-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, QibY+8q355Sf/U9srfyOds/hJ2w6QUwmEOquC/m6vwtRotW0ShUA0saHo2zenj8Z YdewHnLKyrsFsjDtudfyxg== 0000891618-00-001865.txt : 20000331 0000891618-00-001865.hdr.sgml : 20000331 ACCESSION NUMBER: 0000891618-00-001865 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 20000101 FILED AS OF DATE: 20000330 FILER: COMPANY DATA: COMPANY CONFORMED NAME: PIXAR \CA\ CENTRAL INDEX KEY: 0001002114 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-PREPACKAGED SOFTWARE [7372] IRS NUMBER: 680086179 STATE OF INCORPORATION: CA FISCAL YEAR END: 0102 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 000-26976 FILM NUMBER: 586637 BUSINESS ADDRESS: STREET 1: 1001 WEST CUTTING BLVD CITY: RICHMOND STATE: CA ZIP: 94808 BUSINESS PHONE: 5102364000 MAIL ADDRESS: STREET 1: 1001 WEST CUTTING BLVD CITY: RICHMOND STATE: VA ZIP: 94804 10-K405 1 FORM 10-K405 YEAR ENDED JANUARY 1, 2000 1 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------------------ FORM 10-K ------------------------ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED JANUARY 1, 2000 COMMISSION FILE NUMBER 0-26976 PIXAR (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) CALIFORNIA 68-0086179 (STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
1001 WEST CUTTING BOULEVARD, RICHMOND, CALIFORNIA 94804 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE) REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (510) 236-4000 ------------------------ SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: COMMON STOCK, NO PAR VALUE PER SHARE (TITLE OF CLASS) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] As of March 20, 2000, there were 47,033,847 shares of the Registrant's Common Stock outstanding and the aggregate market value of such shares held by non-affiliates of the Registrant (based upon the closing sale price of such shares on the Nasdaq National Market on March 20, 2000) was approximately $600,848,851. Shares of Common Stock held by each executive officer and director have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes. DOCUMENTS INCORPORATED BY REFERENCE Certain sections of Pixar's Annual Report to Shareholders for the year ended January 1, 2000 (the "1999 Annual Report") are incorporated by reference in Parts II and IV of this Form 10-K to the extent stated herein. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- 2 This Annual Report on Form 10-K and the documents incorporated herein by reference contain forward-looking statements that have been made pursuant to the provisions of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are based on current expectations, estimates and projections about Pixar's industry, management's beliefs, and assumptions made by management. Words such as "anticipates," "expects," "intends," "plans," "believes," "seeks," "estimates," variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict; therefore, actual results and outcomes may differ materially from what is expressed or forecasted in any such forward-looking statements. Such risks and uncertainties include those set forth herein under "Risk Factors" on pages 15 through 30 as well as those noted in the documents incorporated herein by reference. Particular attention should be paid to the cautionary language in Risk Factors "-- Dependence on Toy Story 2, A Bug's Life and Toy Story in 2000," "-- Risks Associated with Adequacy of Cash Balances," " -- Risks Associated with Scheduled Successive Release of Films" and "-- Risks Associated with Co-Production Agreement." Unless required by law, Pixar undertakes no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise. PART I ITEM 1. BUSINESS GENERAL Pixar is a leading digital animation studio with the creative, technical and production capabilities to create a new generation of animated feature films and related products. Pixar's objective is to create, develop and produce computer-animated feature films with a new three-dimensional appearance, heartwarming stories and memorable characters that appeal to audiences of all ages. Through the creation of entertaining, enduring and successful films, Pixar seeks to become a leading brand in animated feature films. Pixar's first three films, Toy Story, A Bug's Life and Toy Story 2, were created and produced by Pixar and were marketed and distributed by The Walt Disney Company (along with its subsidiaries hereinafter referred to as "Disney"). Toy Story was released in 1995 and generated over $191 million in domestic box office revenue. Pixar's second animated feature film, A Bug's Life, was released in 1998 and generated over $162 million in domestic box office revenue. Pixar's third and latest animated feature film, Toy Story 2, was released in November 1999 and, as of March 20, 2000 had generated over $241 million in domestic box office revenue, making it the second highest grossing animated feature film of all time. See "-- Recent Developments." In 1997, Pixar extended its existing relationship with Disney (under which Toy Story was created and produced) by entering into the Co-Production Agreement. Under the Co-Production Agreement, Pixar agreed to produce, on an exclusive basis, five original computer-animated feature films (the "Pictures") for distribution by Disney. Pixar and Disney agreed to co-finance and co-brand the films and share equally in the profits of each film and any related merchandise and other ancillary products, after recovery of all marketing and distribution costs and fees. The first original film produced under the Co-Production Agreement was A Bug's Life and Pixar will produce four additional original animated feature films under this agreement. As a sequel, Toy Story 2 does not count toward the five original films; however, it was produced under the Co-Production Agreement and is afforded the same financial terms as the five original films. See "-- Relationship with Disney -- Co-Production Agreement." RECENT DEVELOPMENTS Release of Toy Story 2. In November 1999, Toy Story 2 was released, and as of March 20, 2000 had generated over $241 million in domestic box office revenue and over $200 million in foreign box office revenue, totaling over $441 million worldwide. Toy Story 2 is now the second highest grossing animated feature film ever released in the U.S. In January 2000, Disney and Pixar re-released the original home video of Toy Story. Changes in Management. In March 1999, Lawrence B. Levy resigned from his position as Executive Vice President and Chief Financial Officer. On April 1, 1999, Mr. Levy and Edwin E. Catmull, Pixar's 2 3 Executive Vice President and Chief Technical Officer, became members of Pixar's Board of Directors. In September 1999, Ann Mather was appointed Executive Vice President and Chief Financial Officer. Buzz Lightyear of Star Command. In the fall of 2000, Pixar and Disney plan to launch a co-branded cel-animated television series called "Buzz Lightyear of Star Command" featuring Toy Story and Toy Story 2's Buzz Lightyear as the main character. Sixty-five episodes will be produced, thirteen of which will air on ABC and the balance will air in syndication. The series will be introduced with three episodes packaged for home video release in advance of the television launch. BUSINESS MODEL AND PRODUCTS Pixar's strategy is to become a leading brand in the development and production of animated feature films and related products, such as soundtracks, toys and other merchandise. Pixar has implemented this strategy through the Co-Production Agreement with Disney. Animated Feature Films. Pixar's first computer-animated feature film, Toy Story, was released in November 1995. In November 1998, Pixar released A Bug's Life, its second computer-animated feature film for Disney. A Bug's Life was the first of five original films (the "Pictures") that will be developed and distributed under the new Co-Production Agreement with Disney. In November 1999, Pixar released Toy Story 2, its third computer-animated feature film produced by Pixar for distribution by Disney. While not counting as one of the five original Pictures, Toy Story 2 is subject to the same terms as the five Pictures developed and produced under the Co-Production Agreement. Pixar intends to continue to develop computer-animated feature films for the family entertainment market. In May 1999, Pixar began production of its fourth computer-animated feature film (with the working title "Monsters, Inc."). Monsters, Inc. will count as the second of the five original films to be produced under the Co-Production Agreement. Monsters, Inc. is not expected to be released until late 2001 at the earliest. In 1999, Pixar began story development on its fifth animated feature film, ("Film Five"). Film Five counts as the third original Picture under the Co-Production Agreement and is not expected to be released until 2002 at the earliest. In 1999, Pixar also began concept development on its sixth animated feature film, also governed by the Co-Production Agreement. See "Risk Factors -- Risks Associated with Scheduled Successive Release of Films." Home Videos. Toy Story was released by Disney as a home video in October 1996, and re-released in January 2000, and A Bug's Life was released on home video in April 1999. Disney recently announced a new home video and digital video disc (DVD) strategy by which more titles will be available on a year-round basis. The home video release of Toy Story 2 is scheduled for fall 2000. Pixar believes that its future animated feature films will also lend themselves to home video distribution in both domestic and international markets. Distribution of home video versions of the animated feature films developed and produced under the Co-Production Agreement will also be pursuant to the Co-Production Agreement. Merchandise and Soundtracks. Pixar believes that the characters and music created in animated feature films lend themselves to opportunities for selling merchandise and soundtracks. For example, merchandise such as children's toys based on stories and characters in A Bug's Life and Toy Story 2 were designed using three-dimensional data from Pixar's digital models. Disney has the rights to distribute merchandise and soundtracks from Toy Story, A Bug's Life, Toy Story 2 and the remaining feature films to be made pursuant to the Co-Production Agreement. Pixar shares in the profits, if any, generated from such sales. Short Films. Pixar has developed a number of short films since its inception and continues to invest in developing new short films. In 1997, Pixar created and produced a new short film, Geri's Game. Although the short films have had few commercial opportunities to date, Pixar believes it is an important investment for the development of creative talent and Pixar's computer animation technology. For example, Geri's Game enabled Pixar to further its technology in computer-generated skin and cloth. In addition, such short films provide Pixar with opportunities for valuable publicity and critical acclaim that further establishes the Pixar brand and enhances Pixar's standing in the creative community, which continues to allow us to attract the best talent. For example, in 1998, Geri's Game won an Academy Award for Best Short Film (Animated). In addition, Geri's Game was released theatrically nationwide as the preceding short film to A Bug's Life, and preceding Toy Story 2 was Luxo Jr., Pixar's first ever short film produced in 1986, which earned an Academy Award nomination for Best Short Film (Animated). 3 4 RenderMan. Pixar has been selling its RenderMan software for nearly twelve years. RenderMan has helped visual effects studios create visual effects such as creatures appearing in Star Wars Episode 1: The Phantom Menace, certain dinosaurs in Jurassic Park, the metal cyborg in Terminator 2 and the hoard of horsemen charging over the hill in Mulan. RenderMan runs on Unix-based workstations from Silicon Graphics, Sun Microsystems, Inc. ("Sun"), Digital Equipment Corp. ("Digital Equipment") and on personal computers (PC's) under Linux and Windows NT. Examples of RenderMan customers include movie studios such as Disney, Twentieth Century Fox Film Corporation, Lucasfilm Ltd. through its affiliate Industrial Light and Magic ("ILM"), Sony Pictures Entertainment ("Sony") and Warner Bros. Inc. Customers also include government agencies and universities. The RenderMan ToolKit is sold at a list price of $5,000 per license. Discounts are available for site or multi-use licenses. See "-- Technology -- RenderMan" and "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the 1999 Annual Report to Shareholders. Animation Services. Pixar produces short animation projects, primarily derived from Pixar's films, such as the "Tree of Life" which is currently on display at the Animal Kingdom in Disney World, and animation for the advertising of McDonald's Happy Meals which were tied in to A Bug's Life and Toy Story 2. Moreover, Pixar believes that there may continue to be other opportunities to produce short animation projects for Disney in connection with work performed under the Co-Production Agreement and it helps develop awareness of the characters in Pixar's film and helps Disney promote the films. In the past, Pixar produced animated or partially animated television commercials, including commercials for products such as Coca-Cola, Listerine and Gummi-Savers (a LifeSavers product). However, in 1996, Pixar largely discontinued its business of producing commercials in favor of other opportunities PIXAR COMPUTER ANIMATION PROCESS AND DIGITAL BACK LOT Pixar Computer Animation Process The development and production of animated feature films is extremely complex and time consuming due to the very large number of frames and intricate detail of each frame. At 24 frames per second, a 94-minute animated feature film such as Toy Story 2 requires approximately 135,000 individual frames. Animation for feature films has traditionally been created through hand-drawn cels, requiring hundreds of people working for two to three years. Although computers have been used to assist in some elements of cel animation during the past several years, most frames are still hand-drawn. Pixar believes that its proprietary technology, which allows animators to manipulate hundreds of motion control points within a single character, allows for more intricacy and subtlety of character and personality than traditional two-dimensional cel-based animation. This technology also facilitates the manipulation, editing and re-use of animated images. Pixar makes its computer-animated films and other projects in four stages: creative development, pre-production, production and post-production. Because this process is iterative, there is continual reworking of the film. The basic elements of this highly complex process are outlined below. CREATIVE DEVELOPMENT STORY CONCEPT TREATMENT OUTLINE SCREEN PLAY Creative development is an iterative process in which the story and its characters are created and developed. The first step in creative development involves the development of a story concept, which often takes the form of a story summary or outline known as a "treatment." After numerous iterations and research into the story and characters, a first draft of a screenplay is written. 4 5 PRE-PRODUCTION STORY BOARD STORY REEL EDITING VOICE RECORDING The pre-production stage begins when the screenplay is turned into story boards, which are panels filled with thousands of sketches that represent the story to be animated. The story boards are then transferred to film or video so that they can be electronically edited into a photo play of the film called story reels, a process that enables editing of the film before the production phase begins. Voices are then selected, recorded and added to the story reels. Throughout the creative development and pre-production processes, plans are developed for the style, colors and look of the film. PRODUCTION Modeling Layout Animation Shading and Lighting Rendering Film Recording Pixar's production stage consists of six phases: modeling, layout, animation, shading and lighting, rendering and film recording. In the modeling phase, digitized models of each set and character are created by defining their shapes in three dimensions (height, width and depth) and by adding animation control points that allow the model to be moved or animated. In some cases, a model has hundreds of animation controls. In the layout stage, artists place the digital models into a scene and position the digital cameras at the angles from which the three-dimensional shot is to be seen. The assembled shot is then given to the animator together with the prerecorded voice. In the animation stage, the digitized models are animated, or "brought to life," in three dimensions to create a motion sequence. The next step in completing a scene requires attaching to each object and model, a description of its surface characteristics. These "shaders" describe the pattern, texture, finish and color for every object in the scene. Next, lighting is added by placing digital lights into the scene. In the rendering phase, the renderer takes the modeling, layout, animation, shading and lighting data and, for each frame in the sequence, computes a three-dimensional image of what the scene looks like at that point in time from the point of view of the camera. The final rendering of a single frame takes an average of one to four hours, but a small percentage of more complex frames can take much longer, between 20 and 40 hours each or more. The final rendered digital image is then sent to Pixar's film recorders to be photographed onto film. While film is the primary means of distributing motion pictures to theaters, digital electronic projectors have recently achieved the brightness and high resolution necessary to project movies on theater screens without the use of film. As Pixar's films are produced digitally, they are uniquely suited to this method of presentation. In its November 1999 release, Toy Story 2 was shown digitally in twelve theaters worldwide, making it the first computer-animated feature film to be shown digitally. POST-PRODUCTION Sound Effects Design Print Musical Score Sound Mixing Color Correction Delivery of Print The post-production stage consists of two parallel processes: the picture process and the sound process. In the picture process, images are put on film, the film is sent to a laboratory for color correction and final prints are made. If the film is shown digitally, as was the case in a small number of theaters with Toy Story 2, Pixar transfers the original rendered data for each frame onto a digital image compression device which is then used to project the movie electronically. In the sound process, the sound effects and musical score are added and the final sound is mixed. Pixar's post-production is simpler than post-production in a live-action film, which requires more significant editing. In most live-action films, many hours of film are shot, and the film is then significantly edited and re-edited in the post-production stage to create a feature film. Pixar, like other animation studios, edits the film throughout the entire creative development and production process. Thus post-production involves only final editing. Digital Back Lot The digital models that Pixar develops to create its animated products may be used again in future films, television commercials and other animation products. The Pixar technical team has developed a proprietary 5 6 database of thousands of digital models, sets, textures and surface appearances from its short films and commercials. Much like the traditional movie studio's back lot, this digital database allows Pixar animators to retrieve and re-use these items in other productions and as models for merchandise. For example, some of the models that were used to animate Toy Story were re-used in Pixar's two Toy Story CD-ROM titles and were later re-used in Toy Story 2. CREATIVE DEVELOPMENT GROUP Pixar's creative and technical personnel have collaborated since 1986 to produce three-dimensional computer-animated films. The principal objective of Pixar's creative group is to create heartwarming stories with memorable characters that are targeted for family entertainment, utilizing the medium of computer animation. The members of Pixar's creative and technical teams have been nominated for and received a number of awards. In 1986, the short animated film Luxo Jr. earned an Academy Award nomination for Best Short Film (Animated). In 1988, another of Pixar's short films, Tin Toy, became the first computer-animated film to win the Academy Award for Best Short Film (Animated). In 1998, Pixar's most recent animated short film, Geri's Game, also won an Academy Award for Best Short Film (Animated). The creative team at Pixar is under the direction of John Lasseter, an Academy Award-winning director and animator, and the Director of Toy Story and A Bug's Life, and Co-director of Toy Story 2. In March 1996, Mr. Lasseter received a Special Achievement Oscar from the Academy of Motion Picture Arts and Sciences for the development and application of techniques that made possible the first feature-length computer-animated film, Toy Story. Pixar has built an entire creative team consisting of highly skilled story artists, animators and other artists highly skilled in the art of animation, especially computer animation. Pixar's story department is responsible for a project's concept, treatment, outline, script, story boards and story reels. The art department is responsible for the visual development of a project, including the design of characters and sets and the color, textures, shading and lighting. It is also quite common for creative contributions to come from the technical group. Along with the story department and the art department, the creative team at Pixar includes animators. Pixar strives to hire animators who have superior acting ability, those able to make characters and inanimate objects come to life and appear as though they have their own thought processes. Pixar's proprietary software tools enable artists unfamiliar with computers to quickly become skilled in the art of three-dimensional animation. All groups work closely together in an iterative process. To encourage collaboration, Pixar has created a cooperative working environment and a non-hierarchical culture whereby each member of the creative team, regardless of position or department, considers the ideas of any other member of the team. See "Risk Factors -- We Depend on Certain Key Employees." The success of each animated feature film developed by Pixar will depend in large part upon the Pixar creative team's ability to predict the type of content that will appeal to a broad audience and to develop stories and characters that achieve broad market acceptance. Traditionally, this has been extremely difficult. Disney provided creative assistance throughout the production of Toy Story, A Bug's Life and Toy Story 2, including creative reviews and approvals, and the Co-Production Agreement contemplates that Disney will continue to provide creative assistance to Pixar on feature films and other products made pursuant to that agreement; however, there can be no assurance that Disney will continue to provide assistance to Pixar in the development of creative content for its feature films or related products. In addition, there can be no assurance that voices and other intellectual property rights used in an animated feature film will be available for use in any sequel or other product related to such feature film. For example, Pixar was unable to obtain the rights to use certain voices from Toy Story in the two CD-ROM products based on Toy Story. See "Risk Factors -- We Depend on Successful Development of Appealing Creative Content For Animated Feature Films and Related Products." TECHNOLOGY Pixar has three core proprietary technologies: (1) Marionette, an animation software system for modeling, animating and lighting, (2) Ringmaster, a production management software system for scheduling, coordinating and tracking of a computer animation project and (3) RenderMan, a rendering software system 6 7 for high quality photo-realistic image synthesis that Pixar uses internally and licenses to third parties. Each of these systems is critical to the production of Pixar's animated feature films and other animation products. Marionette. Marionette is Pixar's software system for modeling, animation and lighting for computer animation. Marionette is the primary software tool of every animator and technical director at Pixar. In contrast to many commercially available animation systems, which are designed to address product design, corporate logo graphics or cinematic special effects, Marionette has been designed and optimized for character modeling and animation. Marionette is portable across many of the standard Unix workstations, including those from Silicon Graphics and Sun. Pixar has also ported Marionette to IBM and Hewlett-Packard workstations for hardware evaluation purposes. Ringmaster. Ringmaster is a production management software system for scheduling, coordinating and tracking a computer animation project. Due to the enormous amount of data required in three-dimensional animation, accurate production information is essential for producing high quality animation. Pixar's production coordination staff uses Ringmaster to plan and track projects ranging from short animation projects to feature films. A key component of Ringmaster is a distributed rendering system for managing the huge quantity of images and data that must be rendered to create Pixar's products. Pixar does its rendering on an array of powerful Unix processors, which are dedicated to rendering 24 hours a day. These machines, which Pixar calls the RenderFarm, are connected via a local area network. To achieve the desired quality level, the average time to render a single frame at film resolution is between one and four hours. Since an animated feature film contains well over 100,000 frames, each of which may be rendered several times in the production process, Pixar typically has a large number of frames to render at any given time. To manage this process, Ringmaster coordinates and schedules all the processors in the RenderFarm. Ringmaster includes a compositing system and also maintains an array of disk drives as a central data repository for the digital image files generated by the rendering and compositing steps of the production process. Finally, Ringmaster controls the filming phase of production and is responsible for backing up shots for archival purposes. RenderMan. RenderMan is a rendering software system for high quality photo-realistic image synthesis that Pixar uses internally and also licenses to third parties. Today, RenderMan is used by many major film studios and special effects firms. Examples of projects which have used RenderMan include Star Wars Episode 1: The Phantom Menace, Mulan, Apollo 13, Jurassic Park and Terminator 2. By licensing RenderMan to film studios, visual effects houses, commercial production facilities and other computer animation companies, Pixar believes that RenderMan has been established as a de facto industry standard for high quality rendering. RenderMan was designed to be easily portable. It runs on a wide variety of Unix workstations, including those from Silicon Graphics, Sun and Digital Equipment and on PC's under Linux and Windows NT platforms. RELATIONSHIP WITH DISNEY A critical component of Pixar's objective to become a leading brand in the animated feature film market is to secure strong promotion, marketing and distribution of its films and related products. Pixar believes that Disney is the leader in marketing and distribution of animated feature films and related products and one of the industry's most widely recognized brand names. Consequently, in 1997 Pixar extended its existing relationship with Disney by entering into the Co-Production Agreement. This arrangement allows Pixar to focus on the story and other creative and production elements of making animated feature films while utilizing Disney's significant promotion, marketing and distribution capabilities. Prior Agreements Pixar's relationship with Disney dates to 1986, when Pixar and Disney entered into a joint technical development effort that resulted in the Computer Animated Production System ("CAPS"), a production system owned and used by Disney in certain of its two-dimensional cel-based animated feature films. Disney 7 8 first used CAPS for The Rescuers Down Under and has continued to use it for all of its subsequent animated feature films, such as The Lion King and Tarzan. In 1992, certain employees of Pixar and Disney were jointly awarded an Academy Award for Scientific and Engineering Achievement for CAPS. In May 1991, Pixar entered into the Feature Film Agreement with Walt Disney Pictures, a wholly-owned subsidiary of Disney, which provided for the development, production and distribution of up to three feature-length motion pictures (the "Feature Film Agreement"). It is pursuant to the Feature Film Agreement that Toy Story was developed, produced and distributed. In August 1995, Pixar entered into a non-exclusive CD-ROM development and publishing agreement with Disney Interactive, Inc., a wholly-owned subsidiary of Disney, for the development, production and distribution of CD-ROM titles based on Toy Story (the "CD-ROM Agreement"). It is pursuant to the CD-ROM Agreement that two Toy Story CD-ROM products were developed, produced and distributed. Both the Feature Film Agreement and the CD-ROM Agreement were superseded by the Co-Production Agreement, except as discussed below. Co-Production Agreement The following is a summary of the Co-Production Agreement, which was filed as an exhibit to Pixar's Annual Report on Form 10-K for the year ended December 31, 1996 (the "1996 Form 10-K"). The foregoing summary is not complete, and reference is made to the Co-Production Agreement filed as an exhibit to the 1996 Form 10-K. This summary is qualified in all respects by such reference. Prospective investors in Pixar's Common Stock are encouraged to read the Co-Production Agreement. Overview. On February 24, 1997, Pixar and Disney entered into the Co-Production Agreement pursuant to which Pixar, on an exclusive basis, agreed to produce five original computer-animated feature-length theatrical motion pictures (the "Pictures") for distribution by Disney. Pixar and Disney agreed to Co-finance the production costs of the Pictures, Co-own the Pictures (with Disney having exclusive distribution and exploitation rights), Co-brand the Pictures and share equally in the profits of each Picture and any related merchandise and other ancillary products, after recovery of all marketing and distribution costs (which are financed by Disney), a distribution fee paid to Disney and any other fees or costs, including any participations provided to talent and the like. The Co-Production Agreement generally provides that Pixar produces each Picture and that Disney controls all decisions relating to marketing, promotion, publicity, advertising and distribution of each Picture. The first original Picture under the Co-Production Agreement was A Bug's Life, which was released in November 1998. The second original Picture governed by the Co-Production Agreement will be Monsters, Inc., which is scheduled for release in late 2001. Toy Story 2, the theatrical sequel to Toy Story, was released in November 1999, and is also governed by the Co-Production Agreement, although it does not count towards the five original pictures. The Co-Production Agreement also contemplates that with respect to theatrical sequels, made-for-home video sequels, television productions, interactive media products and other derivative works related to the Pictures, Pixar will have the opportunity to co-finance and produce such products or to earn passive royalties on such products. Pixar will not share in any theme park revenues generated as a result of the Pictures. Production. The Co-Production Agreement provides a mechanism for Pixar's submission and the mutual selection of treatments that will be developed and produced as Pictures. After the selection of a treatment, Pixar generally controls the production of each Picture. Disney is entitled to designate a representative at Pixar to monitor the production and production costs of the Pictures. Financing of Development and Production. Pixar and Disney equally share all production costs. Production costs are defined in the Co-Production Agreement to mean all costs and expenses incurred by Pixar directly related to or fairly allocable to the creation, development, pre-production, production, post- production and delivery to Disney of the Pictures. Production costs include, among other things, all carrying costs incurred by Pixar for retention of employees for production purposes and the overhead attendant thereto, the costs of all treatments prepared by Pixar for submission to Disney, all costs of computer hardware and software used to develop the Pictures, and fair allocations of all costs and expenses of Pixar associated with or benefiting the Picture, including research and development, general and administrative and overhead expenses. The Co-Production Agreement provides mechanisms for Disney and Pixar to agree upon the 8 9 budgets for treatments, development and production of each Picture. Pixar may not exceed production budgets (which may be revised with mutual approval) without Disney's written approval, subject to certain limited exceptions. Distribution. Disney has control over all decisions relating to, and is solely responsible for financing the costs and expenses of, the marketing, promotion, publicity, advertising and distribution of each Picture, subject to certain requirements. Disney is to consult with Pixar regarding all such major marketing and distribution decisions, and Pixar is entitled to designate a representative to monitor marketing and distribution of the Pictures. Provided, in general, that Disney has agreed on the treatment to be developed into each Picture, Disney has committed to initially release each Picture within certain windows and not to release other Disney family films during certain windows. Further, each Picture is to be distributed and marketed under the Walt Disney Pictures brand (or the then current Disney brand for premiere Disney movies) and is to be distributed and marketed by Disney in all markets and media and on a worldwide basis in a manner similar to that in which Disney then currently distributes and markets its premiere animated movies. In addition, the costs for marketing, distribution and promotion of the films and related products are incurred well in advance of the release of such films and products, and Pixar will experience a delay in the receipt of cash proceeds from such films and products until after Disney recovers such costs. Division of Gross Receipts. Pixar and Disney are entitled to share equally in all gross receipts remaining after deduction of: (1) a distribution fee to Disney, (2) mutually agreed participations (payments to third parties such as actors, composers and other artists contingent upon the success of the Pictures), if any, paid by either Disney or Pixar, and (3) Disney's distribution costs. Gross receipts includes all revenues or other consideration received by Disney from the exploitation of the Pictures and any related merchandise, books, soundtracks and other tangible personal property based upon the Pictures, as more specifically provided in the Co-Production Agreement (collectively, "Merchandise"), subject to certain exceptions relating primarily to receipts from Disney's affiliates. The distribution fee payable to Disney is substantially lower than under the prior Feature Film Agreement and reflects Pixar's commitment to finance half of the production costs of the Pictures. Distribution costs are broadly defined in the Co-Production Agreement to include out-of-pocket costs paid (or in certain instances, accrued for payment) to a third party (or in certain instances, to Disney's affiliates) by Disney or certain of its affiliates, provided that such out-of-pocket costs are directly related or fairly allocable to the distribution of the Picture and Merchandise. Pursuant to the Co-Production Agreement, Pixar will receive statements and payments of its share of gross receipts monthly within 45 days after the end of each calendar month, and Pixar has the right to audit Disney's and its affiliates' books and records relating to the Pictures and Merchandise. Derivative Works. Subject to certain exceptions, Disney and Pixar have mutual control of the decision to develop, produce or otherwise exploit any derivative works (or to transfer or license any rights to exploit any derivative works) during the term of the Co-Production Agreement or thereafter. Derivative works include theatrical sequels such as Toy Story 2, made-for-home video sequels, television productions, interactive media products and other derivative works as more specifically provided in the Co-Production Agreement (collectively, "Derivative Works"). Except in certain very limited circumstances, in the event of a disagreement over whether to proceed with a Derivative Work, Disney's decision governs. Pixar is to be given the option to co-finance and produce, or to participate on a passive financial basis with respect to, a Derivative Work that is (1) a theatrical motion picture, (2) a made-for-home video production, (3) a television production , (4) location-based entertainment which uses unique characters or other elements from any of the Pictures or Toy Story as its primary theme, or (5) an interactive product such as CD-ROMs, DVDs, video games and arcade games (collectively, "Interactive Products"). If Pixar elects to co-finance and produce a Derivative Work, such as it did with Toy Story 2, the Co-Production Agreement provides for the following: (1) with respect to theatrical motion pictures and made-for-home video productions, the terms and conditions of the Co-Production Agreement are to be extended to cover such Derivative Works, subject to certain exceptions; 9 10 (2) with respect to (A) location-based entertainment using characters or other elements from a Picture or Toy Story as its primary theme and (B) television productions, Pixar and Disney are to mutually agree upon the terms and the conditions under which such work will be financed, produced and distributed, subject to certain specified requirements in the case of television productions; and (3) with respect to Interactive Products, Disney and Pixar are to mutually agree upon the terms and conditions under which such Interactive Product shall be financed, produced and distributed, subject to certain commitments by Disney with respect to marketing and distribution and provided that there will be no distribution fee payable to Disney. For live entertainment such as stage plays or ice shows, Pixar is entitled to participate on a passive financial basis as specified in the Co-Production Agreement. For all other Derivative Works except theme parks, Pixar is entitled to participate on a passive financial basis in such work and to receive a reasonable royalty to be mutually agreed upon if the work is a revenue-producing work. Disney has the sole and exclusive right in perpetuity to use, without compensation to Pixar, each Picture, the characters therefrom and any story elements thereof in theme parks, location-based entertainment for which Picture or Toy Story characters or elements are not the primary theme and cruise ships. A Derivative Work that is a theatrical motion picture would not count towards the five Pictures to be produced under the Co-Production Agreement. Accordingly, Toy Story 2 does not count as one of the five Pictures to be produced. However, under the Co-Production Agreement, all provisions applicable to the original five Pictures apply to Toy Story 2 as well. Creative Controls. Creative controls and decisions with respect to developing and producing Pictures are generally subject to the mutual approval of Pixar and Disney. The Co-Production Agreement provides for certain dispute resolution procedures in the event of disagreement. Brand/Credit. The Co-Production Agreement sets forth Disney's and Pixar's intent that the Pixar brand be established as a co-equal brand to the Disney brand in connection with the Pictures, Merchandise and Derivative Works. The Co-Production Agreement provides that the Pixar logo, animated logo and credit shall be used in a manner which is perceptually equal to the Disney logo, animated logo and credit, subject to certain specific requirements as set forth in the Co-Production Agreement. Exclusivity. Pixar has agreed not to release or authorize the release of any feature-length animated theatrical motion picture produced by Pixar, other than the Pictures and Derivative Works produced by Pixar under the Co-Production Agreement, until twelve months from delivery of the fifth Picture under the Co- Production Agreement. Pixar has further agreed that it will not enter into any agreement with any third party for the development, production or distribution of any feature length animated theatrical motion picture until after Pixar has delivered the third Picture to Disney under the Co-Production Agreement. Pixar has also agreed that it will not develop or produce any rides or attractions for major theme parks not owned or operated by Disney, and to give Disney a right to negotiate with respect to animated television productions or animated made-for-home video productions that Pixar proposes to produce during the term of the Co-Production Agreement. Disney, however, is not similarly restricted by the exclusivity provisions that bind Pixar under the Co-Production Agreement and, therefore, may develop, produce, or distribute other feature-length animated and computer-animated theatrical motion pictures itself or enter into similar agreements with third parties. See "-- Competition." Proprietary Rights. The copyrights, trademarks and other intellectual property rights in and to the Pictures, all new and unique characters and story elements thereof and the audio-visual images thereof, and Merchandise relating thereto, shall be jointly owned by Disney and Pixar on an undivided 50/50 basis, subject to Pixar's ownership rights in the technology and excluding any intellectual property rights previously owned by Pixar or Disney. Notwithstanding the foregoing, Disney has the exclusive distribution and exploitation rights with respect to the Pictures, Derivative Works and Merchandise relating thereto. Pixar shall own the copyright and all other intellectual property rights in and to all computer programs and other technology developed or discovered by Pixar before, during or after the term of the Co-Production Agreement. 10 11 Term and Termination. The Co-Production Agreement continues until delivery to Disney of the fifth Picture produced and financed under the Co-Production Agreement, unless earlier terminated. Disney is entitled to terminate the Co-Production Agreement in the event that Disney and Pixar fail to agree on a treatment for a Picture within one year after the initial theatrical release of the last Picture for which a treatment has been approved or selected, subject to certain exceptions. Disney is also entitled to terminate the Co-Production Agreement in the event that certain types of competitors directly or indirectly acquire or control a 50% or greater ownership interest in Pixar or Pixar merges or consolidates into such a competitor. Upon termination by Disney pursuant to either of the last two sentences, Disney has certain rights to compel Pixar to complete works in production. In the event of termination, the Co-Production Agreement provides that its terms and conditions continue to apply with respect to Pictures, Merchandise and Derivative Works which have been delivered by Pixar to Disney or which Disney elects to have completed, as well as all future Merchandise and future Derivative Works relating thereto, but otherwise terminates. Effect on Prior Agreements. All Derivative Works based on Toy Story, including Toy Story 2, are to be governed by the Co-Production Agreement and not the original Feature Film Agreement or the CD-ROM Agreement. The original Feature Film Agreement now applies only to the rights and obligations of Disney and Pixar relating to the financial participation in, and the production and distribution of, the theatrical motion picture Toy Story and the financial participation in certain Merchandise related to Toy Story (unless gross receipts in any given month exceed a certain amount, in which case they will be subject to the Co-Production Agreement), and otherwise has no further force or effect. The original CD-ROM Agreement remains in full force and effect with respect to the first and second CD-ROM products developed under that agreement, but otherwise has no force or effect. COMPETITION Pixar experiences intense competition with respect to animated feature films, animation products and software. Movie Studios. Pixar's animated feature films compete and will continue to compete with feature films and other family-oriented entertainment products produced by major movie studios, including Disney (as somewhat limited by the Co-Production Agreement), DreamWorks SKG ("DreamWorks") (which continues to expressly target the animated film market), Warner Bros. Inc., Sony Pictures Entertainment ("Sony"), Twentieth Century Fox Film Corporation ("Twentieth Century Fox"), Paramount Pictures ("Paramount"), Lucasfilm Ltd. ("Lucasfilm"), Universal Studios, Inc. and MGM/UA, as well as numerous other independent motion picture production companies. In 1998 and 1999, competition significantly intensified in the animated feature film market. Family-oriented animated feature films released in 1998 and 1999 included the following: Released in 1998: - Quest for Camelot by Warner Bros., - The Rugrats Movie by Paramount, - Prince of Egypt by DreamWorks, and - Antz, a fully computer-animated movie by DreamWorks with its affiliate Pacific Data Images ("PDI"). Released in 1999: - Pokemon: The First Movie by Warner Bros., - Tarzan by Disney, and - Iron Giant by Warner Bros. In 1998, while the release of A Bug's Life was extremely successful, achieving domestic box office revenues exceeding $162 million, Antz, The Rugrats Movie and Prince of Egypt achieved domestic box office 11 12 revenues of over $91 million, $100 million and $98 million, respectively. These three films were released during or near the 1998 holiday season and directly competed with A Bug's Life. Each of these films was more successful than any preceding animated feature film not released by Disney or the combination of Disney and Pixar. In addition, other non-animated family oriented feature films released during the 1998 holiday season, such as Disney's Mighty Joe Young, also generated competition for A Bug's Life. The release of Toy Story 2 in 1999 was even more successful than A Bug's Life, with domestic box office revenues currently exceeding $241 million. However, other animated family-oriented feature films released during 1999, such as Pokemon: The First Movie, Tarzan, and Iron Giant, achieved domestic box office revenues of over $85 million, $171 million, and $23 million, respectively. Pixar also experienced competition from a non-animated family-oriented film, Stuart Little, released by Sony during the 1999 holiday season, which combined live action with computer-animated characters. As of March 20, 2000, Stuart Little had generated over $138 million in domestic box office revenue. These films generated box office competition for Toy Story 2, and may continue to compete with Toy Story 2 with respect to related merchandise, home video sales, and other future revenue sources. Pixar expects that a variety of animated feature films may be released in the theaters in the next several years that will directly compete with Monsters, Inc. and Film Five, which are targeted for release in late 2001 and 2002, respectively. Due to a potentially large number of releases in the next several years, it is possible that the market for animated films will become further saturated before we can release Monsters, Inc. and Film Five, which could result in failure of such films to achieve the extraordinary commercial success required for Pixar to profit from such films. Pixar's films will continue to compete with the feature films of other movie studios for optimal release dates, audience acceptance and exhibition outlets. In addition, Pixar competes and will continue to compete with other movie studios for the acquisition of literary properties, the services of performing artists, and the services of other creative and technical personnel, particularly in the fields of animation and technical direction. Some of the other movie studios with which Pixar competes have significantly greater financial, marketing and other resources than does Pixar. At least three of these movie studios, Disney, DreamWorks and Lucasfilm, have developed their own internal computer animation capability which may be used for special effects in animated films and live action films. For example, DreamWorks (with PDI) successfully produced Antz in 1998, and is currently (with PDI) developing and producing the animated film Shrek, currently scheduled for release in 2001 and which may compete with Monsters, Inc. In addition, Disney plans to release Dinosaur on May 19, 2000, a film which combines live action backgrounds with computer-animated dinosaurs and special effects. Other movie studios may internally develop, license or sub-contract three-dimensional animation capability. Further, Pixar believes that continuing enhancements in commercially available computer hardware and software technology have lowered and will continue to lower barriers to entry for studios or special effects companies which intend to produce computer animated feature films or other products. For example, Silicon Graphics Inc.'s Alias/ Wavefront subsidiary licenses "Maya," its next generation three-dimensional software for creating high quality animation and visual effects. Maya incorporates many new features and could be used to make a computer-animated feature film. The Co-Production Agreement provides that Pixar will develop and produce five original computer animated feature films. Because Disney co-finances the films developed and produced under the Co-Production Agreement, distributes the films under the "Walt Disney Pictures" label and enjoys financial benefits in the event that such films achieve significant box office revenues, we believe that Disney desires such films to be successful. Nonetheless, during its long history Disney has been a very successful producer of its own animated feature films. Family-oriented motion pictures distributed by Disney or its affiliates are likely to be in the market concurrently with and competing with our animated feature films, such as was the case with the release of Mighty Joe Young during the 1998 holiday season which competed against A Bug's Life. Pixar's contractual arrangement with Disney also presents other risks. See "Risk Factors -- Risks Associated with Co-Production Agreement." Pixar believes that the primary competitive factors in the market for animated feature films include creative content and talent, product quality, technology, access to distribution channels and marketing 12 13 resources. Due in part to Pixar's creative and technical resources and to the Co-Production Agreement with Disney, pursuant to which Disney co-finances the production of the feature films, markets the feature films and provides creative assistance and access to significant distribution channels, Pixar believes that it presently competes favorably with respect to each of these factors. Computer Graphics Special Effects Firms. Pixar also expects to compete with computer graphics special effects firms, including ILM, Rhythm & Hues/VIFX, Digital Domain, and Sony Pictures Imageworks. These computer graphics special effects firms may be capable of creating their own three-dimensional computer animated feature films or may produce three-dimensional computer-animated feature films for movie studios that compete with Pixar. For example, ILM has already created and produced three-dimensional character animation which was used for several central characters in the live action film Star Wars Episode 1: The Phantom Menace, and ILM has a royalty-free, paid-up license to use Pixar's RenderMan software and to obtain at no cost all enhancements and upgrades thereto. Other computer graphics special effects firms have licensed or may license RenderMan. Accordingly, Pixar's RenderMan software may not provide Pixar with a competitive advantage. Pixar also competes, or may in the future compete, with the above firms with respect to animation products other than feature films. Pixar believes that the primary competitive factors in the market for three-dimensional computer animation for feature films and other animation products include creative content and talent, product quality, technology, access to distribution channels and marketing resources. Pixar believes that it presently competes favorably with respect to each of these factors. Software Publishers. Pixar also experiences intense competition with respect to its RenderMan software product. In particular, Pixar competes with makers of computer graphics imaging and animation software, principally Silicon Graphics (which acquired Wavefront Technologies, Inc. ("Wavefront") and Alias Research, Inc. ("Alias")), MentalImage GMD and Avid Technologies (which distributes the MentalImage product). Silicon Graphics, through its Alias/Wavefront subsidiary licenses "Maya", its three-dimensional software for creating high quality animation and visual effects, are each marketing competing rendering software products, usually at lower prices than Pixar. Silicon Graphics has licensed several of Pixar's patents that cover certain rendering techniques and may therefore be better able to market products that compete with Pixar's RenderMan software. Under appropriate circumstances, Pixar might elect to license its rendering technology patents to other companies, some of which may compete with Pixar. In addition, as PC's become more powerful, software suppliers may also be able to introduce products for PC's that would be competitive with RenderMan in terms of price and performance for professional users. Pixar believes that the primary competitive factors in the market for rendering software include product quality, price/performance, technology, functionality, breadth of features and customer service and support. Pixar believes that it presently competes favorably with respect to each of these factors. Pixar expects competition to persist, intensify and increase in each of its business areas in the future. Some of Pixar's current and potential competitors have longer operating histories, larger installed customer bases and significantly greater financial, technical, marketing and other resources than Pixar. There can be no assurance that Pixar will be able to compete successfully against current or future competitors. Such competition could materially adversely affect Pixar's business, operating results or financial condition. PROPRIETARY RIGHTS Pixar's success and ability to compete is dependent in part upon its proprietary technology. While Pixar relies on a combination of patents, copyright and trade secret protection, nondisclosure agreements and cross- licensing arrangements to establish and protect its proprietary rights, Pixar believes that factors such as the technical and creative skills of its personnel are more essential to its success and ability to compete. Pixar currently is the owner of fourteen patents issued in the United States and seven issued in foreign countries. In addition, Pixar has a number of patent applications pending in the United States and in foreign countries. There can be no assurance that patents will issue from any of these pending applications or that, if patents do issue, any claims allowed will be sufficiently broad to protect Pixar's technology. In addition, there can be no assurance that any patents that have been issued to Pixar, or that Pixar may license from third parties, will not be challenged, invalidated or circumvented, or that any rights granted thereunder would provide proprietary protection to Pixar. 13 14 The source code for Pixar's proprietary software is protected both as trade secrets and as a copyrighted work. Pixar generally enters into confidentiality or license agreements with its employees, consultants and vendors, and generally controls access to and distribution of its software, documentation and other proprietary information. Despite these precautions, it may be possible for a third party to copy or otherwise obtain and use Pixar's proprietary information, products or technology without authorization, or to develop similar or superior technology independently. Policing unauthorized use of Pixar's products is difficult. In addition, effective copyright and trade secret protection may be unavailable or limited in certain foreign countries. To license its RenderMan software product, Pixar primarily relies on "shrink wrap" licenses that are not signed by the end-user and, therefore, may be unenforceable under the laws of certain jurisdictions. There can be no assurance that the steps taken by Pixar will prevent misappropriation of its technology or that its confidentiality or license agreements will be enforceable. In addition, litigation may be necessary in the future to enforce Pixar's intellectual property rights, to protect Pixar's trade secrets, to determine the validity and scope of the proprietary rights of others, or to defend against claims of infringement or invalidity. Any such litigation could result in substantial costs and diversion of resources and could have a material adverse effect on Pixar's business, operating results or financial condition. One of the risks of the film production business are claims that Pixar's productions infringe the intellectual property rights of third parties with respect to previously developed films, stories, characters or other entertainment. In addition, Pixar's technology and software may be subject to patent, copyright or other intellectual property claims of third parties. Pixar has received, and is likely to receive in the future, notice of claims of infringement of other parties' proprietary rights. There can be no assurance that infringement or invalidity claims (or claims for indemnification resulting from infringement claims) will not be asserted or prosecuted against Pixar or that any assertions or prosecutions will not materially adversely affect Pixar's business, financial condition or results of operations. Irrespective of the validity or the successful assertion of such claims, Pixar would incur significant costs and diversion of resources with respect to the defense thereof which could have a material adverse effect on Pixar's business, financial condition or results of operations. If any claims or actions are asserted against Pixar, Pixar may seek to obtain a license under a third party's intellectual property rights. There can be no assurance, however, that under such circumstances a license would be available on reasonable terms or at all. Pixar also relies on certain technology that it licenses from third parties, including software that is integrated and used with internally developed software. There can be no assurance that these third party technology licenses will continue to be available to Pixar on commercially reasonable terms. The loss of or inability to maintain any of these technology licenses could result in delays in feature film releases or product shipments until equivalent technology could be identified, licensed and integrated. Any such delays in feature film releases or product shipments could materially adversely affect Pixar's business, operating results or financial condition. In 1996, Pixar entered into a license agreement with Silicon Graphics whereby Pixar granted to Silicon Graphics and its subsidiaries a non-exclusive license to use certain of Pixar's patents covering techniques for creating computer-generated photo-realistic images. These same patents were licensed to Microsoft Corporation in 1995. These patents relate to pseudo-random point sampling techniques in computer graphics, which are incorporated into Pixar's RenderMan. The license agreements with Silicon Graphics and Microsoft will expire no later than the year 2010. Silicon Graphics and Microsoft may use the licensed technology in rendering products, which compete with Pixar's RenderMan software, which could adversely impact sales of RenderMan. EMPLOYEES As of January 1, 2000 Pixar had a total of 448 employees. Although none of Pixar's employees are represented by a labor union, it is common for animators and actors at film production companies to belong to a union. There can be no assurance that Pixar's employees will not join or form a labor union or that Pixar, for certain purposes, will not be required to become a union signatory. Further, Pixar may be directly or indirectly dependent upon union members, and work stoppages or strikes organized by such unions could materially adversely impact Pixar's business, financial condition or results of operations. For example, many of the actors 14 15 who provide voice talent for the Pictures and Derivative Works are members of the Screen Actors Guild. Pixar has not experienced any work stoppages and considers its relations with its employees to be good. Pixar's success depends to a significant extent on the performance of a number of senior management personnel and other key employees, especially its animators, creative personnel and technical directors. In particular, Pixar is dependent upon the services of Steve Jobs, John Lasseter, Edwin E. Catmull, Sarah McArthur and Ann Mather. Pixar does not maintain "key person" life insurance for any of its employees. Pixar does have an employment agreement with Mr. Lasseter, who is fundamental to its relationship with Disney. However, this employment agreement does not necessarily assure his services. Pixar believes that it may be particularly difficult to retain its key employees, especially its animators, creative personnel and technical directors, during periods in which it is not developing animated feature films. The loss of the services of any of Messrs. Jobs, Lasseter, or Dr. Catmull, Ms. McArthur, Ms. Mather or of other key employees, especially its animators, creative personnel and technical directors, could have a material adverse effect on Pixar's business, operating results or financial condition. RISK FACTORS The following is a discussion of certain factors that currently impact or may impact our business, operating results and/or financial condition. You should carefully consider these factors before making an investment decision with respect to our Common Stock. DEPENDENCE ON TOY STORY 2, A BUG'S LIFE, AND TOY STORY IN 2000 In 2000, our revenue and operating results will be largely dependent upon (1) the amount of our revenues from the domestic and foreign theatrical releases of Toy Story 2, (2) the timing of release of Toy Story 2 on home video in domestic and foreign markets and the amount of related home video revenues, (3) the amount and timing of our revenues from merchandise sales related to Toy Story 2, (4) the amount and timing of our revenue from foreign home video sales of A Bug's Life and to a lesser extent from domestic home video sales of A Bug's Life and related merchandise, (5) the amount of our domestic and international home video revenues from the re-release of Toy Story on home video, and residual revenues from Toy Story, if any, and (6) our limited software revenue. DEPENDENCE ON TOY STORY 2 AND A BUG'S LIFE IN 2000 Toy Story 2 Revenue We will be significantly dependent upon the success of Toy Story 2 in 2000. Toy Story 2 was released in November 1999, and has achieved significant box office success, with domestic box office receipts of more than $241 million as of March 20, 2000. In 2000, we expect to see an improved ability, through information available to us from Disney and other sources, to estimate and record our share of film revenues and related costs. As a result, we expect to begin to recognize revenues from Toy Story 2 in the first quarter of 2000. While we anticipate this improved ability will allow us to recognize our share of film revenues and costs on a more timely basis, we will remain dependent on the timing and accuracy of the information provided by Disney, as well as on the continuing commercial success of Toy Story 2 throughout 2000. In 2000, we expect to recognize the vast majority of revenues from the theatrical release of Toy Story 2 and some revenues from related merchandise sales. In addition, with the release of Toy Story 2 on home video in fall 2000, we expect to recognize a portion of domestic and foreign home video revenues. These future revenues of Toy Story 2 will be offset by associated distribution and marketing costs for worldwide theatrical and home video releases, video cost of goods, Disney's distribution fee based on film-related revenues, and other distribution costs such as talent participations and residuals. Fees and participations paid to key talent on Toy Story 2 are substantially greater than for Toy Story or A Bug's Life, which together with other increases in production costs will have the effect of increasing the cost of the film when compared to Pixar's first two films. Toy Story 2 faced significant competition from other family-oriented films released theatrically during the 1999 holiday season, such as Stuart Little and Pokemon: The First Movie. We believe theatrical proceeds and 15 16 product sales from these competing films have and may continue to adversely impact proceeds from Toy Story 2. A Bug's Life Revenue A Bug's Life was released in November 1998, and in 1999 we recognized revenues of $110.3 million, which represents the majority of revenues we expect to recognize over the lifetime of A Bug's Life. Under the Co-Production Agreement, Pixar and Disney share equally in the profits of A Bug's Life after Disney recovers its distribution costs and its distribution fee. Correspondingly, our film revenue in 1999 resulted primarily from the domestic and foreign theatrical revenues from A Bug's Life, related domestic and foreign home video revenue, and related merchandise licensing, offset by Disney's distribution costs and its distribution fee. Distribution costs reported to date include the majority of worldwide theatrical release costs, the majority of Disney's costs to distribute A Bug's Life on home video in the United States, and a portion of the costs to distribute A Bug's Life on home video in foreign markets. We believe that A Bug's Life faced a high number of competing films released during the 1998 holiday season, such as, Antz, The Rugrats Movie and Prince of Egypt, and that the related home video and/or merchandise sales from these films have adversely impacted and may continue to impact sales of A Bug's Life products. The majority of revenues we expect to receive from A Bug's Life have already been reported in 1999, including the vast majority of revenues from the worldwide theatrical release of A Bug's Life, the majority of domestic home video revenues, a portion of foreign home video revenues, and related merchandise revenues. Sources of revenues in 2000 primarily include remaining foreign home video sales, any remaining domestic home video sales, possibly some television revenues, and any future merchandise royalties, all of which must be substantial in order for the film to generate significant revenues in 2000. Moreover, potential future revenues will be offset by future distribution costs, which primarily include marketing costs for the foreign home video release, video cost of goods, remaining distribution costs for the international theatrical release of A Bug's Life, Disney's distribution fee based on film-related revenues, and other distribution costs such as residuals. Difficulty in Forecasting Toy Story 2 and A Bug's Life Revenues It is difficult to forecast the amount and timing of our future revenues from Toy Story 2 and A Bug's Life in 2000. The amount of future revenues depends not only on customer acceptance of the film in its worldwide theatrical release, but also on customer acceptance of related products in each separate release category -- home video, merchandise and television being the most significant. While customer acceptance is initially measured by box office success, customer acceptance within each follow-on product category, such as home video, toys or television, depends on factors unique to each type of product, such as pricing, competitive products, and the time of year or state of the economy in which a product is released, among many other factors. In addition, we have found that the degree of customer acceptance varies widely among foreign countries. While box office success is often a good indicator of general customer acceptance, the relative success of follow-on products is not always directly correlated, and the degree of correlation is difficult to predict. Disney's strategic distribution decisions also impact the amount of our future revenues. For example, in the first half of 1999, Disney reported general softness in its domestic home video sales and worldwide merchandise licensing as compared to levels associated with many of its previous blockbuster animated feature films. As a result, Disney recently announced a new strategy of releasing animated films on home video year-round, and in special editions in both VHS and DVD formats. However, the relative success of that new strategy is not yet known. For this reason and all of the above reasons, while Toy Story 2 has been a remarkable box office success, it is difficult to predict how successful its home video release will be in 2000 or how successful sales of other follow-on products will be in 2000. Similarly, it is difficult to predict video sales of A Bug's Life in 2000. With respect to the difficulty of forecasting the timing of revenues, Disney distributes our films and film-related products and therefore determines the timing of product releases. While the timing of theatrical releases is typically known well in advance of release, the timing of release of follow-on products is often decided just in advance of release, is subject to change, and is therefore less predictable. For example, it was 16 17 not until the first quarter of fiscal year 2000 that it was determined that the Toy Story 2 home video would be released in fall 2000. In all product categories, timing of revenues is particularly uncertain with respect to releases in foreign markets, as a foreign product release is often marked by a rollout across many countries over the course of many months. Therefore, the timing of international revenues is inherently more difficult to predict than the timing of domestic revenues. Lastly, the amount of revenue recognized in any given quarter or quarters from all of our films depends on the timing, accuracy, and sufficiency of the information we receive from Disney and other sources to determine revenues and associated costs. Due to these factors, the amount and timing of our future revenues from Toy Story 2 and A Bug's Life are difficult to forecast, and it is possible, in any given quarter or quarters in 2000 that Pixar will not recognize sufficient film revenue to generate significant earnings. Risks Associated with Toy Story 2 and A Bug's Life Under the Co-Production Agreement, Pixar and Disney share the production costs of Toy Story 2 and A Bug's Life. We initially capitalized our share of these costs as film production costs, under Statement of Financial Accounting Standards ("SFAS") No. 53, Financial Reporting by Producers and Distributors of Motion Picture Films. Our policy is to amortize these costs over the expected revenue streams as we recognize revenues from the associated films. The amount of film costs that will be amortized each quarter will depend on how much future revenue Pixar expects to receive from Toy Story 2 and A Bug's Life. Although Toy Story 2 has achieved substantial domestic and foreign box office success, we believe that the amount spent by Disney for marketing and distribution has been and will continue to be significant. It is possible that total revenue generated in all markets by Toy Story 2 may not generate significant revenue and operating results for us in any given quarter in 2000, even though Toy Story 2 is critically acclaimed and has achieved worldwide box office success. With respect to A Bug's Life, it is difficult to predict how much additional revenue will be derived from home video and merchandise sales and from television airings. In any given quarter, if our forecast changes with respect to total revenue from Toy Story 2 or A Bug's Life, and becomes lower than was previously forecasted, we would be required to accelerate amortization of related film costs, resulting in lower gross margins. Such lower gross margins would adversely impact our business, operating results, and financial condition. See "-- Risks Associated with Co-Production Agreement -- Dependence on Disney for Distribution and Promotion of Feature Films and Related Products," "-- Risks Associated with the Motion Picture Industry," and "Business -- Relationship with Disney. " See also Note 4 of Notes to Financial Statements in the 1999 Annual Report to Shareholders. TOY STORY REVENUE We have already recognized the majority of the revenue we expect to receive from Toy Story. Disney re-released the original Toy Story home video in January 2000. Other than potential revenue from any additional worldwide television airings, the re-release of the home video, any additional merchandise sales, and other minor amounts of revenue in subsequent periods, we do not expect to recognize further significant revenue from Toy Story. Based on terms of the Feature Film Agreement, film revenue from Toy Story is now received from Disney on a semi-annual basis (March and September). SOFTWARE REVENUE We continue to reduce our emphasis on the commercialization of software products. We are not increasing the time and resources necessary to generate higher RenderMan licensing revenues; therefore, we expect that revenue from the licensing of RenderMan will remain flat or possibly decline. In addition, from the acquisition date of Physical Effects, Inc. ("PEI") in June 1998, through January 1, 2000, we received lower license revenue than expected related to the purchased technology associated with the acquisition. If future license revenue continues to be lower than originally estimated, we may be required to write-off all or a significant portion of the unamortized purchased technology. 17 18 CD-ROM REVENUE In March 1997 we discontinued our business of producing CD-ROM products in favor of other opportunities arising, in part, as a result of entering into the Co-Production Agreement. It is unlikely that we will recognize further significant royalty income from these products or from this discontinued operation in 2000 or thereafter. RISK OF NET LOSSES IN 2001 We received the majority of anticipated proceeds from A Bug's Life in 1999, and we expect to receive the majority of proceeds from Toy Story 2 by the end of 2000. We will not release a feature film in 2000, and we do not plan to release the next feature film until late 2001. Therefore, in 2001, our revenues will depend on (1) remaining proceeds from the anticipated fall 2000 home video release of Toy Story 2, remaining Toy Story 2 merchandise revenues, and revenues from Toy Story 2 television airings, if any, (2) remaining proceeds, if any, from television airings of A Bug's Life, and any remaining revenue from A Bug's Life home video sales and related merchandise, (3) remaining proceeds from Toy Story merchandise and home video sales, if any, and (4) our other businesses, such as software and animation services, from which we expect limited revenue. Due to the uncertainty of the amount and timing of revenues from Toy Story 2, A Bug's Life, and other sources, we may not receive sufficient proceeds from operations in any given quarter or quarters in 2001 to generate earnings. RISKS ASSOCIATED WITH MONSTERS, INC. AND FILM FIVE BEYOND 2001 RISK OF DELAY IN PLANNED RELEASE DATES OF MONSTERS, INC. AND FILM FIVE Beyond 2001, we expect to be largely dependent upon the success of Monsters, Inc. and Film Five (together referred to as the "Current Projects"). Although development and/or production of the Current Projects is underway, we cannot provide any assurances that they will be successfully produced and released when scheduled. For example, Monsters, Inc. is currently targeted for release in late 2001. Disney has not formally scheduled the theatrical release of Monsters, Inc., and we cannot provide any assurances as to when the film will be released. We may experience difficulties that could delay or prevent the successful development or production of any of the Current Projects or subsequent animated feature films or related products. If we are unable to produce and develop on a timely basis the Current Projects and subsequent animated feature films and related products that meet with broad market acceptance, our business, operating results and financial condition will be materially adversely affected. RISK OF INSUFFICIENT REVENUES GENERATED FROM MONSTERS, INC. AND FILM FIVE It is rare for animated feature films to achieve extraordinary box office success. While we have been successful in the release of our first three feature films, this level of success is unusual in the motion picture industry, and our future releases may not achieve similar results. Beyond 2001, we will be dependent on the future success of our Current Projects. Unless Monsters, Inc. and Film Five achieve extraordinary box office success and also achieve success in home video and merchandise sales, they may not generate significant revenue and operating results for us in future years. See "-- Risks Associated with Co-Production Agreement -- Dependence on Disney for Distribution and Promotion of Feature Films and Related Products," "-- Risks Associated with the Motion Picture Industry," and "Business -- Relationship with Disney." See also Note 4 of Notes to Financial Statements in the 1999 Annual Report to Shareholders. WE EXPECT OUR OPERATING RESULTS TO CONTINUE TO FLUCTUATE FLUCTUATIONS IN REVENUE We continue to expect significant fluctuations in our future annual and quarterly revenues because of a variety of factors, including the following: - the timing of the domestic and international releases of our animated feature films, - the success of our animated feature films (which can fluctuate significantly from film to film), 18 19 - the timing of the release of related products into their respective markets (such as home videos, television, and merchandising), - the demand for such related products (which is often a function of the success of the related animated feature film), - Disney's costs to distribute and promote the feature films and related products, - Disney's success at marketing the films and related products, - the timing and accuracy of information received from Disney and other sources on which we base estimates of revenue to be recognized from our animated feature films and related products by Disney, - the introduction of new feature films or products by our competitors, and - general economic conditions. In particular, since our revenue under the Co-Production Agreement is directly related to the success of a feature film, our operating results are likely to fluctuate depending on the level of success of our animated feature films and related products. The revenues derived from the production and distribution of an animated feature film depend primarily on the film's acceptance by the public, which cannot be predicted and does not necessarily bear a direct correlation to the production or distribution costs incurred. The commercial success of a motion picture also depends upon promotion and marketing, production costs and other factors. Further, the theatrical success of a feature film can be a significant factor in determining the amount of revenues generated from the sale of the related products. FLUCTUATIONS IN OPERATING EXPENSES Increase in Our Operating Expenses and Effective Tax Rate Over the last few years, we significantly increased our operating expenses, and we plan to continue to increase our operating expenses to fund greater levels of research and development and to expand operations. Specifically, we expect our spending levels to increase significantly due to (1) continued investment in proprietary software systems, (2) increased compensation costs as a result of intense competition for animators, creative personnel, technical directors and other personnel, (3) increased costs associated with the expansion of our facilities, and (4) increased investment in creative development. A portion of our operating expenses that are allocable to film productions is either capitalized by us or reimbursed by Disney under the Co-Production Agreement. To the extent that we do not capitalize (or Disney does not pay for) the increases in expenses, our operating expenses will significantly increase in 2000. Finally, our annual tax rate increased in 1999 and is likely to increase in 2000 and possibly in future years because we have utilized our remaining net operating loss carryforwards except those which originated as non-qualified employee stock option costs. The realization of tax benefits from non-qualified employee stock option costs will not reduce our effective tax rate in the future. Difficulty in Predicting Operating Expenses Moreover, our operating expenses will continue to be extremely difficult to forecast. We budget the direct costs of film productions with Disney, and we share such costs equally. We capitalize our share of these direct costs of film production in accordance with SFAS No. 53. A substantial portion of all of our other costs are incurred for the benefit of feature films ("Overhead"), including research and development expenses and general and administrative expenses. Portions of our Overhead are included in the budgets for the Pictures, and we will share such costs equally with Disney under the Co-Production Agreement. With respect to the portion of our Overhead that is not reimbursed by Disney, we either (1) capitalize such portion as film production costs, if required under SFAS No. 53, or (2) charge it to operating expense in the period incurred. Since a substantial portion of our Overhead is related to the Pictures, and is therefore reimbursed by Disney, and since we capitalize other amounts in accordance with SFAS No. 53, our reported operating expenses for 1999 have not reflected, and future reported operating expenses will not reflect, our true level of spending on the production of animated feature films, related products and overhead. 19 20 Risk Associated with Production Budgets Given the (1) escalation in compensation rates of people required to work on the Current Projects, (2) number of personnel required to work on the Current Projects, and (3) equipment needs, the budget for the Current Projects and subsequent films and related products may continue to be greater than the budgets for Toy Story, A Bug's Life, and Toy Story 2. We will continue to finance these budgets equally with Disney under the Co-Production Agreement. In addition, due to production exigencies which are often difficult to predict, we believe that it is not uncommon for film production spending to exceed film production budgets, and the Current Projects may not be completed within the budgeted amounts. For example, to meet the production schedule of Toy Story 2, we reassigned employees from other projects, including Monsters, Inc., to complete Toy Story 2. This resulted in a larger production staff than originally anticipated and it increased production costs. In addition, when production of each film is completed, we may incur significant carrying costs associated with transitioning personnel on creative and development teams from one project to another, which, although shared with Disney, are treated as film costs, which increase overall production budgets and could have a material adverse effect on our results of operations and financial condition. As a result of the factors discussed above, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful, and you should not rely on our annual and quarterly results of operations as any indication of future performance. Due to the factors discussed above, it is likely that in some future period our operating results will be below the expectations of public market analysts and investors. In such event, the price of our Common Stock would likely be materially adversely affected. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the 1999 Annual Report to Shareholders. RISKS ASSOCIATED WITH ADEQUACY OF CASH BALANCES Pursuant to the Co-Production Agreement, we co-financed A Bug's Life and Toy Story 2 and will co-finance the next four original animated feature films which we produce, including Monsters, Inc. and Film Five. In the future, we may co-finance other derivative works such as sequels, interactive products and television productions. In addition, we are constructing a new studio and headquarters facility in Emeryville, California, which is being financed by the use of our cash and may continue to be financed by the use of our cash. The development and production costs of Monsters, Inc., Film Five and costs of the new Emeryville facility may have an adverse impact on our cash and short-term investment balances. As of January 1, 2000, we had approximately $194.9 million in cash and short-term investments. We believe that these funds will be sufficient to meet our anticipated cash needs for working capital and capital expenditures, including the development and production costs of Monsters, Inc. and Film Five, until we begin receiving cash from the release of Toy Story 2 and any remaining proceeds from A Bug's Life. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources" in the 1999 Annual Report to Shareholders. To date, we have chosen to use our existing cash resources to fund construction costs and film production costs. We may continue to use our cash resources for such expenditures, or may choose to finance such capital expenditures through issuance of additional equity or debt securities, by obtaining a credit facility or by some other financing mechanism. The sale of additional equity or convertible debt securities would result in additional dilution to our shareholders. Moreover, we cannot provide any assurances that we will be successful in obtaining future financing, or even if such financing is available, that we will obtain it on favorable terms or on terms providing us with sufficient funds to meet our obligations and objectives. If we fail to obtain such financing, it would have a material adverse effect on our business, operating results and financial condition. RISKS ASSOCIATED WITH SCHEDULED SUCCESSIVE RELEASES OF FILMS In order to meet our obligations pursuant to the Co-Production Agreement, we have established parallel creative teams so that we can develop more than one film at a time. These teams are currently working on Monsters, Inc., which is currently targeted for release in late 2001, and Film Five, which is currently targeted for release in 2002. We have only produced three prior feature films to date and have limited experience with respect to producing animated feature films in parallel. We have been required, and will continue to be 20 21 required, to expand our employee base, increase capital expenditures and procure additional resources and facilities in order to accomplish the scheduled release of these two feature films. This period of rapid growth and expansion has placed, and continues to place, a significant strain on our resources. We cannot provide any assurances that Monsters, Inc. or Film Five will be released as targeted or that this strain on resources will not have a material adverse effect on our business, financial condition or results of operations. For example, to meet the production schedule of A Bug's Life, we reassigned employees from other projects, including Toy Story 2, to A Bug's Life. Similarly, to meet the production schedule of Toy Story 2, we reassigned employees from other projects, including Monsters, Inc., to Toy Story 2. In addition, John Lasseter, who was previously providing creative oversight for Toy Story 2 in his role as Executive Vice President, Creative, assumed the role of Co-Director of Toy Story 2 in order to expedite development and production of the film. Using the personnel of future films to meet the immediate deadlines of films nearing release, as we have for both A Bug's Life and Toy Story 2, (and we may have to do for Monsters, Inc.) is likely to have the long term impact of pushing out the targeted release dates of future films, substantially increasing film budgets, and adversely impacting our ability to generate creative concepts for subsequent films on a timely basis. While the story treatment and production budget for Monsters, Inc. have been approved pursuant to the Co-Production Agreement, we have not formally agreed with Disney on the timing of its release and we cannot provide any assurances that Disney will agree to release Monsters, Inc. in late 2001 as it is currently targeted. In addition, as Co-Director of Toy Story 2, John Lasseter was focused on Toy Story 2 until its completion in late 1999, and was less available to assist on Monsters, Inc. during its development phase. John Lasseter's availability has been a key ingredient in the successful completion of our prior films. A lack of his availability may adversely impact our ability to release Monsters, Inc. and future films as targeted. If we are able to release films in 2001 and 2002, we cannot provide any assurances that we will release our next film in 2003. Due to the strain on our personnel from the effort required for the release of Monsters, Inc. and Film Five and the time required for creative development of a new film, it is possible that we would be unable to release a successive new film in 2003. It is too early to determine the rate at which any future films are to be released, and we cannot provide any assurances that we will release a film in each successive year or in any particular year. To continue to accommodate growth, we will be required to implement a variety of new and upgraded operational and financial systems, procedures and controls, including improvement and maintenance of our accounting system, other internal management systems and backup systems. In addition, this growth and these diversification activities, along with the corresponding increase in the number of our employees and rapidly increasing costs, have resulted in increased responsibility for our management team. We will need to continue to improve our operational, financial and management information systems and to hire, train, motivate and manage our employees, to integrate them into Pixar and to provide adequate facilities and other resources for them. We cannot provide any assurance we will be successful in accomplishing all of these activities on a timely and cost-effective basis. Any failure to accomplish one or more of these activities on a timely and cost-effective basis would have a material adverse effect on our business, financial condition and results of operations. RISKS ASSOCIATED WITH CO-PRODUCTION AGREEMENT DEPENDENCE ON DISNEY FOR DISTRIBUTION AND PROMOTION OF FEATURE FILMS AND RELATED PRODUCTS The decisions regarding the timing of release of motion pictures and related products and which of Disney's motion pictures and related products will receive extensive promotional support from the studio are important in determining the success of the motion picture and related products. Under the terms of the Co-Production Agreement, we have some general protections with respect to the marketing and distribution of the feature films in the form of commitments by Disney as to release windows, the timing of release of other Disney family films and marketing obligations. However, we ultimately do not control (1) the manner in which Disney distributes our animated feature films and related products, (2) the number of theaters to which Disney distributes our feature films, (3) the specific timing of release of the feature films and related products or (4) the specific amount or quality of promotional support of the feature films and related products and the 21 22 associated promotional and marketing budgets. Because Disney co-finances the films developed and produced under the Co-Production Agreement, distributes the films under the "Walt Disney Pictures" label and may enjoy financial benefits in the event that such films achieve significant box office revenues, we believe that Disney desires such films to be successful. Nonetheless, Disney could make certain decisions as to marketing, distribution or promotion of the animated feature films or related products or the marketing and promotion of its own animated or other family films that could have a material adverse effect on our business, operating results or financial condition. In addition, the costs for marketing, distribution and promotion of the films and related products are incurred well in advance of the release of such films and products, and we will experience a delay in the receipt of proceeds from such films and products until after Disney recovers such costs. We are also dependent on Disney for receiving accurate information on a timely basis on which we base estimates to recognize revenue from the animated feature films and related products. If we failed to receive accurate information from Disney, or failed to receive it on a timely basis, it could have a material adverse effect on our business, operating results or financial condition. EXCLUSIVITY We have agreed not to release or authorize the release of any of our feature length animated theatrical motion pictures, other than the feature films that we produced under the Co-Production Agreement, until twelve months from our delivery of the fifth original feature film under the Co-Production Agreement. We currently anticipate that we will not deliver the fifth Picture until 2004 at the earliest. We have further agreed that we will not enter into any agreement with any third party for the development, production or distribution of any feature length animated theatrical motion picture until after we have delivered the third original feature film to Disney under the Co-Production Agreement. We have also agreed that we will not develop or produce any rides or attractions for major theme parks not owned or operated by Disney, and to give Disney a right to negotiate with respect to animated television productions or animated made-for-home video productions that we propose to produce during the term of the Co-Production Agreement. Disney, however, is not similarly restricted by the exclusivity provisions that bind us under the Co-Production Agreement and, therefore, may develop, produce, or distribute other feature length animated and computer animated theatrical motion pictures itself or enter into similar agreements with third parties. See "Business -- Competition," and "-- Our Markets Are Highly Competitive." FINANCING OF PRODUCTION COSTS Under the Co-Production Agreement, unlike the Feature Film Agreement which is applicable to Toy Story, we will continue to co-finance each of the four remaining original animated feature films and may co-finance other related products to be developed and produced pursuant to the Co-Production Agreement. We co-financed A Bug's Life and Toy Story 2 and are currently co-financing Monsters, Inc. and Film Five under the Co-Production Agreement. Accordingly, unlike the Feature Film Agreement, we will incur significant production costs, which must be offset by proceeds generated by the animated feature films and related products. If the feature films and related products do not generate proceeds sufficient to more than offset our share of their production costs, our business, operating results and financial condition will be materially adversely effected. RIGHTS TO CHARACTERS AND ELEMENTS RETAINED BY DISNEY We share equally with Disney in the profits of each Picture and any related merchandise after Disney recovers certain costs; however, Disney retains the exclusive distribution and exploitation right to all feature films, all characters and story elements of the feature films and all related products we develop under the Co-Production Agreement. Accordingly, except in certain specified circumstances, we are not able to exploit or distribute any of the feature films or characters or elements of any of the feature films or related products developed under the Co-Production Agreement without a license from Disney. We cannot provide any assurances that such a license would be available to us on commercially reasonable terms or at all. 22 23 TERMINATION Under the terms of the Co-Production Agreement, Disney may terminate the agreement under certain circumstances. For example, Disney is entitled to terminate the Co-Production Agreement in the event that we fail to agree with Disney on a treatment for a Picture within one year after the initial theatrical release of the last Picture for which a treatment has been approved or selected, subject to certain exceptions. Disney is also entitled to terminate the Co-Production Agreement in the event that certain types of competitors directly or indirectly acquire or control a 50% or greater ownership interest in Pixar or Pixar merges or consolidates into such a competitor. We cannot provide any assurances that Disney would not terminate the Co-Production Agreement under these circumstances. Disney would not lose any of its rights to distribute and exploit all feature films and all characters and elements of the feature films and other products we develop under the Co-Production Agreement, except for a feature film or related product then in production as to which Disney does not elect to proceed, as to which we would regain the rights subject to a lien in favor of Disney for the costs advanced to date. Further, in the event that Disney terminated the Co-Production Agreement, we would be required to seek alternative channels for distribution of our animated feature films and related products. We cannot provide any assurances that we would be able to find a third party to finance, distribute and promote our animated feature films and related products on terms acceptable to us, if at all. See "Business -- Relationship with Disney." RISKS ASSOCIATED WITH THE MOTION PICTURE INDUSTRY COMMERCIAL SUCCESS OF A MOTION PICTURE IS UNPREDICTABLE The motion picture industry involves a substantial degree of risk. Each motion picture is an individual artistic work, and its commercial success is primarily determined by audience reaction, which is unpredictable. The commercial success of a motion picture also depends upon other factors, such as: - the quality and acceptance of other competing films released into the marketplace at or near the same time, - critical reviews, - the availability of alternative forms of entertainment and leisure time activities, - general economic conditions, - weather conditions, and - other tangible and intangible factors. All of these factors can change and cannot be predicted with certainty. In addition, motion picture attendance is seasonal, with the greatest attendance typically occurring during the summer and holidays. The release of a film during a period of relatively low theater attendance is likely to affect the film's box office receipts adversely. Further, due to the expected release of a large number of animated films by Disney and other movie studios in the next several years, it is possible that the market for animated films will become saturated. Therefore, there is a substantial risk that some or all of our motion pictures will not be commercially successful, which would have a material adverse effect on our business, financial condition and results of operations. See "Business -- Competition." COMPLETION OF A MOTION PICTURE SUBJECT TO UNCERTAINTIES AND FINANCIAL RISKS The production, completion and distribution of motion pictures is subject to numerous uncertainties, including financing requirements, personnel availability and the release schedule of competitive films. We are concurrently developing and producing two animated feature films, Monsters, Inc. and Film Five, which compounds these uncertainties and jeopardizes the successful, timely and cost-effective production and completion of each film. Under the Co-Production Agreement, we have increased our financial involvement in the production costs of motion pictures, which subjects us to substantial financial risks relating to the 23 24 production, completion and release of the motion pictures. In addition, a significant amount of time will elapse between our expenditure of funds and our receipt of proceeds from the animated feature films. WE DEPEND ON SUCCESSFUL DEVELOPMENT OF APPEALING CREATIVE CONTENT FOR ANIMATED FEATURE FILMS AND RELATED PRODUCTS The success of each of our animated feature films will depend in large part upon our creative team's ability to predict the type of content that will appeal to a broad audience and to develop stories and characters that achieve broad market acceptance. Traditionally, this has been extremely difficult. Disney provided creative assistance throughout the production of Toy Story, A Bug's Life, and Toy Story 2. Although the Co-Production Agreement contemplates that Disney will continue to provide creative assistance on feature films and other products made pursuant to that agreement, we cannot provide any assurances that Disney will continue to provide us with assistance in the development of creative content for our feature films or related products. We cannot provide any assurances that voices and other intellectual property rights used in an animated feature film will be available for use in any derivative product related to such feature film. For example, we were unable to obtain the rights to use certain voices from Toy Story in the two CD-ROM products based on Toy Story. See "Business -- Creative Development Group." OUR MARKETS ARE HIGHLY COMPETITIVE We experience intense competition with respect to animated feature films, animation products and software. MOVIE STUDIOS Our animated feature films compete and will continue to compete with feature films and other family oriented entertainment products produced by major movie studios, including Disney (as somewhat limited by the Co-Production Agreement), DreamWorks SKG ("DreamWorks") (which continues to expressly target the animated film market), Warner Bros. Inc., Twentieth Century Fox Film Corporation ("Twentieth Century Fox"), Paramount Pictures ("Paramount"), Sony Pictures Entertainment ("Sony"), Lucasfilm Ltd. ("Lucasfilm"), Universal Studios, Inc. and MGM/UA, as well as numerous other independent motion picture production companies. In 1998 and 1999, competition significantly intensified in the animated feature film market. Family-oriented animated feature films released in 1998 and 1999 included the following: Released in 1998: - Quest for Camelot by Warner Bros., - The Rugrats Movie by Paramount, - Prince of Egypt by DreamWorks, and - Antz, a fully computer-animated movie by DreamWorks with its affiliate Pacific Data Images ("PDI"). Released in 1999: - Pokemon: The First Movie by Warner Bros., - Tarzan by Disney, and - Iron Giant by Warner Bros. In 1998, while the release of A Bug's Life was extremely successful, achieving domestic box office revenues exceeding $162 million, Antz, The Rugrats Movie and Prince of Egypt achieved domestic box office revenues of over $91 million, $100 million and $98 million, respectively. These three films were released during or near the 1998 holiday season and directly competed with A Bug's Life. Each of these films was more successful than any preceding animated feature film not released by Disney or the combination of Disney and 24 25 Pixar. In addition, other non-animated family oriented feature films released during the 1998 holiday season, such as Disney's Mighty Joe Young, also generated competition for A Bug's Life. The release of Toy Story 2 in 1999 was even more successful than A Bug's Life, with domestic box office revenues currently exceeding $241 million. However, other animated family-oriented feature films released during 1999, such as Pokemon: The First Movie, Tarzan, and Iron Giant, achieved domestic box office revenues of over $85 million, $171 million, and $23 million, respectively. We also experienced competition from a non-animated family-oriented film, Stuart Little, released by Sony during the 1999 holiday season, which combined live action with computer-animated characters. As of March 20, 2000, Stuart Little had generated over $138 million in domestic box office revenue. These films generated box office competition for Toy Story 2, and may continue to compete with Toy Story 2 with respect to related merchandise, home video sales, and other future revenue sources. We expect that a variety of animated feature films may be released in the theaters in the next several years that will directly compete with Monsters, Inc. and Film Five, which are targeted for release in late 2001 and 2002, respectively. Due to a potentially large number of releases in the next several years, it is possible that the market for animated films will become further saturated before we can release Monsters, Inc. and Film Five, which could result in failure of such films to achieve the extraordinary commercial success required for us to profit from such films. Our films will continue to compete with the feature films of other movie studios for optimal release dates, audience acceptance and exhibition outlets. In addition, we compete and will continue to compete with other movie studios for the acquisition of literary properties, the services of performing artists, and the services of other creative and technical personnel, particularly in the fields of animation and technical direction. Some of the other movie studios with which we compete have significantly greater financial, marketing and other resources than we do. At least three of these movie studios, Disney, DreamWorks and Lucasfilm, have developed their own internal computer animation capability which may be used for special effects in animated films and live action films. For example, DreamWorks (with PDI) successfully produced Antz in 1998, and is currently (with PDI) developing and producing the animated film Shrek, currently scheduled for release in 2001 and which may compete with Monsters, Inc. In addition, Disney plans to release Dinosaur on May 19, 2000, a film which combines live action backgrounds with computer-animated dinosaurs and special effects. Other movie studios may internally develop, license or sub-contract three-dimensional animation capability. Further, we believe that continuing enhancements in commercially available computer hardware and software technology have lowered and will continue to lower barriers to entry for studios or special effects companies which intend to produce computer animated feature films or other products. For example, Silicon Graphics Inc.'s Alias/ Wavefront subsidiary licenses "Maya," its next generation three-dimensional software for creating high quality animation and visual effects. Maya incorporates many new features and could be used to make a computer animated feature film. The Co-Production Agreement provides that we will develop and produce five original computer animated feature films. Because Disney co-finances the films developed and produced under the Co-Production Agreement, distributes the films under the "Walt Disney Pictures" label and enjoys financial benefits in the event that such films achieve significant box office revenues, we believe that Disney desires such films to be successful. Nonetheless, Disney has been by far the most successful producer of animated feature films. Family-oriented motion pictures distributed by Disney or its affiliates are likely to be in the market concurrently with and competing with our animated feature films, such as was the case with the release of Mighty Joe Young during the 1998 holiday season which competed against A Bug's Life. Our contractual arrangement with Disney also presents other risks. See "Risk Factors -- Risks Associated with Co-Production Agreement." We believe that the primary competitive factors in the market for animated feature films include creative content and talent, product quality, technology, access to distribution channels and marketing resources. Due in part to our creative and technical resources and to the Co-Production Agreement with Disney, pursuant to which Disney co-finances the production of the feature films, markets the feature films and provides creative 25 26 assistance and access to significant distribution channels, we believe that we presently compete favorably with respect to each of these factors. COMPUTER GRAPHICS SPECIAL EFFECTS FIRMS We also expect to compete with computer graphics special effects firms, including ILM, Rhythm & Hues/VIFX, Digital Domain, and Sony Pictures Imageworks. These computer graphics special effects firms may be capable of creating their own three-dimensional computer animated feature films or may produce three-dimensional computer animated feature films for movie studios that we compete with. For example, ILM has already created and produced significant three-dimensional character animation which was used for several central characters in the live action film Star Wars Episode 1: The Phantom Menace, and ILM has a royalty-free, paid-up license to use our RenderMan software and to obtain at no cost all enhancements and upgrades thereto. Other computer graphics special effects firms have licensed or may license RenderMan. Accordingly, our RenderMan software may not provide us with a competitive advantage. We also compete, or may in the future compete, with the above firms with respect to animation products other than feature films. We believe that the primary competitive factors in the market for three-dimensional computer animation for feature films and other animation products include creative content and talent, product quality, technology, access to distribution channels and marketing resources. We believe that we presently compete favorably with respect to each of these factors. SOFTWARE PUBLISHERS We also experience intense competition with respect to our RenderMan software product. In particular, we compete with makers of computer graphics imaging and animation software, principally Silicon Graphics (which acquired Wavefront Technologies, Inc. ("Wavefront") and Alias Research, Inc. ("Alias")), MentalImage GMD and Avid Technologies (which distributes the MentalImage product). MentalImage and Silicon Graphics, through its Alias/Wavefront subsidiary, are each marketing competing rendering software products, usually at prices that are lower than ours. Silicon Graphics has licensed several of our patents that cover certain rendering techniques and may therefore be better able to market products that compete with our RenderMan software. Under appropriate circumstances, we might elect to license our rendering technology patents to other companies, some of which may compete with us. In addition, as PC's become more powerful, software suppliers may also be able to introduce products for PC's that would be competitive with RenderMan in terms of price and performance for professional users. We believe that the primary competitive factors in the market for rendering software include product quality, price/performance, technology, functionality, breadth of features and customer service and support. We believe that we presently compete favorably with respect to each of these factors. We expect competition to persist, intensify and increase in each of our business areas in the future. Almost all of our current and potential competitors have longer operating histories, greater name recognition, larger installed customer bases and significantly greater financial, technical, marketing and other resources. We cannot provide any assurances that we will be able to compete successfully against current or future competitors. Such competition could materially adversely affect our business, operating results or financial condition. WE HAVE A LIMITED OPERATING HISTORY Until 1996, we had generated recurring revenue primarily from the license of our RenderMan software, amounts we received under software development contracts and fees for animated television commercial development. However, we continue to expect to generate a substantial majority of our future revenue from the development and production of animated feature films and related products, as we have since 1996. We have, to date, developed and produced only three animated feature films, Toy Story, A Bug's Life, and Toy Story 2, and only two related products (both CD-ROM titles, which we no longer intend to produce). Accordingly, we have only a limited operating history in implementing our business model upon which an evaluation of Pixar and our prospects can be based. Our prospects must be considered in light of the risks, expenses and difficulties frequently encountered by companies in the early stages of a business enterprise, 26 27 particularly companies in highly competitive markets. To address these risks, we must, among other things, respond to competitive developments, continue to attract, retain and motivate qualified persons, and continue to upgrade our technologies. We cannot provide any assurances that we will be successful in addressing such risks. WE DEPEND ON CERTAIN KEY EMPLOYEES Our success depends to a significant extent on the performance of a number of senior management personnel and other key employees, especially our animators, creative personnel and technical directors. In particular, we are dependent upon the services of Steve Jobs, John Lasseter, Edwin E. Catmull, Ann Mather, and Sarah McArthur. We do not maintain "key person" life insurance for any of our employees. We do have an employment agreement with Mr. Lasseter, who is fundamental to Pixar's relationship with Disney. However, such employment agreement does not necessarily assure the services of Mr. Lasseter. Moreover, although it is standard in the motion picture industry to rely on employment agreements as a method of retaining the services of key employees, we have not required our employees, other than Mr. Lasseter, to enter into employment agreements. We believe that it may be particularly difficult to retain our key employees, especially our animators, creative personnel and technical directors, during periods in which we are not developing animated feature films. The loss of the services of any of Messrs. Jobs, Lasseter, or Catmull, Ms. Mather, Ms. McArthur or of other key employees, especially our animators, creative personnel and technical directors, could have a material adverse effect on our business, operating results or financial condition. Although none of our employees is represented by a labor union, it is common for animators and actors at film production companies to belong to a union. Further, we may be directly or indirectly dependent upon union members, and work stoppages or strikes organized by such unions could materially adversely impact our business, financial condition or results of operations. There can be no assurance that our employees will not join or form a labor union, or that we will not be directly or indirectly impacted by industry related work stoppages or that we, for certain purposes, will not be required to become a union signatory. See "Business -- Employees" and "Management -- Directors and Executive Officers of the Company." OUR CHIEF EXECUTIVE OFFICER HAS DIVIDED RESPONSIBILITIES Pixar's Chief Executive Officer and Chairman, Steve Jobs, is also Chief Executive Officer at Apple Computer, Inc. ("Apple"). Although Mr. Jobs spends time at Pixar and is active in our management, he does not devote his full time and resources to Pixar. WE NEED TO ATTRACT AND RETAIN QUALIFIED PERSONNEL TO BE SUCCESSFUL Our success continues to depend to a significant extent on our ability to identify, attract, hire, train and retain qualified professional, creative, technical and managerial personnel. Competition for such personnel is intense, and there can be no assurance that we will be successful in identifying, attracting, hiring, training and retaining such personnel in the future. The competition for quality animators, creative personnel and technical directors is especially intense because the entertainment market has significantly expanded over the past several years. If we were unable to hire, assimilate and retain qualified personnel in the future, particularly animators, creative personnel and technical directors, such inability would have a material adverse effect on our business, operating results and financial condition. See "Business -- Employees" and "Management -- Executive Officers of the Company." WE FACE DISTRIBUTION RISKS Disney is required to distribute the remaining four animated feature films to be produced pursuant to the Co-Production Agreement. Distribution of a motion picture generally involves domestic and foreign licensing for (1) theatrical exhibition, (2) home video, (3) presentation on television, including pay, basic cable and syndication, (4) non-theatrical exhibition, which includes airlines, hotels and armed forces facilities and (5) marketing of other rights of the picture, which may include merchandising, such as CD-ROM titles, toys and soundtrack recordings. Although the Co-Production Agreement provides us with some protection, we cannot provide any assurances that the feature films made under the Co-Production Agreement will be 27 28 distributed through all of these outlets. For example, Disney has traditionally not made its animated feature films available on pay television other than the Disney Channel or on network television other than ABC, an affiliate of Disney. See "Business -- Business Model and Products." WE DEPEND ON PROPRIETARY TECHNOLOGY AND COMPUTER SYSTEMS FOR TIMELY AND SUCCESSFUL DEVELOPMENT OF FEATURE FILMS AND RELATED PRODUCTS We cannot provide any assurances that we will not experience difficulties that could delay or prevent the successful development or production of future animated feature films or other related products. Among other things, because we are dependent upon a large base of software and a large number of computers for the development and production of our animated feature films and related products, an error or defect in the software, a failure in the hardware or a failure of the backup facilities could result in a significant delay in one or more productions in process which, in turn, could result in potentially significant delays in the release dates of our feature films or other products. For example, early in 1998 we experienced a failure of our backup systems for Toy Story 2 which resulted in substantial effort to restore data and a loss of certain data, but which did not have a material impact on the schedule for production or release of Toy Story 2. However, significant delays in production and significant delays in release dates could have a material adverse effect on our business, operating results or financial condition. Further, because we rely mostly on internally developed software, we would not be able to rely upon assistance from third parties in the event that the software fails. See "Business -- Technology." ONE SHAREHOLDER OWNS A LARGE PERCENTAGE OF OUR STOCK Pixar's Chief Executive Officer, Steve Jobs, beneficially owns approximately 63.8% of the outstanding Common Stock as of March 20, 2000. As a result, Mr. Jobs, acting alone, is able to exercise sole discretion over all matters requiring shareholder approval, including the election of the entire board of directors and approval of significant corporate transactions, including an acquisition of Pixar. Such concentration of ownership may also have the effect of delaying or preventing a change in control of Pixar, impeding a merger, consolidation, takeover or other business combination involving Pixar, or discouraging a potential acquirer from making a tender offer or otherwise attempting to obtain control of Pixar. RISK OF SUBSTANTIAL ADDITIONAL COSTS RELATED TO FACILITIES EXPANSION At January 1, 2000, we had incurred capital expenditures of approximately $54.2 million to purchase and begin development of approximately 15 acres of land in Emeryville, California to build a new headquarters and studio facility. To complete the construction of the facility, we currently expect to incur capital expenditures of approximately $34.2 million in 2000. Due to changes in construction, design and/or other specifications, which may or may not be at the discretion of management and are often difficult to predict, we cannot provide any assurances that construction of the new studio facility can be completed within these specified amounts. On March 16, 2000, Pixar purchased an existing building on 1.76 acres in Emeryville for $7.6 million. While it was purchased for potential future expansion, the building will serve as a rental property, is occupied by commercial tenants and is expected to generate rental income. To date, we have chosen to use our existing cash resources to fund facility-related costs. We may continue to use our cash resources for such expenditures, or may choose to finance such capital expenditures through the issuance of additional equity or debt securities, by obtaining a credit facility or by some other financing mechanism. If we choose to seek financing for such expenditures, we cannot provide any assurances that such financing will be available on terms reasonably acceptable to us or at all. See "-- Liquidity Risks" and "Properties" herein and "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources" in the 1999 Annual Report to Shareholders. WE DEPEND ON TECHNOLOGICAL ADVANCEMENT TO BE SUCCESSFUL Substantially all of our revenues have been derived, and substantially all of our future revenues are expected to be derived, from the use and license of our proprietary technologies. We expect that we will be required to enhance these technologies and to develop new technologies in order to be successful in our 28 29 industry and in the licensing of our RenderMan software. We cannot provide any assurances that we will be successful in enhancing our existing technologies or in developing and utilizing new technologies, or that competitors will not develop technology that is equivalent or superior to our technologies or that makes our technologies obsolete. If we are unable to develop enhancements to our existing technologies or new technologies as required, our business, operating results or financial condition could be materially adversely affected. See "Business -- Technology" and "Business -- Competition -- Movie Studios." WE DEPEND ON PROPRIETARY RIGHTS NO ASSURANCE THAT EFFORTS TO PROTECT PROPRIETARY TECHNOLOGIES WILL SUCCEED Our success and ability to compete is dependent in part upon our proprietary technology. While we rely on a combination of patents, copyright and trade secret protection, nondisclosure agreements and cross-licensing arrangements to establish and protect our proprietary rights, we believe that factors such as the technical and creative skills of our personnel are more essential to our success and ability to compete. We currently own fourteen patents issued in the United States and seven issued in foreign countries. In addition, we have a number of patent applications pending in the United States and in foreign countries. We cannot provide any assurances that patents will issue from any of these pending applications or that, if patents do issue, any claims allowed will be sufficiently broad to protect our technology. In addition, we cannot provide any assurances that any patents that have been issued to us, or that we may license from third parties, will not be challenged, invalidated or circumvented, or that any rights granted thereunder would provide us with any proprietary protection. Failure of the patents to provide protection of our technology may make it easier for our competitors to offer technology equivalent to or superior to our technology. See "Business -- Proprietary Rights." The source code for our proprietary software is protected both as trade secrets and as a copyrighted work. We generally enter into confidentiality or license agreements with our employees, consultants and vendors, and generally control access to and distribution of our software, documentation and other proprietary information. Despite these precautions, it may be possible for a third party to copy or otherwise obtain and use our proprietary information, products or technology without authorization, or to develop similar or superior technology independently. Policing unauthorized use of our products is difficult. In addition, effective copyright and trade secret protection may be unavailable or limited in certain foreign countries. To license our RenderMan software product, we primarily rely on "shrink wrap" licenses that are not signed by the end-user and, therefore, may be unenforceable under the laws of certain jurisdictions. We cannot provide any assurances that the steps we take will prevent misappropriation of our technology or that our confidentiality or license agreements will be enforceable. See "Business -- Proprietary Rights." RISK THAT LITIGATION WILL BE REQUIRED TO ENFORCE PROPRIETARY RIGHTS Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others, or to defend against claims of infringement or invalidity. Any such litigation could result in substantial costs and diversion of resources and could have a material adverse effect on our business, operating results or financial condition. See "Business -- Proprietary Rights." RISK OF INFRINGEMENT CLAIMS One of the risks of the film production business is the possibility of claims that our productions infringe the intellectual property rights of third parties with respect to previously developed films, stories, characters or other entertainment. In addition, our technology and software may be subject to patent, copyright or other intellectual property claims of third parties. We have received, and are likely to receive in the future, notice of claims of infringement of other parties' proprietary rights. There can be no assurance that infringement or invalidity claims (or claims for indemnification resulting from infringement claims) will not be asserted or prosecuted against us, or that any assertions or prosecutions will not materially adversely affect our business, financial condition or results of operations. Irrespective of the validity or the successful assertion of such 29 30 claims, we would incur significant costs and diversion of resources with respect to the defense thereof which could have a material adverse effect on our business, financial condition or results of operations. If any claims or actions are asserted against us, we may seek to obtain a license under a third party's intellectual property rights. We cannot provide any assurances, however, that under such circumstances a license would be available on reasonable terms or at all. See "Business -- Proprietary Rights." NO ASSURANCE THAT THIRD PARTY TECHNOLOGY LICENSES WILL CONTINUE TO BE AVAILABLE We also rely on certain technology that we license from third parties, including software that we integrate and use with our internally developed software. We cannot provide any assurances that these third party technology licenses will continue to be available to us on commercially reasonable terms. The loss of or inability to maintain any of these technology licenses could result in delays in feature film releases or product releases until equivalent technology could be identified, licensed and integrated. Any such delays in feature film releases or product releases could materially adversely affect our business, operating results and financial condition. See "Business -- Proprietary Rights." POSSIBLE VOLATILITY OF SHARE PRICE AND RISK OF LITIGATION The market price of our Common Stock is highly volatile and is subject to wide fluctuations in response to a wide variety of factors including the publication of box office results for our feature films and those of our competitors, fluctuations in our quarterly or annual results of operations, changes in financial estimates by securities analysts, announcements made by us, Disney, or our competitors, budget increases, delays in or cancellation of feature film or other product release dates, or other events or factors. For example, since January 2, 1999, our Common Stock has closed as low as $33.50 and as high as $50 per share. Moreover, in recent years, the stock market in general, and the shares of technology companies in particular, have experienced extreme price and volume fluctuations, some of which have been unrelated or disproportionate to the operating performances of such companies. These broad market and industry fluctuations may adversely affect the market price of our Common Stock. In the past, following periods of volatility in the market price of a company's securities, securities class action litigation has often been instituted against such a company. If brought against Pixar, such litigation could result in substantial costs and a diversion of management's attention and resources, which could have a material adverse effect on our business, operating results or financial condition. See "Market for Registrant's Common Stock and Related Shareholder Matters." ITEM 2. PROPERTIES Pixar leases approximately 128,000 square feet of office space in Richmond, California. The related leases expire on various dates ranging from September 2000 to July 2002. As of January 1, 2000, Pixar had incurred total capital expenditures of approximately $54.2 million to purchase and begin construction on approximately 15 acres of land in Emeryville, California for a new headquarters and studio facility. Pixar expects to incur capital expenditures of approximately $34.2 million in 2000 to complete the project. Pixar's current expectation is to move into the new facility in fall 2000. On March 16, 2000, Pixar purchased an existing building on 1.76 acres in Emeryville for $7.6 million. While it was purchased for potential future expansion, the building will serve as a rental property, is occupied by commercial tenants and is expected to generate rental income. To date, Pixar has chosen to use its existing cash resources to fund facility-related costs. Pixar may continue to use its cash resources for such expenditures, or may choose to finance such capital expenditures through the issuance of additional equity or debt securities, by obtaining a credit facility or by some other financing mechanism. See "Risk Factors -- Risk of Substantial Additional Costs Related to Facilities Expansion" and "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources" in the 1999 Annual Report to Shareholders. 30 31 ITEM 3. LEGAL PROCEEDINGS We are involved in claims arising in the ordinary course of business. We believe these matters will be resolved without material adverse effect on our financial position or cash flows. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. 31 32 EXECUTIVE OFFICERS OF THE COMPANY The executive officers of Pixar and their ages as of March 20, 2000 are as follows:
NAME AGE POSITION ---- --- -------- Steve Jobs..................... 45 Chairman and Chief Executive Officer Edwin E. Catmull............... 54 Executive Vice President and Chief Technical Officer Ann Mather..................... 39 Executive Vice President, Chief Financial Officer and Secretary John Lasseter.................. 43 Executive Vice President, Creative Development Sarah McArthur................. 43 Executive Vice President, Production
Pixar's executive officers are appointed by, and serve at the discretion of, the Board of Directors. Each executive officer is an employee of Pixar. There is no family relationship between any executive officer or director of Pixar. Mr. Jobs is a co-founder of Pixar and has served as its Chairman since March 1991 and as its Chief Executive Officer since 1986. He has been a director of Pixar since 1986. In addition, Mr. Jobs currently serves as Chief Executive Officer and as a member of the Board of Directors of Apple Computer, Inc. ("Apple"). Mr. Jobs was also a co-founder of NeXT Software, Inc. ("NeXT"), which developed and marketed object-oriented software for client/server business applications and the Internet, and served as the Chairman and Chief Executive Officer of NeXT from October 1985 until February 1997, when NeXT was acquired by Apple. Mr. Jobs then served as an advisor on a limited basis, then interim Chief Executive Officer to Apple until assuming his current role as Chief Executive Officer of Apple. Dr. Catmull is a co-founder of Pixar and has served as Executive Vice President and Chief Technical Officer since June 1995. From March 1991 to February 1995, he served as President, from November 1988 to March 1991 he served as Chairman and from February 1986 to November 1988 he served as President. Prior to joining Pixar, he was Vice President of the Computer Division of Lucasfilm. Dr. Catmull received the Scientific and Engineering Award from The Academy of Motion Picture Arts and Sciences in 1992 and also received the SIGGRAPH Coons Award for lifetime contributions in 1993. Dr. Catmull is a member of the Scientific and Technical Awards Committee of The Academy of Motion Picture Arts and Sciences. Dr. Catmull received B.S. degrees in computer science and physics and a Ph.D. in computer science from the University of Utah. Ms. Mather has served as Executive Vice President and Chief Financial Officer since September 1999. Ms. Mather has served as Secretary of Pixar since October 1999. Prior to joining Pixar, she was Executive Vice President and Chief Financial Officer of Village Roadshow Pictures. From 1992 to 1999, Ms. Mather held various executive positions at The Walt Disney Company including Senior Vice President of Finance and Administration of its Buena Vista International Theatrical Division (the division that markets and distributes all of Disney's theatrical films outside of the U.S. and Canada). From 1991 to 1992, she was the European Controller for Alico, a division of AIG, Inc. From 1989 to 1991, she was Director of Finance for Polo Ralph Lauren Europe and from 1984 to 1988, Ms. Mather was at Paramount Pictures Corporation where she held various executive positions in London, Amsterdam and New York. Ms. Mather is a graduate of Cambridge University in England and is a chartered public accountant. Mr. Lasseter has served as Vice President, Creative Development since August 1991 and was promoted to Executive Vice President, Creative Development on February 4, 1999. Mr. Lasseter was Co-Director of Toy Story 2 in addition to serving as creative head of Pixar's other films and projects. Mr. Lasseter joined Pixar in February 1986 as Animator/Director. From 1984 to 1986, he was an animator at Lucasfilm and from 1979 to 1984, he worked as an animator at The Walt Disney Company. For his work in directing Toy Story, Mr. Lasseter received an Academy Award in 1996 for Special Achievement, and for his work in directing Tin Toy, Mr. Lasseter received an Academy Award in 1988 for Best Short Film (Animated). Mr. Lasseter received a B.F.A. degree in film from the California Institute of the Arts. Ms. McArthur has served as Vice President, Production since May 1997 and was promoted to Executive Vice President, Production on February 4, 1999. Ms. McArthur oversees all Pixar production teams and 32 33 manages all aspects of making the films. From 1989 to April 1997, Ms. McArthur worked at The Walt Disney Company, where she was most recently Vice President of Production for Disney Feature Animation, overseeing the production of feature animation films in Disney's Burbank, Florida and Paris studios. During Ms. McArthur's eight years at Disney, she was the Production Manager on The Rescuers Down Under, went on to be the Associate Producer on Beauty and the Beast and an Executive Producer on The Lion King. She was appointed Director of Production in late 1991 and promoted to Vice President of Production in 1994. Prior to working at Disney, Ms. McArthur worked at the Mark Taper Forum as their Production Manager of special projects. Ms. McArthur earned her B.A. degree in Theatre from the University of California, Santa Barbara, and she attended Carnegie-Mellon University's M.F.A. program in Theater Arts. 33 34 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS Pixar's Common Stock trades on The Nasdaq Stock Market's Nasdaq National Market under the trading symbol "PIXR." The following table sets forth the high and low sale prices per share of Pixar's Common Stock for the periods indicated.
HIGH LOW --------- --------- 1998 First Quarter............................................. $38 $20 1/4 Second Quarter............................................ $65 5/8 $33 3/4 Third Quarter............................................. $66 $27 1/2 Fourth Quarter............................................ $53 3/4 $31 1999 First Quarter............................................. $45 $36 1/16 Second Quarter............................................ $49 3/4 $33 5/8 Third Quarter............................................. $49 7/8 $33 1/2 Fourth Quarter............................................ $50 $35 3/8 2000 First Quarter (through March 20, 2000).................... $39 7/8 $35 7/16
As of March 20, 2000, Pixar had approximately 2,928 shareholders of record. The price for the Common Stock as of the close of business on March 20, 2000 was $37.4375 per share. Pixar has never paid any cash dividends on its Common Stock. Pixar intends to retain any earnings for use in its business and does not anticipate paying any cash dividends on its Common Stock in the foreseeable future. ITEM 6. SELECTED FINANCIAL DATA The information required by this item is incorporated by reference to the section entitled "Selected Financial Data" in the 1999 Annual Report to Shareholders and has been filed as an exhibit to this Annual Report on Form 10-K. ITEM 7.MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required by this item is incorporated by reference to the section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the 1999 Annual Report to Shareholders and has been filed as an exhibit to this Annual Report on Form 10-K. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this item is incorporated by reference to the section entitled "Financial Statements and Selected Financial Data" in the 1999 Annual Report to Shareholders and has been filed as an exhibit to this Annual Report on Form 10-K. ITEM 9.CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. 34 35 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY DIRECTORS The members of Pixar's Board of Directors as of March 20, 2000 are as follows:
NAME AGE POSITION WITH PIXAR ---- --- ------------------- Steve Jobs.............................. 45 Chairman and Chief Executive Officer Jill E. Barad........................... 48 Director Skip M. Brittenham...................... 58 Director Edwin E. Catmull........................ 54 Executive Vice President and Chief Technical Officer Joseph A. Graziano...................... 56 Director Lawrence B. Levy........................ 40 Director Larry W. Sonsini........................ 59 Director
Mr. Jobs is a co-founder of Pixar and has served as its Chairman since March 1991, as its Chief Executive Officer since February 1986. He has been a director of Pixar since February 1986. In addition, Mr. Jobs is currently Chief Executive Officer and a member of the Board of Directors of Apple Computer, Inc. ("Apple"). Mr. Jobs was also a co-founder of NeXT Software, Inc. ("NeXT"), which developed and marketed object-oriented software for client/server business applications and the Internet, and served as the Chairman and Chief Executive Officer of NeXT from October 1985 until February 1997, when NeXT was acquired by Apple. Mr. Jobs then served as an advisor to Apple on a limited basis and served as interim Chief Executive Officer until assuming his current role as Chief Executive Officer at Apple. Ms. Barad has served as a director of Pixar since July 1997. She was formerly the Chairman and Chief Executive Officer of Mattel, Inc. from January 1998 to February 2000. From January 1997 to December 1997, she was President and Chief Executive Officer of Mattel, Inc., and from July 1992 until December 1996, she was President and Chief Operating Officer. Mr. Brittenham has served as a director of Pixar since August 1995. He has been an attorney with the law firm of Ziffren, Brittenham, Branca & Fischer, an entertainment law firm, since 1978. Mr. Brittenham currently serves on the board of, or is a trustee of, numerous charitable organizations, including Conservation International, the American Oceans Campaign, the Environmental Media Association and the Alternative Medical AIDS Foundation. Mr. Brittenham received a B.S. from the United States Air Force Academy and a J.D. from the University of California at Los Angeles. Dr. Catmull is a co-founder of Pixar and has served as Executive Vice President and Chief Technical Officer since June 1995. From March 1991 to February 1995, he served as President, from November 1988 to March 1991 he served as Chairman and from February 1986 to November 1988 he served as President. Prior to joining Pixar, he was Vice President of the Computer Division of Lucasfilm. Dr. Catmull received the Scientific and Engineering Award from The Academy of Motion Picture Arts and Sciences in 1992 and also received the SIGGRAPH Coons Award for lifetime contributions in 1993. Dr. Catmull is a member of the Scientific and Technical Awards Committee of The Academy of Motion Picture Arts and Sciences. Dr. Catmull received B.S. degrees in computer science and physics and a Ph.D. in computer science from the University of Utah. Mr. Graziano has served as a director of Pixar since August 1995. From June 1989 to December 1995, he was the Executive Vice President and Chief Financial Officer of Apple and was a member of the Board of Directors of Apple from June 1993 until October 1995. From May 1987 to June 1989, Mr. Graziano served as Chief Financial Officer of Sun Microsystems, Inc. and from October 1981 to May 1985 as Chief Financial Officer of Apple. In addition, he has held accounting positions with various technology companies in the Silicon Valley. Mr. Graziano also serves as a director of Carrier Access Corporation, Packeteer, Inc. and Talk City, Inc. Mr. Graziano received a B.S. in accounting from Merrimack College and is a certified public accountant. 35 36 Mr. Levy has served as a director of Pixar since April 1999. In March 2000, Mr. Levy became Chief Financial Officer and a director of myCustoms.com, a start-up in the business of building an online, realtime system for enabling global e-commerce. Mr. Levy served as Executive Vice President and Chief Financial Officer of Pixar from February 1995 to March 1999. Mr. Levy served as Secretary of Pixar from October 1995 to March 1999. Prior to joining Pixar, he was Vice Chairman and Chief Financial Officer of Electronics for Imaging, Inc. (EFI), a provider of hardware products for the digital color imaging market. Prior to his tenure at EFI, he was head of the Technology Licensing and Distribution Department at the law firm of Wilson Sonsini Goodrich and Rosati. Mr. Levy received a B.S. in business and accounting from Indiana University and a J.D. from Harvard Law school. Mr. Sonsini has served as a director of Pixar since April 1995 and served as Secretary from April 1995 to October 1995. He has been an attorney with the law firm of Wilson Sonsini Goodrich & Rosati since 1966 and currently serves as the Chairman of the firm's Executive Committee. Mr. Sonsini also serves as a director of Lattice Semiconductor Corporation and Novell, Inc. Mr. Sonsini received A.B. and L.L.B. degrees from the University of California, Berkeley. EXECUTIVE OFFICERS The information required by this item concerning the executive officers of Pixar is incorporated by reference to the information set forth in the section entitled "Executive Officers of the Company" at the end of Part I of this Form 10-K. SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE Section 16(a) of the Exchange Act ("Section 16(a)") requires Pixar's executive officers, directors and persons who own more than ten percent of Pixar's Common Stock, to file initial reports of ownership on Form 3 and changes in ownership on Form 4 or Form 5 with the SEC and the National Association of Securities Dealers, Inc. Such executive officers, directors and ten-percent shareholders are also required by SEC rules to furnish Pixar with copies of all such forms that they file. Based solely on its review of the copies of such forms received by Pixar and written representations from certain reporting persons that no Forms 5 were required for such persons, Pixar believes that during fiscal 1999 all Section 16(a) filing requirements applicable to its executive officers, directors and ten-percent shareholders were complied with. 36 37 ITEM 11. EXECUTIVE COMPENSATION SUMMARY COMPENSATION TABLE The following table shows, as to the Chief Executive Officer and each of the five most highly compensated executive officers whose salary plus bonus exceeded $100,000 during the last fiscal year (the "Named Officers"), information concerning compensation paid for services to Pixar in all capacities during the last three fiscal years.
LONG TERM COMPENSATION AWARDS ------------ ANNUAL COMPENSATION SECURITIES ----------------------- UNDERLYING NAME AND PRINCIPAL POSITION YEAR SALARY($) BONUS($) OPTIONS(#) --------------------------- ---- --------- ---------- ------------ Steve Jobs..................................... 1999 $ 52 $ -- -- Chairman, Chief Executive Officer 1998 50 -- -- 1997 -- -- -- Edwin E. Catmull............................... 1999 322,596 54,167 -- Executive Vice President, Chief Technical Officer 1998 295,846 -- -- 1997 208,539 -- -- Ann Mather(1).................................. 1999 124,617 203,600 -- Executive Vice President, Chief Financial Officer 1998 N/A N/A N/A 1997 N/A N/A N/A John Lasseter.................................. 1999 806,726 900,000 -- Executive Vice President, Creative Development 1998 769,315 250,000 -- 1997 625,903 1,250,000 125,000 Sarah McArthur(2).............................. 1999 322,596 54,167 -- Executive Vice President, Production 1998 300,000 -- 200,000 1997 196,148 -- 200,000
- --------------- (1) Ms. Mather joined Pixar in September 1999. (2) Ms. McArthur joined Pixar in February 1997. OPTION GRANTS IN LAST FISCAL YEAR The following table shows, as to each of the Named Officers, information concerning stock options granted during fiscal year 1999.
OPTION GRANTS IN FISCAL 1999 ------------------------------------------------------------ INDIVIDUAL GRANTS ------------------ POTENTIAL REALIZABLE VALUE AT % OF TOTAL ASSUMED ANNUAL RATES OF NUMBER OF OPTIONS STOCK PRICE APPRECIATION FOR SECURITIES GRANTED TO EXERCISE OPTION TERM(4) UNDERLYING OPTIONS EMPLOYEES IN PRICE EXPIRATION ----------------------------- NAME GRANTED(1) FISCAL YEAR(2) ($/SH) DATE(3) 5% 10% ---- ------------------ -------------- -------- ---------- ------------- ------------- Steve Jobs........... -- --% $ -- -- $ -- $ -- Edwin E. Catmull..... -- -- -- -- -- -- Ann Mather........... 500,000(5) 23.8 33.94 9/7/09 10,671,556 27,043,817 John Lasseter........ -- -- -- -- -- -- Sarah McArthur....... -- -- -- -- -- --
- --------------- (1) All options in this table were granted under the 1995 Stock Plan and have exercise prices equal to the fair market value on the date of grant. (2) Pixar granted options for 2,100,077 shares of Common Stock to employees in fiscal 1999. 37 38 (3) Options may terminate before their expiration upon the termination of optionee's status as an employee or consultant, the optionee's death or an acquisition of Pixar. (4) The 5% and 10% assumed rates of appreciation are provided in accordance with rules of the SEC and do not represent Pixar's estimate or projection of the future Common Stock price. This table does not take into account any appreciation in the price of the Common Stock from the date of grant to date. (5) These options are nonstatutory stock options, which vest over a four-year period at the rate of one-fourth at the end of each year from the vesting start date. OPTION EXERCISES AND HOLDINGS The following table sets forth, for each of the Named Officers, certain information concerning stock options exercised during fiscal 1999, and the number of shares subject to both exercisable and unexercisable stock options as of January 1, 2000. Also reported are values for "in-the-money" options that represent the positive spread between the respective exercise prices of outstanding stock options and the fair market value of Pixar's Common Stock as of January 1, 2000. AGGREGATED OPTION EXERCISES IN FISCAL 1999 AND FISCAL 1999 YEAR-END OPTION VALUES
NUMBER OF SECURITIES VALUE OF UNEXERCISED SHARES UNDERLYING UNEXERCISED IN-THE-MONEY OPTIONS AT ACQUIRED ON VALUE OPTIONS AT FISCAL YEAR END FISCAL YEAR END($)(1) EXERCISE REALIZED --------------------------- --------------------------- NAME (#) ($) EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE ---- ----------- ---------- ----------- ------------- ----------- ------------- Steve Jobs........ -- $ -- -- -- $ -- $ -- Edwin E. Catmull......... 83,333 2,988,530 66,667 -- 2,345,012 -- Ann Mather........ -- -- -- 500,000 -- 718,750 John Lasseter..... 260,000 10,663,000 353,542 36,458 11,505,893 774,733 Sarah McArthur.... 60,000 2,097,188 54,167 270,833 1,225,528 4,402,597
- --------------- (1) Market value of underlying securities based on the closing price of Pixar's Common Stock on December 31, 1999 (the last trading day of fiscal 1999) on the Nasdaq National Market of $35.375 minus the exercise price. EMPLOYMENT AGREEMENTS In February 1997, Pixar entered into an employment agreement with John Lasseter that extends until February 23, 2004. Pursuant to the agreement, Mr. Lasseter received a signing bonus of $1,250,000 and was granted additional stock options to purchase 125,000 shares of Pixar's Common Stock which vest over four years. The agreement provides for a current annual salary of $881,837, with 8% annual increases. The agreement also provides for the payment of a bonus (the "Motion Picture Bonus") based upon domestic theatrical box office gross receipts from feature-length animated motion pictures ("Feature Films") directed by Mr. Lasseter. Under the agreement, Mr. Lasseter will direct three Feature Films and has the option to direct certain sequels to Feature Films he directed if Pixar elects to produce such sequels within twelve years after the initial release of the applicable picture. During the term of the agreement, Mr. Lasseter is prohibited from accepting other employment and from becoming financially interested or associated with any entity engaged in a related or competitive business. Pixar can terminate the agreement at any time for any reason. However, if Pixar terminates Mr. Lasseter's employment without cause, Pixar must pay Mr. Lasseter (i) an amount equal to 75% of the balance of the salary Mr. Lasseter would have earned through the remainder of the term of the agreement and (ii) any portion of the Motion Picture Bonus as and if due. In addition, the vesting of Mr. Lasseter's stock options would accelerate so that they would be exercisable in full and Mr. Lasseter could accept employment with any third party. In September 1999, Pixar agreed with Ann Mather that in the event that Ms. Mather is terminated for reasons other than cause during her first 24 months of employment, Pixar will pay an amount equal to her then-current monthly salary times the number of months remaining in her first 24 months of employment. 38 39 DIRECTOR COMPENSATION Directors who are not employees of Pixar receive a fee of $1,000 for each meeting attended of the Board of Directors and a fee of $1,000 for each meeting attended of a committee of the Board of Directors if such committee meeting is not held in conjunction with a meeting of the Board of Directors. All directors are reimbursed for expenses incurred in attending such meetings. Non-employee directors are eligible to receive option grants pursuant to Pixar's 1995 Director Option Plan (the "Director Plan") which was adopted by the Board of Directors in October 1995, approved by the shareholders in November 1995 and took effect in November 1995. A total of 200,000 shares of Common Stock has been reserved for issuance under the Director Plan. As of March 20, 2000, there were 90,000 options outstanding under the Director Plan. The Director Plan provides for an automatic grant of an option to purchase 30,000 shares of Common Stock (the "First Option") to each nonemployee director who first becomes a non-employee director (other than an employee director who ceases to be an employee but remains a director) after the effective date of the Director Plan on the date on which such person first becomes a non-employee director. Beginning on the third anniversary of the date he or she became an outside director, each nonemployee director will automatically be granted an option to purchase 10,000 shares of Common Stock (a "Subsequent Option") each year on the date of such anniversary, provided he or she is then a non-employee director. Each nonemployee director will be eligible to receive a Subsequent Option, regardless of whether such non-employee director was eligible to receive a First Option. First Options and each Subsequent Option will have a term of ten years. One-third of the shares subject to a First Option will vest one year after its date of grant and an additional one-third will vest at the end of each year thereafter, provided that the optionee continues to serve as a director on such dates. All of the shares subject to a Subsequent Option will vest one year after the date of the option grant, provided that the optionee continues to serve as a director on such date. The exercise prices of the First Option and each Subsequent Option will be 100% of the fair market value per share of Pixar's Common Stock on the date of the grant of the option. Ms. Barad was granted a First Option in July 1997 at an exercise price of $15.125 per share. Mr. Sonsini was granted Subsequent Options in April 1998 at an exercise price of $43.50 per share and in April 1999 at an exercise price of $40.875 per share. Messrs. Brittenham and Graziano were each granted Subsequent Options in August 1998 at an exercise price of $30.75 per share and in August 1999 at an exercise price of $33.50 per share. Ms. Barad and Mr. Levy, non-employee directors of Pixar, will be eligible for Subsequent Options under the Director Plan on the third anniversary of the dates they became directors. Messrs. Sonsini, Brittenham and Graziano, also non-employee directors, are eligible for Subsequent Options each year on the anniversary of the dates they became directors. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION Pixar's Compensation Committee is currently composed of Ms. Barad and Mr. Graziano. No interlocking relationships exist between any member of Pixar's Board of Directors or Compensation Committee and any member of the board of directors or compensation committee of any other company, nor has any such interlocking relationship existed in the past. No member of the Compensation Committee is or was formerly an officer or an employee of Pixar. 39 40 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth the beneficial ownership of Common Stock of Pixar as of March 20, 2000 for the following: (i) each person who is known by Pixar to own beneficially more than 5% of the outstanding shares of Pixar's Common Stock; (ii) each of Pixar's directors; (iii) each of the Named Officers; and (iv) all directors and executive officers of Pixar as a group.
NUMBER OF PERCENT OF NAME OF BENEFICIAL OWNER SHARES(1) TOTAL(1) ------------------------ ---------- ---------- Steve Jobs.................................................. 30,000,001 63.8% c/o Pixar 1001 West Cutting Boulevard Richmond, CA 94804 The TCW Group, Inc.(2)...................................... 3,025,869 6.4 865 South Figueroa St Los Angeles, CA 90017 Disney Enterprises, Inc.(3)................................. 2,500,100 5.3 500 South Buena Vista Street Burbank, CA 91521 John Lasseter(4)............................................ 774,558 1.6 Edwin E. Catmull(5)......................................... 442,800 1.0 Sarah McArthur(6)........................................... 75,000 * Ann Mather.................................................. 0 * Lawrence B. Levy............................................ 192,200 * Larry W. Sonsini(7)......................................... 24,528 * Skip M. Brittenham(8)....................................... 40,000 * Joseph A. Graziano(9)....................................... 40,000 * Jill E. Barad (10).......................................... 21,000 * All directors and executive officers as a group (10 persons)(11).......................................... 31,610,087 66.3%
- --------------- * Represents less than 1% of the total. (1) Based on 47,033,847 shares outstanding on March 20, 2000. The number and percentage of shares beneficially owned is determined under rules of the Securities and Exchange Commission ("SEC"), and the information is not necessarily indicative of beneficial ownership for any other purpose. Under such rules, beneficial ownership includes any shares as to which the individual has sole or shared voting power or investment power and also any shares which the individual has the right to acquire within sixty days of March 20, 2000 through the exercise of any stock option or other right. Unless otherwise indicated in the footnotes, each person has sole voting and investment power (or shares such powers with his or her spouse) with respect to the shares shown as beneficially owned. (2) As indicated in the Schedule 13G filed by The TCW Group, Inc. pursuant to the Exchange Act on February 11, 2000. (3) As indicated in the Schedule 13D filed by Disney Enterprises, Inc. pursuant to the Exchange Act on April 18, 1997. Includes 1,500,000 shares issuable upon exercise of warrants. (4) Includes 363,958 shares subject to options that are exercisable within 60 days of March 20, 2000. (5) Includes 66,667 shares subject to options that are exercisable within 60 days of March 20, 2000. (6) Includes 75,000 shares subject to options that are exercisable within 60 days of March 20, 2000. (7) Includes 20,000 shares subject to options that are exercisable within 60 days of March 20, 2000. (8) Includes 40,000 shares subject to options that are exercisable within 60 days of March 20, 2000. (9) Includes 40,000 shares subject to options that are exercisable within 60 days of March 20, 2000. (10) Includes 20,000 shares subject to options that are exercisable within 60 days of March 20, 2000. (11) Includes 625,625 shares subject to options that are exercisable within 60 days of March 20, 2000. 40 41 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Pixar has engaged the law firm of Ziffren, Brittenham, Branca & Fischer ("ZBB&F") to handle certain matters. Skip M. Brittenham, a director of Pixar, is a senior partner of the firm. Pixar has also engaged the law firm of Wilson Sonsini Goodrich & Rosati ("WSGR") to handle certain legal matters. Larry W. Sonsini, a director of Pixar, is a member of the firm. Payments by Pixar to each of ZBB&F and WSGR did not exceed five percent of either law firm's respective gross revenues in the last fiscal year of either such firm. Pixar believes that all of the transactions set forth above were made on terms no less favorable to Pixar than could have been obtained from unaffiliated third parties. All future transactions, including loans, between Pixar and its officers, directors and principal shareholders and their affiliates will be approved by a majority of the Board of Directors, including a majority of the independent and disinterested directors of the Board of Directors, and will be on terms no less favorable to Pixar than could be obtained from unaffiliated third parties. 41 42 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this Form 10-K: 1. Financial Statements. The following financial statements of Pixar and the Independent Auditors' Report thereon are incorporated by reference to the portions of Pixar's 1999 Annual Report to Shareholders filed as Exhibit 13.1 to this Form 10-K: Independent Auditors' Report................................ Balance Sheets as of January 2, 1999 and January 1, 2000.... Statements of Operations for the years ended December 31, 1997, January 2, 1999 and January 1, 2000................... Statements of Shareholders' Equity for the years ended December 31, 1997, January 2, 1999 and January 1, 2000...... Statements of Cash Flows for the years ended December 31, 1997, January 2, 1999 and January 1, 2000................... Notes to Financial Statements............................... 2. Financial Statement Schedule. The following financial statement schedule of Pixar for the years ended December 31, 1997, January 2, 1999 and January 1, 2000 is filed as part of this Form 10-K and should be read in conjunction with the Financial Statements, and related notes thereto, of Pixar. Independent Auditors' Report on Financial Statement Schedule.................................................... S-1 Schedule II -- Valuation and Qualifying Accounts and Reserves.................................................... S-2 Schedules not listed above have been omitted since they are either not required, not applicable, or the information is otherwise included. 3. Exhibits: See Item 14(c) below.
(b) Reports on Form 8-K. No Reports on Form 8-K were filed during the fourth quarter ended January 1, 2000. (c) Exhibits. The exhibits listed on the accompanying index to exhibits immediately following the financial statement schedule are filed as part of, or incorporated by reference into, this Form 10-K. (d) Financial Statement Schedules. See Item 14(a) above. 42 43 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized, on this 29th day of March, 2000. PIXAR By: /s/ ANN MATHER -------------------------------------- Ann Mather Executive Vice President and Chief Financial Officer POWER OF ATTORNEY KNOW ALL THESE PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Steve Jobs, Ann Mather and Edwin E. Catmull and each of them, jointly and severally, his or her attorneys-in-fact, each with full power of substitution, for him or her in any and all capacities, to sign any and all amendments to this Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each said attorneys-in-fact or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this Form 10-K has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated:
SIGNATURE TITLE DATE --------- ----- ---- /s/ STEVE JOBS Chairman of the Board and March 29, 2000 - -------------------------------------------------------- Chief Executive Officer Steve Jobs (Principal Executive Officer) /s/ ANN MATHER Executive Vice President and March 29, 2000 - -------------------------------------------------------- Chief Financial Officer Ann Mather (Principal Financial and Accounting Officer) /s/ JILL E. BARAD Director March 29, 2000 - -------------------------------------------------------- Jill E. Barad /s/ SKIP M. BRITTENHAM Director March 29, 2000 - -------------------------------------------------------- Skip M. Brittenham /s/ EDWIN E. CATMULL Director March 29, 2000 - -------------------------------------------------------- Edwin E. Catmull /s/ JOSEPH A. GRAZIANO Director March 29, 2000 - -------------------------------------------------------- Joseph A. Graziano /s/ LAWRENCE B. LEVY Director March 29, 2000 - -------------------------------------------------------- Lawrence B. Levy /s/ LARRY W. SONSINI Director March 29, 2000 - -------------------------------------------------------- Larry W. Sonsini
43 44 INDEPENDENT AUDITORS' REPORT ON SCHEDULE The Board of Directors and Shareholders Pixar: Under date of February 2, 2000, we reported on the balance sheets of Pixar as of January 2, 1999 and January 1, 2000, and the related statements of operations, shareholders' equity, and cash flows for each of the years in the three-year period ended January 1, 2000, which are incorporated by reference in the annual report on Form 10-K. In connection with our audits of the aforementioned financial statements, we also audited the related financial statement schedule included herein. This financial statement schedule is the responsibility of Pixar's management. Our responsibility is to express an opinion on this financial statement schedule based on our audits. In our opinion, such financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. /s/ KPMG LLP San Francisco, California February 2, 2000 S-1 45 PIXAR SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (IN THOUSANDS)
BALANCE AT DEDUCTIONS: BEGINNING WRITE OFFS OF BALANCE AT CLASSIFICATION OF YEAR ADDITIONS ACCOUNTS END OF YEAR -------------- ---------- --------- ------------- ----------- Allowance for returns and doubtful accounts Year ended December 31, 1997................ $259 $100 $(102) $257 ==== ==== ===== ==== Year ended January 2, 1999.................. $257 $ -- $ (28) $229 ==== ==== ===== ==== Year ended January 1, 2000.................. $229 $ -- $ (5) $224 ==== ==== ===== ====
S-2 46 INDEX TO EXHIBITS
EXHIBIT NUMBER EXHIBITS - ------- -------- 3.1 Amended and Restated Articles of Incorporation (which is incorporated herein by reference to Exhibit 3.3 to the Registrant's Form S-1 Registration Statement No. 33-97918). 3.4 Amended and Restated Bylaws, as amended (which is incorporated herein by reference to Exhibit 3.4 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1997. 4.1 See Exhibit 3.1. 4.2 See Exhibit 3.4. 4.5 Specimen Common Stock Certificate (which is incorporated herein by reference to Exhibit 4.5 to the Registrant's Form S-1 Registration Statement No. 33-97918). 4.6 Common Stock and Warrant Purchase Agreement between the Registrant and Disney Enterprises, Inc. dated as of February 23, 1997 (which is incorporated herein by reference to Exhibit 4.6 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1996). 4.7 Form of Common Stock Purchase Warrant to be issued to Disney Enterprises, Inc. (which is incorporated herein by reference to Exhibit 4.7 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1996). 4.8 Form of Registration Rights Agreement by and between the Registrant and Disney Enterprises, Inc. (which is incorporated herein by reference to Exhibit 4.8 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1996). 10.1* 1995 Stock Plan, as amended (which is incorporated herein by reference to Exhibit 10.1 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1998). 10.2* 1995 Director Option Plan (which is incorporated herein by reference to Exhibit 10.2 to the Registrant's Form S-1 Registration Statement No. 33-97918). 10.3* Form of Indemnification Agreement entered into between the Registrant and each of the executive officers and directors (which is incorporated herein by reference to Exhibit 10.3 to the Registrant's Form S-1 Registration Statement No. 33-97918). 10.4 Agreement between the Registrant and Walt Disney Pictures dated May 3, 1991, as amended (which is incorporated herein by reference to Exhibit 10.4 to the Registrant's Form S-1 Registration Statement No. 33-97918).(1) 10.5 Net Office Lease between the Registrant and Point Richmond R&D Associates dated February 15, 1990, as amended (which is incorporated herein by reference to Exhibit 10.5 to the Registrant's Form S-1 Registration Statement No. 33-97918). 10.6 Patent License Agreement between the Registrant and Microsoft Corporation dated June 21, 1995 (which is incorporated herein by reference to Exhibit 10.7 to the Registrant's Form S-1 Registration Statement No. 33-97918.(1) 10.7* Employment Agreement between the Registrant and John Lasseter dated February 24, 1997 (which is incorporated herein by reference to Exhibit 10.10 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1996).(1) 10.8 Patent License Agreement between the Registrant and Silicon Graphics, Inc. dated March 12, 1996 (which is incorporated herein by reference to Exhibit 10.14 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1995). 10.9 Net Office Lease between the Registrant and Point Richmond R&D Associates dated November 7, 1995 (which is incorporated herein by reference to Exhibit 10.15 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1995).
47
EXHIBIT NUMBER EXHIBITS - ------- -------- 10.10 Co-Production Agreement between the Registrant and Walt Disney Pictures and Television dated February 24, 1997 (which is incorporated herein by reference to Exhibit 10.16 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1996).(1) 10.11 Net Office Lease between the Registrant and Point Richmond R&D Associates dated April 1, 1996 (which is incorporated herein by reference to Exhibit 10.16 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1996). 10.12 Net Office Lease between the Registrant and Point Richmond R&D Associates dated September 12, 1996 (which is incorporated herein by reference to Exhibit 10.17 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1996). 10.13 Agreement of Purchase and Sale between the Registrant and Del Monte Corporation dated as of September 6, 1996, as amended (which is incorporated herein by reference to Exhibit 10.19 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1997). 10.14 Amendment to the September 12, 1996 Net Office Lease between the Registrant and Point Richmond R&D Associates dated as of May 8, 1997 (which is incorporated herein by reference to Exhibit 10.17 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1997). 10.15 Net Office Lease between the Registrant and Point Richmond R&D Associates dated January 11, 1999 (which is incorporated herein by reference to Exhibit 10.15 to the Registrant's Annual Report on Form 10-K for the year ended January 2, 1999). 13.1 Portions of the Annual Report to Shareholders for the fiscal year ended January 1, 2000, expressly incorporated by reference herein. 23.1 Consent of Independent Auditors. 27.1 Financial Data Schedule.
- --------------- (1) Documents for which confidential treatment has been granted for certain portions of these exhibits. * Indicates management compensatory plan, contract or arrangement. EX-13.1 2 ANNUAL REPORT 1 EXHIBIT 13.1 SELECTED FINANCIAL DATA The following selected financial data is derived from our financial statements. This data should be read in conjunction with the Financial Statements and Notes thereto, and with Management's Discussion and Analysis of Financial Condition and Results of Operations.
FISCAL YEAR ---------------------------------------------------------------- 1995 1996 1997 1998 1999 -------- -------- -------- -------- -------- (IN THOUSANDS, EXCEPT PER SHARE DATA) Revenue ................................. $ 12,113 $ 35,218 $ 34,699 $ 14,307 $121,037 Net income from continuing operations ... 3,331 26,342 21,956 7,464 49,102 Net income .............................. 1,627 25,319 22,190 7,822 49,224 Basic net income per share from continuing operations ................. 0.26 0.68 0.53 0.17 1.06 Basic net income per share .............. 0.13 0.66 0.54 0.18 1.07 Diluted net income per share from continuing operations ................. 0.10 0.56 0.46 0.14 0.99 Diluted net income per share ........... 0.05 0.54 0.46 0.15 0.99 Total assets ........................ 152,815 176,941 231,068 250,806 374,905 Total shareholders' equity .......... 142,907 170,804 217,300 235,147 344,443
F-1 2 The foregoing discussion, the preceding Letter to Shareholders and other sections of this Annual Report to Shareholders contain forward-looking statements that have been made pursuant to the provisions of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are based on current expectations, estimates and projections about Pixar's industry, management's beliefs, and assumptions made by management. Words such as "anticipates," "expects," "intends," "plans," "believes," "seeks," "estimates," variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict; therefore, actual results and outcomes may differ materially from what is expressed or forecasted in any such forward-looking statements. Such risks and uncertainties include those set forth herein under "Overview," "--Dependence on Toy Story 2, A Bug's Life and Toy Story in 2000," and "--Risks Associated with Adequacy of Cash Balances" as well as those noted in the section entitled "Risk Factors " in Pixar's Annual Report on Form 10-K for the year ended January 1, 2000 (the "Form 10-K"). Particular attention should be paid to the cautionary language in the section in the Form 10-K entitled "--Dependence on Toy Story 2, A Bug's Life and Toy Story in 2000," " -- Risks Associated with Adequacy of Cash Balances," "Risk Associated with Scheduled Successive Release of Films" and "-- Risks Associated with Co-Production Agreement." Unless required by law, Pixar undertakes no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW Pixar was formed in 1986 when Steve Jobs purchased the computer division of LucasFilm and incorporated it as a separate company. Until 1996, Pixar generated its recurring revenue primarily from the license of RenderMan software, software development contracts and fees for animated television commercials. In 1991, we entered into a feature film agreement (the "Feature Film Agreement") with Walt Disney Pictures, a wholly owned subsidiary of The Walt Disney Company (together with its subsidiaries and affiliates collectively referred to herein as "Disney"), for the development and production of up to three animated feature films to be marketed and distributed by Disney. As a result, in 1992, we began to place more emphasis on products sold for their content, especially feature films, and the continued development of our proprietary software. We reduced emphasis on the commercialization of software and contract development work and moved away from producing computer-animated commercials. We implemented this shift in focus toward feature films over the last seven years. In accordance with this shift in focus, we adopted a new business model pursuant to which we will continue to develop and produce new animated feature films and related products and will produce jointly with Disney other related products such as merchandise and soundtracks. Adoption of this new business model did not materially impact our results of operations and financial condition until 1996, when we first recognized film revenue and cost of film revenue attributable to our first animated feature film, Toy Story, which was released in November 1995. Our share of revenues and expenses from Toy Story have been governed by the terms of the Feature Film Agreement. This agreement was superseded in February 1997 by the Co-Production Agreement, described below, except with respect to treatment of certain Toy Story and Toy Story-related products developed pursuant to the Feature Film Agreement. Accordingly, we believe that results of operations for 1997 and 1998, during which time Toy Story revenue and costs were governed by the terms of the Feature Film Agreement, are not meaningful indicators of future performance. See "Risk Factors-- Risk of Net Losses in 2001" In February 1997, we entered into the Co-Production Agreement ("Co-Production Agreement") with Disney pursuant to which we, on an exclusive basis, agreed to produce five original computer-animated feature-length theatrical motion pictures (the "Pictures") for distribution by Disney. Pixar and Disney agreed to co-finance the production costs of the Pictures, co-own the Pictures (with Disney having exclusive distribution and exploitation rights), co-brand the Pictures and share equally in the profits of each Picture and any related merchandise and other ancillary products, after recovery of all marketing and distribution costs (which Disney finances), a distribution fee paid to Disney and any other fees or costs, including any participations provided to talent and the like. The Co-Production Agreement generally provides that we will produce each Picture and that Disney will control all decisions relating to marketing, promotion, publicity, advertising and distribution of each Picture. Our second feature film, A Bug's Life, was released in November 1998 and counts as the first original Picture under the Co-Production Agreement. The Co-Production Agreement also contemplates that with respect to theatrical sequels, made-for-home video sequels, television productions, interactive media products and other derivative works related to the Pictures, we will have the opportunity to co-finance and produce such products or to earn passive royalties on such products. We will not share in any theme park revenues generated as a result of the Pictures. Pursuant to the Co-Production Agreement, in addition to co-financing the production costs of the Pictures, Disney will reimburse us for our share of F-2 3 certain general and administrative costs and certain research and development costs that benefit the productions. See Note 4 of Notes to Financial Statements. In November 1999, Toy Story 2, our third animated feature film was released. As a sequel, Toy Story 2 is a derivative work of the original Toy Story, therefore is not counted toward the five original Pictures to be produced under the Co-Production Agreement. However, as a derivative work, Toy Story 2 is treated as a Picture under the Co-Production Agreement and all the provisions applicable to the five original Pictures apply. In May 1999, we began production of our fourth theatrical film with the working title "Monsters, Inc." and also in 1999, we began story development of our fifth animated feature film "Film Five" and concept development on our sixth animated feature film. These films will be produced and distributed under the Co-Production Agreement and will count as the second, third and fourth films of the five original films to be produced under the Co-Production Agreement. We do not expect to release Monsters, Inc. until late 2001, at the earliest and Film Five until 2002, at the earliest. Effective for fiscal year 1998, we adjusted our fiscal year end from December 31 to a 52- or 53-week period that ends on the Saturday nearest December 31. The 1999 fiscal year ended on January 1, 2000 and consisted of 52 weeks. RESULTS OF OPERATIONS Revenue In 1999, we derived revenue from A Bug's Life, Toy Story, from software licenses and from fees for other animation services. Revenue from feature films is recognized as earned and reasonably estimable. All payments to us from Disney for development and production of Toy Story under the Feature Film Agreement, and A Bug's Life, Toy Story 2, Monsters, Inc. and Film Five under the Co-Production Agreement have been recorded as cost reimbursements. Accordingly, no revenue has been recognized for such reimbursements; rather, we have netted the reimbursements against the related costs. These reimbursed costs through the end of 1999 are set forth in Note 4 of Notes to Financial Statements. Software license revenue is recognized upon shipment. Animation services revenue is recognized on the percentage-of-completion method of accounting. See Note 1 of Notes to Financial Statements. Total revenue declined from $34.7 million in 1997 to $14.3 million in 1998 and increased to $121.0 million in 1999. The decrease in total revenue from 1997 to 1998 was primarily attributable to a decrease in Toy Story related revenue because Toy Story had been released in its primary and secondary markets in 1996 and 1997. The increase in 1999 is due primarily to revenue generated by A Bug's Life from worldwide theatrical revenues and related merchandise, domestic home video revenues and a portion of foreign home video revenue. No revenues attributable to Toy Story 2 were recognized in 1999. Software revenue includes software license revenue, principally from RenderMan. Software revenue declined from $4.5 million in 1997 to $3.8 million in 1998 and increased to $5.7 million in 1999. Software revenue decreased in 1998 and increased in 1999 due primarily to fluctuations in RenderMan software license revenue. Due to our focus on content creation for animated feature films and related products, we have not increased the time and resources necessary to generate significantly higher RenderMan license revenues. Therefore, we continue to expect ongoing variability in revenue derived from software licenses and that such revenue will remain flat or possibly decline. All historical and future royalty income, if any, associated with our discontinued CD-ROM division is now and will continue to be excluded from software revenue and presented in results of discontinued operations. See "Results of Discontinued Operations." Animation services revenue includes revenue generated from short projects related to our feature films. Fees for animation services, which are fixed in advance, depend on the relative complexity and length of each production and may also depend on the market and other competitive conditions. Animation services revenue decreased from $1.6 million in 1997 to $630,000 in 1998 and increased to $873,000 in 1999. We expect that revenue in this area will continue to vary from year to year due to the sporadic nature of this business and the need to utilize animation services employees on other productions. For example, we transferred substantially all of our animation services employees to assist in the completion of both A Bug's Life and Toy Story 2 during peak production periods. There can be no assurance that we will generate any animation services revenue during periods in which animation services employees are devoted to feature films or other projects. F-3 4 In 1997, film revenue of $26.9 million was recognized, primarily representing our share of Toy Story worldwide home video sales and Toy Story merchandise sales under the Feature Film Agreement. The Toy Story home video, which was released in 1997, was the last major product release for Toy Story. Consequently, film revenue from Toy Story declined significantly in 1998 to $9.8 million and to $4.1 million in 1999, which primarily represented residual amounts of Toy Story merchandise revenue, television airings and home video sales. Under the Co-Production Agreement, Pixar and Disney share equally in the profits of A Bug's Life after Disney recovers its distribution costs and its distribution fee. Therefore, the balance of our film revenue for 1999, $110.3 million, resulted primarily from A Bug's Life theatrical, home video and merchandise revenues, offset by Disney's related distribution costs and fees. Toy Story 2, was released in November 1999. We do not expect to record significant revenue from Toy Story 2 until the first quarter of fiscal 2000. Patent licensing revenue of $1.7 million and $120,000 in 1997 and 1998, respectively, was attributable to a patent license with Silicon Graphics whereby we granted to Silicon Graphics and its subsidiaries a non-exclusive license to use certain of our patents covering techniques for creating computer-generated photo-realistic images. Under the agreement, Silicon Graphics agreed to pay us total compensation of $11.0 million, of which $6.0 million in cash was paid in March 1996 and $5.0 million was to be paid in the form of credits to purchase hardware and software from Silicon Graphics. There were no credits recognized in 1999, with $23,000 remaining available for use. We do not expect that patent licensing revenue will be generated on an on-going basis. See Note 5 of Notes to Financial Statements. For fiscal years 1997 and 1998, Disney accounted for 83% and 76%, respectively, of our revenue from continuing operations, attributable to revenue generated from Toy Story home video, television airings and merchandise sales, animation services and software revenue. For fiscal year 1999, Disney accounted for 92% of our revenue from continuing operations, primarily attributable to revenue generated from the theatrical and home video release of A Bug's Life, and related merchandise. Cost of Revenue Cost of software revenue consists of the direct cost and manufacturing overhead required to reproduce and to package our software products, as well as amortization of purchased technology. Cost of software revenue includes no amortization of internal software development expenses since no such expenses have been capitalized. Cost of software revenue as a percentage of the related revenue increased from 2% in 1997 to 19% in 1998 and decreased to 12% in 1999. Cost of software revenue in 1998 and 1999 was due primarily to the amortization of purchased technology associated with the acquisition of Physical Effects, Inc. ("PEI"). Approximately $2.7 million of the PEI purchase price was assigned to purchased technology, which PEI licensed to a third party. As a result of the ongoing amortization of this purchased technology, it is likely that our software gross profit will be lower during the next few years as compared to software gross profit prior to the 1998 acquisition. In addition, if we determine that the license revenue generated by the purchased technology will be lower than expected and that all or part of the purchased technology asset may not be recoverable, we would, at that point, be required to write off all or a significant portion of the unamortized purchased technology. Cost of animation services revenue consists of production costs, which include salaries, benefits, facility expenses, and department overhead costs. Cost of animation services revenue as a percentage of the related revenue decreased from 63% in 1997 to 22% in 1998 and increased to 59% in 1999. The decrease from 1997 to 1998 reflects our decision in 1996 to largely discontinue our business of producing a number of animated television commercials, in favor of working on a fewer number of animation services projects related to our feature films. The increase in 1999 reflects the fact that animation services projects are negotiated individually and depending on the complexity of the project, profit margins may vary significantly from project to project. In 1997 and 1998, cost of film revenue consisted of the amortized portion of our share of unreimbursed amounts incurred to produce Toy Story. See "Capitalized Film Production Costs." Cost of film revenue was $1.5 million, or 6% of film revenue in 1997. Due to higher than expected film revenue in 1997, which resulted in our amortizing all Toy Story film costs by December 31, 1997, there was no cost of film revenue in 1998. Therefore, any further Toy Story related film revenue will have no associated cost of revenue. Cost of film revenue for fiscal 1999 represents amortization of capitalized film costs associated with A Bug's Life and represented 28% of A Bug's Life revenue. Under the Feature Film Agreement, all payments to us from Disney for our efforts in the development and production of feature films were recorded as cost reimbursements and were netted against the related costs. Under the terms of the Co-Production Agreement, in which we co-finance each film production, amortized film production costs for future feature films will be significantly F-4 5 higher, and gross profit margins on future film projects, if any, will be substantially lower than those achieved on Toy Story (as was the case in 1999 with A Bug's Life). There is no cost of revenue associated with patent licensing revenue. Operating Expenses We intend to continue to increase operating expenses in a number of areas. With respect to general expense growth, as a result of intense competition for animators, creative personnel, technical directors and certain administrative personnel, we have had to pay higher salaries to attract new creative, technical and other personnel. We expect compensation for such personnel to continue to increase. In 1999, we expanded our creative development staff and facilities and expanded other operations. We expect continued growth in operating expenses in these areas. Under the Co-Production Agreement, Disney reimburses us for half of certain general and administrative costs and certain research and development costs that benefit the productions. The funding received from Disney is treated as operating expense reimbursements. See Note 4 of Notes to Financial Statements. To the extent that personnel, facilities and other expenditures are not capitalized by us nor allocated to and paid for by Disney, and precede or are not subsequently followed by an increase in revenue, our business, operating results and financial condition will be materially adversely affected. Included in 1997 was a one-time $2.2 million adjustment, reducing our operating expenses. This reduction was due to an additional reimbursement from Disney under the Co-Production Agreement, which was signed in February 1997. Under this agreement, certain operating expenses benefiting the productions, such as certain research and development and certain general and administrative expenses, are paid half by us and half by Disney. Since the Co-Production Agreement applies to A Bug's Life and Toy Story 2, both of which were in development and production in 1996, we were entitled to reimbursement for Disney's share of certain of our operating expenses incurred prior to signing the agreement. Without this adjustment, our total operating expenses for 1997 were $11.3 million. Operating expenses increased in 1998 to $12.1 million and to $14.8 million in 1999. We recorded amortization of deferred compensation for the difference between the grant price and the deemed fair value of our common stock for options granted during 1995. Amortization of deferred compensation of $635,000, $310,000 and $104,000 was recorded in 1997, 1998 and 1999 respectively; $24,000 was capitalized to film production costs in 1997, and the balance was charged to expense. As of January 1, 2000, all deferred compensation has been amortized. See "Capitalized Film Production Costs" and Note 8 of Notes to Financial Statements. Research and Development. Research and development expenses consist primarily of salaries and support for personnel conducting research and development for the RenderMan product, for our proprietary Marionette and Ringmaster animation and production management software and for creative development of concepts for future films. Research and development expenses decreased from $4.7 million in 1997 to $3.9 million in 1998 due to the completion of a significant research and development project in 1997, the short film entitled Geri's Game, coupled with the reassignment in 1998 of certain research and development employees to assist in the completion of A Bug's Life. Research and development expenses increased to $6.3 million in 1999 due to our increasing investment in creative development and due to our continued investment in proprietary technology and short film projects. We expect research and development expenses to continue to increase in future periods. To date, all research and development costs not reimbursed by Disney have been expensed as incurred. See Note 4 of Notes to Financial Statements. Sales and Marketing. Sales and marketing expenses consist primarily of salaries and overhead, as well as public relations, advertising, technical support and trade show costs required to support the software segment. Sales and marketing expenses decreased slightly from $1.5 million in 1997 to $1.3 million in 1998, due to increased spending for film-specific marketing expenses, which are reimbursed by Disney under the Co-Production Agreement. In 1999, sales and marketing expenses increased to $1.5 million primarily due to selling expenses associated with an increase in software license revenues. We believe that sales and marketing expenses will increase in absolute dollars in future periods, particularly in the areas of public relations and corporate marketing. General and Administrative. General and administrative expenses consist primarily of salaries of management and administrative personnel, insurance costs and professional fees. General and administrative expenses increased from $5.1 million in 1997 to $7.0 million in 1998 and remained level at $7.0 million in 1999. The increase in general and administrative expenses from 1997 to 1998 was primarily due to increased general and administrative staffing and public company costs such as payroll taxes generated from the exercise of stock options. In 1999 general and administrative expenses remained consistent with 1998. We expect general and administrative expenses to further increase in absolute dollars in future periods. F-5 6 Other Income, Net Other income, net was $8.8 million in 1997, $8.8 million in 1998 and $7.5 million in 1999. Other income, net consisted primarily of interest income from investments. Other income decreased in 1999 due to an average decline in cash balances in the first half of 1999 as cash was being used to fund film production and the construction of our new Emeryville facility. Cash balances increased late in the second half of 1999 due to revenue generated from A Bug's Life. Income Taxes Income tax expense from continuing operations of $9.9 million, $2.6 million and $32.9 million for 1997, 1998 and 1999, respectively, consisted primarily of state and federal income taxes. Income taxes decreased in 1998 due to the benefit of certain tax deductions occurring in 1998 coupled with decreased earnings. Income taxes increased in 1999 due to increased earnings offset by the benefit of net operating loss carryforwards, other than those originating from the exercise of non-qualified employee stock options, for which no benefit had been previously recognized. The realization of tax benefits from the exercise of non-qualified employee stock options will reduce the amount of our tax payments and liabilities, but will not reduce our future effective tax rates. We expect our tax rate in the future to be at or near 42%, consistent with statutory levels. See Notes 1 and 7 of Notes to Financial Statements. Results of Discontinued Operations After the Co-Production Agreement was executed, we determined that, despite the fact that our first CD-ROM titles were successful on relative terms, the resources devoted to our interactive products division would be better allocated to other projects arising from the Co-Production Agreement. We determined in March 1997 to discontinue our business of producing CD-ROM and other interactive products and redirected the approximately 60 employees in that division to film and related projects within Pixar. We recorded income from discontinued operations, net of taxes, of $234,000 in 1997, $358,000 in 1998 and $122,000 in 1999 primarily due to royalty income received. We do not expect to receive any significant future CD-ROM royalty income in future periods. See Note 13 of Notes to Financial Statements. RISK FACTORS Dependence on Toy Story 2, A Bug's Life, and Toy Story in 2000 In 2000, our revenue and operating results will be largely dependent upon (1) the amount of our revenues from the domestic and foreign theatrical releases of Toy Story 2, (2) the timing of release of Toy Story 2 on home video in domestic and foreign markets and the amount of related home video revenues, (3) the amount and timing of our revenues from merchandise sales related to Toy Story 2, (4) our revenue from foreign home video sales of A Bug's Life and to a lesser extent from domestic home video sales of A Bug's Life and related merchandise, (5) the amount of our domestic and international home video revenues from the re-release of Toy Story on home video, and residual revenues from Toy Story, if any, and (6) our limited software revenue. Dependence on Toy Story 2 and A Bug's Life in 2000 Toy Story 2 Revenue We will be significantly dependent upon the success of Toy Story 2 in 2000. Toy Story 2 was released in November 1999, and has achieved significant box office success, with domestic box office receipts of more than $241 million as of March 20, 2000. In 2000, we expect to see an improved ability, through information available to us from Disney and other sources, to estimate and record our share of film revenues and related costs. As a result, we expect to begin to recognize revenues from Toy Story 2 in the first quarter of 2000. While we anticipate this improved ability will allow us to recognize our share of film revenues and costs on a more timely basis, we will remain dependent on the timing and accuracy of the information provided by Disney, as well as on the continuing commercial success of Toy Story 2 throughout 2000. F-6 7 In 2000, we expect to recognize the vast majority of revenues from the theatrical release of Toy Story 2 and some revenues from related merchandise sales. In addition, with the release of Toy Story 2 on home video in the fall of 2000, we expect to recognize a portion of domestic and foreign home video revenues These future revenues of Toy Story 2 will be offset by associated distribution and marketing costs for its domestic and foreign theatrical releases, distribution and marketing costs for its domestic and foreign home video releases, video cost of goods, Disney's distribution fee based on film-related revenues, and other distribution costs such as talent participation and residuals. Fees and participations paid to key talent on Toy Story 2 are substantially greater than for Toy Story or A Bug's Life, which together with other increases in production costs will have the effect of increasing the cost of the film when compared to Pixar's first two films. Toy Story 2 faced significant competition from other family-oriented films released theatrically during the 1999 holiday season, such as Stuart Little and Pokemon: The First Movie. We believe theatrical proceeds and product sales from these competing films have and may continue to adversely impact proceeds from Toy Story 2. A Bug's Life Revenue A Bug's Life was released in November 1998, and in 1999, we recognized revenues of $110.3 million, which represents the majority of revenues we expect to recognize over the lifetime of A Bug's Life. Under the Co-Production Agreement, Pixar and Disney share equally in the profits of A Bug's Life after Disney recovers its distribution costs and its distribution fee. Correspondingly, Pixar's film revenue in 1999 resulted primarily from the domestic and foreign theatrical revenues from A Bug's Life, related domestic and foreign home video revenue, and related merchandise licensing, offset by Disney's distribution costs and its distribution fee. Distribution costs reported to date include the majority of worldwide theatrical release costs, the majority of Disney's costs to distribute A Bug's Life on home video in the United States, and a portion of the distribution costs to distribute A Bug's Life on home video in foreign markets. Pixar believes that A Bug's Life faced a high number of competing films released during the 1998 holiday season, such as, Antz, The Rugrats Movie and Prince of Egypt, and that the related home video and/or merchandise sales from these films have adversely impacted and may continue to impact sales of A Bug's Life products. The majority of revenues Pixar expects to receive from A Bug's Life have already been reported in 1999, including revenues from the worldwide theatrical release of A Bug's Life, and the majority of domestic home video revenues, a portion of foreign home video revenues, and related merchandise revenues. Sources of revenues in 2000 primarily include remaining foreign home video sales, any remaining domestic home video sales, possibly some television revenues, and any future merchandise royalties, all of which must be substantial in order for the film to generate significant revenues in 2000. Moreover, potential future revenues will be offset by future distribution costs, which primarily include marketing costs for the foreign home video release, video cost of goods, remaining distribution costs for the international theatrical release of A Bug's Life, Disney's distribution fee based on film-related revenues, and other distribution costs such as residuals. Difficulty in Forecasting Toy Story 2 and A Bug's Life Revenues It is difficult to forecast the amount and timing of our future revenues from Toy Story 2 and A Bug's Life in 2000. The amount of future revenues depends not only on customer acceptance of the film in its worldwide theatrical release, but also on customer acceptance of related products in each separate release category - home video, merchandise and television being the most significant. While customer acceptance is initially measured by box office success, customer acceptance within each follow-on product category, such as home video, toys or television, depends on factors unique to each type of product, such as pricing, competitive products, and the time of year or state of the economy in which a product is released, among many other factors. In addition, we have found that the degree of customer acceptance varies widely among foreign countries. While box office success is often a good indicator of general customer acceptance, the relative success of follow-on products is not always directly correlated, and the degree of correlation is difficult to predict. Disney's strategic distribution decisions also impact the amount of our future revenues. For example, in the first half of 1999, Disney reported general softness in its domestic home video sales and worldwide merchandise licensing as compared to levels associated with many of its previous blockbuster animated feature films. As a result, Disney recently implemented a new strategy of releasing animated films on home video year-round, and in special editions in both VHS and DVD formats. However, the relative success of that new strategy is not yet known. For this reason and all of the above reasons, while Toy Story 2 has been a remarkable box office success, it is difficult to predict how successful its home video release will be in 2000 or how successful sales of other follow-on products will be in 2000. Similarly, it is difficult to predict video sales of A Bug's Life in 2000. F-7 8 With respect to the difficulty of forecasting the timing of revenues, Disney distributes our films and film-related products and therefore determines the timing of product releases. While the timing of theatrical releases is typically known well in advance of release, the timing of release of follow-on products is often decided just in advance of release, is subject to change, and is therefore less predictable. For example, it was not until the first quarter of fiscal year 2000 that it was determined that the Toy Story 2 home video would be released in the fall of 2000. In all product categories, timing of revenues is particularly uncertain with respect to releases in foreign markets as a foreign product release is often marked by a rollout across many countries over the course of many months. Therefore, the timing of international revenues is inherently more difficult to predict than the timing of domestic revenues. Lastly, the amount of revenue recognized in any given quarter or quarters from all of our films depends on the timing, accuracy, and sufficiency of the information we receive from Disney to determine revenues and associated costs. Due to these factors, the amount and timing of our future revenues from Toy Story 2 and A Bug's Life are difficult to forecast, and it is possible, in any given quarter or quarters in 2000 that Pixar will not recognize sufficient film revenue to generate significant earnings. Risks Associated with Toy Story 2 and A Bug's Life Under the Co-Production Agreement, Pixar and Disney share the production costs of Toy Story 2 and A Bug's Life. We initially capitalized our share of these costs as film production costs, under Statement of Financial Accounting Standards ("SFAS") No. 53, Financial Reporting by Producers and Distributors of Motion Picture Films. Pixar's policy is to amortize these costs over the expected revenue streams as we recognize revenues from the associated films. The amount of film costs that will be amortized each quarter will depend on how much future revenue Pixar expects to receive from Toy Story 2 and A Bug's Life. Although Toy Story 2 has achieved substantial domestic and foreign box office success, we believe that the amount spent by Disney for marketing and distribution has been and will continue to be significant. It is possible that total revenue generated in all markets by Toy Story 2 may not generate significant revenue and operating results for us in any given quarter in 2000, even though Toy Story 2 is critically acclaimed and has achieved worldwide box office success. With respect to A Bug's Life, it is difficult to predict how much additional revenue will be derived from home video and merchandise sales and from television airings. In any given quarter, if Pixar's forecast changes with respect to total revenue from Toy Story 2 or A Bug's Life, and becomes lower than was previously forecasted, Pixar would be required to accelerate amortization of related film costs, resulting in lower gross margins. Such lower gross margins would adversely impact Pixar's business, operating results, and financial condition. See Note 4 of Notes to Financial Statements. Toy Story Revenue Pixar has already recognized the majority of the revenue it expects to receive from Toy Story. Disney re-released the original Toy Story home video in January 2000. Other than potential revenue from any additional worldwide television airings, the re-release of the home video, any additional merchandise sales, and other minor amounts of revenue in subsequent periods, we do not expect to recognize further significant revenue from Toy Story. Based on terms of the Feature Film Agreement, film revenue from Toy Story is now received from Disney on a semi-annual basis (March and September). Software Revenue Pixar continues to reduce its emphasis on the commercialization of software products. Pixar is not increasing the time and resources necessary to generate higher RenderMan licensing revenues; therefore, Pixar expects that revenue from the licensing of RenderMan will remain flat or possibly decline. In addition, from the acquisition date of Physical Effects, Inc. ("PEI") in June 1998, through January 1, 2000, Pixar had received lower license revenue than expected related to the purchased technology associated with the acquisition. If future license revenue continues to be lower than originally estimated, Pixar may be required to write-off all or a significant portion of the unamortized purchased technology. CD-ROM Revenue In March 1997 we discontinued our business of producing CD-ROM products in favor of other opportunities arising, in part, as a result of entering into the Co-Production Agreement. It is unlikely that we will recognize any further significant royalty income from these products or from this discontinued operation in 2000 or thereafter. F-8 9 We Expect Our Operating Results to Continue to Fluctuate Fluctuations in Revenue We continue to expect significant fluctuations in our future annual and quarterly revenues because of a variety of factors, including the following: - the timing of the domestic and international releases of our animated feature films, - the success of our animated feature films (which can fluctuate significantly from film to film), - the timing of the release of related products into their respective markets (such as home videos, television, and merchandising), - the demand for such related products (which is often a function of the success of the related animated feature film), - Disney's costs to distribute and promote the feature films and related products, - Disney's success at marketing the films and related products, - the timing and accuracy of information received from Disney and other sources on which we base estimates of revenue to be recognized from our animated feature films and related products by Disney, - the introduction of new feature films or products by our competitors, and - general economic conditions. In particular, since our revenue under the Co-Production Agreement is directly related to the success of a feature film, our operating results are likely to fluctuate depending on the level of success of our animated feature films and related products. The revenues derived from the production and distribution of an animated feature film depend primarily on the film's acceptance by the public, which cannot be predicted and does not necessarily bear a direct correlation to the production or distribution costs incurred. The commercial success of a motion picture also depends upon promotion and marketing, production costs and other factors. Further, the theatrical success of a feature film can be a significant factor in determining the amount of revenues generated from the sale of the related products. Fluctuations in Operating Expenses Increase in Our Operating Expenses and Effective Tax Rate Over the last few years, we significantly increased our operating expenses, and we plan to continue to increase our operating expenses to fund greater levels of research and development and to expand operations. Specifically, we expect our spending levels to increase significantly due to (1) continued investment in proprietary software systems, (2) increased compensation costs as a result of intense competition for animators, creative personnel, technical directors and other personnel, (3) increased costs associated with the expansion of our facilities, and (4) increased investment in creative development. A portion of our operating expenses that are allocable to film productions is either capitalized by us or reimbursed by Disney under the Co-Production Agreement. To the extent that we do not capitalize (or Disney does not pay for) the increases in expenses, our operating expenses will significantly increase in 2000. Finally, our annual tax rate increased in 1999 and is likely to increase in future years because we have utilized our remaining net operating loss carryforwards except those which originated as non-qualified employee stock option costs. The realization of tax benefits from non-qualified employee stock option costs will not reduce our effective tax rate in the future. Difficulty in Predicting Operating Expenses Moreover, our operating expenses will continue to be extremely difficult to forecast. We budget the direct costs of film productions with Disney, and we share such costs equally. We capitalize our share of these direct costs of film production in accordance with SFAS No. 53. A substantial portion of all of our other costs are incurred for the benefit of feature films ("Overhead"), including research and development expenses and general and administrative expenses. Portions of our Overhead are included in the budgets for the Pictures, and we will share such costs equally with Disney under the Co-Production Agreement. With respect to the portion of our Overhead that is not reimbursed by Disney, we either (1) capitalize such portion as film production costs, if required under SFAS No. 53, or (2) charge it to operating expense in the period incurred. Since a substantial portion of our Overhead is related to the Pictures, and is therefore reimbursed by Disney, and since we capitalize other amounts in accordance with F-9 10 SFAS No. 53, our reported operating expenses for 1999 have not reflected, and future reported operating expenses will not reflect, our true level of spending on the production of animated feature films, related products and overhead. Risks Associated with Adequacy of Cash Balances Pursuant to the Co-Production Agreement, we co-financed A Bug's Life and Toy Story 2 and will co-finance the next four original animated feature films which we produce, including Monsters, Inc. and Film Five. In the future, we may co-finance other derivative works such as sequels, interactive products and television productions. In addition, we are constructing new studio and headquarter facilities in Emeryville, California, which is being financed by the use of our cash and may continue to be financed by the use of our cash. The development and production costs of Monsters, Inc., Film Five and costs of the new Emeryville facility may have an adverse impact on our cash and short-term investment balances. As of January 1, 2000, we had approximately $194.9 million in cash and short-term investments. We believe that these funds will be sufficient to meet our anticipated cash needs for working capital and capital expenditures, including the development and production costs of Monsters, Inc. and Film Five, until we begin receiving cash from the release of Toy Story 2 and any remaining proceeds from A Bug's Life. See "--Liquidity and Capital Resources." To date, we have chosen to use our existing cash resources to fund construction costs and film production costs. We may continue to use our cash resources for such expenditures, or may choose to finance such capital expenditures through issuance of additional equity or debt securities, by obtaining a credit facility or by some other financing mechanism. The sale of additional equity or convertible debt securities would result in additional dilution to our shareholders. Moreover, we cannot provide any assurances that we will be successful in obtaining future financing, or even if such financing is available, that we will obtain it on favorable terms or on terms providing us with sufficient funds to meet our obligations and objectives. If we fail to obtain such financing, it would have a material adverse effect on our business, operating results and financial condition. LIQUIDITY AND CAPITAL RESOURCES Cash and short-term investments increased from $149.0 million at January 2, 1999 to $194.9 million at January 1, 2000 due primarily to our share of A Bug's Life film revenue, offset by film production spending and construction spending on our new studio and headquarter facilities in Emeryville, California. Cash provided by operating activities in 1997 largely consisted of net income of $22.2 million primarily resulting from film revenue related to Toy Story, as well a tax benefit from stock option exercises. In 1998, cash provided by operating activities largely consisted of net income of $7.8 million, primarily resulting from film revenue related to Toy Story. In 1999, cash provided by operating activities was primarily attributable to net income of $49.2 million primarily resulting from film revenue related to A Bug's Life, the non-cash impact of deferred income taxes of $19.6 million, and the non-cash impact of depreciation and amortization expense, and amortization of capitalized film production costs, totaling $36.5 million. In 1997, 1998 and 1999, cash used in investing activities primarily consisted of investments in short-term securities, capitalized film production costs and purchase of property and equipment, as described below, offset by net proceeds from maturities of short-term investments. In 1997, cash flows provided by financing activities primarily consisted of the net proceeds of approximately $14.9 million from sale of stock to Disney in conjunction with the signing of the Co-Production Agreement. See Note 4 and Note 6 of Notes to Financial Statements. In 1998 and 1999, cash provided by financing activities primarily consisted of proceeds from exercised stock options. At January 1, 2000, our capital commitments primarily consisted of obligations to fund production costs of films and derivative products under the Co-Production Agreement and costs related to our new studio and headquarter facilities, both discussed below. We also have obligations to pay portions of any revenue derived from each feature film produced under the Co-Production Agreement to our entertainment law firm in consideration for services rendered and we have obligations under operating leases. See Note 9 of Notes to Financial Statements. We expect 2000 cash expenditures for capital equipment to be approximately $11 million, excluding costs related to our new studio and headquarter facilities discussed below. Film Production Costs Under Co-Production Agreement. In fiscal 2000, we expect to spend approximately $41.0 million, net of Disney's film cost reimbursements, on direct film costs and other costs to fund our ongoing film projects under the Co-Production Agreement, which will directly impact working capital. New Studio and Headquarter Facilities. As of January 1, 2000, we had incurred capital expenditures of approximately $54.2 million to purchase and begin construction of approximately 15 acres of land in Emeryville, California to build a new studio and headquarters facility. To complete construction of the facility, we currently expect to incur capital expenditures of approximately $34.2 million in 2000. In addition, we expect to spend approximately $5.9 million in 2000 on related furniture, fixtures and F-10 11 equipment for the new facility. Due to changes in construction, design and/or other specifications, which may or may not be at the discretion of management and are often difficult to predict, we cannot provide any assurances that construction of the new studio facility can be completed within these specified amounts. On March 16, 2000, Pixar purchased an existing building on 1.76 acres in Emeryville for $7.6 million. While it was purchased for potential future expansion, the building will serve as a rental property, is occupied by commercial tenants and is expected to generate rental income. As of January 1, 2000, our principal source of liquidity was approximately $194.9 million in cash and short-term investments. Pursuant to the Co-Production Agreement, we will co-finance the next four original animated feature films, which we produce, including Monsters, Inc. and Film Five. In the future, we may co-finance other derivative works such as theatrical sequels, direct to home video sequels, interactive products and television productions. As we may not generate substantial cash from operations in the first half of 2000, the production costs of Monsters, Inc., Film Five and the construction spending for the new Emeryville studio and headquarter facilities may have an adverse impact on our cash and short-term investment balances. We believe that available funds will be sufficient to meet our anticipated cash needs for working capital and capital expenditures, including the production costs of Monsters, Inc. and Film Five until we begin receiving cash from the release of Toy Story 2. To date, we have chosen to use our existing cash resources to fund both facility construction costs and film production costs. We may continue to use our cash resources for such expenditures, or may choose to finance such capital expenditures through issuance of additional equity or debt securities, by obtaining a credit facility or by some other financing mechanism. THE YEAR 2000 ISSUES As a result of our planning, testing and implementation efforts to date, we have experienced no significant disruptions in our film development and production efforts or our internal computer systems,and we believe those systems successfully respond to the year 2000 date change. We are not aware of any system failures of third party systems that we rely on. The total cost incurred to date to evaluate and remediate Year 2000 compliance issues have not been material and any future costs to remediate any Year 2000 compliance issues are not anticipated to be material to our consolidated results of operations, financial position or cash flows. RECENT ACCOUNTING PRONOUNCEMENTS The Financial Accounting Standards Board issued Statement of Financial Accounting Standards ("SFAS") No. 133 in June 1998, Accounting for Derivatives and Hedging Activities, effective for fiscal years beginning after June 15, 2000 and cannot be applied retroactively. The standard requires that an entity recognizes all derivatives as either assets or liabilities in the balance sheet and measures those instruments at fair value. We believe the adoption of SFAS No. 133 will not have a material effect on our consolidated results of operations, financial position or cash flows. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We invests in a variety of investment grade, interest-bearing securities, including fixed rate obligations of corporations, municipalities, and national governmental entities and agencies. This diversification of risk is consistent with our policy to ensure safety of our principal and maintain liquidity. We only invest in securities with a maturity of 24 months or less, with only government obligations exceeding 12 months. Our investments are fixed rate obligations and carry a certain degree of interest rate risk. A rise in interest rates could adversely impact the fair market value of these securities. All of our financial instruments are held for purposes other than trading and are considered "available for sale" per SFAS 115. The table below provides information regarding our investment portfolio at January 1, 2000. The table presents principal cash flows and related weighted-average fixed interest rates presented by expected maturity date (dollars in thousands):
FISCAL YEAR ---------------------------------------- 2000 2001 TOTAL ------------- ------------ ----------- Available-for-sale securities......... $ 156,025 $ 33,283 $ 189,308 Weighted-average interest rate........ 5.61% 5.25% 5.55%
While our products are distributed in foreign markets by Disney and its affiliates, we derive no direct revenues from foreign markets. We also have no debt. As a result, our foreign currency rate fluctuation and market rate risks are negligible. F-11 12 INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders, Pixar: We have audited the accompanying balance sheets of Pixar as of January 2, 1999 and January 1, 2000 and the related statements of operations, shareholders' equity, and cash flows for each of the years in the three-year period ended January 1, 2000. These financial statements are the responsibility of Pixar's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Pixar as of January 2, 1999 and January 1, 2000, and the results of its operation and its cash flows for each of the years in the three-year period ended January 1, 2000, in conformity with generally accepted accounting principles. /s/ KPMG LLP San Francisco, California February 2, 2000 F-12 13 PIXAR BALANCE SHEETS (In thousands, except share data)
JANUARY 2, JANUARY 1, 1999 2000 ---------- ---------- ASSETS Cash and cash equivalents..................................................... $ 29,557 $ 31,170 Short-term investments........................................................ 119,491 163,779 Trade accounts receivable, net of allowance for returns and doubtful accounts of $229 and $224 as of 1998 and 1999, respectively................................................................ 595 714 Other receivables............................................................. 3,290 16,026 Prepaid expenses and other assets............................................. 4,884 3,888 Deferred income taxes......................................................... 988 34,533 Property and equipment, net................................................... 31,160 60,266 Capitalized film production costs............................................. 60,841 64,529 ---------- ---------- Total assets........................................................ $ 250,806 $ 374,905 ========== ========== LIABILITIES AND SHAREHOLDERS' EQUITY Accounts payable.............................................................. $ 2,615 $ 458 Income taxes payable.......................................................... 97 12,230 Payable to Disney............................................................. 3,363 -- Accrued liabilities........................................................... 8,396 16,475 Unearned revenue.............................................................. 1,188 1,299 ---------- ---------- Total liabilities................................................... 15,659 30,462 ---------- ---------- Shareholders' equity: Preferred stock, no par value; 5,000,000 shares authorized and no shares issued and outstanding........................................ -- -- Common stock, no par value; 100,000,000 shares authorized; 45,335,770 and 46,959,093 shares issued and outstanding as of January 2, 1999 and January 1, 2000, respectively........................ 220,397 281,274 Accumulated other comprehensive income (loss)................................. 249 (660) Deferred compensation......................................................... (104) -- Retained earnings............................................................. 14,605 63,829 ---------- ---------- Total shareholders' equity.......................................... 235,147 344,443 ---------- ---------- Total liabilities and shareholders' equity.......................... $ 250,806 $ 374,905 ========== ==========
See accompanying notes to financial statements. F-13 14 PIXAR STATEMENTS OF OPERATIONS (In thousands, except per share data)
YEARS ENDED ----------------------------------------- DECEMBER 31, JANUARY 2, JANUARY 1, 1997 1999 2000 ------------ ------------ ------------ Revenue: Software ........................................................................ $ 4,499 $ 3,798 $ 5,746 Animation services .............................................................. 1,556 630 873 Film ............................................................................ 26,914 9,759 114,418 Patent licensing ................................................................ 1,730 120 -- ------------ ------------ ------------ Total revenue ........................................................... 34,699 14,307 121,037 ------------ ------------ ------------ Cost of revenue: Software ........................................................................ 81 723 689 Animation services .............................................................. 973 141 513 Film ............................................................................ 1,484 -- 30,503 ------------ ------------ ------------ Total cost of revenue ................................................... 2,538 864 31,705 ------------ ------------ ------------ Gross profit ............................................................ 32,161 13,443 89,332 ------------ ------------ ------------ Operating expenses: Research and development ........................................................ 4,712 3,862 6,281 Sales and marketing ............................................................. 1,450 1,301 1,501 General and administrative ...................................................... 5,129 6,956 7,016 Operating expense reimbursement ................................................. (2,184) -- -- ------------ ------------ ------------ Total operating expenses ................................................ 9,107 12,119 14,798 ------------ ------------ ------------ Income from continuing operations ....................................... 23,054 1,324 74,534 Other income, net ................................................................. 8,766 8,777 7,469 ------------ ------------ ------------ Income from continuing operations before taxes .......................... 31,820 10,101 82,003 Income tax expense ................................................................ 9,864 2,637 32,901 ------------ ------------ ------------ Net income from continuing operations ................................... 21,956 7,464 49,102 Income from discontinued operations (includes income tax expense of $105, $127 and $62 in 1997, 1998 and 1999, respectively) ............................................................ 234 358 122 ------------ ------------ ------------ Net income .............................................................. $ 22,190 $ 7,822 $ 49,224 ============ ============ ============ Basic net income per share from continuing operations ............................. $ 0.53 $ 0.17 $ 1.06 Basic net income per share from discontinued operations ........................... 0.01 0.01 0.01 ------------ ------------ ------------ Basic net income per share ........................................................ $ 0.54 $ 0.18 $ 1.07 ============ ============ ============ Shares used in computing basic net income per share ............................... 41,224 44,185 46,148 ============ ============ ============ Diluted net income per share from continuing operations ........................... $ 0.46 $ 0.14 $ 0.99 Diluted net income per share from discontinued operations ......................... 0.00 0.01 0.00 ------------ ------------ ------------ Diluted net income per share ...................................................... $ 0.46 $ 0.15 $ 0.99 ============ ============ ============ Shares used in computing diluted net income per share ............................. 48,144 51,338 49,810 ============ ============ ============
See accompanying notes to financial statements. F-14 15 PIXAR STATEMENTS OF SHAREHOLDERS' EQUITY (In thousands)
ACCUMULATED RETAINED COMMON STOCK OTHER EARNINGS TOTAL ----------------- COMPREHENSIVE DEFERRED (ACCUMULATED SHAREHOLDERS' COMPREHENSIVE SHARES AMOUNT INCOME COMPENSATION DEFICIT) EQUITY INCOME ------ -------- --------------- ------------ ------------ ------------ ------------ Balances, December 31, 1996 .... 39,413 $187,308 $ (48) $(1,049) $(15,407) $170,804 Exercise of stock options, including tax benefit ........ 1,998 8,709 -- -- -- 8,709 Issuance of common stock and warrants, net of expenses of $115 ...................... 1,000 14,885 -- -- -- 14,885 Amortization of deferred compensation .................. -- -- -- 635 -- 635 Other comprehensive income: Holding gains on securities arising during the period .. -- -- 236 -- -- 236 Less: reclassification adjustment for gains included in income ......... -- -- (230) -- -- (230) Tax expense ................ -- -- 71 -- -- 71 ------ --------- ------ ------- ------- -------- Unrealized gain on investments ................... -- -- 77 -- -- 77 $ 77 Net income ..................... -- -- -- -- 22,190 22,190 22,190 ------ -------- ------ ------- ------- -------- -------- Balances, December 31, 1997 .... 42,411 210,902 29 (414) 6,783 $217,300 $ 22,267 Exercise of stock options, including tax benefit ........ 2,865 6,895 -- -- -- 6,895 Amortization of deferred compensation ................. -- -- -- 310 -- 310 Acquisition of PEI ............. 60 2,600 -- -- -- 2,600 Other comprehensive income: Holding gains on securities arising during the period .. -- -- 222 -- -- 222 Less: reclassification adjustment for gains included in income ......... -- -- (3) -- -- (3) Tax expense ................ -- -- 1 -- -- 1 ------ -------- ------ ------- ------- ------- Unrealized gain on investments .................. -- -- 220 -- -- 220 $ 220 Net income ..................... -- -- -- -- 7,822 7,822 7,822 ------ -------- ------ ------- ------- -------- -------- Balances, January 2, 1999 ...... 45,336 220,397 249 (104) 14,605 235,147 $ 8,042 Exercise of stock options, including tax benefit ........ 1,623 60,877 -- -- -- 60,877 Amortization of deferred compensation ................. -- -- -- 104 -- 104 Other comprehensive income: Holding loss on securities arising during the period .. -- -- (874) -- -- Less: reclassification (874) adjustment for gains included in income ......... -- -- (59) -- -- (59) Tax expense ................ -- -- 24 -- -- 24 ------ -------- ------ ------- ------- -------- Unrealized loss on investments .................. -- -- (909) -- -- (909) $ (909) Net income ..................... -- -- -- -- 49,224 49,224 49,224 ------ -------- ------ ------- ------- -------- ------- Balances, January 1, 2000 ...... 46,959 $281,274 $(660) $ -- $63,829 $344,443 $48,315 ====== ======== ====== ======= ======= ======== =======
See accompanying notes to financial statements. F-15 16 PIXAR STATEMENTS OF CASH FLOWS (In thousands)
YEARS ENDED ------------------------------------------------ DECEMBER 31, JANUARY 2, JANUARY 1, 1997 1999 2000 ------------ ------------ ------------ Cash flows from operating activities: Net income ....................................................... $ 22,190 $ 7,822 $ 49,224 Adjustments to reconcile net income to net cash provided by operating activities: Discontinued operations ........................................ (234) (358) (122) Amortization of deferred compensation, net of capitalization ... 611 310 104 Amortization of purchased technology ........................... -- 630 630 Depreciation and amortization .................................. 3,182 5,826 6,046 Amortization of capitalized film production costs .............. 1,484 -- 30,503 Licenses exchanged for equipment ............................... (1,594) (114) -- Loss on disposition of property and equipment .................. 718 311 706 Cash benefit from option exercises ............................. 7,688 3,636 53,150 Deferred income taxes .......................................... -- (988) (33,545) Changes in operating assets and liabilities: Trade accounts receivable .................................... (392) 726 (119) Other receivables ............................................ 732 (623) (12,736) Prepaid expenses and other assets ............................ 143 (1,491) 366 Accounts payable ............................................. 634 921 (2,157) Other liabilities ............................................ 4,698 2,221 4,716 Income taxes payable ......................................... 1,776 (1,679) 12,133 Unearned revenue ............................................. 584 103 111 ------------ ------------ ------------ Net cash provided by continuing operations ................ 42,220 17,253 109,010 Net cash provided by discontinued operations .............. 1,701 358 122 ------------ ------------ ------------ Net cash provided by operating activities ................. 43,921 17,611 109,132 ------------ ------------ ------------ Cash flows from investing activities: Purchase of property and equipment ............................... (17,761) (16,576) (38,060) Proceeds from sale of property and equipment ..................... 31 741 2,172 Proceeds from sale of short-term securities ...................... 169,210 150,381 140,701 Investments in short-term securities ............................. (127,010) (195,454) (185,898) Capitalized film production costs ................................ (27,098) (32,252) (34,161) ------------ ------------ ------------ Net cash used in investing activities ..................... (2,628) (93,160) (115,246) ------------ ------------ ------------ Cash flows from financing activities: Net proceeds from issuance of common stock and warrants .......... 14,885 -- -- Proceeds from exercised stock options ............................ 1,021 3,259 7,727 ------------ ------------ ------------ Net cash provided by financing activities ................. 15,906 3,259 7,727 ------------ ------------ ------------ Net increase (decrease) in cash and cash equivalents ............... 57,199 (72,290) 1,613 Cash and cash equivalents at beginning of period ................... 44,648 101,847 29,557 ------------ ------------ ------------ Cash and cash equivalents at end of period ......................... $ 101,847 $ 29,557 $ 31,170 ============ ============ ============ Supplemental disclosure of cash flow information: Cash paid during the period for income taxes .............. $ 390 $ 1,796 $ 1,900 ============ ============ ============ Supplemental disclosure of non-cash investing and financing activities: Credits used to purchase equipment ........................ $ 1,730 $ 120 $ -- ============ ============ ============ Value of common stock and liabilities assumed for purchase of PEI ......................................... $ -- $ 3,000 $ -- ============ ============ ============ Non-cash film production costs capitalized ................ $ 24 $ -- $ -- ============ ============ ============ Unrealized gain (loss) on investments ..................... $ 77 $ 220 $ (909) ============ ============ ============
See accompanying notes to financial statements. F-16 17 PIXAR NOTES TO FINANCIAL STATEMENTS (1) SUMMARY OF PIXAR AND SIGNIFICANT ACCOUNTING POLICIES The Company Pixar was incorporated in the state of California on December 9, 1985. Pixar is a digital animation studio with the technical, creative and production capabilities to create a new generation of animated feature films and related products. Cash and Cash Equivalents We consider all highly liquid instruments with an original maturity of 90 days or less to be cash equivalents. Cash equivalents as of January 1, 2000 consisted primarily of U.S. Treasury Bills, demand notes, commercial paper and government agency bonds. Short-Term Investments Our investments are classified as "available-for-sale." Such investments are recorded at fair value, and unrealized gains and losses, if material, are reported as a separate component of equity until realized. Interest income is recorded using an effective interest rate with the associated premium or discount amortized to interest income. The cost of securities sold is based upon the specific identification method. Property and Equipment Property and equipment are stated at cost. Depreciation of property and equipment is calculated using the straight-line method over estimated useful lives ranging from two to seven years. Leasehold improvements are amortized over the lesser of the related lease term or the life of the improvement. We evaluate these assets for impairment whenever changes in circumstances indicate that the carrying amount of the asset may not be recoverable. Impaired assets and assets to be disposed of are reported at the lower of carrying values or fair values, less costs of disposal. Film Production Costs Film production costs include costs to develop and produce computer animated motion pictures, mainly salaries, equipment and overhead. Film production costs in excess of reimbursable amounts are capitalized. Once a film is released, any film production costs capitalized will be amortized in the proportion that the revenue during the year for each film bears to the estimated revenue to be received from all sources under the individual film forecast method. Estimates of anticipated total gross revenues will be reviewed periodically and revised when necessary. Unamortized film production costs will be compared with net realizable value each reporting period on a film-by-film basis. If estimated gross revenues are not sufficient to recover the unamortized film production costs, the unamortized film production costs will be written down to net realizable value. Research and Development Costs Research and development costs are charged to operations as incurred. In accordance with Statement of Financial Accounting Standards (SFAS) No. 86, Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed, development costs related to software products are expensed as incurred until the technological feasibility of the product has been established. After technological feasibility is established, additional F-17 18 costs would be capitalized. To date, we have not capitalized any software development costs after technological feasibility has been established on our software products since we believe our process for developing software is essentially completed concurrently with the establishment of technological feasibility and costs incurred thereafter have not been material. Revenue Recognition Revenue from the distribution of animated feature films and related products is recognized as earned and reasonably estimable. The related revenue cycle is generally five to seven years, with the substantial majority expected to be recognized in the first two years. In accordance with SOP 97-2, software license revenue is recognized upon shipment. Animation services revenue is recognized on the percentage-of-completion method of accounting. Patent licensing revenue is recognized upon release of the rights to the technology. Financial Instruments and Concentration of Credit Risk The carrying value of financial instruments, including marketable securities and accounts receivable, approximate fair value. Financial instruments that potentially subject us to concentrations of credit risk consist primarily of cash equivalents, short-term investments and trade accounts receivable. We invest our excess cash in a variety of investment grade, interest-bearing securities with major banks. This diversification of risk is consistent with our policy to ensure safety of principal and maintain liquidity. Excluding our software business, our revenue is concentrated in one large customer, Disney, as outlined in Note 10. We maintain reserves for potential credit losses and such losses have been within management's expectations. Fiscal Year Effective for the fiscal year 1998, we adopted a 52 or 53-week fiscal year, changing the year end date from December 31 to the Saturday nearest December 31. The 1999 fiscal year ended January 1, 2000 and consisted of 52 weeks. Accounting Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Income Taxes We utilize SFAS No. 109, Accounting for Income Taxes, which requires the use of the asset and liability method of accounting for income taxes. Net Income per Share In accordance with SFAS No. 128, Earnings per Share, basic net income per share is computed using the weighted-average number of common shares outstanding during the period. Diluted net income per share is computed using the weighted average number of common and dilutive common equivalent shares outstanding during the period and using the treasury stock method for options and warrants (see Note 11). F-18 19 Segment Reporting During the fourth quarter of 1998, we adopted SFAS 131, Disclosures about Segments of an Enterprise and Related Information. SFAS 131 establishes annual and interim reporting standards for operating segments of a company (see Note 10). Comprehensive Income On January 1, 1998, we adopted SFAS 130, Reporting Comprehensive Income, which requires classification of other comprehensive income by nature in a financial statement and a breakout of the accumulated balance of other comprehensive income separately in the equity section of the balance sheet. Reclassifications Certain amounts reported in previous years have been reclassified to conform to the 1999 financial statement presentation. Stock Option Plans We use the intrinsic value-based method to account for all of our employee stock-based compensation plans. (2) SHORT-TERM INVESTMENTS All investments were considered available-for-sale securities and consisted of the following (in thousands):
UNREALIZED ESTIMATED COST GAINS (LOSSES) FAIR VALUE ---------- -------------- ---------- JANUARY 2, 1999: U.S. Treasury Bills.................... $ 9,233 $ 45 $ 9,278 U.S. Treasury Notes.................... 59,917 122 60,039 Demand notes........................... 2,585 -- 2,585 Commercial paper....................... 28,385 (1) 28,384 Federal agency obligations............. 40,579 83 40,662 ---------- ------ ---------- $ 140,699 $ 249 $ 140,948 ========== ====== ========== JANUARY 1, 2000: U.S. Treasury Bills.................... $ 9,882 $ (4) $ 9,878 U.S. Treasury Notes.................... 66,024 (512) 65,512 Demand notes........................... 8,204 -- 8,204 Commercial paper....................... 82,605 (10) 82,595 Federal agency obligations............. 23,253 (134) 23,119 ---------- ------- ---------- $ 189,968 $ (660) $ 189,308 ========== ======= ==========
The contractual maturities of available-for-sale debt securities as of January 1, 2000 regardless of their balance sheet classification, are as follows (in thousands):
ESTIMATED COST FAIR VALUE ----------- ---------- Due within one year................... $ 156,260 $ 156,025 Due after one year through two years.. 33,708 33,283 ----------- ---------- $ 189,968 $ 189,308 =========== ==========
As of January 2, 1999 and January 1, 2000, short-term investments include $21,457,000 and $25,529,000, respectively, of investments classified as cash equivalents. F-19 20 (3) BALANCE SHEET COMPONENTS Selected balance sheet components are as follows (in thousands):
JANUARY 2, JANUARY 1, 1999 2000 --------- --------- Property and equipment: Land................................................... $ 7,355 $ 7,498 Equipment.............................................. 14,890 14,878 Leasehold improvements................................. 3,108 3,338 Construction in process................................ 15,070 47,115 --------- --------- 40,423 72,829 Less accumulated depreciation and amortization........... 9,263 12,563 --------- --------- $ 31,160 $ 60,266 ========= ========= Accrued liabilities: Employee-related expenses.............................. $ 3,720 $ 10,835 Professional services.................................. 1,431 1,788 Facilities construction in process..................... 2,232 2,919 Other.................................................. 1,013 933 --------- --------- $ 8,396 $ 16,475 ========= =========
(4) FEATURE FILM AND CO-PRODUCTION AGREEMENTS Feature Film Agreement In 1991, we entered into a feature film agreement with Walt Disney Pictures, a wholly owned subsidiary of Walt Disney Pictures and Television (together with its subsidiaries and affiliates collectively referred to herein as "Disney"), to develop and produce up to three computer-animated feature films (the "Feature Film Agreement"). We are entitled to receive compensation based on revenue from the distribution of these films and related products. In 1995, we released our first feature film under the terms of the Feature Film Agreement, Toy Story. Based on the individual film forecast method, all significant Toy Story film production costs were fully amortized by the year ended December 31, 1997. Co-Production Agreement In February 1997, Pixar and Disney entered into a new co-production agreement (the "Co-Production Agreement") which now governs all films made by us since Toy Story. Under the Co-Production Agreement, we, on an exclusive basis, agreed to produce five original computer-animated theatrical motion pictures (the "Pictures") for distribution by Disney. A Bug's Life, released in 1998, and Toy Story 2, released in November 1999, were the first films produced under this agreement. Films in development or production at Pixar as of January 1, 2000, all governed by this agreement, include our fourth film (with the working title "Monsters, Inc.") and our fifth film (Film Five). A Bug's Life, Monsters, Inc. and Film Five count toward the five original Pictures, whereas Toy Story 2, as a sequel, is a derivative work that will not count toward the Pictures. However, under the Co-Production Agreement, all provisions applicable to the Pictures also apply to derivative works such as Toy Story 2. Pixar and Disney co-own, co-brand and co-finance the production costs of the Pictures, and share equally in the profits of each Picture and any related merchandise and other ancillary products, after recovery of all of Disney's marketing, distribution and other predefined fees and costs. The Co-Production Agreement generally provides that we will produce each Picture and Disney will control decisions relating to film marketing and distribution. F-20 21 The total film production costs and related amounts capitalized are as follows (in thousands):
1997 AND TOTAL THROUGH PRIOR 1998 1999 1999 -------- --------- --------- ------------- RELEASED FILMS: Pixar production costs............................................. $ 27,175 $ 28,840 $ 26,470 $ 82,485 Disney production funding and reimbursement (unaudited)............ 54,897 28,840 26,470 110,207 -------- --------- --------- ---------- Total film production costs (unaudited)...................... $ 82,072 $ 57,680 $ 52,940 192,692 ======== ========= ========= Disney reimbursements of production costs (unaudited).............. (107,882) Amortization of deferred compensation.............................. 360 Participation fees 850 Amortization of film production costs.............................. (33,538) ---------- Total film production costs capitalized for released films.... 52,482 ---------- FILMS IN PROCESS: Pixar production costs............................................. $ 1,163 $ 3,414 $ 7,470 12,047 Disney production funding and reimbursement (unaudited)............ 1,163 3,414 7,470 12,047 -------- --------- --------- ---------- Total film production costs (unaudited)....................... $ 2,326 $ 6,828 $ 14,940 24,094 ======== ========= ========= Disney reimbursements of production costs (unaudited).............. (12,047) ---------- Total film production costs capitalized for films in process.. 12,047 ---------- Total film production costs capitalized....................... $ 64,529 ==========
Under the Co-Production Agreement, certain operating expenses benefiting the productions, such as certain research and development and certain general and administrative expenses, are paid half by us and half by Disney. From the date of the Co-Production Agreement, we recorded the following amounts reimbursed by Disney as offsets to the following expense categories (in thousands):
FEBRUARY 24 TO FISCAL YEAR DECEMBER 31, 1997 1998 1999 ----------------- -------- -------- Research and development.............. $ 2,012 $ 2,818 $ 4,070 General and administrative............ 1,277 2,199 2,593 -------- -------- -------- Total....................... $ 3,289 $ 5,017 $ 6,663 ======== ======== ========
Since the Co-Production Agreement began with A Bug's Life and Toy Story 2, both in various stages of production in 1996 and 1997, we were entitled to reimbursement for Disney's share of certain of our operating expenses incurred in 1996 and the first two months of 1997, prior to signing the Co-Production Agreement. The determination of this $2,184,000 one-time operating expense reimbursement was finalized in the quarter ended September 30, 1997. The amount recorded represented reimbursements of the following expense categories (in thousands):
YEAR ENDED JANUARY 1 TO DECEMBER 31, 1996 FEBRUARY 24, 1997 TOTAL ----------------- ----------------- --------- Research and development.... $ 936 $ 179 $ 1,115 General and administrative.. 620 449 1,069 -------- ------ -------- $ 1,556 $ 628 $ 2,184 ======== ====== ========
At January 2, 1999 and January 1, 2000, the Disney payable of $3,363,000 and receivable of $1,793,000, respectively, consisted of advances net of Disney's actual share of expenditures for all films. The Disney receivable of $1,793,000 and a receivable from Disney for film revenue of $9.9 million, were included in other receivables on the balance sheet as of January 1, 2000. (5) PATENT LICENSING ARRANGEMENTS For the years ended December 31, 1997 and January 2, 1999, fees of $1,730,000 and $120,000, respectively, were recognized on the licensing of certain patents. In 1996, we delivered all rights to utilize the technology underlying the license to the licensee, and received a non-refundable fixed-fee payment of $6,000,000 in cash and $5,000,000 of credits for products to be purchased from the licensee by us over the next four years. Following the release of the rights to utilize the patents to the licensee, we maintained no significant vendor obligations to the F-21 22 licensee, so we recognized as revenue the fixed and determinable amounts of the cash payment received, plus the portion of the credits used. There were no credits recognized in 1999, with $23,000 remaining available for use. (6) RELATED PARTY TRANSACTIONS In conjunction with signing the Co-Production Agreement, Disney purchased for cash 1,000,000 shares of Pixar common stock, which Disney has agreed to hold for at least three years, and two warrants each exercisable for five years: one warrant to purchase 750,000 shares of common stock at an exercise price of $20.00 per share and another warrant to purchase 750,000 shares of common stock at an exercise price of $25.00 per share. We granted certain registration rights for the shares issuable upon exercise of the warrants. Upon consummation of this agreement in March 1997, we received net proceeds of $14,885,000. (7) INCOME TAXES The components of income taxes from continuing operations are as follows (in thousands):
FISCAL YEAR ----------------------------------- 1997 1998 1999 -------- -------- -------- Income taxes: Current: Federal ................................ $ 944 $ -- $ 9,523 State .................................. 1,288 2 3,740 Foreign ................................ 26 79 33 -------- -------- -------- Total current taxes ............... 2,258 81 13,296 -------- -------- -------- Deferred: Federal ................................ -- (786) (26,527) State .................................. -- (202) (7,018) -------- -------- -------- Total deferred taxes .............. -- (988) (33,545) -------- -------- -------- Charge in lieu of taxes attributable to employer stock option plans ............ 7,606 3,544 53,150 -------- -------- -------- Total tax provision ............... $ 9,864 $ 2,637 $ 32,901 ======== ======== ========
The following tabulation reconciles the statutory corporate federal income tax expense (benefit) (computed by multiplying income from continuing operations before income taxes by 35% for the years ended December 31, 1997, January 2, 1999 and January 1, 2000) to income tax expense (in thousands):
FISCAL YEAR ------------------------------------ 1997 1998 1999 -------- -------- -------- Expected income tax expense ....................... $ 11,137 $ 3,535 $ 28,701 State income taxes, net of federal tax effect ..... 1,742 421 4,757 Change in beginning of year valuation allowance ... (3,370) (1,688) (1,085) Other, net ........................................ 355 369 528 -------- -------- -------- Income taxes ...................................... $ 9,864 $ 2,637 $ 32,901 ======== ======== ========
The tax effects of temporary differences attributable to continuing operations that give rise to significant portions of the deferred tax assets are presented below (in thousands):
FISCAL YEAR ---------------------- 1998 1999 -------- -------- Deferred tax assets: Deferred compensation ...................... $ 607 $ 398 Capitalized film costs ..................... 21,879 29,866 Capitalized research expenses............... 69 119 Credit carryforwards ....................... 2,466 -- Net operating loss carryforwards ........... 10,698 -- Property and equipment ..................... (70) 1,267 Reserves and accruals ...................... 1,359 2,883 -------- -------- Total gross deferred tax assets .... 37,008 34,533 Valuation allowance .......................... (36,020) -- -------- -------- Net deferred tax assets ............ $ 988 $ 34,533 ======== ========
F-22 23 Prior to the second quarter of fiscal 1999, we believed that there was sufficient uncertainty regarding the realizability of our deferred tax assets to warrant a significant valuation allowance. From that point on, we developed sufficient confidence in the amount and timing of our anticipated participation revenues from A Bug's Life and Toy Story 2 and the amount and timing of certain offsetting tax-related expenses in the foreseeable future to project that all of these deferred tax assets will be realized, and thus a favorable adjustment for such has been recognized on our balance sheet and in our tax rate during fiscal 1999. The majority of the favorable adjustment was recorded as an adjustment to equity since it related to stock option compensation. (8) SHAREHOLDERS' EQUITY Deferred Compensation We recorded deferred compensation for the difference between the grant price and the deemed fair value of the common stock underlying certain options granted in 1995. This amount was amortized over the vesting period of the individual options, generally four years. Amortization of deferred compensation was approximately $635,000, $310,000 and $104,000 for the years ended December 31, 1997, January 2, 1999 and January 1, 2000, respectively. Of these amounts $24,000 was capitalized as film production costs in 1997. The remaining amount of $611,000 was expensed in 1997. In 1998 and 1999, the entire amounts of $310,000 and $104,000, respectively, were charged to expense. As of January 1, 2000, deferred compensation was fully amortized. Stock Option Plans We have stock option plans for employees, consultants and non-employee directors which provide incentive and nonstatutory stock options. The option exercise price for incentive stock options is not less than the fair market value at the grant date. Nonstatutory options are granted at prices and terms determined by the Board of Directors, or a committee of the Board of Directors. Employee and consultant options generally vest 25% per year over four years. Initial grants to non-employee directors, vest one-third annually for three years; subsequent grants vest after one year. All options have a term not greater than 10 years from the date of grant. As of January 1, 2000, we had 2,486,622 shares reserved and available for issuance under the plans. A summary of activity under the option plans during 1997, 1998 and 1999 are as follows:
WEIGHTED-AVERAGE SHARES EXERCISE PRICE ----------- ---------------- Outstanding at January 1, 1997............. 8,863,840 $ 2.41 Granted.................................. 1,671,700 15.52 Exercised................................ (1,997,605) 0.52 Forfeited................................ (163,317) 12.53 ----------- Outstanding at December 31, 1997........... 8,374,618 5.28 Granted.................................. 3,235,922 26.08 Exercised................................ (2,864,595) 1.14 Forfeited................................ (288,926) 13.11 ----------- Outstanding at January 2, 1999............. 8,457,019 14.38 Granted.................................. 2,130,077 34.98 Exercised................................ (1,623,323) 4.76 Forfeited................................ (207,854) 21.50 ----------- Outstanding at January 1, 2000............. 8,755,919 21.00 ===========
F-23 24 For various price ranges, weighted-average characteristics of outstanding stock options at January 1, 2000 were as follows:
OPTIONS OUTSTANDING OPTIONS VESTED --------------------------------------------- ----------------------------- REMAINING WEIGHTED-AVERAGE WEIGHTED-AVERAGE EXERCISE PRICES SHARES LIFE (YEARS) EXERCISE PRICE SHARES EXERCISE PRICE - --------------- --------- ------------ ---------------- ---------- ---------------- $0.20 1,229,621 5.35 $ 0.20 1,227,417 $ 0.20 $1.25 to $9.60 681,794 5.80 7.90 681,025 7.91 $10.80 to $15.00 1,202,325 7.02 13.45 626,901 13.17 $15.13 to $19.00 379,526 7.16 16.14 185,370 16.13 $19.13 to $25.88 2,068,881 8.00 21.43 155,846 21.61 $27.75 to $39.13 2,824,172 9.31 33.74 163,643 34.11 $39.56 to $61.50 369,600 8.93 44.22 50,950 45.70 --------- --------- 8,755,919 7.75 21.00 3,091,152 9.11 ========= =========
We use the intrinsic value-based method to account for all of our employee stock-based compensation plans. Had compensation cost for our stock option plans been determined consistent with SFAS No. 123, our net income and net income per share would have been reduced to the pro forma amounts indicated below (in thousands, except per share data):
FISCAL YEAR ----------------------------------------- 1997 1998 1999 ---------- ---------- ---------- Pro forma net income (loss) ........................... $ 18,710 $ (2,635) $ 40,083 Pro forma basic net income (loss) per share ........... $ 0.45 $ (0.06) $ 0.87 Pro forma diluted net income (loss) per share ......... $ 0.39 $ (0.06) $ 0.81
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model. The weighted-average fair value of options granted was $6.27, $11.75 and $15.62 for fiscal years 1997, 1998 and 1999, respectively. Values were estimated using zero dividend yield for all years; expected volatility of 50% for all years; risk-free interest rates of 6.17%, 4.96% and 5.78%, for 1997, 1998 and 1999, respectively; and weighted-average expected lives of 3.15 years, 4.29 years and 3.92 years, for 1997, 1998 and 1999, respectively for both plans. Employee Benefit Plans In 1992, we adopted a 401(k) Profit Sharing Plan (the 401(k) Plan) that is intended to qualify under Section 401(k) of the Internal Revenue Code of 1986, as amended. The 401(k) Plan covers substantially all of our employees. Participants may elect to contribute a percentage of their compensation to this plan, up to the statutory maximum amount. We may make discretionary contributions to the 401(k) Plan; none have been made to date. (9) COMMITMENTS AND CONTINGENCIES Lease Commitments Future minimum lease payments under noncancelable operating leases (with initial or remaining lease terms in excess of one year) as of January 1, 2000 were as follows (in thousands):
FISCAL YEAR ----------- 2000........................................... $ 1,241 2001........................................... 631 2002........................................... 96 -------- Total minimum lease payments........... $ 1,968 ========
Rental expense from operating leases amounted to approximately $2,095,000, $2,697,000 and $2,957,000 for the years ended December 31, 1997, January 2, 1999 and January 1, 2000, respectively. F-24 25 Participation Commitment We are obligated to pay 5% of our revenue from the distribution of each of the Pictures under the Co-Production Agreement to a third party in consideration for services rendered. The compensation is subject to a cap of $500,000 for each theatrical motion picture and a cap of $200,000 for each sequel or remake, with a total aggregate cap of $3,000,000. We paid participation fees of $250,000 in 1997 and $250,000 in 1999 under this obligation. No payments were made in 1998. Legal Matters We are involved in claims arising in the ordinary course of business. We believe these matters will be resolved without material adverse effect on our financial position, results of operations or cash flows. (10) SIGNIFICANT CUSTOMERS AND SEGMENT REPORTING Significant Customers The following table summarizes the annual percentage contribution to revenue by customers when revenue from such customers exceeded 10% of total revenue in 1997, 1998 or 1999 and the amounts due from these customers as a percentage of total accounts receivable at the corresponding year end:
PERCENTAGE OF PERCENTAGE OF TOTAL TOTAL REVENUES ACCOUNTS RECEIVABLE AS OF -------------------------------------------- ----------------------------------- 1997 1998 1999 1997 1998 1999 ------------- ------------- ------------- ------------- ------------- --------- Disney................ 83% 76% 95% 23% 12% 72%
Segment Reporting We adopted the provisions of SFAS 131, Disclosures about Segments of an Enterprise and Related Information (see Note 1). Our chief operating decision-maker is considered to be our Chief Executive Officer ("CEO"). The CEO reviews financial information presented on a summary basis accompanied by disaggregated information about film revenue for purposes of making operating decisions and assessing financial performance. The summary financial information reviewed by the CEO is identical to the information presented in the accompanying statement of operations and we have no foreign operations. Therefore, we operate in a single operating segment. (11) EARNINGS PER SHARE CALCULATION Reconciliation of basic and diluted net income per share (in thousands, except per share data):
FISCAL YEAR ----------------------------------------------------------------------------------- 1997 1998 1999 ---------------------------- -------------------------- ------------------------ NET NET NET INCOME SHARES EPS INCOME SHARES EPS INCOME SHARES EPS --------- ------ ------- --------- ------ ------ ------- ------ ----- Basic net income per share...... $ 22,190 41,224 $ 0.54 $ 7,822 44,185 $ 0.18 $49,224 46,148 $ 1.07 Effect of dilutive shares: Warrants/options................ -- 6,920 -- 7,153 -- 3,662 --------- ------ --------- ------ ------- ------ Diluted net income per share.... $ 22,190 48,144 $ 0.46 $ 7,822 51,338 $ 0.15 $49,224 49,810 $ 0.99 ========= ====== ========= ====== ======= ======
(12) BUSINESS COMBINATION On June 16, 1998, we issued 60,468 shares of our common stock in exchange for all of the outstanding common stock of Physical Effects, Inc. ("PEI"). We assumed $300,000 of liabilities as part of this merger. The merger was accounted for under the purchase method of accounting with the operating results of PEI being included in our results of operations from the date of acquisition. The majority of the purchase price was assigned to purchased technology associated with certain technology developed by PEI. The purchased technology is being amortized over F-25 26 a period not to exceed four years. PEI's results of operations prior to the acquisition were immaterial and therefore pro forma financial statements were not materially different from our financial statements. (13) DISCONTINUED OPERATIONS In March 1997, we determined to discontinue our business of producing CD-ROM and other interactive products. We immediately discontinued these operations and reassigned all employees of this division. Since the measurement date and disposal date were virtually simultaneous, no income or loss was measured for the intervening period. We had revenue of $1,212,000, $485,000 and $184,000 in 1997, 1998 and 1999, respectively. We recorded income from discontinued operations of $234,000, $358,000 and $122,000 in 1997, 1998 and 1999, respectively, net of income taxes, primarily due to royalty income received for the Toy Story CD-ROM products. We do not expect any significant future CD-ROM royalty income in future periods. F-26 27 QUARTERLY FINANCIAL INFORMATION (UNAUDITED) The unaudited financial statements have been prepared on substantially the same basis as the audited financial statements and, in the opinion of management, include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the results of operations for such periods (in thousands, except per share data).
QUARTER ENDED --------------------------------------------------------------- MARCH 28 JUNE 27 SEPTEMBER 26 JANUARY 2 ------------ ------------ ------------ ------------ 1998 Revenue ........................... $ 4,997 $ 3,769 $ 2,474 $ 3,067 Gross profit ...................... 4,923 3,669 2,172 2,679 Net income ........................ 3,818 2,057 867 1,080 Basic net income per share ........ 0.09 0.05 0.02 0.02 Diluted net income per share ...... 0.08 0.04 0.02 0.02 QUARTER ENDED ---------------------------------------------------------------- APRIL 3 JULY 3 OCTOBER 2 JANUARY 1 (1) ------------ ------------ ------------ ------------- 1999 Revenue ........................... $ 3,441 $ 13,479 $ 79,235 $ 24,882 Gross profit ...................... 2,717 9,772 57,427 19,416 Net income ........................ 900 6,442 32,287 9,595 Basic net income per share ........ 0.02 0.14 0.70 0.21 Diluted net income per share ...... 0.02 0.13 0.63 0.19
(1) Fourth Quarter Adjustment. For the quarter ended January 1, 2000, and as a result of events that occurred during that quarter, we revised the estimated revenue to be received from all sources under the individual film forecast method for A Bug's Life. This change in estimate resulted in an additional $.02 basic and diluted net income per share for the quarter ended and for the year ended January 1, 2000. F-27 EX-23.1 3 CONSENT OF INDEPENDENT AUDITORS 1 EXHIBIT 23.1 CONSENT OF INDEPENDENT AUDITORS The Board of Directors Pixar: We consent to the incorporation by reference in the registration statements (Nos. 33-99838, 333-62047 and 333-30686) on Form S-8 of Pixar, of our reports dated February 2, 2000, relating to the balance sheets of Pixar as of January 2, 1999 and January 1, 2000, and the related statements of operations, shareholders' equity, and cash flows for each of the years in the three-year period ended January 1, 2000, and the related financial statement schedule, which reports appear or are incorporated by reference in the January 1, 2000 annual report on Form 10-K of Pixar. /s/ KPMG LLP San Francisco, California March 29, 2000 EX-27.1 4 FINANCIAL DATA SCHEDULE
5 1,000 YEAR JAN-01-2000 JAN-03-1999 JAN-01-2000 31,170 163,779 17,023 283 0 0 72,829 12,563 374,905 0 0 0 0 281,274 63,169 374,905 0 121,037 0 31,705 14,798 0 0 82,003 32,901 49,102 122 0 0 49,224 1.07 .99
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