10-Q 1 form10q_93004-3qtr.txt 10Q 93004 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ----------- FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004 ----------- Commission File Number 0-21174 AVID TECHNOLOGY, INC. (Exact name of registrant as specified in its charter) DELAWARE 04-2977748 (State or other jurisdiction of (I.R.S. Employer inorporation or organization) Identification No.) AVID TECHNOLOGY PARK ONE PARK WEST TEWKSBURY, MA 01876 (Address of principal executive offices) Registrant's telephone number, including area code: (978) 640-6789 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 whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes X No ---- ----- The number of shares outstanding of the registrant's Common Stock as of October 20, 2004 was 33,958,648. AVID TECHNOLOGY, INC. FORM 10-Q FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004 TABLE OF CONTENTS PAGE PART I. FINANCIAL INFORMATION ITEM 1. Condensed Consolidated Financial Statements: a) Condensed Consolidated Statements of Operations (unaudited) for the three and nine months ended September 30, 2004 and 2003 ........1 b) Condensed Consolidated Balance Sheets (unaudited) as of September 30, 2004 and December 31, 2003...................................................2 c) Condensed Consolidated Statements of Cash Flows (unaudited) for the nine months ended September 30, 2004 and 2003 ..................3 d) Notes to Condensed Consolidated Financial Statements (unaudited)........4 ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations................................13 ITEM 3. Quantitative and Qualitative Disclosure About Market Risk..........26 ITEM 4. Controls and Procedures............................................27 PART II. OTHER INFORMATION ITEM 1. Legal Proceedings..................................................28 ITEM 6. Exhibits...........................................................28 SIGNATURES....................................................................30 EXHIBIT INDEX.................................................................31 PART I. FINANCIAL INFORMATION ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS AVID TECHNOLOGY, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data) (unaudited)
Three Months Ended Nine Months Ended September 30, September 30, ---------------------------- -------------------------- 2004 2003 2004 2003 ------------- ------------- -------------------------- Net revenues $147,374 $119,090 $414,634 $344,584 Cost of revenues 62,845 52,784 177,943 155,619 Amortization of intangible assets 127 - 127 - ------------- ------------- -------------------------- Gross profit 84,402 66,306 236,564 188,965 ------------- ------------- -------------------------- Operating expenses: Research and development 23,780 20,706 68,996 63,833 Marketing and selling 33,435 27,959 96,945 80,971 General and administrative 7,386 5,670 19,456 16,632 Stock-based compensation * 553 - 553 - Restructuring and other costs, net - 76 - 1,859 Amortization of intangible assets 988 341 1,976 975 ------------- ------------- ------------ ------------ Total operating expenses 66,142 54,752 187,926 164,270 ------------- ------------- ------------ ------------ Operating income 18,260 11,554 48,638 24,695 Other income, net 651 592 686 1,330 ------------- ------------- ------------ ------------ Income before income taxes 18,911 12,146 49,324 26,025 Provision for (benefit from) income taxes (63) 300 137 900 ------------- ------------- ------------ ----------- Net income $18,974 $11,846 $49,187 $25,125 ============= ============= ============ ============ Net income per common share - basic $0.58 $0.40 $1.54 $0.88 Net income per common share - diluted $0.54 $0.35 $1.43 $0.78 Weighted average common shares outstanding - basic 32,737 29,865 31,857 28,663 Weighted average common shares outstanding - diluted 35,033 33,380 34,374 32,059 * Stock-based compensation associated with the acquisition of M-Audio (Note 3) is comprised of $99 of research and development expense, $154 of marketing and selling expense and $300 of general and administrative expense for the three and nine months ended September 30, 2004. The accompanying notes are an integral part of the condensed consolidated financial statements.
1 AVID TECHNOLOGY, INC. CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands) September 30, December 31, (unaudited) 2004 2003 ---------------- ---------------- ASSETS Current assets: Cash and cash equivalents $41,734 $102,649 Marketable securities 78,348 93,660 Accounts receivable, net of allowances of $9,193 and $9,161 at September 30, 2004 and December 31, 2003, respectively 94,438 69,230 Inventories 54,913 38,292 Current deferred tax assets, net 1,047 1,032 Prepaid expenses 7,295 5,117 Other current assets 5,610 7,032 ---------------- ---------------- Total current assets 283,385 317,012 Property and equipment, net 26,558 23,223 Intangible assets, net 50,017 1,815 Goodwill 165,356 3,335 Long-term deferred tax assets, net 2,557 - Other assets 3,804 2,734 ---------------- ---------------- Total assets $531,677 $348,119 ================ ================ LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $26,214 $15,755 Accrued compensation and benefits 22,400 23,753 Accrued expenses and other current liabilities 36,772 27,452 Income taxes payable 10,396 8,504 Deferred revenues 52,615 44,943 ---------------- ---------------- Total current liabilities 148,397 120,407 Long-term debt and other liabilities 1,818 607 ---------------- ---------------- Total liabilities 150,215 121,014 ---------------- ---------------- Contingencies (Note 6) Stockholders' equity: Common stock 339 311 Additional paid-in capital 530,170 419,981 Accumulated deficit (145,288) (194,476) Deferred compensation (4,947) (30) Cumulative translation adjustment 1,381 1,306 Net unrealized gains (losses) on debt securities (193) 13 ---------------- ---------------- Total stockholders' equity 381,462 227,105 ---------------- ---------------- Total liabilities and stockholders' equity $531,677 $348,119 ================ ================ The accompanying notes are an integral part of the condensed consolidated financial statements.
2 AVID TECHNOLOGY, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands - unaudited)
Nine Months Ended September 30, ----------------------------- 2004 2003 -------------- -------------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income $49,187 $25,125 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 10,931 9,343 Provision for doubtful accounts and recourse obligations 91 418 Compensation expense from stock grants and options 583 169 Equity in income of non-consolidated company (85) (155) Changes in operating assets and liabilities: Accounts receivable (14,281) 5,869 Inventories (715) (515) Prepaid expenses and other current assets 956 84 Accounts payable 3,774 (7,627) Income taxes payable 1,156 610 Accrued expenses, compensation and benefits 2,236 742 Deferred revenues and deposits 3,301 6,637 ----------------------------------------------------------------------------------------------------------- NET CASH PROVIDED BY OPERATING ACTIVITIES 57,134 40,700 ----------------------------------------------------------------------------------------------------------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of property and equipment (9,805) (4,578) Payments for other long-term assets (485) (360) Dividend from non-consolidated company - 85 Payments for business acquisitions, net of cash acquired (135,205) (409) Purchases of marketable securities (29,938) (59,181) Proceeds from sales of marketable securities 45,585 11,347 ----------------------------------------------------------------------------------------------------------- NET CASH USED IN INVESTING ACTIVITIES (129,848) (53,096) ----------------------------------------------------------------------------------------------------------- CASH FLOWS FROM FINANCING ACTIVITIES: Payments on capital lease obligations (492) (463) Proceeds from issuance of common stock under employee stock plans 13,215 44,887 ----------------------------------------------------------------------------------------------------------- NET CASH PROVIDED BY FINANCING ACTIVITIES 12,723 44,424 ----------------------------------------------------------------------------------------------------------- Effect of exchange rate changes on cash and cash equivalents (924) 174 ----------------------------------------------------------------------------------------------------------- Net increase (decrease) in cash and cash equivalents (60,915) 32,202 Cash and cash equivalents at beginning of period 102,649 62,174 ----------------------------------------------------------------------------------------------------------- Cash and cash equivalents at end of period $41,734 $94,376 ----------------------------------------------------------------------------------------------------------- The accompanying notes are an integral part of the condensed consolidated financial statements.
3 PART I. FINANCIAL INFORMATION ITEM 1D. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. FINANCIAL INFORMATION The accompanying condensed consolidated financial statements include the accounts of Avid Technology, Inc. and its wholly-owned subsidiaries (collectively, "Avid" or the "Company"). These financial statements are unaudited. However, in the opinion of management, the condensed consolidated financial statements include all adjustments, consisting of only normal, recurring adjustments, necessary for their fair presentation. Interim results are not necessarily indicative of results expected for a full year. The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the instructions for Form 10-Q and therefore do not include all information and footnotes necessary for a complete presentation of operations, financial position, and cash flows of the Company, in conformity with generally accepted accounting principles. The accompanying condensed consolidated balance sheet as of December 31, 2003 was derived from Avid's audited consolidated financial statements, but does not include all disclosures required by generally accepted accounting principles. The Company filed audited consolidated financial statements for the year ended December 31, 2003 in its 2003 Annual Report on Form 10-K, which included all information and footnotes necessary for such presentation; the financial statements contained in this Form 10-Q should be read in conjunction with the audited consolidated financial statements in the Form 10-K. The Company's preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reported periods. The most significant estimates reflected in these financial statements include accounts receivable and sales allowances, inventory valuation and income tax asset valuation allowances. Actual results could differ from those estimates. 2. NET INCOME PER COMMON SHARE Basic and diluted net income per share were as follows (in thousands, except per share data):
Three Months Ended Nine Months Ended September 30, September 30, ---------------------------- -------------------------- 2004 2003 2004 2003 ------------- ------------- ------------ ------------ Net income $18,974 $11,846 $49,187 $25,125 ============= ============= ============ ============ Weighted average common shares outstanding - basic 32,737 29,865 31,857 28,663 Weighted average potential common stock: Options 2,296 3,515 2,517 3,396 ------------- ------------- ------------ ------------ Weighted average common shares outstanding - diluted 35,033 33,380 34,374 32,059 ============= ============= ============ ============ Net income per common share - basic $0.58 $0.40 $1.54 $0.88 Net income per common share - diluted $0.54 $0.35 $1.43 $0.78
For the three and nine months ended September 30, 2004 and 2003, certain stock options and a warrant have been excluded from the diluted net income per share calculation. Their effect would be anti-dilutive since their exercise prices were in excess of the Company's average common stock fair value for the related period. 4 Common stock options and a warrant that were considered anti-dilutive securities and excluded from the diluted net income per share calculations were as follows, on a weighted-average basis:
Three Months Ended Nine Months Ended September 30, September 30, --------------------------- --------------------------- 2004 2003 2004 2003 ------------- ------------ ------------- ------------ Options 242 10 191 102 Warrant 1,155 1,155 1,155 1,155 ------------- ------------ ------------- ------------ Total anti-dilutive common stock options and warrant 1,397 1,165 1,346 1,257 ============= ============ ============= ============
3. ACQUISITIONS M-Audio In August 2004, Avid completed the acquisition of M-Audio, a leading provider of digital audio and MIDI (Music Industry Digital Interface) solutions for electronic musicians and audio professionals. Avid paid cash of $79.6 million net of cash acquired of which $0.5 million will be paid out over a two year period, and issued stock and options with a fair value of $96.5 million. The market price of $42.72 used to value the Avid shares was based on the five-day average closing price of the stock during the period beginning two days before and ending two days after the date that the terms of the acquisition were agreed to and announced publicly. The weighted average price of $35.14 used to value the options was based on the same five-day average, less the weighted average strike price of the options. Avid also incurred $3.3 million of transaction costs. The Company has integrated M-Audio into its Professional Audio segment and will market its line of audio products alongside Digidesign's digital audio workstations for the professional and home/hobbyist markets. The goodwill of $122.0 million resulting from the purchase price allocation reflects the value of the underlying enterprise as well as synergies that Avid expects to realize, including incremental sales of Digidesign products. The following table summarizes the estimated fair value of the assets acquired and liabilities assumed at the date of acquisition (in thousands): Accounts receivable $7,288 Inventories 13,420 Other current assets 903 Equipment and other long-term assets 1,520 Identifiable intangible assets: Customer relationships 28,000 Trade name 4,700 Non-compete covenant 1,200 Developed technology 4,500 Goodwill 122,022 ---------------- Total assets acquired 183,553 Accounts payable (4,626) Other current liabilities (5,065) Deferred compensation related to stock options issued 5,499 ---------------- Net assets acquired $179,361 ================ As part of the purchase agreement, Avid may be required to make additional payments to the former shareholders and option holders of M-Audio of up to $45.0 million, contingent upon the operating results of M-Audio through December 31, 2005. These payments, if required, will be made through the issuance of additional Avid shares. Any additional Avid shares issued to the former shareholders of M-Audio will be recorded as additional purchase price allocated to goodwill. Any additional Avid shares issued to former option holders of M-Audio will be recorded as stock-based compensation. The identifiable intangible assets are being amortized over their estimated useful lives of twelve years for customer relationships, six years for the trade name, four years for the developed technology and two years for the non-compete covenant. Accumulated amortization of these intangible assets was $0.5 million at September 30, 2004. Amortization of these intangible assets in the full year ending December 31, 2004 is expected to be $1.8 million. The $122.0 million of 5 goodwill was assigned to the Company's Audio segment and will not be amortized, in accordance with the requirements of Statement of Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets". This goodwill is not deductible for tax purposes. Avid Nordic AB In September 2004, the Company acquired Avid Nordic AB, a Sweden-based reseller of Avid products operating in the Nordic and Benelux regions of Europe, for cash (net of cash acquired) of Euro 6.1 million ($7.4 million) plus transaction costs of $0.3 million. The Company previously had no ownership interest in Avid Nordic. The acquisition allows Avid to serve customers directly in this region. The following table summarizes the estimated fair value of the assets acquired and liabilities assumed in the transaction (in thousands): Accounts receivable $3,702 Inventory 2,516 Other current assets 589 Equipment and other long-term assets 671 Identifiable intangible asset 4,700 Goodwill 1,955 ----------- Total assets acquired 14,133 Accounts payable (2,571) Other current liabilities (2,260) Long-term deferred tax liability (1,645) ----------- Net assets acquired $7,657 =========== The identifiable intangible asset represents customer relationships developed in the region by Avid Nordic AB. This asset will be amortized over a five-year period. Accumulated amortization of this asset was $0.1 million at September 30, 2004. Amortization for the full year ended December 31, 2004 is expected to be $0.3 million. The goodwill of $2.0 million resulting from the purchase price allocation reflects the value of the assembled workforce and existing infrastructure in the region. This goodwill was assigned to The Video and Film Editing and Effects ("Video") segment and will not be amortized in accordance with the requirements of SFAS No. 142. This goodwill is not deductible for tax purposes. NXN SOFTWARE AG In January 2004, Avid acquired Munich, Germany-based NXN Software AG ("NXN"), a leading provider of asset and production management systems specifically targeted for the entertainment and computer graphics industries, for cash of Euro 35 million ($43.7 million)less cash acquired of $0.8 million. The Company also incurred $1.3 million of transaction costs. The acquisition expands Avid's offering in digital asset management by enabling the Company's film and video post-production, broadcast, audio and 3D animation customers to leverage the workflow capabilities of the NXN Alienbrain(R) product line. NXN is reported within Video segment. The goodwill resulting from the purchase price allocation reflects the synergies the Company hopes to realize by integrating the NXN technology with its other products. The following table summarizes the estimated fair value of the assets acquired and liabilities assumed at the date of acquisition (in thousands): Current assets $2,049 Equipment and other long-term assets 584 Identifiable intangible assets 7,200 Deferred tax assets, net 2,480 Goodwill 38,813 ----------- Total assets acquired 51,126 Current liabilities assumed (6,169) ----------- Net assets acquired $44,957 =========== The identifiable intangible assets include completed technology valued at $4.3 million, customer relationships valued at $2.1 million, and a trade name valued at $0.8 million, most of which are being amortized over a six-year period. 6 Amortization expense relating to these intangibles was $0.3 million and $0.9 million for the three- and nine-month periods ended September 30, 2004, respectively. Amortization of these intangibles for the full year ended December 31, 2004 is expected to be $1.2 million. During the nine-month period ended September 30, 2004, the $38.8 million of goodwill was reduced by $0.7 million to $38.1 million due to a reduction in the estimated fair value of deferred revenue acquired from NXN. This goodwill was assigned to the Video segment and, in accordance with the requirements of SFAS No. 142, will not be amortized. This goodwill is not deductible for tax purposes. Pro Forma Financial Information for Acquisitions (Unaudited) The results of operations of M-Audio, Avid Nordic and NXN have been included in the results of operations of the Company since the respective date of each acquisition. The following unaudited pro forma financial information presents the results of operations for the three- and nine-month periods ended September 30, 2004 and 2003 as if the acquisitions of both M-Audio and NXN had occurred at the beginning of 2003. The Company's pro forma results of operations giving effect to the Avid Nordic AB acquisition as if it had occurred at the beginning of 2003 is not included as it would not differ materially from the reported results. The pro forma financial information for the combined entities has been prepared for comparative purposes only and is not indicative of what actual results would have been if the acquisitions had taken place at the beginning of fiscal 2003, or of future results.
Three Months Ended Nine Months Ended September 30, September 30, ----------------------------- ----------------------------- 2004 2003 2004 2003 ------------ ------------- ------------- ------------ (In thousands, except per share data) Net revenues $156,329 $133,273 $456,918 $384,739 Net income $18,416 $9,549 $46,828 $18,289 Net income per share: Basic $0.54 $0.30 $1.40 $0.60 Diluted $0.51 $0.27 $1.30 $0.54
4. INVENTORIES Inventories consisted of the following (in thousands):
September 30, December 31, 2004 2003 -------------------- -------------------- Raw materials $16,024 $12,086 Work in process 4,694 1,475 Finished goods 34,195 24,731 -------------------- -------------------- $54,913 $38,292 ==================== ====================
As of September 30, 2004 and December 31, 2003, the finished goods inventory included deferred costs of $8.0 million and $14.0 million, respectively, associated with product shipped to customers for which revenue had not yet been recognized. 5. ACCOUNTING FOR STOCK-BASED COMPENSATION The Company accounts for stock-based awards to employees using the intrinsic value method as prescribed by Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. Accordingly, no compensation expense is recorded for options issued to employees in fixed amounts and with fixed exercise prices at least equal to the fair market value of the Company's common stock at the date of grant. When the exercise price of stock options granted to employees is less than the fair market value of common stock at the date of grant, the Company records that difference multiplied by the number of shares under option as deferred compensation, which is then amortized over the vesting period of the options. Additionally, deferred compensation is recorded for restricted stock granted to employees based on the fair market value of the Company's stock at date of grant less the amount paid, if any, for the stock by the employee and is amortized over the period during which the restrictions lapse. For holders of these 7 options or shares who are terminated, the Company ceases amortization and reclassifies the associated deferred compensation to additional paid-in capital. As part of the consideration for the purchase of M-Audio, the Company granted approximately 345,000 options to employees and issued approximately 34,000 shares of restricted stock. In accordance with Financial Accounting Standards Board Interpretation No. 44, a portion of the intrinsic value of the unvested awards was recorded as deferred compensation and is being recognized as stock-based compensation over the remaining future vesting period or, in the case of the restricted stock, as the restrictions lapse. The Company follows the disclosure-only provisions of SFAS No. 123, "Accounting for Stock-Based Compensation," and SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure," for employee awards. All stock-based awards to non-employees are accounted for at their fair value in accordance with SFAS No. 123. The following table illustrates the effect on net income and net income per share as if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee awards (in thousands, except per share data).
Three Months Ended Nine Months Ended September 30, September 30, -------------------------- ------------------------- 2004 2003 2004 2003 ----------- ----------- ----------- ---------- Net income as reported $18,974 $11,846 $49,187 $25,125 Add: Stock-based employee compensation expense included in reported net income 557 35 583 64 Deduct: Total stock-based employee compensation expense determined under the fair value-based method for all awards, net of related tax effects (4,346) (2,737) (11,657) (9,310) ----------- ----------- ----------- ---------- Pro forma net income $15,185 $9,144 $38,113 $15,879 =========== =========== =========== ========== Net income per share: Basic-as reported $0.58 $0.40 $1.54 $0.88 Basic-pro forma $0.46 $0.31 $1.20 $0.55 Diluted-as reported $0.54 $0.35 $1.43 $0.78 Diluted-pro forma $0.44 $0.28 $1.12 $0.50
Under SFAS No. 123, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model and is amortized over the stock option's vesting period. 6. CONTINGENCIES On March 11, 1996, Avid was named as a defendant in a patent infringement suit filed in the United States District Court for the Western District of Texas by Combined Logic Company, a California partnership located in Beverly Hills, California. On May 16, 1996, upon Avid's motion, the suit was transferred to the United States District Court for the Southern District of New York. The complaint alleges infringement by Avid of U.S. patent number 4,258,385, and seeks injunctive relief, treble damages, costs, and attorneys' fees. This patent expired on May 15, 1999 and therefore, would not be applicable to the products currently offered by Avid. Accordingly, potential damages, if any, are limited to the period beginning March 11, 1990 (six years prior to this date of the complaint) and ending May 15, 1999. In its answer to the complaint, the Company asserted that it did not infringe the patent and that the patent is invalid. Avid argued a Motion to Dismiss this claim on November 5, 2004 and is awaiting the decision of the court. The Company is unable to quantify a range of loss in this litigation. Combined Logic Company did not specify an alleged damage amount in its complaint. As only limited discovery has been conducted to date by either side in the eight years since Combined Logic Company filed its complaint, the Company believes it does not have sufficient information to provide any meaningful estimate of the possible range of damages that Combined Logic Company might seek. The Company believes it has meritorious defenses to the complaint and intends to contest it vigorously. However, an adverse resolution of this litigation could have an adverse effect on the Company's 8 consolidated financial position or results of operations in the period in which the litigation is resolved. No costs have been accrued for this possible loss contingency. In March 1999, Avid and Tektronix, Inc. were sued by Glen Holly Entertainment, Inc., a Tektronix distributor, claiming that Tektronix's discontinuance of the Tektronix Lightworks product line was the result of a strategic alliance by Tektronix and Avid. Glen Holly raised antitrust and common law claims against Avid and Tektronix, and sought lost future profits, treble damages, attorneys' fees, and interest. In March 2001, the United States District Court for the District of California dismissed the anti-trust claims against both parties and the remaining common law claim against the Company was dismissed by stipulation and court order on April 6, 2001. Glen Holly subsequently appealed the lower court's decision. On September 9, 2003, a three-judge panel of the U.S. Court of Appeals for the Ninth Circuit reversed in part the lower court's dismissal and sent the antitrust claims back to the lower court for further findings. Avid and Tektronix filed a Petition for a rehearing by the three-judge panel and a rehearing by the full Ninth Circuit on September 23, 2003. The Petition was denied on December 12, 2003. On March 18, 2004, the Company entered into a settlement agreement with Glen Holly whereby each party issued a general release of all claims relating to the allegations made in this lawsuit. In consideration of the settlement, Avid agreed to make a payment to Glen Holly of $1,050,000 and accordingly, $985,000 was paid in March 2004 and the remaining $65,000 was paid in April 2004. On March 19, 2004, Avid filed an application for determination of good faith settlement with the U.S. District Court requesting that it determine whether Tektronix had a right to contribution or indemnification from Avid arising from claims asserted in the lawsuit. On June 17, 2004, the U.S. District Court issued a ruling in which it determined that Tektronix had no such right. On June 24, 2004, Glen Holly filed a stipulation of dismissal with the Court, dismissing all claims alleged against the Company in this proceeding. On July 14, 2004, the court issued an order finding that the settlement agreement between Avid and Glen Holly was entered into in good faith under applicable law. Avid receives inquiries from time to time with regard to possible patent infringement claims. If any infringement is determined to exist, the Company may seek licenses or settlements. In addition, as a normal incidence of the nature of the Company's business, various claims, charges, and litigation have been asserted or commenced against the Company arising from or related to contractual or employee relations, intellectual property rights or product performance. Management does not believe these claims will have a material adverse effect on the financial position or results of operations of the Company. From time to time, the Company provides indemnification provisions in agreements with customers covering potential claims by third parties that Avid products infringe their intellectual property rights. Pursuant to these indemnification provisions, the Company agrees to indemnify customers for losses that they suffer or incur in connection with any valid U.S. patent or copyright infringement claim brought by a third party with respect to Avid products. These indemnification provisions generally offer perpetual coverage for infringement claims based upon the products covered by the agreement. The maximum potential amount of future payments the Company could be required to make under these indemnification provisions is theoretically unlimited; however, to date, the Company has not received any claims under these indemnification provisions. As a result, the Company believes the estimated fair value of these indemnification provisions is minimal. The Company has a standby letter of credit at a bank that is used as a security deposit in connection with the Company's Daly City, California office space lease. In the event of default on this lease, the landlord would be eligible to draw against this letter of credit to a maximum as of September 30, 2004 of $4.3 million, subject to an annual reduction of approximately $0.8 million but not below $2.0 million. The letter of credit will remain in effect at $2.0 million throughout the remaining lease period, which extends to September 2009. As of September 30, 2004, the Company was not in default of this lease. The Company, through a third party, provides lease financing options to its customers, including primarily end-users, and occasionally distributors. During the terms of these leases, which are generally three years, the Company remains liable for any unpaid principal balance upon default by the end-user, but such liability is limited in the aggregate based on a percentage of initial amounts funded or, in certain cases, amounts of unpaid balances. At September 30, 2004 and December 31, 2003, Avid's maximum recourse exposure totaled approximately $16.6 million and $14.8 million, respectively. The Company records revenue from these transactions upon the shipment of products, provided that all other revenue recognition criteria are met. Because the Company has been providing these financing options to its customers for many years, the Company has a substantial history of collecting under these arrangements without providing refunds or concessions to the end user or financing party. To date, the payment default rate has consistently been between 2% and 4% per year. The Company maintains a reserve against the entire portfolio balance, approximately $52.0 9 million and $63.5 million at September 30, 2004 and December 31, 2003, respectively for estimated losses under this recourse lease program based on these historical default rates. At September 30, 2004 and December 31, 2003, the Company's accrual for estimated losses was $2.4 million and $3.3 million, respectively. Avid provides warranty on hardware sold through its Video segment which generally mirrors the manufacturers' warranties. The Company charges the related material, labor and freight expense to cost of revenues in the period incurred. With respect to the Audio business, Avid provides warranty on externally sourced and internally developed hardware and records an accrual for the related liability based on historical trends and actual material and labor costs. The warranty period for all of the Company's products is generally 90 days to one year but can extend up to five years depending on the manufacturer's warranty. The following table sets forth the activity in the product warranty accrual account (in thousands):
Nine Months Ended September 30, 2004 2003 ----------------- ---------------- Accrual balance at beginning of period $1,355 $922 Accruals for product warranties 2,651 1,813 Cost of warranty claims (1,894) (1,511) ----------------- ---------------- Accrual balance at end of period $2,112 $1,224 ================= ================
7. COMPREHENSIVE INCOME Total comprehensive income net of taxes consists of net income, the net changes in foreign currency translation adjustment and net unrealized gains and losses on available-for-sale securities. The following is a summary of the Company's comprehensive income, (in thousands):
Three Months Ended Nine Months Ended September 30, September 30, ---------------------------- ----------------------------- 2004 2003 2004 2003 ------------- ------------- -------------- ------------- Net income $18,974 $11,846 $49,187 $25,125 Net changes in: Foreign currency translation adjustment 1,459 436 75 3,675 Unrealized gains (losses) on securities 99 (6) (206) 40 ------------- ------------- -------------- ------------- Total comprehensive income $20,532 $12,276 $49,056 $28,840 ============= ============= ============== =============
8. SEGMENT INFORMATION The Company's organizational structure is based on strategic business units that offer various products to the principal markets in which the Company's products are sold. These business units equate to two reportable segments: Video and Film Editing and Effects, and Professional Audio. The following is a summary of the Company's operations by reportable segment (in thousands):
Three Months Ended Nine Months Ended September 30, September 30, ------------------------------- ---------------------------- 2004 2003 2004 2003 --------------- ------------- -------------- ----------- Video and Film Editing and Effects: Net revenues $95,605 $86,689 $284,015 $243,420 Operating income $11,395 $9,746 $32,706 $17,574 Professional Audio: Net revenues $51,769 $32,401 $130,619 $101,164 Operating income $8,533 $2,225 $18,588 $9,955 Combined Segments: Net revenues $147,374 $119,090 $414,634 $344,584 Operating income $19,928 $11,971 $51,294 $27,529
10 The following table reconciles operating income for reportable segments to the total consolidated amounts for the three- and nine-month periods ended September 30, 2004 and 2003 (in thousands):
Three Months Ended Nine Months Ended September 30, September 30, ---------------------------- ----------------------------- 2004 2003 2004 2003 ------------- ------------- -------------- ------------- Total operating income for reportable segments $19,928 $11,971 $51,294 $27,529 Unallocated amounts: Restructuring and other costs, net - (76) - (1,859) Stock-based compensation (553) - (553) - Amortization of acquisition-related intangible assets (1,115) (341) (2,103) (975) ------------- ------------- -------------- ------------- Consolidated operating income $18,260 $11,554 $48,638 $24,695 ============= ============= ============== =============
9. RESTRUCTURING AND OTHER COSTS, NET In December 2002, the Company recorded a charge of $3.3 million in connection with vacating excess space in its Tewksbury, Massachusetts; Daly City, California; and Montreal, Canada facilities. The portion of the charge related to Tewksbury ($0.5 million) resulted from a revision of the Company's estimate of the timing and amount of future sublease income associated with that facility, for which a charge had previously been included in a 2001 restructuring. The remaining portion of the charge for Daly City and Montreal was a result of the Company's ceasing to use a portion of each facility in December 2002, and hiring real estate brokers to assist in finding subtenants. The Daly City estimate was revised, and an additional charge recorded, in the fourth quarter of 2003. In March 2003, the Company implemented a restructuring program under which 48 employees worldwide were terminated, and a leased facility in California was vacated. In connection with these actions, the Company recorded a charge of $1.2 million for employee terminations and $0.6 million for unutilized space in Santa Monica that included a write-off of leasehold improvements of $0.4 million. In September 2004, Avid recorded a charge of $0.2 million to reflect the decrease in rent to be received from one of the Company's subtenants and reversed a charge of $0.2 million associated with unutilized space in Tewksbury. The Company recorded the December 2002 and March 2003 charges in accordance with the guidance of SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities". SFAS No. 146 requires that a liability be recognized for an operating lease that is not terminated based on the remaining lease rental costs, measured at its fair value on a discounted cash flow basis, when the entity ceases using the rights conveyed by the operating lease. That amount is reduced by any estimated potential sublease rentals, regardless of whether the entity intends to enter into a sublease. Future changes in the fair value of the Company's obligations are recorded through operating expenses. The following table sets forth the activity in the restructuring and other costs accrual, which is included in Accrued expenses and other liabilities for the nine months ended September 30, 2004 (in thousands):
Employee Facilities Related Related Total -------------- -------------- -------------- Accrual balance at December 31, 2003 $50 $4,843 $4,893 Revisions of estimated liabilities (50) 50 - Cash payments - (1,130) (1,130) -------------- -------------- -------------- Accrual balance at September 30, 2004 $- $3,763 $3,763 ============== ============== ==============
The majority of the facilities-related accrual represents estimated losses on subleases of space vacated as part of the Company's restructuring actions. The leases, and charges against the amount accrued, extend through 2010 unless the Company is able to negotiate an earlier termination. 11 10. RECENT ACCOUNTING PRONOUNCEMENTS In May 2003, the FASB issued SFAS No. 150, "Accounting For Certain Financial Instruments with Characteristics of Both Liabilities and Equity", which establishes standards for how an issuer of financial instruments classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) if, at inception, the monetary value of the obligation is based solely or predominantly on a fixed monetary amount known at inception, variations in something other than the fair value of the issuer's equity shares or variations inversely related to changes in the fair value of the issuer's equity shares. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. On November 7, 2003, the FASB deferred the classification and measurement provisions of SFAS No. 150 as they apply to certain mandatory redeemable non-controlling interests. This deferral is expected to remain in effect while these provisions are further evaluated by the FASB. The Company has not entered into or modified any financial instruments covered by this statement after May 31, 2003 and the application of this standard is not expected to have a material impact on the Company's financial position or results of operations. On October 13, 2004, the FASB concluded that Statement of Financial Accounting Standards No. 123R, "Share-Based Payment" ("Statement 123R"), which would require all companies to measure compensation cost for all share-based payments (including employee stock options) at fair value, would be effective for public companies (except small business issuer as defined in SEC Regulation S-B) for interim or annual periods beginning after June 15, 2005. Retroactive application of the requirements of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation," ("Statement 123"), not Statement 123R, to the beginning of the fiscal year that includes the effective date would be permitted, but not required. Note 5 - "Accounting for Stock Based Compensation" sets forth the pro forma effect on net income and earnings per share assuming Avid had applied the fair value recognition provisions of Statement 123. The retroactive provisions permitted under this conclusion will not impact Avid since the first interim period that Statement 123R will be effective for Avid will be the third quarter of 2005. 12 PART I. FINANCIAL INFORMATION ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW We develop, market, sell and support a wide range of software and hardware for digital media production, management and distribution. Digital media are video, audio or graphic elements in which the image, sound or picture is recorded and stored as digital values, as opposed to analog, or tape-based, signals. Our diverse range of product and service offerings enables customers to "Make, Manage and Move Media." Make Media. Our Video and Film Editing and Effects ("Video") segment offers digital, non-linear video and film editing systems and 3D and special effects software that enable users to manipulate moving pictures and sound in a faster, easier, more creative, and more cost-effective manner than using traditional analog tape-based systems. Non-linear systems allow editors to access material instantaneously rather than requiring them to work sequentially. Our Professional Audio ("Audio") segment, Digidesign, offers digital audio software applications and hardware systems for music, film, television, video, broadcast, streaming media, and web development. These systems are based upon proprietary Digidesign/Avid audio hardware, software, and control surfaces, and allow users to record, edit, mix, process, and master audio in an integrated manner. Manage Media. We provide complete network, storage, and database solutions based on our Avid Unity MediaNetwork technology. This technology enables users to simultaneously share and manage media assets throughout a project or organization. The ability to effectively manage digital media assets is a critical component of success for many broadcast and media companies with multiple nonlinear editing workstations in a range of geographic locations. As a result, professionals can collaborate seamlessly on all production elements, and streamline the process for cost-effectively delivering compelling media experiences and quickly "re-purposing" or finding new uses or markets for media assets. Move Media. We offer products that allow our customers to distribute media over multiple platforms - including air, cable or satellite, or through the Internet. In addition, we provide technology for playback directly to air for broadcast television applications. Many of our products also support the broadcast of streaming Internet video. Our products are used worldwide in production and post-production facilities; film studios; network, affiliate, independent and cable television stations; recording studios; advertising agencies; government and educational institutions; corporate communication departments; and game developers and Internet professionals. Projects produced by our customers using our products have been honored with Oscar(R), Emmy(R), and Grammy(R) awards, as well as a host of other international awards. In addition, we have received numerous awards for technical innovations, including Oscars, Emmys and a Grammy. (Oscar is a registered trademark and service mark of the Academy of Motion Picture Arts and Sciences. Emmy is a registered trademark of ATAS/NATAS. Grammy is a registered trademark of The National Academy of Recording Arts and Sciences, Inc.) An important part of our strategy for the past few years has included expanding and enhancing our product lines and increasing revenues through both acquisitions and internal development of products. In January 2004, we acquired Munich, Germany-based NXN Software AG ("NXN"), a leading provider of asset and production management systems specifically targeted for the entertainment and computer graphics industries. This acquisition expands Avid's offering in digital asset management by enabling our film and video post-production, broadcast, audio and 3D animation customers to leverage the workflow capabilities of the NXN Alienbrain(R) product line. NXN has been integrated into our Video segment. In August 2004, we completed the acquisition of Irwindale, CA-based M-Audio, a leading provider of digital audio and MIDI solutions for electronic musicians and audio professionals. We have integrated M-Audio into our Audio segment as a business within our Digidesign audio division, and will market its line of audio products alongside Digidesign's digital audio workstations for the professional and home/hobbyist markets. Finally, in September 2004, we acquired Avid Nordic AB, a Sweden-based reseller of Avid products operating in the Nordic and Benelux regions of Europe. This acquisition allows us to directly serve customers in this region. In April 2004, we introduced two new audio control surfaces as part of our Digidesign Pro Tools audio product line. D-Control is a high-end, expandable control surface offering instant access to a large number of mixing parameters while mixing or recording audio. Together with the Pro Tools|HD system, D-Control is the basis of the ICON audio production system. Digidesign Command|8 is a semi-professional, small-format control surface which can be used with 13 Digidesign Pro Tools|HD, Pro Tools LE, and Avid Media Composer systems. Both control surfaces include integrated, high-quality audio monitoring. In June 2004, we introduced Avid Xpress Studio Complete and Avid Xpress Studio Essentials, end-to-end content creation suites for DV professionals. Avid Xpress Studio fully integrates Avid Xpress Pro video editing, Avid Pro Tools LE audio production, Avid 3D animation, Avid FX compositing and titling, and Avid DVD authoring software, and offers a choice of Digidesign Mbox or Digidesign 002 and Avid Mojo hardware for tactile audio control and expanded video I/O. Avid Xpress Studio suites deliver best-of-breed software, hardware, and interoperability at an affordable price. Also introduced in June 2004, SOFTIMAGE|XSI(R) version 4.0 is the latest release of the industry-leading non-linear 3-D production environment. Version 4.0 delivers advanced toolsets, performance enhancements, and significant advancements to the core architecture of the software, including new customization, project management, and workgroup capabilities. To bring Softimage's professional animation software to a wider audience, the new version is available in three distinct configurations: XSI Advanced, XSI Essentials, and the new entry-level, very affordable XSI Foundation. In 2004, with the introduction of Avid DNxHD technology, we continued to expand our technology leadership in combining high-quality video and efficient file sizes. Avid DNxHD encoding delivers 8- and 10-bit mastering-quality, high-definition (HD) images at bandwidths normally associated with uncompressed, standard-definition (SD) media. High-efficiency Avid DNxHD formats enable real-time HD collaboration using today's Avid Unity MediaNetwork shared storage environments, supporting workflows for HD that postproduction and broadcast professionals have come to expect for SD. Avid DNxHD technology made its debut with the September 2004 release of Avid DS Nitris version 7.5, expanding the capabilities of Avid's high-performance finishing and mastering system. In April 2003, we introduced a new family of products based on our Digital Nonlinear Accelerator (Avid DNA) architecture: a powerful series of computer hardware products engineered specifically for media processing. When paired with our industry-leading nonlinear editing software, the Avid DNA family enables professionals to achieve real-time functionality and superior image and sound quality when capturing, editing, finishing, and outputting DV, SD, and HD video formats. The Avid DNA family includes the Media Composer Adrenaline and Avid NewsCutter Adrenaline FX systems, both of which began shipping in the second quarter of 2003, and the Avid Xpress Pro and Avid Mojo software/hardware tandem, which began shipping in the third quarter of 2003. The Avid Media Composer Adrenaline system leverages the key features of its predecessors and offers improved quality, speed, and performance in high-pressure, time-sensitive television and film production environments. The Avid NewsCutter Adrenaline FX system expands news editing capabilities by offering speed, reliability, and a range of professional news-focused editing and workflow features in a turnkey PC-based platform. Avid Xpress Pro software and Avid Mojo hardware deliver professional video, film, and audio editing capabilities--including automatic color correction and real-time digital and analog output, and are qualified to run on a wide range of Windows-based CPUs as well as on the Power Mac G5 platform. The Avid DNA family also includes the Avid DS Nitris system, which began shipping in the fourth quarter of 2003. The Avid DS Nitris product is a powerful, high-resolution finishing workstation offering real-time effects and color correction. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles and the Company's discussion and analysis of its financial condition and results of operations requires the Company's management to make judgments, assumptions, and estimates that affect the amounts reported in its consolidated financial statements and accompanying notes. Note 1 of the Notes to Consolidated Financial Statements in the Company's 2003 Form 10-K describes the significant accounting policies and methods used in the preparation of the Company's consolidated financial statements. Management bases its estimates on historical experience and on various other assumptions that it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates. Management believes the Company's critical accounting policies are those related to revenue recognition and allowances for product returns and exchanges, allowance for bad debts and reserves for recourse under financing transactions, inventories and income taxes. Management believes these policies to be critical because they are both important to the portrayal of the Company's financial condition and results of operations, and they require management to make judgments and estimates about matters that are inherently uncertain. Additional information about these critical accounting policies may by found in 14 the Company's 2003 Form 10-K in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," under the heading "Critical Accounting Policies and Estimates." RESULTS OF OPERATIONS Net Revenues Our net revenues are derived mainly from the sales of computer-based digital, nonlinear media editing systems and average selling prices include the impact of price changes, discounting and mix (higher or lower-end) of products sold. Average selling prices also include the impact of related peripherals, licensing of related software, and sales of related software maintenance contracts. This market has been, and we expect it to continue to be, highly competitive. A significant portion of these revenues is generated by sales near the end of each quarter, which can impact our ability to accurately forecast revenues on a quarterly basis. Increasingly, revenues are also being derived from sales of "solutions" encompassing multiple products and networking capabilities that enable users to share and manage media throughout a project or organization. Such solution sales may include training and installation services, as well as workflow management assistance, to be provided by us or a third party. Depending upon the complexity of the arrangement and the level of our involvement, the revenues resulting from these solution sales may be deferred for one or more quarters while the services are being performed. Net revenues increased by $28.3 million (23.8%) to $147.4 million for the quarter ended September 30, 2004 from $119.1 million for the same quarter in 2003. Revenues in our Video business increased $8.9 million or 10.3%, while revenues in our Audio business grew by $19.4 million or 59.8%. The growth in the Video business reflects increased sales volume of our products, specifically the Avid DNA family of products released in the second through fourth quarters of 2003 as well as increased service revenues. Revenue growth in our Audio segment primarily reflects increased sales volume of our products including the ProTools TDM product family and products sold into the Pro Tools LE home/hobbyist market. The Audio segment revenue increase also includes the impact of the acquisition of M-Audio in the current quarter. Revenue growth in both segments was also helped by higher average selling prices in 2004 as compared to 2003. Average selling prices include the impact of price changes, discounting and mix (higher or lower-end) of products sold. Average selling prices also include the impact of related peripherals, licensing of related software, and sales of related software maintenance contracts. Foreign currency exchange rate changes had a favorable impact on both segments in 2004 compared to 2003. Net revenues increased by $70.0 million (20.3%) to $414.6 million for the nine months ended September 30, 2004 from $344.6 million for the nine months ended September 30, 2003. Revenues in our Video business increased $40.6 million or 16.7%, while revenues in our Audio business grew by $29.5 million or 29.1%. The growth in both segments is due to the factors mentioned above. Net revenues derived through indirect channels were approximately 69% and 73% of net revenues for the quarters ended September 30, 2004 and 2003, respectively. Indirect channel revenues were approximately 72% and 74% of net revenues for the nine-month periods ended September 30, 2004 and 2003, respectively. We generally sell directly to our broadcast customers and expect this will be an area of potential revenue growth in the future. Sales in the Americas (North and South America) have typically accounted for approximately 55% of our consolidated net revenues, with sales in Europe and Asia Pacific represent the remaining 45%. However, the relative percentages of sales among the regions can vary based on, among other things, the impact of currency exchange rate fluctuations on revenues, the timing of revenue recognition of solutions sales, and local economic conditions. Sales in the Americas accounted for 54% of our third quarter 2004 and 2003 net revenues. For the nine-month periods ended September 30, 2004 and 2003, sales in the Americas accounted for 55% and 56% of net revenues, respectively. For the three- and nine-month periods ended September 30, 2004, Americas sales increased by approximately $15.0 million or 23.2% and $34.5 million or 18.0%, respectively, compared to the same periods in 2003. Sales in the Europe and Asia Pacific regions accounted for 46% of our third quarter 2004 and 2003 net revenues. For the nine-month periods ended September 30, 2004 and 2003, sales in the Europe and Asia Pacific regions accounted for 45% and 44% of net revenues, respectively. For the three- and nine-month periods ended September 30, 2004, Europe and Asia Pacific regions sales increased by approximately $13.3 million or 24.4% and $35.6 million or 15 23.3%, respectively, compared to the same periods in 2003, with the impact of currency translation being a favorable factor, particularly in Europe. Gross Profit Costs of revenues consists primarily of costs associated with the procurement of components; post-sales customer support costs related to maintenance contract revenue and other services; the assembly, testing, and distribution of finished products; warehousing; and royalties for third-party software included in our products. The resulting gross margin fluctuates based on factors such as the mix of products sold, the cost and proportion of third-party hardware and software included in the systems sold, the offering of product upgrades, price discounts and other sales promotion programs, the distribution channels through which products are sold, the timing of new product introductions, sales of aftermarket hardware products such as disk drives, and currency exchange rate fluctuations. Our gross margin increased to 57.4% in the third quarter of 2004 from 55.7% for the same period of 2003. Margins in both segments improved with the most significant factors being a favorable product mix in the Audio segment and favorable overhead absorption in the Video segment due to higher revenue volume. Additionally, there was a positive impact on revenue from currency exchange rates with no material offsetting impact on costs of revenues as most of our manufacturing costs are transacted in U.S. dollars. Our gross margin increased to 57.1% for the nine months ended September 30, 2004 from 54.8% for the same period in 2003. Margins in both the Video and Audio segments improved, with the most significant factors being due to the factors mentioned above. Research and Development Research and development expenses increased by $3.1 million (14.8%) in the third quarter of 2004 compared to the same period in 2003 and increased by $5.2 million (8.1%) for the nine months ended September 30, 2004 compared to the same period in 2003. The increase in the three-month period ended September 30, 2004 was primarily the result of personnel-related expenses (in part due to the acquisitions of NXN and M-Audio), partially offset by decreased spending on computer supplies and hardware for the development of new products. The increase in the nine-month period ended September 30, 2004 was primarily the result of personnel related expenses (in part due to the acquisition of NXN and to a lesser extent M-Audio), partially offset by decreased fees associated with outsourcing certain engineering activities. Research and development expenses decreased to 16.1% of net revenues in the third quarter of 2004 compared to 17.4% in the same quarter of 2003 and decreased to 16.6% of net revenues for the nine months ended September 30, 2004 from 18.5% for the same period in 2003 due to the increased revenue base. Marketing and Selling Marketing and selling expenses increased by $5.5 million (19.6%) in the third quarter of 2004 compared to the same period in 2003 and increased by $16.0 million (19.7%) for the nine months ended September 30, 2004 compared to the same period in 2003. The increase in both periods was primarily the result of personnel-related expenses (in part due to the acquisition of NXN and M-Audio), trade show and other marketing programs and increased travel expenses. The increase in the nine-month period ended September 30, 2004 also included higher net foreign exchange losses (specifically, transaction and re-measurement gains and losses on net monetary assets denominated in foreign currencies, offset by hedging gains and losses), which are included in marketing and selling expenses. Marketing and selling expenses decreased to 22.7% of net revenues in the third quarter of 2004 compared to 23.5% in the same quarter of 2003 and decreased to 23.4% of net revenues for the nine months ended September 30, 2004 from 23.5% for the same period in 2003 due to the increased revenue base. General and Administrative General and administrative expenses increased by $1.7 million (30.3%) in the third quarter of 2004 compared to the same period in 2003 and increased by $2.8 million (17.0%) for the nine months ended September 30, 2004 compared to the same period in 2003. The increase in both 2004 periods was primarily due to higher personnel-related costs and to higher audit fees related to compliance with the Sarbanes-Oxley Act of 2002. General and administrative expenses increased to 5.0% of net revenues in the third quarter of 2004 compared to 4.8% in the same quarter of 2003 due to the factors mentioned above and decreased to 16 4.7% from 4.8% of net revenues for the nine-month period ended September 30, 2004 due to the increased revenue base. Restructuring and Other Costs, Net In March 2003, we implemented a restructuring program under which 48 employees worldwide were terminated, and a leased facility in California was vacated. In connection with these actions, during the first three months of 2003 we recorded a charge of $1.2 million for employee terminations and $0.6 million for unutilized space in Santa Monica that included a write-off of leasehold improvements of $0.4 million. Amortization of Acquisition-Related Intangible Assets In August 2004, we acquired M-Audio, a leading provider of digital audio and MIDI solutions for electronic musicians and audio professionals, for cash of $79.7 million and stock and stock options with a fair value of $96.5 million. As part of the purchase accounting allocation, we recorded $38.4 million of identifiable intangible assets, consisting of completed technologies, customer relationships, a trade name and a non-compete covenant. The unamortized balance of the identifiable intangible assets relating to this acquisition was $37.9 million at September 30, 2004. In September 2004, we acquired Avid Nordic AB for cash, net of cash acquired, of Euro 6.1 million ($7.4 million). As part of the purchase price allocation we recorded $4.7 million of identifiable intangible assets consisting solely of customer relationships. The unamortized balance was $4.6 million at September 30, 2004. In January 2004, we acquired NXN Software AG, a leading provider of asset and production management systems specifically targeted for the entertainment and computer graphics industries, for cash consideration of (euro)35 million ($43.7 million). As part of the purchase accounting allocation, we recorded $7.2 million of identifiable intangible assets, consisting of completed technologies, customer relationships and a trade name. The unamortized balance of the identifiable intangible assets relating to this acquisition was $6.3 million at September 30, 2004. From 2000 to 2003, we recorded intangible assets as we acquired the following companies or their assets: Rocket Network, Inc. and Bomb Factory Digital, Inc. in 2003; iKnowledge, Inc. in 2002; iNews, LLC in 2001; and The Motion Factory, Inc. in 2000. In connection with these acquisitions, we allocated $7.6 million to identifiable intangible assets consisting of completed technologies and work force, and $2.2 million to goodwill. As of January 1, 2002, in connection with the adoption of SFAS 142, we reclassified $1.1 million of a previously recorded assembled work force intangible to goodwill and, as a result, ceased amortizing this amount. The unamortized balance of the identifiable intangible assets relating to these acquisitions was $1.2 million at September 30, 2004. Included in the operating results for the quarters ended September 30, 2004 and 2003 is amortization for all of these intangible assets of $1.1 million and $0.3 million, respectively; the nine-month periods ended September 30, 2004 and 2003 include amortization of $2.1 million and $1.0 million, respectively. The increased levels of amortization primarily reflect the addition of the M-Audio assets acquired in August 2004 and the NXN assets acquired in January 2004. Other Income, Net Other income, net generally consists of interest income and interest expense. Other income (expense), net for the third quarter of 2004 increased $0.1 million to $0.7 million compared to $0.6 million for the third quarter of 2003. The increase was primarily due to higher interest income, partially off by higher interest expense in the 2004 period. For the nine-month period ended September 30, 2004, other income, net decreased $0.6 million, from $1.3 million to $0.7 million, as compared to the same period in 2003. The decrease was primarily due to a charge in the first quarter of 2004 of $1.1 million related to reaching a pending settlement of a lawsuit, partially offset by higher interest income earned on higher average cash, cash equivalents, and marketable securities balances. Provision for Income Taxes We recorded a net tax benefit of approximately $(0.1) million, and a tax provision of $0.3 million for the quarters ended September 30, 2004 and 2003, respectively. The net tax benefit for the quarter ended September 30, 2004 includes an adjustment for refunds of approximately $0.2 million of taxes previously paid in Canada. Other than this refund, the tax provision for all 17 periods presented was substantially comprised of taxes payable by our foreign subsidiaries with only alternative minimum tax provided on anticipated U.S. taxable profits. The tax provisions for the nine-month periods ending September 30, 2004 and 2003 were $0.1 million and $0.9 million, respectively. The lower tax provision in the first nine months of 2004 reflects a first-quarter reversal of a $1.2 million tax reserve resulting from the expiration of the statute of limitation on that reserve item and the third-quarter above mentioned refund. Other than these adjustments, the tax provision for all periods presented was substantially comprised of taxes payable by our foreign subsidiaries with only alternative minimum tax provided on anticipated U.S. taxable profits. The tax provision in each quarter is significantly affected by net changes in the valuation allowance against our deferred tax assets. Regular federal income taxes resulting from anticipated U.S. profits have been offset by the utilization of deductions from acquisition-related temporary differences and net operating loss carry-forwards; the tax provision benefit of utilizing these items results from the corresponding net reduction in the valuation allowance. However, due to the remaining level of deferred tax assets and the level of related historical taxable income, we have determined that the uncertainty regarding the realization of these remaining assets is sufficient to warrant the continued establishment of a valuation allowance against nearly all of our deferred tax assets. LIQUIDITY AND CAPITAL RESOURCES We have funded our operations to date through both private and public sales of equity securities, including stock option exercises from our employee stock plans, as well as through cash flows from operations. As of September 30, 2004, our principal sources of liquidity included cash, cash equivalents and marketable securities totaling $120.1 million. With respect to cash flow, net cash provided by operating activities was $57.1 million for the nine months ended September 30, 2004 compared to $40.7 million for the same period in 2003. During the nine months ended September 30, 2004, net cash provided by operating activities primarily reflects net income adjusted for depreciation and amortization as well as increases in accounts receivable, accounts payable and deferred revenue. During the nine months ended September 30, 2003, net cash provided by operating activities primarily reflects net income adjusted for depreciation and amortization as well as an increase in deferred revenue and a decrease in accounts receivable, partially offset by a decrease in accounts payable. At September 30, 2004 and December 31, 2003, we held inventory in the amounts of $54.9 million and $38.3 million, respectively. These balances include stockroom, spares, and demonstration equipment inventories at various locations, and inventory at customer sites related to shipments for which we have not yet recognized revenue. The increase in the current quarter reflects primarily the acquisitions of M-Audio and Avid Nordic AB. We review all inventory balances regularly for excess quantities or potential obsolescence and make appropriate adjustments to write-down the inventories to reflect their estimated realizable value. Accounts receivable increased by $25.2 million to $94.4 million at September 30, 2004 from $69.2 million at December 31, 2003, driven primarily by the year-over-year increase in net revenues but also to the acquisition of M-Audio. These balances are net of allowances for sales returns, bad debts and customer rebates, all of which we estimate and record based on historical experience. Days sales outstanding in accounts receivable increased from 49 days at December 31, 2003 to 58 days at September 30, 2004. The increase in days sales outstanding is primarily attributable to the timing of shipments during the quarter and an increase in deferred maintenance contract billings for which revenue is recognized ratably in future quarters. Net cash flow used in investing activities was $129.8 million for the nine-month period ending September 30, 2004 compared to $53.1 million for the same period in 2003. During the nine-month period ended September 30, 2004, we paid cash of $134.2 million for the purchases of NXN, M-Audio and Avid Nordic AB, net of cash acquired. Also, a payment of $1.0 million for our 2003 acquisition of Bomb Factory Digital was made in early 2004, after resolution of acquisition-related contingencies, with the final payments totaling $0.4 million due through December 2004. We purchased $9.8 million of property and equipment during the nine months ended September 30, 2004 compared to $4.6 million in the same period of 2003. Purchases of property and equipment in both 2004 and 2003 were primarily of computer hardware and software to support research and development activities and our information systems. Our full year capital spending for 2004 is currently expected to be about $12.0 million, including purchases of hardware and software to support activities in the research and development, information systems and manufacturing areas, as well as for facilities renovations. 18 During the nine months ended September 30, 2004 and 2003, we generated cash of $13.2 million and $44.9 million, respectively, from the issuance of common stock related to the exercise of stock options and our employee stock purchase plan. In connection with restructuring efforts during 2001 and prior periods, as well as with the identification in 2003 and 2002 of excess space in various locations, we also have cash obligations of approximately $15.4 million under leases for which we have vacated the underlying facilities. We have an associated restructuring accrual of $3.8 million at September 30, 2004 representing the excess of our lease commitments on space no longer used by us over expected payments to be received on subleases of such facilities. These payments will be made over the remaining terms of the leases, which have varying expiration dates through 2010, unless we are able to negotiate an earlier termination. All restructuring related payments will be funded through working capital. Our cash requirements vary depending upon factors such as our planned growth, capital expenditures, the possible acquisition of businesses or technologies complementary to our business and obligations under past restructuring programs. We believe our existing cash, cash equivalents, marketable securities and funds generated from operations will be sufficient to meet our operating cash requirements for at least the next twelve months. In the event we require additional financing, we believe that we will be able to obtain such financing; however, there can be no assurance that we would be successful in doing so, or that we could do so on favorable terms. RECENT ACCOUNTING PRONOUNCEMENTS In May 2003, the FASB issued Statement of Financial Accounting Standards ("SFAS") No. 150, "Accounting For Certain Financial Instruments with Characteristics of Both Liabilities and Equity", which establishes standards for how an issuer of financial instruments classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) if, at inception, the monetary value of the obligation is based solely or predominantly on a fixed monetary amount known at inception, variations in something other than the fair value of the issuer's equity shares or variations inversely related to changes in the fair value of the issuer's equity shares. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. On November 7, 2003, the FASB deferred the classification and measurement provisions of SFAS No. 150 as they apply to certain mandatory redeemable non-controlling interests. This deferral is expected to remain in effect while these provisions are further evaluated by the FASB. The Company has not entered into or modified any financial instruments covered by this statement after May 31, 2003 and the application of this standard is not expected to have a material impact on the Company's financial position or results of operations. On October 13, 2004, the FASB concluded that Statement of Financial Accounting Standards No. 123R, "Share-Based Payment" ("Statement 123R"), which would require all companies to measure compensation cost for all share-based payments (including employee stock options) at fair value, would be effective for public companies (except small business issuer as defined in SEC Regulation S-B) for interim or annual periods beginning after June 15, 2005. Retroactive application of the requirements of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation," ("Statement 123"), not Statement 123R, to the beginning of the fiscal year that includes the effective date would be permitted, but not required. Note 5 - "Accounting for Stock Based compensation" sets forth the pro forma effect on net income and earnings per share assuming Avid had applied the fair value recognition provisions of Statement 123. The retroactive provisions permitted under this conclusion will not impact Avid since the first interim period that Statement 123R will be effective for Avid will be the third quarter of 2005. 19 CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS Some of the statements in this Form 10-Q relating to our future performance constitute forward-looking statements. Such forward-looking statements are based upon management's current expectations and involve known and unknown risks. Realization of any of these risks may cause actual results to differ materially from the results described in the forward-looking statements. Certain of these risks are as follows: Our performance will depend in part on continued market acceptance of our new digital nonlinear editing products. We recently introduced several new digital non-linear products based on our Digital Nonlinear Accelerator architecture, including our next-generation Media Composer (Media Composer Adrenaline) and NewsCutter (NewsCutter Adrenaline) systems, as well as Avid Xpress Pro with Avid Mojo and Avid DS Nitris hardware. We will need to continue to focus marketing and sales efforts on educating potential customers and our resellers about the uses and benefits of these products. The future success of certain of these products, such as Avid DS Nitris, which enable high-definition production, will also depend on consumer demand for appliances, such as television sets and monitors, that utilize the high definition standard. In addition, there are several other risks involved with offering new products in general, including, without limitation, the possibility of defects or errors, failure to meet customer expectations, delays in shipping new products and the introduction of similar products by our competitors. At the same time, the introduction and transition to new products could have a negative impact on the market for our existing products, which could adversely affect our revenues and business. The broadcast market is large, widely dispersed, and highly competitive, and we may not be successful in growing our customer base or predicting customer demand in this market. We are currently building our presence in the digital broadcast market and have augmented our NewsCutter product offering with the Avid Unity for News products, and the server, newsroom, and browser products obtained in the Pluto and iNews acquisitions. The broadcast market is distinguished from our traditional video business in that turnkey, fully integrated, complex solutions (including the configuration of unique workflows), rather than discrete point products, are frequently required by the customer. Success in this market will require, among other things, creating compelling solutions and developing a strong, loyal customer base. In addition, large, complex broadcast orders often require us to devote significant sales, engineering, manufacturing, installation, and support resources to ensure their successful and timely fulfillment. As the broadcast market converts from analog to digital, our strategy has been to build our broadcast solutions team in response to customer demand. To the extent that customer demand for our broadcast solutions exceeds our expectations, we may encounter difficulties in the short run meeting our customers' needs. Meanwhile, our competitors may devote greater resources to the broadcast market than we do, or may be able to leverage their market presence more effectively. If we are unsuccessful in capturing and maintaining a share of this digital broadcast market or in predicting and satisfying customer demand, our business and revenues could be adversely affected. Our revenues are becoming increasingly dependent on sales of large, complex solutions. We expect sales of large, complex solutions to continue to constitute a material portion of our net revenue, particularly as news stations convert from analog, or tape-based, processes to digital formats. Our quarterly and annual revenues could fluctuate significantly if: o sales to one or more of our customers are delayed or are not completed within a given quarter; o the contract terms preclude us from recognizing revenue during that quarter; o news stations' migrations from analog processes to digital formats slows down; o we are unable to complete complex customer installations on schedule; o our customers reduce their capital investments in our products in response to slowing economic growth; and o any of our large customers terminate their relationship with us or significantly reduce the amount of business they do with us. 20 Our products are complex, and may contain errors or defects resulting from such complexity. As we continue to expand our product offerings to include not only point products but also end-to-end solutions, our products have grown increasingly complex and, despite extensive testing and quality control, may contain errors or defects. Such errors or defects could cause us to issue corrective releases and could result in loss of revenues, delay of revenue recognition, increased product returns, lack of market acceptance, and damage to our reputation. The markets for our products are competitive, and we expect competition to intensify in the future. The digital video, audio, and 3D markets are highly competitive, with limited barriers to entry, and are characterized by pressure to reduce prices, incorporate new features, and accelerate the release of new products. Some of our current and potential competitors have substantially greater financial, technical, distribution, support, and marketing resources than we do. Such competitors may use these resources to lower their product costs, allowing them to reduce prices to levels at which we could not operate profitably. Delays or difficulties in product development and introduction may also harm our business. If we are unable to compete effectively in our target markets, our business and results of operations could suffer. In addition to price, our products must also compete favorably with our competitors' products in terms of reliability, performance, ease of use, range of features, product enhancements, reputation and training. New product announcements by our competitors and by us also could have the effect of reducing customer demand for our existing products. New product introductions also require us to devote time and resources to training our sales channels in product features and target customers, with the temporary result that the sales channels have less time to devote to selling our products. We have a significant share of the professional audio market, and therefore growth in this market will depend in part on our ability to successfully introduce new products or expand into new distribution channels. Products from our Digidesign division have captured a significant portion of the professional audio market, due in large part to a series of successful product introductions. Our future success will depend in part upon our ability to offer, on a timely and cost-effective basis, new audio products and enhancements of our existing audio products. This can be a complex and uncertain process, and we could experience design, manufacturing, marketing, or other difficulties that delay or prevent the introduction of new or enhanced products, or the integration of acquired products, which, in turn, could harm our business. At M-Audio, revenue has historically been derived from sales through the same or similar channels as Digidesign. However, M-Audio is currently expanding its sales channel to include sales through the broader consumer market channel. While we are not anticipating that a significant portion of our revenues will come through this channel in the near term, our overall experience addressing the consumer market channel is limited, and there are some costs related to pursuing the consumer market channel which are, to a certain extent, fixed. As a result, we may be unable to adjust our spending in a timely manner to compensate for any unexpected revenue shortfall from this channel, which could harm our operating results. When we acquire other companies or businesses, we become subject to risks that could hurt our business. We periodically acquire businesses and form strategic alliances. For example, and in January 2004, we acquired NXN Software AG, a company that manufactures asset and production management systems specifically targeted for the entertainment and computer graphics industries, and in August 2004, we acquired Midiman, Inc. (d/b/a M-Audio), a leading provider of digital audio and MIDI solutions for electronic musicians and audio professionals. The risks associated with such acquisitions, alliances, and investments include, among others: o the difficulty of assimilating the operations, policies and personnel of the target companies; o the failure to realize anticipated returns on investment, cost savings and synergies; o the diversion of management's time and attention; o the dilution existing stockholders may experience if we decide to issue shares of our common stock or other rights to purchase our common stock as consideration in the acquisition in lieu of cash; o the potential loss of key employees of the target company; 21 o the difficulty in complying with a variety of foreign laws; o the impairment of relationships with customers or suppliers of the target company or our customers or suppliers; and o unidentified issues not discovered in our due diligence process, including product quality issues and legal contingencies. Such acquisitions, alliances, and investments often involve significant transaction-related costs and could cause short-term disruption to normal operations. In the future we may also make debt or equity investments. If we are unable to overcome or counter these risks, it could undermine our business and lower our operating results. Our use of independent firms and contractors to perform some of our product development and manufacturing activities could expose us to risks that could adversely impact our revenues. Independent firms and contractors, some of whom are located in other countries, perform some of our product development and manufacturing activities. We generally own the software developed by these contractors. The use of independent firms and contractors, especially those located abroad, could expose us to risks related to governmental regulation (including tax regulation), intellectual property ownership and rights, exchange rate fluctuation, political instability and unrest, natural disasters, and other risks, which could adversely impact our revenues. An interruption of our supply of certain products or key components from our sole source suppliers, or a price increase in such products or components, could hurt our business. We are dependent on a number of specific suppliers for certain products and key components of our products. We purchase these sole source products and components pursuant to purchase orders placed from time to time. We generally do not carry significant inventories of these sole source products and components and have no guaranteed supply arrangements. If any of our sole source vendors should fail to produce such products or to supply or enhance such components, it could imperil our supply and our ability to continue selling and servicing products that use these components. Similarly, if any of our sole source vendors should encounter technical, operating or financial difficulties, it could threaten our supply of these products or components. While we believe that alternative sources for these products and components could be developed, or our products could be redesigned to permit the use of alternative components, an interruption of our supply could damage our business and negatively affect our operating results. Our gross profit margin varies from product to product depending primarily on the proportion and cost of third-party hardware included in each product. From time to time, we add functionality and features to our products. If we effect such additions through the use of more, or more costly, third-party hardware, and are not able to increase the price of such products to offset these increased costs, our gross profit margin on these products could decrease and our operating results could be adversely affected. Qualifying and supporting our products on multiple computer platforms is time consuming and expensive. Our software engineers devote significant time and effort to qualify and support our products on various computer platforms, including most notably, Microsoft and Apple platforms. Computer platform modifications and upgrades require additional time to be spent to ensure that our products will function properly. To the extent that the current configuration of the qualified and supported platforms changes or we need to qualify and support new platforms, we could be required to expend valuable engineering resources, which could adversely affect our operating results. Our operating results are dependent on several unpredictable factors. The revenue and gross profit from our products depend on many factors, including: o mix of products sold; o cost and proportion of third-party hardware included in such products; o product distribution channels; o acceptance of our new product introductions; o product offers and platform upgrades; o price discounts and sales promotion programs; o volume of sales of aftermarket hardware products; o costs of swapping or fixing products released to the market with defects; 22 o provisions for inventory obsolescence; o competitive pressure on product prices; o costs incurred in connection with "solution" sales, which typically have longer selling and implementation cycles; and o timing of delivery of "solutions" to customers. Changes in any of these factors could affect our operating results. Our operating results could be harmed by currency fluctuations. We generally derive nearly half of our revenues from customers outside of the United States. This business is, for the most part, transacted through international subsidiaries and generally in the currency of the end-user customers. Therefore, we are exposed to the risks that changes in foreign currency could adversely impact our revenues, net income (loss), and cash flow. To hedge against the foreign exchange exposure of certain forecasted receivables, payables and cash balances of our foreign subsidiaries, we enter into foreign currency forward-exchange contracts. We record gains, and losses associated with currency rate exchanges on these contracts in results of operations, offsetting gains and losses on the related assets and liabilities. The success of this hedging program depends on forecasts of transaction activity in the various currencies. To the extent that these forecasts are over- or understated during the periods of currency volatility, we could experience currency gains or losses. Our operating costs are tied to projections of future revenues, which may differ from actual results. Our operating expense levels are based, in part, on our expectations of future revenues. Such future revenues are difficult to predict. A significant portion of our business occurs near the end of each quarter, which can impact our ability to precisely forecast revenues on a quarterly basis. Further, we are generally unable to reduce quarterly operating expense levels rapidly in the event that quarterly revenue levels fail to meet internal expectations. Therefore, if quarterly revenue levels fail to meet internal expectations upon which expense levels are based, our results of operations could be adversely affected. Poor global macroeconomic conditions could disproportionately impact our industry. In recent years, our customers in the media, broadcast and content-creation industries delayed or reduced their expenditures in part because of unsettled economic conditions. The revenue growth and profitability of our business depends primarily on the overall demand for our products. If global economic conditions worsen, demand for our products may weaken, and our business and results of operations could suffer. Terrorism, acts of war, and other catastrophic events may seriously harm our business. Terrorism, acts of war, or other catastrophic events may disrupt our business and harm our employees, facilities, suppliers, distributors, resellers or customers, which could significantly impact our revenue and operating results. The increasing presence of these threats has created many economic and political uncertainties that could adversely affect our business and stock price in ways that cannot be predicted. We are predominantly uninsured for losses and interruptions caused by terrorism, acts of war, and other conflicts and events. If we fail to maintain strong relationships with our resellers, distributors, and suppliers, our ability to successfully deploy our products may be harmed. We sell many of our video products and services, and substantially all of our audio products and services, indirectly through resellers and distributors. The loss of one or more key distributors could reduce our revenues. The resellers and distributors of our video segment products typically purchase Avid software and Avid-specific hardware from us, and third-party components from various other vendors, in order to produce complete systems for resale. Any disruption to our resellers and distributors, or their third-party suppliers, could reduce our revenues. Increasingly, we are distributing our products directly, which could put us in competition with our resellers and distributors and could adversely affect our revenues. In addition, our resellers could diversify the manufacturers from whom they purchase products to sell to the final end-users, which could lead to a weakening of our relationships with our resellers and could adversely affect our revenues. 23 Most of the resellers and distributors of our video products are not granted rights to return products after purchase, and actual product returns from such resellers and distributors have been insignificant to date. However, our revenue from sales of audio products is generally derived from transactions with distributors and authorized resellers that typically allow limited rights of return, inventory stock rotation and price protection. Accordingly, reserves for estimated returns, exchanges and credits for price protection are provided, as a reduction of revenues, upon shipment of the related products to such distributors and resellers, based upon our historical experience. To date, actual returns have not differed materially from management's estimates. However, if returns of our audio segment products were to exceed estimated levels, our revenues and operating results could be adversely impacted. Our future growth could be harmed if we lose the services of our key personnel. Our success depends upon the services of a number of key employees including members of our executive team and those in certain technical positions. The loss of the services of one or more of these key employees could harm our business. Our success also depends upon our ability to attract highly skilled new employees. Competition for such employees is intense in the industries and geographic areas in which we operate. In the past, we have relied on our ability to grant stock options as one mechanism for recruiting and retaining highly skilled talent. Recent proposed accounting regulations requiring the expensing of stock options may impair our future ability to provide these incentives without incurring significant compensation costs. If we are unable to compete successfully for our key employees, our business could suffer. Our websites could subject us to legal claims that could harm our business. Some of our websites provide interactive information and services to our customers. To the extent that materials may be posted on and/or downloaded from these websites and distributed to others, we may be subject to claims for defamation, negligence, copyright or trademark infringement, personal injury, or other theories of liability based on the nature, content, publication or distribution of such materials. In addition, although we have attempted to limit our exposure by contract, we may also be subject to claims for indemnification by end users in the event that the security of our websites is compromised. As these websites are available on a worldwide basis, they could potentially be subject to a wide variety of international laws. Regulations could be enacted that restrict our Internet initiatives. Federal, state, and international authorities may adopt new laws and regulations governing the Internet, including laws and regulations covering issues such as privacy, distribution, and content. For example, the European Union has issued several directives regarding privacy and data protection, including the Directive on Data Protection and the Directive on Privacy and Electronic Communications. The enactment of legislation implementing such directives by member countries is ongoing. The enactment of this and similar legislation or regulations could impede the growth of the Internet, harm our Internet initiatives, require changes in our sales and marketing practices and place additional financial burdens on our business. We could incur substantial costs protecting our intellectual property or defending against a claim of infringement. Our ability to compete successfully and achieve future revenue growth depends, in part, on our ability to protect our proprietary technology and operate without infringing upon the intellectual property rights of others. We rely upon a combination of patent, copyright, trademark and trade secret laws, confidentiality procedures, and contractual provisions, as well as required hardware components and hardware security keys, to protect our proprietary technology. However, our means of protecting our proprietary rights may not be adequate. In addition, the laws of certain countries do not protect our proprietary technology to the same extent as do the laws of the United States. From time to time unauthorized parties have obtained, copied, and used information that we consider proprietary. Policing the unauthorized use of our proprietary technology is costly and time-consuming and we are unable to measure the extent to which piracy of our software exists. We expect software piracy to be a persistent problem. We occasionally receive communications suggesting that our products may infringe the intellectual property rights of others. It is our practice to investigate the factual basis of such communications and negotiate licenses where appropriate. While it may be necessary or desirable in the future to obtain licenses relating to one or more products or relating to current or future technologies, we may be unable to do so on commercially reasonable terms. 24 If we are unable to protect our proprietary technology or unable to negotiate licenses for the use of others' intellectual property, our business could be impaired. We are currently involved in various legal proceedings, including patent litigation. An adverse resolution of any such proceedings could harm our business and reduce our results of operations. See Note I, "Commitments and Contingencies" in our audited financial statements filed on Form 10-K. Our association with industry organizations could subject us to litigation. We are members of several industry organizations, trade associations and standards consortia. Membership in these and similar groups could subject us to litigation as a result of the group's activities. For example, in connection with our anti-piracy program, designed to enforce copyright protection of our software, we are a member of the Business Software Alliance (BSA). From time to time the BSA undertakes litigation against suspected copyright infringers. These lawsuits could lead to counterclaims alleging improper use of litigation or violation of other local law. To date, none of these law suits or counterclaims have had an adverse effect on our results of operations, but should we become involved in material litigation, our cash flows or financial position could be adversely effected. The Sarbanes-Oxley Act of 2002 has caused our operating expenses to increase and has put additional demands on our management. The Sarbanes-Oxley Act of 2002 and newly enacted rules and regulations of the Securities and Exchange Commission and the NASDAQ stock market impose new duties on us and our executives, directors, attorneys and independent auditors. In order to comply with the new legislation, we have had to hire additional personnel and use additional outside legal, accounting and advisory services. These actions have increased our operating expenses. In addition, the new legislation has made some corporate actions more challenging, such as proposing new or amendments to stock option plans, which now require stockholder approval, or obtaining affordable director and officer liability insurance. The added demands imposed by the new legislation may also make it more difficult for us to attract and retain qualified executive officers, key personnel and members of our board of directors. If we experience problems with our third-party leasing program, our revenues could be adversely impacted. We have an established leasing program with a third party that allows certain of our customers who choose to do so to finance their purchases. If this program ended abruptly or unexpectedly, some of our customers might be unable to purchase our products unless or until they were able to arrange for alternative financing, and this could adversely impact our revenues. Our stock price may continue to be volatile. The market price of our common stock has experienced volatility in the past and could continue to fluctuate substantially in the future based upon a number of factors, most of which are beyond our control. These factors include: o changes in our quarterly operating results; o shortfalls in revenues or earnings compared to securities analysts' expectations; o changes in analysts' recommendations or projections; o fluctuations in investors' perceptions of us or our competitors; o shifts in the markets for our products; o development and marketing of products by our competitors; o changes in our relationships with suppliers, distributors, resellers, system integrators, or customers; and o global macroeconomic conditions. Further, the stock market has experienced volatility with respect to the price of equity securities of high technology companies generally, and this volatility has, at times, appeared to be unrelated to or disproportionate to any of the factors above. 25 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK Market Risk Our primary exposures to market risk are financial, including the effect of volatility in currencies on asset and liability positions and revenue and operating expenses of our international subsidiaries that are denominated in foreign currencies, and the effect of fluctuations in interest rates earned on our cash equivalents and marketable securities. Foreign Currency Exchange Risk We generally derive nearly half of our revenues from customers outside the United States. This business is, for the most part, transacted through international subsidiaries and generally in the currency of the end-user customers. Therefore, we are exposed to the risks that changes in foreign currency could adversely impact our revenues, net income (loss) and cash flow. To hedge against the foreign exchange exposure of certain forecasted receivables, payables and cash balances of our foreign subsidiaries, we enter into short-term foreign currency forward-exchange contracts. There are two objectives of our foreign currency forward-exchange contract program: (1) to offset any foreign exchange currency risk associated with cash receipts expected to be received from our customers over the next 30 day period and (2) to offset the impact of foreign currency exchange on the Company's net monetary assets denominated in currencies other than the U.S. dollar. These forward-exchange contracts typically mature within 30 days of purchase. We record gains and losses associated with currency rate changes on these contracts in results of operations, offsetting gains and losses on the related assets and liabilities. The success of this hedging program depends on forecasts of transaction activity in the various currencies. To the extent that these forecasts are over- or understated during the periods of currency volatility, we could experience unanticipated currency gains or losses. For the three- and nine-month periods ended September 30, 2004, net losses resulting from forward-exchange contracts of $0.8 million and $0.7 million, respectively, were included in results of operations, offset by net transaction and re-measurement gains on the related asset and liabilities of $0.6 million for the three-month period ended September 30, 2004 and net losses on the related asset and liabilities of $0.7 million for the nine-month period ended September 30, 2004. A hypothetical 10% change in foreign currency rates would not have a material impact on our results of operations, assuming the above-mentioned forecast of foreign currency exposure is accurate, because the impact on the forward contracts as a result of a 10% change would at least partially offset the impact on the asset and liability positions of our foreign subsidiaries. Interest Rate Risk At September 30, 2004, we held $120.1 million in cash, cash equivalents and marketable securities, including short-term U.S. and Canadian government and government agency obligations. Marketable securities are classified as "available for sale" and are recorded on the balance sheet at market value, with any unrealized gain or loss recorded in other comprehensive income (loss). A hypothetical 10% increase or decrease in interest rates would not have a material impact on the fair market value of these instruments due to their short maturity. 26 ITEM 4. CONTROLS AND PROCEDURES Evaluation of Controls and Procedures. Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of September 30, 2004. In designing and evaluating our disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives, and management necessarily applied its judgment in evaluating the cost-benefit relationships of possible controls and procedures. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of September 30, 2004, our disclosure controls and procedures were (1) designed to ensure that material information relating to us, including our consolidated subsidiaries, is made known to our Chief Executive Officer and Chief Financial Officer by others within those entities, particularly during the period in which this report was being prepared and (2) effective, in that they provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the fiscal quarter ended September 30, 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. 27 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS On March 11, 1996, Avid was named as a defendant in a patent infringement suit filed in the United States District Court for the Western District of Texas by Combined Logic Company, a California partnership located in Beverly Hills, California. On May 16, 1996, upon Avid's motion, the suit was transferred to the United States District Court for the Southern District of New York. The complaint alleges infringement by Avid of U.S. patent number 4,258,385, and seeks injunctive relief, treble damages, costs, and attorneys' fees. This patent expired on May 15, 1999 and therefore, would not be applicable to the products currently offered by Avid. Accordingly, potential damages, if any, are limited to the period beginning March 11, 1990 (six years prior to this date of the complaint) and ending May 15, 1999. In its answer to the complaint, the Company asserted that it did not infringe the patent and that the patent is invalid. Avid argued a Motion to Dismiss this claim on November 5, 2004 and is awaiting the decision of the court. The Company is unable to quantify a range of loss in this litigation. Combined Logic Company did not specify an alleged damage amount in its complaint. As only limited discovery has been conducted to date by either side in the eight years since Combined Logic Company filed its complaint, the Company believes it does not have sufficient information to provide any meaningful estimate of the possible range of damages that Combined Logic Company might seek. The Company believes it has meritorious defenses to the complaint and intends to contest it vigorously. However, an adverse resolution of this litigation could have an adverse effect on the Company's consolidated financial position or results of operations in the period in which the litigation is resolved. No costs have been accrued for this possible loss contingency. In March 1999, Avid and Tektronix, Inc. were sued by Glen Holly Entertainment, Inc., a Tektronix distributor, claiming that Tektronix's discontinuance of the Tektronix Lightworks product line was the result of a strategic alliance by Tektronix and Avid. Glen Holly raised antitrust and common law claims against Avid and Tektronix, and sought lost future profits, treble damages, attorneys' fees, and interest. In March 2001, the United States District Court for the District of California dismissed the anti-trust claims against both parties and the remaining common law claim against the Company was dismissed by stipulation and court order on April 6, 2001. Glen Holly subsequently appealed the lower court's decision. On September 9, 2003, a three-judge panel of the U.S. Court of Appeals for the Ninth Circuit reversed in part the lower court's dismissal and sent the antitrust claims back to the lower court for further findings. Avid and Tektronix filed a Petition for a rehearing by the three-judge panel and a rehearing by the full Ninth Circuit on September 23, 2003. The Petition was denied on December 12, 2003. On March 18, 2004, the Company entered into a settlement agreement with Glen Holly whereby each party issued a general release of all claims relating to the allegations made in this lawsuit. In consideration of the settlement, Avid agreed to make a payment to Glen Holly of $1,050,000 and accordingly, $985,000 was paid in March 2004 and the remaining $65,000 was paid in April 2004. On March 19, 2004, Avid filed an application for determination of good faith settlement with the U.S. District Court requesting that it determine whether Tektronix had a right to contribution or indemnification from Avid arising from claims asserted in the lawsuit. On June 17, 2004, the U.S. District Court issued a ruling in which it determined that Tektronix had no such right. On June 24, 2004, Glen Holly filed a stipulation of dismissal with the Court, dismissing all claims alleged against the Company in this proceeding. On July 14, 2004, the court issued an order finding that the settlement agreement between Avid and Glen Holly was entered into in good faith under applicable law. ITEM 6. EXHIBITS *10.1 Midiman Inc. 2002 Stock Option/Stock Issuance Plan *#10.2 Form of Incentive Stock Option Agreement *#10.3 Form of Nonstatutory Stock Option Agreement *#10.4 Form of Restricted Stock Agreement #10.5 1997 Stock Incentive Plan (incorporated by reference to the Registrant's Proxy Statement as filed with the Commission on April 6, 1998, File No. 000-21174) *31.1 Certification of Principal Executive Officer pursuant to Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 28 *31.2 Certification of Principal Financial Officer pursuant to Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 *32.1 Certifications pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 --------------------- * Documents filed herewith # Management contract or compensatory plan 29 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Avid Technology, Inc. Date: November 9, 2004 By: /s/ Paul J. Milbury ----------------------- Paul J. Milbury Chief Financial Officer (Principal Financial Officer) Date: November 9, 2004 By: /s/ Carol L. Reid ------------------------- Carol L. Reid Vice President and Corporate Controller (Principal Accounting Officer) 30 EXHIBIT INDEX Exhibit No. Description ---------- ----------- *10.1 Midiman Inc. 2002 Stock Option/Stock Issuance Plan *#10.2 Form of Incentive Stock Option Agreement *#10.3 Form of Nonstatutory Stock Option Agreement *#10.4 Form of Restricted Stock Agreement #10.5 1997 Stock Incentive Plan (incorporated by reference to the Registrant's Proxy Statement as filed with the Commission on April 6, 1998, File No. 000-21174) *31.1 Certification of Principal Executive Officer pursuant to Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 *31.2 Certification of Principal Financial Officer pursuant to Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 *32.1 Certifications pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 --------------------- * Documents filed herewith # Management contract or compensatory plan 31