November 1, 2007 and January 31, 2008, we had no accrual for the potential payment of penalties.
As of November 1, 2007, we are not subject to any U.S. federal, state or foreign income tax examinations. Our US federal tax returns have been examined for the tax years 2003 through 2004, with the results of such examinations being reflected in our results of operations as of October 31, 2007. We do not anticipate any significant changes in our unrecognized tax benefits over the next twelve months.
For the three months ended January 31, 2008, we did not identify and record any additional liabilities related to unrecognized income tax benefits. Therefore the adoption of FIN 48 did not impact our net income for the three months ended January 31, 2008.
4. DUE FROM FACTOR
Due from (to) factor consists of the following:
2008
2007 Outstanding accounts receivable sold to factorThe following table sets forth the adjustments to the price protection and other customer sales incentive allowances included as a reduction of the amounts due from factor:
January 31,5. PREPAID EXPENSES
The following table presents the major components of prepaid expenses:
2008
2007 Advance payments for inventory6. ACCOUNTS AND OTHER RECEIVABLES
The following table presents the major components of accounts and other receivables:
2008
2007 Accounts receivable8
Table of Contents7. ACCOUNTS PAYABLE AND ACCRUED EXPENSES
Accounts payable and accrued expenses consist of the following:
2008
2007 Accounts payable – trade8. CONTINGENCIES AND COMMITMENTS
Commitments
At January 31, 2008, the Company had no open letters of credit under the Company’s purchase order assignment arrangements for inventory to be delivered during the subsequent quarter.
At January 31, 2008, the Company was committed under agreements with certain developers for future milestone and license fee payments aggregating $5.1 million, $3.8 million of which are payable through October 31, 2008. Milestone payments represent scheduled installments due to the Company’s developers based upon the developers providing the Company certain deliverables, as predetermined in the Company’s contracts. The milestone payments generally represent advances against royalties to the developers. These payments will be used to reduce future royalties due to the developers from sales of the Company’s videogames.
Effective January 1, 2007, upon his resignation, the Company entered into a transition agreement with Morris Sutton, its former Chairman Emeritus, under which he provides services as a consultant for a two year period. The agreement provides for a monthly retainer of $29,175 and a commission equal to 2% of sales to certain specified accounts.
The Company has entered into ‘‘at will’’ employment agreements with certain key executives. These employment agreements include provisions for, among other things, annual compensation, bonus arrangements and equity compensation. These agreements also contain provisions related to severance terms and change of control provisions.
Contingencies
On September 27, 2007, the Company entered into settlement agreements to settle certain litigations pending in the United States District Court, District of New Jersey: (i) a securities class action brought on behalf of a purported class of purchasers of the Company’s securities; (ii) a private securities action filed by Trinad Capital Master Fund, Ltd.; and (iii) a second action filed by Trinad purportedly on behalf of the Company.
Under the terms of the settlement agreement in the securities class action, which is subject to notice to the shareholder class and court approval, the Company’s insurance carrier will make a cash payment and the Company will contribute shares of its common stock with a market value of $2.5 million. The shares being contributed to the settlement will be distributed to the settlement class if and when the court grants final approval to the settlement and the settlement becomes effective.
At this time, the Company cannot estimate the exact number of shares that will be contributed to the settlement, however, it will not be less than 1.8 million shares. The Company will adjust the fair value of the liability to the fair value of the shares expected to be distributed at each balance sheet date and record the resulting change as a non-cash charge or credit to earnings in each period until
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Table of Contentsthe shares are distributed. The settlement provides that if the fair value of the stock falls below $2.5 million, the Company will issue additional shares, subject to certain limitations, with a fair market value equal to the amount of the decrease. Therefore, the liability will not be adjusted below $2.5 million.
During the twelve months ended October 31, 2007, the Company recorded a $2.8 million charge in connection with the expected settlement of the class action litigation. The charge is comprised of $2.5 million, representing the fair value, on the date the agreement was executed, of the common stock expected to be distributed when the settlement becomes effective and $0.3 million representing the increase in the value of the shares since that date. During the three months ended January 31, 2008, the Company recorded a gain on litigation settlement of $0.3 million representing the decline in the value of the shares to be issued under the settlement, as if it occurred on January 31, 2008.
The settlement of the private securities claim in the action brought by Trinad on its own behalf provides that the Company’s insurance carrier will make a cash payment to Trinad, subject to final approval of the class action settlement by the Court.
The settlement agreement in the action filed by Trinad, purportedly on behalf of the Company, will not result in a payment to the Company. Plaintiff’s attorneys will not receive any fees in connection with the settlement. As a result of the filing of this lawsuit by Trinad, the Company has taken actions which it and Trinad believe will benefit the Company’s shareholders and address some of the issues raised in the lawsuit. This settlement is also subject to notice to the Company’s shareholders and to court approval.
Since the settlement is subject to notice to the Company’s shareholders and to court approval, there is no assurance that the settlement described above will be achieved, and if not achieved, there can be no assurance that the Company’s insurance will be adequate to cover the Company’s costs relating to the Class Action lawsuit or Trinad Capital’s litigation against the Company. Any expenses incurred in connection with such litigation not covered by available insurance or any adverse resolution of such litigation could have a material adverse effect on our financial condition.
On July 26, 2007, Charlie Bolton filed a complaint against the Company and several current and former directors and officers of the Company in the United States District Court for the District of New Jersey. The current or former officers and directors named as defendants in the complaint are Morris Sutton, Jesse Sutton, Joseph Sutton and Carl Yankowski. The allegations in the Complaint are similar to those in the Amended Consolidated Complaint filed in the In re: Majesco Securities Litigation punative class action and the Complaint filed in Trinad Capital’s complaint against the Company and several current and former directors and officers of the Company discussed above. The Complaint alleges four causes of action: (1) a claim under Section 10(b) of the Exchange Act (and Rule 10b-5 promulgated thereunder) against all the named defendants; (2) a claim under Section 20(a) of the Exchange Act against Morris Sutton, Jesse Sutton and Joseph Sutton; (3) a claim under Section 18(a) of the Exchange Act against all the named defendants; and (4) a common law fraud claim against Morris Sutton, Jesse Sutton, Joseph Sutton and Carl Yankowski. Bolton seeks compensatory damages of no less than $2 million and $2 million in punitive damages. No liability has been recorded in the financial statements as of January 31, 2008 for legal or settlement expenses related the complaint, as they can not be reasonably estimated at this time. Expenses incurred in connection with Bolton’s litigation or any adverse resolution thereof could have a material adverse effect on the Company’s financial condition.
The Company at times may be a party to other routine claims and suits brought by the Company and against the Company in the ordinary course of business, including disputes arising over contractual claims and collection matters. In the opinion of management, after consultation with legal counsel, the outcome of such routine claims will not have a material adverse effect on the Company’s business, financial condition, and results of operations or liquidity. However, the costs and other effects of pending or future litigation, governmental investigations, legal and administrative cases and proceedings (whether civil or criminal), settlements, judgments and investigations, claims and changes in those matters (including the matters described above), and developments or assertions by or against
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Table of Contentsthe Company relating to intellectual property rights and intellectual property licenses, could have a material adverse effect on the Company’s business, financial condition, and results of operations or liquidity.
9. RELATED PARTIES
The Company receives printing and packaging services from a business of which the brother of Morris Sutton, the Company’s former Chairman Emeritus, and uncle of Jesse Sutton, the Company’s Chief Executive Officer, is a principal. During the three month periods ended January 31, 2008 and 2007 the Company was charged $0.1 million and $0.6 million, respectively. These charges are included in product costs in the accompanying consolidated statement of operations. Such charges are, to the Company’s knowledge, on terms no less favorable to what the Company could receive from providers of similar services.
Morris Sutton resigned from the company effective January 1, 2007, becoming a consultant. The Company paid approximately $116,000 of commissions and fees to Mr. Sutton under the consulting agreement and $11,000 for reimbursement of business expenses for the three months ended January 31, 2008. The Company recorded approximately $30,000 for his services during the three months ended January 31, 2007. The amount for 2007 represents one month of expense under the consulting agreement. Mr Sutton was paid as an employee for November and December of 2007.
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Table of ContentsItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Overview
We are a provider of interactive entertainment products. We sell our products primarily to large retail chains, specialty retail stores, video game rental outlets and distributors. We also sell our products internationally through distribution agreements with other publishers. We have developed our retail and distribution network over our 20-year history.
We publish video game software for most major interactive entertainment hardware platforms, including Nintendo’s Wii, Game Boy Advance, or GBA, DS, Micro and GameCube, Sony’s PlayStation 2, or PS2, and PlayStation Portable, or PSP, Microsoft’s Xbox, Xbox 360 and the personal computer, or PC.
Our video game titles are targeted at various demographics at a range of price points, from lower-priced ‘‘value’’ titles to more expensive ‘‘premium’’ titles. In some instances, these titles are based on licenses of well-known properties, and in other cases based on original properties. We collaborate and enter into agreements with content providers and video game development studios for the creation of the majority of our video games.
Majesco Sales Inc. was incorporated in 1986 under the laws of the State of New Jersey. On December 5, 2003, Majesco Sales Inc. completed a reverse merger with Majesco Holdings Inc. (formerly, ConnectivCorp) then a publicly traded company with no active operations. Majesco Holdings Inc. was incorporated in 1998 under the laws of the State of Delaware. As a result of the merger, Majesco Sales Inc. became a wholly-owned subsidiary and the sole operating business of the public company. On April 4, 2005, Majesco Sales Inc. was merged into Majesco Holdings Inc., and Majesco Holdings Inc. changed its name to Majesco Entertainment Company.
During 2006, we revised our business model and shifted our product strategy away from capital intensive premium console games to a focus on lower-cost games for both console and handheld systems targeting ‘‘mass market’’ consumers. We believe this strategy allows us to capitalize on our strengths and expertise while reducing some of the cost and risk associated with publishing a large number of premium console titles. We continue to publish titles for popular handheld systems such as the GBA, DS and PSP. We also publish software for Nintendo’s Wii console, as we believe this platform allows us to develop games within our cost parameters, while enabling us to reach ‘‘mass market’’ consumers. In addition, we continue to look opportunistically for titles to publish on the PC and other home console systems.
Net Revenues. Our revenues are principally derived from sales of our video game titles. We primarily provide video games for the mass market and casual game player. We work with third-party development studios to develop our own proprietary titles and we also license rights to properties from third parties. In 2007, we announced the opening of our own development studio. However, we expect to continue to use third party studios for the significant majority of our development. We have also developed, manufactured and marketed a variety of digital media peripherals and applications including ‘‘plug-and-play’’ video game systems.
Our revenues are recognized net of estimated reserves for price protection and other allowances.
Cost of Sales. Cost of sales consists of product costs and amortization of software development costs and license fees. A significant component of our cost of sales is product costs. These are comprised primarily of manufacturing and packaging costs of the disc or cartridge media, royalties to the platform manufacturer and manufacturing and packaging costs of peripherals. Commencing upon the related product’s release, capitalized software development and intellectual property license costs are amortized to cost of sales.
Gross Profit. Gross Profit is the excess of net revenues over product costs and amortization of software development and license fees. Development and license fees incurred to produce video games are generally incurred up front and amortized to cost of sales. The recovery of these costs and total gross profit is dependent upon achieving a certain sales volume, which varies by title. Our value
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Table of Contentstitles are generally characterized as having lower gross profit margin potential than premium titles as a result of their lower sales price, and carry lower financial risk associated with the recovery of upfront development and license fees as compared with premium game titles.
Product Research and Development Expenses. Product research and development expenses relate principally to our cost of supervision of third-party video game developers, testing new products and conducting quality assurance evaluations during the development cycle. Costs incurred are employee-related, may include equipment and are not allocated to cost of sales.
Selling and Marketing Expenses. Selling and marketing expenses consist of marketing and promotion expenses, the cost of shipping products to customers and related employee costs. A large component of these expenses relate to marketing and promotion expenses, which includes certain customer marketing allowances.
General and Administrative Expenses. General and administrative expenses primarily represent employee related costs, including corporate executive and support staff, general office expenses, professional fees and various other overhead charges. Professional fees, including legal and accounting expenses, typically represent the second largest component of our general and administrative expenses. These fees are partially attributable to our required activities as a publicly traded company, such as SEC filings.
Interest and Financing Costs. Interest and financing costs are directly attributable to our factoring and our purchase-order financing arrangements.
(Benefit) Provision for Income Taxes. Utilization of our net operating loss carryforwards may be subject to a substantial annual limitation due to the ‘‘change in ownership’’ provisions of the Internal Revenue Code. The annual limitation may result in the expiration of net operating loss carryforwards before utilization. Since the Company has a history of losses, a full valuation allowance has been established under the provisions of SFAS No. 109 and the company intends to maintain a valuation allowance for its net operating loss carryforwards until sufficient positive evidence exists to support its reversal.
Seasonality and Variations in Interim Quarterly Results
Our quarterly net revenues, gross profit, and operating income are impacted significantly by the seasonality of the retail selling season, and the timing of the release of new titles. Sales of our catalog and other products are generally higher in the first and fourth quarters of our fiscal year (ending October 31 and January 31, respectively) due to increased retail sales during the holiday season. Sales and gross profit, as a percentage of sales, also generally increase in quarters that we release significant new titles because of increased sales volume as retailers make purchases to stock their shelves and meet initial demand for the new release. These quarters also benefit from the higher selling prices that we are able to achieve early in the products life cycle. Sales and gross profit during the quarter ended January 31, 2008 benefited from strong holiday sales of our existing products, and the release of Cooking Mama 2 for the DS. Therefore, our first quarter results are not necessarily indicative of expected results for subsequent quarters during the fiscal year.
Critical Accounting Policies
Our discussion and analysis of the financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States.
The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ materially from these estimates under different assumptions or conditions.
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Table of ContentsWe have identified the policies below as critical to our business operations and to the understanding of our financial results. The impact and any associated risks related to these policies on our business operations is discussed throughout management’s discussion and analysis of financial condition and results of operations where such policies affect our reported and expected financial results.
Revenue Recognition. We recognize revenue upon the shipment of our product when title and risk of loss are transferred and persuasive evidence of an arrangement exists. In order to recognize revenue, we must not have any continuing obligations and it must also be probable that we will collect the accounts receivable. Revenues, including sales to resellers and distributors, are recognized when these conditions are met.
Reserves for Price Protection and Other Allowances. We generally sell our products on a no-return basis, although in certain instances, we may provide price protection or other allowances on certain unsold products in accordance with industry practices. Price protection, when granted and applicable, allows customers a partial credit with respect to merchandise unsold by them. Revenue is recognized net of estimates of these allowances. Sales incentives and other consideration that represent costs incurred by us for assets or services received, such as the appearance of our products in a customer’s national circular advertisement, are generally reflected as selling and marketing expenses. We estimate potential future product price protection and other discounts related to current period product revenue. Generally our price protection for premium-priced titles is higher than that needed for our value titles.
Our reserves for price protection and other allowances fluctuate over periods as a result of a number of factors including analysis of historical experience, current sell-through of retailer inventory of our products, current trends in the interactive entertainment market, the overall economy, changes in customer demand and acceptance of our products and other related factors. Significant management judgments and estimates must be made and used in connection with establishing the allowance for returns and price protection in any accounting period. However, actual allowances granted could materially exceed our estimates as unsold products in the distribution channels are exposed to rapid changes in consumer preferences, market conditions, technological obsolescence due to new platforms, product updates or competing products. For example, the risk of requests for allowances may increase as consoles pass the midpoint of their lifecycle and an increasing number of competitive products heighten pricing and competitive pressures. While management believes it can make reliable estimates regarding these matters, these estimates are inherently subjective. Accordingly, if our estimates change, this will result in a change in our reserves, which would impact the net revenues and/or selling and marketing expenses we report. For the three month periods ended January 31, 2008 and 2007 we provided allowances for future price protection and other allowances of $1.0 million and $0.4 million, respectively. The fluctuations in the provisions reflected our estimates of future price protection based on the factors discussed above. We do not have significant exposure to credit risk as the factor generally buys our receivables without recourse.
Software development costs and prepaid license fees. Software development costs include development fees, most often in the form of milestone payments made to independent software developers for development services. Software development costs are capitalized once technological feasibility of a product is established and it is determined that such costs should be recoverable against future revenues. For products where proven game engine technology exists, this may occur early in the development cycle. Technological feasibility is evaluated on a product-by-product basis. Amounts related to software development that are not capitalized are charged immediately to product research and development costs. Prepaid license fees represent license fees to holders for the use of their intellectual property rights in the development of our products. Minimum guaranteed royalty payments for intellectual property licenses are initially recorded as an asset (prepaid license fees) and a current liability (accrued royalties payable) at the contractual amount upon execution of the contract when no significant performance remains with the licensor. Capitalized software development costs classified as non-current relate to titles for which we estimate the release date to be more than one year from the balance sheet date.
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Table of ContentsCommencing upon a related product’s release, capitalized software development costs and prepaid license fees are amortized to cost of sales based upon the higher of (i) the ratio of current revenue to total projected revenue or (ii) the straight-line method. The amortization period is usually no longer than one year from the initial release of the product. The recoverability of capitalized software development costs and prepaid license fees is evaluated based on the expected performance of the specific products to which the costs relate. The following criteria are used to evaluate expected product performance: historical performance of comparable products using comparable technology; orders for the product prior to its release; and estimated performance of a sequel product based on the performance of the product on which the sequel is based. Significant management judgments and estimates are utilized in the assessment of the recoverability of capitalized costs. In evaluating the recoverability of capitalized costs, the assessment of expected product performance utilizes forecasted sales amounts and estimates of additional costs to be incurred to complete and publish the product. If revised forecasted or actual product sales are less than, and/or revised forecasted or actual costs are greater than, the original forecasted amounts utilized in the initial recoverability analysis, the net realizable value may be lower than originally estimated in any given quarter, which could result in an impairment charge. In the three month periods ended January 31, 2008 and 2007 we charged $1.4 million and $1.8 million, respectively, to cost of sales for amortization of software development costs, prepaid license fees and royalties on products which were sold.
Inventory. Inventory, which consists principally of finished goods, is stated at the lower of cost as determined by the first-in, first-out method, or market. We estimate the net realizable value of slow-moving inventory on a title-by-title basis and charge the excess of cost over net realizable value to cost of sales.
Accounting for Stock-Based Compensation. In December 2004, the Financial Accounting Standards Board ‘‘FASB’’ issued SFAS No. 123 (revised 2004), ‘‘Share Based Payment’’ (‘‘SFAS 123(R)’’). SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. We adopted SFAS 123(R) on November 1, 2005. SFAS 123(R) permits public companies to adopt its requirements using either the modified prospective or modified retrospective transition method. We use the modified prospective transition method, which requires that compensation cost is recognized for all awards granted, modified or settled after the effective date as well as for all awards granted to employees prior to the effective date that remain unvested as of the effective date.
Commitments and Contingencies. The Company accounts for commitments and contingencies in accordance with financial accounting standards board Statement No. 5, Accounting for Contingencies. The company records a liability for commitments and contingencies when the amount is both probable and reasonably estimable.
Results of operations
Three months ended January 31, 2008 versus three months ended January 31, 2007
Net Revenues. Net revenues for the three months ended January 31, 2008 increased to $18.7 million from $14.5 million in the comparable quarter last year. The $4.2 million increase is primarily due to increased revenue from new releases in 2008 including Cooking Mama 2 for the Nintendo DS.
Gross Profit. Gross profit for the three months ended January 31, 2008 was $7.5 million compared to a gross profit of $4.5 million in the same quarter last year. The increase in gross profit is primarily attributable to the higher net revenues discussed above and a higher gross profit percentage resulting from higher priced products. In 2008, a high percentage of our revenue was generated from the release of Cooking Mama 2 for the Nintendo DS which sells at retail for $29.95. The majority of our sales for the same quarter in 2007 were lower priced value and catalog titles. Gross profit as a percentage of net sales was 40% for the three months ended January 31, 2008 compared to 31% for the three months ended January 31, 2007.
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Table of ContentsProduct Research and Development Expenses. Research and development costs increased $0.3 million to $0.9 million for the three months ended January 31, 2008 from $0.6 million for the comparable period in 2007. The increase is the result of the opening of our new development studio and expenses related to the research and development of new products.
Selling and Marketing Expenses. Total selling and marketing expenses increased to $2.3 million for the three months ended January 31, 2008 from $1.7 million in the same three month period in 2007. The $0.6 million increase is primarily due to increased commissions, media and other marketing costs associated with the increased revenues from games that were released in the three months ended January 31, 2008. Selling and marketing expense as a percentage of net sales was approximately 12% for each of the three months ended January 31, 2008 and 2007.
General and Administrative Expenses. For the three month period ended January 31, 2008 general and administrative expenses were $2.1 million, a decrease of $0.2 million from $2.3 million in the comparable period in 2007. The decrease is primarily due to lower legal fees related to shareholder and other litigation.
Settlement of litigation and related charges, net. During the twelve months ended October 31, 2007, we recorded a $2.8 million charge in connection with the fair value of shares of common stock that we have agreed to issue in settlement of a class action securities litigation against the Company. The charge was comprised of $2.5 million, representing the fair value, on the date the settlement agreement was executed, of the common stock expected to be distributed when the settlement becomes effective, and $0.3 million, representing the increase in the value between the date of the agreement and October 31, 2007. During the three months ended January 31, 2008, we recorded a gain on litigation settlement of $0.3 million representing the decline in the value of the shares to be issued under the settlement, as if it occurred on January 31, 2008.
We will adjust the fair value of the liability to the fair value of the shares expected to be distributed at each balance sheet date and record the resulting change as a non-cash charge to earnings in each period until the shares are distributed. The settlement provides that if the fair value of the stock falls below $2.5 million, we will have to issue additional shares, subject to certain limitations, with a fair market value equal to the amount of the decrease. Therefore, the liability will not be adjusted below $2.5 million.
There is no assurance that the settlement described above will be achieved, and if not achieved, there can be no assurance that our insurance will be adequate to cover our costs relating to the litigation. Any expenses incurred in connection with the litigation not covered by available insurance or any adverse resolution of such litigation could have a material adverse effect on our financial condition.
Operating Income (Loss). Operating income for the three months ended January 31, 2008 was $2.4 million, compared to an operating loss ($0.2) million for the three month period ended January 31, 2007. The increase in operating income was primarily due to higher revenues and gross profit percentage discussed above, offset in part by expenses related to the opening of our new development studio.
Interest and Financing Costs, Net. Interest and financing costs decreased to $0.2 million for the three months ended January 31, 2008 from $0.7 million for the three months ended January 31, 2007. The decrease of $0.5 million is the result of a lower percentage of our inventory purchases being financed through letters of credit and lower factoring fees.
Change in fair value of Warrants. On September 5, 2007 we issued warrants in connection with an equity financing. The warrants contain a provision that may require settlement by transferring assets. Therefore, they are recorded at fair value as liabilities in accordance with FASB statement No. 150, Accounting with certain financial instruments with Characteristics of both Liabilities and Equity, and FASB Staff position 150-1 Issuers Accounting for Freestanding Financial Instruments Composed of More Than One option or Forward Contract Embodying Obligations under FASB Statement 150.
We recorded income of $0.5 million for the three months ended January 31, 2008, reflecting the decrease in fair value of the warrants during the period.
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Table of ContentsIncome Taxes. For the three months ended January 31, 2008, we did not provide for income taxes because our net operating loss carryforwards exceeded our taxable income. For the three months ended January 31, 2007, we did not record any income tax benefit because realization of the resulting loss carryforwards can not be assured.
Net Income (Loss). Net income for the three months ended January 31, 2008 was $2.7 million, an increase of $3.7 million from a net loss of ($1.0) million for the comparable period in 2007.
Liquidity and Capital Resources
We incurred a net loss of $4.8 million in 2007 and a net loss of $5.4 million in 2006. Historically, we have funded our operating losses through sales of our equity and use of our purchase order financing and factor arrangements.
We have generated net income of $2.7 million for the three months ended January 31, 2008. While our current plan is to fund our operations through product sales, historically, our business has been seasonal in nature, and we may be required to modify that plan, or seek outside sources of financing if our operating and sales targets are not met. There can be no assurance that such funds will be available on acceptable terms, if at all. Management believes it can operate under the existing level of financing for at least one year. However, if the current level of financing was reduced and the company was unable to obtain alternative financing, it could create a material adverse change in the business.
While our cash and cash equivalents balance was $8.2 million as of January 31, 2008, we expect continued volatility in the use and availability of cash due to the seasonality of our business, timing of receivables collections and working capital needs necessary to finance our business and growth objectives. To satisfy our liquidity needs, we factor our receivables. We also utilize purchase order financing through the factor and through a finance company to provide funding for the manufacture of our products. In connection with these arrangements, the finance company and the factor have a security interest in substantially all of our assets.
Under our factoring agreement we have the ability to take cash advances against accounts receivable and inventory of up to $20 million, and $2 million in letters of credit. The factor, in his sole discretion, can reduce the availability of financing at anytime. In addition we have $10 million of availability for letters of credit and purchase order financing with another lender.
Factoring and Purchase Order Financing. As mentioned above, to provide liquidity, we take advances from our factor and utilize purchase order financing to fund the manufacturing of our products.
Under the terms of our factoring agreement, we assign our accounts receivable to the factor. The factor, in its sole discretion, determines whether or not it will accept a receivable based on its assessment of its credit risk. Once a receivable is accepted by the factor, the factor assumes substantially all of the credit risk associated with the receivable. The factor is required to remit payments to us for the assigned accounts receivable in accordance with the terms of the assigned invoice, regardless of whether the factor receives payment on the receivable, so long as the customer does not have a valid dispute related to the invoice. The amount remitted to us by the factor equals the invoiced amount adjusted for allowances and discounts we have provided to the customer less factor charges of 0.5% of invoiced amounts for these credit and collection services.
Manufacturers require us to present a letter of credit, or pay cash in advance, in order to manufacture the products required under a purchase order. Currently, we utilize letters of credit from a finance company which charges 1.5% of the purchase order amount for each transaction for 30 days, plus administrative fees. Our factor also provides purchase order financing at a cost of 0.5% of the purchase order amount for each transaction for 30 days. Additional charges are incurred if letters of credit remain outstanding in excess of the original time period and/or the financing company is not paid at the time the products are received. When our liquidity position allows, we will pay cash in advance instead of utilizing purchase order financing. This results in reduced financing and administrative fees associated with purchase order financing.
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Table of ContentsIn addition, we may request that the factor provide us with cash advances based on our accounts receivable and inventory. The factor may either accept or reject our request for advances at its discretion. Amounts to be paid to us by the factor for any assigned receivable are offset by any amounts previously advanced by the factor. As our needs require, we may request that the factor advance 70% of the eligible receivables, and advance 50% of inventory up to a maximum of $1.5 million. The interest rate is prime plus 1.5%.
Advances From Customers. On a case by case basis, distributors and other customers have in the past agreed to provide us with cash advances on their orders. These advances were then applied against future sales to these customers. In exchange for these advances, we offer these customers beneficial pricing or other considerations.
Commitments and Contingencies. We do not currently have any material commitments with respect to any capital expenditures.
As of January 31, 2008 we had no open letters of credit for inventory purchases to be delivered during the quarter ended April 30, 2008.
We are committed under agreements with certain developers and content providers for milestone and license fee payments aggregating $5.1 million, $3.8 million of which are payable through October 31, 2008.
As of January 31, 2008 we were committed under operating leases for office space and equipment for approximately $1.2 million through December 2010.
Effective January 1, 2007, upon his resignation, we entered into a transition agreement with Morris Sutton, our former Chairman Emeritus under which he will provide services as a consultant for a two year period. The agreement provides for a monthly retainer of $29,175 and a commission equal to 2% of sales to certain specified accounts.
As previously disclosed, during the quarter ended October 31, 2007, we entered into settlement agreements to settle certain litigations pending in the United States District Court, District of New Jersey: (i) a securities class action brought on behalf of a purported class of purchasers of the Company’s securities; (ii) a private securities action filed by Trinad Capital Master Fund, Ltd.; (iii) and a second action filed by Trinad purportedly on behalf of the Company.
Under the terms of the settlement agreement in the securities class action, which is subject to notice to the shareholder class and court approval, our insurance carrier will make a cash payment and we will contribute shares of our common stock with a market value of $2.5 million. The shares being contributed to the settlement will be distributed to the settlement class if and when the court grants final approval to the settlement and the settlement becomes effective.
At this time, the we cannot estimate the exact number of shares that will be contributed to the settlement, however, it will not be less than 1.8 million shares. We will adjust the fair value of the liability to the fair value of the shares expected to be distributed at each balance sheet date and record the resulting change as a non-cash charge or credit to earnings in each period until the shares are distributed. The settlement provides that if the fair value of the stock falls below $2.5 million, we will issue additional shares, subject to certain limitations, with a fair market value equal to the amount of the decrease. Therefore, the liability will not be adjusted below $2.5 million.
During the twelve months ended October 31, 2007, we recorded a $2.8 million charge in connection with the expected settlement of the class action litigation. The charge is comprised of $2.5 million, representing the fair value, on the date the agreement was executed, of the common stock expected to be distributed when the settlement becomes effective and $0.3 million representing the increase in the value of the shares since that date. During the three months ended January 31, 2008, the we recorded a gain on litigation settlement of $0.3 million representing the decline in the value of the shares to be issued under the settlement, as if it occurred on January 31, 2008.
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Table of ContentsThere is no assurance that the settlement described above will be achieved, and if not achieved, there can be no assurance that our insurance will be adequate to cover our costs relating to the litigation. Any expenses incurred in connection with the litigation not covered by available insurance or any adverse resolution of such litigation could have a material adverse effect on our financial condition.
Cash Flows
Cash and cash equivalents were $8.2 million at January 31, 2008 compared to $7.3 million at October 31, 2007.
Operating Cash Flows. Cash provided by operating activities during the three months ended January 31, 2008 was $1.1 million compared $1.0 million during the same period in the prior year. The $0.1 million increase in cash provided by operations in 2007 was primarily due to increased operating income, partially offset by increases in the net amount of accounts receivable due from our factor, investment in prepaid development and royalty expenses and other working capital items. We expect continued volatility in the use and availability of cash due to the seasonality of our business, timing of receivables collections and working capital needs necessary to finance our business and growth objectives.
Investing Cash Flows. Cash used in investing activities for the three months ended January 31, 2008 and 2007 consists primarily of purchases of computer equipment and leasehold improvements necessary to accommodate our infrastructure growth of $0.1 million.
Financing Cash Flows. Cash used in financing activities in the three months ended January 31, 2007 was $0.8 million relating to a reduction in outstanding inventory financing.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
We are exposed to various market risks, including the changes in foreign currency exchange rates and interest rates. Market risk is the potential loss arising from changes in market rates and prices. Foreign exchange contracts used to hedge foreign currency exposure are subject to market risk. We do not enter into derivatives or other financial instruments for trading or speculative purposes. At January 31, 2008 we did not have any foreign exchange contracts.
Item 4. Controls and Procedures
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures, as defined in Exchange Act Rule 13a-15(e) and 15d-15(e), as of the end of the period covered by this report.
In designing and evaluating our disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives.
While we believe our disclosure controls and procedures and our internal control over financial reporting have improved, no system of controls can prevent errors and fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur. Controls can also be circumvented by individual acts of some people, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with its policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.
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Table of ContentsSubject to the limitations above, management believes that the consolidated financial statements and other financial information contained in this report, fairly present in all material respects our financial condition, results of operations, and cash flows for the periods presented.
Based on the evaluation of the effectiveness of our disclosure controls and procedures, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) were effective at a reasonable assurance level. There were no changes in our internal control over financial reporting that occurred during our most recent fiscal quarter that materially affected, or that are reasonably likely to materially affect, our internal control over financial reporting.
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Table of ContentsPART II. OTHER INFORMATION
Item 1. Legal Proceedings
None
Item 1A. Risk Factors
A description of the risks associated with our business, financial condition, and results of operations is set forth in Part I, Item 1A, of our Annual Report on Form 10-K for the fiscal year ended October 31, 2007. These factors continue to be meaningful for your evaluation of the Company and we urge you to review and consider the risk factors presented in the Form 10-K. There have been no material changes to these risks presented in the Form 10-K.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
None
Item 3. Defaults Upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
None
Item 5. Other Information
None
Item 6. Exhibits
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Table of ContentsSIGNATURE
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.
Chief Executive OfficerDate: March 17, 2008