10QSB/A 1 form10qsba93000.txt FORM 10QSB\A FOR THE PERIOD ENDED 09/30/2000 U.S. SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-QSB/A (Mark One) |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2000 |_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Number 0-27102 eGames, Inc. (Exact name of registrant as specified in its charter) PENNSYLVANIA 23-2694937 (State or other jurisdiction of (IRS Employer incorporation or organization) Identification Number) 2000 Cabot Boulevard West, Suite 110 Langhorne, PA 19047-1811 (address of Principal executive offices) Issuer's Telephone Number, Including Area Code: 215-750-6606 Not Applicable (Former name, former address and former fiscal year, if changed since last report.) Check whether the issuer (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 ( ) APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PRECEDING FIVE YEARS: Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes ( ) No ( ) APPLICABLE ONLY TO CORPORATE ISSUERS State the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date: 9,749,975 shares of common stock, no par value per share, as of November 10, 2000. Transitional Small Business Disclosure Format (check one): Yes ( ) No ( X ) EXPLANATORY NOTE eGames, Inc. (the "Company") is amending its Form 10-QSB to restate its interim financial statements for the three month period ended and as of September 30, 2000, and has revised its interim financial statements for the three month period ended September 30, 1999 for comparative purposes, to address certain revenue recognition issues. The Company has concluded, based upon receipt of delayed reporting of sell-through results from its food and drug retailers, that it does not have the ability to make reliable estimates of product returns for shipments to food and drug retailers in accordance with SFAS No. 48, "Revenue Recognition When the Right of Return Exists," and the additional guidance provided in the SEC's Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements." This Form 10-QSB/A reflects the sale of the Company's products to its food and drug retailers on a product sell-through basis to the end consumer. The Company previously recognized revenue upon shipment of its products to its customers and recorded an allowance for product returns at the time of shipment. The revenues, product costs and royalty costs relating to product shipments to food and drug retailers have been restated in this Form 10-QSB/A to reflect this change in revenue recognition policy for shipments to food and drug retailers. In addition, net sales associated with product shipments to customers that traditionally have sold PC software products are recognized at the time that title passes to the customer. Such net sales have been restated in this Form 10-QSB/A because the Company determined in fiscal 2001 that certain of such product sales provided that title passed to the customer only upon receipt of the Company's product by the customer, and that, therefore, net sales could only be recognized upon the customer's receipt of such product shipments. This Form 10-QSB/A includes changes to the (i) Financial Statements and (ii) Management's Discussion and Analysis of Financial Condition and Results of Operations. INDEX Page ---- Part I. Financial Information Item 1. Financial Statements: Consolidated Balance Sheet as of September 30, 2000............. 3 Consolidated Statements of Operations for the three months ended September 30, 2000 and 1999 .......................... 4 Consolidated Statements of Cash Flows for the three months ended September 30, 2000 and 1999..................................... 5 Notes to Consolidated Financial Statements...................... 6-9 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations ........................ 10-15 Signatures ............................................................ 16 Item 1. Financial Statements eGames, Inc. Consolidated Balance Sheet (Unaudited)
As of September 30, ASSETS 2000 ------ ------------ Current assets: Cash and cash equivalents $ 271,863 Accounts receivable, net of allowances totaling $1,986,702 2,669,775 Inventory 2,483,234 Prepaid royalties and other expenses 366,111 Net current assets of discontinued operation 339,734 ----------- Total current assets 6,130,717 Furniture and equipment, net 231,750 Intangibles and other assets, net 81,615 Net long term assets of discontinued operation 240,768 ----------- Total assets $ 6,684,850 =========== LIABILITIES AND STOCKHOLDERS' EQUITY ------------------------------------ Current liabilities: Note payable $ 56,713 Accounts payable 1,444,503 Customer advance payments 1,008,589 Revolving credit facility 500,000 Accrued expenses 1,063,149 Convertible subordinated debt 150,000 Capital lease obligations 5,210 ----------- Total current liabilities 4,228,164 Note payable, net of current portion 105,243 ----------- Total liabilities 4,333,407 Stockholders' equity: Common stock, no par value (40,000,000 shares authorized; 9,981,875 issued and 9,749,975 outstanding) 9,134,234 Additional paid-in capital 1,148,550 Accumulated deficit (7,299,606) Treasury stock, at cost - 231,900 shares (501,417) Accumulated other comprehensive loss (130,318) ----------- Total stockholders' equity 2,351,443 ----------- Total liabilities and stockholders' equity $ 6,684,850 ===========
See accompanying notes to the consolidated financial statements. eGames, Inc. Consolidated Statements of Operations (Unaudited)
Three months ended September 30, -------------------------- 2000 1999 ----------- ----------- Net sales $ 1,144,874 $ 2,561,636 Cost of sales 751,004 1,004,277 ----------- ----------- Gross profit 393,870 1,557,359 Operating expenses: Product development 181,147 242,847 Selling, general and administrative 1,440,125 1,352,269 ----------- ----------- Total operating expenses 1,621,272 1,595,116 ----------- ----------- Operating loss (1,227,402) (37,757) Interest expense, net 7,353 3,710 ----------- ----------- Loss from continuing operations before income taxes (1,234,755) (41,467) Provision for income taxes 27,846 96,000 ----------- ----------- Loss from continuing operations (1,262,601) (137,467) Discontinued operation (Note 4): Income (loss) from discontinued operation, net of income tax benefits of $25,025 and $6,705 (21,416) 63,233 ----------- ----------- Net loss ($1,284,017) ($74,234) =========== =========== Net loss per common share: - Basic ($ 0.13) ($ 0.01) =========== =========== - Diluted ($ 0.13) ($ 0.01) =========== =========== Weighted average common shares outstanding - Basic 9,749,975 9,633,973 Dilutive effect of common stock equivalents - 0 - - 0 - ----------- ----------- Weighted average common shares outstanding - Diluted 9,749,975 9,633,973 =========== ===========
See accompanying notes to the consolidated financial statements. eGames, Inc. Consolidated Statements of Cash Flows (Unaudited)
Three months ended September 30, --------------------------- 2000 1999 ------------ ----------- Cash flows from operating activities: Net loss ($ 1,284,017) ($ 74,234) Adjustment to reconcile net loss to net cash used in operating activities: Depreciation, amortization and other non-cash items 57,740 79,802 (Income) loss from discontinued operation 21,416 (63,233) Changes in items affecting operations: Restricted cash - 0 - 17,560 Accounts receivable (369,152) (1,569,790) Prepaid royalties and other expenses (158,478) (38,108) Inventory (419,014) (316,878) Accounts payable (544,282) 725,002 Customer advance payments 1,008,589 - 0 - Accrued expenses 346,456 361,214 ------------ ----------- Net cash used in operating activities (1,340,742) (878,665) ------------ ----------- Cash flows from investing activities: Purchase of furniture and equipment (10,249) (29,210) Purchase of software rights and other assets (1,730) (245) ------------ ----------- Net cash used in investing activities (11,979) (29,455) ------------ ----------- Cash flows from financing activities: Proceeds from exercise of warrants and options - 0 - 110,000 Proceeds from borrowings under revolving credit facility 750,000 - 0 - Repayments of borrowings under revolving credit facility (250,000) - 0 - Repayments of note payable (12,866) (11,966) Repayments of capital lease obligations (1,343) (1,722) ------------ ----------- Net cash provided by financing activities 485,791 96,312 Effect of exchange rate changes on cash and cash equivalents (7,260) 3,148 Net cash provided by discontinued operation 6,875 44,771 ------------ ----------- Net decrease in cash and cash equivalents (867,315) (763,889) Cash and cash equivalents: Beginning of period 1,139,178 1,313,853 ------------ ----------- End of period $ 271,863 $ 549,964 ============ =========== Supplemental cash flow information: Cash paid for interest $ 14,423 $ 11,194 ============ =========== Non cash investing and financing activities: Acquisition of furniture and equipment through capital leases $ 11,550 $ 26,809 ============ ===========
See accompanying notes to the consolidated financial statements. eGames, Inc. Notes to Consolidated Financial Statements 1. Summary of Significant Accounting Policies Basis of Presentation The accompanying unaudited interim consolidated financial statements were prepared in accordance with generally accepted accounting principles for interim financial information. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. The Notes to Consolidated Financial Statements included in the Company's Form 10-KSB for the fiscal year ended June 30, 2000 should be read in conjunction with the accompanying statements. These statements include all adjustments the Company believes are necessary for a fair presentation of the statements. The interim operating results are not necessarily indicative of the results for a full year. During the first quarter of fiscal 2001, the Company adopted the Emerging Issues Task Force ("EITF") 00-14, "Accounting for Certain Sales Incentives". Accordingly, net sales amounts for current and prior periods reflect the reclassification of consumer and retailer rebate costs, from selling, general and administrative expenses to net sales. Description of Business eGames, Inc. (the "Company"), a Pennsylvania corporation incorporated in July 1992, develops, publishes, markets and sells a diversified line of personal computer software primarily for consumer entertainment. The Company targets the growing market of home personal computer ("PC") users who value full-featured, value-priced and easy-to-use entertainment software. The Company's sales are made through various national distributors on a non-exclusive basis in addition to direct relationships with certain national and regional retailers. The Company's products generally sell at retail for under $15, a price point that is intended to generate impulse purchases in mass market shopping environments. Consolidation The consolidated financial statements include the accounts of the Company and its previously wholly-owned subsidiary, which due to the sale of this operation in May 2001, the relevant balances and transactions have been presented as a discontinued operation. All inter-company balances and transactions have been eliminated. Revenue Recognition Product Sales: -------------- The Company previously recognized revenue upon shipment of its products to its customers and recorded an allowance for product returns. The Company has concluded, based upon receipt of delayed reporting of sell-through results from its food and drug retailers, which have not historically sold consumer PC software products, that the Company does not have the ability to make reliable estimates of product returns for shipments to food and drug retailers in accordance with SFAS No. 48, "Revenue Recognition When the Right of Return Exists" and the additional guidance provided in the SEC's Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements". Accordingly, the Company's revenues in fiscal 2001 and 2000 associated with product shipments to food and drug retailers are recognized based on the timing of the actual sell-through of the Company's products to the end consumer at the retail location as reported to the Company from the respective food and drug retailer. Revenues associated with the Company's product shipments to its customers that traditionally have sold consumer PC software products (i.e., mass merchant retailers or distributors serving such retailers) are recognized at the time title to the inventory passes to these customers, less a historically based provision for anticipated product returns. The Company determined in fiscal 2001 that certain of its product sales to these customers provided that title passed to the customer only upon receipt of the Company's product by the customer and that, therefore, net sales could only be recognized upon the customer's receipt of such product shipments. Title passes to these customers either upon shipment of the product or receipt of the product by these customers based on the terms of the sale transaction. Notes to Consolidated Financial Statements (continued) Customers generally have the right to return products purchased from the Company. The Company recognizes product sales to its customers who traditionally have sold consumer PC software products, in accordance with the criteria of SFAS No. 48, at the time of the sale based on the following: the selling price is fixed at the date of sale, the buyer is obligated to pay the Company, title of the product transfers to the buyer, the buyer has economic substance apart from the Company, the Company does not have further obligations to assist the buyer in the resale of the product and the returns can be reasonably estimated at the time of sale. While the Company has no other obligations to perform future services subsequent to shipment, the Company provides telephone customer support as an accommodation to purchasers of its products and as a means of fostering customer loyalty. Costs associated with this effort are insignificant and, accordingly, are expensed as incurred. Allowance For Product Returns and Price Markdowns: -------------------------------------------------- The Company distributes the majority of its products through several third-party distributors and directly to national and regional retailers. The distribution of these products is governed by distribution agreements, direct sale agreements or purchase orders, which generally allow for product returns and price markdowns. For shipments to its customers that have traditionally sold consumer PC software products, the Company records an allowance for returns and markdowns as a reduction of gross sales at the time title of the products pass to the customer. This allowance, which is reflected as a reduction of accounts receivable, is estimated based primarily upon historical experience. During the quarters ended September 30, 2000 and 1999, the Company's provisions for product returns and price markdowns for customers that have traditionally sold consumer PC software products were approximately $225,000 and $568,000 or 18% and 18% of related gross shipments, respectively. Customer Advance Payments Although the Company recognizes revenue from food and drug retailers based on the timing of the actual sell-through of the Company's products to the end consumer, the Company may receive payments from these food and drug retailers in advance of such products being sold to the end consumer. These payments are recorded as customer advance payments in the Company's Consolidated Balance Sheet until such time as the products are actually sold through to the end consumer. After the products are sold through to the end consumer, the customer advance payment amount is recorded as revenue. In the event that the Company receives customer advance payments that ultimately exceed the actual product sell-through of the Company's products to the end consumer at such retailers, the Company would owe these retailers such excess amounts. Prepaid Royalties Prepaid royalties represent advance payments made to licensors of software and intellectual properties used in the Company's products. Prepaid royalties are expensed at contractual royalty rates based on net product sales. Marketing and Sales Incentive Costs Marketing costs for which the Company pays its resellers, such as slotting and advertising fees, are charged to expense as incurred and were approximately $370,000 and $239,000 for the quarters ended September 30, 2000 and 1999, respectively. Sales incentive costs, such as rebates and coupons, that the Company offers to the retail consumer are recorded as reductions to net sales as incurred and were approximately $108,000 and $45,000 for the quarters ended September 30, 2000 and 1999, respectively. New Accounting Pronouncements During the first quarter of fiscal 2001, the Company adopted Emerging Issues Task Force ("EITF") 00-14, "Accounting for Certain Sales Incentives". Accordingly, net sales amounts for current and prior periods reflect the reclassification of consumer and retailer rebate costs, from selling, general and administrative expenses to net sales. Notes to Consolidated Financial Statements (continued) Additionally, the Company has evaluated its revenue recognition policies based upon Staff Accounting Bulletin 101 "Revenue Recognition" and related amendments and interpretations. Accordingly, the Company determined it should recognize revenues for fiscal 2001 and 2000 associated with product shipments to food and drug retailers based on the timing of the actual product sell-through activity to the end consumer of the Company's products at these retail locations and not at the time the Company ships its products to these food and drug retailers. The Company made this decision following its determination that it was not able to adequately estimate, at time of product shipment, the amount of product returns for product shipments to food and drug retailers. Revenues associated with the Company's product shipments to its customers that traditionally have sold consumer PC software products (such as mass-merchant retailers, or distributors servicing such retailers) are recognized at the time title to these products passes to these customers, less a historically-based provision for anticipated product returns. The Company is currently evaluating the potential impact of Emerging Issues Task Force ("EITF") 00-10 "Accounting for Shipping and Handling Fees and Costs". This pronouncement will become effective by the Company's fourth quarter of fiscal 2001. The Company does not expect the adoption of EITF 00-10 to have a significant impact on its results of operations, financial position or cash flows. 2. Comprehensive Loss On July 1, 1998, the Company adopted SFAS 130, "Reporting Comprehensive Income". This Statement requires that all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. Comprehensive income (loss) is computed as follows: Three Months Ended September 30, 2000 1999 ------------ ------------ Net loss ($ 1,284,017) ($ 74,234) Other comprehensive income (loss): Foreign currency translation adjustment (61,120) 18,829 ------------ ------------ Comprehensive loss ($ 1,345,137) ($ 55,405) ============ ============ 3. Common Stock On October 26, 1998, the Company's Board of Directors authorized the Company to purchase up to $1,000,000 of its shares of Common Stock in open-market purchases on the Nasdaq SmallCap Market. During the quarter ended September 30, 2000 the Company did not purchase any shares of its Common Stock. As of September 30, 2000, the Company had acquired 231,900 shares of its Common Stock, with an approximate cost of $501,000, pursuant to its stock repurchase program. 4. Discontinued Operation On May 11, 2001, the Company sold eGames Europe Limited, its wholly-owned subsidiary located in the United Kingdom, to a non-related third-party. The Company has reflected the relevant activity and account balances for this operation as a discontinued operation within each of the respective financial statements included in this report. The Company received $300,000 in net proceeds, which approximated the discontinued operation's net book value. The net proceeds consisted of: $150,000 in cash provided at closing, $120,000 in a note receivable to be payable in twelve monthly payments of $10,000 each, and $30,000 in cash held in escrow to be released to the Company, pending any unresolved claims, six months following the closing of the sale. The amounts in the accompanying consolidated financial statements and footnotes have been reclassified for all periods presented to give effect to the discontinued operation. Notes to Consolidated Financial Statements (continued) Net sales for the discontinued operation for the quarters ended September 30, 2000 and 1999 were approximately $590,000 and $576,000, respectively. The income (loss) from the discontinued operation was approximately ($21,000) and $63,000 for the quarters ended September 30, 2000 and 1999, respectively, which amounts were net of income tax benefits of approximately $25,000 and $7,000, respectively. Included in the Company's Consolidated Balance Sheet for September 30, 2000, were net current assets of discontinued operation totaling approximately $340,000, primarily comprised of accounts receivable, which were partially offset by accounts payable and accrued expenses. Additionally, in the Company's Consolidated Balance Sheet for September 30, 2000 were net long term assets of discontinued operation totaling approximately $241,000, primarily comprised of un-amortized goodwill related to the prior acquisition of this discontinued operation during fiscal 1999 and certain furniture and equipment costs. 5. Operations by Reportable Segments SFAS No. 131, "Disclosure about Segments of an Enterprise and Related Information" establishes standards for reporting information about an enterprise's operating segments and related disclosures about its products, geographic areas and major customers. Based on the Company's organizational structure and its presentation of the discontinued operation, the Company operates in only one reportable segment, which is publishing interactive entertainment software for personal computers. 6. Revolving Credit Facility On August 9, 2000, the Company entered into a $2,000,000 revolving credit facility ("new credit facility") with a commercial bank, which expires on October 31, 2001. This new credit facility replaced the $1,500,000 revolving credit facility that it previously had with another commercial bank. Amounts outstanding under this new credit facility are charged interest at one-half of one percent above the bank's current prime rate and such interest is due monthly. The new credit facility is collateralized by substantially all of the Company's assets. The new credit facility requires the Company, among other things, to maintain certain financial ratios, such as: a minimum working capital balance of $1,500,000 and a maximum senior debt to effective net worth ratio of 1.50 to 1.00. Additionally, this new credit facility has a minimum effective net worth covenant starting at $3.1 million at June 30, 2000 and increasing by $150,000 quarterly to a $3.7 million requirement at June 30, 2001. As of September 30, 2000, the Company was not in compliance with the minimum effective net worth covenant and the maximum senior debt to effective net worth covenant. This new credit facility was established to provide, among other things, additional working capital to support the Company's anticipated growth. As of November 13, 2000, the Company had a $500,000 outstanding balance under this new credit facility. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations The accompanying consolidated financial statements as of September 30, 2000 include the accounts of eGames, Inc. (the "Company") and its previously wholly-owned subsidiary that is presented as a discontinued operation. Dollar amounts discussed within the Company's "Management's Discussion and Analysis of Financial Condition and Results of Operations" have been rounded to the nearest thousand ('000). Forward-Looking Statements This Quarterly Report on Form 10-QSB/A and in particular Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements about circumstances that have not yet occurred, including, without limitation, statements regarding the Company's Store-In-A-Store program resulting in the longer-term placement of the Company's products in the food and drug retail channel, which is intended to increase sales volume within this channel and decrease the rate of product returns due to longer product exposure on retailers' product shelves; the level of the Company's international net sales remaining at between 5 % and 10% of the Company's consolidated net sales for the remainder of fiscal 2001; the Company's efforts to increase distribution of its products via the Internet; the payment of certain promotional costs resulting in increased sell-through rates for the Company's products during short-term promotional programs; the ability of the Company's Store-in-a-Store program to reduce promotional expenses, as a percentage of sales, due to more product sales being non-promotional in nature; the sufficiency of the Company's cash and working capital balances to fund the Company's operations for the foreseeable future; the expectation that certain new accounting pronouncements will not have a significant impact on the Company's results of operations, financial position or cash flows; as well as other statements including words such as "anticipate", "believe" or "expect" and statements in the future tense. These forward-looking statements are subject to business and economic risks, and actual events or the Company's actual future results could differ materially from those set forth in the forward-looking statements due to such risks and uncertainties. The Company will not necessarily update information if any forward looking statement later turns out to be inaccurate. The following important factors, among others discussed elsewhere in this report, could cause the Company's actual results to differ materially from those indicated by the forward-looking statements contained in this report: the market acceptance of the Company's Store-in-a-Store program in the food and drug retail channel and the sustainability of the program over time; the ability of the Store-in-a-Store program to secure longer-term shelf space for the Company's products; whether the longer-term placement of the Company's products at retail will result in better sell-through rates and therefore fewer returns from the food and drug retail channel; the market acceptance and successful sell-through results for the Company's products at retail stores and the ability of the Company to accurately estimate sell-through volume when an order is shipped to, or received by, a customer that has traditionally sold PC software; the amount of unsold product that is returned to the Company by retail stores; the Company's ability to accurately predict the amount of product returns that will occur and the adequacy of the reserves established for such returns; the Company's ability to continue to implement its Store-in-a-Store program on commercially acceptable terms; the success of the Company's distribution strategy, including its ability to enter into new distribution and direct sales relationships on commercially acceptable terms; the allocation of adequate shelf space for the Company's products in major retail chain stores; the Company's ability to negotiate lower product promotional costs in its distribution and retail relationships; the Company's ability to collect outstanding accounts receivable and establish adequate reserves for un-collectible receivables; increased selling, general and administrative costs, including increased legal expenses; the continued increase in the number of computers in homes in North America and the world; the ability to deliver products in response to orders within a commercially acceptable time frame; downward pricing pressure; fluctuating costs of developing, producing and marketing the Company's products; the Company's ability to license or develop quality content for its products; the Company's ability to access alternative distribution channels and the success of the Company's efforts to develop its Internet sales; consumers' continued demand for value-priced software; increased competition in the value-priced software category; and various other factors, many of which are beyond the Company's control. Risks and uncertainties that may affect the Company's future results and performance also include, but are not limited to, those discussed under the heading "Risk Factors" in the Company's Annual Report on Form 10-KSB for the fiscal year ended June 30, 2000 as filed with the Securities and Exchange Commission and other documents filed with the Commission. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Results of Operations Three Months Ended September 30, 2000 and 1999 Net Sales Net sales for the quarter ended September 30, 2000 were $1,145,000 compared to $2,562,000 for the quarter ended September 30, 1999, representing a decrease of $1,417,000 or 55%. The $1,417,000 decrease in net sales was primarily attributable to the Company's decrease in net sales to its North American distribution and retail customers of $1,296,000 and $221,000, respectively. These net sales decreases were partially offset by increases in the Company's net sales to North American food and drug retailers and international customers of $52,000 and $48,000, respectively. The Company's net sales to North American traditional software distributors decreased by $1,296,000, while net sales to North American traditional software retailers decreased by $221,000. These net sales decreases resulted in large part from industry-wide reductions of PC software inventory levels held by North American software retailers and distributors. During fiscal 2001, the Company has continued to increase its distribution efforts to North American food and drug retailers, in an attempt to offset some of the previously discussed net sales decreases to its North American traditional software retail and distribution customers. During fiscal 2001, the Company established its first "Store-in-a-Store" entertainment software display sections in approximately 4,000 food and drug retail stores. The establishment of these Store-In-A-Store software display sections within certain national and regional food and drug retail stores is intended to help secure longer-term placement of the Company's products in this retail channel, with the goal of increasing product sell through volume at these food and drug retailers while decreasing the rate of product returns due to longer product exposure on these retailers' product shelves The Company's international net revenues, inclusive of both product net sales and royalty revenues, for the quarter ended September 30, 2000 increased by $48,000 compared to the same period a year ago. As a percentage of net sales, the Company's international net revenues represented 11% and 3% of the Company's net sales for the quarters ended September 30, 2000 and 1999, respectively. The Company anticipates that international net revenues will range from 5% to 10% of the Company's consolidated net sales for the remainder of fiscal 2001. On May 11, 2001, the Company sold its wholly-owned subsidiary "eGames Europe Limited", located in the United Kingdom, to a non-related third-party. By affecting this sale, the Company transitioned the majority of its international product distribution efforts to a licensing revenue model, whereby the Company no longer bears the working capital risk of supporting these multi-country product sales efforts, but will earn a royalty fee based upon net product sales covered under various licensing arrangements with third-party developers. The Company has reflected the net sales activity for this operation as a discontinued operation within the Company's Consolidated Statements of Operations. Net sales for the discontinued operation for the quarters ended September 30, 2000 and 1999 were $590,000 and $576,000, respectively. During fiscal 2000, the Company completed its transition from publishing shareware-based PC game software titles to publishing full-release PC game software titles. There were no net sales of shareware-based software titles during the quarter ended September 30, 2000 compared to $90,000 of net sales of such titles during the quarter ended September 30, 1999. The Company has initiated several programs designed to increase the sale of its products over the Internet, including: the roll-out of an improved and expanded website; improvement of its electronic distribution capabilities by further developing and expanding its affiliation with Digital River, a leading distributor of digital software over the Internet; and incorporation of user-friendly on-line functionality into its products. Sales of the Company's products via the Internet for the quarters ended September 30, 2000 and 1999 were $52,000 and $21,000, respectively, or 5% and 1% of the Company's net sales, respectively. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Most of the Company's non-exclusive arrangements with its traditional software distributors and retailers allow for product returns or price markdowns. During the quarters ended September 30, 2000 and 1999, the Company's provision for product returns and price markdowns relating to product shipments to its traditional software customers totaled $225,000 and $568,000, or 18% and 18% of related gross shipments, respectively. Although the Company has experienced an increase in product shipments to food and drug retailers, the majority of these product shipments have been "promotional" in nature, meaning that the Company's products were merchandised in those retail stores for only six to eight weeks. As a result of this short promotional period, the Company has experienced a higher and more unpredictable rate of product returns from food and drug retailers compared to product return rates from traditional software retailers and distributors where the Company's products typically have a longer period of time to sell through to end consumers. Cost of Sales Cost of sales for the quarter ended September 30, 2000 were $751,000 compared to $1,004,000 for the quarter ended September 30, 1999, representing a decrease of $253,000 or 25%. This $253,000 decrease in cost of sales was caused primarily by decreases in product costs and royalty fees of $195,000 and $113,000, respectively, that were associated with the decrease in net product sales. These decreases were partially offset by increased distribution, packaging and reclamation costs of $60,000 largely associated with the Company's product shipments to food and drug retailers. Most of the revenues related to these product shipments have been deferred until such time as product sell-through to the end consumer is reported to the Company by the food and drug retailer. Product costs consist mainly of replicated compact discs, printed materials, protective jewel cases and boxes for certain products. Gross Profit Margin The Company's gross profit margin for the quarter ended September 30, 2000 decreased to 34.4% of net sales from 60.8% of net sales for the quarter ended September 30, 1999. This 26.4% decrease in gross profit margin was caused primarily by an increase in product costs of 14.1%, as a percentage of net sales, due largely from the Company's: discounting of sales prices of certain software titles with consumer and retailer discounts and rebates; discounting of sales prices of end-of-life-cycle and time-sensitive legal settlement related products; and sales of newly-developed promotional titles with lower per unit margins. Also negatively impacting the Company's gross profit margin was a 12.2% increase, as a percentage of net sales, in distribution, packaging and reclamation costs, largely associated with the Company's product shipments to food and drug retailers, which related revenues were deferred until such time (if ever) that these products sales to the end consumer are reported to the Company by the food and drug retailer. Operating Expenses Product development expenses for the quarter ended September 30, 2000 were $181,000 compared to $243,000 for the quarter ended September 30, 1999, a decrease of $62,000 or 26%. This decrease was caused primarily by a $45,000 decrease in salary and related costs due to headcount reductions among the Company's technology-related staff and no employee bonus accrual for the quarter ended September 30, 2000. Selling, general and administrative expenses for the quarter ended September 30, 2000 were $1,440,000 compared to $1,352,000 for the quarter ended September 30, 1999, an increase of $88,000 or 7%. This $88,000 increase was caused primarily by an $85,000 increase in marketing promotional expenses associated primarily with the increase in product shipments to food and drug retailers and the additional costs charged by traditional software retailers and distributors to support sales of the Company's products relating to the increased competition for retail shelf space. These promotional costs incurred with food and drug retailers are intended to increase the sell-through rate of the Company's products during the short-term promotional programs that these retailers offer periodically to their customers, as well as expand the longer-term placement of the Company's products in the food and drug channel through the Company's Store-in-a-Store program. This program is intended to reduce promotional expenses, as a percentage of net sales, due to more product sales having a longer selling period at these retail locations. Additionally, the Company continues to experience higher promotional costs in the traditional software retail channels due to increased competition for shelf space and the related Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) expenses charged by retailers and distributors to promote and support sales of the Company's products. Interest Expense, Net Net interest expense for the quarter ended September 30, 2000 was $7,000 compared to $4,000 for the quarter ended September 30, 1999, an increase of $3,000. The $3,000 increase was primarily due to the utilization of $500,000 under the revolving credit facility for the quarter ended September 30, 2000. Provision for Income Taxes Provision for income taxes for the quarter ended September 30, 2000 was $28,000 compared to $96,000 for the quarter ended September 30, 1999, a decrease of $68,000 or 71%. This $68,000 decrease in the provision for income taxes was primarily due to the $1,193,000 increase in the Company's loss from continuing operations before income taxes for the quarter ended September 30, 2000. Loss from Continuing Operations As a result of the various factors discussed above, the Company recognized a $1,263,000 loss from continuing operations for the quarter ended September 30, 2000, compared to a $137,000 loss from continuing operations for the quarter ended September 30, 1999, an increase of $1,126,000 in a loss from continuing operations. Income (Loss) from Discontinued Operation The (loss) from discontinued operation for the quarter ended September 30, 2000 was ($21,000), net of a $25,000 income tax benefit, compared to income from discontinued operation for the quarter ended September 30, 1999 of $63,000, net of a $7,000 income tax benefit, resulting in an $84,000 decrease in income from discontinued operation. This $84,000 decrease was caused primarily by a $141,000 increase in operating expenses largely associated with increased marketing promotion costs to support product sales, which was partially offset by increases in gross profit and income tax benefit of $39,000 and $18,000, respectively. Net loss As a result of the factors discussed above, net loss increased to $1,284,000 for the quarter ended September 30, 2000 from a net loss of $74,000 for the quarter ended September 30, 1999, an increase in net loss of $1,210,000. Weighted Average Common Shares The weighted average common shares outstanding on a diluted basis increased by 116,002 for the quarter ended September 30, 2000 to 9,749,975 from 9,633,973 for the quarter ended September 30, 1999. This 116,002 increase in weighted average common shares outstanding was caused primarily by an increase in the number of common stock shares outstanding during the current period. Common stock equivalents ("CSE's") were excluded from the weighted average shares calculations due to their anti-dilutive impact caused by both quarter's net losses. Liquidity and Capital Resources As of September 30, 2000, the Company's cash and working capital balances were $272,000 and $1,903,000, respectively, and the Company's total stockholders' equity balance at September 30, 2000 was $2,351,000. Net cash used in operating activities was $1,341,000 and $879,000 for the quarters ended September 30, 2000 and 1999, respectively. The $1,341,000 in net cash used in operating activities resulted primarily from the Company's net loss of $1,284,000 for the current quarter. Additional items contributing to the $1,341,000 in net cash used in operating activities were increases in accounts receivable of $369,000 and inventory of $419,000 and a $544,000 decrease in accounts payable, which net cash uses were partially offset by cash sources of $1,009,000 in customer advance payments and $346,000 in increased accrued expenses. The $1,009,000 in customer advance payments approximates the amount of customer payments from food and drug retailers that have exceeded the amount of revenue recognized by the Company relating to the actual product sell through of the Company's products to the end consumer reported by food and drug retailers. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Net cash used in investing activities for the quarters ended September 30, 2000 and 1999 was $12,000 and $29,000, respectively. The $12,000 in net cash used in investing activities resulted from purchases of $10,000 in furniture and equipment and $2,000 in other assets. Net cash provided by financing activities for the quarters ended September 30, 2000 and 1999 was $486,000 and $96,000, respectively. The $486,000 in net cash provided by financing activities reflects net proceeds from the Company's borrowing of $750,000 under the revolving credit facility, which was partially offset by repayments of this borrowing under the revolving credit facility, note payable and capital lease obligations of $250,000, $13,000 and $1,000, respectively. Net cash provided by the Company's discontinued operation for the quarters ended September 30, 2000 and 1999 was $7,000 and $45,000, respectively. As September 30, 2000, the Company had received $1,009,000 in customer payments from certain food and drug retailers for products shipped to such retailers prior to the sale of such products to the end consumer being reported to the Company from these retailers. These payments are recorded as customer advance payments in the Company's Consolidated Balance Sheet until such time that these retailers report to the Company that the products are actually sold to the end consumer. After the products are sold through to the end consumer, the customer advance payment amount is recorded as product revenue. In the event that the Company receives customer advance payments that ultimately exceed the actual product sell-through of the Company's products to the end consumer at such retailers, the Company would owe these retailers such excess amounts. The Company's management believes that it is highly likely that the ultimate product sell-through of the Company's products will be substantially less than the customer advance payment balances for these food and drug retailers. If these retailers request that the Company repay this liability, it would likely result in a serious liquidity issue for the Company. On August 9, 2000, the Company entered into a $2,000,000 revolving credit facility ("new credit facility") with a commercial bank, which expires on October 31, 2001. This new credit facility replaced the $1,500,000 revolving credit facility that it previously had with another commercial bank. Amounts outstanding under this new credit facility are charged interest at one-half of one percent above the bank's current prime rate and such interest is due monthly. The new credit facility is collateralized by substantially all of the Company's assets. The new credit facility requires the Company, among other things, to maintain certain financial ratios, such as: a minimum working capital balance of $1,500,000 and a maximum senior debt to effective net worth ratio of 1.50 to 1.00. Additionally, this new credit facility has a minimum effective net worth covenant starting at $3.1 million at June 30, 2000 and increasing by $150,000 quarterly to a $3.7 million requirement at June 30, 2001. As of September 30, 2000, the Company was not in compliance with the minimum effective net worth covenant and the maximum senior debt to effective net worth covenant. This new credit facility was established to provide, among other things, additional working capital to support the Company's anticipated growth. As of November 13, 2000, the Company had a $500,000 outstanding balance under this new credit facility. The Company's ability to achieve and maintain positive cash flow depends upon a variety of factors, including the timeliness and success of the collection of outstanding accounts receivable, the creditworthiness of the primary distributors and retail customers of the Company's products, the continuing retail demand for value-priced PC game software, the development and sell-through of the Company's products, the costs of developing, producing and marketing such products, and various other factors, some of which are beyond the Company's control. In the future, the Company expects its cash and working capital requirements to be affected by each of these factors. The Company believes cash and working capital balances, in addition to the Company's revolving credit facilities mentioned above, will be sufficient to fund the Company's operations for the next twelve months. However, there can be no assurances that the Company will be able to achieve and maintain a positive cash flow or that additional financing will be available if and when required or, if available, will be on terms satisfactory to the Company. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) On November 10, 2000, the Company received notification from Nasdaq that its common stock had failed to maintain a minimum bid price of $1.00 over a period of 30 consecutive trading days as required for continued listing on the Nasdaq SmallCap Market as set forth in Marketplace Rule 4310 (c) (4) (the "Rule"). In accordance with Marketplace Rule 4310 (c) (8) (B), the Company had 90 calendar days, or until February 8, 2001, to regain compliance with this Rule. On February 7, 2001, the Company requested a hearing before a Nasdaq Listing Qualifications Panel, which stayed the delisting of the Company's common stock from the Nasdaq SmallCap Market pending the Panel's decision. The Company's hearing had been scheduled for March 23, 2001. The Company did not attend the scheduled hearing because management did not believe that it had sufficient evidence to present to the hearing board, as of March 23rd, that would have caused them to further stay the Company's de-listing. Accordingly, effective April 2, 2001, the Company's common stock began trading on the OTC Bulletin Board under its existing symbol EGAM. The Company's common stock had traded on the Nasdaq SmallCap Market since October 1995. New Accounting Pronouncements During the first quarter of fiscal 2001, the Company adopted Emerging Issues Task Force ("EITF") 00-14, "Accounting for Certain Sales Incentives". Accordingly, net sales amounts for current and prior periods reflect the reclassification of consumer and retailer rebate costs, from selling, general and administrative expenses to net sales. Additionally, the Company has evaluated its revenue recognition policies based upon Staff Accounting Bulletin 101 "Revenue Recognition" and related amendments and interpretations. Accordingly, the Company determined it should recognize revenues for fiscal 2001 and 2000 associated with product shipments to food and drug retailers based on the timing of the actual product sell-through activity to the end consumer of the Company's products at these retail locations and not at the time the Company ships its products to these food and drug retailers. The Company made this decision following its determination that it was not able to adequately estimate, at time of product shipment, the amount of product returns for product shipments to food and drug retailers. Revenues associated with the Company's product shipments to its customers that traditionally have sold consumer PC software products (such as mass-merchant retailers, or distributors servicing such retailers) are recognized at the time title to these products passes to these customers, less a historically-based provision for anticipated product returns. The Company is currently evaluating the potential impact of Emerging Issues Task Force ("EITF") 00-10 "Accounting for Shipping and Handling Fees and Costs". This pronouncement will become effective by the Company's fourth quarter of fiscal 2001. The Company does not expect the adoption of EITF 00-10 to have a significant impact on its results of operations, financial position or cash flows. SIGNATURES In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. eGames, Inc. (Registrant) Date: March 26, 2002 /s/ Gerald W. Klein -------------- -------------------- Gerald W. Klein, President, Chief Executive Officer and Director Date: March 26, 2002 /s/ Thomas W. Murphy -------------- -------------------- Thomas W. Murphy, Chief Financial Officer and Chief Accounting Officer