10-Q 1 form10q.txt FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) [X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. For the quarterly period ended September 30, 2001 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 of (I.R.S. Employer incorporation or organization) Identification Number) 4520 West Valerio Street, Burbank, California 91505-1046 -------------------------------------------------------- (Address of principal executive offices) (Zip Code) (818) 841-7766 -------------------------------------------------------- (Registrant's telephone number including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No __. The number of shares outstanding of the Registrant's Common Stock, $0.001 par value, at November 7, 2001 was 3,540,903 shares. IWERKS ENTERTAINMENT, INC. INDEX PART I. FINANCIAL INFORMATION Page Number Item 1. Financial Statements Condensed Consolidated Balance Sheets as of September 30, 2001 and June 30, 2001 3 Condensed Consolidated Statements of Operations for the Three Months ended September 30, 2001 and 2000 5 Condensed Consolidated Statements of Cash Flows for the Three Months ended September 30, 2001 and 2000 6 Notes to the Condensed Consolidated Financial Statements 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 10 PART II. OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K 20 Signatures 21 Page 2
IWERKS ENTERTAINMENT, INC. CONSOLIDATED BALANCE SHEETS ASSETS (IN THOUSANDS, EXCEPT SHARE AMOUNTS) September 30, June 30, 2001 2001 (Unaudited) (Audited) ------------- ---------- Current assets: Cash and cash equivalents $ 1,985 $ 2,191 Trade accounts receivable, net of allowance for doubtful accounts 3,408 3,673 Costs and estimated earnings in excess of billings on uncompleted contracts 436 313 Inventories 1,760 1,620 Assets held for sale - current 350 368 Other current assets 28 25 ------------- ----------- Total current assets 7,967 8,190 Property and equipment at cost, net of accumulated depreciation and amortization 3,386 3,372 Film inventory at cost, net of accumulated amortization 433 520 Other assets 1,624 2,072 Assets held for sale - long term 1,291 1,291 ------------- ----------- Total assets $ 14,701 $ 15,445 ============= ===========
See accompanying notes. Page 3
IWERKS ENTERTAINMENT, INC. CONSOLIDATED BALANCE SHEETS LIABILITIES AND STOCKHOLDERS' EQUITY (IN THOUSANDS, EXCEPT SHARE AMOUNTS) September 30, June 30, 2001 2001 (Unaudited) (Audited) ------------- ------------ Current liabilities: Accounts payable $ 948 $ 1,099 Accrued expenses 5,481 6,008 Notes payable, current portion 1,580 1,661 Billings in excess of costs and estimated earnings on uncompleted contracts 2,394 1,585 Deferred revenue 210 309 ----------- ------------ Total current liabilities 10,613 10,662 Note payable, net of current portion 200 - Note payable to shareholder 300 300 ----------- ------------ Total liabilities 11,113 10,962 Stockholders' equity: Preferred stock, $0.01 par value, 1,000,000 authorized, none issued and outstanding - - Common stock, $.001 par value, 50,000,000 shares authorized; 3,540,915 and, 3,540,915 issued and 57 57 outstanding Paid-in capital 78,086 78,086 Treasury stock, 91,600 shares at cost (341) (341) Warrants 250 250 Accumulated deficit (74,464) (73,569) ----------- ------------ Total stockholders' equity 3,588 4,483 ----------- ------------ Total liabilities and stockholders' equity $ 14,701 $ 15,445 =========== ============
See accompanying notes. Page 4
IWERKS ENTERTAINMENT, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) (UNAUDITED) Three months ended September 30, ---------------------------- 2001 2000 ----------- ------------ Revenue $ 3,868 $ 4,912 Cost of Sales 2,836 4,087 ----------- ------------ Gross margin 1,032 825 Selling, general and administrative expenses 1,919 2,019 ----------- ------------ Loss from operations (887) (1,194) Interest income 6 16 Interest expense (14) (44) ----------- ------------ Net loss $ (895) $ (1,222) =========== ============ Loss per common share - basic and diluted $ (0.26) $ (0.35) =========== ============ Weighted average shares outstanding - basic and diluted 3,449,000 3,449,000 =========== ============
See accompanying notes. Page 5
IWERKS ENTERTAINMENT, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED) For the three months ended September 30, ------------------------ 2001 2000 ---------- ---------- OPERATING ACTIVITIES Net loss $ (895) $ (1,222) Depreciation and amortization 531 646 Changes in operating assets and liabilities 239 652 ---------- ---------- Net cash (used in) provided by operating activities (125) 76 INVESTING ACTIVITIES Net proceeds from the sale of portable simulation theatres 18 186 Acquisition of PIER 39 interest (100) - Purchases of property and equipment (118) (110) ---------- ---------- Net cash (used in) provided by investing activities (200) 76 FINANCING ACTIVITIES Issuance of note payable 200 - Payments of notes payable (81) (83) Payments on capital leases - (135) ---------- ---------- Net cash provided by (used in) financing activities 119 (218) ---------- ---------- Net decrease in cash and cash equivalents (206) (66) Cash and cash equivalents at beginning of period 2,191 2,733 ---------- ---------- Cash and cash equivalents at end of period $ 1,985 $ 2,667 ========== ========== Supplemental disclosures Interest paid during the period $ 8 $ 12 ========== ========== Income taxes paid during the period $ - $ 6 ========== ==========
See accompanying notes. Page 6 IWERKS ENTERTAINMENT, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE 1 - INTRODUCTION The accompanying condensed consolidated financial statements of Iwerks Entertainment, Inc. (the "Company") have been prepared without audit pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC"). Certain information and footnote disclosures normally included in the financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations, although the Company believes that the disclosures made are adequate to make the information presented not misleading. In the opinion of management, all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the consolidated financial position of the Company as of September 30, 2001 and the results of its operations for the three months ended September 30, 2001 and 2000 and the cash flows for the three months ended September 30, 2001 and 2000 have been included. The results of operations for interim periods are not necessarily indicative of the results, which may be realized for the full year. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company's latest Annual Report on Form 10-K as filed with the SEC. Certain reclassifications were made to the consolidated financial statements for the three months ended September 30, 2000 to conform to the September 30, 2001 presentation. NOTE 2 - MERGER TRANSACTION On August 31, 2001, the Company, SimEx, Inc., an Ontario, Canada corporation ("SimEx"), and SimEx Acquisition Corporation, a Delaware corporation and wholly-owned subsidiary of SimEx, Inc., entered into an agreement and plan of merger pursuant to which SimEx will acquire all of the outstanding shares of the Company's common stock for a total cash consideration of US $2.25 million. Immediately prior to the effective time of the merger, each issued and outstanding share of the Company's common stock will be converted into the right to receive a ratable portion of US $2.25 million equal to the quotient obtained by dividing (i) US $2.25 million by (ii) the number of shares of the Company's common stock outstanding immediately prior to the effective time of the merger. Assuming the exercise or conversion of all "in-the-money" securities prior to the effective time of the merger, the per share consideration to be offered to the Company's stockholders will be approximately US $0.63. The merger is subject to stockholder approval and other customary closing conditions. If the merger is consummated, the Company will become a wholly owned subsidiary of SimEx. NOTE 3 - PURCHASE OF DISCOVERY THEATRE LIMITED PARTNERSHIP On July 20, 2001, the Company exercised certain buyout rights and acquired the 50% ownership interest held by Sea Lion Entertainment, Inc. and Pier Theatre Limited Partnership in Discovery Theatre Limited Partnership, a California limited partnership, for an aggregate purchase price of $100,000. As a result of the acquisition, the Company, through its subsidiaries, Iwerks Discovery Theatre San Francisco Corp. and Cinetropolis, Inc. owned 100% of Discovery Theatre Limited Partnership. Prior to this acquisition, Discovery Theatre Limited Partnership was operated as a joint venture by the Company, through its subsidiaries and Sea Lion Entertainment, Inc. and Pier Theatre Limited Partnership. The former joint venture operated a Turbo Ride theatre attraction on San Francisco's PIER 39. The Company subsequently dissolved Discovery Theatre Limited Partnership and transferred its assets to Cinetropolis, Inc., which continues to operate the Turbo Ride theatre attraction on PIER 39. Page 7 NOTE 4 - ASSETS HELD FOR SALE In September 1999, the Company decided to sell the assets relating to its Touring Division. These assets are described as the portable ride simulation theatres and are reflected at management's estimate of their net realizable value. Management has discontinued depreciating these assets and will continue to periodically assess the net realizable value of these assets. During fiscal 2001, the Company sold five portable simulation ride theatres for net proceeds of approximately $954,000. No additional sales have been made in fiscal 2002. NOTE 5 - ISSUANCE OF WARRANTS On September 8, 1999, the Company appointed two new outside members to its Board of Directors. The two new members purchased warrants to purchase an aggregate 442,857 shares of Iwerks common stock. The warrants were issued in four tranches of equal amounts ranging in a per share exercise price of $5.01 to $10.50. Certain restrictions apply to the exercise of these warrants, which have a life of five years. These two board members resigned on January 18, 2000. The warrants remain outstanding with the same terms described above. NOTE 6 - DEPRECIATION AND AMORTIZATION Depreciation and amortization expense of property and equipment, goodwill and other is computed using the straight-line method over the estimated useful lives of the assets. Film costs are amortized using the individual film forecast method.
Three months ended September 30, -------------------------- 2001 2000 ---------- ---------- Depreciation on property and equipment $320,000 $170,000 Amortization of film inventory 87,000 293,000 Amortization of goodwill and other 124,000 183,000 ---------- ---------- Total depreciation and amortization $531,000 $646,000 ========== ==========
Depreciation and amortization included in cost of sales was $87,000 and $293,000 for the three months ended September 30, 2001 and 2000, respectively. NOTE 7 - NOTES PAYABLE Notes payable consists of the following:
Sept. 30, June 30, 2001 2001 --------- --------- Customer Note $1,354 $1,354 Equipment Note 226 307 SimEx Note 200 - ------ ------ $1,780 $1,661 Less non-current portion 200 - ------ ------ Current portion of notes payable $1,580 $1,661 ====== ======
Page 8 In the fourth quarter of fiscal 1999, one customer contract relating to a research and development specialty project was terminated. In connection with the termination, the Company agreed to refund payments previously received from the customer and established a note payable ("Customer Note") for approximately $1.5 million. The Customer Note accrues interest at a rate of 7.752 % per annum. The Company is currently in default regarding the Customer Note and therefore the entire balance is classified as a current liability in the accompanying consolidated balance sheets. On June 22, 2000, the Company renegotiated its capital lease and in connection therewith established a $485,000 note payable ("Equipment Note") to purchase certain equipment. The Equipment Note has an 18-month term beginning January 1, 2001 and accrues interest at the rate of 12.5% per annum. On August 21, 2001, SimEx purchased a promissory note from the Company in the aggregate principal amount of $200,000 ("SimEx Note"). The note does not bear interest and is payable in full on the fourth anniversary of the date of issuance. The Company may prepay the note at any time without penalty. The note is secured by one portable ride simulation unit. SimEx has the right to convert, in whole or in part, at any time the entire unpaid and unconverted balance of the note, into shares of common stock of the Company at a conversion price of sixty-three cents ($0.63) per share. NOTE 8 - NET LOSS PER COMMON SHARE Basic and diluted loss per share is calculated using the weighted average number of common shares outstanding during the period. Common equivalent shares, consisting of outstanding stock options and warrants are not included in the computation of diluted loss per common share, as the effect would be antidulitive. On January 13, 2000, the Company's stockholders approved an amendment to the Company's certificate of incorporation to effect a one for three and one-half reverse stock split with no change in par value, effective for stockholders of record on November 12, 1999. The reverse stock split was effective January 18, 2000. All references to per share amounts and shares outstanding included herein have been retroactively restated to reflect the stock split. NOTE 9 - INCOME TAXES At June 30, 2001, the Company had available federal and state tax net operating loss carryforwards of approximately $45,000,000 and $13,000,000, respectively. The federal and state net operating loss carryforwards expire, in varying amounts, through 2020. As a result of these net operating loss carryforwards and current period losses, the Company's effective tax rate was negligible and consequently no income tax provision or benefit was recorded in the periods presented. Under Section 382 of the Internal Revenue Code, the utilization of the net operating loss carryforwards may be limited based on changes in the percentage of ownership of the Company. NOTE 10 - LITIGATION The proceedings to which the Company is a defendant consist of routine litigation in the ordinary course of business. In the opinion of management, and, based in part upon the advice of outside counsel, resolution of these matters will not have a material adverse impact on the Company's consolidated financial position or results of operations. Page 9 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 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 the Company, its directors or officers with respect to, among other things (a) trends affecting the financial condition or results of operations of the Company and (b) the business and growth strategies of the Company. The stockholders of the Company 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 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 "Future Operating Results." The Company undertakes no obligation to publicly revise these forward-looking statements to reflect events or circumstances that arise after the date hereof. Readers should review carefully the risk factors described in other documents the Company files from time to time with the Securities and Exchange Commission, including the Annual Report on form 10-K filed by the Company on September 24, 2001, as amended on October 26, 2001, and previous Quarterly Reports on Form 10-Q and Current Reports on Form 8-K filed by the Company. RESULTS OF OPERATIONS HARDWARE SALES AND SERVICE Revenues on sales of theatre systems are recognized on the percentage-of-completion method over the life of the contract. The gross margin for each contract varies based upon pricing strategies, competitive conditions and product mix. FILM LICENSING AND PRINTS Revenues and related expenses from film licensing are recognized at the beginning of the license period at which time the customer is billed the license fee and the film is delivered to the customer. CAMERAS AND OTHER PRODUCTION SERVICES The Company contracts with third parties to lease its 15/70 and 8/70 large format cameras and related equipment, (including a 3D rig, lenses and accessories). Rental periods range from several days to several months. The Company has developed and manufactured two 15/70 large format cameras and is in the process of completing one additional 15/70 camera. The Company also provides technical and post-production services to third party producers for a fee and maintains a 15/70 and 8/70 projection room at its Burbank facilities for rent to large format filmmakers for use in the post-production process. During 2001, the Company began generating revenues by providing film format conversion services. The Company's internal executive production staff develops and oversees the production of films for the Company's film productions as well as for third party custom film projects. The Company recognizes revenues and costs associated with the production of films on the percentage of completion method. Page 10 OWNED AND OPERATED Revenues from owned and operated (O&O) consist primarily of ticket sales of the simulation theatre site at PIER 39 in San Francisco. To a lesser extent, the Company generates revenue from portable ride simulation theatres (touring), as well as revenues derived from fixed site joint ventures, which includes the Company's contractual share of the sites' revenues or profits as applicable. In September 1999, the Company determined to shut down the touring division and sell the related assets in an effort to concentrate on its core business. THREE MONTHS ENDED SEPTEMBER 30, 2001 COMPARED TO THREE MONTHS ENDED SEPTEMBER 30, 2000 For the three months ended September 30, 2001 the Company recorded revenues of $3,868,000 compared to $4,912,000 for the same period last year. For the three months ended September 30, 2001, the Company recorded a net loss of $895,000 or ($0.26) per share compared to a net loss of $1,222,000 or ($0.35) per share for the same period last year. REVENUES Revenue for the three months ended September 30, 2001 decreased $1,044,000 or 21% from the three months ended September 30, 2000. The following table presents summary information regarding revenues (amounts in thousands):
Three months ended September 30, ------------------- 2001 2000 -------- --------- Hardware Sales & Service $ 1,896 $ 2,262 Film Licensing 1,078 864 Cameras and Other Production Services 595 1,607 Owned and Operated 299 179 -------- --------- Total $ 3,868 $ 4,912 ======== =========
Hardware Sales and Service for the three months ended September 30, 2001 decreased by approximately $366,000 or 16% compared to the same period last year. During the first quarter of fiscal 2002, hardware sales recognized in the Asia-Pacific region and Europe and the Middle East region decreased by approximately $36,000 and $812,000, respectively, from the year ago period. Hardware sales recognized in North America and South America increased by approximately $346,000 and $191,000, respectively, from the year ago period. Revenue generated from Customer Service decreased by approximately $55,000 during the first quarter of fiscal 2002 compared to the first quarter of fiscal 2001. The decrease in hardware sales and service primarily is attributed to the continued economic downturn. Generally, hardware sales are subject to quarterly fluctuations as they are dependent on customer installation dates. Film Licensing revenues for the quarter ended September 30, 2001 increased by approximately $214,000 or 25% compared to the same period last year. This increase primarily is due to a significant film license agreement signed with a new customer, increased Large Format business and the timing of several new film licensing agreements with existing customers. Cameras and Other Production Services revenues for the three months ended September 30, 2001 decreased by approximately $1.0 million or 63% compared to the same period last year. The decrease is due to a lack of film production projects in the first quarter of fiscal 2002. The decrease was partially offset by an increase ($207,000) in facility and camera rentals. The increase was the result of increased 15/70 camera rentals and revenue from film conversions, which is a new line of business for the Company. Page 11 Owned and Operated revenues for the three months ended September 30, 2001 increased by approximately $120,000 as compared to the same period last year. The increase is primarily due to an increase in PIER 39 related revenues resulting from the Company's acquisition of the remaining interest of the partnership which previously operated the attraction at PIER 39 during the first quarter of fiscal 2002. COST OF SALES Cost of sales primarily includes costs of theatre systems sold, costs associated with film production, licensing fees and costs associated with the operation of the PIER 39 theatre. The cost of theatre systems includes the cost of components, customization, engineering, project management, assembly, system integration and installation. Also included in cost of sales are third party commissions and estimated warranty expenses. The costs associated with film license fees primarily reflect amortization of film production costs over the lives of certain films, royalties paid to third parties and the cost of film prints. Cost of sales as a percentage of sales were 73% for the three months ended September 30, 2001 as compared to 83% for the three months ended September 30, 2000. The decrease resulted from reduced film amortization costs as a result of film write-downs made during fiscal 2001. Also, the lack of low margin film production activity helped reduce the cost of sales in the current quarter. Additionally, improved manufacturing efficiencies resulted in lower hardware cost of sales. Finally, reduced warranty claims resulted in lower customer service cost of sales for the quarter ended September 30, 2001. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES Selling, general and administrative expenses include, among other things, personnel costs, trade shows and other promotional expenses, sales commissions, travel expenses, public relations costs, outside consulting and professional fees, depreciation on fixed assets, amortization of goodwill, departmental administrative costs and research and development costs. Selling, general and administrative expenses were approximately $1.9 million and $2.0 million, for the quarters ended September 30, 2001 and 2000, respectively. This decrease primarily is attributable to cost containment efforts relating to expenditures for outside consulting, marketing, travel and entertainment expense and office lease expense. INTEREST INCOME & EXPENSE Interest income for the quarters ended September 30, 2001 and 2000 was approximately $6,000 and $16,000, respectively. The decrease resulted primarily from a reduction in the invested cash balances during the three months ended September 30, 2001. Interest expense for the quarters ended September 30, 2001 and 2000 was approximately $14,000 and $44,000, respectively. The decrease was primarily due to reduced notes payable and capital lease obligation balances in the current quarter as compared to the quarter ended September 30, 2000. NET LOSS The Company recorded a net loss of approximately $895,000 in the quarter ended September 30, 2001, compared to a net loss of approximately $1.2 million in the quarter ended September 30, 2000 due to the reasons mentioned above. LIQUIDITY AND CAPITAL RESOURCES In the three months ended September 30, 2001, approximately $125,000 in cash was used in operating activities and $200,000 was used in investing activities, offset by $119,000 provided by financing activities. Investing activities primarily consisted of the purchase of property and equipment ($118,000) and the purchase of a partnership interest ($100,000). Financing activities consisted of the issuance of a new note ($200,000), partially offset by payments on notes payable ($81,000). Page 12 At September 30, 2001, the Company had cash and short-term investments of approximately $2.0 million. The Company's cash and short-term investment balances have continued to decline since June 30, 2001 and the Company expects to experience further declining balances during the remainder of fiscal 2002. Because of the reductions in the Company's cash balances, the Company may not be able to continue operations at its current levels. The Company is dependent upon current cash collections to meet its operating needs and pay its current liabilities. The Company has historically experienced significant difficulty in accurately projecting its cash balances. The Company's cash flow is dependent on the timing of delivery of hardware systems, collections and the signing of new contracts, all of which are difficult to predict with accuracy. Further complicating its ability to project cash balances is that the timing of progress payments of the hardware projects are dependent upon achieving certain performance milestones under its hardware sales agreements. In addition, progress payments on some of the Company's hardware sales agreements are not sufficient to provide for the cost of assembly and delivery of the systems, requiring the Company to fund the cash cost of performing on the agreements. On August 31, 2001, the Company, SimEx, and SimEx Acquisition Corporation, entered into an agreement and plan of merger pursuant to which SimEx will acquire all of the outstanding shares of the Company's common stock for a total cash consideration of US $2.25 million. Immediately prior to the effective time of the merger, each issued and outstanding share of the Company's common stock will be converted into the right to receive a ratable portion of US $2.25 million equal to the quotient obtained by dividing (i) US $2.25 million by (ii) the number of shares of the Company's common stock outstanding immediately prior to the effective time of the merger. Assuming the exercise or conversion of all "in-the-money" securities prior to the effective time of the merger, the per share consideration to be offered to the Company's stockholders will be approximately US $0.63. The merger is subject to stockholder approval and other customary closing conditions. If the merger is consummated, the Company will become a wholly owned subsidiary of SimEx. In the event the merger does not close, the Company will need to aggressively seek additional debt or equity financing and other strategic alternatives. However, recent operating losses, the Company's declining cash balances, the Company's historical stock performance, the delisting of the Company's common shares from The Nasdaq Stock Market, the recent decline in revenue, a general economic downturn and a general decrease in investor interest in the Company's industry, may make it difficult for the Company to attract equity investments or debt financing or strategic partners on terms that are deemed favorable to the Company. If the Company's financial condition continues to worsen and it is unable to attract alternative equity or debt financing or other strategic transactions, the Company could be forced to consider steps that would protect its assets against it's creditors. The Company's independent auditor's report, for fiscal year ended June 2001, contains an emphasis paragraph indicating there is substantial doubt about the Company's ability to continue as a going concern. The Company is in the process of selling its portable ride simulation theatres, which when sold, will generate cash. The Company is considering a number of other options to improve its financial condition. The Company sold five portable ride simulation units during fiscal 2001. There can be no assurance that any additional ride simulation theatres will be sold. In order to preserve cash, the Company has been required to reduce expenditures for capital projects (including new films), research and development, and in its corporate infrastructure, any of which may have a material adverse affect on the Company's future operations. Further reductions in its cash balances could require the Company to make more significant cuts in its operations, which would have a material adverse impact on its future operations. There can be no assurance that the Company can achieve these reductions over a short enough period of time in order to allow it to continue as a going concern. RISK FACTORS THERE IS DOUBT ABOUT OUR ABILITY TO CONTINUE AS A GOING CONCERN. We have experienced significant operating losses in the current and prior years. Our cash and short-term investment balances continue to decline since June 30, 2001 and we expect to experience Page 13 further declining balances. We have been unable to pay all of our trade creditors and certain other obligations in accordance with their terms and some of our creditors have refused to provide further products or services except on a C.O.D. basis. We intend to improve liquidity by the continued monitoring and reduction of manufacturing, facility and administrative costs including reduction of personnel and the sale of our portable ride simulation units. We expect that our cash on hand and short-term investments, together with cash generated by operations, cannot sufficiently fund future operating losses and capital requirements. We have attempted to raise additional capital through debt or equity financing and to date have had nominal success. If we are unable to obtain financing on terms acceptable to us, or at all, or if we are unable to consummate the merger with SimEx on a timely basis, we will not be able to accomplish any or all of our initiatives and could be forced to consider steps that would protect our assets against our creditors. WE HAVE A HISTORY OF LOSSES AND WE CANNOT ASSURE YOU THAT WE WILL BE ABLE TO ACHIEVE PROFITABLE OPERATIONS IN FISCAL 2002. We have not been profitable in six of the last seven years and have an aggregate net loss for the last seven years of $64.2 million. During fiscal 2001, we incurred a net loss of $5.0 million. Because substantial portions of our expenses are fixed and our gross margin is relatively low, achieving profitability depends upon our ability to generate and sustain substantially higher revenues. Although we have implemented plans to increase revenues and operating margin, we can not assure you that we will be able to do so and consequently we may experience additional losses in fiscal 2002. TERRORISM AND THE UNCERTAINTY OF WAR MAY HAVE A MATERIAL ADVERSE EFFECT ON OUR OPERATING RESULTS. Terrorist attacks, such as the attacks that occurred in New York and Washington, D.C. on September 11, 2001, the response by the United States on October 7, 2001 and other acts of violence or war may affect the market in which our common stock will trade, the markets in which we operate, our operations and profitability and your investment. Further terrorist attacks against the United States or United States businesses may occur. The potential near-term and long-term effect these attacks may have for our customers, the market for our common stock, the markets for our sales and services and the U.S. economy are uncertain. The consequences of any terrorist attacks, or any armed conflicts which may result, are unpredictable, and we may not be able to foresee events that could have an adverse effect on our markets, our business or your investment. OUR COMMON SHARES HAVE BEEN DELISTED FROM THE NASDAQ STOCK MARKET. On November 1, 2000, we were notified by The Nasdaq Stock Market that we did not meet continued listing requirements of The Nasdaq Small Capital Market and our common shares were delisted on the close of business on November 1, 2000. Our common stock currently is trading on the Over The Counter Bulletin Board. It may be more difficult to raise additional debt or equity financing while trading on the Over The Counter Bulletin Board. If we are unable to raise additional financing, we will not be able to accomplish our business objectives and may consider steps to protect our assets against creditors. WE DEPEND ON SINGLE OR LIMITED SUPPLIERS FOR CERTAIN OF OUR COMPONENTS AND IF THESE SUPPLIERS ARE UNABLE TO PROVIDE THESE COMPONENTS, WE MAY EXPERIENCE DELAYS IN PRODUCT SHIPMENT AND ADDITIONAL COSTS. We currently use only one or a limited number of suppliers for certain of the components that we use in our theater systems. If our suppliers are unable to deliver these components to us we may be unable to locate an alternate source of these components, which would result in a material adverse effect on our revenues, results of operations, liquidity and financial position. Our reliance on a limited number of vendors involves many risks including: o shortages of certain key components; o delays in product shipment; Page 14 o product performance shortfalls; o additional costs associated with the purchase of the components from alternative suppliers; and o reduced control over delivery schedules, manufacturing capabilities, quality and costs; If any of our suppliers suffers business disruptions, financial difficulties, or if there is any significant change in condition of our relationship with the supplier, our costs of goods sold may increase or we may be unable to obtain these key components for our products. In either event, our revenues, results of operations, liquidity and financial condition would be adversely affected. While we believe that we can obtain most of the components necessary for our products from other manufacturers, any unanticipated change in the source of our supplies, or unanticipated supply limitations, could adversely affect our ability to meet our product orders. IT IS POSSIBLE THAT OUR CURRENT FILM SOFTWARE MAY NOT SUSTAIN ITS POPULARITY AND OUR NEW FILM SOFTWARE MAY NOT BECOME POPULAR. A substantial portion of our revenue is dependent upon the production and distribution of entertainment film software for exhibition on our theatre systems. Each production is an individual artistic work. We try to develop and produce film software that will achieve high market acceptance. However, market acceptance depends upon many factors beyond our control, including: o audience reaction; o competing programming; o other forms of entertainment; and o perceived quality of programming. We cannot assure you that our film software will obtain market acceptance. If our film software becomes less popular, we will most likely derive less revenue from the license of our film library and from new hardware sales. OUR COMPETITIVE POSITION IS DEPENDENT ON CONTINUING TO INVEST IN NEW FILM PRODUCTIONS. IF WE ARE UNABLE TO DO SO, IT COULD HAVE A NEGATIVE IMPACT ON OUR REVENUES. We believe that our extensive library of films is a competitive advantage and that we must continue to add to our library if we are to be successful. Film production is expensive. We generally spend from $100,000 to $2,000,000 to produce a film. We try to reduce the financial impact of a new film by entering into licensing, participation or other financing arrangements with third parties prior to release. However, we typically do not recoup our costs for two to three years following a film's release. Even if we are able to reduce the costs of production, we cannot assure you that the films we produce and acquire will be popular. In addition, because our cash balances have continued to decline, we have had to decrease the level of our investment in film software and this may have an adverse impact on our revenues in future periods. OUR PRINCIPAL COMPETITORS DEVOTE GREATER FINANCIAL, PERSONNEL AND MARKETING RESOURCES TO THE DEVELOPMENT AND EXPANSION OF COMPETITIVE PRODUCTS. We face significant competition in each of the markets in which we operate. Our principal direct competition for customers comes from manufacturers of competing movie-based attractions and manufacturers of traditional amusement park attractions. In addition, there is also competition from systems integrators and some amusement and theme parks developing and constructing their own Page 15 attractions. We have significantly fewer financial, technical, manufacturing, marketing and other resources than certain of our competitors do. Our competitors may leverage their greater resources to: o develop, manufacture and market products that are less expensive or technologically superior to our products; o reach a wider array of potential customers through increased marketing and sales activities; o attend more trade shows and spend more on advertising and marketing; o operate at lower margins for longer periods; o respond more quickly to new or changing technologies, customer requirements and standards; or o reduce prices in order to preserve or gain market share. In addition, the out-of-home entertainment industry in general is undergoing significant changes, primarily due to technological developments as well as changing consumer tastes. Many companies are developing and are expected to develop new entertainment products or concepts in response to these developments that may be directly competitive with our products. We believe these competitive pressures are likely to continue. We cannot guarantee that our resources will be sufficient to address this competition or that we will manage costs and adopt strategies capable of effectively utilizing our resources. If we are unable to respond to competitive pressures successfully, our prices and profit margins may fall and our market share may decrease. OUR FUTURE SUCCESS WILL DEPEND IN PART UPON OUR ABILITY TO ANTICIPATE CHANGES IN TECHNOLOGY AND DEVELOP NEW AND ENHANCED PRODUCTS ON A TIMELY AND COST-EFFECTIVE BASIS. We operate in a technology-driven segment of the entertainment industry. Consequently, it is important for us to develop new and enhanced products in response to technological changes. Risks inherent in the development and introduction of new products include: o difficulty in forecasting customer demand accurately; o our inability to expand capacity fast enough to meet customer demand; o the possibility that new products may make current products obsolete; o delays or interruptions in the manufacture and installation of new products; o competitors' responses to our introduction of new products; o the desire by customers to evaluate new products for longer periods of time before making a purchase decision; and o the possibility the market may reject certain new technology and products. If we are unable, for technological or other reasons, to develop products in a timely manner or the products or product enhancements that we develop do not achieve market acceptance, our business could be harmed. Page 16 A SIGNIFICANT PORTION OF OUR SALES AND CUSTOMERS ARE LOCATED OUTSIDE THE UNITED STATES. CURRENCY FLUCTUATIONS AND THE INCREASED COSTS ASSOCIATED WITH INTERNATIONAL SALES, COULD MAKE OUR PRODUCTS UNAFFORDABLE IN FOREIGN MARKETS, WHICH COULD REDUCE OUR PROFITABILITY. Sales to customers outside the United States accounted for approximately 58%, 70% and 56% of our revenues in fiscal 2001, 2000 and 1999, respectively. We believe that international sales will continue to represent a significant portion of our total sales. Our foreign sales subject us to a number of risks including: o currency fluctuations could make our products unaffordable to foreign purchasers or more expensive compared to those of foreign manufacturers; o greater difficulty of administering business overseas may increase the costs of foreign sales and support; o foreign governments may impose tariffs, quotas and taxes on our products; o longer payment cycles typically associated with international sales and potential difficulties in collecting accounts receivable may reduce the profitability of foreign sales; o political and economic instability may reduce demand for our products or our ability to market our products; o restrictions on the export or import of technology may reduce or eliminate our ability to sell in certain markets; and o although we have met certain international manufacturing standards, our lack of ISO 9000 certification, a widely accepted method of establishing and certifying the technical characteristics and quality of our products, may hinder our foreign sales. These risks may increase our costs of doing business internationally and reduce our sales or profitability. WE ARE DEPENDENT ON THE STRENGTH OF THE NATIONAL AND INTERNATIONAL ECONOMIES. RECESSIONARY OR DEFLATIONARY CONDITIONS IN ANY OF OUR PRINCIPAL MARKETS COULD REDUCE OUR SALES AND PROFITABILITY. Our revenues and profitability are dependent on the strength of the national and international economies. In a recessionary or deflationary environment, sales of our products 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 us in order to maintain sales activity. OUR QUARTERLY REVENUES AND OPERATING RESULTS ARE DIFFICULT TO FORECAST. IF REVENUES AND OPERATING RESULTS FLUCTUATE UNEXPECTEDLY FROM QUARTER TO QUARTER, OUR STOCK PRICES MAY FLUCTUATE. Our quarterly revenues and operating results are difficult to forecast. As a result, we believe that the period-to-period comparisons for operating results are not necessarily reliable indicators of our future performance. A variety of factors may affect our operating results, including factors which are outside our control. These factors include the following: o the size and timing of customer orders; o the timing, introduction or enhancement of products by us or our competitors; Page 17 o the timing and level of our operating expenses. Any unanticipated change in operating results may cause our stock prices to fluctuate since such changes reflect new information for investors and analysts. New information causes investors and analysts to revalue our stock and this in the aggregate could cause our stock price to fluctuate. OUR CUSTOMERS HAVE THE RIGHT TO TERMINATE THEIR CONTRACTS WITH US IN CERTAIN CIRCUMSTANCES WHICH CAN HAVE AN ADVERSE EFFECT ON OUR CASH FLOW. Our hardware sales contracts typically provide that the customer may terminate our contract prior to delivery. However, a customer canceling its contract is obligated to pay to us a cancellation fee equal to the costs committed plus 20%. Customers typically pay a deposit upon execution of a contract. If a customer cancels a contract and the amount of the deposit exceeds the cancellation fee, we are contractually obligated to refund the excess to the customer. In the event of a large refund, we could experience a negative impact on cash flow. IF WE ARE SUED ON A PRODUCT LIABILITY CLAIM, OUR INSURANCE POLICIES MAY NOT BE SUFFICIENT. Although we maintain general liability insurance and product liability insurance, our insurance may not cover all potential types of product liability claims to which manufacturers are exposed or may not be adequate to indemnify us for all liability that may be imposed. Any imposition of liability that is not covered by insurance or is in excess of our insurance coverage could harm our business. IF WE ARE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS ADEQUATELY, THE ADVANTAGES OF OUR RESEARCH, MANUFACTURING AND DISTRIBUTION SYSTEMS MAY BE REDUCED AS COMPETITORS ADOPT SOME OR ALL OF THESE TECHNIQUES. Since our business depends in part on intellectual property rights, our ability to compete effectively depends in part on our ability to develop and maintain proprietary aspects of our technology in creative works. We currently hold several patents on the design elements of our products and also rely on a combination of trademark, trade secret, copyright and other intellectual property laws to protect our proprietary rights. Such rights, however, may not preclude competitors from developing products that are essentially equivalent or superior to ours. In addition, many aspects of our product are not subject to intellectual property protection and therefore may be reproduced by our competitors. INTELLECTUAL PROPERTY INFRINGEMENT CLAIMS AGAINST US COULD BE TIME CONSUMING AND EXPENSIVE TO DEFEND AND MAY HARM OUR BUSINESS. In recent years there has been significant litigation in the United States involving patents and other intellectual property rights. While we currently are not engaged in any material intellectual property litigation or proceedings, we may become involved in the future. An adverse outcome of litigation could force us to do one or more of the following: o stop selling, incorporating or using our products for services that use the challenged intellectual property; o subject us to significant liabilities to third parties; o obtain from the owners of the infringed intellectual property right a license to sell or use the relevant technology, which license may not be available on reasonable terms or at all; or o redesign those products and services that use such technology, which redesign may be either economically or technologically infeasible. Whether or not an intellectual property litigation claim is valid, the cost of responding to it, in terms of legal fees and expenses and the diversion of management resources, could harm our business. Page 18 THE ABILITY OF OUR BOARD OF DIRECTORS TO ISSUE PREFERRED STOCK AND OUR STOCKHOLDER RIGHTS PLAN MAY MAKE TAKEOVER ATTEMPTS DIFFICULT OR IMPOSSIBLE. Our Board of Directors has the authority, without any action of the shareholders, to issue up to one million shares of Preferred Stock and to fix the rights and preferences of those shares. In addition, we have in place a Stockholder Rights Plan. The ability of our Board to issue Preferred Stock and the existence of the Stockholder Rights Plan may have the effect of delaying, deferring or preventing a change of control, may discourage bids for our common stock at a premium over its market price and may adversely affect the market price, and the voting and rights of the holders of our Common Stock. Page 19 PART II - OTHER INFORMATION ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K A. EXHIBITS: None. B. REPORTS ON FORM 8-K FILED DURING THE QUARTER ENDED SEPTEMBER 30, 2001 A Current Report on Form 8-K, Item 5, was filed on September 10, 2001, regarding the merger agreement with SimEx, Inc. and SimEx Acquisition Corporation. Page 20 SIGNATURES Pursuant to the requirements of Sections 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has caused this report to be signed on its behalf by the undersigned thereunto duly authorized, in the city of Burbank, State of California on the 14th day of November, 2001. IWERKS ENTERTAINMENT, INC. (Registrant) By: /S/ JEFFREY M. DAHL -------------------- Senior Vice President Chief Financial Officer (Principal Finance Officer) By: /S/ DEBRA L. WISE ------------------ Vice President / Controller (Principal Accounting Officer) DATE: NOVEMBER 14, 2001 Page 21