-----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, BzHzPz/pVbux/YuSMoL4gWdK9Yr6MJmnm1fAxl7I4RsXMTYQbL8jfmg1ZrZAr2eX BkCms4utpRGbQdgBj5JbYQ== 0000948703-04-000013.txt : 20041112 0000948703-04-000013.hdr.sgml : 20041111 20041112141439 ACCESSION NUMBER: 0000948703-04-000013 CONFORMED SUBMISSION TYPE: 10QSB PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 20040930 FILED AS OF DATE: 20041112 DATE AS OF CHANGE: 20041112 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: 041138175 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 q12005-10qsb.txt EGAMES FORM 10QSB Q1-2005 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, 2004 |_| 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 CORPORATE ISSUERS State the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date: 10,108,587 shares of common stock, no par value per share, as of November 10, 2004. Transitional Small Business Disclosure Format (check one): Yes ( ) No ( X ) INDEX Page ---- Part I. Financial Information Item 1. Unaudited Financial Statements: Balance Sheet as of September 30, 2004................... 3 Statements of Operations for the three months ended September 30, 2004 and 2003 ................... 4 Statements of Cash Flows for the three months ended September 30, 2004 and 2003 ................... 5 Notes to Financial Statements............................ 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations ................. 12 Factors Affecting Future Performance .................... 24 Item 3. Controls and Procedures ................................. 28 Part II Other Information Item 6. Exhibits ................................................ 28 Exhibit Index ......................................................... 28 Signatures ......................................................... 29 Exhibits ......................................................... 30 Item 1. Unaudited Financial Statements eGames, Inc. Balance Sheet (Unaudited) As of September 30, 2004 ------------- ASSETS - ------ Current assets: Cash and cash equivalents $ 1,553,840 Accounts receivable, net of allowances of $849,849 1,121,740 Inventory, net 842,114 Prepaid and other expenses 473,896 ----------- Total current assets 3,991,590 Furniture and equipment, net 74,969 Intangible assets 24,089 ----------- Total assets $ 4,090,648 =========== LIABILITIES AND STOCKHOLDERS' EQUITY - ------------------------------------ Current liabilities: Accounts payable $ 359,575 Accrued expenses 312,952 ----------- Total current liabilities 672,527 ----------- Commitments and contingencies Stockholders' equity: Common stock, no par value (40,000,000 shares authorized; 10,340,487 issued and 10,108,587 outstanding) 9,179,827 Additional paid-in capital 1,359,970 Accumulated deficit (6,620,259) Treasury stock, at cost - 231,900 shares (501,417) ----------- Total stockholders' equity 3,418,121 ----------- Total liabilities and stockholders' equity $ 4,090,648 =========== See accompanying notes to financial statements. eGames, Inc. Statements of Operations (Unaudited)
Three Months ended September 30, --------------------------- 2004 2003 ----------- ----------- Net sales $ 1,177,829 $ 2,052,472 Cost of sales 571,158 818,185 ----------- ----------- Gross profit 606,671 1,234,287 Operating expenses: Product development 239,115 126,390 Selling, general and administrative 571,132 602,284 ----------- ----------- Total operating expenses 810,247 728,674 ----------- ----------- Operating income (loss) (203,576) 505,613 Interest (income) expense, net (1,230) 4,983 ----------- ----------- Income (loss) before income taxes (202,346) 500,630 Provision (benefit) for income taxes (18,024) 22,284 ----------- ----------- Net income (loss) ($ 184,322) $ 478,346 =========== =========== Net income (loss) per common share: - Basic ($ 0.02) $ 0.05 =========== =========== - Diluted ($ 0.02) $ 0.05 =========== =========== Weighted average common shares outstanding - Basic 10,102,673 9,989,337 Dilutive effect of common share equivalents - 0 - 483,761 ---------- ---------- Weighted average common shares and common share equivalents outstanding - Diluted 10,102,673 10,473,098 ========== ==========
See accompanying notes to financial statements. eGames, Inc. Statements of Cash Flows (Unaudited)
Three Months ended September 30, ------------------------- 2004 2003 ---------- ---------- Cash flows from operating activities: Net income (loss) ($ 184,322) $ 478,346 Adjustment to reconcile net income (loss) to net cash used in operating activities: Stock-based compensation 18,306 8,058 Depreciation and amortization 8,686 4,152 Changes in operating assets and liabilities: Accounts receivable, net 412,119 (511,416) Inventory, net (27,828) (110,437) Prepaid and other expenses (33,766) (72,109) Accounts payable (81,441) 11,001 Accrued expenses (303,842) (66,534) ---------- ---------- Net cash used in operating activities (192,088) (258,939) ---------- ---------- Cash flows from investing activities: Purchases of furniture and equipment (8,796) (7,774) ---------- ---------- Net cash used in investing activities (8,796) (7,774) ---------- ---------- Cash flows from financing activities: Proceeds from exercise of stock options 12,500 - 0 - ---------- ---------- Net cash provided by financing activities 12,500 - 0 - ---------- ---------- Net decrease in cash and cash equivalents (188,384) (266,713) Cash and cash equivalents: Beginning of period 1,742,224 1,024,237 ---------- ---------- End of period $1,553,840 $ 757,524 ========== ========== Supplemental cash flow information: Cash paid during the period for interest $ - 0 - $ 5,475 ========== ========== Cash paid (refunds received) for income taxes $ 23,550 ($ 253) ========== ==========
See accompanying notes to financial statements. eGames, Inc. Notes to Financial Statements (Unaudited) 1. Summary of Significant Accounting Policies Description of Business eGames, Inc. ("eGames", "our" or "we") is a Pennsylvania corporation incorporated in July 1992 that publishes, markets and sells affordable PC software games. We focus on publishing software games for the PC platform, and while we are preliminarily exploring possible opportunities in the mobile phone game market, we currently do not plan to publish products for any other game platform, such as console devices, hand held game devices, mobile phones and personal digital assistants. Our product line enables us to satisfy consumers who are seeking a broad range of high-quality, affordable PC gaming software, which are sold on CDs or online through the Internet. In North America, our PC games are distributed primarily through third-party software distributors who service the mass-merchant and major retailers. In territories outside North America, we license our PC games to third-party software distributors who are responsible for the manufacture and distribution of our PC games within specific geographic territories. 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, 2004 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. Amounts discussed within the "Notes to Financial Statements" have been rounded to the nearest thousand dollars. Fair Value of Financial Instruments The recorded amounts of cash, accounts payable and accrued liabilities at September 30, 2004 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, net is reflected at the amount we expect to ultimately collect from outstanding customer balances, and is shown on our balance sheet net of the allowances for product returns, price markdowns and customer bad debts. The adequacy of these allowances is reviewed throughout each reporting period and any necessary adjustments to these allowances are reflected within the current period's provisions for product returns and price markdowns (reflected as a reduction to gross sales); and customer bad debts (reflected as an operating expense). Actual product returns, price markdowns and customer bad debts are recorded as reductions to these allowances as well as reductions to the customers' individual accounts receivable balances (see Note 2). Inventory, net Inventory, net consists primarily of finished goods and is valued at the lower of cost or market. Cost is determined by the first-in, first-out method (FIFO) (see Note 3). Furniture and Equipment, net Furniture and equipment, net is stated at cost and net of accumulated depreciation. Depreciation is calculated on the straight-line method over the estimated useful lives of the assets ranging from three to five years (see Note 5). Long-Lived Assets, net 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 At September 30, 2004, we had intangible assets of approximately $24,000, which related to the Company's trademark registration activities with the United States Patent and Trademark Office. As of September 30, 2004, we had not recorded any amortization expense relating to these assets based upon our evaluation that no impairment has occurred. Revenue Recognition Product Sales ------------- We distribute the majority of our products through third-party software distributors to North American mass-merchant and major 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 sales agreements, most of which allow for product returns and price markdowns. We recognize sales revenues from product shipments to these software distributors and retailers that traditionally have sold consumer entertainment PC software products at the time title to our inventory passes to these distributors or retailers, less a provision for anticipated product returns and price markdowns. Title passes to most of these distributors and retailers upon receipt of the product by these customers, because most of these customers require shipping terms of FOB destination. In order to recognize sales revenues associated with customer purchase orders having terms of FOB destination, we perform sales cut-off tests, in which we obtain proof of deliveries from the freight companies that deliver our products to our retail and distribution customers for product shipments made during the last two weeks of a reporting period. The results of these sales cut-off tests are reviewed by our Controller, Chief Financial Officer and independent auditors before the reporting period's earnings release is distributed. Based on the results of the sales cut-off tests, any sales revenue and cost of sales 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 and are deferred until the subsequent reporting period. We recognize product sales to customers that traditionally have sold consumer entertainment PC software products in accordance with the criteria of SFAS No. 48 at the time title to our inventory passes to these distributors or retailers, 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 support to consumers who purchase our products as a means of improving consumer satisfaction and brand loyalty. Costs associated with our customer support efforts 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 customer support services, which are comprised of the salary and related costs of our one customer support representative, are recorded as operating expenses in the period incurred. We have also entered into relationships with certain software distributors that expanded our product distribution into various office superstores, which distribution is governed by consignment sales agreements. Accordingly, revenues from product shipments pursuant to these arrangements are only recognized to the extent that the third-party software distributor has reported to us that the actual product sell-through to end consumers has occurred. Provision for Product Returns and Price Markdowns ------------------------------------------------- Our provision for anticipated product returns and price markdowns (reflected as a reduction to gross sales) is based upon, among other factors, our analysis of: historical product return and price markdown results; current product sell-through results at retail store locations; current field inventory quantities at distributors' warehouses and at retail store locations; the length of time that products have been out at retail along with their estimated remaining retail life; outstanding return material and price markdown authorizations; the introduction of new and/or competing software products that could negatively impact the sales of one or more of our current products; and the extent to which quantities of new products with higher retail price points or unproven genres remain in the retail channel. The adequacy of our allowance for product returns and price markdowns is reviewed throughout each reporting period and any necessary adjustment to this allowance 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. Historically, the allowance for product returns and price markdowns has represented a substantial percentage of our gross accounts receivable. As of September 30, 2004, the allowance for product returns and price markdowns was 42% of our gross accounts receivable, compared to 34% of our gross accounts receivable at September 30, 2003. This allowance represents a high percentage of our gross accounts receivable because we have product return and price markdown exposure relating to paid receivables while the physical software units relating to these receivables remain in the retailers' stores or in the retailers' or distributors' warehouses. Until the physical products are actually returned to us, or sell through to end consumers, we continue to evaluate our product return or price markdown exposure for these units remaining in the retail channel. During these time periods, through customer-provided reports, we have regular and timely visibility of the product sell-through results and remaining unit levels in the retail channel for our titles that help us estimate our exposure for future product returns and price markdowns. During the quarters ended September 30, 2004 and 2003, our provisions for product returns and price markdowns for customers that have traditionally sold consumer entertainment PC software products were $228,000 and $308,000, respectively, or 17% and 14%, respectively, of related gross sales. 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, estimated tax payments, certain insurance coverage and various service contracts. Prepaid and other expenses are usually expensed as operating expenses on a straight-line basis over the period of time covered by a contract, except for advance licensing and royalty payments, which are usually expensed in cost of sales at contractual rates based on the net sales of the related software titles at retail (see Notes 4 and 7), and income tax payments reflected as income tax provisions when appropriate. We continually evaluate the recoverability of our advance licensing and royalty payments by evaluating all available information about each title, and in particular the expected volume of future sales. For titles that have achieved a successful launch into their intended retail channels, we charge to cost of sales any amount we determine to be non-recoverable in future periods. For titles that have not yet achieved a successful launch into their intended retail channels, we charge all non-recoverable costs to product development expense. Write-off amounts are recognized in the reporting period in which the determination is reached by management that recoverability in future periods is unlikely. Marketing Costs Marketing costs reflected as operating expenses, such as advertising and merchandising fees, are expensed as incurred. These costs were $20,000 and $23,000, respectively, for the quarters ended September 30, 2004 and 2003. Sales Incentives and Promotional Costs Sales incentives and promotional costs we incur with distributors and retailers, such as rebates and slotting fees, are recorded as reductions to gross sales as incurred or on a straight-line basis over contractual periods. For the quarters ended September 30, 2004 and 2003, our sales incentives and promotional costs were $88,000 and $58,000, respectively, or 7% and 3%, respectively, of related gross sales. 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 (Loss) per Common Share Net income (loss) per common share is computed in accordance with SFAS No. 128, "Earnings per Share". Basic earnings (loss) 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 9). 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 customer bad debts, in addition to 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 either a negative or positive impact on future financial results. 2. Accounts Receivable, net Accounts receivable, net consists of the following: Accounts receivable, gross $ 1,972,000 Allowance for product returns and price markdowns (836,000) Allowance for bad debts (14,000) ------------ Accounts receivable, net $ 1,122,000 ============ 3. Inventory, net Inventory, net consists of the following: Raw materials - warehouse $ 153,000 Finished goods - warehouse 751,000 Product returns - retailer and distributor locations 107,000 ------------ 1,011,000 Allowance for obsolescence (169,000) ------------ Inventory, net $ 842,000 ============ 4. Prepaid and Other Expenses Prepaid and other expenses consists of the following: Royalties $ 247,000 Insurances 103,000 Federal tax 61,000 Retailer slotting fees 33,000 Other expenses 30,000 ------------ Prepaid and other expenses $ 474,000 ============ 5. Furniture and Equipment, net Furniture and equipment consists of the following: Furniture and equipment $ 355,000 Accumulated depreciation (280,000) ------------ Furniture and equipment, net $ 75,000 ============ 6. Accrued Expenses Accrued expenses consists of the following: Accrued payroll and vacation $ 84,000 Accrued state income taxes 62,000 Customers with credit balances 57,000 Accrued professional fees 41,000 Other accrued expenses 37,000 Marketing promotions 32,000 ------------ Accrued expenses $ 313,000 ============ 7. Commitments and Contingencies Our 5,000 square foot office facility located in Langhorne, Pennsylvania is occupied under an operating lease through September 30, 2007. Additionally, we currently rent certain office equipment through various operating lease agreements. Total rent expense amounted to $22,000 and $21,000 for the quarters ended September 30, 2004 and 2003, respectively. As of September 30, 2004, we had future operating lease commitments of $206,000 that are scheduled to be paid as follows: $64,000 in less than one year; $138,000 in one to three years; and $4,000 in three to five years. Under various licensing agreements with third-party software developers, we are required to pay royalties for the use of licensed content in our products. 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. As of September 30, 2004, assuming performance by certain third-party software developers under such agreements, we had future commitments to pay $92,000 in advance royalty payments to various software developers scheduled to be paid as follows: $80,000 in less than one year; and $12,000 in one to three years. 8. Credit Facility In September 2003, we entered into a $500,000 credit facility agreement with Hudson United Bank ("HUB"), which matures on December 1, 2004. We expect to renew this facility before its expiration date. Amounts outstanding under this credit facility are 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 customer 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, 2004, we were in compliance with each of those covenants. This credit facility was established to provide working capital for our operations. As September 30, 2004, we had not utilized any of this credit facility, although we were eligible to draw up to $500,000 under this credit facility, based upon qualified accounts receivable as of that date. 9. Accounting for Stock-Based Compensation As of September 30, 2004, 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. The 1995 Plan allows for such granting of options to purchase shares of our common stock through July 1, 2005, after which date any previously granted options will remain in effect throughout their respective contractual terms. 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. 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 option grants made on or after that date. As of January 1, 2003, we adopted the provisions of SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure". During the quarters ended September 30, 2004 and 2003, we recognized stock-based compensation expense of $18,000 and $8,000, respectively, within our financial statements. All stock options that vested during these quarters had been previously valued under the fair value method, and accordingly no reconciliation of stock-based compensation expense between the valuation methods for APB Opinion No. 25 and SFAS No. 123 is necessary. 10. Dependence on One Large Software Distributor - Atari Atari is our primary software distributor servicing the North American mass-merchants and other major retailers, such as Wal-Mart, Target, and Best Buy, among others. During the quarter ended September 30, 2004, Atari accounted for $514,000 of our net sales, or 44% of net sales, compared to the quarter ended September 30, 2003, when Atari accounted for $1,569,000 in net sales, or 76% of net sales. Throughout fiscal 2004 we increased our product distribution through Atari to the major North American mass-merchant retailers by increasing the number of our individual titles carried by these retailers and the number of stores within these retailers' store chains that offer our titles to consumers. During the quarter ended September 30, 2004, one of the largest North American mass - -merchant retailers serviced by Atari indicated that it was reducing the number of $9.99 retail priced titles within their PC software departments, in order to expand its offering of higher priced ($19.99 and above) game and productivity titles. This change in this retailer's marketing emphasis had a negative impact on our net sales during the quarter as a result of lower replenishment and initial product orders from Atari due to its changing inventory requirements from this decision. Our financial condition and ability to continue as a going concern would be significantly affected in the event that we would lose our distribution capability through Atari, or if they would not be able to or willing to make timely receivable payments in the normal course of business. However, because the distribution of PC software to these retailers is a competitive business within itself, there are several alternative distributors that could potentially distribute our products to these retailers if, for example, Atari chose to discontinue distributing our titles, Atari was unable or unwilling to make timely receivable payments in the normal course of business, or if any of these retailers decided to discontinue its relationship with Atari. We can provide no assurance, however, that we would be able to secure agreements with such alternative distributors on commercially reasonable terms or at all, or if such distributors would be acceptable to these retailers. 11. 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 only one reportable segment, which is publishing consumer entertainment software for PCs. 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 Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. 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 volatility, economic risk, and world events, which 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. In particular, these forward-looking statements include, among others, statements about: - Possible opportunities in the mobile phone game market; - Our anticipation that during fiscal 2005 the majority of our net sales, accounts receivable and related cash receipts will continue to be attributable to Atari; - Our expectation that the recent decision by one of North America's largest mass-merchant retailers to decrease the size of its ($9.99 retail priced) jewel case PC game software department chain-wide will continue to impact our financial results for the foreseeable future; - The likely increase in product distribution at the retailers and through the distributors that charge sales incentive and promotional fees during the remainder of fiscal 2005, and that these types of costs will continue having a negative impact on our net sales, gross profit and gross profit margin; - Our expectation that our gross profit margin will continue to be impacted by higher royalty rates associated with new titles during the remainder of fiscal 2005; - Our goal to increase the distribution of our products offered at retail locations to provide us with sufficient profitability and cash flows, as well as continued access to these retail markets; - Our launch of a new online games website to complement our existing e-commerce website and the increase in profitability of our overall Internet sales; - The increase in our receipt of additional quantities of discontinued titles back from the retail channel for liquidation, along with the liquidation of any remaining quantities of these titles still in our warehouse; and - Our intention to ultimately meet the listing standards for the American Stock Exchange and to apply for listing on the American Stock Exchange, or an equivalent exchange. The following important factors, as well as those factors discussed under "Factors Affecting Future Performance" beginning on page 24 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 shelf space Wal-Mart, Target and Best Buy allocate to ($9.99 retail priced) jewel case PC game software; - The amount of unsold product that is returned to us by retail stores and distributors; - The amount of price markdowns we grant 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 continued success of our current business model of selling, primarily through third-party distributors, to a concentrated number of select mass-merchant and major 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 distribute our products into key North American mass-merchant retailers and to enter into new distribution and direct sales relationships on commercially acceptable terms; - Our ability to collect outstanding accounts receivable and establish an adequate allowance for bad debts; - Downward pricing pressure; - Fluctuating costs of developing, producing and marketing our products; - Our ability to license or develop quality content for our products; - The success of our efforts to increase website traffic and product sales over the Internet; - Consumers' continued demand for affordable consumer entertainment PC software; - Increased competition in the affordable PC software category; and various other factors set forth in our Annual Report on Form 10-KSB for the fiscal year ended June 30, 2004 as filed with the Securities and Exchange Commission on September 27, 2004. Overview The following overview is a summary of our operating results as well as some identified trends in our business. We believe that an understanding of these trends is important in order to understand our results for the quarter ended September 30, 2004, as well as our future results. This summary is not intended to be exhaustive, nor is it intended to be a substitute for the detailed discussion and analysis provided elsewhere in this Form 10-QSB, including in this Item 2 "Management's Discussion and Analysis of Financial Condition and Results of Operations" and under "Factors Affecting Future Performance" or the financial statements and the related notes. About eGames We publish, market and sell consumer entertainment PC software games to consumers seeking a broad range of high-quality, affordably priced PC games, either on CDs or online at www.egames.com. We focus on publishing software games for the PC platform, and while we are preliminarily exploring possible opportunities in the mobile phone game market, we currently do not plan to publish products for any other game platform, such as console devices, hand held game devices, mobile phones and personal digital assistants. In North America, our PC games are distributed primarily through third-party software distributors who service the mass-merchant and major retailers. In territories outside North America, we license our PC games to third-party software distributors who are responsible for the manufacture and distribution of our PC games within specific geographic territories. We promote the eGames(TM) and Home Office Help(TM) brands in order to generate customer loyalty, encourage repeat purchases and differentiate eGames software products to retailers and consumers. We also publish and market RealAge(R) Games & Skills, a collection of PC software activities and games designed to help build and maintain mental sharpness. Summary of First Quarter Fiscal 2005 Financial Results Net sales decreased by $874,000, or 43%, to $1,178,000 for the three months ended September 30, 2004, compared to $2,052,000 in net sales for the three months ended September 30, 2003. The $874,000 decrease in net sales was caused by a $927,000 decrease in net sales to software distributors that serve the major North American mass-merchant retailers, which was partially offset by increases in Internet and inventory liquidation net sales. For the quarter ended September 30, 2004, we experienced a net loss of $184,000, or $0.02 per diluted share, compared to net income of $478,000, or $0.05 per diluted share, for the quarter ended September 30, 2003. This $662,000 decline in profitability for the quarter ended September 30, 2004 compared to the year ago quarter was caused primarily by a decrease in gross profit resulting from lower net sales, combined with a lower gross profit margin and higher operating expenses associated with the write-off of costs related to the RealAge Games & Skills project. During the quarter ended September 30, 2004, we experienced a decrease in cash of $188,000, compared to the year ago quarter when cash decreased by $267,000. The $188,000 decrease in cash during the current quarter resulted from $192,000 in cash used in operating activities (as a result of the $184,000 net loss) and $9,000 in cash used in investing activities (for computer network upgrades), which were partially offset by $13,000 in cash provided by financing activities (in proceeds from stock option exercises). Primary Trends in our Business Dependence on One Large Software Distributor - Atari ---------------------------------------------------- We continue to have a highly concentrated customer base of a few large software distributors and retailers. Atari is our primary software distributor serving the mass-merchant and major retailers in North America, such as Wal-Mart, Target, and Best Buy, among others. During the three months ended September 30, 2004, Wal-Mart accounted for about half of our business with Atari, while Best Buy and Target accounted for most of our remaining units sold through Atari. During the quarter ended September 30, 2004, we recognized net sales to Atari of $514,000, which represented 44% of our total net sales, compared to the quarter ended September 30, 2003, when we had $1,569,000 in net sales to Atari, which represented 76% of our total net sales. As of September 30, 2004, Atari represented 57% of our total net accounts receivable, compared to September 30, 2003 when Atari represented 82% of our total net accounts receivable. Additionally, during the quarters ended September 30, 2004 and 2003, we collected receivable payments of $1.1 million and $1.0 million, respectively, from Atari, which represented 69% and 72%, respectively, of our total customer receipts during those quarters. We anticipate that during fiscal 2005 the majority of our net sales, accounts receivable and related cash receipts will continue to be attributable to Atari. Our financial condition and ability to continue as a going concern would be significantly affected if we lost our distribution capability through Atari, if the amount of net sales to Atari were to substantially decrease, or if Atari would not be able or willing to make timely receivable payments to us in the normal course of business. The Affordable Jewel Case PC Game Software Market is Shrinking -------------------------------------------------------------- The affordable ($9.99 retail priced) jewel case PC game software market is not growing and is in fact decreasing in size. An indication of this trend was the recent decision by one of North America's largest mass-merchant retailers to decrease the size of its ($9.99 retail priced) jewel case PC game software department chain-wide, which has more than halved the number of our titles that are now being sold in that retailer's stores. This event negatively affected our net sales and operating results for the quarter ended September 30, 2004 and we expect that it will continue to impact our results for the foreseeable future. We have begun launching titles in the productivity software market, and are also exploring different PC game genres that have recently performed well. In addition to these strategies, we have launched a new online game website, with free online game play and chat rooms, in an effort to tap into potential revenue streams from the growing online game market. We cannot predict whether these new opportunities and strategies will be effective in increasing net sales and offsetting the decreases in net sales caused by recent reductions in the affordable PC game software market at retail. Product Returns and Price Markdowns ----------------------------------- During the quarter ended September 30, 2004, our provision for product returns and price markdowns for customers that have traditionally sold PC software increased to 17% of related gross sales, compared to 14% of related gross sales for the year ago quarter. Sales Incentives and Promotional Costs -------------------------------------- During the quarters ended September 30, 2004 and 2003, these types of fees (recognized as reductions to gross sales) were $88,000 and $58,000, respectively, or 7% and 3%, respectively, of related gross sales. For the remainder of fiscal 2005, our product distribution will likely increase at the retailers and through the distributors that charge such fees, and so we expect these types of costs to continue having a negative impact on our net sales, gross profit and gross profit margin. Gross Profit Margin ------------------- During the quarter ended September 30, 2004, our gross profit margin declined to 51.5%, compared to 60.1% for the quarter ended September 30, 2003. This 8.6% decrease in the gross profit margin was due to increases, as a percentage of net sales, of: 4.1% in royalty costs related to product mix and the write-off of advanced royalties related to titles discontinued at retail; 2.3% in freight costs due to lower sales to software distributors within the United States, and 2.2% in other cost of sales traceable to inventory liquidation sales. For the remainder of fiscal 2005, we expect that our gross profit margin will continue to be impacted by higher royalty rates associated with new titles, combined with continued pricing pressures from software distributors and retailers. Employee Incentive Compensation Expense --------------------------------------- During the quarter ended September 30, 2004, we did not accrue any expense relating to the fiscal 2005 employee incentive compensation plan due to the net loss we experienced, and our uncertainty that we would achieve the operating income threshold required for bonus payments to be made pursuant to that plan. This is in contrast to the quarter ended September 30, 2003, which included approximately $75,000 in compensation expense ($13,000 in product development expense and $62,000 in selling, general and administrative expense) relating to accruals for anticipated bonus payments under the fiscal 2004 employee incentive compensation plan. Critical Accounting Policies and Estimates 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 revenue recognition and inventory valuation accounting policies require us to make significant judgments and estimates that could materially affect the amount of revenue we recognize, the cost of sales we expense, and the values of our inventory and accounts receivable. 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 judgments and estimates that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates for product returns, price markdowns, customer bad debts, inventory obsolescence, income taxes, contingencies and litigation risks. We base our estimates on historical experience and on various other factors and 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) -------------------------------------------------------------------- We distribute the majority of our products through third-party software distributors to mass-merchant and major retailers and directly to certain PC software retailers, all of which have traditionally sold consumer entertainment PC software products. The distribution of our products is governed by purchase orders, distribution agreements or direct sale agreements, most of which allow for product returns and price markdowns. For product shipments to these software distributors or retailers, we record a provision for product returns and price markdowns as a reduction of gross sales at the time the title of our product passes to these distributors or retailers. Key Assumptions Our provision for anticipated product returns and price markdowns is based on the assumptions we make after evaluating various factors, including: our analysis of historical product return and price markdown results; current product sell-through results at retail store locations; current field inventory quantities at distributors' warehouses and at retail store locations; the length of time that products have been out at retail along with their estimated remaining retail life; 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 and price markdown authorizations; and the extent to which units of new products with higher price points or unproven genres remain in the retail channel. The adequacy of our allowance for product returns and price markdowns is continually reviewed throughout each reporting period and any necessary adjustment to this allowance 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. Significant management judgments and estimates must be made and used in order to determine how much sales revenue 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 compared to actual results. These differences, if material, would significantly affect our operating results and financial condition in any given period. Inventory Valuation ------------------- Our accounting policy for inventory valuation requires management to make estimates and assumptions about the recoverability of the carrying value of inventory that affect the reported value of inventory at the end of any reporting period and cost of sales during any reporting period. Our inventory could be valued differently at the close of any reporting period and the amount recorded as cost of sales during any reporting period could differ, if management's judgments or estimates of provisions for the potential impairment of inventory value are insufficient or excessive when compared to actual results. These differences, if material, would significantly affect our operating results and financial condition. Key Assumptions Our provision for inventory obsolescence is based on the assumptions we make after evaluating various factors related to the remaining value of existing warehouse and field inventory units, including: estimating the remaining product life of existing titles based on how long the titles have been out at retail; analyzing the trend of current product sell-through results to consumers for existing titles; identification of competitors' new products with capabilities or technologies that could replace or shorten the lifecycles of our existing titles; assessing the potential for litigation that may terminate our ability to sell existing titles containing certain product content; monitoring of expiration dates of licensing agreements with software developers related to content within existing titles that could stop our further distribution of certain titles; and tracking the current market value for remaining units of discontinued titles based on recent liquidation sales of similar products. 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 original manufactured costs. If we cannot liquidate such inventory, or if we are unable to sell any remaining units due to legal or other reasons, we would then write down the remaining inventory value to zero. The adequacy of our allowance for inventory obsolescence is reviewed throughout each reporting period, and any adjustments are reflected in the current period's inventory obsolescence provision. Results of Operations The following discussion should be read together with our Financial Statements and Notes beginning on page 3. Quarter Ended September 30, 2004 Compared to the Quarter Ended September 30, 2003 Net Sales Net sales decreased by $874,000, or 43%, to $1,178,000 for the three months ended September 30, 2004, compared to $2,052,000 in net sales for the three months ended September 30, 2003. The $874,000 decrease in net sales was caused by a $927,000 decrease in net sales to software distributors that service the major North American mass-merchant retailers due to the effects of less retail shelf space being allocated to $9.99 retail priced PC software products, combined with less promotional box titles being sold in the current quarter compared to the year ago quarter. Additionally, direct sales to various retailers decreased by $10,000, while Internet sales and inventory liquidation sales increased by $25,000 and $38,000, respectively, during the same period. The following table represents our net sales by distribution channel for the quarters ended September 30, 2004 and 2003: Net Sales by Distribution Channel --------------------------------- Quarters ended September 30, -----------------------------------------
Increase % Distribution Channel 2004 % 2003 % (Decrease) Change - ---------------------------------------------------------------------------------------------- Software Distributors $ 815,000 69% $ 1,742,000 85% ($ 927,000) (53%) Software Retailers 160,000 14% 170,000 8% (10,000) (6%) Licensing 101,000 9% 101,000 5% - 0 - n/m Internet 64,000 5% 39,000 2% 25,000 64% Inventory Liquidators 38,000 3% - 0 - n/m 38,000 n/m - ---------------------------------------------------------------------------------------------- Totals $ 1,178,000 100% $ 2,052,000 100% ($ 874,000) (43%) =========== ==== =========== ==== ========= ===
The overall decrease in net sales was primarily driven by decreased sales of our products to our largest software distributor, Atari, which services many of the larger North American mass-merchant and major retailers (such as Wal-Mart, Target and Best Buy). Partially offsetting this net sales decrease were net sales increases resulting from expanded distribution of our products to major office superstores within the United States, such as Office Max, through Take Two Interactive's software distribution division, along with increased product distribution to various Canadian retailers, such as EB Games, Future Shop, Radio Shack and Business Depot through software distributors such as Jack of All Games and Softek. Retailers that have historically been successful in merchandising PC game software typically designate the distributor that they want to use for the distribution of our products to their stores, and in certain instances retailers have decided that we should distribute our software products directly to them. Our goal is to increase the distribution of our products offered at retail locations, by whatever means - third party distribution or direct shipments to retailers - that will provide us with sufficient profitability and cash flows, as well as continued access to these retail markets. Software Distributors --------------------- For the quarter ended September 30, 2004, net sales to software distributors amounted to $815,000, which represented a decrease of $927,000 or 53% from the quarter ended September 30, 2003. For the quarter ended September 30, 2004, net sales to software distributors decreased to 69% of total net sales, compared to 85% of total net sales for the quarter ended September 30, 2003. For the quarter ended September 30, 2004, the $927,000 decrease in net sales to software distributors was predominantly driven by the $1,055,000 decrease in net sales to Atari that resulted from: o The impact on replenishment and initial product orders related to the recent decision by one of North America's largest mass-merchant retailers to change its marketing emphasis to feature higher retail price point ($19.99 and above) game and productivity titles, thereby reducing the retail shelf space allocated to PC game software titles at the $9.99 retail price point; o No sales during the quarter ended September 30, 2004 of certain promotional box titles retail priced at $19.99, which in the year ago quarter had represented approximately $280,000 in net sales; combined with o Decreased demand for value priced game software, in general, which we believe has been caused in part by increased competition in the overall consumer entertainment marketplace from a growing number of alternative game-playing technologies available to consumers, including game consoles, hand-held game devices, mobile phones and online game websites. Partially offsetting this decrease in net sales to Atari were net sales increases of: o $51,000 to Take Two Interactive, o $44,000 to Softek, and o $26,000 to Jack of All Games. Dependence on One Large Software Distributor - Atari ---------------------------------------------------- Atari is our primary software distributor serving the mass-merchants and major retailers in North America, such as Wal-Mart, Target, and Best Buy, among others. During the quarter ended September 30, 2004, Atari accounted for $514,000, or 44%, of our net sales, compared to the quarter ended September 30, 2003 when Atari accounted for $1,569,000, or 76%, of our net sales. During the quarter ended September 30, 2004, we continued to rely heavily on our product distribution through Atari to the major North American mass-merchant retailers, although Atari's percentage of our total business declined to 44% of net sales. Our financial condition and ability to continue as a going concern would be significantly affected in the event that we would lose our distribution capability through Atari, or if the amount of net sales to Atari were to substantially decrease over a short period of time. The distribution of PC software to these retailers is a competitive business within itself, and there are several alternative distributors that could potentially distribute our products to these retailers if, for example, Atari chose to discontinue distributing our titles, Atari was not able or willing to make timely receivable payments in the normal course of business or if any of these retailers decided to discontinue its relationship with Atari. We can provide no assurance, however, that we would be able to secure agreements with alternative distributors on commercially reasonable terms or at all, or if such distributors would be acceptable to these retailers. Software Retailers ------------------ For the quarter ended September 30, 2004, net sales made directly to software retailers were $160,000, which represented a $10,000 decrease compared to the quarter ended September 30, 2003. This $10,000 decrease in net sales made directly to software retailers resulted primarily from a $29,000 decrease in net sales to CompUSA due to a reduced number of our titles being offered at CompUSA stores, which was partially offset by various net sales increases to other retailers. Licensing --------- During the quarter ended September 30, 2004, licensing revenues were generated primarily from sales made by our international software distributors under a series of licensing agreements covering various territories outside of North America, with the majority of our licensing revenues originating from Germany, the United Kingdom, and Brazil. For the quarters ended September 30, 2004 and 2003, licensing revenues amounted to $101,000 for both periods, and represented 9% and 5%, respectively, of net sales during these quarters. Internet -------- Internet sales were $64,000 and $39,000 for the quarters ended September 30, 2004 and 2003, respectively, and represented 5% and 2%, respectively, of net sales during these quarters. This $25,000 increase in Internet sales during the quarter ended September 30, 2004 represented a 64% rise from the year ago quarter, and resulted from our decision to manage our Internet sales internally in order to more effectively market our titles on the Internet. In October 2004, we launched a new online games website, www.egamesonline.com, which is intended to complement our existing e-commerce website and increase the profitability of our overall Internet sales, through additional advertising revenues, and downloadable demos that are designed to generate incremental sales on the main eGames website by cross-promoting the full game versions of those eGames titles. Inventory Liquidators --------------------- For the quarter ended September 30, 2004, net sales to inventory liquidators were $38,000 and represented 3% of total net sales, compared to no such sales during the year ago quarter. Net sales to inventory liquidators consist of sales of residual inventory titles that have been discontinued at retail because these titles have reached the end of their product lifecycles. As retailers continue to routinely change the mix of software titles displayed on their store shelves - - usually on a quarterly basis - we expect to receive additional quantities of discontinued titles back from the retail channel that will then need to be liquidated, along with any remaining quantities of these titles still in our warehouse. Inventory liquidation sales are usually made at discount prices, below a product's previous wholesale price point, and are usually sold to these inventory liquidators with no right to return products or to receive price markdowns. Product Returns and Price Markdowns ----------------------------------- During the quarters ended September 30, 2004 and 2003, our provisions for product returns and price markdowns for customers that have traditionally sold consumer entertainment PC software products were $228,000 and $308,000, respectively, or 17% and 14%, respectively, of related gross sales. This $80,000 decrease in the provisions for product returns and price markdowns resulted from a 38% decrease in gross sales compared to the year ago quarter, that was partially offset by a higher provision rate needed against the current quarter's gross sales to maintain an adequate allowance for product returns and price markdowns based upon our evaluation of the salability of the titles remaining in the retail channel as of September 30, 2004. Sales Incentives and Promotional Costs -------------------------------------- In order to gain or maintain retail shelf space for our titles, we incur sales incentives and promotional costs from distributors and retailers, such as rebates and slotting fees, and recognize them as reductions to gross sales. During the quarters ended September 30, 2004 and 2003, our sales incentives and promotional costs were $88,000 and $58,000, respectively, or 7% and 3%, respectively, of related gross sales. For the remainder of fiscal 2005, we plan to increase our product distribution at the retailers and through the distributors that charge such fees, and so we expect these types of costs to continue impacting our net sales, gross profit and gross profit margin. Cost of Sales Cost of sales consists of the following costs that are associated with the publishing of our PC games for retail distribution: actual product costs; royalty costs incurred with third-party software developers for licensing product content; freight and handling costs; inventory obsolescence provisions and other costs. The following table represents our cost of sales for the quarters ended September 30, 2004 and 2003: September 30, % of September 30, % of Increase % 2004 net sales 2003 net sales (Decrease) Change - ------------------------------------------------------------------------------- $ 571,000 48.5% $ 818,000 39.9% ($ 247,000) (30.2%) During the quarter ended September 30, 2004, cost of sales decreased by $247,000, or 30.2%, to $571,000, due to the 43% decrease in overall net sales, which was partially offset by a higher cost of sales percentage on those reduced sales. For the quarter ended September 30, 2004, cost of sales, as a percentage of net sales, increased to 48.5% from 39.9% for the quarter ended September 30, 2003. This 8.6% increase in cost of sales, as a percentage of net sales, was due to: o a 4.1% increase in royalty costs resulting from product mix changes and the write-off of advance royalty payments related to various game titles removed from retail distribution; o a 2.3% increase in freight costs due to a smaller proportion of sales to software distributors within the United States, combined with a greater percentage of higher costing product deliveries made to Canadian distributors and to North American retailers; and o a 2.2% increase in other costs related primarily to increased inventory liquidation sales. For the remainder of fiscal 2005, we expect our gross profit margin to continue to be impacted by higher average royalty rates associated with our new titles, combined with continued pricing pressures from our distributors and retailers (such as sales incentives and promotional costs reflected as selling price adjustments), as we attempt to maintain or increase our share of retail shelf space. Product Development Product Development expenses consist of personnel costs related to product management, quality assurance testing, packaging design and website administration, along with outside services for product ratings and website maintenance, in addition to non-recoverable project costs related to products prior to achieving a successful launch into their intended retail channels. The following table represents our product development expenses for the quarters ended September 30, 2004 and 2003: September 30, % of September 30, % of Increase % 2004 net sales 2003 net sales (Decrease) Change - ------------------------------------------------------------------------------- $ 239,000 20.3% $ 126,000 6.2% $ 113,000 89.7% For the quarter ended September 30, 2004, product development expenses increased by $113,000, or 89.7%, to $239,000, compared to the quarter ended September 30, 2003. This expense increase resulted from the write-off of $122,000 in capitalized licensing and inventory costs related to the RealAge Games & Skills title due to our determination during the quarter that the recovery of these costs in future periods was unlikely, based upon our consideration of all available information, and in particular on the expected amount of any future sales. The write-off of these costs was charged to product development expense, rather than to cost of sales, because we determined that these costs were related to a business development project that had not yet achieved a successful launch into its intended retail channels. This project was not designed for traditional retail distribution through our normal business operations, but rather through alternative retail distribution channels such as direct response TV and direct to consumer marketing campaigns. To date, all of our efforts to launch this title and brand into its intended retail channels have been unsuccessful, and we are currently evaluating its future commercial viability. The RealAge Games & Skills brand was developed during fiscal 2004, in an attempt to attract new consumers to the PC game category by providing consumers with a compelling reason to play PC games because they can help maintain mental sharpness. Selling, General and Administrative Selling, General and Administrative expenses consist of personnel related costs, insurance costs, stock-based compensation expense, professional service fees for legal, accounting and public relations, along with occupancy costs including rent, utilities and phones. The following table represents our selling, general and administrative expenses for the quarters ended September 30, 2004 and 2003: September 30, % of September 30, % of Increase % 2004 net sales 2003 net sales (Decrease) Change - ------------------------------------------------------------------------------- $ 571,000 48.5% $ 602,000 29.3% ($ 31,000) (5.1%) For the quarter ended September 30, 2004, selling, general and administrative expenses decreased by $31,000 to $571,000 compared to the quarter ended September 30, 2003. This $31,000 expense decrease was caused by a $40,000 decrease in public relations costs associated with the RealAge Games & Skills brand, which was partially offset by a $10,000 increase in stock-based compensation expense relating to the vesting of stock options. During the remainder of fiscal 2005, we anticipate incurring additional expenses relating to our compliance efforts associated with the requirements under Section 404 of the Sarbanes-Oxley Act of 2002. Interest (Income) Expense, net The following table represents our net interest income for the quarter ended September 30, 2004 and our net interest expense for the quarter ended September 30, 2003: September 30, % of September 30, % of Increase % 2004 net sales 2003 net sales (Decrease) Change - ------------------------------------------------------------------------------- ($ 1,000) (0.1%) $ 5,000 0.2% ($ 6,000) (120.0%) For the quarter ended September 30, 2004, we earned net interest income of $1,000 compared to recognizing $5,000 in net interest expense in the quarter ended September 30, 2003. Provision (Benefit) for Income Taxes The following table represents our income tax benefit for the quarter ended September 30, 2004 and our income tax provision for the quarter ended September 30, 2003: September 30, % of September 30, % of Increase % 2004 net sales 2003 net sales (Decrease) Change - ------------------------------------------------------------------------------- ($ 18,000) (1.5%) $ 22,000 1.1% ($ 40,000) (181.8%) For the quarter ended September 30, 2004, our benefit for income taxes was $18,000 compared to the year ago quarter's provision for income taxes of $22,000. This $40,000 decrease in the provision for income taxes related to the estimated taxable loss for state income purposes during the current quarter compared to the estimated taxable income for state income tax purposes for the year ago quarter. As of the beginning of fiscal 2005, we had approximately $2.3 million in net operating loss carry-forwards ("NOL's") available to offset future taxable income for federal income tax purposes. Net Income (Loss) The following table represents our net loss for the quarter ended September 30, 2004 and our net income for the quarter ended September 30, 2003: September 30, % of September 30, % of Increase % 2004 net sales 2003 net sales (Decrease) Change - ------------------------------------------------------------------------------- ($ 184,000) (15.6%) $ 478,000 23.3% ($ 662,000) (138.5%) Weighted Average Common Shares The weighted average common shares outstanding on a diluted basis decreased by 370,425 for the quarter ended September 30, 2004 to 10,102,673 from 10,473,098 for the quarter ended September 30, 2003. The current quarter's decrease in the diluted basis calculation of weighted average common shares resulted from this quarter's amount not including any common share equivalents due to the quarter's net loss, compared to the year ago quarter's amount that did include common share equivalents. Liquidity and Capital Resources As of September 30, ------------------------ 2004 2003 Change ------------------------------------- Cash and cash equivalents $ 1,554,000 $ 758,000 $ 796,000 =========== ========= ========= Percent of total assets 38% 23% === === Quarters September 30, ----------------------- 2004 2003 Change ----------------------------------- Cash used in operating activities ($ 192,000) ($259,000) $ 67,000 Cash used in investing activities (9,000) (8,000) (1,000) Cash provided by financing activities 13,000 - 0 - 13,000 ----------------------------------- Net decrease in cash and cash equivalents ($ 188,000) ($ 267,000) $ 79,000 ========= ========= ======== Changes in Cash Flow, Operating Activities During the quarter ended September 30, 2004, we had $192,000 of cash used in operating activities compared to $259,000 of cash used in operating activities for the quarter ended September 30, 2003. The $192,000 of cash used in operating activities for the quarter ended September 30, 2004 resulted primarily from the $184,000 net loss we experienced, combined with reductions in: o Accrued expenses traceable to employee bonus payments made pursuant to the fiscal 2004 employee incentive compensation plan; and o Accounts payable resulting from accelerated vendor payments in exchange for obtaining cash discounts, combined with lower purchasing requirements traceable to lower sales volumes. Partially offsetting these cash uses, was the cash provided from additional customer receivable payments received during the quarter ended September 30, 2004. Accounts Receivable, net ------------------------ During the quarter ended September 30, 2004, net accounts receivable decreased by $412,000, which reflected a $732,000 decrease in gross accounts receivable and a $320,000 decrease in our allowances for product returns, price markdowns and bad debts. The $412,000 decrease in net accounts receivable for the current quarter resulted directly from receiving $1.6 million in cash from our customers, which exceeded the $1.2 million in net sales during the quarter. Generally, we have been able to collect our net accounts receivable in the ordinary course of business, but have from time to time experienced periods of slowness in customer payments. Accordingly, we continually monitor our receivable balances and communicate with our customers in order to expedite their payments of past due amounts or to process authorized credits for product returns and price markdowns. Since we do not hold any collateral to secure payment from any of our customers and because most of our customers have the right to return products and receive price markdowns that can be used to reduce their payments to us, the valuation of our accounts receivable is continually reviewed and analyzed in order to help anticipate any liquidity issues that could result from our inability to collect a receivable balance in the normal course of business. We continue to have a highly concentrated customer base consisting of a few large software distributors and retailers. In particular, as of September 30, 2004, our largest software distributor, Atari, represented 57% of our net accounts receivable, compared to September 30, 2003, when Atari represented 82% of our net accounts receivable. Additionally, during the quarters ended September 30, 2004 and 2003, we collected receivable payments of $1.1 million and $1.0 million, respectively, from Atari, which represented 69% and 72%, respectively, of our total customer receipts during those quarters. Our ability to collect, in a timely manner, the net receivable amount owed by Atari remains critical for us to be able to meet our financial obligations and to fund normal operations. If at any time Atari would become unable or unwilling to make its receivable payments to us in a timely manner, our ability to continue ongoing operations would be significantly impaired. Inventory, net -------------- During the quarter ended September 30, 2004, we experienced a $28,000 increase in net inventory, which resulted from a $76,000 increase in our gross inventory that was partially offset by a $48,000 increase in the allowance for inventory obsolescence. The increase in our gross inventory was largely due to many of our newly manufactured titles not being shipped to Atari within the current quarter, as a result of the recent decision by one of North America's largest mass-merchant retailers to reduce the size of its ($9.99 retail priced) jewel case PC software department, which had a negative impact on both replenishment and initial product orders from Atari during the quarter ended September 30, 2004. We anticipate that this change at retail will continue to negatively impact our net sales and inventory levels for the remainder of fiscal 2005. Prepaid and Other Expenses -------------------------- During the quarter ended September 30, 2004, prepaid and other expenses increased by $34,000 due to payments related to insurances and federal taxes, which were partially offset by a decrease in advanced royalties due to amounts written off that related to certain discontinued titles. Accounts Payable ---------------- During the quarter ended September 30, 2004, our accounts payable decreased by $81,000, which resulted from our continued acceleration of payments to certain trade vendors in exchange for receiving cash discounts, combined with decreased purchasing requirements traceable to reduced sales activity. During the quarter ended September 30, 2004, our vendor cash discounts amounted to $20,000. Accrued Expenses ---------------- During the quarter ended September 30, 2004, our accrued expenses decreased by $304,000 as a result of employee bonus payments made pursuant to the fiscal 2004 employee incentive compensation plan. There was no such expense accrual made during the current quarter relating to the fiscal 2005 employee incentive compensation plan due to the net loss we experienced, and our uncertainty that we would achieve the operating income threshold required for bonus payments to be made pursuant to that plan. Changes in Cash Flow, Non-Operating Activities For the quarter ended September 30, 2004, we had net cash used from investing activities of $9,000 for equipment upgrades to our computer network. For the quarter ended September 30, 2004, we had $13,000 in net cash provided by financing activities from the proceeds related to the exercise of options to purchase shares of our common stock. Credit Facility In September 2003, we entered into a $500,000 credit facility agreement with Hudson United Bank ("HUB"), which matures on December 1, 2004. We expect to renew this facility before its expiration date. Amounts outstanding under this credit facility are 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 and customer bad debts. This 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 10, 2004, we were in compliance with each of those covenants. This credit facility was established to provide working capital for our operations. As of November 10, 2004, we had not utilized any of this credit facility, although we were eligible to draw up to $500,000 under this credit facility, based upon qualified accounts receivable as of that date. Contractual Obligations and Commitments We occupy our 5,000 square foot office facility located in Langhorne, Pennsylvania under an operating lease that is scheduled to expire on September 30, 2007. Additionally, we currently rent certain office equipment through various operating lease agreements. As of September 30, 2004, we had future operating lease commitments of $206,000, as reflected in the table below. Under various licensing agreements with third-party software developers, we are required to pay royalties for the use of licensed content in our products. Most of these licensing agreements require us to make advance royalty payments to these software developers prior to the time we recognize any net sales of software titles containing this licensed content. As of September 30, 2004, assuming performance by certain third-party software developers under such agreements, we had commitments to pay $92,000 in future advance royalty payments to various software developers as reflected in the table below. These 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 $ 206,000 $ 64,000 $ 138,000 $ 4,000 $ - 0 - Advanced royalties 92,000 80,000 12,000 - 0 - - 0 - - --------------------------------------------------------------------------------------------- Totals $ 298,000 $ 144,000 $ 150,000 $ 4,000 $ - 0 - ========= ========= ========= ======= ========
Liquidity Risk Our ability to maintain positive cash flow remains essential to our survival as a going concern because our access to our existing credit facility is limited to the lesser of $500,000 or 75% of our qualified accounts receivable. In particular, our ability to maintain positive cash flow depends upon a variety of factors, including the timing of the collection of outstanding accounts receivable, the creditworthiness of our primary software distributors and retailers, sell-through of our products to consumers, and the costs of developing, producing, marketing and promoting of our PC software titles. There are significant challenges that we will need to successfully manage in order to fund our operations in the future. These challenges include, but are not limited to, maintaining our relationships with our principal distributors and retailers, maintaining timely receivable payments from our concentrated group of distributors and retailers, in addition to maintaining acceptable payment terms with our trade vendors. For example, our liquidity would be severely impacted if Atari, and to a lesser extent Take Two Interactive, Softek or EB Carlson, did not make receivable payments to us on a timely basis, or if other business conditions caused them to fail to pay us at all. Additionally, there are market factors beyond our control that could also significantly affect our operating cash flow. The most significant market factors are the market acceptance and sell-through rates of our products to consumers, and the shelf space allocated to our products at retail. If any of our software titles do not sell through to consumers at a rate acceptable to retailers, then we could be exposed to unanticipated product return and price markdown credit authorizations that could then be used by distributors and retailers to reduce their upcoming receivable payments to us, along with a reduction in retailer and/or distributor replenishment orders for these products. If we experienced a negative trend in any of these factors, we may not be able to maintain positive cash flow. Additional outside financing to supplement our cash flow 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 potential stockholder dilution it may cause or other costs associated with such financing that we could not accept. Listing of Our Common Stock Our common stock trades on the OTC Bulletin Board under the symbol EGAM. It is our intention to ultimately meet the listing standards for the American Stock Exchange. If we are able to achieve these standards, we plan to apply for listing on the American Stock Exchange, or an equivalent exchange, at that time. FACTORS AFFECTING FUTURE PERFORMANCE 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 our future performance. A significant part of our sales come from a limited number of customers, and if we are unable to continue viable business relationships with key distributors and retailers, this could materially harm our business. The majority of our current sales are to software distributors that service the mass-market and major retailers in North America, and therefore our business relies on a concentrated group of these large customers. Atari is our primary North American distributor servicing the major mass-merchant retailers in North America, such as Wal-Mart, Target, and Best Buy, among others. During fiscal 2004, Wal-Mart accounted for about half of our unit sales to Atari, while Best Buy and Target accounted for most of our remaining business with Atari. During the first quarter of fiscal 2005, the decision by one of North America's largest mass-merchant retailers to decrease the size of its PC game software department (allocated to $9.99 jewel case titles) chain-wide more than halved the number of our titles that are now being sold in that retailer's stores. This event negatively affected our net sales and operating results for the quarter ended September 30, 2004, and we expect that it will continue to impact our results for the foreseeable future. Our net sales to Atari during the fiscal year ended June 30, 2004 were $5.5 million and represented 69% of our total net sales. We anticipate that net sales to Atari may represent approximately 70% of our total net sales during fiscal 2005. Accordingly, we expect to continue depending upon a limited number of significant distributors and retailers, and in particular Atari, for the foreseeable future. We do not have long-term agreements with the primary distributors of our products (Atari, Take Two Interactive, Jack of All Games, Softek and E.B. Carlson), and the terms of our business relationships with these distributors do not require them to purchase our products. If these distributors were to stop distributing our products, our sales would decline substantially and in a brief period of time. In addition, if distributors of our products were only willing to distribute our products on terms that were commercially unacceptable to us, our financial condition would be materially harmed. We also might not be successful in distributing our products directly to key retailers. Even if we were successful in selling our products directly to these retailers, it might be on terms that are not commercially acceptable. Our inability to negotiate commercially viable distribution relationships with major software 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. 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 limited amount of shelf space, which has diminished over time. Retailers have a finite amount of shelf space on which to display consumer entertainment PC software products, and changes to shelf space allocations, such as the ones that recently occurred at a major retailer, will negatively affect our future sales and operating results. There is intense competition among consumer entertainment PC software publishers for retail shelf space and promotional support from retailers. The competition for retail shelf space continues to intensify and we are seeing shifts in the retail marketing of PC software games that are likely to continue to affect our operating results. Competition for retail shelf space also results in greater leverage for retailers and distributors in negotiating terms of sale, including price markdowns and product return policies, and our larger competitors may have more leverage than we do to negotiate more and better-positioned shelf space than we do. 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. We depend on the market acceptance of our products, and these products typically have relatively short product life cycles. Our profitability is dependent on our ability to publish and get into retail stores successful new PC software titles. Consumer preferences for entertainment PC software products are difficult to predict and few products achieve sustained market acceptance. The market for consumer entertainment PC software is also subject to shifts in consumer preferences and typical product life cycles of no more than six to fifteen months. 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 royalty, inventory, development, marketing and promotional costs. Also, if a product does not sell through to consumers at a rate satisfactory to our retailers or distributors, we could be forced to accept substantial product returns or be required to issue significant 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 to the retailers. Failure of new products to achieve or sustain market acceptance would adversely impact our business, operating results and financial condition. We may need additional funds, and we may not be able to obtain such funding if we need it. In September 2003, we entered into a $500,000 credit facility agreement with Hudson United Bank ("HUB"), which matures on December 1, 2004. We expect to renew this facility before its expiration date. Our capital requirements are currently funded from the cash flow generated from product sales and our $500,000 credit facility with Hudson United Bank. This credit facility is subject to limitations based on the value of our accounts receivable, and therefore working capital may not be available to us 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 in the future. 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, small size, and our historical fluctuating financial results could make it difficult for us to obtain additional financing, which makes 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. If our major distributors or retailers are not able to or are unwilling to pay us at all or within the normal course of business, this would materially harm our financial condition. 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 some of these companies have failed. If any significant retailer or distributor of our products experienced financial difficulties, became insolvent, or went out of business, this 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. If any of our major distribution or retail customers failed to pay an outstanding receivable, particularly Atari, which as of September 30, 2004 represented 57% of our total net accounts receivable balance, our business, operating results and financial condition would be significantly harmed. Our distributors and retailers 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 retailers and distributors servicing such retailers. These allowances are based upon, among other factors, our analysis of: historical product return and price markdown results; current product sell-through results at retail store locations; current field inventory quantities at distributors' warehouses and at retail store locations; the length of time that products have been out at retail along with their estimated remaining retail life; outstanding return material and price markdown authorizations; the introduction of new and/or competing software products that could negatively impact the sales of one or more of our current products; and the extent to which quantities of new products with higher retail price points or unproven genres remain in the retail channel. Our sales to these customers are reported net of product return and price markdown provisions. Actual product returns and price markdowns could exceed our allowances for these anticipated amounts, particularly for products that have higher price points than our typical $9.99 jewel case products, or are in genres that have not been proven to be successful for us, 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. Comparative sequential and year-to-year quarterly operating results may provide little meaningful information or guidance because of our relatively small size and the impact on our net sales resulting from the timing of purchase orders from retailers and distributors and other changes in market forces. Fluctuations in quarterly operating results will depend upon many factors including: o Seasonality of consumer entertainment PC software purchases; o Shelf space allocations by major retailers; o Timing of major distributor and retailer purchase orders; o Amount and timing of product returns and price markdowns; and o Timing of our new product introductions, product enhancements and those of our competitors. 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 each reporting period. We are exposed to seasonality in the purchases of our products. The PC game software industry is highly seasonal, with sales tending to be higher during the quarter ending December 31st. This is due to increased demand for PC software games during the back-to-school and holiday selling seasons primarily because retailers experience greater store traffic during these periods. Delays in product development or manufacturing can affect the timing of the release of our products, causing us to miss out on key selling periods - typically referred to as merchandising "resets" - 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 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 these key selling periods, our financial results for the entire fiscal year would be adversely affected. We rely entirely on third party independent software developers for our product content, and therefore our success depends on our ability to secure commercially viable licensing agreements with these developers. Independent software developers develop all of the content for our software titles. Our success in introducing new high quality PC software titles depends on our ability to maintain relationships and obtain licensing agreements on favorable terms with skilled independent software developers. Increased competition for the licensing rights to quality consumer entertainment PC software content has compelled us to agree to 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 advance and minimum payments do not generate sufficient sales volumes to recover these costs, this would have a negative impact on our financial results. Additionally, if we are not able to obtain quality content on commercially viable terms from independent software developers, this would also adversely affect our business. Our present or future competitors may develop products that are comparable or superior to ours. Our competitors may offer higher quality products, lower priced products or adapt more quickly than we do to new technologies or evolving customer requirements. Our competitors typically have more financial resources to spend on marketing promotions, sales incentives, licensing recognizable brands, and advertising efforts. Competition has continued to intensify as our industry has consolidated, since we have remained a small software publisher and some of our competitors have grown larger. 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 adversely affect our operating results and financial condition. Our common stock has experienced low trading volumes and other risks on the OTC Bulletin Board. Our shares of Common Stock are currently traded on the OTC Bulletin Board under the symbol EGAM. 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 can 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. Regulation of our product content and features could affect the marketability of our products. 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 and online 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. 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 for our product content, trademarks and trade names and other marketing 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 top-selling 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 and on the overall value of our company. 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. A significant amount of unauthorized copying of our products would adversely affect our business, operating results and financial condition. 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 may give rise to claims of infringement. In past 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 initiation 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 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 can be 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, primarily consisting of licensing revenues, represented 9% of our net sales for the quarter ended September 30, 2004. We anticipate that in fiscal 2005 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 the related outstanding licensing receivable, 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, 2004 (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 to provide reasonable assurance that the information required to be disclosed in our reports filed or furnished under the Exchange Act are recorded, processed, summarized and reported, within the periods specified in the SEC's rules and forms. We believe that a controls system, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the controls system are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected. (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, 2004 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Part II. Other Information Item 6. Exhibits Exhibit No. Description of Exhibit - ----------- ---------------------- 10.1 1995 Amended and Restated Stock Option Plan 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. 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 12, 2004 /s/ Gerald W. Klein ----------------- -------------------- Gerald W. Klein, President, Chief Executive Officer and Director Date: November 12, 2004 /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 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 12, 2004 - ----------------------- /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 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 12, 2004 - ----------------------- /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, 2004 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, based on my knowledge, 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 12, 2004 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, 2004 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, based on my knowledge, 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 12, 2004 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. EX-10 2 ex1995soplan.txt EGAMES 1995 AMENDED AND RESTATED SO PLAN Exhibit 10.1 AMENDED AND RESTATED 1995 STOCK OPTION PLAN PART I - DEFINITIONS AND ADMINISTRATIVE MATTERS SECTION 1 - PURPOSE; DEFINITIONS The purpose of the eGames, Inc. Amended and Restated 1995 Stock Option Plan (the "Plan") is to enable employees, officers, directors and independent contractors of eGames, Inc. ("the Company") to: (i) own shares of stock in the Company, (ii) participate in the stockholder value which has been created, (iii) have a mutuality of interest with other stockholders and (iv) enable the Company to attract, retain and motivate employees, officers, directors and independent contractors of particular merit. For the purposes of the Plan, the following terms shall be defined as set forth below: (a) "Board" means the Board of Directors of the Company. (b) "Code" means the Internal Revenue Code of 1986, as amended from time to time, and any successor thereto. (c) "Company" means eGames, Inc., its Subsidiaries or any successor organization. (d) "Disability" means permanent and total disability within the meaning of Section 22(e)(3) of the Code. (e) "Disinterested Person" shall have the meaning set forth in the Rules. (f) "Eligible Independent Contractor" means an independent contractor hired by the Company who is neither an Employee of the Company nor a Non-Employee Director. (g) "Employee" means any person, including a director, who is employed by the Company and is compensated for such employment by a regular salary. (h) "Exchange Act" means the Securities Exchange Act of 1934, as amended. (i) "Fair Market Value" means the per share value of the Stock as of any given date, as determined by reference to the price of the last traded share of Stock on the over-the-counter market, as reported by the National Association of Securities Dealers, Inc. Automated Quotation ("NASDAQ") System for such date or the next preceding date that Stock was traded on such market, or, in the event the Stock is listed on a stock exchange, the closing price per share of Stock as reported on such exchange for such date. (j) "Incentive Stock Option" means any Stock Option intended to be and designated as an "Incentive Stock Option" within the meaning of Section 422 of the Code. (k) "Insider" means a Participant who is subject to Section 16 of the Exchange Act. (l) "Non-Employee Director" means any member of the Board who is not an Employee of the Company and is not compensated for employment by a regular salary. (m) "Non-Qualified Stock Option" means any Stock Option that is not an Incentive Stock Option. (n) "Parent" means any corporation which owns stock entitling such corporation to fifty percent (50%) or more of the voting power of the Company. (o) "Participant" means an Employee, officer, Non-Employee Director or Eligible Independent Contractor to whom an award is granted pursuant to the Plan. (p) "Plan" means the eGames, Inc. Amended and Restated 1995 Stock Option Plan, as hereinafter amended from time to time. (q) "Rules" means Rule 16(b)(3) and any successor provisions promulgated by the Securities and Exchange Commission under Section 16 of the Exchange Act. (r) "Securities Act" shall mean the Securities Act of 1933, as amended. (s) "Securities Broker" means the registered securities broker acceptable to the Company who agrees to effect the cashless exercise of an Option pursuant to Section 5(d) hereof. (t) "Stock" means the Common Stock of the Company, without par value. (u) "Stock Option" or "Option" means any option to purchase shares of Stock (including Restricted Stock, if the Board so determines) granted pursuant to Section 5 below. (v) "Subsidiary" means any corporation owned, in whole or in part, by the Company. SECTION 2 - ADMINISTRATION 2.1 The portion of the Plan with respect to the grant of Options pursuant to Part II shall be administered by the Board, provided, however, that the Board reserves the right to delegate such administration to a committee of the Board comprised of such directors as the Board may determine, and who shall serve at the pleasure of the Board. The Board shall have the authority to grant pursuant to the terms of the Plan: Stock Options to Employees (including directors who are Employees) and officers of the Company, and Eligible Independent Contractors. In particular, the Board shall, subject to the limitations and terms of the Plan, have the authority: (i) to select the officers, directors (who are Employees) and other Employees of the Company, and the Eligible Independent Contractors to whom Stock Options may from time to time be granted hereunder; (ii) to determine whether and to what extent incentive Stock Options are to be granted hereunder; (iii) to determine the number of shares to be covered by each such award granted hereunder; (iv) to determine the terms and conditions, not inconsistent with the terms of the Plan, of any award granted hereunder, including the option or exercise price and any restrictions or limitations, based upon such factors as the Board shall determine, in its sole discretion; (v) to determine whether and under what circumstances a Stock Option may be exercised and settled in cash or Stock or without a payment of cash; (vi) to determine whether, to what extent and under what circumstances Stock and other amounts payable with respect to an award under this Plan shall be deferred either automatically or at the election of the Participant; and (vii) to amend the terms of any outstanding award (with the consent of the Participant) to reflect terms not otherwise inconsistent with the Plan, including amendments concerning exercise price changes, vesting acceleration or forfeiture waiver regarding any award or the extension of a Participant's right with respect to awards granted under the Plan, as a result of termination of employment or service or otherwise, based on such factors as the Board shall determine, in its sole discretion. The Board shall have the authority to adopt, alter and repeal such administrative rules, guidelines and practices governing the Plan as it shall, from time to time deem advisable; to interpret the terms and provisions of the Plan and any award issued under the Plan (and any agreements relating thereto); and to otherwise supervise the administration of the Plan, provided that the Board may delegate to the Chief Executive Officer of the Company, or such other officer as may be designated by the Board, the authority, subject to guidelines prescribed by the Board, to grant Options to Employees and Eligible Independent Contractors who are not then subject to the provisions of Section 16 of the Exchange Act, and to determine the number of shares to be covered by any such Option, and the Board may authorize any one or more of such persons to execute and deliver documents on behalf of the Board, provided that no such delegation may be made that would cause grants of Options to persons subject to Section 16 of the Exchange Act to fail to comply with all applicable conditions of Rule 16b-3 or its successors under the Exchange Act. Determinations, interpretations or other actions made or taken by the Board pursuant to the provisions of the Plan shall be final and binding and conclusive for all purposes and upon all persons. No member of the Board or any committee designated by the Board to administer the Plan shall be liable for any action or determination made in good faith with respect to the Plan or any Stock Option granted under it. Nothing herein shall be deemed to expand the personal liability of a member of the Board or any such committee beyond that which may arise under any applicable standards set forth in the Company's by-laws and Pennsylvania law, nor shall anything herein limit any rights to indemnification or advancement of expenses to which any member of the Board or such committee may be entitled under any by-law, agreement, vote of the stockholders or directors, or otherwise. 2.2 The portion of the Plan with respect to the grant of Options to Non-Employee Directors pursuant to Part II shall be administered by the Board. The Board shall have the same authority with respect to the grant of Options to Non-Employee Directors under Part II as is provided to the Board pursuant to Section 2.1 2.3 (a) The portion of the Plan with respect to the grant of Options pursuant to Part III shall be administered by the Board. Grants of Stock Options under Part III of the Plan and the amount, price and timing of the awards to be granted will be automatic, as described in Part III hereof. All questions of interpretation of the Plan with respect to the Grant of Options pursuant to Part III will be determined by the Board, and such determination shall, unless otherwise determined by the Board, be final and conclusive on all persons having any interest hereunder. (b) The Board reserves the right to amend the terms of any outstanding award (with the consent of the Participant) to reflect terms not otherwise inconsistent with the Plan, including amendments concerning exercise price changes, vesting acceleration or forfeiture waiver regarding any award or the extension of a Participant's right with respect to awards granted under the Plan, as a result of termination of service or otherwise, based on such factors as the Board shall determine, in its sole discretion. SECTION 3 - STOCK SUBJECT TO THE PLAN 3.1 The aggregate number of shares of Stock that may be issued or transferred under the Plan is 2,950,000, subject to adjustment pursuant to Section 3.2 below. Such shares may be authorized but unissued shares or reacquired shares. If the number of shares of Stock issued under the Plan and the number of shares of Stock subject to outstanding awards (taking into account the share counting requirements established under the Rules) equals the maximum number of shares of Stock authorized under the Plan, no further awards shall be made unless the Plan is amended in accordance with the Rules or additional shares of Stock become available for further awards under the Plan. If and to the extent that Options granted under the Plan terminate, expire or are canceled without having been exercised, such shares shall again be available for subsequent awards under the Plan. 3.2 If any change is made to the Stock (whether by reason of merger, consolidation, reorganization, recapitalization, stock dividend, stock split, combination of shares, or exchange of shares or any other change in capital structure made without receipt of consideration), then unless such event or change results in the termination of all outstanding awards under the Plan, the Board shall preserve the value of the outstanding awards by adjusting the maximum number and class of shares issuable under the Plan to reflect the effect of such event or change in the Company's capital structure, and by making appropriate adjustments to the number and class of shares subject to an outstanding award and/or the option price of each outstanding Option, except that any fractional shares resulting from such adjustments shall be eliminated by rounding any portion of a share equal to .500 or greater up, and any portion of a share equal to less than .500 down, in each case to the nearest whole number. 3.3 In any fiscal year of the Company, the maximum number of shares of Common Stock with respect to which Options may be granted to any optionee shall not exceed 5% of the Common Stock outstanding, as adjusted for stock splits, stock dividends or other similar changes affecting the Common Stock. SECTION 4 - DESIGNATION OF OPTIONEES 4.1 Optionees under Part II of the Plan shall be selected, from time to time, by the Board from among those Employees and Eligible Independent Contractors who, in the opinion of the Board, occupy responsible positions and who have the capacity to contribute materially to the continued growth, development and long-term success of the Company and its Subsidiaries. Optionees under Part II may also be selected from among those Non-Employee Directors who, in the opinion of the Board, have the capacity to devote themselves to the Company's success. 4.2 All Non-Employee Directors on the date of grant shall be eligible to receive Options under Part III of the Plan. PART II - GRANTS TO EMPLOYEES, ELIGIBLE INDEPENDENT CONTRACTORS AND NON-EMPLOYEE DIRECTORS SECTION 5 - STOCK OPTIONS Any Stock Option granted under Part II of the Plan shall be in such form as the Board may from time to time approve. Stock Options granted under Part II of the Plan may be of two types: (i) Incentive Stock Options and (ii) Non-Qualified Stock Options. The Board shall have the authority to grant Incentive Stock Options, Non-Qualified Stock Options or both types of Stock Options. To the extent that any Stock Option does not qualify as an Incentive Stock Option, it shall constitute a Non-Qualified Stock Option. The Board shall have the authority to grant Non-Qualified Stock Options to Non-Employee Directors under Part II. Anything in the Plan to the contrary notwithstanding, no term of this Plan relating to Incentive Stock Options shall be interpreted, amended or altered, nor shall any discretion or authority granted under the Plan be so exercised, so as to disqualify the Plan under Section 422 of the Code, or, without the consent of the optionee(s) affected, to disqualify any Incentive Stock Option under Section 422. Options granted hereunder shall be subject to the following terms and conditions and shall contain such additional terms and conditions, not inconsistent with the terms of the Plan, as the Board shall deem appropriate: 5.1 OPTION PRICE. The option price per share of Stock purchasable under a Stock Option shall be determined by the Board at the time of grant; provided, however, that the option price per share for any Stock Option shall be not less than 100% of the Fair Market Value of the Stock on the date of grant. Any Incentive Stock Option granted to any optionee who, at the time the Option is granted, owns more than 10% of the voting power of all classes of stock of the Company or of a Parent or Subsidiary corporation (within the meaning of Section 424 of the Code), shall have an exercise price no less than 110% of Fair Market Value per share on the date of the grant. 5.2 OPTION TERM. The term of each Stock Option shall be fixed by the Board, but no Stock Option shall be exercisable more than ten years after the date the Stock Option is granted. However, any Incentive Stock Option granted to any optionee who, at the time the Option is granted, owns more than 10% of the voting power of all classes of stock of the Company or of a Parent or Subsidiary corporation may not have a term of more than five years. No Option may be exercised by any person after expiration of the term of the Option. 5.3 EXERCISABILITY. Stock Options shall be exercisable at such time or times and subject to such terms and conditions as shall be determined by the Board at or after grant. If the Board provides, in its discretion, that any Stock Option is exercisable only in installments, the Board may waive such installment exercise provisions at any time at or after grant in whole or in part, based on such factors as the Board shall determine, in its sole discretion. 5.4 METHOD OF EXERCISE. Subject to whatever installment exercise provisions apply under Section 5.3, Stock Options may be exercised in whole or in part at any time and from time to time during the Option period, by giving written notice of exercise to the Company specifying the number of shares to be purchased. Such notice shall be accompanied by payment in full of the purchase price, either by cash, check, or such other instrument as the Board may accept. As determined by the Board, in its sole discretion, at or after grant, payment in full or in part may also be made in the form of unrestricted Stock already owned by the optionee (based upon the Fair Market Value of a share of Stock on the business date preceding tender if received prior to the close of the stock market and at the Fair Market Value on the date of tender if received after the stock market closes); provided, however, that, (i) in the case of an Incentive Stock Option, the right to make a payment in the form of unrestricted Stock already owned by the optionee may be authorized only at the time the Option is granted and (ii) the Company may require that the Stock has been owned by the Participant for a minimum period of time specified by the Board. In addition, if such unrestricted Stock was acquired through exercise of an Incentive Stock Option, such Stock shall have been held by the optionee for a period of not less than the holding period described in Section 422(a)(1) of the Code on the date of exercise, or if such Stock was acquired through exercise of a Non-Qualified Stock Option or of an option under a similar plan of the Company, such Stock shall have been held by the optionee for a period of more than one year on the date of exercise, and further provided that the optionee shall not have tendered Stock in payment of the exercise price of any other Option under the Plan or any other stock option plan of the Company within six calendar months of the date of exercise. To the extent permitted under the applicable laws and regulations, at the request of the Participant, and with the consent of the Board, the Company shall permit payment to be made by means of a "cashless exercise" of an Option. Payment by means of a cashless exercise shall be effected by the Participant delivering to the Securities Broker irrevocable instructions to sell a sufficient number of shares of Stock to cover the cost and expenses associated therewith and to deliver such amount to the Company. No shares of Stock shall be issued until full payment therefor has been made. An optionee shall not have any right to dividends or other rights of a stockholder with respect to shares subject to the Option until such time as Stock is issued in the name of the optionee following exercise of the Option in accordance with the Plan. 5.5 STOCK OPTION AGREEMENT. Each Option granted under this Plan shall be evidenced by an appropriate Stock Option agreement, which agreement shall expressly specify whether such Option is an Incentive Stock Option or a Non-Qualified Stock Option and shall be executed by the Company and the optionee. The agreement shall contain such terms and provisions, not inconsistent with the Plan, as shall be determined by the Board. Such terms and provisions may vary between optionees or as to the same optionee to whom more than one Option may be granted. 5.6 REPLACEMENT OPTIONS. If an Option granted pursuant to the Plan may be exercised by an optionee by means of a stock-for-stock swap method of exercise as provided in 5.4 above, then the Board may, in its sole discretion and at the time of the original Option grant, authorize the Participant to automatically receive a replacement Option pursuant to this part of the Plan. This replacement Option shall cover a number of shares determined by the Board, but in no event more than the number of shares equal to the difference between the number of shares of the original Option exercised and the net shares received by the Participant from such exercise. The per share exercise price of the replacement Option shall equal the then current Fair Market Value of a share of Stock, and shall have a term extending to the expiration date of the original Option. The Board shall have the right, in its sole discretion and at any time, to discontinue the automatic grant of replacement Options if it determines the continuance of such grants to no longer be in the best interests of the Company. 5.7 NON-TRANSFERABILITY OF OPTIONS. No Stock Option shall be transferable by the optionee other than by will, by the laws of descent and distribution, pursuant to a qualified domestic relations order, or as permitted under the Rules, and all Stock Options shall be exercisable, during the optionee's lifetime, only by the optionee. Notwithstanding the foregoing, the Board may grant non-qualified Options that are transferable, without payment of consideration, to immediate family members (i.e., spouses, children and grandchildren) of the Optionee or to trusts for, or partnerships whose only partners are, such family members. The Board may also amend outstanding non-qualified Options to provide for such transferability. 5.8 TERMINATION OF EMPLOYMENT BY REASON OF DEATH. Unless otherwise determined by the Board at or after grant, if any optionee dies during the optionee's period of employment by the Company, or during the periods referred to in Sections 5.9, 5.10 or 5.11, any Stock Option held by such optionee may thereafter be exercised, to the extent then exercisable or on such accelerated basis as the Board may determine at or after grant, by the legal representative of the estate or by the legatee of the optionee under the will of the optionee, for a period of one year (or such shorter period as the Board may specify at grant) from the date of such death or until the expiration of the stated term of such Stock Option, whichever period is shorter. 5.9 TERMINATION OF EMPLOYMENT BY REASON OF DISABILITY. Unless otherwise determined by the Board at or after grant, if an optionee's employment by the Company terminates by reason of Disability, any Stock Option held by such optionee may thereafter be exercised by the optionee, to the extent it was exercisable at the time of termination, or on such accelerated basis as the Board may determine at or after grant, for a period of one year (or such shorter period as the Board may specify at grant) from the date of such termination of employment or until the expiration of the stated term of such Stock Option, whichever period is shorter. In the event of termination of employment by reason of Disability, if an Incentive Stock Option is exercised after the expiration of the exercise periods that apply for purposes of Section 422 of the Code, such Stock Option will thereafter be treated as a Non-Qualified Stock Option. 5.10 TERMINATION OF EMPLOYMENT UPON RETIREMENT. Unless otherwise determined by the Board at or after grant, if an optionee's employment terminates due to retirement (as hereinafter defined), any Stock Option held by such optionee may thereafter be exercised by the optionee, to the extent it was exercisable at the date of retirement, or on such accelerated basis as the Board may specify at grant, for a period of one-year (or such shorter period as the Board may specify at grant) from the date of such retirement or until the expiration of the stated term of such Stock Option, whichever period is shorter. For purposes of this Section 5.10, "Retirement" shall mean any Employee retirement under the Company's retirement policy. 5.11 OTHER TERMINATION OF EMPLOYMENT. Unless otherwise determined by the Board at or after grant, in the event of termination of employment (voluntary or involuntary) for any reason other than death, Disability or retirement, or if an Employee is terminated for cause, any Stock Option held by such optionee may thereafter be exercised by the optionee, to the extent it was exercisable at the time of such termination or on such accelerated basis as the Board may determine at or after grant, for a period of three months (or such shorter period as the Board may specify at grant) from the date of such termination of employment or the expiration of the stated term of such Stock Option, whichever period is shorter. If an Employee is terminated for cause, any Stock Option held by such Optionee shall terminate immediately. 5.12 INCENTIVE STOCK OPTION LIMITATION. The aggregate Fair Market Value (determined as of the time of grant) of the Stock with respect to which Incentive Stock Options are exercisable for the first time by the optionee during any calendar year under the Plan and/or any other stock option plan of the Company shall not exceed $100,000. 5.13 TERMINATION OF ELIGIBLE INDEPENDENT CONTRACTORS OPTIONS. The termination provisions of Options granted to Eligible Independent Contractors shall be determined by the Board in its sole discretion. 5.14 WITHHOLDING AND USE OF SHARES TO SATISFY TAX OBLIGATIONS. The obligation of the Company to deliver Stock upon the exercise of any Option shall be subject to applicable federal, state and local tax withholding requirements. If the exercise of any Option is subject to the withholding requirements of applicable federal tax laws, the Board, in its discretion (and subject to such withholding rules ("Withholding Rules") as shall be adopted by the Board), may permit the optionee to satisfy the federal withholding tax, in whole or in part, by electing to have the Company withhold (or by delivering to the Company) shares of Stock, which Stock shall be valued, for this purpose, at their Fair Market Value on the date the amount of tax required to be withheld is determined (the "Determination Date"). Such election must be made in compliance with and subject to the Withholding Rules, and the Board may not withhold shares of Stock in excess of the number necessary to satisfy the minimum federal income tax withholding requirements. If Stock acquired upon the exercise of an Incentive Stock Option is used to satisfy such withholding requirement, such Stock must have been held by the optionee for a period of not less than the holding period described in Section 422(a)(1) of the Code on the Determination Date. If Stock acquired through the exercise of a Non-Qualified Stock Option or of an option under a similar plan is delivered by the optionee to the Company to satisfy such withholding requirement, such Stock must have been held by the optionee for a period of more than one year on the Determination Date. For Optionees subject to Section 16 of the Exchange Act, to the extent required by Section 16, the election to have Stock withheld by the Company hereunder must be either (a) an irrevocable election made six months before the Determination Date; or (b) an irrevocable election where both the election and the Determination Date occur during one of the ten-day periods beginning on the third business day following the date of release of the Company's quarterly or annual summary financial data and ending on the twelfth business day following such release. 5.15 ISSUANCE OF SHARES AND COMPLIANCE WITH SECURITIES ACTS. Within a reasonable time after exercise of an Option, the Company shall cause to be delivered to the optionee a certificate for the Stock purchased pursuant to the exercise of the Option. At the time of any exercise of any Option, the Company may, if it shall deem it necessary and desirable for any reason connected with any law or regulation of any governmental authority relative to the regulation of securities, require the optionee to represent in writing to the Company that it is his or her then intention to acquire the Stock for investment and not with a view to distribution thereof and that such optionee will not dispose of such Stock in any manner that would involve a violation of applicable securities laws. In such event, no Stock shall be issued to such holder unless and until the Company is satisfied with such representation. Certificates for shares of Stock issued pursuant to the exercise of Options may bear an appropriate securities law legend. 5.16 TERMINATION OF NON-EMPLOYEE DIRECTORS OPTIONS. Section 11 of the Plan shall apply to the termination of Options granted to Non-Employee Directors under Part II. PART III - GRANTS TO NON-EMPLOYEE DIRECTORS SECTION 6 - GRANT OF OPTIONS Options to purchase 10,000 shares of Common Stock, subject to adjustment as provided in Section 3.2 (the "Initial Options") and options to purchase 5,000 shares, subject to adjustments as provided in Section 3.2 (the "Annual Options"), shall be granted to Non-Employee Directors as follows: (a) Each Non-Employee Director on the 30th day after the stockholders of the Company have approved the Plan shall be granted an Initial Option. (b) Each Non-Employee Director who is not granted an Initial Option pursuant to Section 6(a), shall be granted an Initial Option on the first business day immediately following the date that such person is first elected or appointed to serve as a Non-Employee Director. (c) Each year on January 1, each Non-Employee Director on such date shall be granted an Annual Option. SECTION 7 - TYPES OF OPTIONS All options granted under Part III of the Plan shall be non-qualified Stock Options for purposes of the Code. SECTION 8 - OPTION PRICE The purchase price of each share of Stock issuable upon exercise of an Option will be equal to the Fair Market Value of the Stock on the date of grant. SECTION 9 - OPTION TERM AND RIGHTS TO EXERCISE 9.1 PERIOD OF OPTION AND RIGHTS TO EXERCISE. Except as set forth herein, each Non-Employee Director who receives options under this Plan must continue to hold office as a Non-Employee Director of the Company for six months from the date that the Initial Option is granted and six months from the date each Annual Option is granted before he can exercise any part thereof. Thereafter, subject to the provisions of the Plan, options will vest and be exercisable as follows: (a) Initial Options. (i) Each Initial Option will vest and be exercisable in full six months from the date of grant. (ii) The right to exercise an Initial Option will expire on the fifth anniversary of the date on which the option was granted. (iii) Once an Initial Option has become exercisable, such option may be exercised in whole at any time or in part from time to time until the expiration of the option, whether or not any option granted previously to the optionee remains outstanding at the time of such exercise. (b) Annual Options. (i) Each Annual Option will vest and be exercisable on a cumulative basis as to 2,500 shares beginning six months from the date of grant and 2,500 additional shares beginning on the first anniversary of the date of grant. (ii) The right to exercise an Annual Option will expire on the fifth anniversary of the date on which the option was granted. (iii) Once each installment of an Annual Option has become exercisable, it may be exercised in whole at any time or in part from time to time until the expiration of the option, whether or not an option granted previously to the optionee remains outstanding at the time of such exercise. SECTION 10 - PAYMENT OF OPTION PRICE Payment or provision for payment of the purchase price shall be made as follows: (i) in cash or check; (ii) by exchange of Stock valued at its Fair Market Value on the date of exercise; (iii) by means of a cashless exercise procedure by the delivery to the Company of an exercise notice and irrevocable instructions to the Securities Broker to sell a sufficient number of shares of Stock to pay the purchase price of the shares of Common Stock as to which such exercise relates and to deliver promptly such amount to the Company; or (iv) by any combination of the foregoing. Where payment of the purchase price is to be made with shares of Stock acquired through exercise of a non-qualified Stock Option or of an option under a similar plan of the Company, such Stock shall have been held by the optionee for a period of more than one year on the date of exercise, and further provided that the optionee shall not have tendered Stock in payment of the exercise price of any other Option under the Plan or any other stock option plan of the Company within six calendar months of the date of exercise. SECTION 11 - TERMINATION OF SERVICE Upon cessation of service as a Non-Employee Director (for reasons other than retirement or death), including cessation of service due to physical or mental disability that prevents such person from rendering further services as a Non-Employee Director, only those options exercisable at the date of cessation of service shall be exercisable by the Non-Employee Director, or on such accelerated basis as the Board may determine at or after grant, for a period of three months, or such other period as the Board may specify from time to time. Upon the retirement or death of a Non-Employee Director, options shall be exercisable as follows: (a) Retirement. Upon retirement as a Non-Employee Director after the Non-Employee Director has served for at least six consecutive years as a director, all Options shall continue to be exercisable during their terms as if such person had remained a Non-Employee Director. (b) Death. In the event of the death of a Non-Employee Director while a member of the Board, or within the period after termination of service referred to in the first paragraph of Section 11, the Options granted to him shall be exercisable, to the extent then exercisable, for a period of one year from the date of the Non-Employee Director's death, or until the expiration of the Option, whichever period is shorter. SECTION 12 - NO GUARANTEED TERM OF OFFICE Nothing in this Plan or any modification thereof, and no grant of an option, or any term thereof, shall be deemed an agreement or condition guaranteeing to any Non-Employee Director any particular term of office or limiting the right of the Company, the Board or the stockholders to terminate the term of office of any Non-Employee Director under the circumstances set forth in the Company's Certificate of Incorporation or Bylaws, or as otherwise provided by law. SECTION 13 - OTHER RESTRICTIONS Sections 5.5, 5.7 and 5.15 of the Plan shall apply to options granted pursuant to Part III of the Plan. PART IV - MISCELLANEOUS SECTION 14 - CHANGE IN CONTROL A "Change in Control" for purposes of this Plan shall mean any one of the events described below: 14.1 "Any person" or "group" (as those terms are defined in the Securities Exchange Act of 1934, as amended, and the rules and regulations promulgated thereunder) is or becomes the "beneficial owner" (as defined in Rule 13d-3 under the Exchange Act), directly or indirectly, of securities of the Company representing fifty percent (50%) or more of the voting power of then outstanding securities of the Company. 14.2 The individuals who are members of the Company's Board of Directors as of the date hereof (the "Existing Directors"), cease, for any reason, to constitute more than fifty percent (50%) of the number of authorized directors of the Company as determined in the manner prescribed in the Company's Articles of Incorporation and Bylaws; provided, however, that if the appointment, or the election, or nomination for election, by the Company's shareholders of any new director, was approved by a vote of at least fifty percent (50%) of the Existing Directors, such new director shall be considered an Existing Director; provided further, however, that no individual shall be considered an Existing Director if such individual initially assumed office as a result of either an actual or threatened election contest (as described in Rule 14a-12(c) promulgated under the Exchange Act) or other actual or threatened solicitation of proxies by or on behalf of anyone other than the Board of Directors (a "Proxy Contest"), including by reason of any agreement intended to avoid or settle any election contest or Proxy Contest. 14.3 The consummation of a merger, consolidation or share exchange to which the Company is a party in which either (i) the Company will not be the surviving corporation, or (ii) the Company will be the surviving corporation and any outstanding shares of Common Stock will be converted into shares of any other company. 14.4 The consummation of a sale, assignment, lease, conveyance or other disposition of 50% or more of the assets or assets representing 50% or more of the earning power of the Company, in one or a series of related transactions to any Person(s). 14.5 A complete liquidation of the Company. If a Change in Control has occurred, all outstanding options granted under the Plan shall be immediately exercisable by the holders of the options for the total remaining number of Shares covered by the options and shall survive any such event. SECTION 15 - AMENDMENTS AND TERMINATION The Board may amend, alter or discontinue the Plan at any time and from time to time, but no amendment, alteration or discontinuation shall be made which would impair the rights of an optionee or Participant under a Stock Option award theretofore granted, without the optionee's or Participant's consent, or which, without the approval of the Company's stockholders, would require stockholder approval under the Rules. The Board may amend the terms of any stock option theretofore granted, prospectively or retroactively, but no such amendment shall impair the rights of any holder without the holder's consent. The Board may also substitute new stock options for previously granted stock options, including previously granted stock options having higher option prices. Subject to the above provisions, the Board shall have broad authority to amend the Plan, to take into account changes and applicable tax laws, securities laws, and accounting rules, as well as other developments. SECTION 16 - UNFUNDED STATUS OF PLAN The Plan is intended to constitute an "unfunded" plan of incentive and deferred compensation. With respect to any payments not yet made to a Participant or optionee by the Company, nothing contained herein shall give any such Participant or optionee any rights that are greater than those of a general creditor of the Company. In its sole discretion, the Board may authorize the creation of trusts or other arrangements to meet the obligations created under the Plan to deliver Stock or payments in lieu of or with respect to awards hereunder; provided, however, that, unless the Board otherwise determines with the consent of the affected Participant, the existence of such trusts or other arrangements is consistent with the "unfunded" status of the Plan. SECTION 17 - GENERAL PROVISIONS 17.1 All certificates for shares of Stock or other securities delivered under the Plan shall be subject to such stop-transfer orders and other restrictions as the Board may deem advisable under the rules, regulations and other requirements of the Securities Act, the Exchange Act, any stock exchange or over-the-counter market upon which the Stock is then listed, and any applicable federal or state securities law, and the Board may cause a legend or legends to be put on any such certificates to make appropriate reference to such restrictions. 17.2 Nothing contained in this Plan shall prevent the Board from adopting other or additional compensation arrangements, subject to stockholder approval if such approval is required, and such arrangements may be either generally applicable or applicable only in specific cases. 17.3 The adoption of the Plan shall not confer upon any Participant any right to continued employment with the Company nor shall it interfere in any way with the right of the Company to terminate its relationship with any of its Employees, directors or Independent Contractors at any time. 17.4 No later than the date as of which an amount first becomes includable in the gross income of the Participant for federal income tax purposes with respect to any award under the Plan, the Participant who is an Employee of the Company shall pay to the Company, or make arrangements satisfactory to the Board regarding the payment of, any federal, state, or local taxes of any kind required by law to be withheld with respect to such amount. To the extent permitted by the Board, in its sole discretion, the minimum required withholding obligations may be settled with Stock, including Stock that is part of the award that gives rise to the withholding requirement. The obligations of the Company under the Plan shall be conditional on such payment or arrangements and the Company shall, to the extent permitted by law, have the right to deduct any such taxes from any payment of any kind otherwise due to the Participant. 17.5 The Board shall establish such procedures as it deems appropriate for a Participant to designate a beneficiary to whom any amounts payable in the event of the Participant's death are to be paid. The Plan shall be governed by and subject to all applicable laws and to such approvals by any governmental or regulatory agency as may be required. SECTION 18 - EFFECTIVE DATE AND TERM OF PLAN The Plan shall be effective as of the effective date the Plan is adopted by the Board of Directors and Shareholders of the Company, (the "Effective Date"), subject to the consent or approval of the Company's stockholders as provided below. No Stock Option award shall be granted pursuant to the Plan on or after ten years from the Effective Date, but Stock Options granted prior to such tenth anniversary may be exercised after such date. If the Plan is not approved by a majority of the votes cast at a duly held meeting at which a quorum representing a majority of all outstanding voting stock of the Company is, either in person or by proxy, present and voting on the Plan, within 12 months after such effective date, any Incentive Stock Options that have been granted shall automatically become Non-Qualified Stock Options. SECTION 19 - INTERPRETATION A determination of the Board as to any question which may arise with respect to the interpretation of the provisions of this Plan or any Options shall be final and conclusive, and nothing in this Plan, or in any regulation hereunder, shall be deemed to give any Participant, his legal representatives, assigns or any other person any right to participate herein except to such extent, if any, as the Board may have determined or approved pursuant to this Plan. The Board may consult with legal counsel who may be counsel to the Company and shall not incur any liability for any action taken in good faith in reliance upon the advice of such counsel. SECTION 20 - GOVERNING LAW With respect to any Incentive Stock Options granted pursuant to the Plan and the agreements thereunder, the Plan, such agreements and any Incentive Stock Options granted pursuant thereto shall be governed by the applicable Code provisions to the maximum extent possible. Otherwise, the laws of the Commonwealth of Pennsylvania shall govern the operation of, and the rights of Participants under, the Plan, the agreements and any Options granted thereunder. SECTION 21 - COMPLIANCE WITH THE RULES 21.1 Unless an Insider could otherwise transfer shares of Stock issued hereunder without incurring liability under Section 16(b) of the Exchange Act, at least six months must elapse from the date of grant of an Option to the date of disposition of the Stock issued upon exercise of such Option. 21.2 It is the intent of the Company that this Plan comply in all respects with the Rules in connection with any grant of Options to, or other transaction by, an Insider. Accordingly, if any provision of this Plan or any agreement relating to an Option does not comply with the Rules as then applicable to any such Insider, such provision will be construed or deemed amended to the extent necessary to conform to such requirements with respect to such person. In addition, the Board shall have no authority to make any amendment, alteration, suspension, discontinuation, or termination of the Plan or any agreement hereunder, or take other action if such authority would cause an Insider's transactions under the Plan not to be exempt under the Rules. 21.3 Certain restrictive provisions of the Plan have been implemented to facilitate the Company's and Insiders' compliance with the Rules. The Board, in its discretion, may waive certain of these 13 14 restrictions, provided the waiver does not relate in any way to an Insider and, provided further, such waiver or amendment is carried out in accordance with Section 15 hereof. SECTION 22 - SUBSTITUTION OF OPTIONS IN A MERGER, CONSOLIDATION OR SHARE EXCHANGE In the event that the Company becomes a party to a merger, consolidation or share exchange (a "Business Combination") and in connection therewith substitutes options under the Plan for options of another party to such Business Combination, notwithstanding the provisions of the Plan, the terms of such substituted options may have the same terms and conditions (provided that the number of shares issuable and the exercise prices are adjusted in accordance with the terms of the Business Combination) as the former options of such other party to the Business Combination, provided, however, that the exercise price of the Options to be granted under the Plan shall be lawful consideration as determined by the Board. -----END PRIVACY-ENHANCED MESSAGE-----