-----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, SNJ/5sxLovCAykvrhmSBRxBUONTBkGF5KwNWpqHT8/R5+U87KF3wuiMeYVOt63dr QgzAQ38zx+uMsUKcLft+eQ== 0000891618-99-003870.txt : 19990818 0000891618-99-003870.hdr.sgml : 19990818 ACCESSION NUMBER: 0000891618-99-003870 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19990703 FILED AS OF DATE: 19990817 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-Q SEC ACT: SEC FILE NUMBER: 000-26976 FILM NUMBER: 99694746 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-Q 1 FORM 10-Q 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) (X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JULY 3, 1999. OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ________ to ________. Commission File 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 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes (X) No ( ) The number of shares outstanding of the registrant's Common Stock as of August 13, 1999 was 46,367,246. 2 PART I -- FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS PIXAR BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE DATA)
July 3, January 2, 1999 1999 ------------ ------------ ASSETS Cash and cash equivalents $ 16,991 $ 29,557 Short-term investments 119,147 119,491 Receivables, net 3,559 3,885 Prepaid expenses and other assets 4,846 4,884 Deferred income taxes 13,117 988 Capitalized film production costs 73,146 60,841 Property and equipment, net 42,945 31,160 ------------ ------------ Total assets $ 273,751 $ 250,806 ============ ============ LIABILITIES AND SHAREHOLDERS' EQUITY Accounts payable $ 1,107 $ 2,615 Income taxes payable 1,372 97 Payable to Disney -- 3,363 Accrued liabilities 8,652 8,396 Unearned revenue 3,754 1,188 ------------ ------------ Total liabilities 14,885 15,659 ------------ ------------ 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; 46,254,291 and 45,335,770 shares issued and outstanding as of July 3, 1999 and January 2, 1999, respectively 237,395 220,397 Accumulated other comprehensive income (loss) (447) 249 Deferred compensation (29) (104) Retained earnings 21,947 14,605 ------------ ------------ Total shareholders' equity 258,866 235,147 ------------ ------------ Total liabilities and shareholders' equity $ 273,751 $ 250,806 ============ ============
SEE ACCOMPANYING NOTES TO FINANCIAL STATEMENTS. -2- 3 PIXAR STATEMENTS OF OPERATIONS (In thousands, except per share data)
QUARTER ENDED SIX MONTHS ENDED ---------------------------- ---------------------------- JULY 3, 1999 JUNE 27, 1998 JULY 3, 1999 JUNE 27, 1998 ------------ ------------- ------------ ------------- Revenue: Software $ 1,240 $ 854 $ 2,814 $ 1,527 Animation services -- -- 222 171 Film 12,239 2,912 13,884 6,948 Patent licensing -- 3 -- 120 ---------- ---------- ---------- ---------- Total revenue 13,479 3,769 16,920 8,766 ---------- ---------- ---------- ---------- Cost of revenue: Software 133 100 431 136 Animation services -- -- 154 38 Film 3,574 -- 3,846 -- ---------- ---------- ---------- ---------- Total cost of revenue 3,707 100 4,431 174 ---------- ---------- ---------- ---------- Gross profit 9,772 3,669 12,489 8,592 ---------- ---------- ---------- ---------- Operating expenses: Research and development 1,320 946 2,666 1,812 Sales and marketing 304 434 652 652 General and administrative 1,554 1,780 2,941 3,546 ---------- ---------- ---------- ---------- Total operating expenses 3,178 3,160 6,259 6,010 ---------- ---------- ---------- ---------- Income from continuing operations 6,594 509 6,230 2,582 Other income, net 1,793 2,162 3,658 4,562 ---------- ---------- ---------- ---------- Income from continuing operations before income taxes 8,387 2,671 9,888 7,144 Income tax expense 2,012 614 2,613 1,643 ---------- ---------- ---------- ---------- Net income from continuing operations 6,375 2,057 7,275 5,501 Income from discontinued operations, net of taxes 67 -- 67 374 ---------- ---------- ---------- ---------- Net income $ 6,442 $ 2,057 $ 7,342 $ 5,875 ========== ========== ========== ========== Basic net income per share from continuing operations $ 0.14 $ 0.05 $ 0.16 $ 0.13 Basic net income per share from discontinued operations -- -- -- 0.01 ---------- ---------- ---------- ---------- Basic net income per share $ 0.14 $ 0.05 $ 0.16 $ 0.14 ========== ========== ========== ========== Shares used in computing basic net income per share 46,023 43,839 45,785 43,497 ========== ========== ========== ========== Diluted net income per share from continuing operations $ 0.13 $ 0.04 $ 0.14 $ 0.11 Diluted net income per share from discontinued operations -- -- -- 0.01 ---------- ---------- ---------- ---------- Diluted net income per share $ 0.13 $ 0.04 $ 0.14 $ 0.12 ========== ========== ========== ========== Shares used in computing diluted net income per share 51,334 51,432 51,260 50,948 ========== ========== ========== ==========
SEE ACCOMPANYING NOTES TO FINANCIAL STATEMENTS. -3- 4 PIXAR STATEMENTS OF CASH FLOWS (IN THOUSANDS)
Six Months Ended ----------------------------- July 3, June 27, 1999 1998 ----------- ----------- Cash flows from operating activities: Net income $ 7,342 $ 5,875 Adjustments to reconcile net income to net cash provided by (used in) continuing operating activities: Discontinued operations (67) (374) Amortization of deferred compensation 75 185 Depreciation and amortization 3,297 2,567 Amortization of capitalized film production costs 3,846 -- Tax benefit from disqualifying dispositions 14,163 -- Credits from patent licensing, net of expense items -- (114) Deferred income tax (12,129) -- Changes in operating assets and liabilities: Receivables 326 (1,021) Prepaid expenses and other assets (351) (295) Accounts payable (1,508) (540) Income taxes payable 1,275 (42) Payable to Disney (3,363) (600) Accrued liabilities 256 (1,277) Unearned revenue 2,566 (325) ----------- ----------- Net cash provided by continuing operations 15,728 4,039 Net cash provided by discontinued operations 67 374 ----------- ----------- Net cash provided by operating activities 15,795 4,413 ----------- ----------- Cash flows from investing activities: Purchase of property and equipment (16,259) (5,882) Proceeds from sale of property and equipment 994 -- Proceeds from sale of short-term securities 86,692 79,943 Investments in short-term securities (87,044) (125,612) Capitalized film production costs (15,579) (15,120) ----------- ----------- Net cash used in investing activities (31,196) (66,671) ----------- ----------- Cash flows from financing activities: Proceeds from exercised stock options 2,835 1,581 ----------- ----------- Net cash provided by financing activities 2,835 1,581 ----------- ----------- Net decrease in cash and cash equivalents (12,566) (60,677) Cash and cash equivalents at beginning of period 29,557 101,847 ----------- ----------- Cash and cash equivalents at end of period $ 16,991 $ 41,170 =========== =========== Supplemental disclosure of cash flow information: Cash paid during the period for income taxes $ -- $ 1,796 =========== =========== Supplemental disclosure of non-cash investing and financing activities: Value of common stock issued and liabilities assumed for purchase of PEI $ -- $ 3,000 =========== =========== Loss on equipment disposals capitalized as film production costs $ (572) $ -- =========== =========== Credits from patent licensing $ -- $ 120 =========== =========== Unrealized loss on investments $ (696) $ (48) =========== ===========
SEE ACCOMPANYING NOTES TO FINANCIAL STATEMENTS. -4- 5 NOTES TO FINANCIAL STATEMENTS (1) BASIS OF PRESENTATION The accompanying unaudited financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of management, the accompanying unaudited financial statements reflect all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation of Pixar's financial condition, results of operations, and cash flows for the periods presented. These financial statements should be read in conjunction with the audited financial statements as of January 2, 1999 and for each of the years in the three-year period ended January 2, 1999, including notes thereto, incorporated by reference into Pixar's Annual Report on Form 10-K for the year ended January 2, 1999. The results of operations for the three and six months ended July 3, 1999 are not necessarily indicative of the results expected for the current year or any other period. Certain amounts reported in previous periods have been reclassified to conform to the 1999 financial statement presentation. (2) FISCAL YEAR Effective in fiscal year 1998, Pixar adopted a 52 or 53-week fiscal year, changing the year end date from December 31 to the Saturday nearest December 31. As a result, fiscal year 1998 ended on January 2, 1999 and consisted of 53 weeks. The second quarter of 1999 represents the thirteen-week period ended July 3, 1999, and fiscal year 1999 will end on January 1, 2000 and consist of 52 weeks. (3) EARNINGS PER SHARE CALCULATION 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, using the treasury stock method for options and warrants. Reconciliation of basic and diluted net income per share (in thousands, except per share amounts):
QUARTER ENDED ------------------------------------------------------------------------------ July 3, 1999 June 27, 1998 ------------------------------------- ------------------------------------- Net Net Income Shares EPS Income Shares EPS ----------------------- --------- ----------------------- --------- BASIC NET INCOME PER SHARE $ 6,442 46,023 $ 0.14 $ 2,057 43,839 $ 0.05 EFFECT OF DILUTIVE SHARES: Warrants/options -- 5,311 -- 7,593 ----------------------- ----------------------- DILUTED NET INCOME PER SHARE $ 6,442 51,334 $ 0.13 $ 2,057 51,432 $ 0.04 ======================= =======================
SIX MONTHS ENDED ------------------------------------------------------------------------------ July 3, 1999 June 27, 1998 ------------------------------------- ------------------------------------- Net Net Income Shares EPS Income Shares EPS ----------------------- --------- ----------------------- --------- BASIC NET INCOME PER SHARE $ 7,342 45,785 $ 0.16 $ 5,875 43,497 $ 0.14 EFFECT OF DILUTIVE SHARES: Warrants/options -- 5,475 -- 7,451 ----------------------- ----------------------- DILUTED NET INCOME PER SHARE $ 7,342 51,260 $ 0.14 $ 5,875 50,948 $ 0.12 ======================= =======================
-5- 6 (4) FEATURE FILM AND CO-PRODUCTION AGREEMENTS FEATURE FILM AGREEMENT In 1991, Pixar entered into a 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") to develop and produce up to three computer-animated feature films (the "Feature Film Agreement"). Pixar is entitled to receive compensation based on the revenue from the distribution of these films and related products. In 1995, Pixar released its 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 governs all films made by Pixar after Toy Story. Under the Co-Production Agreement, Pixar, on an exclusive basis, agreed to produce five computer-animated theatrical motion pictures (the "Pictures") for distribution by Disney. Pixar's first film produced under this agreement was A Bug's Life. Films in development or production at Pixar as of July 3, 1999, which include Toy Story 2 and Pixar's fourth film (with the working title "Monsters, Inc.") are also governed by this agreement. A Bug's Life and Monsters, Inc. count toward the five Pictures, whereas Toy Story 2 is a derivative work that will not count towards the Pictures. However, Pixar and Disney have agreed that all provisions of the Co-Production Agreement applicable to the Pictures will also apply to 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 Pixar will produce each Picture and Disney will control decisions relating to film marketing and distribution. (5) INCOME TAXES Pixar's tax rate for the three months ended July 3, 1999 reflects Pixar's expected tax rate for fiscal year 1999 (of approximately 40%) net of a non-recurring tax benefit recorded in the second quarter, which lowered Pixar's effective tax rate for the three and six months ended July 3, 1999 to 24% and 26%, respectively. The tax benefit recorded in the second quarter related to the reversal of certain deferred tax asset reserves. Prior to the second quarter, Pixar believed that there was sufficient uncertainty regarding the realizability of its deferred tax assets to warrant the reserves. As of July 3, 1999, Pixar believes that it has sufficient confidence in the amount and timing of its anticipated participation revenues from A Bug's Life and the amount and timing of certain offsetting tax-related expenses in the foreseeable future to project that a portion of these deferred tax assets will be realized, and thus a favorable adjustment for such has been recognized on Pixar's balance sheet and in its tax rate in the second quarter. (6) DISCONTINUED OPERATIONS In March 1997, Pixar determined to discontinue its business of producing CD-ROM and other interactive products. Pixar immediately discontinued these operations and reassigned all employees of this division. Since the measurement date and the disposal date were virtually simultaneous, no income or loss was measured for the intervening period. Pixar recorded income from discontinued operations of $374,000 and $67,000, net of income taxes, for the six months ended June 27, 1998, and July 3, 1999, respectively, due to royalty income received for the Toy Story CD-ROM products. Pixar does not expect to receive significant Toy Story CD-ROM royalty income in future periods. -6- 7 (7) SEGMENT REPORTING Pixar adopted the provisions of SFAS 131, Disclosures about Segments of an Enterprise and Related Information. Pixar's chief operating decision-maker is considered to be Pixar's Chief Executive Officer ("CEO"). The CEO reviews financial information accompanied by disaggregated information about film revenue for purposes of making operating decisions and assessing financial performance. The financial information reviewed by the CEO is identical to the information presented in the accompanying statements of operations and Pixar has no foreign operations. Therefore, the Company operates in a single operating segment. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This "Management's Discussion and Analysis of Financial Condition and Results of Operations" contains 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 "Dependence on Toy Story, A Bug's Life, Toy Story 2 and Monsters, Inc.," 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 2, 1999 (the "Form 10-K"). Particular attention should be paid to the cautionary language in the section in the Form 10-K entitled "Risk Factors--Our Dependence on Toy Story, Our Dependence on A Bug's Life and Our Dependence on Toy Story 2 and Film Four," "--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. Pixar's operating performance each quarter is subject to various risks and uncertainties as discussed in the Company's Form 10-K. The following discussion should be read in conjunction with the sections entitled "Risk Factors" and "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Form 10-K. In particular, the factors set forth below in "Risk Factors" could affect the Company's operating results and financial condition. CO-PRODUCTION AGREEMENT In February 1997, Pixar and Walt Disney Pictures, a wholly owned subsidiary of The Walt Disney Company (together with its subsidiaries and affiliates collectively referred to herein as "Disney"), entered into a co-production agreement (the "Co-Production Agreement") pursuant to which Pixar, on an exclusive basis, agreed to produce five computer-animated feature-length theatrical motion pictures (the "Pictures") for distribution by Disney over approximately ten years. 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 participations provided to talent and the like. The Co-Production Agreement generally provides that Pixar will produce each Picture and that Disney will control all decisions relating to marketing, promotion, publicity, advertising and distribution of each Picture. Pixar's second feature film, A Bug's Life, was released on November 25, 1998 and is the first 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, -7- 8 interactive media products and other derivative works related to the Pictures, Pixar has 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. Pursuant to the Co-Production Agreement, in addition to co-financing the production costs of the Pictures, Disney will reimburse Pixar for its share of certain general and administrative costs and certain research and development costs that benefit the productions. In February 1998, Pixar and Disney agreed to produce a theatrical motion picture sequel to Toy Story, entitled "Toy Story 2". Toy Story 2 will be Pixar's third feature film and is scheduled for release in November 1999. Because Toy Story 2 is a derivative work of the original Toy Story, it will not be counted toward the five Pictures to be produced under the Co-Production Agreement. However, for all other purposes, Toy Story 2 will be treated as a Picture under the Co-Production Agreement. Accordingly, Toy Story 2 has been added to the definition of Pictures produced and financed under the Co-Production Agreement and all the provisions applicable to the other five Pictures apply. In May 1999, Pixar began production of its fourth theatrical film (with the working title "Monsters, Inc."). This film will be produced and distributed under the Co-Production Agreement and will count as the second of the five original films to be produced under the Co-Production Agreement. Pixar is currently scheduled to complete production of Monsters, Inc. in the spring of 2001 at the earliest. RESULTS OF OPERATIONS REVENUE Total revenue for the three and six months ended July 3, 1999 were $13.5 million and $16.9 million, respectively, compared to $3.8 million and $8.8 million in the corresponding periods of the prior year. The increases were primarily due to revenue from the domestic and foreign theatrical releases of A Bug's Life and related merchandise. Software revenue includes software license revenue, principally from RenderMan. Software revenue increased 45% to $1.2 million for the quarter ended July 3, 1999 from $854,000 in the corresponding prior year period and increased 84% to $2.8 million in the six months ended July 3, 1999 from $1.5 million in the corresponding prior year period. The increase in software revenue resulted from a general increase in RenderMan software licensing. Due to Pixar's focus on content creation for animated feature films and related products, Pixar has not increased the time and resources necessary to generate significantly higher RenderMan sales. Therefore, Pixar expects ongoing variability in revenues derived from software licenses and that such revenue will remain flat or possibly decline. All historical and future royalty income associated with Pixar's discontinued CD-ROM division is now and will continue to be excluded from software revenue and will be presented in results of discontinued operations. See "Results of Discontinued Operations." Animation services revenue includes revenue generated from short projects related to Pixar's films. Animation services revenue increased slightly to $222,000 for the six months ended July 3, 1999 from $171,000 in the corresponding prior year period. Pixar expects that revenue in this area will continue to vary significantly from quarter to quarter due to the sporadic nature of this business and the need to utilize animation services employees on other productions. For example, as occurred with A Bug's Life, Pixar has transferred substantially all of its animation services employees to assist in the completion of Toy Story 2. There can be no assurance that Pixar will generate any animation services revenues during periods in which its animation services employees are devoted to feature films or other projects. Film revenue for the quarter ended July 3, 1999 was $12.2 million compared with $2.9 million in the corresponding prior year period. Film revenue for the six months ended July 3, 1999 was $13.9 million compared with $6.9 million in the corresponding period. 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, Pixar's film revenue for the three and six months ended July 3, 1999 resulted primarily from theatrical revenues from A Bug's Life (most of which have already been reported by Disney) and related merchandise, offset by Disney's distribution costs and its distribution fee. Distribution costs reported to date include theatrical -8- 9 distribution costs as well as the majority of Disney's costs to market A Bug's Life home video, released in April 1999. Also included in film revenue for the six months ended July 3, 1999 were residual Toy Story merchandise and home video revenue of $559,000. Film revenue for the six months ended June 27, 1998 represented proceeds from Toy Story merchandise and home video sales and Toy Story television airings. Patent licensing revenue of $120,000 for the six months ended June 27, 1998 was attributable to a patent license with Silicon Graphics, Inc. ("SGI"), whereby Pixar granted to SGI and its subsidiaries a non-exclusive license to use certain of Pixar's patents covering techniques for creating computer-generated photorealistic images. Under the agreement, SGI agreed to pay Pixar total compensation of $11.0 million, of which $6.0 million was paid in cash in March 1996 and $5.0 million was to be paid in the form of purchase credits for SGI hardware and software. As of the end of 1998, Pixar had used substantially all of the remaining credits and does not expect that patent licensing revenue will be generated on an on-going basis. For the three and six months ended July 3, 1999, Disney accounted for 91% and 83% respectively, of Pixar's total revenue. The revenue from Disney consisted of film and animation services revenue. Due to the Co-Production Agreement, Disney is expected to continue to represent significantly in excess of 10% of Pixar's revenue in 1999 and for the foreseeable future. A portion of the Disney revenue for the quarter was included in receivables and represented 17% of the balance at July 3, 1999. For the three and six months ended June 27, 1998, Disney accounted for 77% and 81%, respectively, of Pixar's total revenue, primarily from film and animation services revenue. COST OF REVENUE Cost of software revenue consists of the direct costs and manufacturing overhead required to reproduce and package Pixar's software products, as well as amortization of purchased technology. Cost of software revenue includes no amortization of capitalized software development expenses. Cost of software revenue as a percentage of the related revenue was 11% and 15% for the three and six months ended July 3, 1999, compared to 12% and 9% for the three and six month corresponding prior year periods. The percentage increase for the six months ended July 3, 1999 was due to amortization of purchased technology associated with the June 1998 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. Over a period not to exceed four years, Pixar will amortize the purchased technology against related license revenue, thereby essentially eliminating any gross profit with respect to license revenue associated with this purchased technology until such amortization has been completed. As a result of the ongoing amortization of this purchased technology, it is likely that Pixar's total software gross profit will be substantially lower during the next few years. In addition, if Pixar determines 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, Pixar 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 related revenue increased to 69% for the six months ended July 3, 1999 from 22% in the prior year period. Animation services projects are negotiated individually and depending on the complexity of the project, profit margins vary significantly from project to project. Cost of film revenue represents amortization of film costs capitalized by Pixar. See "Capitalized Film Production Costs." Due to higher than expected Toy Story film revenue, which resulted in Pixar's amortizing all Toy Story related film costs by December 31, 1997, there was no cost of revenue associated with the Toy Story revenue for the six months ended July 3, 1999 or June 27, 1998. Cost of film revenue from A Bug's Life was 29% and 28% of total film revenue for the three and six months ended July 3, 1999, respectively. Under the Feature Film Agreement all payments to Pixar from Disney for Pixar's efforts in the development and production of feature films were recorded as cost reimbursements and were netted against the related costs. Since Pixar's share of production costs under the terms of the Co-Production Agreement are capitalized, amortized -9- 10 film production costs for A Bug's Life and future feature films will be significantly higher, and the related gross profit margins will be substantially lower than those achieved on Toy Story. There is no cost of revenue associated with patent licensing revenue. OPERATING EXPENSES Total operating expenses for the three and six months ended July 3, 1999 were slightly higher than in the prior year, and Pixar intends to continue to increase its spending levels in a number of areas. As a result of competition for animators, creative personnel, technical directors and certain administrative personnel, Pixar has had to pay higher salaries to attract new creative, technical and other personnel, and compensation for such personnel may continue to increase. In addition, Pixar expects increases in systems and facilities costs and to expand other operations. Under the Co-Production Agreement, Disney reimburses Pixar for its share 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. Further, a portion of Pixar's general and administrative overhead costs which benefit the productions are capitalized by Pixar. In addition, because Disney is responsible for paying all film marketing costs under the Co-Production Agreement, to the extent that Pixar incurs film marketing costs, Disney is responsible for reimbursing Pixar for such costs. To the extent that personnel, facilities and other expenditures are not capitalized by Pixar nor allocated to and paid for by Disney, and precede or are not subsequently followed by an increase in revenue, Pixar's business, operating results and financial condition will be materially adversely affected. Research and development expenses consist primarily of salaries and support for personnel conducting research and development for the RenderMan product and for Pixar's proprietary Marionette and Ringmaster animation software, for production management for short film projects and for certain other unreimbursed projects. Research and development expenses increased 40% to $1.3 million in the three months ended July 3, 1999 from $946,000 in the corresponding prior year period and increased 47% to $2.7 million in the six months ended July 3, 1999 from $1.8 million in the corresponding prior year period. The increases are due to Pixar's continued investment in proprietary technology and short film development projects. Pixar expects research and development expenses to increase in future periods. To date, all research and development costs not reimbursed by Disney have been expensed as incurred. Sales and marketing expenses consist primarily of salaries and related overhead, as well as advertising, technical support, public relations and trade show costs required to support software sales and complement film activities. Sales and marketing expenses decreased by 30% to $304,000 for the three months ended July 3, 1999 from $434,000 in the corresponding prior year period and remained flat at $652,000 for the six months ended July 3, 1999 and June 27, 1998. The decrease for the quarter ended July 3, 1999 resulted from increased corporate marketing and promotion in the corresponding prior year period related to Pixar's short animated film, Geri's Game. Pixar expects these and other marketing expenses may increase in future periods. General and administrative expenses consist primarily of salaries of management and administrative personnel, insurance costs and professional fees. General and administrative expenses decreased 13% to $1.6 million for the three months ended July 3, 1999 from $1.8 million in the corresponding prior year period and decreased 17% to $2.9 million for the six months ended July 3, 1999 from $3.5 million in the corresponding prior year period. The decrease was primarily due to the favorable timing of certain payroll-related and outside services costs. Pixar expects general and administrative expenses to increase in future periods as Pixar incurs additional costs to expand its administrative staff and facilities. -10- 11 OTHER INCOME, NET Other income, net consists primarily of interest income on Pixar's short-term investments. Other income, net was $1.8 million and $3.7 million for the three and six months ended July 3, 1999, respectively, and $2.2 million and $4.6 million for the three and six months ended June 27, 1998, respectively. The decreases are primarily due to a decline in Pixar's cash and short-term investment balances. INCOME TAXES Income tax expense from continuing operations for the three and six months ended July 3, 1999 reflects Pixar's federal and state income tax liability after recognition of a non-recurring tax benefit recorded in the second quarter of 1999. This one-time adjustment reflects Pixar's sufficient confidence in anticipated revenue from A Bug's Life such that Pixar will realize the benefit of certain tax assets. Pixar's tax rate for the three months ended July 3, 1999 was 24%. In future quarters, Pixar expects that quarterly tax rates will return to statutory levels. RESULTS OF DISCONTINUED OPERATIONS Pixar determined in March 1997 to discontinue its business of producing CD-ROM and other interactive products and redirected all employees in that division to film and related projects within Pixar. Pixar recorded income from discontinued operations of $67,000 and $374,000, net of income taxes, for the six months ended July 3, 1999 and June 27,1998, respectively. This income is due to royalty income received for the Toy Story CD-ROM products. Pixar does not expect to receive significant CD-ROM royalty income in future periods. RISK FACTORS The following is a discussion of certain factors that currently impact or may impact Pixar's business, operating results and/or financial condition. Anyone making an investment decision with respect to Pixar's capital stock or other securities is cautioned to carefully consider these factors, along with the factors discussed in Pixar's Form 10-K under the section entitled "Risk Factors." DEPENDENCE ON TOY STORY, A BUG'S LIFE, TOY STORY 2 AND MONSTERS, INC. DEPENDENCE ON A BUG'S LIFE FOR THE BALANCE OF 1999 AND THE FIRST HALF OF 2000 For the balance of 1999 and the first half of 2000, Pixar's revenue and operating results will be largely dependent upon (1) Pixar's share of revenue from the theatrical and video releases of A Bug's Life and related merchandise, (2) whatever revenues remain from Toy Story, if any, and (3) Pixar's software and animation services revenue, from which Pixar expects limited revenue. A BUG'S LIFE REVENUE A Bug's Life was released in November 1998, and in the three months ended July 3, 1999, Pixar received its first significant share of film revenues. 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 for the six months ended July 3, 1999 resulted primarily from the domestic and foreign theatrical revenues from A Bug's Life (most of which have already been reported by Disney) 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 marketing and distribution costs, and the majority of Disney's costs to market A Bug's Life home video, which was released in April 1999. While A Bug's Life has done extremely well in its theatrical release, Disney recently 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. In addition, Pixar believes that A Bug's Life faced an unusually 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 sales of A Bug's Life products. As a result, Pixar expects that revenues associated with A Bug's Life home video sales and merchandise licensing will be lower than previously anticipated. -11- 12 For the remainder of 1999 and the first half of 2000, Pixar expects to be significantly dependent upon the success of A Bug's Life. Because most revenues from the worldwide theatrical release of A Bug's Life have been reported by Disney, sources of future revenues primarily include domestic and foreign home video sales and any future merchandise royalties, both of which must be substantial in order for Pixar to generate significant revenues. Revenue from any future television airings of A Bug's Life are not expected until a few years after release of the film, at the earliest. Moreover, potential future revenues will be offset by future distribution costs, which primarily include remaining marketing costs for the domestic release of A Bug's Life home video, marketing costs for the foreign 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. Therefore, it is difficult to predict the timing of Pixar's future revenues from A Bug's Life, particularly in the second half of 1999 and the first half of 2000, because of the many variables involved. Such variables include the amount and timing of distribution cost outlays, and the amount and timing of revenue and cash flows generated from (1) worldwide home video sales, (2) sales of film related merchandise, and (3) remaining foreign box office. For example, the timing of the release of A Bug's Life video in foreign countries is particularly uncertain since the video will be released in various countries over the course of six months or more. All decisions regarding its international release are made by Disney and such decisions are subject to change. It is possible, in any given quarter or quarters for the remainder of 1999 and in 2000 that Pixar will not recognize sufficient revenue from A Bug's Life to generate significant earnings. TOY STORY REVENUE Pixar has already recognized the vast majority of the revenue it expects to receive from Toy Story. While Pixar may receive minor amounts of revenue in subsequent periods, Pixar does not expect to recognize any further significant revenue from Toy Story. Based on the terms of the Feature Film Agreement, future film revenue from Toy Story, if any, will be received from Disney on a semi-annual basis going forward. SOFTWARE REVENUE As a result of Pixar's shift in focus to products sold for their content, Pixar has reduced 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 PEI on June 16, 1998, through July 3, 1999, Pixar has received significantly less license revenue than expected related to the purchased technology associated with the acquisition. If future license revenue continues to be substantially lower than originally estimated, Pixar may be required to write off all or a significant portion of the unamortized purchased technology. RISK ASSOCIATED WITH A BUG'S LIFE Under the Co-Production Agreement, Pixar shares with Disney the production costs of A Bug's Life. These costs were initially capitalized as film production costs under SFAS No. 53, and Pixar is amortizing these costs over the expected revenue stream as Pixar recognizes revenue from the film. The amount of film costs that will be amortized each quarter will depend on how much future revenue Pixar expects to receive from A Bug's Life. Although A Bug's Life has achieved substantial domestic and foreign box office success and has done well in its domestic home video release, the home video has not been substantially released in foreign markets, nor have any significant domestic or home video proceeds been received by Pixar. It is difficult to predict how much additional revenue will be derived from merchandise sales and from television airings of A Bug's Life. In addition, Pixar believes that the amount spent by Disney for marketing and distribution, particularly for distribution of the home video, will continue to be significant. In any given quarter, if Pixar's forecast changes with respect to total revenue from 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 from A Bug's Life would adversely impact Pixar's business, operating results, and financial condition. -12- 13 DEPENDENCE ON TOY STORY 2 AND MONSTERS, INC. Pixar expects to receive the majority of the proceeds from A Bug's Life by the end of 2000. In addition, while Toy Story 2 is scheduled for release in November 1999, Pixar does not expect to recognize any revenue from Toy Story 2 until six to twelve months after its release. Therefore, Pixar is unlikely to recognize any revenue from Toy Story 2 until the second half of 2000 at the earliest. Beyond 2000, Pixar expects to be largely dependent upon the success of Toy Story 2 and Monsters, Inc. (together referred to as the "Current Projects"). Although production of the Current Projects is underway, Pixar cannot provide any assurances that the Current Projects will be successfully produced and released when targeted. Pixar is currently scheduled to complete production of Monsters, Inc. in the spring of 2001. Disney has not formally scheduled the theatrical release of Monsters, Inc., and Pixar cannot provide any assurances as to when the film will be released. Pixar cannot provide any assurances that it will not 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 Pixar is 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, its business, operating results and financial condition will be materially adversely affected. RISKS ASSOCIATED WITH TOY STORY 2 It is rare for animated feature films to achieve extraordinary box office success. Pixar believes, based on available information, that there is a reasonable basis to conclude that of the more than 40 animated feature films introduced since 1990, only two films generated domestic box office revenues greater than A Bug's Life and Toy Story, and both of those films were produced and distributed solely by Disney. During at least the last five years, Pixar believes that The Rugrats Movie and The Prince of Egypt are the only fully-animated feature films (other than Toy Story and A Bug's Life) produced or developed by a studio other than Disney that have achieved more than $100 million in domestic box office revenues. Unless Toy Story 2 achieves extraordinary box office success and also achieves success in home video and merchandise sales, Toy Story 2 may not generate significant revenue and operating results. As a sequel, there are also risks unique to Toy Story 2. With a theatrical sequel, the story concept and characters are not as novel as the original film. In the vast majority of cases in which a film that achieved domestic box office receipts of greater than $100 million was followed by the release of a sequel, the sequel did not perform as well at the box office as the original. This was the case for sequels to such films as Star Wars, Jurassic Park, Home Alone, Jaws, Batman, Raiders of the Lost Ark, Beverly Hills Cop, Ghostbusters and Back to the Future, among others. In many cases, sequels substantially under-perform the original film. In far fewer cases have sequels performed as well or better than the original blockbuster feature film, and in almost all of these cases, the original feature films and related sequels were action-adventure films, such as Lethal Weapon and Die Hard. Accordingly, Pixar cannot provide any assurances that Toy Story 2 will perform as well as Toy Story at the box office. It is possible that Toy Story 2 will substantially under-perform the original feature film. In addition, fees and participations paid to key talent on Toy Story 2 are substantially greater than for the original film, which together with other increases in production costs will have the effect of increasing the cost of the film when compared to Toy Story. As a result of these factors, Toy Story 2 and related products may not generate significant revenue and operating results for Pixar, even if Toy Story 2 is critically acclaimed and achieves substantial, but not extraordinary, box office success. RISKS ASSOCIATED WITH PRODUCTION BUDGETS Given (1) the escalation in compensation rates of people required to work on the Current Projects, (2) the number of people required to work on the Current Projects, and (3) the equipment needs, the budget for the Current Projects and subsequent films and related products are and will continue to be substantially greater than the budgets for Toy Story and A Bug's Life. Pixar 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, Pixar believes that it is not uncommon for film production spending to exceed film production budgets, and Pixar cannot provide any -13- 14 assurances that any of the Current Projects can be completed within the budgeted amounts. For example, in order to meet the production schedule for Toy Story 2, Pixar has reassigned employees from its animation services group and from Monsters, Inc. to Toy Story 2 for the completion of its production, which will result in a larger production staff than originally anticipated and which will generate additional production costs. In addition, when production of each film is completed, if completed, Pixar 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 generally treated as film costs which increase overall production budgets and could have a material adverse effect on results of operations and financial condition. RISKS ASSOCIATED WITH ADEQUACY OF CASH BALANCES Pursuant to the Co-Production Agreement, Pixar will co-finance the next four animated feature films that it produces, including Monsters, Inc. Pixar will also co-finance Toy Story 2 on the same basis as the other theatrical films. In the future, Pixar may co-finance other derivative works such as sequels and television productions. In addition, Pixar is building a new headquarters and studio facility in Emeryville, California, which is being financed by the use of cash and may continue to be financed by the use of cash. Since Pixar does not expect to generate substantial cash from operations until the third or fourth quarter of 1999 at the earliest, the development and production costs of the Current Projects and the costs of the new Emeryville facility will have a material adverse impact on Pixar's cash and short-term investment balances. As of July 3, 1999, Pixar had approximately $136.1 million in cash and short-term investments. Pixar believes that these funds, along with any further cash received from the release of A Bug's Life, will be sufficient to meet its anticipated cash needs for working capital and capital expenditures, including the development and production costs of the Current Projects, until cash is received from the future release of additional films. However, even if A Bug's Life and these films generate cash in future quarters, unless each film is a success such that Pixar recovers on a timely basis its share of the production costs, as well as other operating expenses and capital expenditures, Pixar may be required to seek financing for its ongoing commitments under the Co-Production Agreement and any other requirements of its operations. Pixar may also seek additional financing in connection with the construction of its new facility. See also "--Liquidity and Capital Resources". The sale of additional equity or convertible debt securities would result in additional dilution to Pixar's shareholders. Moreover, there can be no assurance that Pixar will be successful in obtaining future financing, or even if such financing is available, that it will be obtained on terms favorable to Pixar or on terms providing Pixar with sufficient funds to meet its obligations and objectives. The failure to obtain such financing would have a material adverse effect on Pixar's business, operating results and financial condition. PIXAR EXPECTS OPERATING RESULTS TO CONTINUE TO FLUCTUATE In addition to the factors set forth above, Pixar continues to expect significant fluctuations in future annual and quarterly operating results because of a variety of factors, including the following: o the timing of the domestic and international releases of animated feature films, o the success of animated feature films (which can fluctuate significantly from film to film), o the timing of the release of related products into their respective markets (such as home videos and merchandising), o the demand for such related products (which is often a function of the success of the related animated feature film), o film production costs, o Disney's costs to distribute and promote the feature films and related products, o Disney's success at marketing the films and related products, o the timing of receipt of proceeds from animated feature films and related products by Disney, o the timing of revenue recognition under the Co-Production Agreement and the Feature Film Agreement, as the case may be, -14- 15 o the introduction of new feature films or products by Pixar's competitors, and o general economic conditions. In particular, since Pixar's revenue under the Co-Production Agreement is directly related to the success of a feature film, operating results are likely to fluctuate depending on the level of success of Pixar's animated feature films and related products. The revenue derived from the production and distribution of an animated feature film depends 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. Moreover, Pixar's operating expenses will continue to be extremely difficult to forecast. Pixar budgets the direct costs of film productions with Disney, and shares such costs equally. Pixar capitalizes its share of these direct costs of film production in accordance with Statement of Financial Accounting Standards ("SFAS") No. 53, Financial Reporting by Producers and Distributors of Motion Picture Films. A substantial portion of all of Pixar's other costs are incurred for the benefit of feature films ("Overhead"), including research and development expenses and general and administrative expenses. Portions of overhead are included in the budgets for the Pictures, and Pixar will share such costs equally with Disney under the Co-Production Agreement. With respect to the portion of overhead that is not reimbursed by Disney, Pixar either (1) capitalizes such portion as film production costs, if required under SFAS No. 53, or (2) charges it to operating expense in the period incurred. Since a substantial portion of overhead is related to the Pictures and is, therefore, reimbursed by Disney, and since Pixar capitalizes other amounts in accordance with SFAS No. 53, reported operating expenses for the first six months of 1999 have not reflected, and future reported operating expenses will not reflect, the true level of spending on the production of animated feature films, related products and overhead. Although Pixar was profitable for financial statement purposes, Pixar has not been profitable for federal income tax purposes for each of fiscal 1996, 1997 and 1998 due to additional tax deductible items and the utilization of federal net operating loss carryforwards. Pixar was profitable for state income tax purposes for each of 1996 and 1997, but at levels significantly lower than those reported for financial statement purposes. Pixar maintains a valuation allowance that offsets a portion of its deferred tax asset, given the dependence on the success of A Bug's Life and future films, which continues to be uncertain. In addition, Pixar's effective tax rate increased for 1998 and is likely to return to statutory rates in the 40% range in the second half of 1999. As a result of the factors discussed above, Pixar believes that period-to-period comparisons of its results of operations are not necessarily meaningful, and one should not rely on Pixar's 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 Pixar's operating results will be below the expectations of public market analysts and investors. In such event, the price of Pixar's Common Stock would likely be materially adversely affected. CAPITALIZED FILM PRODUCTION COSTS Pixar had $73.1 million in capitalized film production costs as of July 3, 1999, consisting primarily of costs relating to A Bug's Life, Toy Story 2 and Monsters, Inc., all of which are being co-financed by Disney under the Co-Production Agreement. All Toy Story capitalized film costs were fully amortized as of December 31, 1997. LIQUIDITY AND CAPITAL RESOURCES Cash and short-term investments decreased $12.9 million to $136.1 million at July 3, 1999 from $149.0 million at January 2, 1999 due primarily to cash used for film development and production costs and for construction of the Emeryville facility. -15- 16 Net cash provided by continuing operations for the six months ended July 3, 1999 was primarily attributable to net income of $7.3 million, and the non-cash impacts of depreciation and amortization expense, and amortization of capitalized film production costs totaling $7.2 million. Cash used in investing activities was due primarily to funding of film production costs of $15.6 million and the purchase of property and equipment of $16.2 million. Cash provided by financing activities was due to proceeds from the exercise of stock options. As of July 3, 1999, Pixar's principal source of liquidity was approximately $136.1 million in cash and short-term investments. Pixar believes that these funds will be sufficient to meet the Company's operating requirements through the next twelve months. THE YEAR 2000 The Year 2000 problem is the result of computer programming using two digits rather than four to define the applicable year. Computer programs that have time-sensitive software may recognize a date using "00" as the Year 1900 rather than the Year 2000. This could result in a major system failure or miscalculation. Pixar has formed a committee to address Year 2000 issues and the committee is currently reviewing Pixar's products, Pixar's internal computer systems and the systems of third parties on which Pixar relies for handling the Year 2000. This committee is composed of senior management and personnel from the systems department and the finance and administration staff. The committee's strategy for identifying and addressing Year 2000 issues involves five phases: Phase 1 -- Inventory: Prepare an inventory of software, hardware, third party services and building systems used by Pixar and determine Year 2000 compliance. For third party software, hardware and services, vendors are contacted and written certification is obtained to verify that such items are Year 2000 compliant. This phase was completed in April 1999. To date, most items in the inventory are either Year 2000 compliant or will be with minor modifications, and most of the Year 2000 issues identified by Pixar relate to the financial software that Pixar uses. Phase 2 -- Assessment: Determine which of the inventory items identified in Phase 1 are critical or important as they relate to Pixar's business. For third party software, hardware and services that are deemed to be critical or important, Pixar is reviewing the written certification provided by vendors and performing internal testing where possible. This phase was completed in May 1999. To date, Pixar has identified a few third party systems that are not Year 2000 compliant. Phase 3 -- Strategy: Prepare strategies to modify or replace systems that are not Year 2000 compliant. To date, the few items in the inventory that have been identified as not being Year 2000 compliant are software items that can be made compliant by upgrading to the most recent versions of the software. This phase also includes monitoring the Year 2000 compliance programs of third parties whose services have been deemed to be critical to Pixar's business. This phase is approximately 80% complete, and is anticipated to be complete in August 1999. Phase 4 -- Remediation: Initiate remediation strategies. Pixar is planning to upgrade certain of its systems to the most recent versions of the software and most required fixes are underway. This phase is approximately 80% complete, and is anticipated to be complete in November 1999. Phase 5 -- Testing: Test and certify all critical and certain important systems where appropriate. Testing schedules have been set for Pixar's financial systems and studio tools. This phase is approximately 50% complete, and is anticipated to be complete in November 1999. Based on information available to date, Pixar believes that it will be able to complete its Year 2000 compliance review and make any necessary modifications to its internal systems prior to the end of 1999. Pixar expects that the total costs associated with resolving its Year 2000 issues will not be material and does not expect -16- 17 such costs to exceed $500,000. The majority of these costs will result from consultants, software upgrades and dedicated program equipment. Pixar's most significant Year 2000 risk results from Pixar's relationship with Disney, a public company. Pixar relies on Disney for the distribution and marketing of its films. Toy Story 2 is expected to be released at the end of 1999. The disruption of Disney's distribution activities as a result of Year 2000 problems could result in lost revenues for Toy Story 2 and related merchandise. In addition, if the accounting and financial systems of Disney are adversely affected by Year 2000 issues and Disney is unable to issue revenue reports to Pixar, Pixar's recognition of its share of the revenue generated pursuant to the Co-Production Agreement and the Feature Film Agreement could be delayed. There can be no assurance that the failure of any third parties to have systems that are Year 2000 compliant would not have a material adverse effect on Pixar's financial position or results of operations. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Pixar 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 Pixar's policy to ensure safety of its principal and maintain liquidity. Pixar only invests in securities with a maturity of 24 months or less, with only government obligations exceeding 12 months. Pixar's 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 Pixar's financial instruments are held for purposes other than trading and are considered "available for sale" per SFAS 115. The table below provides information regarding Pixar's investment portfolio at July 3, 1999. The table presents principal amounts and related weighted average fixed interest rates presented by expected maturity date (dollars in thousands):
< 1 YEAR > 1 YEAR TOTAL ----------- ----------- ----------- Available-for-sale securities $ 79,525 $ 54,895 $ 134,420 Weighted-average interest rate 5.12% 5.13% 5.13%
-17- 18 PART II -- OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K (a) Exhibits 27.1 Financial Data Schedule (b) Reports on Form 8-K No reports on Form 8-K were filed by Pixar during the quarter ended July 3, 1999. Items 1, 2, 3, 4 and 5 are not applicable and have been omitted. -18- 19 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. PIXAR Date: August 17, 1999 By: /s/ Sarah S. Flatley ------------------- ----------------------------- Sarah S. Flatley, Vice President, Finance (Principal Accounting Officer And Duly Authorized Officer) -19- 20 EXHIBIT INDEX EXHIBIT DOCUMENT DESCRIPTION - ------- -------------------- 27.1 Financial Data Schedule EX-27.1 2 FINANCIAL DATA SCHEDULE
5 1,000 6-MOS JAN-01-2000 JAN-03-1999 JUL-03-1999 16,991 119,147 3,851 292 0 0 53,160 10,215 273,751 0 0 0 0 237,395 21,471 273,751 0 16,920 0 4,431 6,259 0 0 9,888 2,613 7,275 67 0 0 7,342 0.16 0.14
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