-----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, ERUYkrM1jLuF2GKKVAe9HHy8qsSVTDckMxtS4cVp+4VutgLwyBZP6VVmDQigpycF rwAcd8PGU6X/eCiDTXBlKw== 0000898430-98-003423.txt : 19980929 0000898430-98-003423.hdr.sgml : 19980929 ACCESSION NUMBER: 0000898430-98-003423 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 19980630 FILED AS OF DATE: 19980928 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: IWERKS ENTERTAINMENT INC CENTRAL INDEX KEY: 0000830404 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-MOTION PICTURE THEATERS [7830] IRS NUMBER: 954439361 STATE OF INCORPORATION: DE FISCAL YEAR END: 0630 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-22558 FILM NUMBER: 98716432 BUSINESS ADDRESS: STREET 1: 4540 WEST VALERIO ST CITY: BURBANK STATE: CA ZIP: 91505 BUSINESS PHONE: 8188417766 MAIL ADDRESS: STREET 1: 4540 WEST VALERIO ST CITY: BURBANK STATE: CA ZIP: 91505 10-K 1 ANNUAL REPORT FOR YEAR ENDED JUNE 30, 1998 ================================================================================ SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended June 30, 1998 OR [_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission file number 0-22558 IWERKS ENTERTAINMENT, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) Delaware 95-4439361 (STATE OR OTHER JURISDICTION (I.R.S. EMPLOYER IDENTIFICATION NO.) OF INCORPORATION OR ORGANIZATION) 4540 West Valerio Street Burbank, California 91505-1046 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES AND ZIP CODE) (818) 841-7766 (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE) SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: None SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: Common stock, $.001 par value per share Preferred Stock Purchase Rights (Title of Class) Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ___ --- Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this 10-K or any Amendment to this Form 10-K. [_] At September 18, 1998, there were outstanding, 12,348,307 shares of the Common Stock of Registrant, and the aggregate market value of the shares held on that date by non-affiliates of Registrant, based on the closing price ($1.375 per share) of the Registrant's Common Stock on the NASDAQ National Market System was $14,841,266. For purposes of this computation, it has been assumed that the shares beneficially held by directors and executive officers of Registrant were "held by affiliates;" this assumption is not to be deemed to be an admission by such persons that they are affiliates of Registrant. DOCUMENTS INCORPORATED BY REFERENCE Portions of Registrant's Proxy Statement relating to its 1998 Annual Meeting of Stockholders are incorporated by reference in Part III of this Annual Report. 1 IWERKS ENTERTAINMENT, INC. FISCAL YEAR 1998 FORM 10-K ANNUAL REPORT TABLE OF CONTENTS
Page ---- PART I. Item 1. Business.......................................................................................... 3 Item 2. Properties........................................................................................ 12 Item 3. Legal Proceedings................................................................................. 12 Item 4. Submission of Matter to a Vote of Security Holders................................................ 12 PART II. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters............................. 13 Item 6. Selected Financial Data........................................................................... 14 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations........................................................................................ 15 Item 8. Financial Statements and Supplementary Data....................................................... 30 Item 9. Changes and Disagreements with Accountants on Accounting and Financial Disclosure........................................................................................ 49 PART III. Item 10. Directors and Executive Officers of Registrant.................................................... 49 Item 11. Executive Compensation............................................................................ 49 Item 12. Security Ownership of Certain Beneficial Owners and Management.................................... 49 Item 13. Certain Relationships and Related Transactions.................................................... 49 Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.................................. 50
2 SPECIAL NOTE REGARDING FORWARD-LOOKING INFORMATION This Report contains statements that constitute "forward-looking statements" within the meaning of Section 21E of the Exchange Act and Section 27A of the Securities Act. The words "expect", "estimate", "anticipate", "predict", "believe" and similar expressions and variations thereof are intended to identify forward-looking statements. Such statements appear in a number of places in this filing and include statements regarding the intent, belief or current expectations of Iwerks, its directors or officers with respect to, among other things (a) trends affecting the financial condition or results of operations of Iwerks and (b) the business and growth strategies of Iwerks. The stockholders of Iwerks are cautioned not to put undue reliance on such forward looking statements. Such forward-looking statements are not guarantees of future performance and involve risks and uncertainties, and that actual results may differ materially from those projected in this Report, for the reasons, among others, discussed in the Sections - "Management's Discussion and Analysis of Financial Condition and Results of Operations", and "Factors that may Affect Future Results". Iwerks undertakes no obligation to publicly revise these forward looking statements to reflect events or circumstances that arise after the date hereof. Readers should carefully review the risk factors described in other documents the Company files from time to time with the Securities and Exchange Commission, including the Quarterly Reports on Form 10-Q to be filed by the Company in calendar years 1998 and 1999 and any Current Reports on Form 8-K filed by the Company. PART 1 BUSINESS OF IWERKS ITEM 1. BUSINESS. - ----------------- GENERAL Iwerks Entertainment, Inc. and its subsidiaries ("Iwerks" or "the Company") is a leading full service provider of high-tech software-based theatre attractions for the out-of-home entertainment market and film-based software in large format, ride simulation and specialty venue attractions. The Company's products combine advanced theatre systems with entertainment or educational software to create high-impact "attractions" which immerse audiences in the action. The Company's products include ride simulation, giant screen, 3-D custom film and video theatres, and various other specialty attractions. In addition, the Company owns and operates a fleet of 16 touring ride simulation theatres. The Company also produces film and video software for ride simulators and special format theatres, and rents large format cameras and related equipment as well as provides certain post production services to large format filmmakers. Further, an important element of the Company's business strategy is the participation in the operation of its fixed-base attractions either through direct equity ownership or through other participation arrangements. The Company is currently a participant in several joint ventures to own and operate multiple ride simulation theatres in the United States and Australia. The Company continues to evaluate new opportunities to participate in the operation of its fixed-based attractions. The primary markets for the Company's attractions are theme parks, museums, movie theatres, various types of location-based-entertainment centers, visitor centers and special events. The popularity 3 of entertainment attractions of the type sold by the Company has led to their increasing use as the featured attraction in these locations. In addition, high- profile retail sites and casinos are expanding their entertainment offerings to broaden appeal, extend the visitors stay, and stimulate repeat visits. The Company's attractions are well suited to meet this demand because, in addition to their drawing power, they require relatively little space and can be easily refreshed by changing the film or other software. Since inception in 1986 through September 18, 1998, the Company has installed more than 250 fixed-base theatres and touring attractions in 28 countries. Of these, 119 were ride simulation theatres, which the Company supports with a library of 41 ride simulation films, the industry's largest ride simulation film library. The Company's ride simulation film projects include: Escape from Dino Island, a 3D sequel to its highly successful Dino Island; Super Speedway, a thrill ride through seven North American race tracks hosted by Craig T. Nelson; Superstition, a haunted scream park adventure hosted by Elvira, Mistress of the Dark; Secrets of the Lost Temple, an explorer's adventure through a Mayan temple; Red Rock Run, a computer generated high speed ride through a volcano; Aliens: Ride at the Speed of Fright, based on the futuristic movie thriller of the same name; Dino Island, a fantasy based on a newly discovered volcanic island with prehistoric reptiles; Days of Thunder: The Ride, featuring a "200 mph race" to the checkered flag at the Daytona 500, for Paramount Parks and RoboCop: The Ride, a futuristic fantasy ride through the streets of Detroit with the popular movie character, "RoboCop". Fiscal 1999 releases will include Journey Through the Center of the Earth, a 3D ride to the center of the earth and back, and Kid Koster, a roller coaster ride through a child's room, along with other film projects to which the Company has not yet committed. The Company has the largest installed base of film ride simulation theatres and the largest library of ride simulation films in the world. The Company is a Delaware corporation with principal executive offices located at 4540 West Valerio Street, Burbank, California 91505, telephone number (818) 841-7766. In addition to its principal executive offices, Iwerks has sales offices in Sarasota, Florida and London, England. A sales representative maintains offices in Hong Kong and Shanghai. BUSINESS STRATEGY The Company believes that there is an increasing worldwide consumer demand for a variety of out-of-home entertainment options. The Company's goal is to capitalize on its position as a leader in the ride simulation attraction business to become the leading full-service provider, not just of its hardware systems, but also of a full range of support services and film-based software in the ride simulation, large format and specialty venue attractions. The Company's current strategies to achieve its objectives include the following: FULL SERVICE PROVIDER OF COMPLETE ENTERTAINMENT BUSINESS SOLUTIONS. The Company intends to expand its market penetration by offering its customers a complete line of services and products to support the design, development and operation of specialty format theater attractions. The Company has installed over 250 specialty format theater attractions and currently licenses film software to over 75 installed simulation theaters. The Company believes that this track record of successes positions itself as a leader in terms of industry experience and operating expertise in the specialty format theater market. By focusing its services and products on solutions designed to assist its customers in building their business, the Company believes that it will continue to expand its own business opportunities in the 4 future. EXTEND THE COMPANY'S PRODUCT LINE THROUGH INNOVATIVE USE OF ITS CURRENT TECHNOLOGIES. Management believes that the Company has the opportunity of increasing its product offerings without incurring significant additional research and development costs. Management believes there are opportunities to leverage the Company's existing technology to provide new, innovative products designed to meet current market requirements. The Company also intends to continue to explore alliances with other companies with the objective of developing joint incremental sales prospects taking advantage of each partner's expertise and technological and market strengths. EXPAND INTO NEW MARKETS. The Company is exploring potential new markets for its attractions products and services. The Company continues its expansion efforts in South America and Europe. In addition, the Company is exploring market opportunities for its giant screen theaters in commercial locations, such as movie theater multiplexes, and its ride simulation theaters in untapped commercial settings including casinos and retail businesses. IDENTIFY NEW STRATEGIC PARTNERS. Management believes that the Company can optimize its market position and performance through the formation of strategic alliances with companies who have complementary technologies, manufacturing or distribution. Management is pursuing an aggressive agenda of forming strategic partnerships to accelerate the accomplishment of the Company's priorities in these areas. OTHER. Charles Goldwater, Chief Executive Officer of the Company, joined the Company at the end of February 1998. Two of the Company's other four senior executive officers, Jack Shishido, Senior Vice President of Worldwide Sales and Marketing, and Dan Griesmer, Senior Vice President and General Manager, joined the Company in June 1998 and March 1998, respectively. The Company and its new management team continue to examine and refine its strategic and operating strategies. In June 1998 the Company engaged Schroder & Co. Inc. to assist in seeking long-term strategic partners, identifying financing opportunities for core activities such as film production, and for possible joint ventures, and accelerating the Company's aggressive expansion in the large-format arena. IWERKS PRODUCTS FIXED-BASE RIDE SIMULATION THEATRES. The Company's line of fixed-base ride simulators is marketed as Iwerks TurboRide and combines high-resolution projector film or video software, digital surround sound and moving seats to fully involve the audience in a realistic, simulated experience. Software currently available includes a variety of live action and fantasy experiences such as being chased by dinosaurs, flying at supersonic speeds, racing with Indy cars, riding a roller coaster, white-water rafting and space and underwater adventures. The Company's ride simulation theatre product line is the broadest in the industry, enabling the Company to offer its customers seat, row and platform-based simulators in a variety of configurations and at multiple price points. The Company derived approximately 44%, 41% and 21% of its revenues from the sale of fixed-base ride simulation theatres in fiscal 1996, 1997 and 1998, respectively. The Company's ride simulators are designed to operate in theatres which typically seat 18 to 100 people, and feature screens up to 52 feet high, with six-channel surround sound. In these rides, guests watch a high resolution film with a fast action point-of-view perspective while sitting in seats that move in synchronization with the action on the screen. Films for the Company's ride simulation theatres typically range between three and five minutes. The 5 Iwerks TurboRide can be reprogrammed to create new adventures. PORTABLE RIDE SIMULATION THEATRES. The Company also has developed a portable ride simulation theatre called the "Reactor", which is transported by tractor trailers. The trailers transform to create a theatre with a high definition video projection system and digital surround sound. The simulation theatres have on-board generators which enable them to operate independent of other power sources. The Reactor incorporates the same ride simulation technology as the Company's TurboRide and can accommodate up to 18 people per show. The Reactors can be used to exhibit the Company's ride simulation films developed for its fixed-base ride simulation theatres as well as films developed specifically for use in the Reactor at air shows, boat and car races, state fairs and other special events. The Company also seeks corporate sponsors for its touring Reactor units. The Company derived approximately 20%, 17% and 22% of its revenues in fiscal 1996, 1997 and 1998, respectively, from the operation and sponsorship of portable ride simulation theatres. GIANT SCREEN THEATRES. The Company's giant screen theatres are marketed under the name Iwerks CineDome and Iwerks Theatres, and feature screens which are much larger than standard movie screens and projection systems that deliver a sharper, brighter image than conventional movies. The result is a high- impact, immersive, sensory experience for the audience. These theatres seat up to 475 people, have steeply raked seating and exhibit films typically lasting between 15 and 40 minutes. The Company offers both 15/70 (15 perforations, 70 millimeter film) and 8/70 (8 perforations, 70 millimeter film) format systems including its exclusive patented Linear Loop projectors. The Company's giant screen theatres are available in a variety of configurations. Its flat screen theatres use screens as large as 81 feet high by 110 feet wide, more than five times the size of most movie theatre screens. The Company's domed screen theatres use a dome-shaped screen up to 85 feet in diameter which wraps around and above the audience filling the audience's field of vision. The Company also offers 3D systems which use dual projectors to create a 3D image. The Company derived approximately 9%, 12% and 8% of its revenues from the sale of giant screen theatres in fiscal 1996, 1997 and 1998, respectively. CUSTOM AND OTHER THEATRES. The Company offers a wide range of custom film and video-based theatre systems utilizing 70 millimeter and 35 millimeter film formats. Among its offerings is the Iwerks Video 360 Theater, a video based cylindrical theater incorporating a show control system allowing the operator to make real time modifications to the projected image. The Company's custom projects range from the sale of individual projectors to complete theatre systems. The Company derived approximately 3%, 5% and 11% of its revenues from the sale of custom and other theatres in fiscal 1996, 1997 and 1998, respectively. FILM SOFTWARE. The Company produces film and video software for the Company's attractions with a production strategy that is similar to that of a movie studio, where a small core of executives hire supplemental production talent and specialists on a project-by-project basis. This structure allows the Company to maintain creative control of projects without incurring substantial, continuing overhead expenses. In addition, the Company has acquired distribution rights for ride simulation films purchased or owned by others. The Company also provides executive producer and postproduction services to third parties filming in the Company's film or video projection formats. The Company has a film library which includes, as of September 18, 1998, the distribution rights to 6 41 ride simulation films, 4 giant screen films and 8 3D films. The Company's library of ride simulation films is the largest in the industry. In addition to the Iwerks' film library, owners of Iwerks' giant screen theatres have access to a library of over 100 films which are generally available in the marketplace. The Company believes that the quality and size of its film library is a significant competitive advantage in the markets in which it competes, particularly in the ride simulation market. Growth in the installed base of theatres provides the Company an opportunity to increase film licensing revenue. The Company derived approximately 11%, 14 % and 22% of its revenue in fiscal 1996, 1997 and 1998, respectively, from film license agreements. The Company's recent ride simulation films include Escape from Dino Island, a 3D sequel to its highly successful film Dino Island; Super Speedway, a thrill ride through seven North American race tracks hosted by Craig T. Nelson; Superstition, a haunted scream park adventure hosted by Elvira - Mistress of the Dark; Mad Racers, Iwerks first ride simulation 3D film; Secrets of the Lost Temple, based on an explorer's adventure through a Mayan temple; Aliens Ride at the Speed of Fright, based on the futuristic movie thriller of the same name; Dino Island, a fantasy ride through a dinosaur-inhabited island; Moon Raid Alpha, a space chase adventure fantasy; a film for Time Warner Six Flags theme parks called The Right Stuff; a film for the Iwerks Reactor called Fly With The Blue Angels featuring the Blue Angels flight team; a film for Paramount theme parks based on the motion picture Days of Thunder and a film based on the motion picture RoboCop. Fiscal 1999 releases will include Journey to the Center of the Earth, a 3D ride to the center of the earth and back and Kid Koster, a roller coaster ride through a child's room. The Company continues to look at additional projects which may increase the number of films released in fiscal 1999. Many of the Company's ride simulation and other productions have received industry recognition. For the second year in a row, the Company won the prestigious Image Award for Best Overall Presentation at the November 1997 International Association of Amusement Parks and Attractions (IAAPA) convention in Orlando. The dramatic Iwerks TurboRide 3D! took first honors for best New Entertainment Technology at the November 1996 IAAPA convention in New Orleans. Secrets of the Lost Temple, premiered at IAAPA 1996, also received an award in the Best New Product category. Dino Island was rated the best new attraction at IAAPA convention, 1994. The Company also produces and distributes large format and specialty films to theme parks. In fiscal 1999, the Company is scheduled to release "Encounter in the Third Dimension" a large format 3D film based on the history and technology of 3D effects. This film will be available in 15/70 and 8/70 formats to the existing network of approximately 40 large format 3D theaters. A shortened version of this film will also be available for specialty theater exhibition. Typically, a film produced for exhibition on a theatre system is sold or licensed to a customer as part of the sale of the theatre system. When sold, the customer pays all or most of the production cost; the Company attempts to retain limited distribution rights beyond an exclusive exhibition territory retained by the customer. When licensed, the Company typically licenses the film for a one-year period for a flat fee which varies based upon the film. In limited cases, the Company will accept its fees as a percentage of the ticket sales. Film rentals vary according to the quality of the film, the initial price paid for the theatre systems and other factors. CAMERAS AND OTHER PRODUCTION SERVICES The Company owns four 8/70 large format cameras and related equipment, including lenses and 7 accessories, which it rents on a short-term basis, generally from several days to several months. In fiscal 1998, the Company contracted with a third party to develop and manufacture three 15/70 large format cameras, and a 3D rig for both 15/70 and 8/70 cameras, which are expected to be completed in fiscal 1999. The Company intends to rent these cameras to third party film producers. The Company also provides technical and post-production services to third party producers for a fee and maintains a 15/70 projection room at its Burbank facilities for rent to giant screen film makers for use in the post-production process. MARKETING AND CUSTOMERS The Company distributes its theatre systems, software and services through multiple distribution channels including a direct sales and marketing force as well as independent sales representatives in selected areas. The sales and marketing staff consists of 19 employees. A sales representative maintains foreign sales offices in Hong Kong and Shanghai which provide support to the Company's Asian marketing programs and assist in customer service. A satellite sales office was established in London, England in May 1997 to support the European and Middle East marketplaces. In addition, the Company has sales professionals located in Burbank, California and Sarasota, Florida. Itochu Corporation, also a stockholder, has a non-exclusive distribution agreement to sell the Company's product in Asia. The Company markets its attractions, including theatre systems and film software, mainly to theme parks, museums, movie theaters, visitor centers, casinos, world expositions, location-based-entertainment centers and special event venues. The Company's theatre systems include projection and audio equipment, show control systems and film handling equipment. The Company also provides ride simulation systems; these include motion bases, film projection and audio equipment, show control and other effects. The customer supplies its own theatre space and other necessary site improvements to operate the theatre. The Company provides installation, training, design, maintenance and other support services. A primary market for the Company's 3D and 2D ride simulation theatres has been the worldwide amusement and theme park industry. Continuing sales will come from previously existing parks looking for new attractions, parks under development looking for an array of attractions and the expanding location- based-entertainment industry. Most new park development is occurring outside of the United States and management believes that international operators will continue as important customers for this product. The Company has also developed customers in the family entertainment center, movie theater, institutional and casino markets as well as tourist, vacation, destination shopping and convention locations for its ride simulation theatres. The Company sells its ride simulation theatres at prices which are separately negotiated, depending upon the product, the number of motion bases, the configuration of the theatre space, optional components selected and the level of design service provided. The Company licenses its ride simulation films for a range of prices depending on the film and the license term. The Company tours its Reactor units at a variety of special events, primarily air shows, boat and car races, state fairs, trade shows and other outdoor events. Revenue is generated through admission tickets of between $3 and $6 per person or through lease of the system to corporate sponsors who may use the system for promotional campaigns in connection with new product introductions and other promotional purposes. 8 The primary markets for the Company's giant screen 2D and 3D theatres have been museums, visitor destination centers, world expositions and other institutional exhibition facilities frequented by large numbers of visitors. Increasingly, commercial movie theatre operators are also viewing giant screen theatres as a new entertainment option for their guests. The Company sells its giant screen and custom and video theatres at prices which are separately negotiated. No single customer accounted for more than 10% of revenues in fiscal 1996, 1997 and 1998. The Company's sales typically are made pursuant to written contracts, and are denominated in United States dollars. International hardware sales are generally backed by letters of credit. Consequently, the Company's operations have not historically been subject to risks related to currency fluctuations. During fiscal 1996, 1997 and 1998, 49%, 55% and 46% of the Company's revenues, respectively, were derived from sales outside the United States. The Company's sales contracts typically provide for progress payments which are timed to match related expenditures by the Company. The customer generally has the right to terminate the contract before completion by paying Iwerks its nonrecoverable costs plus a termination fee. The Company offers a warranty on sales of its products, generally for a period of 12 months. The Company believes that its material contract terms are consistent with industry practices. ENABLING TECHNOLOGIES With limited exceptions, the underlying technologies employed by the Company are in the public domain and generally available in the marketplace. However, the Company possesses substantial expertise in the design, modification and engineering of projection, film-handling, camera and audio technologies which it believes to be an important competitive factor. IMAGING SYSTEMS. The Company offers a variety of technologically advanced imaging systems. Iwerks Quatro is a projection system designed to offer small ride simulation venues high-clarity film quality in locations which were previously limited to video systems. The Iwerks Quatro houses four ride simulation films on one reel. Two 35mm frames are placed side by side on the 70mm film with two films operating in the forward direction and two in the reverse direction. This eliminates the need for a film storage system while providing fast cycle times. All claims have been allowed on the Company's patent application on certain features of the Quatro projection system and the Quatro is now a patented proprietary projection technology. The Company's 8/70 is an eight perforation, 70-millimeter film system that operates at 30 frames per second. By comparison, most motion picture theatres use four perforation, 35-millimeter film that runs at 24 frames per second and standard 70-millimeter film is five perforation which also runs at 24 frames per second. The larger frame size and faster speed gives the Company's 8/70 a brighter and sharper image without the flicker and stroboscopic effects common with conventional 35- and 70-millimeter film systems. The Company's 8/70 is used in the Company's array of ride simulation systems and destination theatres common to museums and visitor centers where screen sizes smaller than 60' high and 80' wide or dome screens of 75' or less in diameter are suitable. The Company's 15/70 is a fifteen perforation, 70-millimeter rolling loop projection system 9 which handles the largest commercially available film size. This system projects an image area more than nine times that of conventional 35-millimeter film and 300% larger than standard 70-millimeter film. The Company's 15/70 is capable of achieving screen sizes up to 81' high and 110' wide and dome screens up to 85' in diameter that are generally found in high capacity theatres at world expositions and larger museums and visitor centers. Iwerks 8/70 and 15/70 are used in the Iwerks Dome and Giant Screen Theatres. In fiscal 1997, the Company acquired Pioneer Technology Corporation and the proprietary Linear-Loop Projection ("LLP") Technology to offer the expanding giant screen market a genuine alternative to existing projection techniques. The LLP gently pushes film through the projector on a column of air unlike most projection systems that use levers to pull film through. The LLP is designed to produce an image that is brighter and more stable than other projectors available. The Company offers high resolution digital video imaging systems that utilize a laser disc source and produce a high quality video image. This imaging system is ideal for Iwerks Reactors and small ride simulation theatre systems. In the Iwerks Video 360 theatre, the video imaging and show control systems allow real-time manipulation of the projected image to allow a variety of special effects. MOTION BASES. The Company's ride simulation theatres utilize seat-based ride simulation technologies with per-base capacities ranging from two to eight. The Turbo Tour is a compact and highly responsive three-axis system, allowing a multitude of combinations of pitch (tilt from front to rear), vertical (move up and down) and roll (tilt from side to side) movements, which keep passengers in constant motion with the image. Each motion base is a self-contained system, requiring only electronic communications and electrical power connections. The Transporter is a two- and four-seat, six-axis motion base capable of producing the most realistic ride simulation available. These six-axis systems permit pitch, roll, vertical, sway, yaw (a turning motion), and surge (forward and back), all the motions available within a given motion envelope. Iwerks is developing an electro-magnetic 8-seat six-axis motion base offering the same quality as the Transporter with greater seat capacity. FILM STORAGE. The Company's film-based systems are offered with specially designed film loop cabinets. These cabinets allow the film to be spliced into an endless loop, more fully automating the projection system and providing the fastest possible recycle time for maximum theatre throughput. The loop cabinet also includes other important features: the film is housed in a dust-free humidity-controlled environment; the film is cleaned twice on each trip through the system so that dust picked up during projection doesn't accumulate; and the film picture area never rubs on itself or any other surface, eliminating degradation common on reel to reel and platter systems. MANUFACTURING The Company manufactures and assembles its theatre systems at its facilities in Burbank, California. A majority of the components for these theatre systems are purchased from outside vendors. The Company's manufacturing operations consist of assembly, testing, quality control and system integration of its theatre system components, subassemblies and final assemblies, including modifications and the programming of the show-control and motion-control components, and installation of the completed theatre systems. The Company is the exclusive distributor of 15/70-format giant screen projection systems, manufactured by Cinema Technologies, Inc.. This distribution agreement expires in September, 2003. 10 In order to maintain its exclusive rights under the agreement, Iwerks is required to meet certain minimum purchase and other requirements. As of the date of this report, Iwerks had satisfied all such requirements. The Company's manufacturing operations utilize a wide variety of electrical and mechanical components, raw materials and other supplies and services. The Company has developed multiple commercial sources for most components and materials, but it does use single sources for a limited number of standard and custom components. While delays in delivery of such single source components could cause delay in shipments of certain products by Iwerks, at this time, the Company has no reason to believe that any of the single-source vendors present a serious risk. Consistent with industry practice, the Company generally purchases components of its theatre systems upon receipt of an order. Certain components used by Iwerks, including lenses, hydraulic power sources and motion bases must be ordered up to four months in advance to assure timely delivery. The Company maintains an inventory of these items as it deems appropriate to service forecasted demand. Research and development costs are incurred in the design, construction and testing of prototype systems and are charged to expense as incurred. The research and development expenses were $358,000, $726,000 and $766,000 for the years ended June 30, 1996, 1997 and 1998, respectively. Of the expenses, 32%, 23% and 66% in 1996, 1997 and 1998, respectively, were for improvements to existing products and the remainder was for development of new products. In fiscal 1997, the Company acquired the technology and patents to produce the Linear Loop Projector ("LLP") which is a new technology in film handling and projection. The Company utilizes LLP not only in its Giant Screen Theatres, but also as its projector of choice in larger ride simulation installations. Since the acquisition of this technology in 1997, the Company has continued to make modifications and enhancements to the LLP and has not begun to produce the projectors in large quantity. The LLP is not an upgrade or rework of existing vendored products. The technology is unique, patented and has a distinctive advantage compared to "geneva" driven models that preceded it. The Company is exploring with several vendors the possibility of the vendor manufacturing and distributing the projector for a royalty payment. The Company acquires certain other projectors from third party suppliers. The Company makes modifications to the projectors to fit the Company's use. Lenses and lamphouses incorporated in the projection systems are supplied to the Company by third parties. The Company and Vickers Incorporated, a manufacturer of hydraulic components, jointly developed the hydraulically actuated seats which are used in the Turbo Tour ride simulation theatre. Under the agreement pursuant to which the hydraulically actuated seats were developed, the Company owns all rights in and to the seats. Vickers continues as the sole manufacturer of these motion bases on behalf of the Company; however, the Company has the right under its agreement with Vickers to secure alternate sources of manufacturing at any time. The Company also purchases other products from Vickers. EMPLOYEES At September 18, 1998, the Company employed 123 persons, of whom 31 were employed in management, finance and administration, 19 were employed in sales and marketing, and 73 were 11 employed in operations (including 38 employees working in the field on the Company's touring units). None of the Company's employees are represented by a collective bargaining agreement. The Company believes that its relations with its employees are satisfactory. ITEM 2. PROPERTIES. - ------------------- The Company maintains its principal facility in Burbank, California where it leases space under four separate leases on adjacent facilities consisting of 36,000, 23,460, 7,596 and 5,184 square feet each, expiring between September 30, 1999 and September 30, 2001. The Company leases the space for an aggregate lease payment of approximately $42,400 per month. The Company believes that its current facilities are adequate to meet its needs for the immediate future; however is evaluating the possibility of a facility reduction in light of its efforts to reduce ongoing costs. ITEM 3. LEGAL PROCEEDINGS. - --------------------------- The Company is a party to various other actions arising in the ordinary course of business which, in the opinion of management, will not have a material adverse impact on the Company's financial condition; however, there can be no assurance that the Company will not become a party to other lawsuits in the future, and such lawsuits could potentially have a material adverse effect on the Company's financial condition and results of operations. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. - ------------------------------------------------------------- During the last quarter of the Registrant's fiscal year ended June 30, 1998, no matter was submitted to a vote of the security holders of the Registrant. 12 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. - ----------------------------------------------------------------------------- The Company's Common Stock is listed for quotation on The NASDAQ National Market. The table below sets forth, for the calendar quarters indicated, the high and low closing sales prices per share as reported on The NASDAQ National Market for the Iwerks Common Stock.
High Low ------- --------- Year Ended June 30, 1997 - ------------------------------------- First Quarter $10 3/8 $ 6 3/8 Second Quarter 7 1/4 4 5/8 Third Quarter 6 4 1/4 Fourth Quarter 5 1/4 3 11/16 Year Ended June 30, 1998 - ------------------------------------- First Quarter $ 5 5/8 $ 3 1/2 Second Quarter 4 3/8 2 1/4 Third Quarter 3 1/4 2 1/4 Fourth Quarter 3 5/16 1 5/6 Year Ended June 30, 1999 - ------------------------------------- First Quarter (through September 18, $ 2 5/8 $ 1 1/4 1998)
As of September 18, 1998, Iwerks had approximately 953 holders of record. No dividends have been declared or paid since incorporation. Iwerks currently intends to retain earnings for use in its business and does not anticipate paying any cash dividends on its common stock in the foreseeable future. 13
ITEM 6. SELECTED FINANCIAL DATA - ------------------------------- Fiscal Year Ended June 30, --------------------------------------------------------------- 1994(1) 1995 1996 1997(2) 1998(3) ---------- ---------- ---------- --------- --------- (in Thousands Except Per Share Information) OPERATIONS: Total revenue $ 36,625 $ 44,975 $ 48,516 $ 39,584 $ 25,073 Income (loss) from operations (8,522) (13,893) 2,464 (10,573) (12,132) Net income (loss) $ (8,055) $(13,473) $ 3,099 $ (9,956) $(11,560) Net income (loss) per share - basic $ (1.05) $ (1.32) $ 0.28 $ (0.84) $ (0.95) Net income (loss) per share - diluted $ (1.05) $ (1.32) $ 0.26 $ (0.84) $ (0.95) Weighted average shares outstanding - basic 7,666 10,210 10,945 11,855 12,212 Weighted average shares outstanding - diluted 7,666 10,210 12,144 11,855 12,212 FINANCIAL POSITION (AT PERIOD END): Cash, cash equivalents and short-term investments $ 26,526 $ 20,586 $ 25,281 $ 19,067 $10,464 Total assets 81,235 71,626 72,926 64,529 50,803 Capital lease obligations and long-term debt 3,349 2,130 2,732 1,827 1,082 Stockholders' equity 62,335 50,374 56,665 48,386 36,834 Total liabilities and stockholders' equity $81,235 $ 71,626 $ 72,926 $ 64,529 $ 50,803 PER SHARE DATA (AT END OF PERIOD): Net book value per common share $ 6.25 $ 4.76 $ 4.89 $ 3.97 $ 2.98 Common shares outstanding 9,968 10,592 11,588 12,160 12,345
(1) Selected financial data includes Omni Films International, Inc. since the acquisition date of May 18, 1994. (2) Net loss for 1997 includes the write down of $5.6 million ($0.47 loss per share) for the asset impairment of long lived assets for the portable ride simulation business and other fixed assets. (3) Net loss for 1998 includes approximately $1.6 million of severance costs associated with a company-wide layoff and termination of certain officers, and an additional $1.6 million for merger related costs associated with the failed merger. 14 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - ------------------------------------------------------------------------ RESULTS OF OPERATIONS - --------------------- GENERAL - ------- The Company is engaged in the business of designing, engineering, manufacturing, marketing and servicing specialty theatre systems which employ a variety of projection, show control, ride simulation and software technologies. The Company is currently in the business of: (a) selling and installing ride simulation attractions in specialty theatres, (b) selling and installing giant screen theatres (generally such theatres require projection technology which utilizes film sizes ranging between five perforations per frame by 70 millimeters (5/70) and fifteen perforations per frame by 70 millimeter (15/70)), (c) licensing and distributing the films in its library to ride simulation theatres, (d) producing films in the 5/70, 8/70 and 15/70 film format for its film library as well as producing films in these formats for third parties, (e) investing in joint ventures by contributing its ride simulation technology, design and equipment and participating in the theatre profits, (f) operating a fleet of 16 mobile ride simulation attractions which it owns and (g) renting facilities, cameras and related equipment to large format film makers. The selling and installation of both ride simulation theatres and large screen theatres includes providing all or part of the design of such theatres, sale of the projector screens, show control systems, motion simulators and sound systems. The Company's operating results in fiscal 1997 through fiscal 1998 have been adversely impacted by several trends and other developments. Revenues attributable to sales in Asia declined from $17.3 million in fiscal 1996 (representing 35.7% of the Company's revenues) to $5.7 million in fiscal 1998 (representing 22.6% of the Company's revenues). In addition, the Company did not enter into a new hardware sales contract for delivery in Asia during the fiscal year 1998. This decline in revenues primarily resulted from the continuing impact of the economic downturn and deflationary environment recently experienced throughout most of the Asia Pacific Region. In addition, the Company experienced a significant decline in sponsorship revenues during this period primarily resulting from the termination of a single contract with a major telecommunications company (AT&T Corp). The Company derived $6.6 million, $3.3 million and $1.4 million of revenues in fiscal 1996, 1997 and 1998, respectively, from sponsorship of its fleet of touring motion simulators. Sponsorship revenues prior to January 1996 were primarily derived from the Company's advertising contract with AT&T Corp, which had sponsored the Company's touring motion simulators from March 1994 through September 1996. The Company currently has only limited sponsorship contracts and the Company has been unsuccessful in securing sponsorship arrangements that approach the levels enjoyed prior to fiscal 1997. In fiscal 1997, the Company sold one touring unit and continues to explore other strategic alternatives for the touring operations. Results were also impacted by certain one-time charges. In the fourth quarter of fiscal 1997, the Company took approximately $8.4 million in charges, including a loss on impairment of assets, legal and dispute reserves, additional film amortization expense and an increase in bad debt reserve. In fiscal 1998 results were adversely impacted by nonrecurring expenses related to a proposed merger between Iwerks and Showscan which did not receive the required shareholder vote in March 1998. In addition, in light of reduced revenues and earnings in fiscal 1997 and 1998, during fiscal 1998, Iwerks reduced its workforce by approximately 10 percent in order to more closely align staffing levels with expected revenues going forward. In an unrelated event, effective February 23, 15 1998, Charles Goldwater was appointed Chairman of the Board, Chief Executive Officer and President succeeding Roy A. Wright. RESULTS OF OPERATIONS - --------------------- The Company derives its revenues primarily from three sources: sales of hardware systems, owned and operated (primarily portable simulation theatres), and licensing of films. To a lesser extent, revenues are also earned from service to existing theatre owners, rental of facilities and camera equipment and production of films for third parties. Revenues for the fiscal year ended June 30, 1996, 1997 and 1998 are analyzed in the following table (in thousands):
Fiscal Year Ended June 30 ------------------------------------------------ 1996 % 1997 % 1998 % ------- ---- ------- ---- ------- ---- Hardware sales & service $27,998 58% $25,829 65% $12,132 48% Owned and operated 13,469 28% 8,072 20% 6,871 28% Film licensing 4,800 10% 5,358 14% 5,521 22% Film production and other 2,249 4% 325 1% 549 2% ------- --- ------- --- ------- --- $48,516 100% $39,584 100% $25,073 100% ======= === ======= === ======= ===
Revenues on sales of theatre systems are recognized on the percentage-of- completion method, measured by the ratio of percentage of labor hours incurred to-date to estimated total labor hours for each fixed-price contract, over the life of the contract. Accordingly, the timing of shipment schedules as dictated by the customer can result in variability of quarterly revenues and earnings. Likewise, the cash received and used for the contract can vary from quarter-to- quarter with the revenue and cost recognition on the contract. The gross margin for each contract varies based upon pricing strategies, competitive conditions and product mix. Revenues from owned and operated (O & O) consist of portable ride simulation theatre revenues derived primarily from ticket sales at state fairs, air shows, and similar events, as well as revenues derived from fixed site joint venture revenues which includes Iwerks' contractual share of the sites' revenues or profits as applicable. Admission revenues from the portable ride simulation theatres are subject to variability due to the seasonal nature of these events and are higher during the summer months. In addition, revenues from O&O for fiscal 1996 and fiscal 1997 were benefited by significant corporate sponsorships. Sponsorship revenues for the portable theatres are recognized ratably over the term of the contract. Sponsorship revenues recognized in fiscal 1998 were significantly lower than the fiscal 1996 and 1997 levels. The Company typically licenses its film software under one year film license agreements. Revenues and related expenses are recognized at the beginning of the license period at which time the customer is billed the license fee and film is delivered to the customer. The Company recognizes revenues and costs associated with the production of custom films at the 16 time of completion and acceptance by the customer. Accordingly, the timing of completion of custom films can result in substantial variability of quarterly revenues and gross margin. The Company typically realizes a smaller margin from the sale of custom films in comparison to its theatre system sales. A significant portion of the Company's sales are made to customers located outside of the United States, primarily in Asia, South America, Europe and Canada. Revenues for the fiscal years ended June 30, 1996, 1997 and 1998 attributable to sales to these areas are summarized in the following table (in thousands):
1996 1997 1998 --------------------------- ------------------------- ------------------------ Percentage of Percentage of Percentage of Amount Total Revenue Amount Total Revenue Amount Total Revenue --------- -------------- --------- ------------- -------- ------------- Asia $17,311 35.7% $13,682 34.6% $5,660 22.6% South America 972 2.0% 5,375 13.6% 2,493 9.9% (including Mexico) Europe 4,409 9.1% 2,085 5.3% 1,672 6.7% Canada 1,131 2.3% 516 1.3% 1,596 6.4% --------- --------- --------- -------- -------- -------- Total Export Revenues $23,823 49.1% $21,658 54.7% $11,421 45.6% ========= ========= ========= ======== ======== ========
The Company maintained an office in Hong Kong and in June 1998 closed this office to affiliate with a sales representative that has offices in Hong Kong and Shanghai to support sales to Asia. The Company also maintains a satellite office in London, England to support its European sales. South American sales are supported out of the Sarasota, Florida office. International operations and sales may be subject to political and economic risks, including political instability, currency fluctuations, changes in import/export regulations, tariff and freight rates. In addition, various forms of protectionist trade legislation have been proposed in the United States and in certain other countries. Any resulting change in current tariff structures or other trade and monetary policies could adversely affect Iwerks' international operations. Political and economic factors have been identified by the Company with respect to certain markets in which it competes. There can be no assurance that these factors will not result in customers of the Company defaulting on payments owed to Iwerks, or in the reduction of potential purchases of the Company's products. Recent turmoil in the economies of the countries in Asia have had a material adverse affect on the Company's revenues and results of operations. Revenues attributable to sales in Asia declined from $17.3 million for fiscal 1996 (representing 35.7% of the Company's revenues) to $5.7 million in fiscal 1998 (representing 22.6% of the Company's revenues). In addition, the Company did not enter into a new hardware sales contract for delivery in Asia during the fiscal year ended June 30, 1998. Subsequent to June 30, 1998, however, the Company finalized two sales contracts totaling $3.4 million with Chinese customers and an additional two contracts totaling $1.4 million with customers in Japan. If recent economic problems experienced in Asia, Russia, and Eastern Europe were to spread to Europe, South America or the United States, it could have a material adverse affect upon the Company's revenues and results of operations. The Company is not able to predict to what extent, or for what period, these economic trends may adversely affect the sales of its products. Typically, sales outside the United States are denominated in United States dollars and are backed by bank letters of credit, which reduce the risks related to international sales. 17 COMPARISON OF YEAR ENDED JUNE 30, 1998 TO YEAR ENDED JUNE 30, 1997 - ------------------------------------------------------------------ REVENUES Revenue for the fiscal year ended June 30, 1998 decreased $14.5 million or 37% from the fiscal year 1997 revenue. Hardware sales and service decreased by $13.7 million or 53% from the prior fiscal year. Most severely impacted were hardware sales in the Asia-Pacific region, which decreased $8.1 million due to the continued economic downturn in that part of the world. North American and South American hardware sales declined in 1998 by $6.0 million primarily as a result of timing of projects. However, North American hardware bookings were higher in fiscal 1998 as compared to fiscal 1997. Owned and operated revenue decreased $1.2 million or 15%, primarily from the Company's 16 touring ride simulators (Reactors), due primarily to the loss of a major sponsor (AT&T Corp.) during fiscal year 1997. In addition, there was one less Reactor in 1998 as it was sold in June of 1997. The loss of AT&T Corporation accounted for $1.4 million in lower revenues, however the general admission portion of this business increased by $570,000. The Company continues to actively seek other sponsors as well as other alternatives to increase the utilization of the 16 Reactors. Film licensing revenue increased 3% from fiscal 1997 to fiscal 1998 due primarily to a net increase in the number of theatres which license films partially offset by pricing declines. The increase in film production and other was primarily due to additional revenue generated for theatre and equipment rentals. COST OF SALES Cost of sales primarily includes costs of theatre systems sold, expenses associated with operating portable ride simulation theatres, and costs associated with film production and licensing fees. The cost of theatre systems include the cost of components, customization, engineering, project management, assembly, system integration and installation. Also included in cost of sales are royalties payable to a former joint venture partner and estimated warranty expenses. The costs associated with film license fees primarily reflect amortization of film production costs over the lives of certain films and royalties paid to third parties. The cost of sales associated with operating portable ride simulation theatres include costs for personnel, depreciation and amortization, event fees, fuel, insurance and maintenance. Cost of sales as a percentage of sales was 73% and 78% for the fiscal years ended June 30, 1997 and 1998, respectively. The increase in cost of sales, in 1998 compared with 1997, as a percentage of sales was primarily due to the absorption of certain fixed overhead charges which did not decrease as revenues decreased. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES Selling, general and administrative expenses (SG&A) include personnel costs, trade shows and other promotional expenses, sales commissions, travel expenses, public relations costs, amortization of goodwill, professional fees, research and development costs and divisional administrative costs. Selling, general and administrative expenses were $15.4 million and $16.0 million, for the years ended June 30, 1997 and 1998, respectively. 18 The $600,000 increase in selling, general and administrative expenses between fiscal 1997 and 1998 was due primarily to a $1.6 million charge for severance payments made to employees, including the former Chief Executive Officer and other officers, partially offset by a 10 percent decrease in employee related expenses. This decrease in employee related expenses was due primarily to lower overall staffing levels than that of the prior year as a result of work force reductions made in fiscal 1998. MERGER RELATED EXPENSES The Company incurred a total of $1.8 million of non-recurring expenses related to the proposed merger with Showscan which did not receive the required shareholder vote in March 1998. These costs were primarily professional legal, accounting and investment banking fees of which $1.6 million was expensed in fiscal 1998 and $250,000 expensed in fiscal 1997. INTEREST INCOME & EXPENSE Interest income for fiscal 1997 and 1998 was $1.1 million and $0.8 million, respectively. The decrease from 1997 to 1998 resulted primarily from a reduction in the invested cash balances during the 1998 fiscal year. Interest expense for fiscal 1997 and 1998 was $391,000 and $247,000, respectively. This decrease resulted primarily from the scheduled maturity of notes payable in fiscal 1998. INCOME TAXES The provisions for income taxes were $117,000 and $23,000 to the years ended June 30, 1997 and 1998, respectively. As the Company has significant net losses, the income tax provisions are primarily for foreign taxes and minimum state taxes. NET INCOME (LOSS) The Company recorded net loss of $9,956,000 in 1997, compared to a net loss of $11,560,000 in 1998 due to the reasons mentioned above. COMPARISON OF YEAR ENDED JUNE 30, 1997 TO YEAR ENDED JUNE 30, 1996 - ------------------------------------------------------------------ REVENUES Revenue for the fiscal year ended June 30, 1997 decreased $8.9 million or 18% from the fiscal year 1996 revenue. Owned and operated revenue decreased $5.4 million or 40%, primarily from the Company's 17 Reactors, due primarily to the loss of a major sponsor (AT&T Corp.) in the first quarter of fiscal 1997. In addition, fiscal 1996 revenue included a $2.5 million cancellation settlement for an event which was to be held at World Expo in Tokyo, Japan and there were no such cancellation revenue in fiscal 1997. During the remaining portion of the fiscal year the Company aggressively pursued new sponsorship opportunities and looked at other options to replace these revenues. The loss of the major sponsor, that utilized 5 of the Reactors throughout fiscal 1996, resulted in excess capacity between early 19 Fall and late Spring of fiscal 1997. In June, 1997 one of the Reactors was sold to a customer in Korea. The $2.2 million reduction in hardware sales and service resulted from a reduced number of hardware contracts in fiscal 1997 compared with fiscal 1996. Film licensing revenue increased 12% from fiscal 1996 to fiscal 1997 due primarily to an increase in the number of theatres which license films. The decrease in film production and other was due to no films produced in fiscal 1997 compared to two films produced in fiscal 1996. COST OF SALES Cost of sales as a percentage of sales was 59% and 73% for the fiscal years ended June 30, 1996 and 1997, respectively. One of the primary reasons for the decrease in the gross margins between fiscal 1997 and 1996 was due to $1.5 million of charges to cost of sales made in the fourth quarter of fiscal 1997 due to changes in accounting estimates. These included additional film amortization expense on films which have not achieved their projected revenue ($746,000), additional reserve disputes ($450,000), increased warranty reserve ($147,000) due to increased work performance on a contract, and a reduction of previously recognized earnings by $205,000 in connection with the cancellation of a contract. In addition, the costs related to the revenue received from the cancellation settlement of the Tokyo World Expo in 1996 were nominal resulting in an unusually high margin in fiscal 1996 which did not occur in fiscal 1997. SELLING GENERAL AND ADMINISTRATIVE EXPENSES Selling General and Administrative Expenses were $17.4 million and $15.4 million for the fiscal years ended June 30, 1996 and 1997, respectively. The $2.0 million reduction in Selling, General and Administrative expenses between fiscal 1997 and 1996 was due primarily to reduced employee related compensation ($2.3 million), legal and accounting expenses ($0.6 million) and travel and entertainment expenses ($0.6 million). These reductions were partially offset by an increase in the provision for doubtful accounts ($0.8 million), increased research and development expenditures ($0.4 million) and increased accrued expenses related to a regulatory audit ($0.3 million). LOSS ON IMPAIRMENT OF ASSETS Due to the Company being unable to replace the major sponsorship revenue from AT&T Corp. for its portable simulation theatre business and the resulting excess capacity this generated during the winter months as described above in the "Revenues" section, the Company recognized a non-cash charge of $5.6 million in fiscal 1997 primarily for its portable simulation theatres in accordance with Financial Accounting Standards Board (FASB) release Number 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of". The loss was calculated as the excess of the carrying value of the portable simulation theatre assets over the estimated future discounted cash flow from these theatres during the next six fiscal years. (See Note 12 of Notes to Consolidated Financial Statements). The impairment occurred in the fourth quarter of fiscal 1997 as a result of disappointing results and an under utilization of Reactors during the quarter, sponsorship and general admission events below expectations, and the lack of significant sponsorship backlog as of June 30, 20 1997. INTEREST INCOME AND EXPENSE Interest income for fiscal 1996 and 1997 was $1.2 million and $1.1 million, respectively. This decrease resulted primarily from changes in the invested cash balances during the respective periods. Interest expense for fiscal 1996 and 1997 was $380,000 and $391,000 resulted primarily from financing costs on the portable ride simulation theatres. INCOME TAXES The provisions for income taxes were $149,000 and $117,000 for the years ended June 30, 1996 and 1997, respectively. As the Company had significant net operating loss carry forwards, the income tax provisions are primarily for foreign taxes and state taxes. NET INCOME (LOSS) The Company recorded a net income of $3,099,000 in 1996, compared to net loss of $9,956,000 in 1997 due to the reasons mentioned above. SEASONALITY AND FLUCTUATING QUARTERLY RESULTS - --------------------------------------------- The following tables set forth unaudited data regarding operations for each quarter of fiscal 1997 and 1998 and the percentage of the Company's revenue and expenses represented by each item of the respective quarter. This quarterly information has been prepared on the same basis as the annual consolidated financial statements and, in management's opinion, contains all adjustments necessary to fairly state the information set forth herein. The operating results for any quarter are not necessarily indicative of results for any future period.
Fiscal 1997 Fiscal 1998 ------------------------------------- ----------------------------------------- First Second Third Fourth First Second Third Fourth (Dollars in thousands) Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter - ---------------------- -------- -------- ------- ------- ---------- -------- -------- -------- Revenue $9,594 $10,023 $11,042 $ 8,925 $ 8,052 $ 5,989 $ 4,483 $ 6,549 Cost of Sales 6,236 6,955 7,335 8,422 4,789 5,168 4,195 5,501 ------ ------- ------- ------- ------- ------- ------- ------- Gross Margin 3,358 3,068 3,707 503 3,263 821 288 1,048 Selling, general and administrative 3,381 3,322 3,582 5,088 3,605 4,311 4,637 3,446 Merger related expenses -- -- -- 250 313 218 888 134 Loss on impairment of assets -- -- -- 5,586 -- -- -- -- Interest (income) expense, net (197) (197) (145) (195) (149) (208) (160) (78) ------ ------ ------- -------- ------- ------- ------- ------- Income (loss) before provision for taxes 174 (57) 270 (10,226) (506) (3,500) (5,077) (2,454) Provision for taxes -- -- -- 117 -- -- -- 23 ------ ------ ------- -------- ------- ------- ------- ------- Net income (loss) $ 174 $ (57) $ 270 $(10,343) $ (506) $(3,500) $(5,077) $(2,477) ====== ====== ======= ======== ======= ======= ======= =======
21 The Company's operating results fluctuate from quarter to quarter as a result of the timing of theatre system shipments, the mix of theatre system contracts, the completion of custom film contracts and the amount of revenues from portable simulation theatre and film licensing agreements. Hardware sales will likely continue to experience inexplicable quarterly fluctuations as they are substantially dependent on the customers' varying delivery and installation requirements. A significant portion of the Company's operating expenses are relatively fixed, and planned expenditures are primarily based upon revenue forecasts. The decline in revenue, as shown in the above chart, is primarily from hardware sales which were significantly lower from customers in the Asia-Pacific region. The sales cycle for the sale of a single attraction by the Company typically ranges between six and eighteen months. The Company has little control over the timing of customer purchases. Although revenue decreased in fiscal 1998, backlog orders for new hardware contracts was higher at June 30, 1998 than on the same date in 1997. In fiscal 1997, the fourth quarter net income was impacted by the charge for the asset impairments of $5.6 million as well as cost of sales expenses totaling $1.5 million for additional film amortization expense on films which have not achieved their projected revenue, additional reserve for disputes, increased warranty reserve and a reduction of previously recognized earnings in connection with the cancellation of a contract. Also Selling, General and Administrative expenses were higher in the fourth quarter of fiscal 1997 due to an increase to the allowance for doubtful accounts due to receivables which were deemed uncollectable, a legal reserve that first arose in the fourth quarter and increased accrual due to a regulatory audit. In the second and third quarters of fiscal 1998, the Company's selling, general and administrative expenses increased due to severance costs associated with a Company wide layoff and termination of certain others, including the Chief Executive Officer, as well as recruitment costs for new management and directors. Also as a result of this downsizing, the Company's selling, general and administrative expenses were lower in the fourth quarter of fiscal 1998. The seasonal fluctuations in earnings also may cause volatility in the stock prices of the Company. While a significant portion of the Company's expense levels are relatively fixed, the timing of increases in expense levels is based in large part on the Company's forecasts of future sales. If net sales are below expectations in any given period, the adverse impact on results of operations may be magnified by the Company's inability to adjust spending quickly enough to compensate for the sales shortfall. The Company may also choose to reduce prices or increase spending in response to market conditions, which may have a material adverse effect on the Company's results of operations. LIQUIDITY AND CAPITAL RESOURCES - ------------------------------- Since 1994, the Company has financed its operations primarily from net proceeds of $47 million from an initial public offering of the Company's Common Stock in fiscal 1994 and cash flow from operations. The Company has also received cash in the amount of $5 million for the sale of certain distribution rights during the three fiscal years ending June 30, 1996 and proceeds from the financing of certain equipment purchases. In fiscal 1998, approximately $1.3 million in cash was used in operating activities. Iwerks' major investing activities included the sale of debt securities partially offset by purchases of property and equipment and additions to the film library. During fiscal 1998, the major financing activities were the scheduled payments of capital leases and notes payable. 22 In fiscal 1997, approximately $1.0 million was provided by operating activities. The Company's major investing activities included investments in joint ventures for $1.2 million, additions to film library of approximately $2.5 million, acquisition of Pioneer (see Note 2 of Notes to Consolidated Financial Statements) and related patent for $1.09 million, and purchase of property and equipment for $1.2 million. Financing activities included repayment of notes payable and capital leases of $2.1 million. At June 30, 1998 the Company had cash and short-term investments of approximately $10.5 million compared to $19.1 million at June 30, 1997 and $25.3 million (including long-term investments of approximately $5.8 million) at June 30, 1996. In addition, the Company maintained an unsecured $5 million bank line of credit. The Company's cash and short-term investment balances have continued to decline since June 30, 1998 and the Company expects to experience further declining balances during the remainder of fiscal 1999. In addition, the history of losses and negative cash flow resulted in the Company's bank terminating the Company's line of credit. Management believes that its existing cash balances and short-term investments, combined with anticipated cash flow from operations, will continue to decline, however they will be sufficient to meet its cash requirements through the end of fiscal 1999. However, if the Company is unable to achieve its projected cash flow from operations, the Company may experience significantly reduced cash and short-term investments, which could result in the Company not being able to meet its operating needs. Recent operating losses, the Company's declining cash balances, the ongoing financial turmoil in Asia (historically the Company's largest market and a significant source of operating revenues), the Company's historical stock performance, and a general decrease in investor interest in the Company's industry, may make it difficult for the Company to attract equity investments on terms that are deemed to be favorable to the Company. In addition, the losses in fiscal 1997 and fiscal 1998 make it more difficult for the Company to attract significant debt financing. Although the Company anticipates that its cash balances will decrease during fiscal 1999, management is in the process of implementing a plan which it believes will facilitate a return to profitability and increase the cash flow beyond fiscal 1999. This plan includes, among other things, changes to senior management, expansion of the Board of Directors, developing and marketing new products, seeking new markets for the Company's simulation and film capabilities, the establishment of new strategic vendor and customer partnerships and aggressively reducing expenses. In the event that cash flow from operations is less than that anticipated, in order to preserve cash, the Company would be required to reduce expenditures for capital projects (including new films) and research and development, or effect further reductions in its corporate infrastructure, any of which could have a material adverse affect on the Company's future operations. At June 30, 1998 the Company was committed to approximately $3.1 million of capital expenditures to be made in fiscal 1999. IMPACT OF YEAR 2000 - ------------------- Some of the Company's older computer programs were written using two digits rather than four to define the applicable year. As a result, those computer programs have time-sensitive software that recognize a date using "00" as the year 1900 rather than the year 2000. This could cause a system failure or miscalculations causing disruptions of operations, including among other things, a temporary inability to process transactions, send invoices, or engage in similar normal business activities. The Company with the assistance of consultants, has completed its initial assessment of its existing internal computer systems and after reviewing various factors, one of which being the year 2000 issue, has determined that modifications or upgrades to or replacements of certain software and hardware 23 is required. The Company's most critical software systems are its assembly and financial software systems. The Company has determined that these systems will require replacement. The Company's initial estimate of the cost of such replacement is $400,000, which includes approximately $350,000 for the purchase and implementation of new software and hardware (which will be capitalized and amortized over their respective useful lives) and approximately $50,000 of which will be expenses in the period incurred. The Company has not yet completed the process of selecting its preferred systems or vendors and consequently the Company's estimates may change depending upon the systems but does not believe they will be material. At June 30, 1998, the Company had incurred approximately $25,000 in connection with this project. The Company believes that the required changes to its existing computer systems will be installed and tested by June 30, 1999, which is prior to any anticipated impact on its operating systems. Although the Company believes that with these changes, the year 2000 issue will not pose significant operational problems for the Company, there can be no assurances that the Company will not experience serious unanticipated negative consequences and/or material additional costs caused by an undetected error or defect in the technology used in its internal systems which are purchased from third parties. The costs of the project and the date on which the Company believes it will complete the conversion are based on management's best estimates, which were derived utilizing numerous assumptions of future events, including the continued availability of certain resources and other factors. However, there can be no guarantee that these estimates will be achieved and actual results could differ materially from those anticipated. The Company's engineers have reviewed all of the Company's significant products and do not believe there is any date sensitive software included in products sold by the Company since 1994. Some products sold by Omni Entertainment, a company acquired in 1994, may have date-sensitive computers which may result in incorrect date displays. The Company is in the process of notifying these customers of this concern and is providing the necessary tools to test their equipment. The Company does not expect to incur a material cost to test or correct products initially sold by the Company. The Company is also in the process of surveying key vendors to insure they are year 2000 compliant. As of September 18, 1998 the Company is unaware of any key vendors who are not compliant, however such survey is not yet complete. FACTORS THAT MAY AFFECT FUTURE RESULTS - -------------------------------------- HISTORY OF OPERATING LOSSES; FLUCTUATING PERIODIC OPERATING RESULTS AND CASH FLOW The Company has sustained substantial operating losses in four of its last five fiscal years. The Company's revenues in fiscal 1998 decreased by $14.5 million or 37% from fiscal year 1997 revenues. Although the Company expects to sustain a loss in the first quarter of fiscal 1999, revenues will be higher than in the prior three quarters. For all of fiscal 1999, the Company will not be able to achieve profitable operations unless revenues significantly increase to pre-1998 levels or above, or unless expenses are substantially decreased. Management believes that the fiscal 1999 revenues from hardware sales will exceed the fiscal 1998 level because the revenue to be recognized from the hardware sales backlog (defined as a signed sales contract with a customer deposit) at September 18, 1998 will exceed 24 the hardware revenue recognized in all of fiscal 1998. Additionally, while the Company took measures in fiscal 1998 to decrease the level of its SG&A expenses, management continues to examine its operations to achieve greater operating efficiencies and increase its revenues. However, there can be no assurance that the Company will be able to achieve profitable operations in fiscal 1999. DEPENDENCE ON PRODUCTION OF FILM SOFTWARE; FINANCIAL RISKS OF FILM PRODUCTION The Company's ability to implement its business strategy depends in large part upon its ability to successfully create, produce and market entertainment and educational film software for exhibition in its theatre systems. The size and quality of the Company's library of film software titles is a material factor in competing for sales of the Company's attractions and developing the Company's base of recurring revenue. The Company has invested $0.8 million, $2.5 million and $3.9 million in film software during fiscal 1996, 1997 and 1998, respectively. The Company has commitments to invest approximately $0.7 million in film software in fiscal 1999. The Company's recent operating losses and declining cash balance have caused it to decrease the level of its investments in film software, which may have an adverse affect on revenues on future periods. The Company generally produces and develops specialty films and videos for its library with production budgets ranging from approximately $100,000 to $2.0 million. While the Company may enter into participation, licensing or other financing arrangements with third parties in order to minimize its financial involvement in production, the Company generally is subject to substantial financial risks relating to the production and development of new entertainment and educational software. The Company typically is required to pay for the production of software during the production period prior to release and typically is unable to recoup these costs from revenues from exhibition licenses prior to 24 to 36 months following release. There can be no assurance that Iwerks will be able to create and produce additional software for its library which will be perceived by its customers to be of high quality or high entertainment value. At June 30, 1998, the Company had recorded on its balance sheet $5.3 million in film library costs. The Company periodically reviews the net realizable value of its film inventory and makes adjustments to its carrying value when appropriate. While the current carrying value of the Company's film inventory reflects management's belief that it will realize the net amount recorded on its balance sheet, there can be no assurance that it will be able to do so. INTENSE COMPETITION; UNPREDICTABILITY OF CONSUMER TASTES Competition in each of the markets in which the Company competes is intense. The principal direct competition for customers comes from manufacturers of competing movie-based attractions, and in the case of amusement and theme parks, manufacturers of traditional amusement park attractions. In addition to direct competitors, there is also competition from systems integrators and some amusement and theme parks developing and constructing their own attractions. Many of the Company's competitors have better name recognition, and substantially greater financial and other resources than the Company. In the large screen, special format motion picture business, Iwerks' main competitor is Imax. The 15 perforation 70 millimeter ("15/70") film format is the most predominant large film format due primarily to the large number of films that have been available in that format. Imax is by far the dominant company in this market. Increasingly, large format films are being made available in the 8/70 format, 25 such as "Everest" and others. The Company also sells 8/70 systems that can benefit from this trend. Additionally, the out-of-home entertainment industry in general is undergoing significant changes, primarily due to technological developments as well as changing consumer tastes. Numerous companies are developing and are expected to develop new entertainment products or concepts for the out-of-home entertainment industry in response to these developments that are or may be directly competitive with existing products. There is severe competition for financial, creative and technological resources in the industry and there can be no assurance that existing products will continue to compete effectively or that products under development will ever be competitive. Further, the commercial success of products is ultimately dependent upon audience reaction. Audience reaction will to a large extent be influenced by the audience's perception of how the Company's products compare with other available entertainment options out of the home. There can be no assurance that new developments in out-of-home entertainment will not result in changes in consumer tastes that will make the Company's products less competitive. NEW PRODUCT DEVELOPMENT The Company operates in a technology driven segment of the entertainment business. As such the Company must continually improve its products to increase their entertainment value while also facing pressure to continually reduce the price of its products to respond to competitive pressures. The Company intends to extend the current product line through innovative use of its current technologies. This also can be accomplished with the Company's effort to identify new strategic partners (see "Business Strategy" section). The Company's recent operating losses and declining cash balances have caused it to consider reducing the level of its capital expenditures and research and development efforts. The inability of the Company to develop new products and to respond to technological developments of its competitors could have a materially adverse effect on its business, operations and financial condition. INTERNATIONAL OPERATIONS A significant portion of the Company's sales and film licensing are made to customers located outside of the United States, primarily, in the Far East, Europe, South America and Canada. During fiscal 1996, 1997 and 1998, 49%, 55% and 46% of the Company's revenues, respectively, were derived from sales outside the United States. During fiscal 1998, no country (other than the United States) accounted for more than 10% of the Company's revenues. During fiscal 1997, China accounted for approximately 14% of the Company's revenues and in fiscal 1996 Japan accounted for approximately 11% of the Company's revenues. The Company expects a significant portion (between 40% and 60%) of the Company's sales in fiscal 1999 and 2000 will be to customers outside of the United States, similar to the percentage experienced in the past three years. International operations and sales of the Company may be subject to political and economic risks, including political instability, currency controls, exchange rate fluctuations (which, in the event of a decrease in value of foreign currency to the dollar can significantly affect the affordability of the Company's products overseas), changes in import/export regulations, tariff and freight rates, longer accounts receivable collection patterns, changes in regional or worldwide economic or political conditions and natural disasters. In addition, various forms of protectionist trade legislation have been proposed in the United States and certain other countries. Any resulting changes in current tariff structures or other trade and monetary policies could adversely affect the Company's international operations. Political and economic factors have been identified by the 26 Company with respect to certain markets in which it competes. There can be no assurance that these factors will not result in customers of the Company defaulting on payments due to it, or in the reduction of potential purchases of their products. The Company does not engage in any hedging programs. CURRENT TRENDS IN THE GLOBAL ECONOMY The Company's revenues and profitability are dependent on the strength of the national and international economies. In a recessionary or deflationary environment, sales of the Company's products and products of other entertainment companies may be adversely affected. Theme parks and other out-of-home entertainment venues may also experience a downturn in sales which could reduce the funds available for capital improvements and film licensing, resulting in price and other concessions and discounts by the Company in order to maintain sales activity. Recent turmoil in the economies of the countries in Asia have had a material adverse affect on the Company's revenues and results of operations. Revenues attributable to sales in Asia declined from $17.3 million for fiscal 1996 (representing 35.7% of the Company's revenues) to $5.7 million in fiscal 1998 (representing 22.6% of the Company's revenues). In addition, the Company did not enter into a new hardware sales contract for delivery in Asia during the fiscal year ended June 30, 1998. Subsequent to June 30, 1998 however, the Company finalized two sales contracts totaling $3.4 million with Chinese customers and an additional two contracts totaling $1.4 million with customers in Japan. If recent economic problems experienced in Asia, Russia, and Eastern Europe were to spread to Europe, South America or the United States, it could have a material adverse affect upon the Company's revenues and results of operations. The Company is not able to predict to what extent, or for what period, these economic trends may adversely affect the sales of its products. DEPENDENCE ON DIRECTORS AND SENIOR MANAGEMENT; RECENT CHANGES TO KEY PERSONNEL During fiscal 1998, many of the Company's executive officers including its CEO have changed. Current executive officers are Charles Goldwater, Chairman of the Board and Chief Executive Officer, Bruce C. Hinckley, Executive Vice President, Chief Financial Officer and Secretary, Jack Shishido, Senior Vice President of Worldwide Sales and Marketing, Jon Corfino, Senior Vice President Film Development and Distribution and Dan Griesmer, Senior Vice President and General Manager. Further, during fiscal 1998 and the first two months of fiscal 1999, as a result of downsizing and voluntary resignations, the Company has experienced a reorganization in its sales, marketing, human resources, film distribution, engineering, project management and assembly staffs. Between March 6, 1997, and June 30, 1998 three members of the Board of Directors have resigned and since February 1998 three new Board members have joined the Company. The Company continues to search for one additional Board member which will bring the total members of the Board to seven. The recruitment, retention and motivation of skilled directors, executives, sales, technical and creative personnel and other employees are important to the operations of the Company. The Company's turnover in management personnel has placed, and could continue to place, a significant strain on Iwerks' management and other resources. In addition, there is competition for management and creative personnel in the industries in which the Company operates. Also, the recruitment and retention of qualified employees is restricted because as of September 18, 1998 the Company has less than 25,000 shares available for future stock option grants under its existing stock option plans. There can be no assurance that the Company will not encounter difficulties in recruiting and retaining qualified personnel in the future. Should any key executive officer cease to be affiliated with the Company before a qualified 27 replacement is found, the Company's business could be materially adversely affected. VOLATILITY OF STOCK PRICE The Company's stock price has been, and could continue to be, highly volatile. The market price of the Company's Common Stock has fluctuated substantially in recent periods. During fiscal 1998 and through September 18, 1998, the Company's market price has ranged from a low of $1.25, to a high of $5.625 per share. Future announcements concerning the Company or its competitors, quarterly variations in operating results, introduction of new products or changes in product pricing policies by the Company or its competitors and acquisition or loss of significant customers may affect or be perceived to affect the Company's operations, or changes in earnings estimates by analysts, among other factors, could cause the market price of the Company's Common Stock to fluctuate substantially. In addition, stock markets have experienced extreme price and volume volatility in recent years. This volatility has had a substantial effect on the market prices of securities of many smaller public 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. ENVIRONMENTAL MATTERS AND OTHER GOVERNMENTAL REGULATIONS Under various Federal, state and local environmental laws and regulations, a current or previous owner or occupant of real property may become liable for the costs of removal or remediation of hazardous substances at such real property. Such laws and regulations often impose liability without regard to fault. The Company leases its corporate headquarters and manufacturing facilities. The Company could be held liable for the costs of remedial actions with respect to hazardous substances on such properties under the terms of the governing lease and/or governing law. Although the Company has not been notified of, and is not otherwise aware of, any current environmental liability, claim or non-compliance, there can be no assurance that the Company will not be required to incur remediation or other costs in the future in connection with its leased properties. In addition, the Company's subcontractors and other third parties, with which it has contractual relations, are similarly subject to such laws. EFFECT OF ANTI-TAKEOVER PROVISIONS The Company's Board has the authority to issue up to 1,000,000 shares of preferred stock and to determine the price, rights, preferences and privileges of those shares without any further vote or action by the Company's stockholders. The rights of the holders of the Common Stock will be subject to, and may be adversely affected by, the rights of the holders of preferred stock. While the Company has no present intention to issue shares of preferred stock, such issuance, while providing desirable flexibility in connection with the possible acquisitions and other corporate purposes, could have the effect of delaying, deferring or preventing a change in control of the Company and entrenching existing management. In addition, such preferred stock may have other rights, including economic rights senior to the Company's Common Stock, and, as a result, the issuance thereof could have a material adverse effect on the market value of the Company's Common Stock. A number of provisions of the Company's Certificate of Incorporation and By-Laws and the 28 Delaware General Corporation Law ("DGCL") and regulations relating to matters of corporate governance, certain rights of Directors and the issuance of preferred stock without stockholder approval, may be deemed to have and may have the effect of making more difficult, and thereby discouraging, a merger, tender offer, proxy contest or assumption of control and change of incumbent management, even when stockholders other than Iwerks' principal stockholders consider such a transaction to be in their best interest. In addition, the Company has adopted a Stockholder Rights Plan (the "Rights Agreement"). Pursuant to the Rights Agreement each outstanding share of the Company's Common Stock has received one right entitling the holder to purchase 1/100th of a share of Series A Preferred Stock of the Company's for each share of the Company's Common Stock then held by such holder. Each right becomes exercisable upon certain triggering events related to an unsolicited takeover attempt of the Company. PATENTS AND TRADEMARKS The Company has several United States and selected other countries' patents on various processes and elements related to film projection and ride simulation. The Company has registered its principal trademarks in the United States and selected other countries. While the Company's patents have not been challenged and the Company believes that its patents are valid, third parties could still challenge the patents and a court could determine that one or more of them are invalid. Declarations of invalidity, particularly of key patents, could adversely affect the marketability of the Company's products and services. 29 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. - ---------------------------------------------------- REPORT OF INDEPENDENT AUDITORS The Board of Directors Iwerks Entertainment, Inc. We have audited the accompanying consolidated balance sheets of Iwerks Entertainment, Inc. as of June 30, 1997 and 1998, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended June 30, 1998. Our audits also included the financial statement schedule listed in the Index at Item 14(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Iwerks Entertainment, Inc. at June 30, 1997 and 1998 and the consolidated results of its operations and its cash flows for each of the three years in the period ended June 30, 1998, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. Los Angeles, California Ernst & Young LLP August 5, 1998 30 Iwerks Entertainment, Inc. Consolidated Balance Sheets Assets (in Thousands)
June 30, ----------------- 1997 1998 ------- ------- Current assets: Cash and cash equivalents $ 3,608 $ 7,542 Short-term investments (Note 3) 15,459 2,922 Trade accounts receivable, net of allowance for doubtful accounts (Note 1) 5,447 3,521 Costs and estimated earnings in excess of billings on uncompleted contracts (Note 4) 6,339 1,574 Inventories 3,835 3,366 Other current assets 567 706 ------- ------- Total current assets 35,255 19,631 Portable simulation theatres at cost, net of accumulated depreciation 4,018 3,413 Property and equipment at cost, net of accumulated depreciation and amortization (Note 6) 2,920 4,329 Film inventory at cost, net of amortization (Note 1) 3,439 5,308 Goodwill, net of amortization (Notes 1 and 2) 15,367 14,742 Other assets 3,530 3,380 ------- ------- Total assets $64,529 $50,803 ======= =======
See accompanying notes. 31 Iwerks Entertainment, Inc. Consolidated Balance Sheets Liabilities and Stockholders' Equity (in Thousands, Except Share Amounts)
June 30, --------------------- 1997 1998 -------- --------- Current liabilities: Accounts payable $ 3,435 $ 1,982 Accrued expenses 8,793 6,823 Notes payable, current portion 81 - Billings in excess of costs and estimated earnings on uncompleted contracts (Note 4) 990 2,971 Deferred revenue 278 308 Capital leases, current portion (Note 10) 739 803 -------- -------- Total current liabilities 14,316 12,887 Capital lease obligations, excluding current portion (Note 10) 1,827 1,082 -------- -------- Total liabilities 16,143 13,969 Commitments and contingencies (Note 10) Stockholder's' equity (Note 9): Preferred stock, $0.01 par value, 1,000,000 - - authorized, none issued and outstanding Common stock, $.001 par value, 50,000,000 shares 57 57 authorized; 12,160,102 (1997) and 12,344,807 (1998) issued and outstanding Paid-in capital 78,016 78,024 Deficit (29,687) (41,247) -------- -------- Total stockholders' equity 48,386 36,834 -------- -------- Total liabilities and stockholders' equity $ 64,529 $ 50,803 ======== ========
See accompanying notes. 32 Iwerks Entertainment, Inc. Consolidated Statements of Operations (in Thousands, Except Per Share Amounts)
Years ended June 30, ---------------------------------- 1996 1997 1998 -------- -------- -------- Revenue $48,516 $ 39,584 $ 25,073 Cost of sales 28,675 28,948 19,653 ------- -------- -------- Gross margin 19,841 10,636 5,420 Selling, general and administrative expenses 17,377 15,373 15,999 Merger related expenses - 250 1,553 Loss on impairment of assets - 5,586 - ------- -------- -------- Income (loss) from operations 2,464 (10,573) (12,132) Interest income 1,164 1,125 842 Interest expense (380) (391) (247) ------- -------- -------- Income (loss) before provision for income taxes 3,248 (9,839) (11,537) Provision for income taxes (Note 8) 149 117 23 ------- -------- -------- Net income (loss) $ 3,099 $ (9,956) $(11,560) ======= ======== ======== Basic income (loss) per common share (Note 5) $ .28 $ (.84) $ (.95) ======= ======== ======== Diluted income (loss) per common share (Note 5) $ .26 $ (.84) $ (.95) ======= ======== ======== Weighted average shares outstanding - Basic 10,945 11,855 12,212 ======= ======== ======== Weighted average shares outstanding - Diluted 12,144 11,855 12,212 ======= ======== ========
See accompanying notes. 33 Iwerks Entertainment, Inc. Consolidated Statements of Stockholders' Equity (in Thousands)
Common Stock Retained ---------------- Paid Unearned stock Earnings Shares Amount capital compensation (deficit) Total ------ ------- ------- -------------- ---------- ------ Balance at June 30, 1995 10,592 $ 55 $73,411 $ (263) $(22,830) $ 50,373 ------ ------- ------- -------------- -------- -------- Issuance of common stock in connection with the 75 - 1,600 - - 1,600 class action settlement (Note 15) Common stock options and warrants exercised (Note 9) 961 1 1,579 - - 1,580 Retirement of common stock (40) - (250) - - (250) Amortization of unearned stock compensation - - - 263 - 263 Net income - - - - 3,099 3,099 ------ ------- ------- -------------- -------- -------- Balance at June 30, 1996 11,588 56 76,340 - (19,731) 56,665 ------ ------ ------- -------------- -------- -------- Common stock issued in connection with the Purchase of 299 1 1,200 - - 1,201 Pioneer (Note 2) Common stock options and warrants exercised (Note 9) 273 - 476 - - 476 Net loss - - - - (9,956) (9,956) ------ ------- ------- -------------- -------- -------- Balance at June 30, 1997 12,160 57 78,016 - (29,687) 48,386 ------ ------- ------- -------------- -------- -------- Common stock options and warrants exercised (Note 9) 25 - 8 - - 8 Issuance of common stock issued in connection with the class action settlement (Note 15) 160 - - - - - Net loss - - - - (11,560) (11,560) ------ ------- ------- -------------- -------- -------- Balance at June 30, 1998 12,345 $ 57 $78,024 $ - $(41,247) $ 36,834 ====== ====== ======= ============== ======== ========
See accompanying notes. 34 Iwerks Entertainment, Inc. Consolidated Statements of Cash Flows (in Thousands)
Year ended June 30, -------------------------------- 1996 1997 1998 OPERATING ACTIVITIES ------- ------- -------- Net (loss) income $ 3,099 $(9,956) $(11,560) Adjustments to reconcile net (loss) income to net cash provided by (used in) operating activities: Depreciation and amortization 6,438 6,279 4,628 Write-down of assets to net realizable value - 5,587 - Changes in operating assets and liabilities: Trade accounts receivable, net 1,282 (639) 1,926 Costs and estimated earnings in excess of billings on uncompleted contracts (2,772) (637) 4,765 Inventories (656) (1,012) 469 Other current assets 412 (152) (139) Accounts payable and accrued expenses (775) 1,389 (3,423) Billings in excess of costs and estimated earnings on uncompleted contracts (1,424) (116) 1,981 Deferred revenue (1,873) 217 30 ------- ------- -------- Net cash provided by (used in) operating activities 3,731 960 (1,323) INVESTING ACTIVITIES Investment in limited partnership and joint ventures - (1,162) (426) Investment in portable simulation theatres and patents (184) (108) (46) Purchases of property and equipment (312) (1,247) (2,333) Additions to film inventory (790) (2,548) (3,917) Investment in debt securities 2,247 (2,851) 12,537 Purchase of Pioneer and acquisition of related patent net of cash acquired and stock issued - (1,088) - Proceeds from sale of portable simulation unit - 1,184 - ------- ------- -------- Net cash provided by (used in) investing activities 961 (7,820) 5,815 FINANCING ACTIVITIES Proceeds from capital lease 3,000 - - Repayment of notes payable to related parties (372) (875) - Repayment of notes payable (1,819) (571) (81) Payments on capital leases (129) (700) (681) Exercise of stock options and warrants 1,580 476 8 Retirement of common stock (250) - - Other 241 (536) 196 ------- ------- -------- Net cash provided by (used in) financing activities 2,251 (2,206) (558) ------- ------- -------- Net increase (decrease) in cash 6,943 (9,066) 3,934 Cash and cash equivalents at beginning of year 5,731 12,674 3,608 ------- ------- -------- Cash and cash equivalents at end of year $12,674 $ 3,608 $ 7,542 ======= ======= ========
35 SUPPLEMENTAL INFORMATION TO CONSOLIDATED STATEMENTS OF CASH FLOWS
Year ended June 30, ------------------------ 1996 1997 1998 ------ ------ ------ Cash paid during the year for: Interest, net of amount capitalized $ 419 $ 411 $ 244 ====== ====== ====== Income taxes $ 61 $ 65 $ 23 ====== ====== ======
Supplemental disclosures of non-cash investing and financing activities: In 1997, the Company purchased patents, other assets and all the outstanding common stock of the Pioneer related entities for cash and Iwerks common stock. The Common Stock issued was valued at $1.2 million (see Note 2). In 1996, $1,600,000 was recorded to stockholders' equity from accrued expenses due to the issuance of common stock and warrants in connection with the class action settlement (see Note 15). Capital lease obligations increased by $3,000,000, in 1996, due to the purchase of portable simulation theatres. See accompanying notes. 36 IWERKS ENTERTAINMENT, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES CONSOLIDATION AND BASIS OF PRESENTATION - Iwerks is a Delaware corporation. Iwerks designs, manufactures, installs and services high resolution, proprietary motion picture theatre attractions. Iwerks' attractions are built around a variety of theatre systems, including fixed and portable simulators, giant screen theatres, 3D theatres and the licensing of the related software. Iwerks operates in one business segment, the manufacture, distribution and operation of entertainment and educational hardware and software. The financial statements consolidate the accounts of Iwerks and its wholly owned subsidiaries. All significant intercompany amounts and transactions have been eliminated in consolidation. Certain reclassifications were made to the financial statements for the year ended June 30, 1997 and 1996 in order to conform to the fiscal 1998 presentation. REVENUE AND COST RECOGNITION - Revenue from fixed-price-contracts are recognized on the percentage-of-completion method, measured by the ratio of percentage of labor hours incurred to date to estimated total labor hours for each contract. Management considers expended labor hours to be the best available measure of progress on such contracts. A contract is considered substantially complete upon delivery and acceptance of the product by the customer. These contracts average six to eighteen months in duration. Contract costs include direct materials, direct labor cost and indirect costs related to contract performance, such as indirect labor, supplies and tools. Costs and estimated earnings in excess of billings on uncompleted contracts represents costs incurred and gross profit recognized in excess of amounts billed. Billings in excess of costs and estimated earnings on uncompleted contracts represents billings in excess of costs incurred and gross profit recognized. Billings to customers are in accordance with the terms of the contract and generally follow a payment schedule. Iwerks performs a quarterly review of uncompleted contracts. Changes in estimates are reflected in the period of the change. Provisions for estimated losses on uncompleted contracts are made in the period in which such losses are determined. Iwerks provides a warranty for contracts generally for a period of twelve months. Such warranty costs are included in cost of sales. The warranty accrual as of June 30, 1997 and 1998 was $1,205,000, and $1,014,000, respectively, and are included in accrued expenses in the accompanying consolidated balance sheet. Iwerks also earns revenues for the production of films for outside parties. Iwerks recognizes revenue from such projects when the film is complete and has been accepted by the customer. Iwerks generally licenses films at agreed-upon minimum amounts. Revenues from film licenses are recognized when the license period begins and the programming is available pursuant to the terms of the license agreement. 37 Revenues from portable simulation theatres ticket sales are recorded at the time collected and fees from leasing of these simulators are recognized over the related lease periods. TRADE ACCOUNTS RECEIVABLE primarily consists of amounts due on contracts and film licenses. Allowance for doubtful accounts was $1,111,000 in 1997 and $1,893,000 in 1998. INVENTORIES consist primarily of simulation system equipment components and are stated at the lower of cost or market on an average cost basis. FILM INVENTORY consists of production and print costs and are stated at the lower of cost or net realizable value. The individual film forecast method is used to amortize film costs. Costs accumulated in the production of a film are amortized in the proportion that gross revenues realized bear to management's estimate of total gross revenues expected to be received. Revenue estimates on a film-by-film basis are reviewed quarterly by management and are revised, if warranted, based upon management's appraisal of current market conditions. Unamortized film costs are written down to net realizable value based on this appraisal, where applicable. Estimated liabilities for royalties and participation are accrued and expensed in the same manner as film costs are amortized. Film inventory is comprised of the following (in thousands):
June 30, --------------------- 1997 1998 -------- -------- Films released $ 15,204 $ 19,968 Films in process and development 1,639 792 -------- -------- Total 16,843 20,760 Less accumulated amortization (13,404) (15,452) -------- -------- $ 3,439 $ 5,308 ======== ========
The Company estimates that approximately 84% of unamortized film costs at June 30, 1998 will be amortized over the next three fiscal years. Many of the Company's films that have been fully amortized continue to generate revenues. PORTABLE SIMULATION THEATRES - Sixteen portable simulation theatres are in operation at June 30, 1998. Depreciation on the portable simulation theatres is computed using the straight line method over the estimated useful lives of the related assets, which range from seven to ten years. Accumulated depreciation was $4,327,000 in 1997 and $ 4,977,000 in 1998 (see Note 12). DEPRECIATION AND AMORTIZATION OF PROPERTY AND EQUIPMENT is computed using the straight line method over the estimated useful lives of the assets, which range from three to ten years. Leasehold improvements are amortized over five years or the term of the lease, whichever is shorter. GOODWILL (excess purchase price and liabilities assumed over the fair market value of assets acquired) primarily resulted from the acquisition of Omni and is being amortized over thirty years using the straight line method. The remaining goodwill relates to the acquisition of Pioneer Marketing Corporation and a related company (collectively referred to as "Pioneer") (see Note 2)and prior acquisitions and is being amortized over 16 to 25 years. Goodwill is reviewed periodically to determine if the facts and circumstances suggest that it may be impaired. If this review indicates that goodwill will not be recoverable, as determined based upon discounted cash flows of the acquired business over the remaining amortization period, then the carrying value of the related goodwill will be reduced by the estimated shortfalls of cash flows. Accumulated 38 amortization was $2,737,000 in 1997 and $ 3,421,000 in 1998. OTHER ASSETS - Patents are stated at cost, and are being amortized using the straight line method between 10 and 25 years. Iwerks acquired a patent in fiscal 1997 in connection with the Pioneer acquisition in the amount of $1,094,000, and a covenant not to compete in the amount of $50,000 (see Note 2). Accumulated amortization was $329,000 in 1997 and $278,000 in 1998. The Company has entered into joint venture arrangements whereby the Company contributes ride simulation theatre equipment and the joint venture partner contributes site improvements. The Company retains title to the assets it contributes to certain joint ventures, and therefore its investment in joint ventures is carried at historical cost and depreciated over 5 years. The Company receives film licensing fees and cash flow income is split between the joint venture partners. ACCRUED EXPENSES - The Company provides for commission and applicable royalties on revenue recognized in connection with certain agreements. The commission accrual as of June 30, 1997 and 1998 was $1,683,000 and $427,000, respectively, and the royalty accrual as of June 30, 1997 and 1998 was $2,285,000 and $2,847,000, respectively. These amounts are included in accrued expenses in the accompanying consolidated balance sheets. The Company had legal accruals as of June 30, 1997 and 1998 in the amounts of $671,000 and $584,000, respectively. The Company also had compensation accruals in the amount of $250,000 and $215,000 as of June 30, 1997 and 1998, respectively. These amounts are included in accrued expenses in the accompanying consolidated balance sheets. DEFERRED REVENUE represents advance payments received for rental of portable theatre systems and theatre service contracts and are recognized as revenue over the life of the respective agreements. RESEARCH AND DEVELOPMENT COSTS are incurred in the design, construction and testing of prototype systems and are charged to expense when incurred. The research and development expenses amounted to $358,000, $726,000 and $766,000 for the years ended June 30, 1996, 1997 and 1998, respectively. INCOME TAXES - The Company has applied Statement of Financial Accounting Standards No. 109, (Accounting for Income Taxes), which utilizes the liability method. Deferred income taxes under the liability method arise primarily from the difference between the timing of recognition of certain revenue and expense items for financial reporting and income tax purposes. CASH AND CASH EQUIVALENTS - The Company places its temporary cash investments with one high quality financial institution. The investments mature within 30 to 90 days and therefore are subject to limited risk. CONCENTRATION OF CREDIT RISK - The Company conducts credit evaluations of customers and believes the credit risk from its customers is minimal. QUALIFIED 401K PLAN - The Company has a Defined Contribution 401k Plan ("Plan") for all of its eligible employees. Under the Plan, each employee who has attained the age of eighteen and who has completed three months of service with the Company is eligible to become a participant. Under the Plan, each participant is permitted to make tax deferred voluntary contributions of an amount not to exceed the lesser of 15% of his or her respective compensation and the applicable statutory limitation. Effective July 1997, the Company began making matching contributions not to exceed 3% of participants salaries to the Plan, and has consequently recorded an expense of 39 approximately $109,000 in fiscal 1998. USE OF ESTIMATES - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that effect the amounts reported in the financial statements and accompanying notes. Actual results could differ from these estimates. FAIR VALUE OF FINANCIAL INSTRUMENTS - The Company's financial instruments, other than cash, accounts receivable and accounts payable, consist primarily of investments in debt securities. The fair value of investments in debt securities is based on quoted market prices. 2. ACQUISITION OF PIONEER On March 4, 1997 two newly formed wholly-owned subsidiaries of the Company acquired all the stock of Pioneer (a manufacturer of motion picture projectors) in exchange for 299,101 shares of Iwerks Common Stock. Concurrently, the Company purchased a patent from a partnership related to Pioneer for approximately $1,114,000 in cash. These transactions were accounted for as a purchase with an aggregate purchase price of approximately $2,784,000 including acquisition costs. The aggregate purchase price of Pioneer in excess of the fair value of the identifiable assets of Pioneer at the date of acquisition was $1,536,000 which has been allocated to goodwill. The operations of Pioneer have been consolidated with the operations of the Company from March 4, 1997. 3. SHORT-TERM INVESTMENTS The carrying amounts of the Company's investments in debt securities at June 30, 1997 and 1998 (maturing October, 1998) are as follows (in thousands):
Carrying Amount ------------------- Security 1997 1998 -------- ------- ------- U.S. Treasury Notes $ 8,542 $ - FNMA Discount Notes 1,532 - Banker's Acceptances 5,385 - Commercial Paper - 2,922 ------- ------- Total Short-Term Investments $15,459 $ 2,922 ======= =======
The principal amount, cost and fair value are not materially different than the carrying amount as shown above. There were no sales of available for sale securities for the fiscal year ended 1998 and $5,369,000 of proceeds for the fiscal year ended June 30, 1997. Realized gains or losses from debt securities sold during the year ended June 30, 1997 were not material. The basis on which cost was determined on calculating gains and losses was the specific identification method. Investments in debt securities at June 30, 1997 and 1998 are classified as available-for-sale, and the unrealized gains and losses, net of tax, were not material for any year presented. 40 4. BILLINGS IN EXCESS OF COSTS AND ESTIMATED EARNINGS ON UNCOMPLETED CONTRACTS Billings in excess of costs and estimated earnings on uncompleted contracts at June 30, 1997 and 1998 consist of the following (in thousands): 1997 1998 -------- -------- Costs incurred on uncompleted contracts $ 17,684 $ 14,486 Estimated earnings 15,513 13,228 -------- -------- 33,197 27,714 Less billings to date (27,848) (29,111) -------- -------- $ 5,349 $ (1,397) ======== ======== Such costs are included in the accompanying balance sheets at June 30, 1997 and 1998 under the following captions (in thousands):
1997 1998 ------- ------- Costs and estimated earnings in excess of billings on uncompleted contracts $ 6,339 $ 1,574 Billings in excess of costs and estimated earnings on uncompleted contracts (990) (2,971) ------- ------- $ 5,349 $(1,397) ======= =======
5. NET (LOSS) INCOME PER COMMON SHARE In February 1997, the Financial Accounting Standards Board ("FASB") issued SFAS No. 128, Earnings Per Share, which is effective for annual and interim financial statements issued for periods ending after December 15, 1997. The statement requires restatement of prior years' earnings (loss) per share ("EPS"). SFAS No. 128 was issued to simplify the standards for calculating EPS previously found in APB No. 15, Earnings Per Share. SFAS 128 replaces the presentation of primary EPS with a presentation of basic EPS. Basic EPS excludes the dilutive effects of stock options and warrants. Diluted EPS reflects all potential dilutive securities. The reconciliation of fiscal 1996 weighted average shares outstanding is as follows (in Thousands):
Weighted average shares outstanding - Basic 10,945 Effect of dilutive securities: Options 867 Warrants 332 ------ Weighted average shares outstanding - Diluted 12,144 ======
Options and warrants to purchase 425,430 and 109,162 shares of common stock during the years ended June 30, 1997 and 1998, respectively were not included in the computation of diluted loss per common share as the effect would be antidilutive. 41 6. PROPERTY AND EQUIPMENT Property and equipment, at cost, are summarized as follows at June 30, 1997, and 1998 (in thousands):
1997 1998 ------ ------ Office equipment, furniture and fixtures $2,120 $2,247 Operating equipment 1,147 1,226 Film production equipment 2,616 4,012 Demonstration theatres 2,878 3,548 Leasehold improvements 1,279 1,279 ------ ------ Total 10,040 12,312 Less accumulated depreciation (7,120) (7,983) ------ ------ $2,920 $4,329 ====== ======
Certain transportation equipment aggregating $3,711,000 at June 30, 1997 and 1998 were recorded under capital lease agreements. Accumulated depreciation on this equipment was $1,018,000 and $ 1,307,293 at June 30, 1997 and 1998, respectively. Depreciation expense amounted to $3,113,000, $2,750,00 and $1,797,000 for the years ended June 30, 1996, 1997 and 1998, respectively, including amounts related to assets under capital leases. 7. RELATED PARTY TRANSACTIONS During 1993, Itochu Corporation ("Itochu"), a stockholder, agreed to pay the Company $5 million primarily for the right to become the Company's exclusive distributor for a three year term in Asia for its Cinetropolis concept. Cinetropolis is a location based entertainment attraction utilizing multiple Iwerks products combined with food and beverage, retail and other entertainment in a stand-alone 35,000 to 60,000 square foot facility. The $5 million was recorded in deferred revenue and has been amortized over the three year exclusivity period. In addition, Itochu became a nonexclusive agent for Iwerks' other products for seven years. Itochu earns sales commissions on collections from customers on any theatre systems and related software sold by Itochu or its agents. During the years ended June 30, 1996, 1997 and 1998, $610,000, $489,000, and $291,000 respectively, was paid to Itochu in connection with this arrangement. 42 8. INCOME TAXES Provision for income taxes for the three years ended June 30 consists of (in thousands):
1996 1997 1998 ----- ----- ----- Current: Federal $ 47 $ 40 $ - State 25 24 8 Foreign 77 53 15 ----- ----- ----- 149 117 23 Deferred: Federal - - - State - - - ----- ----- ----- $ 149 $ 117 $ 23 ===== ===== ===== Reconciliation of effective rate of income taxes: 1996 1997 1998 -------- --------- -------- Provision for income taxes at statutory federal rate of 35% $ 1,137 $(3,444) $(3,828) State and local taxes 25 24 8 Foreign taxes 77 53 15 Nondeductible items and nontaxable items 399 1,019 266 NOL benefit (1,489) - - Benefit of net operating loss not currently recognized - 2,465 3,562 ------- ------- ------- $ 149 $ 117 $ 23 ======= ======= ======= The deferred tax asset at June 30 consists of (in thousands): 1997 1998 ------ ------ Net operating loss $ 7,461 $ 8,160 Reserves (405) (450) Asset impairment reserve (1,507) (1,507) Deferred revenues (62) (74) Film cost amortization 785 542 Other 8 9 ------- ------- 6,280 6,680 Valuation allowance (6,280) (6,680) ------- ------- $ - $ - ======= =======
At June 30, 1998, Iwerks had available federal and state tax net operating loss carryforwards of approximately $ 20,400,000 and $ 9,200,000, respectively, expiring through 2013. 43 9. STOCK OPTIONS AND WARRANTS The Company has elected to follow Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25) and related Interpretations in accounting for its employee stock options because, as discussed below, the alternative fair value accounting provided for under FASB Statement No. 123, "Accounting for Stock-Based Compensation," requires use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, because the exercise price of Iwerks' employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized. The Company has three stock incentive plans adopted in 1987, 1993, and 1994, respectively, (the "Plans") which provide for the granting to officers, directors, employees and consultants options to purchase shares of Iwerks Common Stock. In aggregate, 3,250,000 shares of Iwerks Common Stock are reserved for issuance under the Plans. In addition the Company has granted other options to purchase 100,000 shares of Iwerks Common Stock to certain officers outside of the Plans. Options generally vest over a four-year period and expire in ten years. Terminated employees have 90 days to exercise options, however certain officers, having separation agreements, have as long as 36 months to exercise options. At June 30, 1998, there were 876,500 vested options outstanding relating to four terminated officers which expire at varying dates until May, 2001. Pro forma information regarding net income and earnings per share is required by Statement 123, and has been determined as if the Company had accounted for its employee stock options under the fair value method of that Statement. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions for fiscal year 1996, 1997 and 1998, respectively: risk-free interest rates of 5.74%, 6.36% and 5.55%; weighted-average expected life of the option of 4.64 years, 4.19 years and 4.75 years; zero dividend yields; and a volatility factor of the expected market price of Iwerks' Common Stock of 51%, 51% and 57.5%. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. Given this method of amortization, the initial impact of applying FAS 123 on pro forma net income (loss) and pro forma earnings (loss) per share is not representative of the potential impact on pro forma amounts in future years when the effect of amortization from multiple awards would be reflected. The Company's pro forma information follows (in thousands except for per share information): 44
1996 1997 1998 ------ -------- -------- Pro Forma net income (loss) $2,717 $(10,685) $(12,483) Pro Forma net income (loss) per share $ 0.23 $ (0.90) $ (1.02)
A summary of the Company's stock option activities and related information for the years ended June 30 are as follows:
Number of Shares Weighted Average (in thousands) Exercise Price -------------- -------------- Options outstanding July 1, 1995 1,708 $3.54 Options granted 877 5.23 Options exercised (385) 1.64 Options terminated (274) 6.46 Options exercisable at June 30, 1996 604 $3.07 Options outstanding July 1, 1996 1,926 $4.26 Options granted 660 5.54 Options exercised (260) 1.82 Options terminated (425) 4.96 Options exercisable at June 30, 1997 696 $4.30 Options outstanding July 1, 1997 1,901 $4.88 Options granted 464 2.90 Options exercised (24) .35 Options terminated (159) 5.33
The weighted-average fair value of options granted was $1.45 in fiscal year 1998, $2.64 in fiscal year 1997 and $2.57 in fiscal year 1996. 45 The following table summarizes information about stock options outstanding at June 30, 1998:
Options Outstanding Options Weighted Average Exercisable -------------------------------------- ----------------------- Weighted Average Outstanding Remaining at Contractual Weighted Exercisable at Weighted Range of June 30, 1998 Life Average June 30, 1998 Average Exercise Prices in Thousands in Years Exercise Price in Thousands Exercise Price - --------------- ------------- ----------- -------------- -------------- -------------- $ .10-.74 71 3.4 $ .46 71 $ .46 $2.25-3.28 435 8.3 $2.68 152 $2.71 $3.38-5.02 1,158 4.3 $4.71 906 $4.82 $5.19-7.56 488 7 $5.79 265 $5.77 $9.00-9.75 30 7 $9.38 20 $9.29 ----- ----- 2,182 1,414 ===== =====
As of June 30, 1996, 1997 and 1998 the Company had 580,593, 364,582 and 23,099 shares available for future grants under the Plans. As of June 30, 1998 Iwerks has reserved 2,205,446 shares of unissued Iwerks Common Stock for issuance upon exercise of options granted under the Plans and outside the Plans. At June 30, 1998 the Company had 470,494 warrants exercisable at $8.78 per share and expiring July 2, 1999 and 8,000 warrants exercisable at $7.30 per share expiring April, 2003. (See Note 15). 10. COMMITMENTS AND CONTINGENCIES The Company leases facilities under operating leases that expire through 2001. Leases that expire are expected to be renewed or replaced. Rental expense for the years ended June 30, 1996, 1997 and 1998 was approximately $617,000, $641,000 and $641,000, respectively. Future minimum lease payments under capital and operating leases at June 30, 1998 are as follows (in thousands):
Capital Operating leases leases -------- --------- 1999 $ 963 $435 2000 867 240 2001 294 60 2002 - - 2003 - - ------- ---- Total minimum lease payments 2,124 $735 ==== Less amount representing interest (239) ------- $ 1,885 =======
The Company has also from time to time, provided standby letters of credit to customers as performance bonds. The customers may draw on the letters of credit should Iwerks fail to perform under the terms of the contracts. There were no standby letters of credit outstanding as of June 30, 46 1998. During the year, the Company has entered into employment contracts with four key officers including the CEO. In aggregate, these contracts provide for minimum annual compensation of $740,000. The contracts provide for annual salaries, annual rate increases between 4% and 5%, bonus compensation based on performance and stock options. These contracts have a term of two and three years and provide for termination benefits of a minimum of 15 months annual salary in the event of termination without cause or change of control. The Company has guaranteed the debt of a customer in connection with the purchase of a hardware system. The total amount of this debt at June 30, 1998 was approximately $355,000. Subsequent to June 30, 1998, this debt became due and the customer is in default. The Company believes that no material amounts will become payable under its guarantee. 11. SIGNIFICANT CUSTOMERS AND GEOGRAPHIC INFORMATION In 1996, 1997 and 1998 Iwerks had no customers who accounted for more than 10% of consolidated revenue. Export revenue by geographic area for the years ended June 30 consist of (in thousands):
1996 1997 1998 -------- -------- -------- Asia $ 17,311 $ 13,682 $ 5,660 South America 972 5,375 2,493 Europe 4,409 2,085 1,672 Canada 1,131 516 1,596 -------- -------- -------- Total export revenue $ 23,823 $ 21,658 $ 11,421 ======== ======== ========
12. ASSET IMPAIRMENT IN FISCAL 1997 The fourth quarter of fiscal 1997 includes a non-cash charge of $5.6 million to record the impact of the adoption of SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be disposed of." This charge consisted primarily of a reduction in the carrying value of the portable simulation business (touring) to the net present value of the future cash flows expected from these assets. Of the charge, $1.8 million reduced Goodwill, and the balance reduced Iwerks' fixed assets. The Company lost AT&T as a major sponsor of the Reactor' fleet in the first quarter of fiscal 1997. The loss of the major sponsor that utilized five of the Reactors throughout fiscal 1996 resulted in excess capacity between early fall and late spring of fiscal 1997. Since that time, and through the fourth quarter of fiscal 1997, the Company aggressively pursued new sponsorship opportunities and other options to replace those revenues. The failure to consummate those opportunities prior to the end of fiscal 1997 and the lack of sponsorship backlog as of June 30, 1997 prompted the Company to take the charge under SFAS 121. 47 13. FOURTH QUARTER ADJUSTMENTS IN FISCAL 1997 In the fourth quarter of fiscal 1997, certain events occurred which resulted in changes in accounting estimates. These include additional film amortization of $746,000 due to changes in revenue estimates; increased bad debt reserve by $557,000 due to an account which was deemed uncollectable, established a legal and dispute reserve of $850,000 for disputes that first arose in the fourth quarter of fiscal 1997; increase the warranty reserve by $147,000 due to increase work performed on a contract, increased accrued expenses by $320,000 due to a regulatory audit and reduced previously recognized earnings by $205,000 in connection with the cancellation of a contract. 14. STOCKHOLDERS RIGHTS PLAN The Company has adopted a Stockholder Rights Plan (the "Agreement"). Pursuant to the Agreement each outstanding share of Iwerks' Common Stock has received one right entitling the holder to purchase 1/100th of a share of Series A Preferred Stock of Iwerks for each share of Iwerks Common Stock then held by such holder. Each right becomes exercisable upon certain triggering events related to an unsolicited takeover attempt of Iwerks. 15. LITIGATION In the fourth quarter of fiscal year ended 1996, the Company reached an agreement with the plaintiffs to settle all pending shareholder class action suits against the Company and certain of its officers and directors in the United States District Court of the Central District of California. In accordance with the principal terms of the agreement, $1.75 million was paid by the Company's insurance carrier (with unclaimed amounts being returned to the carrier). In fiscal 1996 and 1998 an aggregate of 235,246 shares of Iwerks' Common Stock and 470,494 warrants to purchase Iwerks' Common Stock were issued by the Company to the plaintiffs and their attorneys. The warrants are exercisable through July 2, 1999, and the exercise price is $8.78. The Company will receive the proceeds from the exercise of the warrants if and when they are exercised. The Company took a charge against earnings of $1.7 million in the fourth quarter of fiscal 1995 to reflect the anticipated costs of the settlement. Further, there can be no assurance that others not included in the settlement will not file similar claims in the future. Fred Hollingsworth III, a former director of the Company and former chief executive officer and founder of Omni Films International, Inc., filed suit in 1996 against the Company and seven of its current or former officers and directors. In February, 1997 the Company and Mr. Hollingsworth reached an out-of-court settlement. The Company made a cash payment to Mr. Hollingsworth which the Company was reimbursed by its insurance carrier in the quarter ended June 30, 1997. There are no material legal proceedings to which the Company is a party other than ordinary routine litigation in the course of business. In the opinion of management, resolution of these matters will not have a material adverse impact on the Company's financial position or results of operations. 48 ITEM 9. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL - -------------------------------------------------------------------------------- DISCLOSURE. - ---------- None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT. - -------------------------------------------------------- On February 21, 1998 Charles Goldwater was appointed Chairman of the Board, Chief Executive Officer and President replacing Roy A. Wright. Mr. Goldwater was formerly the Chief Executive Officer and President of Mann Theatres (Cinemerica Theatres L.P.) In March, 1998 Daniel Griesmer was appointed Senior Vice President and General Manager overseeing all areas of product development, touring ride simulation business, manufacturing, project design and field operations. In June, 1998 Jack Shishido was appointed Senior Vice President Worldwide Sales and Marketing. On June 8, 1998 the Company announced the appointment of two new outside members to its Board of Directors bringing the number of outside Directors to six. The two new directors were Bruce A. Beda, Chief Executive of Orion Partners and Peter Hanelt, Chief Operating Officer of Natural Wonders. Information regarding directors and executive officers of the Company will appear in the Proxy Statement for the 1998 Annual Meeting of Stockholders, and is incorporated herein by this reference. ITEM 11. EXECUTIVE COMPENSATION. - -------------------------------- Information regarding executive compensation will appear in the Proxy Statement for the 1998 Annual Meeting of Stockholders, and is incorporated herein by this reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. - ------------------------------------------------------------------------ Information regarding security ownership of certain beneficial owners and management of the Company will appear in the Proxy Statement for the 1998 Annual Meeting of Stockholders, and is incorporated herein by this reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. - -------------------------------------------------------- Information regarding certain relationships and related transactions will appear in the Proxy Statement for the 1998 Annual Meeting of Stockholders, and is incorporated herein by this reference. 49 ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. - ---------------------------------------------------------------------------
(a) FINANCIAL STATEMENTS: PAGE NUMBER ----------- Report of Independent Auditors 30 Consolidated Balance Sheets 31-32 June 30, 1997 and 1998 Consolidated Statements of Operations 33 Years Ended June 30, 1996, 1997 and 1998 Consolidated Statements of Stockholders' Equity 34 Years Ended June 30, 1996, 1997 and 1998 Consolidated Statements of Cash Flows 35-36 Years Ended June 30, 1996, 1997 and 1998 Notes to Consolidated Financial Statements 37-48
FINANCIAL STATEMENT SCHEDULES: Schedule II - Valuation and Qualifying Accounts for the years ended June 30, 1996, 1997 and 1998. All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. (b) EXHIBITS: See Exhibit List attached to this Annual Report on Form 10-K. (c) REPORTS ON FORM 8-K: (i) Report on Form 8-K, filed on April 2, 1998 with respect to an event occurring on March 31, 1998 - Item 5. (ii) Report on Form 8-K, filed on June 18, 1998 with respect to an event occurring on June 15, 1998 - Item 5. 50 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. IWERKS ENTERTAINMENT, INC. (Registrant) By: /s/ Charles Goldwater --------------------- Charles Goldwater Chief Executive Officer Date: September 24, 1998 Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of Registrant and in the capacities and on the dates indicated.
Signature Title Date --------- ----- ---- /s/ Charles Goldwater Chairman, President and CEO September 24, 1998 - ------------------------------- (Principal Executive Officer) Charles Goldwater Executive Vice President September 24, 1998 /s/ Bruce C. Hinckley Chief Financial Officer - ------------------------------- (Principal Finance Officer) Bruce C. Hinckley /s/ Jeffrey M. Dahl Vice President /Controller September 24, 1998 - ------------------------------- (Principal Accounting Officer) Jeffrey M. Dahl /s/ Donald W. Iwerks Vice Chairman of the Board September 24, 1998 - ------------------------------- Donald W. Iwerks /s/ Dag Tellefsen Director September 24, 1998 - ------------------------------- Dag Tellefsen /s/ Gary J. Matus Director September 24, 1998 - ------------------------------- Gary J. Matus /s/ Bruce Beda Director September 24, 1998 - ------------------------------- Bruce Beda /s/ Peter Hanelt Director September 24, 1998 - ------------------------------- Peter Hanelt
51 SCHEDULE II IWERKS ENTERTAINMENT, INC. VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED JUNE 30, 1996, 1997 AND 1998
Balance at beginning Balance at Classification of year Additions Write-Offs end of year - -------------- ---------- ----------- ----------- ----------- FOR THE YEAR ENDED JUNE 30, 1996 Allowance for doubtful accounts $932,255 - $639,265 $292,990 FOR THE YEAR ENDED JUNE 30, 1997 Allowance for doubtful accounts $292,990 $843,495 $25,171 $1,111,315 FOR THE YEAR ENDED JUNE 30, 1998 Allowance for doubtful accounts $1,111,315 $1,808,250 $1,026,333 $1,893,232
52 EXHIBIT INDEX 3.1 Certificate of Amendment of Certificate of Incorporation dated August 1, 1997. *** 3.2 Bylaws of Iwerks. ** 4.1 Specimen Certificate evidencing Common Stock of Iwerks.* 4.3 Warrant Agreement, dated April 30, 1993, by and between Iwerks and Richard King International.* 10.1 Form of Indemnification Agreement and schedule of indemnified parties.* 10.2 Purchase Agreement dated January 23, 1991, by and between Iwerks and Ride and Show Engineering, Inc.* 10.3 Amended and Restated 1987 Stock Option, Purchase and Appreciation Rights Plan of Iwerks.* 10.6 1993 Stock Incentive Plan of Iwerks.* 10.7 Lease for 4540 W. Valerio Street, Burbank, California 91505, dated May 15, 1990, by and between Iwerks as lessee and Sheldon Plutsky as lessor.* 10.8 Lease for 4520 Valerio Street, Burbank, California 91505, dated September 1, 1992, and the Amendment thereto, dated September 22, 1992, by and between Iwerks as lessee and James E. McGraw as lessor.* 10.9 Lease for 4535 W. Valerio Street, Burbank, California 91505, dated September 11, 1991, by and between Iwerks as lessee and R.C. Associates as lessor.* 10.10 Lease for 4525 W. Valerio Street, Burbank, California 91505, dated March 23, 1994 by and between Iwerks as lessee and the Penney Family Trust as lessor.*** 10.12 1994 Stock Incentive Plan of Iwerks Entertainment, Inc.** 10.15 Lease Agreement - Matrix Funding Corporation*** 10.16 Separation Agreement dated October 31, 1997 between the Company and Roy A. Wright ***** 10.17 Separation Agreement dated October 31, 1997 between the Company and Bruce Hinckley ***** 10.18 Separation Agreement dated October 31, 1997 between the Company and William J. Battison III ***** 10.22 Employment Agreement dated February 21, 1998 between the Company and Charles Goldwater ****** 10.23 Employment Agreement dated March 2, 1998 between the Company and Dan Griesmer ******* 10.24 Employment Agreement dated August 3, 1998 between the Company and Jack Shishido. 22.1 Subsidiary List.** 23.1 Consent of Independent Auditors - Ernst & Young LLP
53 27.1 Exhibit 27.1 - Schedule of Financial Information
______________ * Incorporated by reference from Iwerks' Registration Statement on Form S-1, SEC File No. 68022 declared effective on October 19, 1993. ** Incorporated by reference from Registrants Annual Report on Form 10-K for the year ended June 30, 1995. *** Incorporated by reference from Registrants Annual Report on Form 10-K for the year ended June 30, 1996. **** Incorporated by reference from Registrants Annual Report on Form 10-K for the year ended June 30, 1997. ***** Incorporated by reference from Registrants Quarterly Report on Form 10-Q for the quarter and six months ended December 31, 1997. ****** Incorporated by reference from Registrants Registration Statement on Form S-4 filed on March 4, 1998. ******* Incorporated by reference from Registrants Quarterly Report on Form 10-Q for the quarter and nine months ended March 31, 1998. 54 EX-10.24 2 EMPLOYMENT AGREEMENT Exhibit 10.24 Iwerks Entertainment, Inc. 4540 West Valerio Street Burbank, California 91505 August 3, 1998 Mr. Jack Shishido 416 N. Isabel Street #D Glendale, CA 91206 Dear Mr. Shishido Iwerks Entertainment, Inc. (the "Company") and you have agreed as follows: 1. Employment and Services: ----------------------- The Company has employed you as Senior Vice President - World Wide Sales and Marketing and you have agreed, commencing on June 29, 1998 (the "Commencement Date"), to perform your exclusive and full-time services in that capacity for the Company upon the terms and conditions herein set forth. You shall report directly to the Company's Chief Executive Officer or his duly authorized representatives. You shall have all the duties customarily accorded to a Senior Vice President - World Wide Sales and Marketing of a corporation and such additional duties commensurate with your offices as are from time to time delegated to you by the Chief Executive Officer of the Company. You shall devote your business time, energy and efforts faithfully and diligently to promote the Company's interests. You will render your services primarily at the Company's offices which shall be in the Los Angeles metropolitan area and which are presently on West Valerio Street in Burbank, and shall travel on business on a temporary basis to such other places as the Company may direct. 2. Term: ---- The term of this Agreement shall be the Initial Period and the Additional Period, if the Company's option is exercised, unless sooner terminated. a. Initial Period: The initial period shall commence on the Commencement -------------- Date and continue for a two year period; and b. Additional Period: The Company shall have the irrevocable option to ----------------- extend the Term of this Agreement following the termination of the Initial Period for an additional two year period (the "Additional Period"), upon the same terms and conditions as during the Initial Period. Such option is exercisable by written notice sent on or before March 29, 2000. c. Notice at Expiration of Additional Term. If the option referred ---------------------------------------- to in clause b above is exercised by the Company, the Company shall provide to you written notice on or prior to March 29, 2000 as to whether it desires to extend the Term beyond the Additional Term. 3. Salary: ------ As compensation for all your services rendered under this Agreement, and so long as you are not in default of any material obligation, for the period ending on the date immediately preceding the first anniversary of the Commencement Date, the Company shall pay you a base salary at an annual rate of $160,000. Commencing on the first anniversary of the date of this Agreement, your base salary for each subsequent contract year during the Term of your employment (including the Initial Term and the Additional Term) shall be increased by an amount equal to 4% of the base salary prevailing during the prior contract year. Such compensation shall be payable in equal installments on the Company's regular paydays during the Term subject to the usual and required employee payroll deductions, withholding and reduction to offset payments you receive from governmental agencies or programs, including, but not limited to, State Disability Insurance benefits. (You are obligated to seek such payments or benefits and report them to the Company). The Company is not obligated to actually utilize your services, subject to its obligations set forth in this Agreement. 4. Performance Bonus: ----------------- Commencing in Fiscal 1999, you will be eligible for a performance based bonus pursuant to a bonus plan adopted by the Compensation Committee of the Board of Directors. You will be eligible to receive a bonus in an amount of up to 50% of your then current annual base salary upon achieving 100% of the established performance goals. It is anticipated that the bonus plan will provide bonus payments in amounts less than this percentage if the Company achieves a portion of the stated goals and a percentage greater than 50% (up to an agreed upon maximum contemplated to be set at 100%) if the Company's performance exceeds the stated goals. Performance goals will be established by the Compensation Committee of the Board of Directors after consultation with the Chief Executive Officer during the first quarter of each fiscal year and shall be commensurate with the corresponding bonus targets. It is anticipated that the performance goals will include financial goals for the Company as well as nonfinancial goals for the Company. 5. Stock Options: ------------- The Company will grant to you options to purchase 75,000 shares of common stock of the Company upon commencement of your employment hereunder. Of these 75,000 options, 45,000 options shall be priced at the closing sale price of the Company's common stock on the Nasdaq National Market on the trading date immediately prior to the Commencement Date (the "Closing Price"). Of the remaining options, 15,000 shall be priced at 125% of the Closing Price and 15,000 shall be priced at 150% of the Closing Price. Effective as of the beginning of each fiscal year in which you are employed by the Company (commencing with the fiscal year ending June 30, 2000) and if the Company achieves 100% of the performance goals as established for purposes of the 2 performance bonus described above for the prior fiscal year, you will be granted options to purchase an additional 75,000 shares of common stock at the closing sale price of the common stock on the Nasdaq National Market on the last trading day of such prior fiscal year. If the Company achieves less than 100% of the performance goals for any fiscal year, but you qualify for a bonus under the bonus plan for such fiscal year, you shall be granted options for that number of shares which bears the same ratio to 45,000 as the percentage bonus actually received bears to 50%. Of the options described herein, 18,750 shall vest on the first anniversary of your employment by the Company and the remaining options shall vest in equal monthly installments over the next three years. All options described herein shall be subject to accelerated vesting as described below under "Severance Arrangements" and "Change of Control." All options shall terminate on the earlier to occur of three years from the date of your termination of employment and ten years from the date of grant. 6. Benefits: -------- During the period for which the Company actually utilizes your services and so long as you are not in default of any material obligation: a. Vaction. You shall be entitled to three weeks paid vaction for each calendar year during your employment; provided, however, that vaction shall -------- ------- only be taken at such times as not to interfere with the necessary performance of your duties and obligations under this Agreement. Vacation time shall accrue and may be carried over only in accordance with Company policy. It shall be your responsibility to schedule and take all accrued vacation prior to the expiration of the Term hereof. b. Automobile. The Company shall provide you with an automobile allowance in an amount equal to $1,000.00 per month. c. Reimbursement. You shall be entitled to reimbursement from the Company for the reasonable costs and expenses incurred in connection with the performance of the duties and obligations provided for in this Agreement in accordance with the Company's travel policies. Reimbursement shall be paid upon prompt presentation of expense statements or vouchers and such other supporting information as the Company may from time to time require. d. Other Benefits; Insurance. During the term of your employment under this Agreement, if and to the extent eligible, you shall be entitled to participate in all operative employee benefit and welfare plans of the Company then in effect ("Company Officer Benefit Plans"), including, to the extent then in effect, group life, medical, disability and other insurance plans, all on the same basis generally applicable to the executives of the Company; provided -------- however, that nothing contained in this Section 6.d shall, in any manner - ------- whatsoever, directly or indirectly, require or otherwise prohibit the Company from amending, modifying, curtailing, discontinuing or otherwise terminating, any Company Officer Benefit Plan at any time (whether during or after the Term hereof). 7. Severance Arrangements: ----------------------- 3 In the event of a termination not "for cause" or a "defacto termination", (either prior to or at the expiration of the Initial Term or Additional Term, as applicable (i.e. whether you are terminated during the Initial Term or the Additional Term, as applicable, or your employment is terminated as a result of the Company's failure to renew your employment at the end of the Initial Term or Additional Term, as applicable), you will be entitled to receive the following (the "Severance Amount"): (I) a cash amount equal to the base salary which would have been payable to you over the remaining Term (but not less than 15 months), as computed based on your base salary at the date of notice of termination, (ii) a cash amount equal to the pro rated portion (based on time served) of the performance bonus which would have been paid to you under the performance bonus plan for the fiscal year in which the termination occurs, if your employment had continued through the end of the fiscal year and the Company had achieved 100% of its scheduled performance goals, and (iii) the automobile allowance, (iv) COBRA benefits for you and your family (medical and dental, if applicable), and (v) other applicable benefits under other Company Officer Benefit Plans for the remaining Term (but not less than 15 months). In addition, if termination occurs for any of the foregoing reasons prior to or at the expiration of the Initial Term or Additional Term, as applicable, all of the stock options then held by you which would vest during the remainder of the Initial Term or Additional Term, as applicable, and during the 12 months thereafter, shall become vested and immediately exercisable and the time for exercise shall be extended until the expiration of three years from the date of termination of employment. Notwithstanding the foregoing, (x) if a termination giving rise to an obligation by the Company to pay the Severance Amount occurs at any time during the Initial Term or upon the expiration of the Initial Term, each reference to 15 months above shall be deemed to refer to 18 months, and (y) if during the fiscal year in which a termination giving rise to an obligation by the Company to pay the Severance Amount occurs the Company achieves 100% of its scheduled performance goals, the Company shall pay to you 100% of the performance bonus (in lieu of the pro rated portion referred to above) as part of the Severance Amount. The amounts payable to you pursuant to this Section 7 shall be paid to you within 10 days of your termination. "For cause" is defined to mean (a) an act of fraud, embezzlement or similar conduct by you involving the Company, (b) any action by you involving your arrest for violation of any criminal statute constituting a felony or a misdemeanor involving moral turpitude if the Board of Directors reasonably determines that the continuation of your employment after such event would have an adverse impact on the operations or reputation of the Company in the financial community, (c) gross misconduct or habitual negligence in the performance of your duties, (d) an act constituting a breach of your fiduciary duty to the Company under the Delaware General Corporation Law, or (e) a continuing, repeated and willful failure or refusal by you to perform your duties. A "defacto termination" is defined to include any of the following events: (a) the Company reduces your base salary in an aggregate amount in excess of 10% from that paid in the prior fiscal year, except as part of a general reduction of compensation of executive officers, (b) the Company fails to cause you to remain an executive officer of the Company, (c) you were not afforded the authority, powers, responsibilities and privileges customarily accorded to an executive with your title, or (d) the Company requires your primary services to be rendered in an area other than the Company's principal offices in the greater Los Angeles metropolitan area. 4 8. Change in Control: ----------------- If there is a "change in control" of the Company during the Initial Term or the Additional Term, as applicable, upon the expiration of 90 days (or such longer period as is then mutually agreeable to you and the Company) following the date of such Change in Control (if you are requested to serve during such period) and for a 180 day period thereafter you shall be entitled to terminate your employment by delivery of written notice and receive (I) a cash amount equal to the base salary which would have been payable to you over the remaining Term (but not less than 18 months), as computed based on your base salary at the date of notice of termination, (ii) a cash amount equal to the performance bonus which would have been paid to you under the performance bonus plan for the fiscal year in which the termination occurs, if your employment had continued through the end of the fiscal year and the Company had achieved 100% of its scheduled performance goals, and (iii) the automobile allowance, (iv) COBRA benefits for you and your family (medical and dental, if applicable), and (v) other applicable benefits under other Company Officer Benefit Plans for the remaining Term (but not less than 18 months). In addition, all options held by you on the date of the Change in Control which are unvested shall vest and become exercisable at the time of the Change in Control and will remain exercisable (if they are not terminated as a result of the Change in Control) for a period ending at the end of the third year following the date of such Change in Control. Nothing contained in this Section 8 shall modify or alter the Company's obligations under Paragraph 7 above with respect to termination without cause or defacto termination during the period following a Change in Control; provided, however, if a termination without cause or a defacto termination occurs between the date of a Change in Control and the expiration of the period in which you are entitled to terminate your employment pursuant to this Section 8, the Severance Amount payable to you shall be the benefits described in this Section 8 and not the benefits described in Section 7. The amounts payable to you pursuant to this Section 8 shall be paid to you within 10 days of your termination. A "change in control" is defined to mean (a) the acquisition by any individual, entity or group (within the meaning of the Exchange Act of 1934, as amended) of 25% or more of the combined voting power of the then outstanding voting securities of the Company entitled to vote in the election of directors, (b) a liquidation, dissolution, reorganization, merger or consolidation of the Company, except where (I) more than 60% of the combined voting power of the then outstanding voting securities of the resulting corporation entitled to vote in the election of directors shall be owned by substantially all of the persons who were owners immediately prior to such event in substantially the same proportions as their respective ownership immediately prior to such event, or (ii) no person owns 25% or more of the combined voting power of the resulting corporation, or (iii) at least a majority of the members of the Board of Directors shall have been members of the Board of Directors at the time of the execution of the initial agreement providing for such event, or (c) a change in the membership of the Board of Directors such that the directors sitting on the Board of Directors on the effective date of this Agreement cease to constitute at least a majority of the Board of Directors following the event. 5 9. No Mitigation: ------------- The payments required to be paid to you by the Company pursuant to Sections 7 and 8 shall not be reduced by or mitigated by amounts which you earn or are capable of earning during any period following your termination date. 10. Indemnification: --------------- The Company and you are parties to an Indemnification Agreement, pursuant to which, inter alia, the Company has agreed, on the terms and conditions ----- ---- therein set forth, to indemnify you against certain claims arising by reason of the fact that you were an officer or director of the Company. 11. Trade Secrets: ------------- The Company and you are parties to a separate confidentiality agreement in a form which is required of all employees pursuant to the Company's personnel policies. 12. Injunctive Relief ----------------- You hereby recognize, acknowledge and agree that in the event of any material breach by you of any of your covenants, agreements, duties or obligations hereunder, the Company would suffer great and irreparable harm, injury and damage, the Company would encounter extreme difficulty in attempting to prove the actual amount of damages suffered by the Company as a result of such breach, and the Company would not be reasonably or adequately compensated in damages in any action at law. You therefore agree that, in addition to any other remedy the Company may have at law, in equity, by statute or otherwise, in the event of any material breach by you of any of the covenants, agreements, duties or obligations hereunder, and after written notice is provided to you with a reasonable opportunity to cure, the Company or its subsidiaries shall be entitled to seek and receive temporary, preliminary and permanent injunctive and other equitable relief from any court of competent jurisdiction to enforce any of the rights of the Company or its subsidiaries or any of the covenants, agreements, duties or obligations of you hereunder, or otherwise to prevent the violation of any of the terms or provisions hereof, all without the necessity of proving the amount of any actual damage to the Company or its subsidiaries thereof resulting therefrom; provided, however, that nothing contained in this Section 12 shall be deemed or construed in any manner whatsoever as a waiver by the Company or its subsidiaries of any of the rights which any of them may have against you at law, in equity, by statute or otherwise arising out of, in connection with or resulting from the breach by you of any of your covenants, agreements, duties or obligations hereunder. 13. Survivability: ------------- Without prejudice to the survival of any of your other rights or obligations and/or any of the Company's other rights or obligations, you and we expressly acknowledge that your obligations 6 and/or the Company's rights under paragraphs 7, 8, 9, 12 and 13 will survive the expiration or termination of this Agreement. 14. Notices: ------- All notices, requests, consents and other communications required or permitted to be given hereunder shall be written and shall be deemed to have been duly given if delivered personally or sent by prepared telegram, by facsimile, or mailed first-class, postage prepaid, as follows: Employee: Jack Shishido 416 N. Isabel Street #D Glendale, CA 91206 the Company: Iwerks Entertainment, Inc. 4540 West Valerio Street Burbank, CAlifornia 91505 with a copy to: Troop Meisinger Steuber & Pasich LLP 10940 Wilshire Boulevard, Suite 800 Los Angeles, California 90024 Attn: C.N. Franklin Reddick III, Esq. or at such other addresses as either party may specify by written notice to the other. 15. General: ------- a. During the Term of this Agreement, except within the final one hundred eighty (180) days of the Term or a Change in Control (whichever is the first to occur), you shall not seek, or negotiate for, employment other than with the Company. b. This Agreement set forth the entire agreement and understanding of the parties hereto, and, effective on the Commencement Date hereof, supersedes all prior agreements, arrangements, and understandings. No representation, promise or inducement has been made by either party that is not embodied in this Agreement. c. Nothing herein contained shall be construed so as to require the commission of any act contrary to law. Wherever there is any conflict between any provision of this Agreement and any present or future statute, law, ordinance or regulation, the latter shall prevail, but in such event the provision of this Agreement affected shall be curtailed and limited only to the extent necessary to bring it within legal requirements. Without limiting the generality of the foregoing, in the event any compensation payable hereunder shall be in excess of the amount permitted by any statute, law, ordinance or regulation, payment of the maximum amount allowed thereby shall constitute full compliance by the Company with the payment requirements of this Agreement. 7 d. The section headings contained herein are for reference purposes only and shall not in any way affect the meaning or interpretation of this Agreement. e. The provisions of this Agreement are severable, and if any one or more provisions are determined to be judicially unenforceable, in whole or in part, the remaining provisions shall nevertheless be binding and enforceable. f. This Agreement and all obligations and benefits of you and the Company hereunder shall bind and inure to the benefit of you and the Company and your and the Company's respective affiliates, successors and assigns; provided, however, you shall not be entitled to assign any of your obligations under this Agreement and the Company's right to assign this Agreement is subject to the provisions of Section 8 hereof. g. No amendment or waiver of any term or provision of this Agreement shall be effective unless made in writing. Any written amendment or waiver shall be effective only in the instance given and then only with respect to the specific term or provision (or portion thereof) of this Agreement to which it expressly relates, and shall not be deemed or construed to constitute a waiver of any other term or provision (or portion thereof) waived in any other instance. h. This Agreement has been made and entered into in the State of California and shall be construed in accordance with the laws of the State of California without regard to the conflict of laws principles thereof. i. This Agreement may be executed in any number of counterparts, each of which shall be deemed to be an original, but all of which together shall constitute one and the same instrument. j. You have read this Agreement, fully understand its contents and terms, and have had the opportunity to ask the Company about any questions, concerns or issues you may have in connection with the Agreement or the terms of the Agreement. You also have had the opportunity, and taken it to the extent you choose, to consult legal counsel or any other advisers of your choice in connection with this Agreement. Very truly yours, IWERKS ENTERTAINMENT, INC. By: /s/ Charles Goldwater ------------------------ Charles Goldwater Chief Executive Officer AGREED: /s/ Jack Shishido - ------------------------- Jack Shishido 8 EX-23.1 3 CONSENT OF ERNST & YOUNG EXHIBIT 23.1 CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in the Registration Statement (Form S-8 No. 33-77816) pertaining to the Employees' incentive stock options and other stock option and warrant agreements of Iwerks Entertainment, Inc. of our report dated August 5, 1998, with respect to the consolidated financial statements and schedule of Iwerks Entertainment, Inc. included in the Annual Report (Form 10-K) for the year ended June 30, 1998. Ernst & Young LLP Los Angeles, California September 24, 1998 EX-27.1 4 FINANCIAL DATA SCHEDULE
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE ACCOMPANYING FINANCIAL STATEMENTS AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 12-MOS JUN-30-1998 JUL-01-1997 JUN-30-1998 7,542 2,922 5,414 (1,893) 3,366 19,631 41,462 (28,412) 50,803 12,887 1,082 0 0 78,081 (41,247) 50,803 25,073 25,915 19,653 19,653 17,552 1,808 247 (11,537) 23 (11,560) 0 0 0 (11,560) (0.95) (0.95) INCLUDES COSTS AND ESTIMATED EARNINGS IN EXCESS OF BILLINGS ON UNCOMPLETED CONTRACTS OF $1,574 AND OTHER CURRENT ASSETS OF $706. INCLUDES PORTABLE SIMULATION THEATERS OF $8,390 AND FILM INVENTORY OF $20,760. INCLUDES PORTABLE SIMULATION THEATERS OF $4,977 AND FILM INVENTORY OF $15,452. INCLUDES THE NON-CURRENT PORTIONS OF CAPITAL LEASES. ACCUMULATED DEFICIT. INCLUDES INTEREST INCOME OF $842. CONSISTS OF SELLING, GENERAL AND ADMINISTRATIVE EXPENSES OF $15,999 AND MERGER RELATED EXPENSES OF $1,553.
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