-----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, JhCbf9LBjDjH5P6fja7zATRJrv4rem9uALY7yNvjqCuI2NyUFRa/YpjN2U7oDD6w zJ1UZSUZ7XPpZpdBhoUqsw== 0001017062-99-000983.txt : 19990518 0001017062-99-000983.hdr.sgml : 19990518 ACCESSION NUMBER: 0001017062-99-000983 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19990331 FILED AS OF DATE: 19990517 FILER: COMPANY DATA: COMPANY CONFORMED NAME: INTERPLAY ENTERTAINMENT CORP CENTRAL INDEX KEY: 0001057232 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-PREPACKAGED SOFTWARE [7372] IRS NUMBER: 330102707 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 000-24363 FILM NUMBER: 99627406 BUSINESS ADDRESS: STREET 1: 16815 VON KARMAN AVE CITY: IRVINE STATE: CA ZIP: 92606 BUSINESS PHONE: 9495536655 MAIL ADDRESS: STREET 1: 16815 VON KARMAN AVE CITY: IRVINE STATE: CA ZIP: 92606 10-Q 1 QUARTERLY REPORT UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [x] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended March 31, 1999 or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 For the transition period from __________ to __________ Commission File Number 0-24363 Interplay Entertainment Corp. (Exact name of the registrant as specified in its charter) Delaware 33-0102707 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 16815 Von Karman Avenue, Irvine, California 92606 (Address of principal executive offices) (949) 553-6655 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No --- --- Indicate the number of shares outstanding of each of the issuer's classes of common stock as of the latest practicable date. Class Issued and Outstanding at May 7, 1999 ----- ------------------------------------- Common Stock, $0.001 par value 20,808,861 INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES FORM 10-Q MARCH 31, 1999 TABLE OF CONTENTS ______________ Page Number ----------- Part I. Financial Information Item 1. Financial Statements Consolidated Balance Sheets as of March 31, 1999 and December 31, 1998............................................. 3 Consolidated Statements of Operations for the Three Months ended March 31, 1999 and 1998........................ 4 Consolidated Statements of Cash Flows for the Three Months ended March 31, 1999 and 1998........................ 5 Notes to Unaudited Consolidated Financial Statements.............. 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations............................................. 13 Item 3. Quantitative and Qualitative Disclosures About Market Risk........ 29 Part II. Other Information Item 1. Legal Proceedings................................................. 30 Item 2. Changes in Securities and Use of Proceeds......................... 30 Item 3. Defaults Upon Senior Securities................................... 30 Item 4. Submission of Matters to a Vote of Security Holders............... 30 Item 5. Other Information................................................. 30 Item 6. Exhibits and Reports on Form 8-K.................................. 30 Signatures................................................................. 31 2 PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
March 31, December 31, ASSETS 1999 1998 ------ --------- ------------ (Unaudited) Current Assets: (Dollars in thousands) Cash and cash equivalents $ 363 $ 614 Restricted cash 2,000 - Trade receivables, net of allowances of $17,214 and $18,431, respectively 26,266 33,991 Inventories 6,888 6,303 Prepaid licenses and royalties 20,023 18,128 Deferred income taxes 5,358 5,358 Other 2,716 3,101 --------- ------------ Total current assets 63,614 67,495 Property and Equipment, net 4,885 5,679 Other Assets 1,819 1,792 --------- ------------ $ 70,318 $ 74,966 ========= ============ LIABILITIES AND STOCKHOLDERS' EQUITY ------------------------------------ Current Liabilities: Accounts payable $ 18,935 $ 23,403 Accrued liabilities 22,030 22,300 Current portion of long-term debt 22,753 24,521 Income taxes payable 254 254 --------- ------------ Total current liabilities 63,972 70,478 Long-Term Debt, net of current portion 73 130 Deferred Income Taxes - 22 Minority Interest 118 143 Commitments and Contingencies Redeemable Common Stock 1,000 - Stockholders' Equity: Preferred stock, no par value, authorized 5,000,000 shares; issued and outstanding, none - - Common stock, $.001 par value, authorized 50,000,000 shares; issued and outstanding 20,808,861 shares as of March 31, 1999 and 18,292,431 shares as of December 31, 1998 20 18 Paid-in capital 61,178 51,918 Retained earnings (accumulated deficit) (56,375) (48,097) Accumulated comprehensive income adjustments 332 354 --------- ------------ Total stockholders' equity 5,155 4,193 --------- ------------ $ 70,318 $ 74,966 ========= ============
The accompanying notes are an integral part of these consolidated financial statements. 3 INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) Three Months Ended March 31, --------------------------- 1999 1998 ----------- ----------- (Dollars in thousands, except per share amounts) Net revenues $ 21,620 $ 40,996 Cost of goods sold 12,566 19,221 ----------- ----------- Gross profit 9,054 21,775 Operating expenses: Marketing and sales 7,544 8,589 General and administrative 3,518 2,855 Product development 5,382 5,819 ----------- ----------- Total operating expenses 16,444 17,263 ----------- ----------- Operating income (loss) (7,390) 4,512 Other income (expense): Interest income 45 6 Interest expense (814) (1,346) Other (119) (78) ----------- ----------- Total other income (expense) (888) (1,418) Income (loss) before provision for income taxes (8,278) 3,094 Provision for income taxes - 245 ----------- ----------- Net income (loss) $ (8,278) $ 2,849 =========== =========== Net income (loss) per share: Basic $ (0.44) $ 0.26 =========== =========== Diluted $ (0.44) $ 0.20 =========== =========== Weighted average number of common shares outstanding: Basic 18,689,344 10,952,375 =========== =========== Diluted 18,689,344 14,144,627 =========== =========== The accompanying notes are an integral part of these consolidated financial statements. 4 INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
Three Months Ended March 31, ------------------------------- 1999 1998 ------- ------- Cash flows from operating activities: (Dollars in thousands) Net income (loss) $(8,278) $ 2,849 Adjustments to reconcile net income (loss) to cash provided by (used in) operating activities: Depreciation and amortization 779 841 Noncash expense for stock options 10 76 Deferred income taxes (22) 270 Minority interest in earnings (loss) of subsidiary (25) 47 Changes in assets and liabilities: Trade receivables 7,725 (3,549) Inventories (585) 273 Income taxes receivable - 1,427 Other current assets 685 853 Other assets 282 - Prepaid licenses and royalties (1,895) 246 Accounts payable (4,468) (2,928) Accrued liabilities (270) (318) Income taxes payable - 243 ------- ------- Net cash provided by (used in) operating (6,062) 330 activities Cash flows from investing activities: Purchase of property and equipment (294) (466) ------- ------- Net cash used in investing activities (294) (466) Cash flows from financing activities: Net (repayments) borrowings on line of credit (1,758) 574 Repayments on notes payable (67) (48) Net proceeds from issuance of common stock 9,944 - Proceeds from exercise of stock options 8 10 Additions to restricted cash (2,000) - Other financing activities - - ------- ------- Net cash provided by financing activities 6,127 536 ------- ------- Effect of exchange rate changes on cash and cash equivalents (22) 1 ------- ------- Net increase (decrease) in cash and cash equivalents (251) 401 Cash and cash equivalents, beginning of period 614 1,536 ------- ------- Cash and cash equivalents, end of period $ 363 $ 1,937 ======= ======= Supplemental cash flow information: Cash paid for: Interest $ 814 $ 1,372 Income taxes - -
The accompanying notes are an integral part of these consolidated financial statements. 5 INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS Amounts and disclosures as of March 31, 1999 and for the three months ended March 31, 1999 and 1998 are unaudited (Dollars in thousands, except per share amounts) Note 1. Basis of Presentation The accompanying interim consolidated financial statements of Interplay Entertainment Corp. and its subsidiaries (the "Company") are unaudited and reflect all adjustments (consisting only of normal recurring adjustments) that, in the opinion of management, are necessary for a fair presentation of the results for the interim period in accordance with instructions for Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all information and footnotes required by generally accepted accounting principles for complete financial statements. The results of operations for the current interim period are not necessarily indicative of results to be expected for the current year or any other period. These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company's annual report on Form 10-K for the year ended December 31, 1998 as filed with the Securities and Exchange Commission. Use of 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. Reclassifications Certain reclassifications have been made to the prior year's financial statements to conform to classifications used in the current period. Restricted Cash Restricted cash represents cash collateral deposits made in accordance with the Company's amended Loan and Security Agreement (see Note 4). Equity Investments Investments in unconsolidated affiliate companies, in which the Company has a significant influence but less than a 50% interest, are carried at cost, adjusted for the Company's proportionate share of their undistributed earnings or losses. Revenue Recognition Revenues are recorded when products are delivered to customers in accordance with Statement of Position (SOP) 97-2, Software Revenue Recognition. For those agreements that provide the customers the right to multiple copies in exchange for guaranteed amounts, revenue is recognized at the delivery of the product master or the first copy. Per copy royalties on sales that exceed the guarantee are recognized as earned. The Company is generally not contractually obligated to accept returns, except for defective product. However, the Company permits customers to return or exchange product and may provide price protection on products unsold by a customer. In accordance with SFAS No. 48, revenue is recorded net of an allowance for estimated returns, exchanges, markdowns, price concessions, and warranty costs. Such reserves are based upon management's evaluation of historical experience, current industry trends and estimated costs. The amount of reserves ultimately required could differ materially in the near term from the amounts included in the accompanying consolidated financial statements. Postcontract customer support provided by the Company is limited to telephone support. These costs are not material and are charged to expenses as incurred. 6 INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS Amounts and disclosures as of March 31, 1999 and for the three months ended March 31, 1999 and 1998 are unaudited (Dollars in thousands, except per share amounts) Factors Affecting Future Performance For the three months ended March 31, 1999 the Company incurred a net loss of $8,278 and used cash in operating activities of $6,467. Partially because of these losses, the Company's liquidity deteriorated during the period ended March 31, 1999. At March 31, 1999, the Company had negative working capital of $658, although the Company did have borrowing availability under its line of credit of $6,032 (See Note 4). To provide working capital to support the Company's future operations, the Company took several actions during the period, including extending the expiration of its line of credit to January 1, 2000, in connection with which the Company's Chief Executive Officer personally guaranteed $5 million of the Company's obligations under such line of credit. Further, In March 1999, the Company entered into a Stock Purchase Agreement with an investor which provides for the issuance of 2.5 million shares of the Company's Common Stock for $10 million (See Note 8), and in May 1999, the Company entered into a letter of intent for a $25,000 proposed equity transaction with the same investor (See Note 10). The Company believes that funds available under its line of credit, funds received from the sale of equity securities, amounts to be received under various product license and distribution agreements and anticipated funds from operations, if any, will be sufficient to satisfy the Company's projected working capital and capital expenditure needs and debt obligations in the normal course of business at least through the expiration of its line on January 1, 2000 (see Note 4). Based upon the Company's estimates, including the Company's ability to achieve anticipated operating results, the Company believes that it will be able to renew its line of credit or obtain alternate financing on reasonable terms. In addition to the risks related to the Company's liquidity discussed above, the Company also faces numerous other risks associated with its industry. These risks include dependence on new product introductions, product completion and release delays, rapidly changing technology, intense competition, dependence on distribution channels and risk of customer returns. Certain additional risks are discussed on pages 19-29 of the Company's Quarterly Report on Form 10-Q for the period ended March 31, 1999. The Company's consolidated financial statements have been presented on the basis that it is a going concern. Accordingly, the consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities or any other adjustments that might result should the Company be unable to continue as a going concern. The Company has placed a partial valuation allowance against it's deferred tax asset. This valuation allowance relates primarily to net operating loss and tax credit carryforward. The Company will continue to evaluate the uncertainty surrounding the realization of the net deferred tax asset in future years, and may increase the valuation allowance placed against its net deferred tax assets. Note 2. Prepaid Licenses and Royalties Prepaid licenses and royalties consist of payments for intellectual property rights, payments to celebrities and sports leagues and advanced royalty payments to outside developers. In addition, such costs include certain other outside production costs generally consisting of film cost and amounts paid for digitized motion data with alternative future uses. Payments to developers represent contractual advance payments made for future royalties. These payments are contingent upon the successful completion of milestones, which generally represent specific deliverables. Royalty advances are generally recoupable against future sales based upon the contractual royalty rate. The Company amortizes the cost of licenses, prepaid royalties and other outside production costs to cost of goods sold over six months commencing with the initial shipment of the title at a rate based upon the number of units shipped. Management evaluates the future realization of such costs quarterly and charges to cost of goods sold any amounts that management deems unlikely to be fully realized through future sales. Such costs are classified as current and noncurrent assets based upon estimated net product sales. 7 INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS Amounts and disclosures as of March 31, 1999 and for the three months ended March 31, 1999 and 1998 are unaudited (Dollars in thousands, except per share amounts) Note 3. Inventories Inventories consist of the following: March 31, December 31, 1999 1998 --------- ------------ Packaged software $4,996 $4,070 CD-ROMs, cartridges, manuals, packaging and supplies 1,892 2,233 ------ ------ $6,888 $6,303 ====== ====== Note 4. Long-Term Debt Long-term debt consists of the following: March 31, December 31, 1999 1998 --------- ------------ Loan Agreement $ 22,717 $ 24,475 Other 109 176 -------- -------- 22,826 24,651 Less--current portion (22,753) (24,521) -------- -------- $ 73 $ 130 ======== ======== Loan Agreement Borrowings under the Loan and Security Agreement ("Loan Agreement") bear interest at LIBOR (4.97 percent at March 31, 1999 and 5.62 percent at December 31, 1998) plus 4.87 percent (9.84 percent at March 31, 1999 and 10.49 percent at December 31, 1998). On March 18, 1999 the Company amended its line of credit under the Loan Agreement with a financial institution to extend its current line of credit through January 1, 2000 and thereafter, based on qualifying receivables and inventory. Under the terms of the Amendment the $37,500 maximum credit line will continue through November 29, 1999, $30,000 through December 30, 1999 and $25,000 thereafter. Within the total credit limit, the Company may borrow up to $14,000 in excess of its borrowing base through July 30, 1999, $10,000 in excess through September 29, 1999, $7,000 through November 29, 1999 and $5,000 in excess thereafter. Under the amended line of credit the Company is required to place a cash collateral deposit of $2,000 by March 15, 1999 and an additional $500 on April 15, 1999. In addition, the Company is required to maintain certain borrowing limitations beginning July 30, 1999 where actual borrowings are limited to $35,000 with various month end limitations, generally decreasing to $25,000 at December 31, 1999 and the $5,000 personal guarantee by the Company's Chairman and Chief Executive Officer will remain in place throughout the term. All other terms and conditions remain in full force and effect. The Company is in compliance with the terms of the Loan Agreement. As of March 31, 1999, the Company had $6,032 of availability under it's Loan Agreement. 8 INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS Amounts and disclosures as of March 31, 1999 and for the three months ended March 31, 1999 and 1998 are unaudited (Dollars in thousands, except per share amounts) Note 5. Net Income (Loss) Per Share Basic net income (loss) per share is calculated by dividing net income (loss) available to common stockholders by the weighted average number of common shares outstanding and does not include the impact of any potentially dilutive common stock equivalents. Diluted net income (loss) per share is calculated by dividing net income (loss) by the weighted average number of shares outstanding, adjusted for the dilutive effect of outstanding stock options. The following table sets forth the computation of basic and diluted net income (loss) per share: Three Months Ended March 31, ------------------------ 1999 1998 ---------- ----------- BASIC Net income (loss) $ (8,278) $ 2,849 Average common shares outstanding 18,689,344 10,952,375 ----------- ----------- Net income (loss) per common share - basic $ (0.44) $ 0.26 =========== =========== DILUTED Net income (loss) $ (8,278) $ 2,849 Average common shares outstanding 18,689,344 10,952,375 Stock option adjustment - 3,192,252 ----------- ----------- Average common shares outstanding 18,689,344 14,144,627 ----------- ----------- Net income (loss) per common share - diluted $ (0.44) $ 0.20 =========== =========== Options and warrants to purchase 2,468,973 shares of common stock at March 31, 1999 were not included in the computation of diluted earnings per share as the effect would be antidilutive. The weighted average exercise price of the outstanding options and warrants at March 31, 1999 and 1998 was $4.40 and $4.79, respectively. Note 6. Distribution, Publishing and Investment in Affiliate Distribution and Publishing Agreements On February 10, 1999 the Company signed an International Distribution Agreement with Virgin Interactive Entertainment Limited ("Virgin") which provides for the exclusive distribution of substantially all of the Company's products in Europe, CIS, Africa and the Middle East for a seven year period, cancelable under certain conditions, subject to termination penalties and costs. Under the Agreement, the Company pays Virgin a monthly overhead fee and a distribution fee based on net sales, subject to a minimum annual payment, and Virgin provides certain market preparation, warehousing, sales and fulfillment services on behalf of the Company. In connection with this arrangement the Company paid $420 in distribution fees and $455 in overhead fees to Virgin in the first quarter of 1999. In addition, the Company recorded an asset valuation and restructuring charge of $584 in the first quarter of 1999 in connection with the reductions in the Company's European operations. The Company has also executed a Product Publishing Agreement with Virgin which provides the Company with an exclusive license to publish and distribute substantially all of Virgin's products within North America, Latin America and South America for a royalty based on net sales. During the three months ended March 31, 1999, the Company did not distribute any of Virgin's products. 9 INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS Amounts and disclosures as of March 31, 1999 and for the three months ended March 31, 1999 and 1998 are unaudited (Dollars in thousands, except per share amounts) Investment in Affiliate In connection with the International Distribution Agreement and Product Publishing Agreement, the Company has also executed an Operating Agreement with Virgin which, among other terms and conditions, provides the Company with a 43.9% equity interest in VIE Acquisition Group LLC ("VIE"), the parent entity of Virgin under which the Company was obligated to make a cash payment of $9. However, the Company is not obligated to make any future contributions to the working capital of Virgin. In addition, two members of Interplay Europe's management have also acquired a 6.0% interest in VIE. The Company accounts for its investment in VIE in accordance with the equity method of accounting. The Company did not recognize any material income or loss in connection with it's investment in VIE for the quarter ended March 31, 1999. Note 7. Comprehensive Income (Loss) Comprehensive income (loss) consists of the following: Three Months Ended March 31, ------------------- 1999 1998 ------- ------ Net income (loss) $(8,278) $2,849 Other comprehensive income (loss), net of income taxes: Foreign currency translation adjustments (22) 1 ------- ------ Other comprehensive income (loss) (22) 1 ------- ------ Total comprehensive income (loss) $(8,300) $2,850 ======= ====== For the three months ended March 31, 1999 and 1998, the Company had pre-tax increase (decrease) in foreign currency translations of $(22) and $1, respectively. Note 8. Stockholders' Equity On March 18, 1999, the Company entered into a Stock Purchase Agreement with an investor which provides for the issuance of 2.5 million shares of the Company's Common Stock for $10,000. Under the terms of the Stock Purchase Agreement up to 2.5 million additional shares of the Company's common stock may be issued without additional consideration based on the average closing share price per share of the Company's Common Stock as of certain specified future dates; provided, however, the investor will not be issued a total number of shares equaling or exceeding 20% of the Company's current outstanding Common Stock without the approval of the Company's stockholders (See Note 10). As consideration for the extension of a $5,000 personal guarantee by the Company's Chairman and Chief Executive Officer (the "Chairman") under the Company's Loan Agreement (See Note 4), the Company agreed to assume the obligation of the Chairman under an agreement between the Chairman and the Company's President, pursuant to which the Chairman granted certain put rights to the President with respect to the 271,528 common stock options held by the President. The Company recorded compensation expense of approximately $700 through December 31, 1998 in connection with the grant of the options, and an additional $300 will be amortized as interest expense over the remaining term of the Loan Agreement. During the first quarter of 1999, the Company recorded the Redeemable Common Stock outside of stockholders' equity. 10 INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS Amounts and disclosures as of March 31, 1999 and for the three months ended March 31, 1999 and 1998 are unaudited (Dollars in thousands, except per share amounts) Note 9. Segment and Geographical Information The Company operates in three principal business segments. Information about the Company's operations in the United States and foreign areas is as follows: Three Months Ended March 31, ------------------- 1999 1998 ------- ------- Net revenues: United States $12,262 $31,245 United Kingdom 9,358 9,751 Other - - ------- ------- Consolidated net revenues $21,620 $40,996 ======= ======= Operating income (loss): United States $(6,867) $ 1,478 United Kingdom (523) 3,034 Other - - ------- ------- Consolidated (loss) income from operations $(7,390) $ 4,512 ======= ======= Expenditures made for the acquisition of long-lived assets: United States $ 294 $ 348 United Kingdom - 118 Other - - ------- ------- Total expenditures for long-lived assets $ 294 $ 466 ======= ======= Net revenues were made to geographic regions as follows: Three Months Ended March 31, ---------------------------------------- 1999 1998 ------------------ ------------------ Amount Percent Amount Percent ------- ------- ------- ------- North America $ 8,751 40.5% $23,516 57.4% Europe 8,078 37.4 8,265 20.2 Rest of World 1,865 8.6 2,958 7.2 OEM, royalty and licensing 2,926 13.5 6,257 15.2 ------- ----- ------- ----- $21,620 100.0% $40,996 100.0% ======= ===== ======= ===== 11 INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS Amounts and disclosures as of March 31, 1999 and for the three months ended March 31, 1999 and 1998 are unaudited (Dollars in thousands, except per share amounts) Investments in long-lived assets by geographic regions, net are as follows: March 31, December 31, 1999 1998 ------------------ ------------------ Amount Percent Amount Percent ------- ------- ------- ------- North America $ 6,259 96.3% $ 6,621 89.6% Europe 173 2.7 723 9.8 Rest of World - - - - OEM, royalty and licensing 67 1.0 44 0.6 ------- ----- ------- ----- $ 6,499 100.0% $ 7,388 100.0% ======= ===== ======= ===== Note 10. Subsequent Events Distribution Agreement On April 3, 1999 the Company entered into an exclusive North American distribution agreement with an investor which provides for the distribution of eight titles on multiple platforms for a two year period. Under the terms of the arrangement, the Company will receive a distribution fee for all orders shipped and will provide certain services including marketing, order processing, billings and collections. Product Development Agreement On April 3, 1999 the Company signed a letter of intent to enter into a multi- product development agreement with a developer which provides for the delivery of ten titles to the Company during 1999 in exchange for $500 paid in cash installments and the issuance of $1,000 in unregistered, restricted Common Stock of the Company. The shares of Common Stock will be restricted as to registration rights until such products are delivered and accepted by the Company. The arrangement also includes certain penalties to the developer in the event of noncompliance and the terms and conditions are subject to the approval by the Company's underwriters and lenders, if necessary. Litigation In April 1999, the Company was named as one of many defendants in a multi- party civil action which was filed in the Western District of Kentucky which alleges that the Company, along with the other defendants, contributed to the unlawful actions of a convicted felon. The Company believes that this civil action is without merit and will vigorously defend its position. Convertible Loan; Potential Change in Control On May 12, 1999 the Company signed a letter of intent with Titus Interactive S.A. ("Titus") pursuant to which Titus will loan the Company $5 million, and the Company and Titus will negotiate certain additional transactions. Should the definitive agreements contemplated by the letter of intent not be entered into by the Company and Titus, the loan must be repaid by the Company, or, at the option of Titus, may be convertible into the Company's Common Stock. In the event the agreements contemplated by the letter of intent are entered into, Titus will make a strategic equity investment of $25 million in the Company, purchasing 6.25 million shares of Common Stock at a purchase price of $4 per share. As part of the agreements to be negotiated under the letter of intent, Titus chairman and chief executive officer Herve Caen would become president of Interplay. The letter of intent also contemplates the swap by Brian Fargo, the Company's chairman and chief executive officer, of 2 million personal shares of Interplay Common Stock for an agreed upon number of Titus shares. If the transactions to be negotiated pursuant to the letter of intent are consummated, Titus will own approximately 51% of the Company's outstanding Common Stock, resulting in a change of control of the Company in favor of Titus. 12 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Cautionary Statement The information contained in this Form 10-Q is intended to update the information contained in the Company's Annual Report on Form 10-K for the year ended December 31, 1998 and presumes that readers have access to, and will have read, the "Management's Discussion and Analysis of Financial Condition and Results of Operations" and other information contained in such Form 10-K. This Form 10-Q contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities and Exchange Act of 1934 and such forward-looking statements are subject to the safe harbors created thereby. For this purpose, any statements contained in this Form 10-Q except for historical information may be deemed to be forward-looking statements. Without limiting the generality of the foregoing, words such as "may," "will," "expect," "believe," "anticipate," "intend," "could," "estimate" or "continue" or the negative or other variations thereof or comparable terminology are intended to identify forward-looking statements. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. The forward-looking statements included herein are based on current expectations that involve a number of risks and uncertainties, as well as on certain assumptions. For example, any statements regarding future cash flow, financing activities, cost reduction measures, compliance with the Company's line of credit and an extension or replacement of such line are forward-looking statements and there can be no assurance that the Company will generate positive cash flow in the future or that the Company will be able to obtain financing on satisfactory terms, if at all, or that any cost reductions effected by the Company will be sufficient to offset any negative cash flow from operations or that the Company will remain in compliance with its line of credit or be able to renew or replace such line. Additional risks and uncertainties include possible delays in the completion of products, the possible lack of consumer appeal and acceptance of products released by the Company, fluctuations in demand, lost sales because of the rescheduling of products launched or orders delivered, failure of the Company's markets to continue to grow, that the Company's products will remain accepted within their respective markets, that competitive conditions within the Company's markets will not change materially or adversely, that the Company will retain key development and management personnel, that the Company's forecasts will accurately anticipate market demand, that there will be no material adverse change in the Company's operations or business. Additional factors that may affect future operating results are discussed in more detail in "Factors Affecting Future Performance," below as well as the Company's Annual Report on Form 10-K on file with the Securities and Exchange Commission. Assumptions relating to the foregoing involve judgments with respect to, among other things, future economic, competitive and market conditions, and future business decisions, all of which are difficult or impossible to predict accurately and many of which are beyond the control of the Company. Although the Company believes that the assumptions underlying the forward-looking statements are reasonable, the business and operations of the Company are subject to substantial risks that increase the uncertainty inherent in the forward-looking statements, and the inclusion of such information should not be regarded as a representation by the Company or any other person that the objectives or plans of the Company will be achieved. In addition, risks, uncertainties and assumptions change as events or circumstances change. The Company disclaims any obligation to publicly release the results of any revisions to these forward-looking statements which may be made to reflect events or circumstances occurring subsequent to the filing of this Form 10-Q with the SEC or otherwise to revise or update any oral or written forward-looking statement that may be made from time to time by or on behalf of the Company. 13 Results of Operations The following table sets forth certain selected consolidated statements of operations data, segment data and platform data for the periods indicated in dollars and as a percentage of total net revenues:
Three Months Ended March 31, ----------------------------------------------------- 1999 1998 ------------------------ ------------------------ % of Net % of Net Amount Revenues Amount Revenues ----------- -------- ----------- -------- (Dollars in thousands) Net revenues $ 21,620 100.0% $ 40,996 100.0% Cost of goods sold 12,566 58.1% 19,221 46.9% ----------- ----- ----------- ----- Gross profit 9,054 41.9% 21,775 53.1% Operating expenses: Marketing and sales 7,544 34.9% 8,589 21.0% General and administrative 3,518 16.3% 2,855 7.0% Product development 5,382 34.9% 5,819 14.2% ----------- ----- ----------- ----- Total operating expenses 16,444 76.1% 17,263 42.2% ----------- ----- ----------- ----- Operating income (loss) (7,390) -34.2% 4,512 10.9% Other income (expense) (888) -4.1% (1,418) -3.5% ----------- ----- ----------- ----- Income (loss) before income taxes (8,278) -38.3% 3,094 7.4% Provision for income taxes - 0.0% 245 0.6% ----------- ----- ----------- ----- Net income (loss) $ (8,278) -38.3% $ 2,849 6.8% =========== ===== =========== ===== Net revenues by geographic region: North America $ 8,751 40.5% $ 23,516 57.3% International 9,943 46.0% 11,223 27.4% OEM, royalty and licensing 2,926 13.5% 6,257 15.3% Net revenues by platform: Personal computer $ 14,020 64.9% $ 21,191 51.7% Video game console 4,674 21.6% 13,548 33.0%
Net Revenues Net revenues for the three months ended March 31, 1999 decreased 47.3% to $21.6 million from $41 million in the comparable 1998 quarter. North America net revenues decreased to $8.8 million, or 40.5% of net revenues, from $23.5 million, or 57.3% of net revenues, in the 1998 quarter. International net revenues decreased to $9.9 million, or 46% of net revenues, from $11.2 million, or 27.4% of net revenues in the 1998 quarter. OEM, royalty and licensing net revenues decreased to $2.9 million, or 13.5% of net revenues, in the 1999 quarter from $6.3 million, or 15.3% of net revenues, in the 1998 quarter. The decrease in North America and International net revenues for the three months ended March 31, 1999 was primarily due to decreased title releases and a high level of product returns and markdowns. The Company expects that OEM, royalty and licensing net revenues may continue to decline, both in dollars and as a percentage of net revenues during the remainder of 1999 as a larger proportion of OEM, royalty and licensing net revenues are generated from royalty-based licensing transactions, as opposed to the shipment of finished goods, and as such distribution channels become more competitive. Cost of Goods Sold; Gross Margin Cost of goods sold decreased 34.6% in the three months ended March 31, 1999 to $12.6 million, or 58.1% of net revenues, from $19.2 million, or 46.9% of net revenues in the comparable 1998 quarter. Gross margin decreased to 41.9% in the 1999 quarter from 53.1% in the 1998 quarter. The decrease in gross margin during the three months ended March 31, 1999 was primarily a result of a lower net revenues base than in the 1998 period. The 1999 period also included the effects of additional write-off's of prepaid royalties relating to titles or platform versions of titles which had been canceled or were expected to achieve lower unit sales than were originally anticipated. 14 Operating Expenses Total operating expenses decreased 4.7% to $16.4 million, or 76.1% of net revenues, in the three months ended March 31, 1999 from $17.3 million, or 42.2% of net revenues, for the comparable 1998 quarter. Marketing and Sales. Marketing and sales expenses primarily include advertising and retail marketing support, sales commissions, marketing and sales personnel, customer support services and other costs. Marketing and sales expenses decreased 12.2% to $7.5 million, or 34.9% of net revenues, for the three months ended March 31, 1999 from $8.6 million, or 21.0% of net revenues for the comparable 1998 quarter. The decreases in absolute dollars were primarily attributable to decreased advertising and other marketing costs associated with the decrease in major titles launched and products sold during the 1999 period, as well as a reduction of personnel as a result of International Distribution Agreement entered into in February 1999 between the Company and Virgin Interactive Entertainment Limited ("Virgin"), offset in part by increased marketing development funds in the U.S. market. The increase as a percentage of net revenues for the three months ended March 31, 1999 was primarily attributable to a lower net revenues base than the 1998 period. The Company expects that in future periods marketing and sales expenses will increase in absolute dollars, but may vary as a percentage of net revenues. General and Administrative. General and administrative expenses primarily include administrative personnel expenses, facilities costs, professional expenses and other overhead charges. General and administrative expenses increased 23.2% to $3.5 million, or 16.3% of net revenues, in the three months ended March 31, 1999 from $2.9 million, or 7.0% of net revenues in the comparable 1998 quarter. The increase in absolute dollars in the three months ended March 31, 1999 was primarily due to a $0.6 million anticipated asset valuation and restructuring charge in connection with the Company's transaction with Virgin. The increase as a percentage of net revenues was primarily due to a lower net revenues base than in the 1998 period. The Company may in the future be required to make additional payments of approximately $0.2 million in the aggregate under a lease of equipment originally utilized by Engage. The Company is attempting to mitigate this potential expense by using or subleasing a portion of the equipment. The Company expects that in future periods general and administrative expenses will increase in absolute dollars, but may vary as a percentage of net revenues. Product Development. Product development expenses, which primarily include personnel and support costs, are charged to operations in the period incurred. Product development expenses decreased 7.5% to $5.4 million, or 24.9% of net revenues, in the three month period ended March 31, 1999 from $5.8 million, or 14.2% of net revenues, in the comparable 1998 quarter. The decreases in absolute dollars in the three months ended March 31, 1999 was primarily due to decreased labor and overhead costs as a result of personnel reductions. The increases as a percentage of net revenues was due to a lower net revenues base than in the 1998 period. The Company expects that in future periods product development expenses will increase in absolute dollars, but may vary as a percentage of net revenues. Other Expense Other expense for the three month period ended March 31, 1999 primarily included interest expense on the Company's line of credit. Other expense decreased to $0.9 million in the three months ended March 31, 1999 from $1.4 million in the comparable 1998 quarter. The decrease in the three months ended March 31, 1999 was primarily due to decreased interest expense resulting from the repayment of the Subordinated Secured Promissory Notes and the reduction of the outstanding balance of the line of credit from the proceeds of the IPO in June 1998, $9.8 million related to distribution and other advances on future products and $10 million related to a Stock Purchase Agreement with an investor for 2.5 million shares of the Company's Common Stock. Provision (Benefit) for Income Taxes The Company recorded no tax benefit in the three months ended March 31, 1999 compared to a tax provision of $0.2 million in the three months ended March 31, 1998. No tax benefit was recorded in the 1999 quarter due to the uncertainty of realization in future periods. 15 Liquidity and Capital Resources The Company has funded its operations to date primarily through the use of lines of credit and equipment leases, through cash generated by the private sale of securities and from the proceeds from the initial public offering and from operations. As of March 31, 1999 the Company's principal sources of liquidity included cash and short term investments of approximately $0.4 million and the Company's line of credit bearing interest at the London Interbank Offered Rate plus 4.87% (9.84% as of March 31, 1999), expiring January 1, 2000. Under the terms of the line of credit as in effect on March 31, 1999, the Company had available borrowings and letters of credit up to $37.5 million through November 29, 1999, $30.0 million through December 30, 1999 and $25 million thereafter, based in part upon qualifying receivables and inventory. Within the overall credit limit, the line of credit as of March 31, 1999 also provided that the Company could borrow up to $14 million in excess of its borrowing base through July 30, 1999, $10 million in excess through September 29, 1999, and up to $5 million in excess of its borrowing base thereafter. Under the line of credit the Company is required to place a cash collateral deposit of $2 million by March 15, 1999 and an additional $0.5 million for a total of $2.5 million on April 15, 1999. In addition, the Company is required to maintain certain borrowing limitations beginning July 30, 1999 where actual borrowings are limited to $35 million with various month end limitations, generally decreasing to $25 million at December 31, 1999 and the $5 million personal guarantee by the Company's Chairman and Chief Executive Officer will remain in place throughout the term. All other terms and conditions remain in full force and effect. The Company is in compliance with the terms of the Loan Agreement. As of March 31, 1999, the Company's balance on the line of credit was $22.7 million with stand by letters of credit outstanding totaling $2.6 million. Based upon certain assumptions, including without limitation, the Company's ability to achieve anticipated operating results, the Company believes that it will be able to renew its line of credit or obtain alternate financing on reasonable terms. However, there can be no assurance that the assumptions relied on by the Company will prove correct or that the Company will be able to renew or replace its line of credit or obtain alternate financing on reasonable terms, if at all. In March 1999, the Company obtained equity financing by selling 2.5 million shares of its Common Stock to Titus for $10 million. The purchase price of such transaction will be recalculated based upon the per share price of the Company's common stock at certain future dates. As a consequence of such recalculation, Titus may be issued additional shares by the Company pursuant to such transaction. In the event such additional number of shares results in aggregate ownership by Titus of 20% or greater of the outstanding Common Stock of the Company, the Company must have obtained the approval of its stockholders for such issuance. In the event such approval is not obtained, the Company would be required to issue Titus a promissory note in a principal amount equal to the value of the shares in excess of 20% of the Company's outstanding Common Stock to which Titus would otherwise be entitled, with interest at a rate of 10%. There can be no assurance that the Company will obtain the approval of its stockholders for any additional issuance, and that the Company will not issue a promissory note to Titus as set forth above. In May 1999, the Company and Titus signed a letter of intent under the terms of which Titus loaned the Company $5 million, which obligation must be repaid by the Company in the event the transactions contemplated by the letter of intent are not consummated, or, in lieu of such repayment and at the option of Titus, such obligation may be converted into shares of the Company's Common stock at an agreed upon price. The letter of intent contemplates a strategic equity investment by Titus of $25 million, subject to the entering into of definitive agreements concerning such transaction by the Company and Titus. There can be no assurance that the transactions contemplated by the letter of intent, including the additional equity investment by Titus, will be consummated. The Company's primary capital needs have historically been to fund working capital requirements necessitated by its sales growth, the development and introduction of products and related technologies and the acquisition or lease of equipment and other assets used in the product development process. The Company's operating activities used cash of $6.1 million during the three months ended March 31, 1999 and provided $0.3 million during the three months ended March 31, 1998. The cash used by operating activities in the three months ended March 31, 1999 was primarily attributable to the net loss incurred and decreases in accounts payable, offset in part by a decrease in accounts receivable. Cash provided by financing activities of $6.1 million in the three months ended March 31, 1999 resulted primarily from the issuance of Common Stock to an investor, offset in part by repayments on the line of credit. Cash provided by financing activities of $0.5 million in the three months ended March 31, 1998 resulted primarily from borrowings under the Company's line of credit. 16 Cash used in investing activities of $0.3 million and $0.5 million in the three months ended March 31, 1999 and 1998, respectively, consisted of capital expenditures, primarily for office and computer equipment used in Company operations. The Company does not currently have any material commitments with respect to any capital expenditures. To provide liquidity, the Company has implemented certain measures during the forth quarter of 1998 and the first quarter of 1999, including a reduction of personnel, a decrease in management compensation and the delay, cancellation or scale back of certain product development and marketing programs, among other actions. There can be no assurance that the Company's operating expenses or current obligations will not materially exceed cash flows available from the Company's operations in fiscal 1999 and beyond or that the increased line of credit will be sufficient to finance any negative cash flow from operations or that such line of credit will be renewed or replaced on reasonable terms, if at all. In addition, no assurance can be given that the measures heretofore effected will not materially adversely affect the Company's ability to develop and publish commercially viable titles, or that such measures, whether alone or in conjunction with increased net revenues, if any, will be sufficient to generate operating profits in fiscal 1999 and beyond. The Company may be required to seek additional funds through debt or equity financings, product licensing or distribution transactions or some other source of financing in order to provide sufficient working capital for the Company. Certain of such measures may require third party consents or approvals, including the Company's financial institution, and there can be no such assurance that such consents or approvals can be obtained. The Company believes that funds available under its line of credit, amounts to be received under various product license and distribution agreements, anticipated funds from operations, and the proceeds from potential debt or equity financings will be sufficient to satisfy the Company's projected working capital and capital expenditure needs and debt obligations in the normal course of business at least through the expiration of its line on January 1, 2000. Based upon certain assumptions, including without limitation, the Company's ability to achieve anticipated operating results and the completion of the proposed transaction with Titus under the May 1999 letter of intent or other potential debt or equity financings, the Company believes that it will be able to renew its line of credit or obtain alternate financing on reasonable terms. However, there can be no assurance that the assumptions relied on by the Company will prove correct or that the Company will be able to renew or replace its line of credit on satisfactory terms, if at all. Further, there can be no assurance that the Company will complete the proposed transaction with Titus or other potential debt or equity financings during such period. If the Company is required to raise additional working capital, there can be no assurance that the Company will be able to raise such additional working capital on acceptable terms, if at all. In the event the Company is unable to raise additional working capital, further measures would be necessary including, without limitation, the sale or consolidation of certain operations, the delay, cancellation or scale back of product development and marketing programs and other actions. No assurance can be given that such measures would not materially adversely affect the Company's ability to develop and publish commercially viable titles, or that such measures would be sufficient to generate operating profits in fiscal 1999 and beyond. Certain of such measures may require third party consents or approvals, including the Company's financial institution, and there can be no such assurance that such consents or approvals can be obtained. Year 2000 Issue Many existing computer systems and applications, and other control devices, use only two digits to identify a year in the date field, without considering the impact of the upcoming change in the century. Therefore, they do not properly recognize a year that begins with "20" rather than "19". Others do not correctly process "leap year" dates. As a result, such systems and applications could fail or create erroneous results unless corrected so that they can correctly process data related to the year 2000 and beyond. The Company relies on its systems and applications in operating and monitoring all major aspects of its business, including financial systems (such as general ledger, accounts payable and payroll modules), customer services, networks and telecommunications systems equipment and end products. The Company also relies, directly and indirectly, on external systems of suppliers for the management and control of product development and of business enterprises such as developers, customers, suppliers, creditors, financial organizations, and governmental entities, both domestic and international, for accurate exchange of data. The Company could be affected through disruptions in the operation of the enterprises with which the Company interacts or from general widespread problems or an economic crisis resulting from non-compliant Year 2000 systems. Despite the Company's efforts to address the Year 2000 impact on its internal systems and business operations, there can be no assurance that such impact will not result in a material disruption 17 of its business or have a material adverse effect on the Company's business, operating results and financial condition. The Company is currently in the process of assessing the potential impact of the Year 2000 issue on its business and the related foreseeable expenses that may be incurred in attempting to remedy such impact. The Company is employing a combination of internal resources and outside consultants to evaluate and address Year 2000 issues. The Company's Year 2000 plan includes (i) Assessment: Conducting an evaluation of the Company's computer based systems, facilities and products (and those of significant dealers, vendors and other third parties with which the Company does business) to determine their Year 2000 compliance, (ii) Remediation: Coordinating the replacement and/or upgrade of non-compliant systems, as necessary, and (iii) Test and Implement: Developing and overseeing the implementation of all of the initiatives in the Company's Year 2000 compliance plan. For example, the Company is in the process of upgrading its internal accounting software and expects such upgrade to be completed prior to the commencement of the 3rd quarter in 1999. Although the Company has identified certain systems and applications that are not Year 2000 compliant and the Company is in the process of upgrading its software to address the Year 2000 issue, there can be no assurance that such upgrades will be completed on a timely basis at reasonable costs, or that such upgrades will be able to anticipate all of the problems triggered by the actual impact of the year 2000. In addition, the inability of any internal system to achieve Year 2000 compliance could result in material disruption to the Company's operations. With respect to customers, developers, suppliers and other enterprises upon which the Company relies, even where assurances are received from such third parties, there remains a risk that failure of systems and applications of such third parties could have a material adverse effect on the Company. The Company is currently assessing its products for Year 2000 compliance and anticipates such assessment to be complete prior to the end of the 3rd quarter in 1999. However, there can be no assurance that any of the Company's products are or will be Year 2000 compliant. The failure of any of the Company's products to achieve Year 2000 compliance would result in increased warranty costs, customer satisfaction issues, potential lawsuits and other material costs and liabilities. In addition, if the computer systems on which the consumers use the Company's products are not Year 2000 compliant, such non compliance could adversely affect the consumers ability to use such products. The Company believes that it will substantially complete the implementation of its Year 2000 plan prior to the commencement of the 3rd quarter in 1999. However, if the Company does not complete its Year 2000 plan prior to the commencement of the year 2000, or if the Company fails to identify and remediate all critical Year 2000 problems or if major suppliers, developers or customers experience material Year 2000 problems, the Company's results of operations or financial condition could be materially adversely effected. The Company has estimated that the total cost of Year 2000 compliance will be less than $500,000, $46,000 of which had been spent. The costs of compliance have been included in the Company's 1999 budget. The Company currently does not have a formal contingency plan in the event that an area of its operations does not become Year 2000 compliant. The Company will consider adopting a formal plan upon completion of the Year 2000 assessment or if, pending such completion, it becomes more evident that there will be an area of non-compliance in its systems or at a critical third party. The foregoing statements are based upon management's best estimates at the present time, which were derived utilizing numerous assumptions of future events, including the continued availability of certain resources, third party modification plans and other factors. There can be no assurance that these estimates will be achieved and actual results could differ materially from those anticipated. Specific factors that might cause such material differences include, but are not limited to, the availability and cost of personnel trained in this area, the ability to locate and correct all relevant computer codes, the nature and amount of programming required to upgrade or replace each of the affected programs, the rate and magnitude of related labor and consulting costs and the success of the Company's external customers, developers and suppliers in addressing the Year 2000 issue. The Company's evaluation is ongoing and it expects that new and different information will become available to it as the evaluation continues. Consequently, there can be no assurance that all material elements will be Year 2000 compliant in time. 18 FACTORS AFFECTING FUTURE PERFORMANCE Future operating results of the Company depend upon many factors and are subject to various risks and uncertainties. Some of the risks and uncertainties which may cause the Company's operating results to vary from anticipated results or which may materially and adversely affect its operating results are as follows: Liquidity; Future Capital Requirements The Company used net cash in operations of $6.1 million and provided net cash from operations of $0.3 million, respectively, in the three months ended March 31, 1999 and 1998. There can be no assurance that the Company will ever generate positive cash flow from operations. The Company's ability to fund its capital requirements out of available cash, its line of credit and cash generated from operations will depend on numerous factors, including the progress of the Company's product development programs, the rate of growth of the Company's business, and the commercial success of the Company's products. The Company may be required to seek additional funds through debt or equity financings, product licensing or distribution transactions or some other source of financing in order to provide sufficient working capital for the Company. The issuance of additional equity securities by the Company could result in substantial dilution to stockholders. If the Company is required to raise additional working capital, there can be no assurance that the Company will be able to raise such additional working capital on acceptable terms, if at all. In the event the Company is unable to raise additional working capital, further cost reduction measures would be necessary including, without limitation, the sale or consolidation of certain operations, the delay, cancellation or scale back of product development and marketing programs and other actions. No assurance can be given that such measures would not materially adversely affect the Company's ability to publish commercially viable titles, or that such measures would be sufficient to generate operating profits. Certain of such measures may require third party approvals, including the Company's financial institution, and there can be no assurance that such consents or approvals can be obtained. Fluctuations in Operating Results; Uncertainty of Future Results; Seasonality The Company's operating results have fluctuated significantly in the past and will likely fluctuate significantly in the future, both on a quarterly and an annual basis. A number of factors may cause or contribute to such fluctuations, and many of such factors are beyond the Company's control. Such factors include, but are not limited to, delays in shipment, demand for the Company's and its competitors' products, the size and rate of growth of the market for interactive entertainment software, changes in computing platforms, the number of new products and product enhancements released by the Company and its competitors during the period, changes in product mix, product returns, the timing of orders placed by distributors and dealers, delays in shipment, the timing of development and marketing expenditures, price competition and the level of the Company's international and OEM, royalty and licensing net revenues. The uncertainties associated with the interactive entertainment software development process, lengthy manufacturing lead times for Nintendo- compatible products, possible production delays, and the approval process for products compatible with the Sony Computer Entertainment, Nintendo and Sega video game consoles, as well as approvals required from other licensors, make it difficult to accurately predict the quarter in which shipments will occur. Because of the limited number of products introduced by the Company in any particular quarter, a delay in the introduction of a product may materially adversely affect the Company's operating results for that quarter and may not be recaptured in subsequent quarters. A significant portion of the Company's operating expenses is relatively fixed, and planned expenditures are based primarily on sales forecasts. If net revenues do not meet the Company's expectations in any given quarter, operating results may be materially adversely affected. The interactive entertainment software industry is highly seasonal, with the highest levels of consumer demand occurring during the year-end holiday buying season, followed by demand during the first calendar quarter. As a result, net revenues, gross profits and operating income for the Company have historically been highest during the fourth and the following first calendar quarters, and have declined from those levels in subsequent second and third calendar quarters. The failure or inability of the Company to introduce products on a timely basis to meet such seasonal increases in demand may have a material adverse effect on the Company's business, operating results and financial condition. The Company may over time become increasingly affected by the industry's seasonal patterns. Although the Company seeks to reduce the effect of such seasonal patterns on its business by distributing its product release dates more evenly throughout the year, there can be no assurance that such efforts will be successful. There can be no assurance that the Company will be profitable in any particular period given the uncertainties associated with 19 software development, manufacturing, distribution and the impact of the industry's seasonal patterns on the Company's net revenues. As a result of the foregoing factors and the other factors discussed in "Management's Discussion and Analysis of Financial Condition and Results of Operations--Factors Affecting Future Performance," it is likely that the Company's operating results in one or more future periods will fail to meet or exceed the expectations of securities analysts or investors. In such event, the trading price of the Common Stock would likely be materially adversely affected. Significant Recent Losses The Company has experienced significant losses in recent periods, including a loss of $8.3 million and $16.6 million for each of the three months ended March 31, 1999 and December 31, 1998, respectively. These losses resulted primarily from delays in the completion of certain products, a higher than expected level of product returns and markdowns on products released during the year and lower than expected worldwide sales of certain releases, as well as from operating expense levels that were high relative to the Company's revenue level. There can be no assurance that the Company will not experience similar problems in current or future periods or that the Company will be able to generate sufficient net revenues or adequate working capital, or bring its costs into line with revenues, so as to attain or sustain profitability in the future. Dependence on New Product Introductions; Risk of Product Delays and Product Defects The Company's products typically have short life cycles, and the Company depends on the timely introduction of successful new products, including enhancements of or sequels to existing products and conversions of previously released products to additional platforms, to generate net revenues to fund operations and to replace declining net revenues from older products. If in the future for any reason net revenues from new products were to fail to replace declining net revenues from existing products, the Company's business, operating results and financial condition could be materially adversely affected. The timing and success of new interactive entertainment software product releases remains unpredictable due to the complexity of product development, including the uncertainty associated with new technology. The development cycle of new products is difficult to predict but typically ranges from 12 to 24 months and another six to 12 months for the porting of a product to a different technology platform. In the past, the Company has frequently experienced significant delays in the introduction of new products, including certain products currently under development. Because net revenues associated with the initial shipments of a new product generally constitute a high percentage of the total net revenues associated with a product, any delay in the introduction of, or the presence of a defect in, one or more new products expected in a period could have a material adverse effect on the ultimate success of such products and on the Company's business, operating results and financial condition. The costs of developing and marketing new interactive entertainment software have increased in recent years due to such factors as the increasing complexity and content of interactive entertainment software, increasing sophistication of hardware technology and consumer tastes and increasing costs of obtaining licenses for intellectual properties, and the Company expects this trend to continue. There can be no assurance that new products will be introduced on schedule, if at all, or that, if introduced, they will achieve significant market acceptance or generate significant net revenues. In addition, software products as complex as those offered by the Company may contain undetected errors when first introduced or when new versions are released. There can be no assurance that, despite testing by the Company, errors will not be found in new products or releases after commencement of commercial shipments, resulting in loss of or delay in market acceptance, which could have a material adverse effect on the Company's business, operating results and financial condition. Uncertainty of Market Acceptance; Dependence on Hit Titles Consumer preferences for interactive entertainment software are continually changing and are extremely difficult to predict. Historically, few interactive entertainment software products have achieved sustained market acceptance. Rather, a limited number of releases have become "hits" and have accounted for a substantial portion of revenues in the industry. Further, publishers with a history of producing hit titles have enjoyed a significant marketing advantage because of their heightened brand recognition and consumer loyalty. The Company expects the importance of introducing hit titles to increase in the future. There can be no assurance that new products introduced by the Company will achieve significant market acceptance, that such acceptance, if achieved, will be sustainable for any significant period, or that product life cycles will be sufficient to permit the Company to recover 20 development and other associated costs. Most of the Company's products have a relatively short life cycle and sell for a limited period of time after their initial release, usually less than one year. The Company believes that these trends will continue and that the Company's future revenue will continue to be dependent on the successful production of hit titles on a continuous basis. Because the Company introduces a relatively limited number of new products in a given period, the failure of one or more of such products to achieve market acceptance could have a material adverse effect on the Company's business, operating results and financial condition. Further, if market acceptance is not achieved, the Company could be forced to accept substantial product returns or grant significant markdown allowances to maintain its relationship with retailers and its access to distribution channels. For example, the Company had higher than expected product returns and markdowns in the three months ended March 31, 1999 and there can be no assurance that higher than expected product returns and markdowns will not continue in the future. In the event that the Company is forced to accept significant product returns or grant significant markdown allowances, its business, operating results and financial condition could be materially adversely affected. Continued Listing on the NASDAQ National Market The Company's Common Stock is currently quoted on the NASDAQ National Market under the symbol "IPLY." For continued inclusion on the NASDAQ National Market, a company must meet certain tests, such as a minimum bid price of $1.00 and net tangible assets of at least $4.0 million. In the event that the Company fails to satisfy the listing standards on a continuous basis, the Company's Common Stock may be removed from listing on the NASDAQ National Market. If the Company's Common Stock is delisted from the NASDAQ National Market, trading of the Company's Common Stock, if any, would be conducted in the over-the-counter market in the so-called "pink sheets" or, if available, the NASD's "Electronic Bulletin Board." In such event, investors could find it more difficult to dispose of, or to obtain accurate quotations as to the value of, the Company's Common Stock and the trading price per share would most likely be reduced as a result. Upon consummation of the proposed transaction contemplated by the May 12, 1999 letter of intent between the Company and Titus, or the conversion of the $5 million loan, See note 10 of the notes to unaudited Consolidated Financial Statements, the Company should continue to meet the listing standards of the NASDAQ National Market. Distribution Agreement In February 1999 in connection with the Company's acquisition of a 43.9% membership interest in Virgin's parent entity, the Company signed an International Distribution Agreement with Virgin. Under this Agreement, the Company appointed Virgin as the exclusive distribution for substantially all of the Company's products in Europe, CIS, Africa and the Middle East, subject to certain reserved rights, for a seven year period. Because of the exclusive nature of the Agreement, if Virgin were to experience problems with its business, or were to fail to perform as expected, the Company's business, operating results and financial condition could be materially and adversely affected. In connection with this Agreement, Virgin will hire the Company's European sales and marketing personnel, and the Company will pay Virgin a distribution fee for its marketing and distribution of the Company's products, subject to a minimum amount, as well as a fixed overhead fee, subject to reduction in certain events. Because of the minimum distribution fee, in the event the Company's European sales are lower than expected, the Company may effectively pay a higher distribution fee on the units sold, which could have a material adverse effect on the Company's business, operating results and financial condition. In addition, due to the fixed nature of the overhead fee, the Company will not be able to reduce its European sales and marketing expenses in response to downturns in the Company's sales in Europe, which could have a material adverse effect on the Company's business, operating results and financial condition. Dependence on Third Party Software Developers The Company relies on third party interactive entertainment software developers for the development of a significant number of its interactive entertainment software products. As reputable and competent third party developers continue to be in high demand, there can be no assurance that third party software developers that have developed products for the Company in the past will continue to be available to develop products for the Company in the future. Many third party software developers have limited financial resources, which could expose the Company to the risk that such developers may go out of business prior to completing a project. In addition, due to the limited control that the Company exercises over third party software developers, there can be no assurance that such developers will complete products for the Company on a timely basis or within acceptable quality standards, if at all. Increased competition for skilled third party software developers has required the Company to enter into agreements with licensors of intellectual property and developers of games that involved advance payments by the Company of royalties and guaranteed minimum royalty payments, and the Company expects to continue to enter into such arrangements. If the sales volumes of products subject to such arrangements are not sufficient to recover 21 such royalty advances and guarantees, the Company would be required to write-off unrecovered portions of such payments, which could have a material adverse effect on its business, operating results and financial condition. Further, there can be no assurance that third party developers will not demand renegotiation of their arrangements with the Company. Rapidly Changing Technology; Platform Risks The interactive entertainment software industry is subject to rapid technological change. The introduction of new technologies, including operating systems such as Microsoft Windows 98, technologies that support multi-player games, new media formats such as on-line delivery and digital video disks ("DVDs") and as yet unreleased video game platforms could render the Company's current products or products in development obsolete or unmarketable. The Company must continually anticipate and assess the emergence of, and market acceptance of, new interactive entertainment software platforms well in advance of the time the platform is introduced to consumers. Because product development cycles are difficult to predict, the Company is required to make substantial product development and other investments in a particular platform well in advance of introduction of the platform. If the platforms for which the Company develops software are not released on a timely basis or do not attain significant market penetration, the Company's business, operating results and financial condition could be materially adversely affected. Alternatively, if the Company fails to develop products for a platform that does achieve significant market penetration, then the Company's business, operating results and financial condition could also be materially adversely affected. The emergence of new interactive entertainment software platforms and technologies and the increased popularity of new products and technologies may materially and adversely affect the demand for products based on older technologies. The broad range of competing and incompatible emerging technologies may lead consumers to postpone buying decisions with respect to products until one or more of such technologies gain widespread acceptance. Such postponement could have a material adverse effect on the Company's business, operating results and financial condition. The Company is currently actively developing products for the Microsoft Windows 98, PlayStation and Nintendo 64 platforms, as well as for the Sega Dreamcast platform scheduled for release in Fall 1999. The Company's success will depend in part on its ability to anticipate technological changes and to adapt its products to emerging game platforms. There can be no assurance that the Company will be able to anticipate future technological changes, to obtain licenses to develop products for those platforms on terms favorable to the Company or to create software for those new platforms, and any failure to do so could have a material adverse effect on the Company's business, operating results and financial condition. Industry Competition; Competition for Shelf Space The interactive entertainment software industry is intensely competitive and is characterized by the frequent introduction of new interactive entertainment software platforms and software platforms. The Company's competitors vary in size from small companies to very large corporations with significantly greater financial, marketing and product development resources than those of the Company. Due to these greater resources, certain of the Company's competitors are able to undertake more extensive marketing campaigns, adopt more aggressive pricing policies, pay higher fees to licensors of desirable motion picture, television, sports and character properties and pay more to third party software developers than the Company. The Company believes that the principal competitive factors in the interactive entertainment software industry include product features, brand name recognition, access to distribution channels, quality, ease of use, price, marketing support and quality of customer service. The Company competes primarily with other publishers of PC and video game console interactive entertainment software. Significant competitors include Electronic Arts, GT Interactive Software Corp., Mattel, Activision, Inc., Microsoft Corporation, LucasArts Entertainment Company, Midway Games Inc., Acclaim Entertainment Inc., Havas Interactive and Hasbro Inc. In addition, integrated video game console hardware/software companies such as Sony Computer Entertainment, Nintendo and Sega compete directly with the Company in the development of software titles for their respective platforms. Large diversified entertainment companies, such as The Walt Disney Company, many of which own substantial libraries of available content and have substantially greater financial resources than the Company, may decide to compete directly with the Company or to enter into exclusive relationships with competitors of the Company. The Company also believes that the overall growth in the use of the Internet and on-line services by consumers may pose a competitive threat if 22 customers and potential customers spend less of their available home PC time using interactive entertainment software and more on the Internet and on-line services. Retailers of the Company's products typically have a limited amount of shelf space and promotional resources, and there is intense competition among consumer software producers, and in particular interactive entertainment software products, for high quality retail shelf space and promotional support from retailers. To the extent that the number of consumer software products and computer platforms increases, competition for shelf space may intensify and may require the Company to increase its marketing expenditures. Due to increased competition for limited shelf space, retailers and distributors are in an increasingly better position to negotiate favorable terms of sale, including price discounts, price protection, marketing and display fees and product return policies. The Company's products constitute a relatively small percentage of any retailer's sale volume, and there can be no assurance that retailers will continue to purchase the Company's products or to provide the Company's products with adequate levels of shelf space and promotional support, and a prolonged failure in this regard may have a material adverse effect on the Company's business, operating results and financial condition. Dependence on Distribution Channels; Risk of Customer Business Failures; Product Returns The Company currently sells its products directly through its own sales force to mass merchants, warehouse club stores, large computer and software specialty chains and through catalogs in the U.S. and Canada, as well as to certain distributors. Outside North America, the Company generally sells to third party distributors. The Company's sales are made primarily on a purchase order basis, without long-term agreements. The loss of, or significant reduction in sales to, any of the Company's principal retail customers or distributors could materially adversely affect the Company's business, operating results and financial condition. The distribution channels through which consumer software products are sold are characterized by continuous change, including consolidation, financial difficulties of certain distributors and retailers, and the emergence of new distributors and new retailers such as warehouse chains, mass merchants and computer superstores. As more consumers own PCs, the distribution channels for interactive entertainment software have changed are expected to continue to change. Mass merchants have become the most important distribution channels for retail sales of interactive entertainment software. A number of these mass merchants, including Wal-Mart, have entered into exclusive buying arrangements with other software developers or distributors, which arrangements prevent the Company from selling certain of its products directly to that mass merchant. If the number of mass merchants entering into exclusive buying arrangements with software distributors other than the Company were to increase, the Company's ability to sell to such merchants would be restricted to selling through the exclusive distributor. Because sales to distributors typically have a lower gross profit than sales to retailers, this would have the effect of lowering the Company's gross profit. In addition, this trend could increase the material adverse impact on the Company's business, operating results and financial condition. In addition, emerging methods of distribution, such as the Internet and on-line services, may become more important in the future, and it will be important for the Company to maintain access to these channels of distribution. There can be no assurance that the Company will maintain such access or that the Company's access will allow the Company to maintain its historical levels of sales volume. Distributors and retailers in the computer industry have from time to time experienced significant fluctuations in their businesses, and there have been a number of business failures among these entities. The insolvency or business failure of any significant distributor or retailer of the Company's products could have a material adverse effect on the Company's business, operating results and financial condition. Sales are typically made on unsecured credit, with terms that vary depending upon the customer and the nature of the product. Although the Company has obtained insolvency risk insurance to protect against any bankruptcy, insolvency or liquidation that may occur involving its customers, such insurance contains a significant deductible and a co-payment obligation, and the policy does not cover all instances of non-payment. In addition, while the Company maintains a reserve for uncollectible receivables, the actual reserve may not be sufficient in every circumstance. As a result, a payment default by a significant customer could have a material adverse effect on the Company's business, operating results and financial condition. The Company is exposed to the risk of product returns and markdown allowances with respect to its distributors and retailers. The Company allows distributors and retailers to return defective, shelf-worn and damaged products in accordance with negotiated terms, and also offers a 90-day limited warranty to its end users that its products will be free from manufacturing defects. In addition, the Company provides markdown allowances to its customers to 23 manage its customers' inventory levels in the distribution channel. Although the Company maintains a reserve for returns and markdown allowances, and although the Company's agreements with certain of its customers place certain limits on product returns and markdown allowances, the Company could be forced to accept substantial product returns and provide markdown allowances to maintain its relationships with retailers and its access to distribution channels. Product return and markdown allowances that exceed the Company's reserves could have a material adverse effect on the Company's business, operating results and financial condition. In this regard, the Company's results of operations for the three months ended March 31, 1999 were adversely affected by a higher than expected level of product returns and markdown allowances and consequently reduced net revenues. There can be no assurance that the Company will not continue to experience such high levels of product returns and markdown allowances in future periods, which could have a material adverse effect on the Company's business, operating results and financial condition. Dilution; Shares Eligible for Future Sale In March 1999, the Company entered into a Stock Purchase Agreement with Titus Interactive S.A. ("Titus"), pursuant to which Titus purchased from the Company 2.5 million shares of the Company's Common Stock for an aggregate purchase price of $10 million. Pursuant to such Agreement, the Company may become obligated to issue additional shares of Common Stock to Titus without additional consideration in certain events (see Note 8 to the Company's Consolidated Financial Statements.) Such issuance could result in material dilution to the Company's stockholders. In addition, the Company has agreed to register all of the shares held by Titus (up to 9,658,216 shares if Titus exercises its option to acquire the shares owned by Universal and the maximum number of additional shares are issued) for resale under the Securities Act of 1933, as amended. Such registration could temporarily impair the Company's ability to raise capital through the sale of its equity securities, and, if such registered shares are sold, could have a material adverse effect on the market price of the Company's Common Stock. On May 12, 1999 the Company signed a letter of intent with Titus pursuant to which Titus will loan the Company $5 million, and the Company and Titus will negotiate certain additional transactions. Should the definitive agreements contemplated by the letter of intent not be entered into by the Company and Titus, the loan must be repaid by the Company, or, at the option of Titus, may be convertible into the Company's Common Stock. In the event the agreements contemplated by the letter of intent are entered into, Titus will make a strategic equity investment of $25 million in the Company, purchasing 6.25 million shares of Common Stock at a purchase price of $4 per share. As part of the agreements to be negotiated under the letter of intent, Titus chairman and chief executive officer Herve Caen would become president of Interplay. The letter of intent also contemplates the swap by Brian Fargo, the Company's chairman and chief executive officer, of 2 million personal shares of Interplay Common Stock for an agreed upon number of Titus shares. If the transactions to be negotiated pursuant to the letter of intent are consummated, Titus will own approximately 51% of the Company's outstanding Common Stock, resulting in a change of control of the Company in favor of Titus. Dependence Upon Third Party Licenses Many of the Company's products, such as its Star Trek, Major League Baseball and Caesar's Palace titles, are based on original ideas or intellectual properties licensed from third parties. There can be no assurance that the Company will be able to obtain new licenses, or renew existing licenses, on commercially reasonable terms, if at all. For example, Paramount has granted the Star Trek license to a third party upon the expiration of the Company's rights. Should the Company be unable to obtain licenses for the underlying content that it believes offers the greatest consumer appeal, the Company would either have to seek alternative, potentially less appealing licenses, or release the products without the desired underlying content, either of which events could have a material adverse effect on the Company's business, operating results and financial condition. There can be no assurance that acquired properties will enhance the market acceptance of the Company's products based on such properties, that the Company's new product offerings will generate net revenues in excess of their costs of development and marketing or minimum royalty obligations, or that net revenues from new product sales will meet or exceed net revenues from existing product sales. 24 Dependence on Licenses from and Manufacturing by Hardware Companies The Company is required to obtain a license to develop and distribute software for each of the video game console platforms for which the Company develops products, including a separate license for each of North America, Japan and Europe. The Company has obtained licenses to develop software for the PlayStation in North America and is currently negotiating agreements covering additional territories. In addition, the Company has obtained a license to develop software for the Nintendo 64 in North America, Europe and Australia and is currently negotiating with Nintendo for licenses covering additional territories. There can be no assurance that the Company will be able to obtain licenses from hardware companies on acceptable terms or that any existing or future licenses will be renewed by the licensors. In addition, each of Sony Computer Entertainment, Nintendo and Sega have the right to approve the technical functionality and content of the Company's products for such platform prior to distribution. Due to the nature of the approval process, the Company must make significant product development expenditures on a particular product prior to the time it seeks such approvals. The inability of the Company to obtain such approvals could have a material adverse effect on the Company's business, operating results and financial condition. Hardware companies such as Sony Computer Entertainment, Nintendo and Sega may impose upon their licensees a restrictive selection and product approval process, such that licensees are restricted in the number of titles that will be approved for distribution on the particular platform. While the Company has prepared its future product release plans taking this competitive approval process into consideration, if the Company has incorrectly predicted the impact of this restrictive approval process, and as a result the Company fails to obtain approvals for all products in the Company's development plans, such failure could have a material adverse effect on the Company's business, operating results and financial condition. The Company depends upon Sony Computer Entertainment and Nintendo for the manufacture of the Company's products that are compatible with their respective video game consoles. As a result, Sony and Nintendo have the ability to raise prices for supplying such products at any time and effectively control the timing of the Company's release of new titles for those platforms. PlayStation products consist of CD-ROMs and are typically delivered by Sony Computer Entertainment within a relatively short lead time. Manufacturers of Nintendo and other video game cartridges typically deliver software to the Company within 45 to 60 days after receipt of a purchase order. If the Company experiences unanticipated delays in the delivery of video game console products from Sony Computer Entertainment or Nintendo, or if actual retailer and consumer demand for its interactive entertainment software differs from that forecast by the Company, its business, operating results and financial condition could be materially adversely affected. Dependence on Key Personnel The Company's success depends to a significant extent on the continued service of its key product design, development, sales, marketing and management personnel, and in particular on the leadership, strategic vision and industry reputation of its founder and Chief Executive Officer, Brian Fargo. The Company's future success will also depend upon the Company's ability to continue to attract, motivate and retain highly qualified employees and contractors, particularly key software design and development personnel. Competition for highly skilled employees is intense, and there can be no assurance that the Company will be successful in attracting and retaining such personnel. Specifically, the Company may experience increased costs in order to attract and retain skilled employees. The Company's failure to retain the services of Brian Fargo or its other key personnel or to attract and retain additional qualified employees could have a material adverse effect on the Company's business, operating results and financial condition. Risks Associated with International Operations; Currency Fluctuations International net revenues accounted for 46.0% and 27.4% of the Company's total net revenues in the three months ended March 31, 1999 and 1998, respectively. Additionally, in February 1999, the Company entered into an International Distribution Agreement with Virgin for the exclusive distribution of its products in selected international territories. The Company intends to continue to expand its direct and indirect sales, marketing and product localization activities worldwide. Such expansion will require significant management time and attention and financial resources in order to develop improved international sales and support channels. There can be no assurance, however, that the Company will be able to maintain or increase international market demand for its products. International sales and operations are subject to a number of inherent risks, including the impact of possible recessionary environments in economies outside the U.S., the time and financial costs associated with translating and localizing products for foreign markets, longer accounts receivable collection periods and greater 25 difficulty in accounts receivable collection, unexpected changes in regulatory requirements, difficulties and costs of staffing and managing foreign operations, and political and economic instability. For example, the Company has recently experienced difficulties selling products in certain Asian countries as a result of economic instability in such countries, and there can be no assurance that such difficulties will not continue or occur in other countries in the future. There can be no assurance that the foregoing factors will not have a material adverse effect on the Company's future international net revenues and, consequently, on the Company's business, operating results and financial condition. The Company currently does not engage in currency hedging activities. Although exposure to currency fluctuations to date has been insignificant, there can be no assurance that fluctuations in currency exchange rates in the future will not have a material adverse effect on net revenues from international sales and licensing, and thus on the Company's business, operating results and financial condition. Risks Associated with New European Currency On January 1, 1999, eleven of the fifteen member countries of the European Union ("Participating Countries") established fixed conversion rates between their existing sovereign currencies and a new European currency, the "euro". The euro was adopted by the Participating Countries as the common legal currency on that date. A significant portion of the Company's sales are made to Participating Countries and consequently, the Company anticipates that the euro conversion will, among other things, create technical challenges to adapt information technology and other systems to accommodate euro-denominated transactions and limit the Company's ability to charge different prices for its producers in different markets. While the Company anticipates that the conversion will not cause material disruption of its business, there can be no assurance that the conversion will not have a material effect on the Company's business or financial condition. Protection of Proprietary Rights The Company regards its software as proprietary and relies on a combination of patent, copyright, trademark and trade secret laws, employee and third party nondisclosure agreements and other methods to protect its proprietary rights. The Company owns or licenses various copyrights and trademarks, and holds the rights to one patent application related to the software engine for its Messiah title. While the Company provides "shrinkwrap" license agreements or limitations on use with its software, the enforceability of such agreements or limitations is uncertain. The Company is aware that unauthorized copying occurs within the computer software industry, and if a significantly greater amount of unauthorized copying of the Company's interactive entertainment software products were to occur, the Company's operating results could be materially adversely affected. While the Company does not generally copy protect its products, it does not provide source code to third parties unless they have signed nondisclosure agreements with respect thereto. The Company relies on existing copyright laws to prevent unauthorized distribution of its software. Existing copyright laws afford only limited protection. Policing unauthorized use of the Company's products is difficult, and software piracy can be expected to be a persistent problem, especially in certain international markets. Further, the laws of certain countries in which the Company's products are or may be distributed either do not protect the Company's products and intellectual property rights to the same extent as the laws of the U.S. or are weakly enforced. Legal protection of the Company's rights may be ineffective in such counties, and as the Company leverages its software products using emerging technologies, such as the Internet and on-line services, the ability of the Company to protect its intellectual property rights, and to avoid infringing the intellectual property rights of others, becomes more difficult. There can be no assurance that existing intellectual property laws will provide adequate protection to the Company's products in connection with such emerging technologies. As the number of interactive entertainment software products in the industry increases and the features and content of these products further overlap, software developers may increasingly become subject to infringement claims. Although the Company makes reasonable efforts to ensure that its products do not violate the intellectual property rights of others, there can be no assurance that claims of infringement will not be made. Any such claims, with or without merit, can be time consuming and expensive to defend. From time to time, the Company has received communications from third parties of such parties. There can be no assurance that existing or future infringement claims against the Company will not result in costly litigation or require the Company to license the intellectual property rights of third parties, either of which could have a material adverse effect on the Company's business, operating results and financial condition. 26 Entertainment Software Rating System; Governmental Restrictions Legislation is periodically introduced at the state and federal levels in the U.S. and in foreign countries to establish a system for providing consumers with information about graphic violence and sexually explicit material contained in interactive entertainment software products. Such a system would include procedures with which interactive entertainment software publishers would be expected to comply by identifying particular products within defined rating categories and communicating such ratings to consumers through appropriate package labeling and through advertising and marketing presentations consistent with each products' rating. In addition, many foreign countries have laws which permit governmental entities to censor the content of certain works, including interactive entertainment software. In certain instances, the Company may be required to modify its products to comply with the requirements of such governmental entities, which could delay the release of those products in such countries. Such delays could have a material adverse effect on the Company's business, operating results and financial condition. While the Company currently voluntarily submits its products to industry-created review boards and publishes their ratings on its game packaging, the Company believes that mandatory government-run integrative entertainment software products rating systems eventually will be adopted in many countries which represent significant markets or potential markets for the Company. Due to the uncertainties inherent in the implementation of such a rating system, confusion in the marketplace may occur, and the Company is unable to predict what effect, if any, such a rating system would have on the Company's business. In addition to such regulations, certain retailers have in the past declined to stock certain of the Company's products because they believed that the content of the packaging artwork or the products would be offensive to the retailer's customer base. While to date such actions have not had a material adverse effect on the Company's business, operating results or financial condition, there can be no assurance that similar actions by the Company's distributors or retailers in the future would not have a material adverse effect on the Company's business, operating results and financial condition. Control by Directors and Officers The Company's directors and executive officers and Universal Studios, Inc. ("Universal"), which currently has two representatives on the Company's Board of Directors, beneficially own, in the aggregate, approximately 52.5% of the Company's outstanding Common Stock. These stockholders, if acting together with Titus, see "Potential for Control by Titus", would be able to control substantially all matters requiring approval by the stockholders of the Company, including the election of directors (subject to the cumulative voting rights of the Company's stockholders) and the approval of mergers or other business combination transactions. Such concentration of ownership could discourage or prevent a change in control of the Company. Potential for Control by Titus Titus beneficially owns approximately 12.0% of the Company's outstanding Common Stock, and may be issued additional shares based upon the Company's stock price at certain future dates, further increasing its ownership in the Company in addition to any other potential increases in ownership. Titus also holds an option to purchase the 4,658,216 shares of the Common Stock currently held by Universal, which would increase its ownership percentage to approximately 34.4%. Further, the $5 million loan made by Titus to the Company is convertible into Common Stock of the Company at the option of Titus in the event the transactions contemplated by the letter of intent are not consummated, resulting in a further ownership increase. If the transactions contemplated by the letter of intent are entered into by the Company and Titus, Titus would own approximately 51.0% of the Common Stock of the Company, resulting in a change in control of the Company in favor of Titus. The effect of such a change in control on the Company is uncertain, and there can be no assurance that such a change in control would not have a material adverse effect on the Company's business, operating results or financial condition. Year 2000 Compliance Many existing computer systems and applications, and other control devices, use only two digits to identify a year in the date field, without considering the impact of the upcoming change in the century. Therefore, they do not properly recognize a year that begins with "20" rather than "19". Others do not correctly process "leap year" dates. As a result, such systems and applications could fail or create erroneous results unless corrected so that they can correctly process data related to the Year 2000 and beyond. The Company relies on its systems and applications in operating and monitoring all major aspects of its business, including financial systems (such as general ledger, accounts payable and payroll modules), customer services, networks and telecommunications systems equipment 27 and end products. The Company also relies, directly and indirectly, on external systems of suppliers for the management and control of product development and of business enterprises such as developers, customers, suppliers, creditors, financial organizations, and governmental entities, both domestic and international, for accurate exchange of data. The Company could be affected through disruptions in the operation of the enterprises with which the Company interacts or from general widespread problems or an economic crisis resulting from noncompliant Year 2000 systems. Despite the Company's efforts to address the Year 2000 impact on its internal systems and business operations, there can be no assurance that such impact will not result in a material disruption of its business or have a material adverse effect on the Company's business, operating results and financial condition. The Company is currently in the process of assessing the potential impact of the Year 2000 issue on its business and the related foreseeable expenses that may be incurred in attempting to remedy such impact. Although the Company has identified certain systems and applications that are not Year 2000 compliant and the Company is in the process of upgrading its software to address the Year 2000 issue, there can be no assurance that such upgrades will be completed on a timely basis at reasonable costs, or that such upgrades will be able to anticipate all of the problems triggered by the actual impact of the Year 2000. In addition, the inability of any internal system to achieve Year 2000 compliance could result in material disruption to the Company's operations. With respect to customers, developers, suppliers and other enterprises upon which the Company relies, even where assurances are received from such third parties, there remains a risk that failure of systems and applications of such third parties could have a material adverse effect on the Company. Development of Internet/On-Line Services or Products The Company seeks to establish an on-line presence by creating and supporting sites on the Internet. The Company's future plans envision conducting and supporting on-line product offerings through these sites or others. The ability of the Company to successfully establish an on-line presence and to offer on- line products will depend on several factors that are outside the Company's control, including the emergence of a robust on-line industry and infrastructure and the development and implementation of technological advancements to the Internet to increase bandwidth and the speed of responsiveness to the point that will allow the Company to conduct and support on-line product offerings. Because global commerce and the exchange of information on the Internet and other similar open, wide area networks are relatively new and evolving, there can be no assurance that a viable commercial marketplace on the Internet will emerge from the developing industry infrastructure, that the appropriate complementary products for providing and carrying Internet traffic and commerce will be developed, that the Company will be able to create or develop a sustainable or profitable on-line presence or that the Company will be able to generate any significant revenue from on-line product offerings in the near future, it at all. If the Internet does not become a viable commercial marketplace, or if such development occurs but is insufficient to meet the Company's needs or if such development is delayed beyond the point where the Company plans to have established an on-line service, the Company's business, operating results and financial condition could be materially adversely affected. Risks Associated with Acquisitions As part of its strategy to enhance distribution and product development capabilities, the Company intends to review potential acquisitions of complementary businesses, products and technologies. Some of these acquisitions could be material in size and scope. While the Company will continue to search for appropriate acquisition opportunities, there can be no assurance that the Company will be successful in identifying suitable acquisition opportunities. If any potential acquisition opportunity is identified, there can be no assurance that the Company will consummate such acquisition, and if such acquisition does occur, there can be no assurance that it will be successful in enhancing the Company's business or will be accretive to the Company's earnings. As the interactive entertainment software industry continues to consolidate, the Company may face increased competition for acquisition opportunities, which may inhibit its ability to complete suitable transactions or increase the cost thereof. Future acquisitions could also divert substantial management time, could result in short term reductions in earnings or special transaction or other charges and may be difficult to integrate with existing operations or assets. The Company may, in the future, issue additional shares of Common Stock in connection with one or more acquisitions, which may dilute its stockholders. Additionally, with respect to future acquisitions, the Company's stockholders may not have an opportunity to review the financial statements of the entity being acquired or to vote on such acquisitions. 28 Anti-Takeover Effects; Delaware Law and Certain Charter and Bylaw Provisions The Company's Certificate of Incorporation and Bylaws, as well as Delaware corporate law, contain certain provisions that could have the effect of delaying, deferring or preventing a change in control of the Company and could materially adversely affect the prevailing market price of the Common Stock. Certain of such provisions impose various procedural and other requirements that could make it more difficult for stockholders to effect certain corporate actions. Stock Price Volatility The trading price of the Company's Common Stock has been and could continue to be subject to wide fluctuations in response to quarter to quarter variations in results of operations, announcements of new products by the Company or its competitors, product development or release schedule, general conditions in the computer, software, entertainment, media or electronics industries, changes in earnings estimates or buy/sell recommendations by analysts, investor perceptions and expectations regarding the products, plans and strategic position of the Company, its competitors and its customers, or other events or factors. In addition, the public stock markets have experienced extreme price and trading volume volatility, particularly in high technology sectors of the market. This volatility has significantly affected the market prices of securities of many technology companies for reasons frequently unrelated to the operating performance of the specific companies. These broad market fluctuations may adversely affect the market price of the Company's Common Stock. Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company does not have any derivative financial instruments as of March 31, 1999. Further, the Company is not exposed to interest rate risk as the Company's revolving line of credit agreement has a variable interest rate. Therefore, the fair value of these instruments are not affected by changes in market interest rates. The Company believes that the market risk arising from holdings of its financial instruments is not material. 29 PART II - OTHER INFORMATION Item 1. Legal Proceedings The Company is involved in various legal proceedings, claims and litigation arising in the ordinary course of business, including disputes arising over the ownership of intellectual property rights and collection matters. In the opinion of management, the outcome of such routine claims will not have a material adverse effect on the Company's business, financial condition or results of operations. Item 2. Changes in Securities and Use of Proceeds On March 18, 1999, the Company issued and sold 2.5 million shares of the Company's Common Stock for $10 million to Titus Interactive S.A., a French corporation. Such shares were issued in reliance upon the exemption provided by Section 4(2) of the Securities Act. Item 3. Defaults Upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders None Item 5. Other Information None Item 6. Exhibits and Reports on Form 8-K (a) Exhibits - The following exhibits are filed as part of this report: Exhibit Number Exhibit Title ------- ------------- 27.1 Financial data schedule for the three month period ended March 31, 1999. (b) Reports on Form 8-K ------------------- None 30 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. INTERPLAY ENTERTAINMENT CORP. Date: May 14, 1999 By: /s/ BRIAN FARGO ------------------------------ Brian Fargo, Chairman of the Board and Chief Executive Officer (Principal Executive Officer) Date: May 14, 1999 By: /s/ MANUEL MARRERO ----------------------------- Manuel Marrero, Chief Financial Officer (Principal Financial and Accounting Officer) 31 EX-27.1 2 FINANCIAL DATA SCHEDULE
5 1,000 3-MOS DEC-31-1999 JAN-01-1999 MAR-31-1999 363 0 26,226 17,214 6,888 63,614 4,885 (1,091) 70,318 63,972 0 0 0 20 4,803 70,318 28,350 21,620 12,566 12,566 17,332 8,631 814 (8,278) 0 (8,728) 0 0 0 (8,278) (.44) (.44)
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