-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, IZQRht+grxrTB9XxGo6PB++4tF8ngJtYtbf8/73hKGXVi6AjP1Phl8bRWAladJGK U87eyM5vL/0hd/YuKrjXKA== 0000948703-03-000027.txt : 20031113 0000948703-03-000027.hdr.sgml : 20031113 20031113151610 ACCESSION NUMBER: 0000948703-03-000027 CONFORMED SUBMISSION TYPE: 10QSB PUBLIC DOCUMENT COUNT: 1 CONFORMED PERIOD OF REPORT: 20030930 FILED AS OF DATE: 20031113 FILER: COMPANY DATA: COMPANY CONFORMED NAME: EGAMES INC CENTRAL INDEX KEY: 0000948703 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-PREPACKAGED SOFTWARE [7372] IRS NUMBER: 232694937 STATE OF INCORPORATION: PA FISCAL YEAR END: 0630 FILING VALUES: FORM TYPE: 10QSB SEC ACT: 1934 Act SEC FILE NUMBER: 000-27102 FILM NUMBER: 03997760 BUSINESS ADDRESS: STREET 1: 2000 CABOT BLVD STREET 2: SUITE 110 CITY: LANGHORNE STATE: PA ZIP: 19047-1833 BUSINESS PHONE: 2157506606 MAIL ADDRESS: STREET 1: 2000 CABOT BLVD SUITE 110 CITY: LANGHORNE STATE: PA ZIP: 19047-1833 10QSB 1 q12004-10qsb.txt EGAMES, INC. FORM 10 QSB Q1-2004 U.S. SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-QSB (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, 2003 |_| 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: 9,989,337 shares of common stock, no par value per share, as of November 10, 2003. Transitional Small Business Disclosure Format (check one): Yes ( ) No (X) INDEX Page Part I. Financial Information Item 1. Financial Statements: Balance Sheet as of September 30, 2003.................... 3 Statements of Operations for the three months ended September 30, 2003 and 2002 .................... 4 Statements of Cash Flows for the three months ended September 30, 2003 and 2002..................... 5 Notes to Financial Statements............................. 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations .................. 15 Risk Factors.............................................. 26 Item 3. Controls and Procedures................................... 31 Part II Other Information Item 6. Exhibits and Reports on Form 8-K.......................... 32 Exhibit Index .......................................................... 32 Signatures .......................................................... 33 Exhibits .......................................................... 34 Item 1. Financial Statements eGames, Inc. Balance Sheet (Unaudited) As of September 30, ASSETS 2003 ----------- Current assets: Cash and cash equivalents $ 757,524 Accounts receivable, net of allowances totaling $865,252 1,659,951 Inventory 609,952 Prepaid and other expenses 309,345 ----------- Total current assets 3,336,772 Furniture and equipment, net 22,875 ----------- Total assets $ 3,359,647 =========== LIABILITIES AND STOCKHOLDERS' EQUITY Current and total liabilities: Accounts payable $ 584,098 Accrued expenses 543,335 ----------- Total current liabilities and total liabilities 1,127,433 Stockholders' equity: Common stock, no par value (40,000,000 shares authorized; 10,221,237 issued and 9,989,337 outstanding) 9,179,827 Additional paid-in capital 1,251,195 Accumulated deficit (7,697,391) Treasury stock, at cost - 231,900 shares (501,417) ----------- Total stockholders' equity 2,232,214 ----------- Total liabilities and stockholders' equity $ 3,359,647 =========== See accompanying notes to financial statements. eGames, Inc. Statements of Operations (Unaudited) Three months ended September 30, --------------------------- 2003 2002 ------------ ------------ Net sales $ 2,052,472 $ 1,859,156 Cost of sales 818,185 879,803 ------------ ------------ Gross profit 1,234,287 979,353 Operating expenses: Product development 126,390 102,806 Selling, general and administrative 602,284 645,292 ------------ ------------ Total operating expenses 728,674 748,098 ------------ ------------ Operating income 505,613 231,255 Interest expense, net 4,983 18,475 ------------ ------------ Income before income taxes 500,630 212,780 Provision for income taxes 22,284 - 0 - ------------ ------------ Net income $ 478,346 $ 212,780 ============ ============ Net income per common share: - Basic $ 0.05 $ 0.02 ============ ============ - Diluted $ 0.05 $ 0.02 ============ ============ Weighted average common shares outstanding - Basic 9,989,337 9,989,337 Dilutive effect of common share equivalents 483,761 303,344 ------------ ------------ Weighted average common shares outstanding - Diluted 10,473,098 10,292,681 ============ ============ See accompanying notes to financial statements. eGames, Inc. Statements of Cash Flows (Unaudited)
Three months ended September 30, -------------------------- 2003 2002 ----------- ----------- Cash flows from operating activities: Net income $ 478,346 $ 212,780 Adjustment to reconcile net income to net cash used in operating activities: Stock-based compensation 8,058 34,260 Depreciation, amortization and other non-cash items 4,152 10,704 Provisions for product returns, price markdowns, bad debts and inventory obsolescence, net of adjustments 392,073 355,730 Changes in items affecting operations: Accounts receivable (821,128) (903,891) Prepaid and other expenses (72,109) 27,663 Inventory (192,798) 14,555 Accounts payable 11,001 257,681 Accrued expenses (66,534) (211,858) ----------- ----------- Net cash used in operating activities (258,939) (202,376) ----------- ----------- Cash flows from investing activities: Purchases of furniture and equipment (7,774) - 0 - ----------- ----------- Net cash used in investing activities (7,774) - 0 - ----------- ----------- Cash flows from financing activities: Repayments of credit facility/bank debt - 0 - (210,000) Repayments of note payable - 0 - (16,592) ----------- ----------- Net cash used in financing activities - 0 - (226,592) ----------- ----------- Net decrease in cash and cash equivalents (266,713) (428,968) Cash and cash equivalents: Beginning of period 1,024,237 700,109 ----------- ----------- End of period $ 757,524 $ 271,141 =========== =========== Supplemental cash flow information: Cash paid for interest $ 5,475 $ 18,475 =========== =========== Cash received from income tax refunds $ 253 $ - 0 - =========== ===========
See accompanying notes to financial statements. eGames, Inc. Notes to Financial Statements 1. Summary of Significant Accounting Policies Description of Business eGames, Inc. is a Pennsylvania corporation incorporated in July 1992 that publishes, markets and sells value-priced consumer entertainment PC software games. PC software games today are a substantial consumer products category at mass-merchant and specialty retail stores. Our product line enables us to serve consumers who are seeking a broad range of high-quality, value-priced PC software, distributed on CD-ROM media and also electronically via the Internet. In North America, our products are mostly distributed through third-party distributors on a non-exclusive basis who service mass-merchant and specialty retailers. We also sell our products directly to certain PC software retailers. In territories outside North America, our products are distributed through third-party distributors that license our PC software content for their own manufacture and distribution within specific geographic territories. The word "customer (s)" as used in this document is defined as third-party distributor (s)and/or retailer (s), as compared to the word "consumer (s)," which is defined as being the end consumer (s) shopping at retail stores or over the Internet. Liquidity As of September 30, 2003, we had stockholders' equity of $2,232,000 and working capital of $2,209,000. For the three months ended September 30, 2003, we earned net income of $478,000. Additionally, as of September 30, 2003, we had a cash balance of $757,000 representing a $267,000 decrease in cash since June 30, 2003. From the first quarter of fiscal 2002 until September 18, 2003, the date on which we entered into our new credit facility agreement, we did not have access to a credit facility and had been dependent entirely on cash flow from operations to meet our financial obligations. Our ability to achieve and maintain positive cash flow remains essential to our survival as a going concern, because our access to this credit facility is limited to the lesser of $500,000 or seventy-five percent of our qualified accounts receivable. Our ability to do this depends upon a variety of factors, including the timing of the collection of outstanding accounts receivable, the creditworthiness of the primary distributors and retail customers of our products, and sell-through of our products to consumers, and the costs of producing and marketing such products. We believe that our projected cash and working capital balances may be sufficient to fund our operations, including the contractual obligations and commitments described in our "Management's Discussion and Analysis of Results of Operations and Financial Condition", through June 30, 2004, but there are significant challenges that we will need to successfully manage in order to be able to fund our operations through that period of time and beyond. These challenges include, but are not limited to: agreeing to and maintaining acceptable payment terms with our vendors; and maintaining timely receivable payments from a concentrated group of customers. Additionally, our accounts payable have historically increased substantially during our first and second fiscal quarters (third and fourth calendar quarters) when we increase the amount of inventory we purchase to meet anticipated customer orders for the back to school and holiday selling seasons. If we are not paid timely by our customers during the period following this seasonal increase in inventory purchases, we may have difficulty paying our vendors in a timely manner, which would then significantly impact our ability to continue normal operations. Additionally, there are market factors beyond our control that could also significantly affect our operating cash flow. The most significant of these market factors is the market acceptance and sell-through rates of our current products to consumers, and the growth of the consumer entertainment PC software market, and in particular our share of that market. If any of our software titles do not sell through to consumers at the rate anticipated, we could be exposed to additional product returns or price markdowns and a lack of customer replenishment orders for these products. As a result of these factors, we may not be able to achieve or maintain positive cash flow. Additional outside financing to supplement our cash flows from operations may not be available if and when we need it. Even if such financing were available from a bank or other financing source, it may not be on terms satisfactory to us because of the dilution it may cause or other costs associated with such financing. Basis of Presentation The accompanying unaudited interim financial statements were prepared in accordance with generally accepted accounting principles for interim financial information as promulgated in the United States of America. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. The Notes to Financial Statements included in our Form 10-KSB for the fiscal year ended June 30, 2003 should be read in conjunction with the accompanying statements. These statements include all adjustments that management believes are necessary for a fair presentation of the statements. These interim operating results are not necessarily indicative of the results for a full year. Certain dollar amounts discussed within the "Notes to Financial Statements" have been rounded to the nearest thousand ("000"). Fair Value of Financial Instruments The recorded amounts of accounts receivable and accounts payable at September 30, 2003 approximate fair value due to the relatively short period of time between origination of the instruments and their expected realization. All liabilities are carried at cost, which approximate fair value for similar instruments. Cash and Cash Equivalents For purposes of the statements of cash flows, we consider all highly liquid instruments purchased with an original maturity of three months or less to be cash equivalents. Accounts Receivable, net Accounts receivable is reflected at the amount we expect to ultimately collect from outstanding customer balances, and is shown on our balance sheet net of allowances for product returns, price markdowns and bad debts. The adequacy of these allowances is reviewed at the end of each reporting period and any necessary adjustments to these allowances are made through additional provisions for: product returns and price markdowns (reflected as a reduction to net sales); and customer bad debts (reflected as an operating expense). Actual product returns, price markdowns and bad debts are recorded as reductions to these allowances as well as reductions to the customers' individual accounts receivable balances. Inventory Inventory, consisting primarily of finished goods, is valued at the lower of cost or market. Cost is determined by the first-in, first-out method (FIFO). Furniture and Equipment Furniture and equipment are stated at cost. Depreciation is calculated on the straight-line method over the estimated useful lives of the assets ranging from three to five years. Leasehold improvements have been fully amortized on the straight-line method over the shorter of the lease term or estimated useful life of the assets. Maintenance and repair costs are expensed as incurred. Long-Lived Assets In accordance with Statement of Financial Accounting Standards ("SFAS") No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," we record impairment losses on long-lived assets, including intangible assets, used in operations when the fair value of those assets, less the cost to sell, is lower than our carrying value for those assets. Intangible Assets As of September 30, 2003, we had intangible assets totaling $741,000, which costs have been fully amortized. These assets resulted primarily from the purchase of software rights, and their expense was amortized, on a straight-line basis, over no more than a three-year period. For the three months ended September 30, 2003 and 2002, we did not record any amortization expense. Revenue Recognition Product Sales: - -------------- We distribute the majority of our products through third-party distributors to mass-merchant retailers and directly to certain PC software retailers. These retailers have traditionally sold consumer entertainment PC software products. The distribution of our products is governed by distribution agreements, direct sale agreements or purchase orders, all of which generally allow for product returns and price markdowns. We recognize revenues from product shipments to the customers that traditionally have sold consumer entertainment PC software products at the time title to our inventory passes to these customers, less a provision for anticipated product returns and price markdowns. The provision for anticipated product returns and price markdowns is based upon, among other factors: historical product return and price markdown results, analysis of customer provided product sell-through and field inventory data when available to us, the introduction of new and/or competing software products, review of outstanding return material authorizations, and the extent to which new products with higher price points or unproven genres are being launched. 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 sales transaction. Most of our customers require shipping terms of FOB destination, which results in the title to our product passing at the time when the customer actually receives our product. In order to recognize revenues associated with customer purchase orders having terms of FOB destination, we obtain proof of deliveries from the freight companies that deliver our products to our customers for product shipments made during the last two weeks of a reporting period. Revenues and cost of revenues associated with product shipments received by our customers after the reporting period and having FOB destination terms are excluded from the current period's operating results. The results of the sales cut-off tests are reviewed by our Controller, Chief Financial Officer and independent auditors before the period's earnings release is distributed. We recognize product sales to the customers that traditionally have sold consumer entertainment 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 us, title of the product transfers to the buyer, the buyer has economic substance apart from us, we do not have further obligations to assist the buyer in the resale of the product and the product returns and price markdowns can be reasonably estimated at the time of sale. After deliveries to our distribution and retail customers are made, we do not provide any further services or materials that are essential to our products' functionality. However, we do provide basic telephone and web-based customer support to consumers who purchase our products as a means of fostering consumer loyalty. Costs associated with our customer support effort usually occur within one year from the period we recognize revenue and these costs have continued to be minimal (averaging about 1% of net sales). These costs to render our customer support services, which are comprised of the salary and related costs of our one customer support representative, are expensed in the period incurred and are reflected within the Statements of Operations as operating expenses under "Selling, general and administrative." Prior to fiscal 2003, we recognized revenues for product shipments to customers that have not traditionally sold consumer entertainment PC software products (primarily drug store retailers and distributors) when our products actually sold through to the end consumer at these retail locations or when the right of return no longer existed. We did not recognize these revenues at the time we shipped our products to these drug store retailers or distributors based upon our revenue recognition policy for these types of customers. During fiscal 2002, we transitioned our direct distribution relationships with drug store retailers to a licensing relationship with a third-party distributor, United American Video ("UAV"), which assumed the responsibilities and costs of: order processing and receivable collections, inventory production, distribution, promotion and merchandising of our products to these drug store retailers. We recognize licensing revenues, which are reflected in net sales, based upon contractual royalty rates applied to the licensees' net sales of our software titles during each reporting period. Provision for Product Returns and Price Markdowns: - -------------------------------------------------- We currently distribute the majority of our products through third-party distributors to mass-merchant retailers and directly to certain PC software retailers, which retailers have traditionally sold consumer entertainment PC software products. The distribution of our products is governed by distribution agreements, direct sale agreements or purchase orders, all of which generally allow for product returns and price markdowns. The provision for anticipated product returns and price markdowns is based upon, among other factors, our analysis of historical product return and price markdown results, product sell-through results at retail store locations, current field inventory quantities at distributors' warehouses and at retail store locations, outstanding return material authorizations, and the introduction of new and/or competing software products that could negatively impact the sales of one or more of our current products. The adequacy of our allowance for product returns and price markdowns is reviewed at the end of each reporting period and any necessary adjustment to this allowance (positive or negative) is reflected within the current period's provision. At the end of each reporting period, the allowance for product returns and price markdowns is reflected as a reduction to the accounts receivable balance reflected on our balance sheet. During the three months ended September 30, 2003 and 2002, our provisions for product returns and price markdowns for customers that have traditionally sold consumer entertainment PC software products (inclusive of inventory liquidation distributors) were $308,000 and $316,000, respectively, or 14% and 15% of related gross sales, respectively. Prepaid and Other Expenses Prepaid and other expenses represent advance payments made to third parties for, among other things, items such as licensing of software and intellectual properties used in our products, maintenance contracts, certain insurance coverage and retailers' slotting fees. Prepaid and other expenses are expensed at contractual rates or on a straight-line basis over the period of time covered by a contract. Marketing, Sales Incentive and Promotional Costs Marketing costs reflected as operating expenses, such as advertising fees and display costs, are charged to expense as incurred or when shipped to a customer. These costs were $23,000 and $19,000 for the three months ended September 30, 2003 and 2002, respectively. Sales incentives, such as rebates and coupons, that we grant retailers or consumers are recorded as reductions to net sales as incurred, and were $26,000 and $10,000 for the three months ended September 30, 2003 and 2002, respectively. Promotional costs, such as slotting fees required by certain retailers, are recorded as reductions to net sales on a straight-line basis over the contractual period. These costs were $32,000 and $52,000 for the three months ended September 30, 2003 and 2002, respectively. Income Taxes We use the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and for net operating loss and credit carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. Computation of Net Income per Common Share Net income per common share is computed in accordance with SFAS No. 128, "Earnings per Share". Basic earnings per share is computed by dividing net earnings by the weighted average number of common shares outstanding during each period. Diluted earnings per share is computed by dividing net earnings by the weighted average number of common shares and common share equivalents ("CSE's") outstanding during each period that we report net income. CSE's may include stock options and warrants using the treasury stock method. Accounting for Stock-Based Compensation As of July 1, 2002, we adopted within our financial statements the provisions of SFAS No. 123, "Accounting for Stock-Based Compensation," by applying the fair value method for stock option grants made on or after that date. For stock option grants made prior to July 1, 2002, we recognized stock-based compensation using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25). As of January 1, 2003, we adopted the provisions of SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure" (see Note 10). Management's Estimates The 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, including allowances for inventory obsolescence, product returns, price markdowns and bad debts (from uncollectible accounts receivable), and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. We recognize the critical nature and potential impact from making these and any other estimates and attempt to make reliable estimates, based upon the information available to us as of any reporting period. However, we also recognize that actual results could differ from any of our estimates and such differences could have a negative or positive impact on future financial results. New Accounting Pronouncements In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation -- Transition and Disclosure -- an Amendment of FASB Statement No. 123". SFAS No. 148 amends FASB Statement No. 123, "Accounting for Stock-Based Compensation", to provide alternative methods of transition for an entity that voluntarily changes to the fair-value-based method of accounting for stock-based employee compensation. It also amends the disclosure provisions of that statement to require prominent disclosure about the effects on reported net income and earnings per share and the entity's accounting policy decisions with respect to stock-based employee compensation. Certain of the disclosure requirements are required for all companies, regardless of whether the fair value method or intrinsic value method is used to account for stock-based employee compensation arrangements. This amendment to SFAS No. 123 became effective for financial statements for fiscal years ended after December 15, 2002 and for interim periods beginning after December 15, 2002. Accordingly, we adopted the disclosure provisions of this statement effective January 1, 2003. In March 2003, the Emerging Issues Task Force published Issue No. 00-21 "Accounting for Revenue Arrangements with Multiple Deliverables" (EITF 00-21). EITF 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which it performs multiple revenue generating activities and how to determine whether such an arrangement involving multiple deliverables contains more than one unit of accounting for purposes of revenue recognition. The guidance in this Issue is effective for revenue arrangements entered in fiscal periods beginning after June 15, 2003. The adoption of EITF 00-21 on July 1, 2003 did not have any impact on our financial statements. 2. Accounts Receivable, net Accounts receivable consists of the following: Accounts receivable, gross $ 2,525,203 Allowance for product returns (773,880) Allowance for price markdowns (77,372) Allowance for bad debts (14,000) ----------- Accounts Receivable, net $ 1,659,951 =========== 3. Inventory Inventory consists of the following: Raw materials $ 167,257 Finished goods 437,380 Product returns, estimated 130,253 ----------- 734,890 Allowance for inventory obsolescence (124,938) ----------- Inventory $ 609,952 =========== 4. Prepaid and Other Expenses Prepaid and other expenses consists of the following: Advance royalty fees $ 140,582 Prepaid insurance expenses 109,746 Slotting fees 41,000 Other expenses 18,017 ----------- Prepaid and Other Expenses $ 309,345 =========== 5. Furniture and Equipment, net Furniture and equipment consists of the following: Furniture and equipment $ 912,279 Accumulated depreciation (889,404) ----------- Furniture and Equipment, net $ 22,875 =========== 6. Accrued Expenses Accrued expenses consist of the following: Accrued payroll, bonus and vacation expenses $ 120,974 Accrued royalty fees 110,475 Inventory receipts 107,828 Customers with credit balances 59,696 Accrued professional fees 40,730 Income taxes 32,538 Accrued marketing promotion costs 24,665 Other accrued expenses 46,429 ----------- Accrued Expenses $ 543,335 =========== 7. Dependence on One Major Distributor We distribute the majority of our products through third-party software distributors to mass-merchant retailers and directly to certain PC software retailers. These retailers have traditionally sold consumer entertainment PC software products successfully, and they typically designate the distributor they want us to use to fulfill the distribution of our products to their stores, or they may decide to have us distribute our products directly to them. Atari, Inc. ("Atari") is our primary North American distributor serving the major mass-merchant retailers in North America, such as Wal-Mart, Target and Best Buy, among others. During the three months ended September 30, 2003 and 2002, Atari accounted for $1,569,000 and $992,000, in net sales, or 76% and 53% of net sales, respectively. We have continued to increase our product distribution through Atari to these major mass-merchant retailers by increasing the number of retail facings - designated positions for our software titles within a retailer's shelf space - in these retailers' stores. eGames' financial condition and our ability to continue as a going concern could be significantly affected in the event that we would lose our distribution capability through Atari. However, product distribution to these retailers is a competitive business within itself and there are other distributors who also serve these leading national retail chains. These alternative distributors could potentially distribute our products to these retailers if, for example, Atari would chose to discontinue distributing our titles or if any of these retailers would decide to discontinue their relationship with Atari. 8. Commitments and Contingencies Our 5,000 square foot office facility located in Langhorne, Pennsylvania is occupied under an operating lease that is scheduled to expire on September 30, 2004. Additionally, we currently rent certain office equipment through various operating lease agreements. Net rent expense incurred under our operating leases was $21,000 and $18,000 for the three month periods ended September 30, 2003 and 2002, respectively. Under various licensing agreements with third-party software developers, we are required to pay royalties for the use of licensed content in our products. Royalty expense under such agreements, which is recorded in cost of sales, was $226,000 and $224,000 for the three months ended September 30, 2003 and 2002, respectively. Additionally, most of these licensing agreements require us to make advance royalty payments to these developers prior to the time we recognize any net sales of software titles containing this licensed software content. We have commitments to pay $214,000 in advance royalty payments to various software developers under such agreements. Included in this $214,000, is our remaining obligation to pay Greenstreet Software Limited ("GSL") by August 2004 an advance royalty of $40,000 for the licensing of one of its PC software titles. In conjunction with the launching of a new software title, RealAge Games & Skills, the Company has two existing contracts that contain relatively significant financial commitments by the Company. Specifically, we have a $15,000 commitment remaining with a public relations firm for future services to be performed during fiscal 2004. A second contract for the license of a trademark requires that a second of two $50,000 advance royalty payments be made by May 2004, regardless of actual royalties earned. The first $50,000 advance royalty payment was made to this licensor during fiscal 2003 upon signing the contract, and is classified on our September 30, 2003 balance sheet within "Prepaid and other expenses". These guaranteed royalty and licensing commitments are expected to be funded by cash flows generated through anticipated income from operations. 9. International Sales, Licensing Revenues and Internet Sales International net sales (including both licensing revenues and product net sales) represented 4% and 3%, respectively, of net sales for the three months ended September 30, 2003 and 2002. For the three months ended September 30, 2003 and 2002, licensing revenues comprised 100% and 95%, respectively, of international net sales. Licensing revenues represented 5% and 6%, respectively, of net sales for the three months ended September 30, 2003 and 2002. Internet sales accounted for 2% of net sales for both three-month periods ended September 30, 2003 and 2002. 10. Accounting for Stock-based Compensation - Transition and Disclosure, per SFAS No. 148 As of September 30, 2003, we had one existing stock-based employee compensation plan, which was adopted, amended and restated during 1995. This Plan, known as our 1995 Amended and Restated Stock Option Plan (the "1995 Plan"), is administered by the Board of Directors and provides for the grant of incentive stock options and non-qualified stock options to employees and eligible independent contractors and non-qualified stock options to non-employee directors at prices not less than the fair market value of a share of common stock on the date of grant. At our fiscal 2000 Annual Meeting of Shareholders, the shareholders of our company approved an amendment to increase the number of shares available for issuance under the 1995 Plan from the 1,950,000 shares of common stock previously approved to a total of 2,950,000 shares. Prior to July 1, 2002, we accounted for all stock option grants under the recognition and measurement provisions of APB Opinion No. 25, "Accounting for Stock Issued to Employees", and related Interpretations. No stock-based employee compensation cost relating to stock option grants is reflected in net income before fiscal 2003, as all stock option grants had an exercise price equal or greater than the market value of the underlying common stock on the date of grant. Effective July 1, 2002, we adopted within our financial statements the provisions of SFAS No. 123, "Accounting for Stock-Based Compensation" by applying the fair value method prospectively for stock options grants made on or after that date. Therefore, the cost related to stock-based employee compensation included in the determination of net income for the three months ended September 30, 2003 and 2002 is less than that which would have been recognized if the fair value based method had been applied to all stock option grants since the original effective date of SFAS No. 123. Additionally, the stock-based employee compensation amounts ($23,010 and $91,245) included in the table below for the three months ended September 30, 2002 do not include $11,250 in stock-based compensation expense reflected in that period's net income, due to being related to a common stock warrant issued to a non-employee third-party (Fleet Bank). As of January 1, 2003, we adopted the provisions of SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure". Accordingly, the following table illustrates the effect on net income and net income per share if the fair value method had been applied to all outstanding stock option grants in each period.
Three Months Ended September 30, --------------------- 2003 2002 --------- --------- Net income, as reported $ 478,346 $ 212,780 Add: Stock-based employee compensation expense included in reported net income, net of tax effects 8,058 23,010 Deduct: Total stock-based employee compensation expense determined under fair value based method for stock option grants, net of tax effects (8,416) (91,245) --------- --------- Pro forma net income $ 477,988 $ 144,545 ========= ========= Net income per common share: - - Basic, as reported $ 0.05 $ 0.02 ======= ======= - - Basic, pro forma $ 0.05 $ 0.01 ======= ======= - - Diluted, as reported $ 0.05 $ 0.02 ======= ======= - - Diluted, pro forma $ 0.05 $ 0.01 ======= =======
11. Credit Facility and Repayment of Prior Bank Debt On September 18, 2003, we entered into a $500,000 credit facility agreement with Hudson United Bank ("HUB"), which matures on December 1, 2004. Amounts outstanding under this new credit facility will be charged interest at one-half of one percent above HUB's current prime rate and such interest is due monthly. Our access to these funds is limited to the lesser of $500,000 or seventy-five percent of qualified accounts receivable, which are defined as invoices less than ninety days old and net of any allowances for product returns, price markdowns or bad debts. The credit facility is secured by all of the Company's assets and requires us, among other things, to maintain the following financial covenants to be tested quarterly: a total liabilities to tangible net worth ratio of 1.25 to 1.00 and a tangible net worth requirement of $1.5 million. As of September 30, 2003, we were in compliance with each of those covenants. This credit facility was established to provide working capital for our operations. As of September 30, 2003, we did not have any outstanding balance under this credit facility. On January 16, 2003, we repaid the then remaining $420,000 principal balance outstanding on our term loan with Fleet Bank ("Fleet"), together with accrued interest, in full satisfaction of all obligations under the November 2, 2001 forbearance agreement and underlying loan documents. Additionally on January 16, 2003, we redeemed the warrant we had previously issued to Fleet in connection with the forbearance agreement for $50,000. 12. Operations by Reportable Segment and Geographic Area 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 our products, geographic areas and major customers. Based on our organizational structure, we operate in only one geographic area, which is North America, and one reportable segment, which is publishing consumer entertainment software for personal computers. 13. Listing of Company's Common Stock In April 2001, our common stock was delisted from the Nasdaq SmallCap Market as a result of our failure to maintain a minimum bid price of $1.00 over a period of 30 consecutive trading days. Our stock then began trading on the OTC Bulletin Board under the existing symbol EGAM. We periodically review our alternatives with respect to listing on an exchange, such as the American Stock Exchange or the Nasdaq SmallCap Market. At this time we do not meet several of the criteria for listing on these exchanges. We will, therefore, from time to time continue to evaluate our available alternatives to the OTC Bulletin Board. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations This Quarterly Report on Form 10-QSB contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All statements made in this Quarterly Report on Form 10-QSB, other than statements of historical fact, including statements regarding industry prospects and future results of operations or financial position, are forward looking. We use the words "believe", "expect", "anticipate", "intend", "will", "should", "may" and similar expressions to identify forward-looking statements. These forward-looking statements are subject to business and economic risk, and are inherently uncertain and difficult to predict. Our actual results could differ materially from management's expectations due to such risks. We will not necessarily update information if any forward-looking statement later turns out to be inaccurate. The following important factors, as well as those factors discussed under "Risk Factors" at pages 26 to 31 in this report, could cause our actual results to differ materially from those indicated by the forward-looking statements contained in this report: - the market acceptance and successful sell-through results for our products at retail stores, particularly at North American mass-merchant retailers where consumer entertainment PC software has traditionally been sold; - the continued successful business relationship between us and Atari, as our largest customer and our distributor to Wal-Mart, Target, and Best Buy, among others; - the amount of unsold product that is returned to us by retail stores and distributors; - the amount of price markdowns granted to retailers and distributors; - our ability to accurately estimate the amount of product returns and price markdowns that will occur and the adequacy of the allowances established for such product returns and price markdowns; - the successful sell-through to consumers of our new higher price point products, in all retail channels where they are sold; - the continued success of our current business model of selling, primarily through third-party distributors, to a concentrated number of select mass-merchant, specialty and PC software retailers; - our ability to control the manufacturing and distribution costs of our software titles; - the success of our distribution strategy, including the ability to continue to increase the distribution of our products into key North American mass-merchant retailers and to enter into new distribution and direct sales relationships on commercially acceptable terms; - the allocation of shelf space (retail facings) for our products in major retail chain stores; - the ability of our international product distribution through licensing agreements to earn a royalty and the ability of our licensees to pay us such royalties within agreed upon terms; - our ability to collect outstanding accounts receivable and establish an adequate allowance for bad debts; - the continued increase in the number of computers in homes in North America and worldwide; - the ability to deliver products in response to customer orders within a commercially acceptable time frame; - downward pricing pressure; - fluctuating costs of producing and marketing our products; - our ability to license quality content for our products; - the success of our efforts to increase website traffic and product sales over the Internet; - consumers' continued demand for value-priced consumer entertainment PC software; - increased competition in the value-priced software category; and various other factors, many of which are beyond our control. Critical Accounting Policies - ---------------------------- Our significant accounting policies and methods used in the preparation of the Financial Statements are discussed in Note 1 of the Notes to Financial Statements. We believe our accounting policies with respect to revenue recognition and the valuation of inventory involve the most significant management judgments and estimates. Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make and judgments and estimates that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to product returns, price markdowns, bad debts, inventory obsolescence, income taxes, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. Revenue Recognition (Net Sales, Product Returns and Price Markdowns) - -------------------------------------------------------------------- Significant management judgments and estimates must be made and used in order to determine when revenues can be recognized in any reporting period. Material differences may result in the amount and timing of our revenue for any period if management's judgments or estimates for product returns or price markdowns prove to be insufficient or excessive based upon actual results. These differences, if material, would significantly affect our operating results and financial condition in any given period. We distribute the majority of our products through third-party distributors to mass-merchant retailers and directly to certain PC software retailers. These retailers have traditionally sold consumer entertainment PC software products. The distribution of our products is governed by purchase orders, distribution agreements or direct sale agreements, all of which generally allow for product returns and price markdowns. For product shipments to distributors or retailers that have traditionally sold consumer entertainment PC software products, we record a provision for product returns and price markdowns as a reduction of gross sales at the time title of the product passes to the distributors or retailers. The provision for anticipated product returns and price markdowns is based upon many factors, including our analysis of historical product return and price markdown results, product sell-through results at retail store locations, current field inventory quantities at distributors' warehouses and at retail store locations, the introduction of new and/or competing software products that could negatively impact the sales of one or more of our current products, outstanding return material authorizations, and the extent to which new products with higher price points or unproven genres are being launched. The adequacy of our allowance for product returns and price markdowns is reviewed at the end of each reporting period and any necessary adjustment to this allowance (positive or negative) is reflected within the current period's provision. At the end of each reporting period, the allowance for product returns and price markdowns is reflected as a reduction to our gross accounts receivable balance and is reflected in "Accounts receivable, net of allowances" on our balance sheet. Historically, the allowance for product returns and price markdowns has represented a substantial portion of our gross accounts receivable. This occurs because we have product return exposure relating to paid receivables while the products relating to these receivables remain in the retailers' stores or in the retailers' or distributors' warehouses. Until the products actually sell through to the end consumers or are returned to us, we continue to evaluate our product return or price markdown exposure for these units not yet sold through to consumers. During these time periods, through customer provided reports, we have regular and timely visibility of the sell-through results for each title to help us estimate our exposure for product returns or price markdowns. Additionally, we have experienced significant sales growth to distributors and retailers that have traditionally sold consumer entertainment PC software games since June 30, 2002, so that our overall allowance for and exposure to product returns and price markdowns has increased as a function of having more total units of our products (combined with higher average selling prices for those units) in the traditional PC software retail channel. We recognize revenues from product shipments to distributors and retailers that have traditionally sold consumer entertainment PC software products in accordance with the criteria of SFAS No. 48, "Revenue Recognition When the Right of Return Exists," 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 us; title of the product transfers to the buyer; the buyer has economic substance apart from us; we do 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. Title passes to these distributors or retailers either upon shipment of the product or receipt of the product by these distributors or retailers based on the terms of the sale transaction. Most of our distributors and retailers require shipping terms of FOB destination, which results in the title to our product passing at the time that the distributors or retailers actually receive our product. In order to recognize revenues associated with customer purchase orders having terms of FOB destination, we obtain proof of deliveries from the freight companies that deliver our products to our customers for product shipments made during the last two weeks of a reporting period. Revenues and cost of revenues associated with product shipments received by our distributors or retailers after the reporting period and having FOB destination terms are excluded from the current period's operating results. The results of the sales cut-off tests for each reporting period are reviewed by our Controller, Chief Financial Officer and independent auditors before the reporting period's earnings release is distributed. During fiscal 2002, we recognized revenues for product shipments to customers that have not traditionally sold consumer entertainment PC software products (primarily drug store retailers and distributors serving these drug store retailers) when our products actually sold through to the end consumer at these retail locations or when the right of return no longer existed. We did not recognize these revenues at the time we shipped our products to these drug store retailers or distributors based upon our revenue recognition policy for these types of customers. During fiscal 2002, we discontinued the distribution of our products directly to these drug store retailers and distributors serving these drug store retailers. Inventory Valuation - ------------------- Our accounting policy for inventory valuation requires management to make estimates and assumptions as to the recoverability of the carrying value of inventory that affect the reported value of inventory and cost of sales for any reporting period. Differences may result in the valuation of our inventory at the close of any reporting period and the amount reflected as cost of sales during any reporting period, if management's judgments or estimates with respect to provisions for the potential impairment of inventory value prove to be insufficient or excessive based upon actual results. These differences, if material, would significantly affect our operating results and financial condition. We are exposed to product obsolescence due to the relatively short product life cycles (averaging six to eighteen months) of our consumer entertainment PC software products. From time to time, our competitors may introduce new products, capabilities or technologies that have the potential to replace or shorten the life cycles of our existing products, which would require us to write-down the value of such inventory. Additionally, from time to time, we have been subject to litigation or threatened litigation involving product content, which has caused certain products to no longer be saleable. License agreements with third-party software developers for product content may also expire before such inventory has been sold. Although we attempt to accurately match production requirements of our products to forecasted consumer demand, we may from time to time produce an amount of inventory of a product that exceeds the eventual consumer demand for such product. When this occurs, we attempt to liquidate these excess quantities of remaining inventory, frequently at closeout prices below their previous carrying costs net of our allowance for obsolescence. If we cannot liquidate such inventory, or if we are unable to sell any remaining units due to legal or other reasons, we then write down the remaining value to zero. The adequacy of our allowance for inventory obsolescence is reviewed at the close of each reporting period, and any adjustments (positive or negative) are reflected in the current period's provision. Results of Operations The following discussion should be read together with our Financial Statements and Notes beginning on page 3. The word "customer (s)" as used in this document is defined as third-party distributor (s) and/or retailer (s), as compared to the word "consumer (s)," which is defined as being the end consumer (s) shopping at retail stores or over the Internet. Three Months Ended September 30, 2003 Compared to the Three Months Ended September 30, 2002 Net Sales - --------- For the three months ended September 30, 2003, net sales increased by $193,000, or 10%, to $2,052,000 compared to $1,859,000 for the same quarter a year ago. The $193,000 increase in net sales resulted from a $506,000 increase in net product sales to traditional software distributors and retailers, due primarily to the increased distribution of our software titles to the major North American mass-merchant and specialty retailers served by our largest distributor (Atari, Inc.). This $506,000 net sales increase to traditional software distributors and retailers was partially offset by a $233,000 decrease in net product sales to inventory liquidation distributors and retailers, combined with a $75,000 decrease in net product sales to non-traditional software distributors and retailers and a $5,000 decrease in licensing revenues compared to the prior year's same quarter. The following tables represent our net sales by distribution channel and customer for the three months ended September 30, 2003 and 2002, respectively:
Three Months Ended September 30, ----------------------------------- Increase Distribution Channel 2003 2002 (Decrease) - -------------------------------------------------------------------- ----------- ----------- --------- Traditional software distributors and retailers $ 1,951,000 $ 1,445,000 $ 506,000 Inventory liquidation distributors and retailers - 0 - 233,000 (233,000) Non-traditional software distributors and retailers - 0 - 75,000 (75,000) Licensing revenues 101,000 106,000 (5,000) - -------------------------------------------------------------------- ----------- ---------- --------- Net Sales $ 2,052,000 $ 1,859,000 $ 193,000 =========== =========== =========
Three Months Ended September 30, ----------------------------------- Increase Customer Customer Type 2003 2002 (Decrease) - -------------------------------------- ----------------------------- ----------- ----------- --------- Atari Distributor $ 1,569,000 $ 992,000 $ 577,000 CompUSA Retailer 93,000 67,000 26,000 Jack of All Games Distributor 54,000 61,000 (7,000) Inventory liquidators, various Distributors & Retailers - 0 - 233,000 (233,000) Licensees, various Distributors 101,000 106,000 (5,000) Other Distributors & Retailers 235,000 400,000 (165,000) - -------------------------------------- ----------------------------- ----------- ----------- --------- Net Sales $ 2,052,000 $ 1,859,000 $ 193,000 =========== =========== =========
Increased distribution of our software titles to major North American mass-merchant and specialty retailers served by our largest distributor, Atari, Inc. ("Atari"), combined with an increase in our average selling price, were the major factors contributing to the $506,000 increase in net product sales to traditional software distributors and retailers. Our net product sales increase to Atari was $577,000 during the current quarter, which represented a 58% increase over the net product sales during the same quarter a year ago. As the table above indicates, we primarily sell our products through national software distributors, in particular, Atari, that serve North American mass-merchant retailers such as Wal-Mart, Target and Best Buy. We have also established direct sales relationships with certain PC software retailers, such as CompUSA, that require direct-to-store distribution and replenishment capability, and accordingly we have electronic data interchange ("EDI") hardware and software systems available in order to process these type of orders. We have continued to increase the number of retail facings - designated positions for our software titles within a retailer's shelf space - at mass-merchant retailers such as Wal-Mart, Target and Best Buy, as well as PC software retailers like CompUSA. Product distribution to these retailers, which have historically been successful in merchandising consumer entertainment PC software, has increased as a result of strong product sell through activity to consumers at these retailers' store locations. These retailers typically designate the distributor that they want us to use to fulfill the distribution of our products to their stores, and in certain instances retailers have decided to have us distribute software products directly to them. Distribution to these retailers is a competitive business within itself and there are other distributors who also serve these leading national retail chains. If Atari chose to discontinue distributing our titles or if any of these retailers decided to discontinue their relationship with Atari, one or more of these alternative distributors could potentially distribute our products to these retailers. During the three months ended September 30, 2003, our net sales were categorized as follows: o 87% of product shipments to traditional software distributors, including Atari and Jack of All Games; o 8% of product shipments made directly to traditional software retailers, such as CompUSA; and o 5% of licensing revenues. This compares to the three months ended September 30, 2002, when our net sales were categorized as follows: o 62% of product shipments to traditional software distributors, including Atari and Jack of All Games; o 15% of product shipments to traditional software retailers, such as CompUSA; o 13% of product shipments to various inventory liquidators; o 6% of licensing revenues; and o 4% of product shipments to non-traditional software retailers and distributors. During the three months ended September 30, 2003 and 2002, we had one major distributor, Atari that represented 76% and 53%, respectively, of net sales. (See "Our success depends on continued viable business relationships with key distributors and retailers" and "A significant part of our sales come from a limited number of customers" under "Risk Factors," page 27). We did not have any sales to inventory liquidation distributors and retailers during the quarter ended September 30, 2003, compared to $233,000 in such sales during the quarter ended September 30, 2002, primarily due to the improved quality of our on-hand inventory units. Additionally, we did not receive anticipated units of recently discontinued titles back from the retail channel before the end of the current reporting period, and accordingly any future inventory liquidation sales of such discontinued titles received after September 30, 2003 will be reflected in those subsequent periods. Throughout fiscal 2004, as retailers periodically reset the mix of software titles on their store shelves, we expect to receive additional quantities of certain discontinued titles back from the retail channel that will then need to be liquidated through sales to liquidation distributors and retailers. The decrease in net sales to non-traditional software retailers and distributors was the result of our fiscal 2002 decision to transition our direct distribution relationships with drug store retailers and distributors to a licensing relationship with a third-party distributor (United American Video or "UAV"). We believe this is a lower-risk, higher-margin relationship, due to UAV assuming the responsibilities and costs of order processing and receivable collections, inventory production, distribution, promotion and merchandising of our products to drug store retailers, who have not traditionally sold software products to consumers. During fiscal 2004, we expect that any net sales of our software products generated at drug store retail locations will be through our licensing agreement with UAV. Due to the overall performance of the PC software category at drug store retailers (compared to the stronger sales performance of similar titles sold at mass-merchant and specialty software retailers), we expect that licensing revenues from UAV and any other similar sources will remain low. We have transitioned our international distribution efforts to a series of licensing agreements covering various territories outside of North America, with the majority of our international revenues originating from the United Kingdom, Germany, Australia and Brazil. As a result of these agreements, we no longer bear the working capital risk of supporting these multi-country sales efforts, but expect to earn a licensing fee based on these third-party distributors' sales of our products. These third-party licensees assume the responsibilities and costs of order processing, accounts receivable collections, inventory production, distribution, promotion, and merchandising of our products with their retail customers. However, these arrangements give us much less direct control over the marketing and sales of our products in these territories, making us dependent on our licensees' capability to effectively market and sell our products, and on their ability to pay us royalties earned when due. International net revenues, including both product net sales and licensing revenues, for the three months ended September 30, 2003 and 2002 were $79,000 and $58,000, respectively, or 4% and 3%, respectively, of net sales. During fiscal 2004, we believe that international net revenues may represent approximately 5% of net sales and will be generated primarily from licensing revenues split equally between Greenstreet Software Limited ("GSL") and Rondomedia. Licensing revenues for the three months ended September 30, 2003 and 2002, were $101,000 and $106,000, respectively, or 5% and 6%, respectively, of net sales. Licensing revenues are generated primarily from sales made by our international distributors. This $5,000 decrease in licensing revenues was primarily due to licensing revenue decreases from UAV and Anasoft, which were partially offset by licensing revenue increases from Rondomedia and GSL. We experienced some difficulty in the collection of our accounts receivable from GSL during fiscal 2003. Accordingly, during fiscal 2004, we will continue to evaluate GSL's ability to increase or maintain its market share in the territories in which it distributes our products, as well as its ability to make timely receivable payments to us. We will continue to base our decision to recognize revenue from this licensing arrangement with GSL on the information available to us as of each reporting period. As of September 30, 2003, our accounts receivable balance with GSL was approximately $33,000. Internet sales accounted for 2% of net sales for the three months ended September 30, 2003 and 2002, and we anticipate Internet sales representing about 3% of net sales during the remainder of fiscal 2004. During fiscal 2004, we have launched a new e-commerce system, which is intended to increase the profitability of our Internet sales. In conjunction with the launch of this new system, we have revamped the look of our websites and we will continue to improve the more popular features of our websites, including our free online game arcade, in order to drive web traffic and sales on our websites. We will also continue programs implemented in fiscal 2003 to expand on-line registration of our retail products in order to increase our database of registered users who are interested in receiving promotional offers about our products. Product Returns and Price Markdowns During the three months ended September 30, 2003 and 2002, our provision for product returns and price markdowns for customers that have traditionally sold consumer entertainment PC software products (inclusive of inventory liquidation distributors) was $308,000 and $316,000, respectively, or 14% and 15% of related gross sales, respectively. Based upon historical results and current trends in our product sell-through rates to consumers, combined with continued inventory controls being maintained by retailers and distributors, we anticipate our overall fiscal 2004 provision for product returns and price markdowns may be approximately 15% of related gross sales. Among other things, a factor that we will continue to closely evaluate in determining our provision for anticipated product returns and price markdowns will be the consumer sell-through results of our higher priced products that were introduced during the first quarter of this fiscal year. We expect to continue expanding our distribution of certain higher priced products during fiscal 2004. The sale of such products, with a targeted retail price of $19.99, represents a departure from our typical value-priced product offering to the casual gamer that has historically been retail priced at about $9.99. Accordingly, these higher priced titles represent a greater risk of price markdown exposure if they do not sell through to consumers at anticipated rates. Cost of Sales - ------------- Cost of sales for the three months ended September 30, 2003 were $818,000 compared to $880,000 for the three months ended September 30, 2002, representing a decrease of $62,000 or 7%. This cost of sales decrease was caused primarily by decreases of: o $75,000 in product costs; o $20,000 in freight costs; and o $14,000 in other cost of sales. These cost of sales decreases were partially offset by cost of sales increases of: o $45,000 in provision for inventory obsolescence; and o $2,000 in royalty costs. The $75,000 decrease in product costs was caused primarily by the reduction in inventory liquidation sales of end-of-lifecycle products. This decrease in product costs was partially offset by an increase in sales of box titles having higher product costs, due to these box titles containing additional CD's, compared to similarly priced box titles sold during the year ago quarter. The $20,000 decrease in freight costs was due to the increase in cost effective product shipments to a concentrated group of retailers' and distributors' locations. The $14,000 decrease in other cost of sales resulted primarily from cost reductions in warehousing, packaging and direct-to-store handling costs. The $45,000 increase in the provision for inventory obsolescence resulted from our determination that the remaining inventory quantities of certain titles, recently discontinued by various retailers, needed to be revalued down to estimated inventory liquidation sales values that were below their previous carrying costs. The $2,000 increase in royalty costs was caused by the increase in overall net sales, which was partially offset by a slightly lower average royalty rate on titles sold during the current quarter, compared to the average royalty rate on the titles sold in the same quarter last year, due to product mix. Gross Profit Margin - ------------------- Our gross profit margin for the three months ended September 30, 2003 increased to 60.1% of net sales from 52.7% of net sales for the three months ended September 30, 2002. The 7.4% increase in gross profit margin was caused by cost decreases, as a percentage of net sales, of: o 6.2% in product costs; o 1.3% in freight costs; o 1.0% in royalty costs; and o 0.9% in other costs. The reasons for the percentage of net sales decreases in these cost of sales categories are discussed under "Cost of Sales," above. These cost of sales decreases were partially offset by a 2.0% increase, as a percentage of net sales, in the provision for inventory obsolescence, which was related to our determination that the remaining inventory quantities of certain titles, recently discontinued by various retailers, needed to be revalued down to estimated inventory liquidation sales values that were below their previous carrying costs. Operating Expenses - ------------------ Product development expenses for the three months ended September 30, 2003 were $126,000 compared to $103,000 for the three months ended September 30, 2002, an increase of $23,000 or 22%. This $23,000 increase was caused primarily by increased salary and related costs, combined with costs associated with upgrading our web site. Selling, general and administrative expenses for the three months ended September 30, 2003 were $603,000 compared to $645,000 for the three months ended September 30, 2002, a decrease of $42,000 or 7%. As a result of various cost saving initiatives, we have continued to achieve cost savings across various categories. The primary cost reductions were: o $40,000 in professional services, outside labor and consultants expense; o $23,000 in bad debt expense; and o $26,000 in stock-based compensation expense related to the valuation of stock options and warrants. These cost decreases were partially offset by cost increases of: o $40,000 in public relations costs related to a new product launch; and o $7,000 in other various operating expenses. The $40,000 decrease in professional services, outside labor and consultants expense resulted from non-recurring support and consulting costs relating to our EDI system and administrative services incurred in the year ago quarter, combined with decreased legal and accounting fees. The $23,000 decrease in bad debt expense was caused by the overall improvement in the quality and related collectibility of our accounts receivable balances. The $26,000 decrease in stock-based compensation expense was comprised of a $14,000 decrease in expense related to the vesting of stock options previously granted, combined with a $12,000 decrease related to the prior period's stock warrant expense. The $40,000 increase in public relations costs resulted from costs associated with the launching of a new software title, RealAge Games & Skills. We have contracted with a public relations firm to incur at least another $15,000 on this project, and during the next few months we will decide how much more in financial resources, if any, to commit towards additional services with this firm. The $7,000 increase in other operating expenses resulted from cost savings in various categories, such as depreciation expense and tradeshow costs. Interest Expense, Net - --------------------- Net interest expense for the three months ended September 30, 2003 was $5,000 compared to $18,000 for the three months ended September 30, 2002, a decrease of $13,000. This $13,000 decrease was due to the elimination of our previous bank debt, which was repaid in full on January 16, 2003. The decrease in net interest expense was partially offset by a $5,000 commitment fee related to our recently established credit facility with Hudson United Bank. Provision for Income Taxes - -------------------------- During the three months ended September 30, 2003, our provision for income taxes was $22,000 compared to no provision for the quarter ended September 30, 2002. The current period's provision related to the estimated taxable income related to various states, combined with no estimated taxable income calculated for federal income tax purposes because of remaining federal net operating loss carry-forwards ("NOL's"), which were sufficient to offset estimated taxable income for federal income tax purposes for the quarter ended September 30, 2003. Net Income - ---------- As a result of the factors discussed above, our net income for the three months ended September 30, 2003 was $478,000 compared to $213,000 for the same period a year earlier, an increase in net income of $265,000. Weighted Average Common Shares - ------------------------------ The weighted average common shares outstanding on a diluted basis increased by 180,417 for the three months ended September 30, 2003 to 10,473,098 from 10,292,681 for the three months ended September 30, 2002. The current period's increase in the diluted basis calculation of weighted average common shares resulted from including additional common share equivalents ("CSE's"), compared to the year ago period, due to more CSE's being "in the money" or having an exercise price less than the average price of the Company's common shares during the current period. Liquidity and Capital Resources At September 30, 2003, we had $2,209,000 in working capital and $2,232,000 in stockholders' equity, compared to $1,727,000 in working capital and $1,746,000 in stockholders' equity at June 30, 2003. At September 30, 2003, we had $757,000 in cash compared to $1,024,000 at June 30, 2003. This $267,000 decrease in cash resulted from $259,000 in net cash used in operating activities, combined with $8,000 in net cash used in investing activities. For the three months ended September 30, 2003, net cash used in operating activities was $259,000 compared to net cash used in operating activities of $202,000 for the three months ended September 30, 2002. The $259,000 in net cash used in operating activities during the three months ended September 30, 2003 was from cash uses incurred from: o $821,000 in increased accounts receivable; o $193,000 in increased inventory; o $72,000 in increased prepaid and other expenses; and o $66,000 in decreased accrued expenses. Partially offsetting these cash uses were cash sources generated from $478,000 in net income, in addition to increases of: o $392,000 in provision for product returns, price markdowns, bad debts and inventory obsolescence; o $11,000 in accounts payable; o $8,000 in stock-based compensation; and o $4,000 in depreciation and amortization. For the three months ended September 30, 2003, net cash used in investing activities was $8,000 compared to no investing activities for the three months ended September 30, 2002. The $8,000 in net cash used in investing activities during the three months ended September 30, 2003 related to upgrades of our computer network. During fiscal 2004, we anticipate investing activities to continue relating to scheduled upgrades of our computer network's hardware and software. For the three months ended September 30, 2003, we had no financing activities compared to the three months ended September 30, 2002 when we had net cash used in financing activities of $227,000. On September 18, 2003, we entered into a $500,000 credit facility agreement with Hudson United Bank ("HUB"), which matures on December 1, 2004. Amounts outstanding under this new credit facility will be charged interest at one-half of one percent above HUB's current prime rate and such interest is due monthly. Our access to these funds is limited to the lesser of $500,000 or seventy-five percent of qualified accounts receivable, which are defined as invoices less than ninety days old and net of any allowances for product returns, price markdowns or bad debts. The new credit facility is secured by all of the Company's assets and requires us, among other things, to maintain the following financial covenants to be tested quarterly: a total liabilities to tangible net worth ratio of 1.25 to 1.00 and a tangible net worth requirement of $1.5 million. As of November 12, 2003, we were in compliance with each of those covenants. This new credit facility was established to provide working capital for our operations. As of November 12, 2003, we did not have any outstanding balance under this new credit facility. On July 23, 2001, Fleet Bank ("Fleet") notified us that due to our violation of the financial covenants under our credit facility as of June 30, 2001, and material adverse changes in our financial condition, Fleet would no longer continue to fund the prior $2,000,000 credit facility. On November 2, 2001, we entered into an agreement with Fleet to pay off the credit facility's then outstanding balance of $1,400,000 over a twenty-two month period. The agreement provided that the remaining outstanding balance owed under the credit facility was to be repaid by July 31, 2003 in monthly installments, with interest at the prime rate plus three percent. On January 16, 2003, we repaid the then remaining $420,000 principal balance outstanding on this term loan, together with accrued interest, in full satisfaction of all obligations under the November 2, 2001 forbearance agreement. Contractual Obligations and Commitments - --------------------------------------- Our 5,000 square foot office facility located in Langhorne, Pennsylvania is occupied under an operating lease that is scheduled to expire on September 30, 2004. Additionally, we currently rent certain office equipment through various operating lease agreements. Net rent expense incurred under our operating leases was $21,000 and $18,000 for the three month periods ended September 30, 2003 and 2002, respectively. Under various licensing agreements with third-party software developers, we are required to pay royalties for the use of licensed content in our products. Royalty expense under such agreements, which is recorded in cost of sales, was $226,000 and $224,000 for the three months ended September 30, 2003 and 2002, respectively. Additionally, most of these licensing agreements require us to make advance royalty payments to these developers prior to the time we recognize any net sales of software titles containing this licensed software content. We have commitments to pay $214,000 in advance royalty payments to various software developers under such agreements. Included in this $214,000 is our remaining obligation to pay Greenstreet Software Limited ("GSL") by August 2004 an advance royalty of $40,000 for the licensing of one of its PC software titles. In conjunction with the launching of a new software title, RealAge Games & Skills, the Company has two existing contracts that contain relatively significant financial commitments by the Company. Specifically, we have a $15,000 commitment remaining with a public relations firm for future services to be performed during fiscal 2004. A second contract for the license of a trademark requires that a second of two $50,000 advance royalty payments be made by May 2004, regardless of actual royalties earned. The first $50,000 advance royalty payment was made to this licensor during fiscal 2003 upon signing the contract, and is classified on our September 30, 2003 balance sheet within "Prepaid and other expenses". These guaranteed royalty and licensing commitments are expected to be funded by cash flows generated through anticipated income from operations. The following table represents a summary of our off-balance sheet contractual obligations and commitments.
Payments Due by Period ------------------------------------------------------- Less than 1-3 3-5 More than Contractual Obligations Total 1 year years years 5 years - --------------------------------------- --------- ---------- --------- --------- Operating Leases $ 125,000 $ 63,000 $ 38,000 $ 24,000 $ - 0 - Advance Royalty Commitments 214,000 189,000 25,000 - 0 - - 0 - Product Launch 65,000 65,000 - 0 - - 0 - - 0 - - --------------------------------------- --------- ---------- --------- --------- Total $ 404,000 $ 317,000 $ 63,000 $ 24,000 $ - 0 - ========= ========= ========== ========= =========
Liquidity Risk - -------------- From the first quarter of fiscal 2002 until September 18, 2003, the date on which we entered into our new credit facility agreement, we did not have access to a credit facility and had been dependent entirely on cash flow from operations to meet our financial obligations. Our ability to achieve and maintain positive cash flow remains essential to our survival as a going concern because our access to this credit facility is limited to the lesser of $500,000 or seventy-five percent of our qualified accounts receivable. Our ability to do this depends upon a variety of factors, including the timing of the collection of outstanding accounts receivable, the creditworthiness of the primary distributors and retail customers of our products, the sell-through of our products to consumers, and the costs of developing, producing and marketing such products. We believe that our projected cash and working capital balances may be sufficient to fund our operations, including the contractual obligations and commitments described above, through June 30, 2004, but there are significant challenges that we will need to successfully manage in order to be able to fund our operations through that period of time and beyond. These challenges include, but are not limited to: agreeing to and maintaining acceptable payment terms with our vendors; and maintaining timely receivable payments from our concentrated group of customers. For example, our liquidity would be severely impacted if Atari, and to a lesser extent Jack of All Games or CompUSA, did not make payments on a timely basis, or if other business conditions caused them to fail to pay us. Additionally, our accounts payable have historically increased substantially during our first and second fiscal quarters (third and fourth calendar quarters) when we increase the amount of inventory we purchase to meet anticipated customer orders for the back to school and holiday selling seasons. If we are not paid timely by our customers during the period following this seasonal increase in inventory purchases, we may have difficulty paying our vendors in a timely manner, which would then significantly impact our ability to continue normal operations. Additionally, there are market factors beyond our control that could also significantly affect our operating cash flow. The most significant of these market factors is the market acceptance and sell-through rates of our current products to consumers, and the growth of the consumer entertainment PC software market, and in particular our share of that market. If any of our software titles do not sell through to consumers at the rate anticipated, we could be exposed to additional product returns and a lack of customer replenishment orders for these products. As a result of these factors, we may not be able to achieve or maintain positive cash flow. Additional outside financing to supplement our cash flows from operations may not be available if and when we need it. Even if such financing were available from a bank or other financing source, it may not be on terms satisfactory to us because of the dilution it may cause or other costs associated with such financing. New Accounting Pronouncements In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation -- Transition and Disclosure -- an Amendment of FASB Statement No. 123". SFAS No. 148 amends FASB Statement No. 123, "Accounting for Stock-Based Compensation", to provide alternative methods of transition for an entity that voluntarily changes to the fair-value-based method of accounting for stock-based employee compensation. It also amends the disclosure provisions of that statement to require prominent disclosure about the effects on reported net income and earnings per share and the entity's accounting policy decisions with respect to stock-based employee compensation. Certain of the disclosure requirements are required for all companies, regardless of whether the fair value method or intrinsic value method is used to account for stock-based employee compensation arrangements. This amendment to SFAS No. 123 became effective for financial statements for fiscal years ended after December 15, 2002 and for interim periods beginning after December 15, 2002. Accordingly, we adopted the disclosure provisions of this statement effective January 1, 2003. In March 2003, the Emerging Issues Task Force published Issue No. 00-21 "Accounting for Revenue Arrangements with Multiple Deliverables" (EITF 00-21). EITF 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which it performs multiple revenue generating activities and how to determine whether such an arrangement involving multiple deliverables contains more than one unit of accounting for purposes of revenue recognition. The guidance in this Issue is effective for revenue arrangements entered in fiscal periods beginning after June 15, 2003. The adoption of EITF 00-21 on July 1, 2003 did not have any impact on our financial statements. Listing of Company's Common Stock In April 2001, our common stock was delisted from the Nasdaq SmallCap Market as a result of our failure to maintain a minimum bid price of $1.00 over a period of 30 consecutive trading days. Our stock then began trading on the OTC Bulletin Board under the existing symbol EGAM. We periodically review our alternatives with respect to listing on an exchange, such as the American Stock Exchange or the Nasdaq SmallCap Market. At this time we do not meet several of the criteria for listing on these exchanges. We will, therefore, from time to time continue to evaluate our available alternatives to the OTC Bulletin Board. FACTORS AFFECTING FUTURE PERFORMANCE Risk Factors - ------------ Our business is subject to many risks and uncertainties that could affect our future financial performance. The following discussion highlights some of the more important risks we have identified, but they may not be the only factors that could affect future performance. During our recent history, we have experienced significant volatility in our financial results, making it difficult to evaluate our future financial prospects. In particular, we experienced a $5,933,000 loss in fiscal 2001, followed by net income of $2,181,000 in fiscal 2002 and net income of $1,592,000 in fiscal 2003, Prior to those periods, we earned approximately $253,000, $463,000 and $1,253,000 in fiscal 2000, 1999 and 1998, respectively. We began operations in July 1992, and experienced significant losses from inception through the end of fiscal 1997. Prior to fiscal 1998, we funded our operations mostly through proceeds from our initial public offering of common stock in October 1995 and through the sale of preferred stock in private offerings in November 1996, and January and April 1997, in addition to proceeds from the exercise of various common stock warrants and stock options. We have since funded our business activities from cash generated from operations and bank borrowings. Currently, we have access only to a $500,000 credit facility with Hudson United Bank ("HUB") that is subject to borrowing restrictions based on the value of our accounts receivable. Our accumulated deficit at June 30, 2003 was $8,176,000. Even though we achieved profitability in fiscal 2002 and 2003, given current economic conditions in the United States in general, there can be no assurance that we will be profitable in fiscal 2004 and beyond. Our operations today continue to be subject to all of the risks inherent in the operation of a small business, which has suffered liquidity problems in a highly competitive industry dominated by larger competitors. These risks include, but are not limited to, development, distribution and marketing difficulties, competition, and unanticipated costs and expenses. Our future success will depend on our ability to be profitable in the development, marketing and distribution of our current and future software products. We have experienced severe liquidity problems. On July 23, 2001, Fleet Bank ("Fleet") notified us that due to our violation of the financial covenants under our credit facility as of June 30, 2001, and the material adverse changes in our financial condition, Fleet would no longer continue to fund the $2,000,000 credit facility. On November 2, 2001, we entered into a forbearance agreement with Fleet to pay off the credit facility's outstanding balance of $1,400,000 over a twenty-two month period. The remaining outstanding balance owed under the credit facility was to be repaid by July 31, 2003 in monthly installments, with interest at the prime rate plus three percent. On January 16, 2003, we repaid the then remaining $420,000 principal balance outstanding on our term loan with Fleet, together with accrued interest, in full satisfaction of all obligations under the November 2, 2001 forbearance agreement. Additionally on January 16, 2003, we redeemed from Fleet the warrant associated with the forbearance agreement for $50,000. While we currently have access to a $500,000 credit facility, it is subject to limitations based on the value of our accounts receivable, and therefore working capital may not be available when we need it. Our ability to continue operations essentially requires us to generate sufficient cash flow from operations to fund our business activities. In the past we have experienced dramatic fluctuations in cash flows, so we cannot be sure we will be able to continue achieving sufficient cash flows to fund our operations. We may need additional funds. Our capital requirements are currently funded from the cash flow generated from product sales and our $500,000 credit facility. If we are not able to achieve cash flow from operations at a level sufficient to support our business activities, we may require additional funds. Our current financial condition and our poor financial performance in fiscal 2001 could adversely affect our ability to obtain additional financing and could make us more vulnerable to industry downturns and competitive pressures. Additionally, we may only be able to raise needed funds on terms that would result in significant dilution or otherwise be unfavorable to existing shareholders. Our inability to secure additional funding when needed, to access funds from our credit facility when needed, or generate adequate funds from operations, would adversely impact our long-term viability. Our success depends on continued viable business relationships with key distributors and retailers. Many of the largest mass-market retailers have buying relationships with certain distributors, such as Atari, and these retailers often will only buy consumer entertainment PC software from such distributors. Our financial condition could be materially harmed if these distributors were unwilling to distribute our products. Additionally, even if the distributors are willing to purchase our products, distributors are frequently able to dictate the price, timing and other terms on which we can distribute our products to such retailers. We also may not be able to distribute our products directly to key retailers on terms that we consider commercially acceptable. Our inability to negotiate commercially viable distribution relationships with significant retailers and distributors, or the loss of, or significant reduction in sales to, any of our key distributors or retailers, would adversely affect our business, operating results and financial condition. A significant part of our sales come from a limited number of customers. Due to our decision during fiscal 2002 to discontinue selling our consumer entertainment PC software products directly to drug store retailers and distributors serving these drug store retailers and to focus instead on selling our products to mass-merchant, specialty and PC software retailers that have traditionally sold value-priced consumer entertainment PC software, we now rely on a concentrated group of large customers. The majority of our current sales are to mass merchant, specialty and PC software retailers, and distributors serving such retailers, and in particular to Atari. Atari is our primary North American distributor that services the major mass-merchant retailers in North America, such as Wal-Mart, Target, and Best Buy, among others. Our net sales to Atari during the fiscal year ended June 30, 2003 were $4,370,000 and represented 61% of our total net sales. We anticipate that net sales to Atari may represent greater than 65% of our total net sales during fiscal 2004. Accordingly, we expect to continue depending upon a limited number of significant customers, and in particular Atari, for the foreseeable future. Most of our customers, including Atari, may terminate their relationship with us at any time. In the event that we lose our distribution capability through Atari or any of our other large distributors or retailers, it would significantly harm our financial condition and our ability to continue as a going concern. We may experience customer payment defaults and uncollectible accounts receivable if our distributors' or retailers' businesses fail or if they otherwise cannot pay us. Distributors and retailers in the consumer entertainment PC software industry and in mass-market retail channels can and have experienced significant fluctuations in their businesses and many of these businesses have failed. These business failures have increased and may continue to increase as a result of economic conditions in the United States. The insolvency or business failure of any significant retailer or distributor of our products would significantly harm our business, operating results and financial condition. Our sales are typically made on credit, with terms that vary depending upon the customer and the nature of the product. We do not hold collateral to secure payment. We maintain an allowance for bad debts for anticipated uncollectible accounts receivable which we believe to be adequate. The actual allowance required for any one customer's account or on all of the accounts receivable in total, may ultimately be greater than our allowance for bad debts at any point in time. The failure to pay an outstanding receivable by a major customer would significantly harm our business, operating results and financial condition. Our customers have the right to return our products and to take price markdowns, which could reduce our net sales and results of operations. Most of our customer relationships allow for product returns and price markdowns. We establish allowances for future product returns and price markdowns at the time revenue is recognized for sales to traditional software retail customers and distributors servicing such retailers. These allowances are based on historical product return and price markdown results with these types of customers, product sell-through information and channel inventory reports supplied by these retailers and the distributors that serve them, among other factors. Our sales to these customers are reported net of product return and price markdown provisions. Actual product returns and price markdowns could exceed these anticipated amounts, particularly for products that have higher price points than our typical $9.99 jewel case products, which would negatively impact our future results of operations. Our operating results fluctuate from quarter to quarter, which makes our future operating results uncertain and difficult to predict. Our quarterly operating results have varied significantly in the past and will likely vary significantly in the future depending on numerous factors, many of which are not under our control. Fluctuations in quarterly operating results will depend upon many factors including: o seasonality of customer buying patterns; o the size and rate of growth of the consumer entertainment PC software market; o the demand for our typical value-priced and new higher-priced PC software products; o product and price competition; o the amount of product returns and price markdowns; o the timing of our new product introductions and product enhancements and those of our competitors; o the timing of major customer orders; o product shipment delays; o access to distribution channels; o product defects and other quality problems; o product life cycles; o ability to accurately forecast inventory production requirements; o international royalty rates and licensing revenues; and o our ability to develop and market new products and control costs. Products are usually shipped within days following the receipt of customer orders so we typically operate with little or no backlog. Therefore, net sales in any reporting period are usually dependent on orders booked, shipped and received by our customers during that period. We are exposed to seasonality in the purchases of our products. The consumer entertainment PC software industry is highly seasonal, with sales tending to be higher during the third and fourth calendar quarters (our first and second fiscal quarters). This is due to increased demand for PC software games during the back-to-school and holiday selling seasons. Delays in product development or manufacturing can affect the timing of the release of our products, causing us to miss key selling periods such as the year-end holiday buying season. Our ability to maintain adequate liquidity to satisfy critical software developers with required advance royalty payments and paying our manufacturing vendors within acceptable timeframes are critical to avoiding any such delays in having product available for sale throughout the year, but especially during seasonal peaks in demand. If we miss product deliveries during these key selling periods, or if our products are not ready for shipment to meet these critical selling periods, our net sales and operating results would be adversely affected. Additionally, if our products do not adequately sell-in to our customers' retail locations or sell-through to consumers at these retail locations during the back-to-school or holiday selling seasons, our financial results for the entire fiscal year would be adversely affected. The consumer entertainment PC software market is highly competitive and changes rapidly. The market for consumer entertainment PC software is highly competitive, particularly at the retail shelf level where a constantly increasing number of software titles are competing for a finite amount of shelf space. Retailers have a limited amount of shelf space on which to display consumer entertainment PC software products. There is intense competition among consumer entertainment PC software publishers for shelf space and promotional support from retailers. As the number of PC software titles continues to increase, the competition for shelf space continues to intensify, resulting in greater leverage for retailers and distributors in negotiating terms of sale, including price discounts and product return policies. Also, our larger competitors may have more leverage than us to negotiate more and better-positioned shelf space than us. Our retail and distribution customers have no long-term obligations to purchase our products, and may discontinue purchasing our products at any time. If any of our large customers stopped buying our products or significantly reduced their purchases, our operating results and financial condition would be negatively impacted. Increased competition for acquiring the licensing rights to quality consumer entertainment PC software content has compelled us to agree to make increasingly higher advance royalty payments and, in some cases, to guarantee minimum royalty payments to content licensors and PC software game developers. If the products subject to these advances and minimums do not generate sufficient sales volumes to recover these costs, our financial results would be negatively impacted. Our present or future competitors may also develop products that are comparable or superior to ours. Our competitors may offer higher quality products, lower priced products or adapt more quickly than us to new technologies or evolving customer requirements. Our competitors typically have more financial resources to spend on marketing promotions, licensing recognizable brands, and advertising efforts. Competition is expected to intensify. In order to be successful in the future, we must be able to respond to technological changes, customer requirements and competitors' current products and innovations. We may not be able to compete effectively in this market, which would have an adverse effect on our operating results and financial condition. We depend on the market acceptance of our products, and these products typically have relatively short product life cycles. The market for consumer entertainment PC software has been characterized by shifts in consumer preferences and short product life cycles. Consumer preferences for entertainment PC software products are difficult to predict and few products achieve sustained market acceptance. New products we introduce may not achieve any significant degree of market acceptance, or the product life cycles may not be long enough for us to recover advance royalties, development, marketing and other promotional costs. Also, if a product does not sell-through to consumers at a rate satisfactory to our retail or distribution customers, we could be forced to accept substantial product returns or be required to issue additional price markdowns to maintain our relationships with these distributors and retailers. We may also lose retail shelf space if our products do not sell-through to consumers at satisfactory rates. Failure of new products to achieve or sustain market acceptance or product returns or price markdowns results in excess of our expectations would adversely impact our business, operating results and financial condition. We are vulnerable to rapid technological change that could make our products less marketable. Frequent new product introductions and enhancements, rapid technological developments, evolving industry standards and swift changes in customer requirements characterize the market for our products. Our future success depends on our ability to continue to quickly and efficiently develop and introduce new products and enhance existing products to incorporate technological advances and responses to customer requirements. If any of our competitors introduce products more quickly than us, or if they introduce better products than ours, then our business could be adversely affected. We may also not be successful in developing and marketing new products or enhancements to our existing products on a timely basis. Our new or enhanced products may not adequately address the changing needs of the marketplace. From time to time, our competitors may announce new products, capabilities or technologies that have the potential to replace or shorten the life cycles of our existing products. Announcements of currently planned or other new products by competitors may cause customers to delay their purchasing decisions in anticipation of such products, which could adversely affect our business, liquidity and operating results. Additionally, technological advancements in computer operating systems that cause our products to be obsolete or not to function as expected would adversely affect our financial results if product returns exceeded our allowance, and the related inventory was deemed valueless (and exceeded our allowance for inventory obsolescence). Our common stock has experienced low trading volumes and other risks on the OTC Bulletin Board. In April 2001, our common stock was delisted from the Nasdaq SmallCap Market as a result of our failure to maintain a minimum bid price of $1.00 over a period of 30 consecutive trading days. Our stock then began trading on the OTC Bulletin Board under the existing symbol EGAM. In March 2002, our common stock was not eligible to be traded on the OTC Bulletin Board because we were not current with our reporting requirements under the Securities Exchange Act of 1934, as amended (the "1934 Act"). In April 2002, our common stock resumed trading on the OTC Bulletin Board, when we became current with our 1934 Act filings. If we do not remain current with our 1934 Act filings, we would not be able to maintain the trading of our stock on the OTC Bulletin Board. Even if we are successful in maintaining trading of our stock on the OTC Bulletin Board, many stocks traded on the OTC Bulletin Board have experienced extreme price and trading volume fluctuations. These fluctuations are often unrelated or disproportionate to the operating performance of individual companies. Our stock price may be adversely affected by such fluctuations, regardless of our operating results. Additionally, many common stocks traded on the OTC Bulletin Board are thinly traded, such as our common stock, which would make it difficult to sell our stock. If our stock is not eligible to be traded on the OTC Bulletin Board, our stock will then be traded on the Pink Sheets, which may have even less trading volume potential and more price fluctuations than the OTC Bulletin Board. We have experienced increased regulation of our product content and features. Due to the competitive environment in the consumer entertainment software industry, we have and will continue to incorporate features into our products, such as an Internet browser-like interface, advertising technology and on-line consumer registration capabilities, to differentiate our products to retailers, provide value-added features to consumers, and to potentially increase website traffic and create new revenue streams based on advertising and promotional opportunities. These features may not enhance the product's value, and in fact such features may detract from a product's value if they are not accepted in the marketplace or if new regulations governing the Internet and related technologies are enacted which impact these features. We may have difficulty protecting our intellectual property rights. We either own or have licensed the rights to copyrights on our products, manuals, advertising and other materials. We also hold trademark rights in our corporate logo, and the names of the products owned or licensed by us. Our success depends in part on our ability to protect our proprietary rights to the trademarks, trade names and content used in our principal products. We rely on a combination of copyrights, trademarks, trade secrets, confidentiality procedures and contractual provisions to protect our proprietary rights. These initiatives to protect our proprietary rights require us to use internal resources as well as outside legal counsel. We may not have sufficient resources to adequately protect our intellectual property rights, and our existing or future copyrights, trademarks, trade secrets or other intellectual property rights may not be of sufficient scope or strength to provide meaningful protection or commercial advantage to us. Also, in selling our products, we rely on "click-through" licenses that are not signed by licensees and, therefore, may be unenforceable under the laws of certain jurisdictions. In addition, the laws of some foreign countries do not protect our proprietary rights, as do the laws of the United States. Our inability to sufficiently protect our intellectual property rights would have an adverse effect on our business and operating results. Policing unauthorized use of an easily duplicated and broadly disseminated product such as computer software is very difficult. Software piracy is expected to be a persistent problem for the software industry for the foreseeable future. Software piracy is a much greater problem in certain international markets. If a significant amount of unauthorized copying of our products were to occur, our business, operating results and financial condition could be adversely affected. We may incur substantial expenses and be required to use our internal resources to defend infringement claims, and settlements may not be favorable or attainable. We may from time to time be notified that we are infringing on the intellectual property rights of others. Combinations of content acquired through past or future acquisitions and content licensed from third-party software developers will create new products and technology that may give rise to claims of infringement. In recent years, we have incurred significant defense costs and utilized internal resources in defending trademark and copyright claims and lawsuits. Other third parties may initiate infringement actions against us in the future. Any future claims could result in substantial costs to us, and diversion of our limited resources. If we are found to be infringing on the rights of others, we may not be able to obtain licenses on acceptable terms or at all, and significant damages for past infringement may be assessed, or further litigation relating to any such licenses or usage may occur. Our failure to obtain necessary licenses or other rights, or the commencement of litigation arising from any such claims, could materially and adversely affect our operating results. We are exposed to the risk of product defects. Products we offer can contain errors or defects. The PC hardware environment is characterized by a wide variety of non-standard peripherals, such as sound and graphics cards, and configurations that make pre-release testing for programming or compatibility errors difficult and time-consuming. Despite the extensive testing performed by our quality assurance personnel, new products or releases may contain errors discovered after shipments have commenced, resulting in a loss of or delay in market acceptance or widespread product recalls, which would adversely affect our business, operating results and financial condition. We depend on key management and technical personnel. Our success depends to a significant degree on the continued efforts of our key management, marketing, sales, product development and operational personnel. The loss of one or more key employees could adversely affect our operating results. We also believe our future success will depend in large part on our ability to attract and retain highly skilled management, technical, marketing, sales, product development and operational personnel. Competition for such personnel is intense, and, due to our limited resources and size, we may not be successful in attracting and retaining such personnel. We may experience unique risks with our international revenues and distribution efforts. International net revenues, including both product net sales and licensing revenues, represented 4% of our net sales for the fiscal years ended June 30, 2003 and 2002. We anticipate that in fiscal 2004 our international business will continue to be transacted primarily through third-party licensees, which is subject to some risks that our domestic business is not, including: varying regulatory requirements; difficulties in managing foreign distributors; potentially adverse tax consequences; and difficulties in collecting delinquent accounts receivable. Additionally, because our international business is concentrated among a small number of third-party licensees, the business failure of any one of these licensees, and the resulting inability for us to collect outstanding licensing receivables, could have a material adverse effect on our financial condition. Item 3. Controls and Procedures (a) Disclosure Controls and Procedures. Under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, we carried out an evaluation of the effectiveness of our disclosure controls and procedures, as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as of September 30, 2003 (the "Evaluation Date"). Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that as of the Evaluation Date, our disclosure controls and procedures were effective in recording, processing, summarizing and reporting, in the periods specified in the SEC's rules and forms, the information required to be disclosed by the Company in its reports filed or furnished under the Exchange Act. (b) Changes in Internal Control Over Financial Reporting. There have not been any changes in our internal control over financial reporting during the fiscal quarter ended September 30, 2003 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Part II. Other Information Item 6. Exhibits and Reports on Form 8-K (a) Exhibits Exhibit No. Description of Exhibit - ----------- ---------------------- 31.1 Certification of Gerald W. Klein as President and Chief Executive Officer of eGames, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of Thomas W. Murphy as Vice President and Chief Financial Officer of eGames, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certification of Gerald W. Klein as President and Chief Executive Officer of eGames, Inc. pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certification of Thomas W. Murphy as Vice President and Chief Financial Officer of eGames, Inc. pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (b) Reports on Form 8-K On July 23, 2003, the Company furnished a report on Form 8-K under Item 12 regarding a press release announcing the date that it expects to release its financial results for the fiscal year ended June 30, 2003. On August 25, 2003, the Company furnished a report on Form 8-K under Item 12 regarding a press release announcing the Company's financial results for the fiscal year ended June 30, 2003. On September 19, 2003, the Company filed a report on Form 8-K under Item 5 regarding a press release announcing it had entered into a Business Loan Agreement with Hudson United Bank ("HUB") to permit the Company to borrow up to $500,000 from HUB. 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: November 13, 2003 /s/ Gerald W. Klein ----------------- -------------------- Gerald W. Klein, President, Chief Executive Officer and Director Date: November 13, 2003 /s/ Thomas W. Murphy ----------------- -------------------- Thomas W. Murphy, Chief Financial Officer and Chief Accounting Officer Exhibit 31.1 Certification ------------- I, Gerald W. Klein, certify that: 1. I have reviewed this quarterly report on Form 10-QSB of eGames, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: November 13, 2003 - ----------------------- /s/ Gerald W. Klein ------------------- Gerald W. Klein President and Chief Executive Officer (Principal Executive Officer) Exhibit 31.2 Certification ------------- I, Thomas W. Murphy, certify that: 1. I have reviewed this quarterly report on Form 10-QSB of eGames, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: November 13, 2003 - ----------------------- /s/ Thomas W. Murphy -------------------- Thomas W. Murphy Chief Financial Officer (Principal Financial Officer) Exhibit 32.1 CERTIFICATION PURSUANT TO ------------------------- 18 U.S.C. SECTION 1350, ----------------------- AS ADOPTED PURSUANT TO ---------------------- SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 --------------------------------------------- In connection with the Quarterly Report of eGames, Inc. (the "Company") on Form 10-QSB for the fiscal quarter ended September 30, 2003 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Gerald W. Klein, President and Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, that: 1. The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and 2. The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Gerald W. Klein - ------------------- Gerald W. Klein President and Chief Executive Officer November 13, 2003 The foregoing certification is being furnished to the Securities and Exchange Commission pursuant to 18 U.S.C. Section 1350 as an exhibit to the Report and is not being filed as part of the Report or as a separate disclosure document. Exhibit 32.2 CERTIFICATION PURSUANT TO ------------------------- 18 U.S.C. SECTION 1350, ----------------------- AS ADOPTED PURSUANT TO ---------------------- SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 --------------------------------------------- In connection with the Quarterly Report of eGames, Inc. (the "Company") on Form 10-QSB for the fiscal quarter ended September 30, 2003 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Thomas W. Murphy, Vice President and Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, that: 1. The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and 2. The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Thomas W. Murphy - -------------------- Thomas W. Murphy Chief Financial Officer November 13, 2003 The foregoing certification is being furnished to the Securities and Exchange Commission pursuant to 18 U.S.C. Section 1350 as an exhibit to the Report and is not being filed as part of the Report or as a separate disclosure document. -----END PRIVACY-ENHANCED MESSAGE-----