ITEM 1. BUSINESS
Macrovision Corporation, a Delaware corporation founded in 1983, enables businesses reliant on the deployment of software or content to protect, enhance, or distribute their offering among digital distribution channels and destination devices. These digital lifecycle management solutions include anti-piracy and content protection technologies and services, digital rights management products and technologies, embedded licensing technologies, usage monitoring for enterprises, access control and billing, and several other related technologies and services from installation to update to back-office entitlement management. We market the FLEXnet licensing platform and the InstallShield suite of software installation, repackaging, and update solutions. We also operate a game network for digital distribution of downloadable PC games, and market our Rights products, which enable the sale and security of digital goods and services, such as text, audio, video, streaming media, games and applications. Our customers consist of entertainment producers such as motion picture studios and music labels, software publishers, hardware manufacturers, consumer electronic firms, personal computer manufacturers, digital set-top box manufacturers, digital pay-per-view and video-on-demand network operators, publication companies and enterprise information technology organizations.
We own or have rights to various copyrights, trademarks and trade names used in our business. These include, but are not limited to, Macrovision®, ActiveMark®, ActiveReach™, AdminStudio®, C-Dilla®, eMeta®, FLEXbill™, FlexCertified™, FLEXenabled®, Flexible License Manager®, FLEXlm®, FLEXnet®,, Flexnet Connect™, GLOBEtrotter®, Hawkeye®, InstallShield®, Install From The Web®, InstallShield Developer®, InstallShield DevStudio®, InstallShield Professional®, It All Starts Here®, M1 Mediabolic®, Mediabolic®, One-Click Install®, PackageExpert™, Package for the Web®, PowerUpdate®, Quick Patch®, RipGuard®, SafeAuthenticate®, SafeDisc®, SOFTSUMMIT®, TryGames™, Trymedia Systems®, Un-Installshield®, and Zero G Software®.
Industry Background
The design, distribution, protection and consumption of all forms of digital content and software are continuing to experience an unprecedented amount of change. In the case of entertainment content, with the expansion of high-bandwidth internet infrastructure and the industry shift to digital media, PC-based entertainment platforms, digital portable devices, networked devices, Internet downloads and the proliferation of
peer-to-peer file sharing networks, content and copyright owners are vulnerable to unauthorized use of their content. Inexpensive, easy to use in-home copying devices, such as VCRs, CD and DVD recorders, and PC based hard drive recorders enable consumers to make unauthorized copies of video, audio and software content. Content owners lose billions of dollars every year to casual copying and professional or bootleg piracy and Internet/peer-to-peer (“P2P”) piracy. Many of the same challenges confront the software industry. Independent software vendors and systems vendors are similarly concerned about unlicensed or illicit use of their application software, both in the enterprise environment (where license terms may be lost in the midst of corporate IT confusion or ignored) and in the consumer markets (where PC software may be copied and redistributed). As technological advances facilitate digital downloads and digital copying, motion picture studios, music labels, cable television program distributors and software games publishers have become more concerned with protecting their intellectual property.
In addition, in the software industry, publishers need simple, scalable solutions to account for the use of their products and also are seeking ways to flexibly price and package their products in order to reach a larger share of the available market. Furthermore, as software complexity grows, publishers are seeking ways to simplify their customers’ software experience. Enterprise customers are particularly focused on reducing their total cost of ownership of software and reducing their support burden. Tools that provide a simple installation, activation and maintenance experience are winning favor with these enterprise customers. The challenge for the software industry, and their end-customers, is to simultaneously optimize accountability, manageability, stability and delivery in a constantly evolving business environment.
Macrovision Business and Solutions
We develop and market a broad array of commerce, protection and management solutions for software, entertainment and information publishing industries across three distinct customer groups: Entertainment and Content Producers and Distributors, Software Publishers, and Enterprise End Users.
Entertainment and Content Producers and Distributors
Macrovision solutions enable the delivery, protection and use of digital goods in the entertainment and content marketplaces. Our solutions provide enhanced consumer experiences, digital distribution, merchandising and advertising, as well as flexible content security, such as authentication and digital rights management (“DRM”).
Video Technology
Packaged Media Solutions. Motion pictures typically generate two-thirds of their revenue from the sales of packaged media, primarily DVDs. Any household that owns a DVD-R, personal video recorder (“PVR”), PC, media center or a VCR is capable of making unauthorized high quality digital and analog copies unless that content is properly copy protected against this variety of threats. As new distribution models evolve, including video portability, simultaneous theatrical and DVD release dates, Internet and other electronic distribution and the developing PC-based home theater experience, solutions that protect the DVD from unauthorized copying are critical to preserving the motion picture studio revenues.
Our business originated in analog video content security, or analog copy protection (“ACP”), which has been used to protect over 4.7 billion videocassettes worldwide since 1985 and over 7.1 billion DVDs worldwide since 1997. Our ACP technologies allow consumers to view programming stored on prerecorded videocassettes and DVDs or transmitted as digital pay-per-view (“PPV”) or video-on-demand (“VOD”) programs via cable or satellite, but deter unauthorized consumer copying of such programming on both VCRs and recordable DVD devices. Most of the Motion Picture Association of America (“MPAA”) studios use our video content security technology to protect some or all movie releases on videocassette or DVD. In addition, nearly every DVD player, VCR, DVD recorder, DVD drive and PC manufactured contains software and/or hardware technology, licensed by Macrovision, to ensure that ACP-secured DVDs and VHS tapes are properly recognized and thus secured.
In recent years, digital content protection has increased in importance. Consumers can make a perfect digital copy of a DVD in minutes by using inexpensive PC DVD burners coupled with copying software that is widely available in electronics stores and from Internet sites, with many of these software products being available free-of-charge. This class of software technology, known as DeCSS rippers, breaks the CSS encryption code that is used on most movie DVDs, and often circumvents the Macrovision analog content security. Therefore, we believe such software packages violate the U.S. Digital Millennium Copyright Act of 1998 (“DMCA”) and infringe our patents. Nevertheless many consumers acquire this type of software and add hacker software available on the Internet, and engage in unauthorized ripping and copying activities. Our RipGuard DVD technology, which is applied to the DVD at the time of manufacture, is designed to prevent unauthorized ripping on PCs without requiring any modification to the PC. We introduced RipGuard DVD in 2005, and to date, over 278 million DVDs that used the comprehensive content security solution of RipGuard DVD and ACP were shipped. In addition, RipGuard DVD is THX Verified to ensure high quality audio and video fidelity and also is certified “Spyware Safe” by PC Tools, a leading member of the Anti-Spyware Coalition.
PPV and VOD Solutions. Digital PPV/VOD services enable consumers to purchase and view movies and other programming in their homes through cable or satellite systems, or Internet-based download services. As entertainment content producers consider the idea of simultaneous or more closely staged theatrical, DVD and/or PPV/VOD release of content, studios have realized the importance of content security in digital PPV/VOD networks because high quality VHS and DVD copies can be made from the source analog video signal. Many digital PPV/VOD system operators have implemented our content security capability in their digital set-top boxes at the request of the Hollywood studios.
To protect content in such circumstances, Macrovision introduced our ACP-VOD and ACP-WMDRM solutions, which are derived from the same ACP technology used in our packaged media solution. These products are designed to allow content owners to copy protect their PPV/VOD movies, while at the same time allow consumers to store, move or share content as long as it is done within the parameters of the rules defined by copyright owners. To date, our content security technology has been embedded in over 249 million digital set-top boxes and digital video recorders (“DVR”) worldwide.
Peer-to-Peer File Sharing Solutions. Millions of online users have reported using file sharing applications to share music, movies or photos on a monthly or more frequent basis. Content owners believe they have been harmed by the free and unauthorized file sharing over these networks to such an extent that they have initiated lawsuits against several of the file sharing networks and even the individual consumers themselves. Our RipGuard DVD content security solution is designed to inhibit unauthorized video and music content from being made available over P2P networks. Our Hawkeye Peer-to-Peer Anti-Piracy service is a global network solution designed to deter the majority of users from obtaining any unauthorized copies of copyrighted content from P2P file sharing networks. Content owners are able to designate which music tracks, music albums, movies, television episodes, games or software applications they want to protect, and our technology is activated as a service to find and protect those specific files on various file sharing networks.
PC Games Technology
The PC games industry is facing a range of issues as its market adjusts to changing distribution opportunities. They continue to suffer the effects of piracy negatively impacting sales, as the retail distribution market becomes more consolidated with less shelf space available to games. At the same time, for core game publishers games now require much larger budgets for creating and promoting games. Publishing, distributing, merchandising, selling, and marketing video games is more costly now than it has ever been. Increasingly immersive and sophisticated games cost millions to produce, yet the timeframe to develop them has remained the same. To counterbalance these trends, the growth of broadband Internet connections to the home and small office has created a new class of casual game publishers reaching a broader market demographic. Our digital distribution capabilities along with our SafeDisc and ActiveMARK technologies are designed to (i) enable an entirely new revenue channel with online merchandising and digital distribution of games and (ii) protect both CD/DVD-ROM and digital game content from unauthorized copying.
Our technologies are enabling a significant change in the gaming market-digital distribution. Our games solution provides an integrated technology platform so that publishers, distributors, and community sites can easily adapt to new distribution and business models, quickly protect copyrighted content from piracy at all stages of its lifecycle, continuously promote and merchandise to game consumers, and seamlessly renew, update, and patch games after release-all while simplifying the underlying technology to deliver these services. Currently, we have a network of over 300 distribution partners and a catalog of over 1,600 games that it protects and promotes online.
Software Publishers
Software and hardware manufacturers have access to a variety of tools with which to design and develop software. However, when such software needs to be delivered to customers, manufacturers have primarily relied on homemade solutions to handle electronic downloading, advanced installation, embedded licensing enforcement, automatic updates, and back-office tracking of entitlements. This not only places restrictions on the business models with which manufacturers can engage their customers, but also can lead to general business problems such as confusion as to which updates are needed and difficulty with installations.
Our FLEXnet Publisher product offers an extensive set of solutions for manufacturers and publishers. By incorporating our technologies into their products, manufacturers are able to improve their ability to provide a standard and seamless installation and activation experience, simplify product-marketing strategies, reduce unpaid usage and lower costs associated with product development, distribution, and delivery. We also offer manufacturers back-office products to help them better manage the entitlements they have granted their customers, as well as a hosted update service that enables manufacturers to keep their deployed products up to date and automatically deliver updates over the Internet.
Software as a Service
Our Rights products, which include RightAccess and RightCommerce, also support content publishers moving from a shrinkwrap software model to a software as a service (“SaaS”) model. Our products allow media, publishing, entertainment and software companies to add subscription entitlement, access control, business intelligence and commerce functionality to their content and products. Our Rights products enable the sale and security of digital goods and services, such as text, audio, video, streaming media, games and applications. By using our Rights products, the customer’s end-user is able to access content over the internet, without the need for any installation, in order to have a seamless commerce experience. Additionally, our Rights products put control in the hands of business users, allowing sales and marketing professionals to test products, promotions and business models in real-time.
Enterprise End-Users
Enterprise IT teams are looking for ways to keep their software end-users as productive as possible while minimizing their support costs. Organizations want to ensure they purchase enough licenses to fulfill the needs of their end-users but not waste money by continuing to license unnecessary assets. Such organizations also desire automated solutions that help them stay within the bounds of their purchased licenses, allow them to flexibly expand those bounds as needed, and maximize the reliability and availability of those licenses. Larger organizations also face significant challenges in rolling out software products to their thousands of employees and need to ensure that software is deployed easily without productivity loss to the enterprise.
Complementing our FLEXnet Publisher offerings for manufacturers, we offer the FLEXnet Manager offerings for enterprise customers, to help such customers better manage their FLEXnet enabled products. FLEXnet Manager captures and analyzes software usage data to help enterprises determine where to allocate their software purchases and related costs and helps administer software access rights (electronic licenses) over
global networks. We also offer the AdminStudio family of products to help enterprise system administrators prepare various software applications and upgrades for deployment across the enterprise (via repackaging and patch impact management).
Technology Licensing, Sales and Marketing
Technology Licensing. Content owners and software vendors utilize our solutions to secure their content or software and to ensure that their end-user customers pay them for the use of such content or software. We generate recurring revenues from a variety of sources by licensing our portfolio of digital content value management and software technologies. We receive royalties and recurring revenues as follows:
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Video and PC games content owners typically pay us a per-unit licensing fee for the right to use our proprietary content security solutions for DVDs, videocassettes and CD-ROM games and a service-based fee for the right to use our peer-to-peer file sharing content management technologies;
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Software vendors, enterprise end-user and Rights products customers pay us a fee to license our technology using either time-based licenses or perpetual licenses combined with annual maintenance fees;
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Content publishers pay us a fee to license our Rights product technology using perpetual licenses combined with annual maintenance fees, or for our hosted service, a subscription-based fee;
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Consumer software publishers pay us a per-unit licensing fee to use our technology for CD-ROM content security and time-based or perpetual licenses for our DRM technology;
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Digital set-top box and DVR manufacturers license our video content security solutions for an up-front fee and a per-unit royalty, a portion of which may be tied to product activation by system operators;
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Semiconductor companies that incorporate our digital PPV/VOD and DVD content security solutions into their semiconductor and reference designs pay us a one-time service fee to verify correct implementation of our content security technology in digital-to-analog application specific integrated circuits (“ASICs”) that are embedded in digital set-top boxes and DVD hardware. They are authorized to sell these Macrovision-capable ASICs to Macrovision-licensed DVD hardware manufacturers and to Macrovision-licensed digital set-top box and DVR manufacturers;
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Cable and satellite television system operators pay us a one-time license fee for the right to incorporate our video content security technology into their networks for PPV or VOD services. In addition, we are entitled to transaction-based royalty payments when content security for digital PPV or VOD programming is activated by system operators and content protected programs are purchased by subscribers; and
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DVD hardware manufacturers (DVD consumer electronic player manufacturers and PC DVD drive suppliers) license our technology for an up-front fee and annual license fee.
Sales and Marketing. We market our digital content management and software management solutions directly to content owners and software vendors in the video, games and software markets. We also license our software asset management solutions directly to end-user enterprise customers. We supplement our direct sales efforts with reseller programs and service partnerships among VHS, DVD, and CD duplicator, replicator and authoring organizations, and third party professional services, value added reseller, and systems integrator organizations in our enterprise software business. We also utilize a variety of lead generating marketing initiatives, including trade show participation, trade advertisements, public relations, industry education and newsletters. As part of our FLEXnet platform, we established alliances with several companies to extend the FLEXnet ecosystem to include other third-party services and solutions. We have a worldwide network of resellers who help us sell our InstallShield products. The rapid expansion of broadband Internet connections for consumers and small businesses and the continued tightening of enterprise IT budgets may result in the adoption of new licensing and distribution models for our solutions. We believe this has created a large market opportunity for our products and solutions.
Customers
Our customers include major Hollywood studios; independent video producers; game producers and distributors, hardware and software vendors; information publishers; consumer electronic, PC and digital set-top box manufacturers; PPV and VOD network operators; online retailers and portal and enterprise IT organizations.
No customer accounted for more than 10% of our net revenues in 2006, 2005 or 2004.
Entertainment Producers and Distributors
We believe that our DVD content security technology is utilized as the leading analog-to-analog and analog-to-digital content security solution that satisfies the principles established by the DVD licensing and standards group, and has been tested and accepted for compatibility with TV sets by leading consumer electronics companies. As of December 31, 2006, 423 companies that manufacture DVD players or Personal Computers with DVD-ROM drives had signed agreements with us to incorporate our DVD content security technology into their hardware. In addition, our entertainment content security solutions are licensed to 384 DVD authoring houses, 47 RipGuard mastering and/or replication providers, 38 RipGuard embedding service providers, 123 replication facilities, 228 VHS commercial duplication facilities, 153 digital set-top box and DVR manufacturers, 72 semiconductor component suppliers and 48 PPV/VOD system operators worldwide.
Our PPV/VOD content security technology is embedded in more than 249 million digital set-top boxes and digital media recorders currently in use worldwide. We have licensed our content security technology for digital PPV/VOD to 153 set-top box and DVR manufacturers and have licensed our analog content security solutions to Microsoft for home media center PC applications to protect PPV and VOD content.
Our content security technology customers include the following leading companies:
Motion Picture Studios
PPV/VOD System Operators
Set Top Box / DVR Manufacturers
• Buena Vista Home Video (Disney)
• British Sky Broadcasting (UK)
• Fujitsu Limited
• HBO Home Video
• EchoStar Communications (USA)
• Hitachi Limited
• New Line Cinema
• FOXTEL Management (Australia)
• Mitsubishi Electric
• Paramount Pictures
• Korea Digital Satellite Broadcast (Korea)
• Panasonic (MEI)
• Twentieth Century Fox Home Entertainment
• LodgeNet Entertainment (USA)
• Philips Business Electronics
• Universal Studios Home Video (NBC)
• Netflix
• Pioneer Electronics
• NTL (UK)
• Samsung Electronics
• Premiere Fernsehen (Germany)
• Scientific-Atlanta
• SkyPerfecTV! (Japan)
• Sony Electronics
• THOMSON Multimedia
• TiVo
• Toshiba
Information Publishers
PC Games/Software Publishers
Trymedia
• Channel 4 (UK)
• Activision
• Atari
• FT.com
• Eidos
• Disney
• Hoovers
• Electronic Arts
• Take2 Interactive
• IDG
• Microsoft
• Yahoo!
• IEEE
• 3DO
• New York Times
• Ubisoft Entertainment
• Standard & Poors
• Vivendi Universal
• Turner
Software Publishers
We believe that FLEXnet Publisher, our core licensing technology supporting digital content management for software publishers, is a leader in the electronic license management market. We have licensed our FLEXnet-related technologies in a range of markets to more than 3,900 software and hardware manufacturers, including:
• Adobe
• IBM
• Autodesk
• Sybase
• Cadence Design Systems
• Synopsys
• Cisco Systems
• UGS PLM Solutions
• Citrix
• Wind River Systems
In addition, we believe that our InstallShield (for Windows) and InstallAnywhere (for multi-platform environments) are industry-leading installation authoring solutions, having been sold to over 71,000 customers. Ninety-eight of the top 100 software publishers use InstallShield.
Enterprise End-Users
In addition we license our FLEXnet Manager to corporate/enterprise end-users, enabling these end-users to deploy, manage, and track the software they have purchased from our software vendor customers. Similarly, we have licensed our AdminStudio solutions to over 4,000 enterprise customers. Examples of such corporate end-user customers include:
• 3M
• IBM
• BP
• Liberty Mutual
• BMW
• Lockheed Martin
• Boeing
• Motorola
• Costco
• Nokia
• Eastman Kodak
• Philips
• Ford Motor Company
• Siemens
• Honeywell
• Sun Microsystems
• Hewlett Packard
The Macrovision Growth Strategy
Build Upon Key Customer Relationships. We currently maintain relationships with customers in various industry and market segments, including:
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Video and PC games’ content providers such as the major Hollywood studios, independent movie producers and PC games publishers and distributors;
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Information Publishers, such as major media corporations, technical organizations and commerce generating companies that have expanded their printed properties into the digital marketplace;
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Large online retailers and portal websites;
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Hardware and software vendors, as well as enterprise organizations that use their products;
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Content distributors such as the leading cable and satellite television system operators; and
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Consumer electronics manufacturers of DVD players, CD and DVD drives, PVRs, and digital set-top boxes.
We intend to build our business by capitalizing on these customer relationships and targeting them for delivery of our existing and future digital and distribution management technologies.
Introduce New Product Applications and Technologies. We intend to develop and acquire additional digital management solutions to sell to our extensive customer base. We have committed significant resources to expand our technology base, to enhance our existing products, to introduce additional products and to participate in industry standard-setting efforts and organizations. We intend to pursue opportunities to improve technologies in our current fields of operations as well as in the areas of future optical formats, internet downloaded files, P2P file sharing antipiracy and commerce enablement, DRM licensing and interoperability, software as a service, electronic license management and digital distribution solutions.
Expand and Protect Patent Position. We have built, and continue to add to, a large patent portfolio that helps differentiate our products. We believe that our future success will depend on our ability to continue to introduce proprietary solutions for rights management and content security solutions that can be supplemented by enabling features that will incent consumers and users to pay for legitimate video, audio and software products, rather than trying to get them for free in an unauthorized fashion. We have patented many of these proprietary solutions, and our patents underpin our strong competitive position and financial model. We also have acquired key software rights management and content security patents. We intend to continue to obtain patents and to protect and defend our patented technologies aggressively, including developing and obtaining patents covering a number of processes and devices that unauthorized parties could use to circumvent our DRM and content security solutions.
Continue To Make Strategic Acquisitions. We intend to continue to expand our technology portfolio and extend our businesses by pursuing licensing arrangements, joint ventures and strategic acquisitions of companies whose technologies or proprietary rights complement our technologies.
Between 1999 and 2003, we made a number of acquisitions of companies and technologies. Through these acquisitions, we acquired solutions for application software content security, electronic license management, software asset management and the DRM business. In August 2003, we acquired intellectual property and other assets from NetPD, including patents and software that can be used to track and manage content in the peer-to-peer file sharing space; in July 2004 and in June 2005, we acquired the intellectual property and assets of InstallShield Software Corporation and Zero G Software, Inc., respectively, both of which provided us with the ability to expand our product portfolio in the software management category and reach a larger software developer customer base. In July 2005, we acquired Trymedia Systems, Inc., which allowed us to move into the digital distribution and ecommerce enablement for the PC games market. In February 2006, we acquired eMeta Corporation, which extended our reach from physical distribution into the fast-growing online digital distribution segment and extended the breadth of our portfolio to include a broad spectrum of access control, usage entitlement, e-commerce and subscription management solutions. In January 2007, we acquired Mediabolic, Inc., which extended our capabilities in the delivery and enhancement of digital content through networking solutions to a wide variety of connected consumer electronics devices for the digital home. Mediabolic’s entertainment networking software enables TVs, stereos, DVRs, PCs and other familiar consumer electronic devices to discover, store and play personal and internet-based content over the home network.
Technology
Entertainment Producers and Distributors
Video Technology
Our technology was originally designed to prevent unauthorized copying of VHS cassettes. We extended our solution to inhibit unauthorized PPV/VOD copying and DVD-to-VHS copying. Hardware manufacturers have designed their DVD-R devices to recognize our content security signal to inhibit DVD-to-DVD copying as well. The majority of the recently introduced PVRs, DVD/VCR combo units include recording devices that are designed to sense widely used content security solutions, and, as a result, they recognize Macrovision’s proprietary analog content security process and disable digital recording onto DVD discs.
DVD and Digital PPV/VOD Content Security. Videocassettes and DVDs are encoded with our video content security signal as they are manufactured. The result is that videocassettes and DVDs that are encoded with our content security signal will play normally on an analog TV set, but will cause generally unwatchable copies to be made on most of VCRs, and will shut down the analog-to-digital recording circuit of DVD recording devices, which include DVD-R devices and personal computers. The DVD and digital PPV/VOD versions of our video content security solutions employ proprietary electronic pulses placed in analog video streams and a second patented content security process which affects the color playback circuit of a VCR causing colored horizontal stripes to appear in the picture of an unauthorized copy. The combination of the two processes provides a higher level of effectiveness than that provided by either process alone. In addition, the second patented content security process is more effective against circumvention by most “black box” circumvention devices that were sold in the past. Content protection is implemented in DVD and digital PPV/VOD applications by embedding a copy protection signal generator integrated circuit within the DVD player or digital set-top box. The content security circuits remain dormant until activated by data commands, which are either embedded in the DVD disc or sent along with the PPV movie transmission to the subscriber’s set-top box or hard drive recorder. The integrated circuit is activated by copy protection control codes, which are embedded into the DVD media or the PPV transmission. Once the integrated circuit is activated, it adds the content security signal to the analog output of the DVD player or digital set-top box. As with videocassette content security, consumers are able to see a clear picture on their television sets, but generally cannot make a usable videocassette or DVD-R copy.
ACP-VOD Content Management. Our ACP-VOD technology can be used by content owners to control how long their PPV/VOD content may be stored on compliant digital PVR units and home media center PC hard drives.
RipGuard DVD. RipGuard DVD is the digital content security counterpart of our ACP technology. It is designed to inhibit software ripper programs that are used on consumer PCs to make unauthorized copies of DVDs. It can be used in conjunction with ACP to give a combination analog and digital content security solution for optical discs. RipGuard DVD is a unilateral content security solution, in that it is applied to the DVD disc at the time of manufacture, and is designed to have no impact on the quality of the displayed video and requires no hardware or special software on the PC or DVD player device.
Peer-to-Peer File Sharing Solutions. Our Hawkeye technology can be used to protect content by deterring the unauthorized file sharing of all types of digital content, including video, music and games over numerous P2P networks.
PC Games Technology
Our SafeDisc Advanced technology is licensed directly to software publishers, and to mastering and replication facilities that embed our patented digital signature during the CD manufacturing process. It is designed to prevent unauthorized copying by CD recorders or transfer from a CD/DVD-ROM to a hard disc drive, in a CD/DVD-ROM. SafeDisc is a “unilateral” content security solution, which means that all of the
proprietary content security technology resides on the CD/DVD-ROM and nothing has to be added to or changed in the PC or CD/DVD-ROM hardware. Each CD/DVD-ROM published with the patented SafeDisc Advanced technology is premastered with encrypted executable files and contains authenticating instructions and a unique SafeDisc digital signature. Because SafeDisc Advanced is designed to operate while the disc is in the CD/DVD-ROM drive, it is ideally suited to PC games and education software and is not applicable for console games like Sony Playstation or Microsoft Xbox. When a user inserts an original SafeDisc-protected disc in a CD/DVD-ROM drive, the authentication software reads the digital signature, allowing the program to be decrypted and run normally. The digital signature and authentication process is transparent to the user. If a consumer or pirate uses a CD recording device or professional mastering equipment to duplicate a CD/DVD-ROM and make an unauthorized copy, SafeDisc is designed to inhibit the transfer of the digital signature to the copy. If someone attempts to use such an unauthorized copy, the digital signature cannot be found, decryption will not take place and the copy will not run.
SafeDisc also contains anti-hacking technology which is designed to prevent the compromise of its security features. Because of our widespread penetration in the PC games’ market, hackers have targeted and cracked several versions of SafeDisc. For us to continue to be successful in this market, we must continually stay a step ahead of the hacker community.
Macrovision’s ActiveMARK 2007 is a digital rights management solution that secures game content in a single binary for both physical and online distribution. ActiveMARK 2007’s easy-to-use packaging tools allow publishers to apply rights management and security criteria, build a consistent brand across all channels, and leverage with-game advertising in trials. The ActiveMARK platform provides a flexible, turnkey solution for the digital distribution of game content online. ActiveMARK offers the capabilities required to get a branded game channel or storefront up and running quickly and easily, including comprehensive catalog, DRM, customer service and support, eCommerce, vast distribution network, merchandising, royalty reporting, in-content advertising and hosting.
Software Publishers
FLEXnet Publisher enables software publishers and hardware manufacturers to price, package, and protect their software. Using FLEXnet Publisher, customers can electronically generate, track, enforce, and update their software licenses and guard against unauthorized use by implementing product activation or content security. FLEXnet Publisher also enables software publishers to generate additional revenue by offering their customers a broad choice of pricing and licensing models, including subscription- and usage-based models.
Software and hardware vendors integrate FLEXnet Publisher solutions into their products to monitor or control a customer’s compliance with a product’s license terms. Terms of the license are typically stored in an authenticated license file that resides either on the local computer’s hard disk drive or on a network-connected central server. Compliance with those license rights is automatically monitored. The software vendor may choose to block users from running a product if doing so violates or exceeds the license rights, or simply provide notification to the user or system administrator when product use has exceeded the customer’s license rights. This allows end user customers to buy software licenses using much more flexible license terms than traditional one-computer-one-license or site license approaches. These terms may include floating licenses (where a specific number of licenses are shared over a network), product suites (where several product licenses are combined to be licensed as a single product) and demo licenses (where a prospective customer has full functional use of a product, but the right to use expires on a specific date or after a specific number of uses). With FLEXnet Publisher, software vendors can enable users to “activate” previously unlicensed copies of the software over the Internet, or by typing in a series of digits provided. Electronic licensing can also record the use of licensed software into a transaction log, which is authenticated and encrypted so software vendors and customers can use this information as a basis for pay-per-use or other usage-based pricing or licensing.
Software and hardware vendors apply our InstallShield technology to their finished products, in effect “wrapping” the application for installation. Software programs are then able to be installed and confirm to operating system standards. We cover non-Windows platforms with our InstallAnywhere product.
Our FLEXnet Connect technology is implemented as a program that resides on the end-user’s machine. It periodically checks the Internet for updates and downloads them as configured. End-users and/or their IT department system administration group can control how frequently (if at all) they want the service to check for updates, and what to do with those updates when available.
Software as a Service
Macrovision’s Rights products give the customer the ability to derive more value out of their digital assets, whether they are a content publisher, software vendor, entertainment provider, or any other digital goods or services supplier. Our Rights products are made up of two core products: RightAccess for access control and RightCommerce for commerce, both of which can help the customer generate revenue and improve customer relationships by effectively controlling and commercializing digital goods and services.
RightAccess is an access control application that provides advanced authentication, authorization, product segmentation and delegated administration features for all types of digital goods and services, including Web-based software applications. RightAccess also enables registration and single sign-on. Additionally, it offers flexible licensing opportunities, whether end-users are consumers or institutional customers.
RightCommerce is a billing application that allows companies to implement a myriad of pricing models-including pay-per-view or -use, bundles and subscriptions-enabling them to generate revenue from digital assets. The assets can include text, audio, video, streaming media, games and applications. In addition, RightCommerce users can target their customers with free trials, discounts and gift certificates, while increasing incremental or add-on purchases with promotions and targeted pricing.
Enterprise End-Users
Macrovision’s asset management software enables larger organizations to more effectively manage their licensed software, by providing interfaces to control licensed servers and set alerts to important licensing events. Moreover, this software can read and interpret the usage transaction logs described in the preceding section, enabling customers to better manage their FLEXnet enabled software assets and to allocate software-related costs to different departments or projects within the company through use of our FLEXnet Manager product. Our AdminStudio technology helps enterprise system administrators prepare various software applications and upgrades for deployment across the enterprise.
Research and Development
Our internal research and development efforts are focused on developing enhancements to existing products, new applications for our current technologies and new technologies related to our various digital content value management offerings. Our core competencies are in electronic license management and license delivery software, installer software, anti-hacking software, digital and analog video and audio engineering, content security engineering and optical media formats. We have acquired other companies and technologies to supplement our research and development expenditures. In 2006, 2005 and 2004, our expenses for research and development were $52.8 million, $34.4 million and $28.7 million, respectively.
Our primary locations for product development are in our Santa Clara (California), Schaumburg (Illinois), San Francisco (California), New York (New York), Alicante (Spain) and Maidenhead (United Kingdom) offices.
Intellectual Property Rights
Patents Issued & Pending. As of February 1, 2007, we hold 123 U.S. patents and have 134 U.S. patent applications pending. Of the issued patents, 45 relate to our content security solutions, 26 relate to video scrambling, 19 relate to audio scrambling, nine relate to electronic license management and five relate to DRM technology (namely content usage control, tracking, and e-transactions). Of the pending patent applications, 49 relate to our content security solutions, six relate to video scrambling, six relate to audio scrambling, 31 relate to electronic license management, 15 relate to DRM technology 16 relate to home networks and two relate to peer-to-peer networks. The last of our issued U.S. patents expires in 2024. The last of our core group of analog content security patents expires in the year 2020. We also have 868 foreign patents issued and 381 foreign patent applications pending in 43 countries. Of the issued foreign patents, 565 relate to our content security solutions, 104 relate to video scrambling, 33 relate to audio scrambling, and 49 relate to electronic license management and DRM.
Circumvention Technology Patents. Included in the patents related to our content security solutions are 14 U.S. and 117 foreign patents covering a number of processes and devices that unauthorized parties could use to circumvent our video content security solutions. We also have nine U.S. and 21 foreign circumvention technology patents pending. We have historically used these patents to limit the proliferation of devices intended to circumvent our video content security solutions.
Competition
Entertainment Producers and Distributors
Video Technology
Our video content security solutions are proprietary and have broad U.S. and international patent coverage. We have the only analog content security solution that has been widely deployed on commercial products that significantly distorts or inhibits copying by VHS VCRs, DVD recorders and hard drive recorders. Currently, our video content security technology is embedded in nearly 100% of all DVD players and most digital set-top boxes worldwide. While it is possible that a competitive video content security technology could be developed and deployed, we believe it would take years for the competitive technology to be accepted by hardware manufacturers or embedded into the consumer electronic devices. By the time this would happen, it is unlikely any other analog content security technology would displace our content security infrastructure and our extensive video content security “ecosystem.”
Our technology is designed to inhibit or prevent unauthorized consumer copying; it is not designed to prevent professional piracy. We believe that our customers are very concerned with professional piracy of their video, audio and software products. We believe that our customers’ assessment of the relative threats of professional versus consumer piracy may present a certain level of competition to our video content security business, to the extent that some content owners may decide to devote more of their resources to fighting professional video piracy instead of using our content protection to deter unauthorized consumer copying.
With the increase in online content distribution over the Internet, and with the continuing advance of digital content and high definition formats, our analog video content security solutions that protect standard definition content on optical media and digital PPV/VOD signals may be viewed by our customers as being less important than the other digital and network content protection solutions. As a result, other Internet-based digital content security or DRM technologies may present significant competition to our video content security business, such as DRM offerings by Intertrust, Microsoft, Apple, RealNetworks, Contentguard, Philips, IBM and Sony. In addition, Sony’s ARccOS product presents competition to our RipGuard DVD business. Competitors may also bundle their products with their own replication services, and by doing so, those competitors may be able to offer lower prices for the combined offering and therefore studios may switch to such replication facilities.
Peer-to-Peer File Sharing Content Management Technology. We believe there are two primary competitors in the P2P file sharing content management segment: ARTISTdirect’s MediaDefender and SafeNet’s MediaSentry. While these competitors were the first in this segment and are very competitive in terms of pricing, we believe that our Hawkeye technology has the advantage of being able to more efficiently scale the solution to accommodate growing numbers of simultaneous titles/tracks that are content protected and has been proven to be more effective at deterring more downloads than the competition.
PC Games Technology
We believe that there are a limited number of competitors in our SafeDisc Advanced consumer software content protection segment, including Sony SecuROM (developed and marketed by Sony’s DADC optical disk manufacturing subsidiary), StarForce Technologies, Settec and Smarte Solutions.
We also believe that there are a small number of competitors to ActiveMARK for the protection and digital distribution of games online, most notably Boonty, Oberon and Real Network’s RealArcade.
Software Publishers
Our primary competition in the electronic license management market comes from customers and prospects that develop their own homemade solutions. We have other more traditional competitors in various subcomponents of our offerings, including SafeNet (who acquired Rainbow Technologies, and has a license management offering) and Altiris (who acquired Wise and has an installer offering). There are other much smaller competitors as well, including companies such as XtreamLok, Softwrap and Reprise Software. Operating system developers such as Microsoft, IBM and Sun already integrate limited license management and installation functionality into their products, and they could expand this functionality, which could pose an increased competitive threat. Similarly, microprocessor suppliers may choose to integrate rights management solutions into their products, and software resellers could also begin to develop their own electronic license management solutions.
Software as a Service
In both the content access control and digital commerce portion of our Rights products business, homegrown solutions may have a competitive impact (build vs. buy). In addition, other vendors such as CA/Netegrity, RSA Security (now part of EMC), Oracle, Novell and Citrix, may sell internal enterprise solutions to Information Publishers even though content access control is not core to their offering. As for additional competitors in the digital commerce space outside of homegrown who offer subscription management or content commerce platform, ThinkSubscription, Amdocs/Qpass. BitPass and others may appear in a competitive situation.
Enterprise End-Users
Macrovision provides software asset management solutions to help end users monitor, manage, and track FLEXenabled and other software applications. Because we encrypt the FLEXnet usage log files, we are the only ones authorized to read and interpret the FLEXnet usage log files for purposes of software asset management. We believe that there are currently no significant competitors in this particular software asset management area. In the larger market of software asset management in general, products such as CA Unicenter, BMC Remedy and IBM Tivoli offer related and sometimes overlapping functionality.
AdminStudio enables enterprise system administrators to prepare various software applications and upgrades for deployment across the enterprise (via repackaging and patch impact management). It is used as a front-end preparation tool to assess whether there are any software application conflicts with other installed software prior to deploying to all the end user PCs. We believe our primary competitor is Altiris (for our AdminStudio and Windows installer business). Altiris acquired Wise’s PackageStudio product.
Operations and Technical Support
We have technical support and certification operations to support our DVD manufacturer licensees, set-top box licensees, authorized semiconductor manufacturers, and our other hardware licensees. We provide technical support and professional services to our independent software vendor customers and enterprise end user organizations during pre-sale, installation, implementation and maintenance phases of our contracts.
We provide a variety of technical support to our customers, including:
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We support our licensed duplicators and replicators with hardware and software installation assistance and quality assurance. In addition, we support licensed duplicator/replicator sales personnel by providing sales training and marketing literature, and by participating in trade shows;
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We provide pre- and post-sales professional services and technical support, post-sales technical support, maintenance support, training, integration and software development services to customers incorporating FLEXnet and InstallShield in their applications, as well as to enterprises who use our FLEXnet Manager and Admin Studio solutions;
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We provide professional services for implementation and customization for both our RightAccess and Right Commerce solutions, including installation of access control, billing and payments infrastructure software.
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We support the efforts of television, VCR, PVR and DVD hardware manufacturers, digital PPV/VOD system operators and PPV/VOD set-top box manufacturers to design hardware that properly incorporates and is compatible with our video content security solutions;
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We assist semiconductor manufacturers in incorporating and certifying our video content security solutions into a variety of digital video integrated circuits;
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We regularly test the effectiveness and transparency of our video, audio and PC games content protection technologies on representative samples of consumer televisions, VCRs, DVD players, DVD drives, PVRs and recorder devices to determine whether modifications or enhancements may be necessary;
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We provide training and professional services to assist our independent software vendor licensees in wrapping their executables with our SafeDisc modules;
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We provide training and application support for the SafeDisc and RipGuard software toolkits; and
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We test for SafeDisc and RipGuard compatibility and effectiveness with a variety of PC and CD/DVD drive software and hardware.
Our strategy is to license our technologies to third parties that manufacture products or software incorporating our technologies. For our InstallShield products which are mostly distributed on CD-ROMs as boxed software, we contract with outside replicators to produce, package, and fulfill orders. Our manufacturing operations are limited to low volume video and audio content security processors used by third party replicators that require in-house system integration and quality control efforts.
Legislative and Regulatory Actions
A number of government and legislative initiatives have been enacted in recent years to encourage development and implementation of technologies that protect the rights and intellectual property of the content owners.
In the United States, Congress enacted the Digital Millennium Copyright Act (“DMCA”) in October 1998. This law required all VCRs to comply with analog copy protection technologies that are in widespread use, such
as those covered in our patents, beginning in May 2000. The DMCA includes a clause that outlaws all circumvention devices and technologies that could be used to defeat widely used copy protection technologies. Based on our tests of new DVD recorder devices, we believe that manufacturers have designed them so they will not record analog input that is Macrovision copy-protected. Hence, our technology prevents copying on both VCRs and DVD-R devices. We also believe that software “ripper” products, when they include circumvention of copy protection or CSS encryption, are illegal under the law. In addition, we believe that software ripper companies who update their ripper products in order to circumvent RipGuard may be in violation of the anti-circumvention provisions of the DMCA. The U.S. law is based on a set of guidelines for amending basic copyright laws to deal with the protection of digital media. The guidelines were adopted in 1996 by the World Intellectual Property Organization, an agency of the United Nations.
Several countries in Europe have adopted a similar EU-wide copyright directive, which includes a provision aimed at controlling hardware and software circumvention devices and technologies. Individual countries’ legislatures are currently discussing these new copyright initiatives. The implementation of the Copyright Directive throughout Europe is continuing, with more countries enacting legislation. To date, Austria, Denmark, Germany, Greece, Italy and UK have implemented the Copyright Directive. The Directive brings into effect prohibitions on the manufacture, import, distribution, sale and marketing of circumvention devices and services. We have already taken action under the newly enacted German and UK Copyright Acts and obtained injunctions against a number of retailers to stop sales of devices that circumvent our technology.
In Japan, a revision to the Japanese copyright law went into effect in October 1999 prohibiting the sale, manufacture, and import of circumvention devices. In addition, an industry directive that became effective in 1997 requires all digital recording devices to be responsive to analog copy protection technologies that utilize automatic gain control techniques, such as those covered by our patents.
Strategic Investments
We have made strategic investments in companies with complementary technologies and markets where we felt we could broaden our market reach or technology portfolio. The adjusted cost of our strategic investments as of December 31, 2006 was $22.7 million and consisted of several investments, including an investment in Digimarc Corporation (“Digimarc”), a provider of patented digital watermarking technologies that allow digital code to be embedded in traditional and digital content, including movies, photographic images and documents such as financial instruments, passports and event tickets. In December 1997, we made our initial investment and signed a joint development agreement with Digimarc. We made two subsequent investments in June 1999 and October 2000, for a total of $25.3 million. Digimarc completed an initial public offering in December 1999. As of December 31, 2006, we owned approximately 9.5% of Digimarc, which translated to a valuation of $17.7 million. During 2005 and 2004, we determined that the decline in value of Digimarc stock was other-than-temporary and took a charge to earnings of $5.8 million and $5.3 million, respectively, as a result. There were no impairment charges relating to Digimarc in 2006.
In addition to the above investment, we made a $5.0 million investment in a privately-held digital watermarking company for strategic purposes in 2006. We also have made and hold strategic investments in other companies that have been written down and have no recorded value as of December 31, 2006. During 2004, we recorded an other-than-temporary charge to earnings of $180,000 related to our investment in iVast, a privately held company.
Our strategic investments represented 2.8% and 2.4% of our total assets as of December 31, 2006 and 2005, respectively. In total, we wrote off $5.8 million and $5.5 million for the years ended December 31, 2005 and 2004, respectively, related to impairments that were other-than-temporary. There were no other-than-temporary impairment charges in 2006. In the future, we may continue to evaluate and make such minority investments for strategic purposes.
Employees
As of December 31, 2006, we had 784 full-time employees. Of these employees, 217 were based outside of the United States. We expect to hire additional employees in 2007, particularly in engineering, marketing, sales and support. Except for our employees located in our Alicante, Spain office, none of our employees are covered by a collective bargaining agreement or are represented by a labor union. We have not experienced any organized work stoppages. We believe that our future success will depend in part upon the continued service of our key employees and on our continued ability to hire and retain qualified personnel. We may not be able to retain our key employees and may not be successful in attracting and retaining sufficient numbers of qualified personnel to conduct our business in the future.
Available Information
Our Internet website is located at http://www.macrovision.com. We make available free of charge on our website our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, as soon as reasonably practicable after we electronically file such material with, or otherwise furnish it to, the Securities and Exchange Commission (the “SEC”). The reference to our Internet website does not constitute incorporation by reference of the information contained on or hyperlinked from our Internet website and should not be considered part of this document.
The public may also read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Rooms by calling the SEC at 1-800-SEC-0330. The SEC also maintains an Internet website that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC. The SEC’s Internet website is located at http://www.sec.gov.
ITEM 1A.
ITEM 1A. RISK FACTORS
In addition to the other information contained in this Annual Report on Form 10-K, you should consider carefully the following risks. If any of these risks occurs, our business, financial condition or operating results could be adversely affected.
The success of our business depends on the continued use by major movie studios of our video content protection technology.
If major motion picture studios were to determine that the benefits of our technology do not justify the cost of licensing the technology, then demand for our technology would decline. Historically, we have derived a significant percentage of our net revenues and operating income from fees for the application of our patented video content protection technology to various video formats, including prerecorded videocassettes, DVDs and digital PPV and VOD programs.
Any future growth in revenues from these fees will depend on (a) growth in the various media formats, (b) increased use of our video content protection technology on a larger number of videocassettes, DVDs, digital PPV/VOD programs or PCs, or (c) increases in usage fees or royalties. To increase or maintain our market penetration, we must continue to persuade content owners that the cost of licensing our technology is outweighed by the increase in revenues that content owners and retailers gain as a result of using content protection, such as revenues from additional sales of the copy protected material or subsequent revenues from other distribution channels.
Any decline in demand for our video content protection technology, including a change of video content protection policy by the major motion picture studios, or a decline in sales of prerecorded videocassettes and
DVDs that are encoded with our video content protection technology due to a shift from physical media distribution to digital distribution or otherwise, or additional declines in our average unit royalties, would have a material adverse effect on our business. If one or more of the motion picture studios were to withdraw its support for our content protection technologies or otherwise determine not to copy protect a significant portion of prerecorded videocassettes, DVD or digital PPV/VOD programs, our business would be harmed.
Our operating results may fluctuate, which may adversely affect the price of our common stock.
Our quarterly and annual revenues, expenses and operating results could vary significantly in the future and period-to-period comparisons should not be relied upon as indications of future performance. Due to limited visibility in predicting software licensing revenues and, particularly, revenues that are generated from perpetual licenses (under which license fee revenue is recognized upfront on a one-time basis), we may experience volatility in revenues which may cause us to not be able to sustain our revenue levels, or our rate of revenue growth, on a quarterly or annual basis. In addition, we may be required to delay or extend recognition of revenue on more complex licensing arrangements as required under generally accepted accounting principles in the United States. Fluctuations in our operating results may cause the price of our common stock to decline.
Other factors that could affect our operating results include:
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The timing and number of releases of popular movies on videocassettes, DVDs or by digital PPV/VOD transmission;
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The ability of the Motion Picture Association of America (MPAA) studios utilizing our content protection technology to produce a sufficient number of major releases annually;
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The acceptance of our content protection technologies by major motion picture studios and software companies;
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The amount by which theatrical content is being replaced by television content, and the extent to which entertainment producers decide to apply our protection technologies to television content;
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Expenses related to, and the financial impact of, possible acquisitions of other businesses and the integration of such businesses;
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The acceptance of our software solutions (electronic licensing, installation, update service, software asset management, packaging) by software vendors and end-user organizations;
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The timing and ability of signing high-value hardware licensing settlement agreements during a specific period;
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The potential that we may not be in a position to anticipate a decline in revenues in any quarter until (i) late in the quarter due to the closing of new sales agreements late in the quarter or (ii) after the quarter ends due to the delay inherent in reporting from certain licensees;
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The extent to which new content technologies or formats replace technologies to which our solutions are targeted;
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Adverse changes in the level of economic activity in the United States or other major economies in which we do business as a result of the threat of terrorism, military actions taken by the United States or its allies, or generally weak and uncertain economic and industry conditions;
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The timing and popularity of releases of computer software CD-ROM multimedia titles;
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The extent to which various hacking technologies are viewed by our customers to undermine and devalue our technologies; and
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The extent to which we are able to transition our market leading position in optical media (i.e., packaged media) content protection and our DRM patents into digital content value management via the Internet.
If our entertainment technologies customers decide to focus on other methods to inhibit piracy, the demand for our products may decrease and our business would be harmed.
We have been successful historically in licensing our content protection technologies to control unauthorized casual consumer copying. Other content piracy sources include camcorders in movie theaters, peer-to-peer file sharing services and PC-based DVD copying software. To the extent that our customers spend money to prevent or litigate or support legislative initiatives against these other piracy sources, they may reduce spending on our technology. Additionally, if our customers are unable to prevent their content from becoming available through these other piracy sources, they may consider our technology to be less valuable. In either event, our business would be harmed.
As our entertainment technologies customers try to minimize costs, they may decrease their content protection usage or negotiate decreases in their usage fees, which may result in a substantial decline in our entertainment related revenues.
The retail prices of DVDs are falling. As retail prices drop, consumers trend toward purchases rather than rental of DVDs, therefore causing studios to face increased pressure to trim manufacturing expenses. This includes cutting back their content protection usage, as well as negotiated reductions in their usage fees. Recently, diminishing margins that studios have been experiencing have contributed to a reduction in the prices we can charge them to include our video content protection technology in their products. As such, we have experienced a decline in our entertainment technologies’ per-unit revenue associated with DVDs in the last two years and we have seen our usage fees on a per unit basis decline over time. Even though we have contracts with minimum annual volume commitments, it is possible for some studios to copy protect a smaller percentage of their titles and still achieve their minimum volume commitments. In addition, some studios choose to copy protect selected titles, or choose to not use any copy protection, and their actions may influence other studios to do the same, which could harm our business.
We experience seasonality in our operating results, which may affect the price of our common stock.
Because of the nature of the products that we offer, we have experienced significant seasonality in our business, and our business is likely to be affected by seasonality in the future. We have typically experienced our highest revenue in the fourth quarter of each calendar year followed by lower revenue and operating income in subsequent quarters of the next year. We believe that this trend has been principally due to the tendency of our customers to release their more popular movies and games during the year-end holiday shopping season as well as the pronounced fourth quarter seasonality in the software business.
We depend on a small number of key customers for a high percentage of our entertainment-related revenues and the loss of a significant customer could result in a substantial decline in our revenues and profits.
Our customer base and our entertainment-related revenue are highly concentrated among a limited number of customers, primarily due to the fact that the MPAA studios dominate the motion picture industry and the loss of any one customer would have a significant adverse impact on our entertainment related business. Historically, we have derived the majority of our entertainment-related revenue from a relatively small number of customers. No customer accounted for more than 10% of our net revenues in 2006, 2005 or 2004.
We expect that revenues from the MPAA studios will continue to account for a substantial portion of our net revenues for the foreseeable future. We have multi-year agreements with some of the major home video companies for copy protection of all or a substantial part of their videocassettes and/or DVDs in the U.S. As these agreements expire, they may or may not be renewed, or, if renewed, may be at substantially reduced per unit prices and on other terms less favorable to us than the existing agreements. Changes in management, ownership or control of the MPAA studios could affect the renewal of their contracts with us. The failure of any
one of these customers to renew its contract, or to enter into a new contract with us on terms that are favorable to us, would likely result in a substantial decline in our entertainment-related revenue and operating income, and our business would be harmed.
We depend on signing high-value license agreements with major software customers for our FLEXnet product and the inability to sign or complete these agreements could result in a decline or deferral of our revenue and profits in any particular reporting period.
Currently, a material portion of our FLEXnet revenues are generated from perpetual licenses, under which license fee revenue is generally recognized up front on a one-time basis, combined with an annual maintenance fee that is ratably recognized generally over a 12-month period. Failure to close a small number of high-value perpetual licenses during any period could result in a decline in our revenues and profits. We currently offer our customers the choice between a perpetual license and a time-based license, the latter of which results in ratable recognition of the license fee over the term of the license, which is generally 12 months.
We have limited control over existing and potential customers’ and licensees’ decisions to include our technology in their product offerings.
In general, we are dependent on our customers and licensees-including producers and distributors of content for films, videos, software and games-to incorporate our technology into their products. Although we have license agreements with many of these companies, many of these license agreements do not require any minimum purchase commitments, or are on a non-exclusive basis, or do not require incorporation of our technology in their products. Furthermore, while we may be successful in obtaining mandatory status for our technology in one or more industry standards, there is no guarantee that products associated with these standards will be successful in the market. Our licensees and other manufacturers might not utilize our technology in the future. If this were to occur, our business would be harmed.
A significant portion of our revenues is derived from international sales. Economic, political, regulatory and other risks associated with our international business could have an adverse effect on our operating results.
International and export sales together represented 45%, 43% and 42% of our consolidated net revenues in 2006, 2005 and 2004, respectively. We expect that international and export sales will continue to represent a substantial portion of our net revenues for the foreseeable future. Our future growth will depend to a large extent on worldwide acceptance and deployment of our content protection and DRM solutions for digital PPV networks, DVDs, and consumer software. Worldwide adoption of our FLEXnet software solutions will also be an important driver of future growth.
To the extent that foreign governments impose restrictions on importation of programming, technology or components from the U.S., the requirement for content protection and rights management solutions in these markets could diminish. In addition, the laws of some foreign countries may not protect our intellectual property rights to the same extent as do the laws of the U.S., which increases the risk of unauthorized use of our technologies and the ready availability or use of circumvention technologies. Such laws also may not be conducive to copyright protection of digital content and software, which may make our content protection technology less effective and reduce the demand for it.
Because we sell our products worldwide, our business is subject to the risks associated with conducting business internationally, including:
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foreign government regulation;
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changes in diplomatic and trade relationships;
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changes in, or imposition of, foreign laws and regulatory requirements;
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changes in, or weakening of copyright and intellectual property (patent) laws and support for content protection and DRM technologies;
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difficulty of effective enforcement of contractual provisions in local jurisdictions;
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tariffs or taxes and other trade barriers and restrictions;
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fluctuations in our net effective income tax rate driven by changes in the percentage of revenues that we derive from international sources;
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changes in a specific country’s or region’s political or economic condition, including changes resulting from the threat of terrorism;
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difficulty in staffing and managing foreign operations; and
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fluctuations in foreign currency exchange rates.
Our business could be materially adversely affected if foreign markets do not continue to develop, if we do not receive additional orders to supply our technologies or products for use in foreign prerecorded video, PPV and other applications requiring our content protection solutions or if regulations governing our international businesses change. For example, our products are eligible for export under the U.S. Export Administration Act and U.S. export regulations. We have implemented a program to comply with these laws and regulations, but cannot guarantee that any particular product can be exported to any particular location at any particular time. Any changes to the statute or the regulations with respect to export of encryption technologies could require us to redesign our products or technologies or prevent us from selling our products and licensing our technologies internationally.
If we fail to develop and deliver innovative technologies in response to changes in the entertainment industry, our business could decline.
The markets for our products and technologies are characterized by rapid change and technological evolution. We will need to continue to expend considerable resources on research and development in the future in order to continue to design and deliver enduring, innovative entertainment products and technologies. Despite our efforts, we may not be able to develop and effectively market new products, technologies and services that adequately or competitively address the needs of the changing marketplace. In addition, we may not correctly identify new or changing market trends at an early enough stage to capitalize on market opportunities. At times such changes can be dramatic, such as the shift from VHS videocassettes to DVDs for consumer playback of movies in homes and elsewhere, the anticipated shift to high definition DVD or the transition from packaged media to Internet distribution. Our future success depends to a great extent on our ability to develop and deliver innovative technologies that are widely adopted in response to changes in the entertainment industry and that are compatible with the technologies or products introduced by other entertainment industry participants. If we are unsuccessful in developing and delivering new technologies, our business would be harmed.
Our success is heavily dependent upon our proprietary technologies.
We believe that our future success will depend on our ability to continue to introduce proprietary solutions for digital content and software solutions and technologies that can be supplemented by enabling features that will incent consumers and users to pay for legal, authorized video, audio and software products, rather than trying to get them for free in an illegal or unauthorized fashion. We rely on a combination of patent, trademark, copyright and trade secret laws, nondisclosure and other contractual provisions, and technical measures to protect our intellectual property rights. Our patents, trademarks or copyrights may be challenged and invalidated or circumvented. Our patents may not be of sufficient scope or strength or be issued in all countries where products incorporating our technologies can be sold. The last of our core group of analog copy protection patents expire in the year 2020. In many cases, we have filed applications to expand our patent claims and for improvement patents to extend the current expiration dates, however, expiration of some of our patents may harm our business. If we are not successful in protecting our intellectual property, our business would be harmed.
Others may develop technologies that are similar or superior to our technologies, duplicate our technologies or design around our patents. A number of companies with extensive financial resources have developed intellectual property in the digital rights management field, including InterTrust, Philips, Sony, RealNetworks, ContentGuard, IBM, Apple and Microsoft. Such competitive threats could harm our business.
Effective intellectual property protection may be unavailable or limited in some foreign countries. Despite efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise use aspects of processes and devices that we regard as proprietary. Policing unauthorized use of our proprietary information is difficult, and the steps we have taken may not prevent misappropriation of our technologies.
We may initiate patent infringement or patent interference actions or other litigation to protect our intellectual property, which could be costly and harm our business.
We are currently engaged in litigation, and litigation may be necessary in the future, to enforce our patents and other intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others.
We, and many of our current and potential competitors, dedicate substantial resources to protection and enforcement of intellectual property rights, especially patents in the area of digital rights management technologies. We believe that companies will continue to take steps to protect these technologies, including, but not limited to, seeking patent protection. As a result, disputes regarding the ownership of these technologies and the associated rights are likely to arise in the future and may be very costly. Companies in the technology and content-related industries have frequently resorted to litigation regarding intellectual property rights. We may be forced to litigate to determine the validity and scope of other parties’ proprietary rights. Any such litigation could be very costly and could distract our management from focusing on operating our business. The existence and/or outcome of such litigation could harm our business.
We may be subject to intellectual property infringement claims or other litigation, which are costly to defend and could limit our ability to use certain technologies in the future.
From time to time we receive claims and inquiries from third parties alleging that our internally developed technology, technology we have acquired or technology we license from third parties may infringe other third parties’ proprietary rights, especially patents. Third parties have also asserted and most likely will continue to assert claims against us alleging infringement of copyrights, trademark rights or other proprietary rights, or alleging unfair competition or violations of privacy rights. For example, we are engaged in litigation with Altiris. We could be required to spend significant amounts of time and money to defend ourselves against such claims. If any of these claims were to prevail, we could be forced to pay damages, comply with injunctions, or stop distributing our products and services while we re-engineer them or seek licenses to necessary technology, which might not be available on reasonable terms or at all. We could also be subject to claims for indemnification resulting from infringement claims made against our customers and strategic partners, which could increase our defense costs and potential damages. For example, we have received notices from certain customers requesting indemnification in patent-related lawsuits. We have evaluated the requests and do not believe we are obligated to provide such indemnification to such customers. Customers or strategic partners making such requests could become unwilling or hesitant to do business with us if we decline such requests. An adverse determination with respect to such requests or in any of these events described above could require us to change our business practices and have a material impact on our business and results of operations.
Litigation could harm our business and result in:
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substantial settlement or related costs, including indemnification of customers;
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diversion of management and technical resources;
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either our customers discontinuing to use or ourselves discontinuing to sell infringing products;
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our expending significant resources to develop non-infringing technology; and
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our obtaining licenses to infringed technology.
We are involved in the business of protection and enablement of audio, video and software content on the Internet and P2P networks. There has been, and we believe that there will continue to be, an increasing level of litigation to determine the applicability of current laws to, and impact of new technologies on, the use and distribution of content over the Internet and P2P networks and through new devices, especially as it relates to the motion picture and software industries. P2P network providers and consumer activist groups have been very active in litigation against attempts to restrict the free use and distribution of content over the Internet and P2P networks. As we develop products and services that protect, provide or enable the provision of content in such ways, the risk of litigation against us may increase.
It may be time-consuming and costly to enforce our patents against devices and hacking techniques that attempt to circumvent our content protection technology, and our failure to control them could harm our business.
We use our patents to limit the proliferation of devices and technologies intended to circumvent our video content protection technologies. In the past, we have initiated a number of patent infringement disputes against manufacturers and distributors of these devices and software. In the event of an adverse ruling in such litigation, the value of our video protection technology may decline due to the legal availability of such a circumvention device, or we may have to obtain rights to the offending devices to protect the value of our technology. The legal availability of circumvention devices could result in the increased proliferation of devices that defeat our content protection technology and a decline in demand for our technologies, which could have a material adverse effect on our business.
Any legal or other enforcement action that we may initiate could be time-consuming to pursue, involve costly litigation, divert management’s attention from operations or may not be successful.
In the PC games copy protection market, a number of individuals have developed and posted SafeDisc Advanced hacks on the Internet, or CD cloning software. If we are not able to develop technologies that deter the hackers from developing circumvention or cloning techniques, our customers could reduce their usage of our technology because it was compromised. We expect to encounter similar challenges with our RipGuard DVD anti-ripper product and our Hawkeye P2P file sharing antipiracy service.
CGMS-A is an alternative analog copy protection technology for which we have patents that apply in the United States. We believe this technology has applicability in protecting digital content within home media centers, Internet downloads, and digital PPV/VOD broadcasts. We would like to license these patents to both content owners and hardware manufacturers, but in order to maintain strong customer relationships, we may not be able to monetize these patents. If potential customers decline to license these patents or the patents are contested, we may find that the cost in terms of litigation expense, management diversion, and reduced customer goodwill from enforcing our patent rights may offset the revenue potential and could harm our business.
Legislative initiatives seeking to weaken copyright law or new governmental regulation or new interpretation of existing laws that cause resulting legal uncertainties could harm our business.
Consumer rights advocates and other constituencies continuously challenge copyright law, notably the U.S. Digital Millennium Copyright Act of 1998, or DMCA, through both legislative and judicial actions. Legal uncertainties surrounding the application of the DMCA may adversely affect our business. If copyright law is compromised, or devices that can circumvent our technology are permitted by law and become prevalent, this could result in reduced demand for our technologies, and our business would be harmed.
Many laws and regulations are pending and may be adopted in the United States, individual states and local jurisdictions and other countries with respect to the Internet. These laws may relate to many areas that impact our business, including copyright and other intellectual property rights, digital rights management, property ownership and taxation. These types of regulations are likely to differ between countries and other political and geographic divisions. Other countries and political organizations are likely to impose or favor more and different regulation than that which has been proposed in the United States, thus furthering the complexity of regulations. In addition, state and local governments may impose regulations in addition to, inconsistent with, or stricter than federal regulations. Changes to or the interpretation of these laws could increase our costs, expose us to increased litigation risk, substantial defense costs and other liabilities or require us or our customers to change business practices. It is not possible to predict whether or when such legislation may be adopted, and the adoption of such laws or regulations, and uncertainties associated with their validity, interpretation, applicability and enforcement, could materially and adversely affect our business.
Our relationships with entertainment industry participants are particularly important to our businesses, and if we fail to maintain such relationships our business could be materially harmed.
If we fail to maintain and expand our relationships with a broad range of participants throughout the entertainment industry, including motion picture studios, broadcasters, video game designers and manufacturers of consumer electronics products, our business and prospects could be materially harmed. Relationships have historically played an important role in the entertainment industries that we serve. If we fail to maintain and strengthen these relationships, these entertainment industry participants may not purchase and use our technologies, which could materially harm our business and prospects. In addition to directly providing a substantial portion of our revenue, these relationships are also critical to our ability to have our technologies adopted as industry standards. Moreover, if we fail to maintain our relationships, or if we are not able to develop relationships in new markets in which we intend to compete in the future, including markets for new technologies and expanding geographic markets, our business, operating results and prospects could be materially and adversely affected. In addition, if major industry participants form strategic relationships that exclude us, our business and prospects could be materially adversely affected.
We must establish and maintain licensing relationships with companies other than content owners or software publishers to continue to build and support a worldwide content value management ecosystem and to expand our business, and failure to do so could harm our business prospects.
Our future success will depend upon our ability to establish and maintain licensing relationships with companies in related business fields, including:
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DVD and CD authoring facilities, mastering houses and replicators;
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DVD and CD authoring tools software companies and replicator test equipment suppliers;
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DVD and CD hardware manufacturers;
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videocassette duplicators;
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semiconductor and equipment manufacturers;
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operators of digital PPV and VOD networks;
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consumer electronics, digital PPV/VOD set-top hardware manufacturers, and PC manufacturers;
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DRM suppliers; and
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Internet portals and other digital distribution companies.
Substantially all of our license agreements are non-exclusive, and therefore our licensees are free to enter into similar agreements with third parties, including our competitors. Our licensees may develop or pursue alternative technologies either on their own or in collaboration with others, including our competitors.
Some of our third party license arrangements will require that we license others’ technologies and/or integrate our solutions with others. In addition, we rely on third parties to report usage and volume information to us. Delays, errors or omissions in this information could harm our business. If these third parties choose not to support integration efforts or delay the integration, our business could be harmed.
We must continue to provide satisfactory support and maintenance services to our software customers.
Our future success will depend on our ability to provide adequate software support and maintenance services to our independent software vendor electronic license management customers. As they release new applications or modify their software to run on new platforms, it is important that their businesses not be disrupted as a result of inadequate support from us. Failure to deliver such services could harm our business.
We depend on third parties to implement and support our SafeDisc Advanced and our RipGuard DVD anti-ripper software modules within their optical disc encoding and quality assurance equipment.
We rely on third party vendors such as DCA, Eclipse, Media Morphics and CD Associates to develop and incorporate software modules that will:
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apply the various digital signature, formatting, and copy protection technology at licensed replication facilities; and
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allow replicators to run specialized quality assurance tests to confirm our technologies are applied.
Our operations could be disrupted if our relationships with third party vendors are disrupted or if their products are defective, not available or not accepted by licensed replicators. This could result in a loss of customer orders and revenue.
Our various digital content value management solutions are available in many of the world’s largest mastering and replication facilities, and are designed to be fully compatible with standard CD manufacturing processes. Nevertheless, we rely on such third parties to properly apply these technologies to optical media-based content on behalf of our customers and to properly perform quality assurance testing with respect to such content. Any improper application of the technology or improper quality assurance testing by such third party mastering and replication facilities may result in content that does not contain our copy protection technology or may result in other defects in the rights holders content, and may therefore, result in a loss of revenue or a claim against us by the content owner.
We rely on our licensees and others to accurately prepare manufacturing reports in determining our entertainment related licensing revenue, and if these reports are inaccurate, our operating results could be materially adversely affected.
Our entertainment related licensing revenue is generated primarily from content owners who license our technologies and incorporate them in their products. Under our existing arrangements, these licensees typically pay us a per-unit licensing fee based on the number of units of product they manufacture that incorporates our technologies. We depend on third party replicators to properly apply our content protection technology to content on behalf of our customers, to properly perform quality assurance testing with respect to such content and to accurately report the number of copy protected units manufactured. In collecting our license fees, preparing our financial reports, projections and budgets and directing our sales and product development efforts, we rely on those manufacturing reports from our customers and their replicators. However, it is often difficult for us to independently determine whether or not our licensees are reporting shipments accurately. Although we generally have audit rights, audits are expensive and time consuming and initiating audits could harm our customer relationships. To the extent that our licensees understate or fail to report the number of products incorporating our technologies that they ship, we will not collect and recognize revenue to which we are entitled, which could
adversely affect our operating results. To the extent that these same parties improperly report and overstate the number of products incorporating our technologies that they ship, we may have to issue credits for past revenue, which could adversely affect our operating results.
Our operating results may fluctuate depending upon when we receive manufacturing reports from our entertainment related licensees.
Our quarterly operating results may fluctuate depending upon when we receive royalty reports from our entertainment related licensees. We recognize a portion of our entertainment related license revenue only after we receive royalty reports from our licensees regarding the manufacture of their products that incorporate our technologies. As a result, the timing of our entertainment related revenue is dependent upon the timing of our receipt of those reports, some of which are not delivered until late in the quarter or after the end of the quarter. This may put us in a position of being not able to anticipate a decline in revenues in any given quarter. In addition, it is not uncommon for royalty reports to include corrective or retroactive royalties that cover extended periods of time. Furthermore, there have been times in the past when we have recognized an unusually large amount of entertainment related licensing revenue from a licensee in a given quarter because not all of our revenue recognition criteria were met in prior periods. This can result in a large amount of entertainment related licensing revenue from a licensee being recorded in a given quarter that is not necessarily indicative of the amounts of entertainment related licensing revenue to be received from that licensee in future quarters, thus causing fluctuations in our operating results and resulting in potential volatility in the price of our common stock.
We are exposed to risks associated with expanding our technology base through strategic acquisitions and investments.
We have expanded our technology base in the past through strategic acquisitions and investments in companies with complementary technologies or intellectual property and intend to do so in the future. Acquisitions always hold special challenges in terms of successful integration of technologies, products and employees. Most recently, we completed the acquisition of eMeta Corporation in February 2006 and Mediabolic, Inc. in January 2007. We may not realize the anticipated benefits of these or any other companies we have acquired in the past and companies we acquire in the future, and we may not be able to incorporate any acquired services, products or technologies with our existing operations, or integrate personnel from the acquired businesses, in which case our business could be harmed.
Acquisitions and other strategic investments involve numerous risks, including:
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problems integrating the purchased operations, technologies, personnel or products over geographically disparate locations;
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unanticipated costs, litigation and other contingent liabilities;
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adverse effects on existing business relationships with suppliers and customers;
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risks associated with entering into markets in which we have no, or limited, prior experience;
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incurrence of significant exit charges if products acquired in business combinations are unsuccessful;
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significant diversion of management’s attention from our core business and diversion of key employees’ time and resources;
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inability to retain key customers, distributors, vendors and other business partners of the acquired business; and
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potential loss of our key employees or the key employees of an acquired organization.
Financing for future acquisitions may not be available on favorable terms, or at all. If we identify an appropriate acquisition candidate for any of our businesses, we may not be able to negotiate the terms of the
acquisition successfully, finance the acquisition or integrate the acquired business, products, technologies or employees into our existing business and operations. Future acquisitions may not be well-received by the investment community, which may cause our stock price to fall. We cannot ensure that we will be able to identify or complete any acquisition in the future.
If we acquire businesses, new products or technologies in the future, we may incur significant acquisition-related costs. In addition, we may be required to amortize significant amounts of identifiable intangible assets and we may record significant amounts of goodwill that will be subject to annual testing for impairment. We have in the past and may in the future be required to write off all or part of one or more of these investments that could harm our operating results. If we consummate one or more significant future acquisitions in which the consideration consists of stock or other securities, our existing stockholders’ ownership could be significantly diluted. If we were to proceed with one or more significant future acquisitions in which the consideration included cash, we could be required to use a substantial portion of our available cash. Acquisition activities could also cause operating margins to fall depending upon the financial models of the businesses acquired.
Our strategic investments may involve joint development, joint marketing, or entry into new business ventures, or new technology licensing. Any joint development efforts may not result in the successful introduction of any new products by us or a third party, and any joint marketing efforts may not result in increased demand for our products. Further, any current or future strategic acquisitions and investments by us may not allow us to enter and compete effectively in new markets or enhance our business in our existing markets.
We currently hold minority equity interests in a number of companies, including Digimarc, a public corporation. Other than Digimarc, our strategic investments are in privately held companies. There is no active trading market for the securities of privately held companies and our investments in them are illiquid at best. Other than a $5.0 million investment in a privately-held digital watermarking company that we made in 2006, we have written off all of our investments in such privately held companies and we may never have an opportunity to realize any return on our investments in them. Through December 31, 2006, we had invested an aggregate of $58.3 million in strategic investments, including the $5.0 million investment made in 2006. Since January 1, 2001, we have written off $40.2 million of strategic investments resulting from impairment that was other-than-temporary, and we may have to write off additional amounts in the future.
Our products could be susceptible to errors, defects, or unintended performance problems that could result in lost revenues, liability or delayed or limited market acceptance.
We offer and develop a series of complex content management and software solutions, which we license to customers. The performance of these products typically involves working with sophisticated software, computing and communications systems. Due to the complexity of these products offered and developed, and despite our quality assurance testing, the products may contain undetected defects or errors that may affect the proper use or application of such products by the customer. Because our products are embedded in digital content and other software, our solutions’ performance could unintentionally jeopardize our customers’ product performance. Any such defects, errors, or unintended performance problems in existing or new products, and any inability to meet customer expectations in a timely manner, could result in loss of revenue or market share, failure to achieve market acceptance, diversion of development resources, injury to our reputation, increased insurance costs and increased service, any of which could materially harm our business.
In addition, we rely on the customer and third party replicators to properly use our products to protect the software and applications to which our technology may be applied. Any improper use or application of the software by the customer or the third party replicators may render our technologies useless and result in losses from claims arising out of such improper use of the products.
Because customers rely on our products for copy protection and digital rights management of their software and applications, defects or errors in our products may discourage customers from purchasing our products.
These defects or errors could also result in product liability or warranty claims. Although we attempt to reduce the risk of losses resulting from these claims through warranty disclaimers and limitation of liability clauses in our agreements, these contractual provisions may not be enforceable in every instance. Furthermore, although we maintain errors and omissions insurance, this insurance may not adequately cover these claims. If a court refused to enforce the liability-limiting provisions of our contracts for any reason, or if liabilities arose that were not contractually limited or adequately covered by insurance, our business could be materially harmed.
In protecting copyrights and other intellectual property rights of our customers, our products affect consumer use of our customers’ products. Consumers may view this negatively and discontinue or threaten to discontinue purchase or use of our customers’ products unless our customers stop using our technologies. This may cause a decline in demand for our products or legal actions against us by our customers or consumers.
If use of the Internet for delivery of software does not increase as we anticipate, our business may suffer.
Some of our products are designed to support using the Internet to deliver, install, deploy, activate, update or pay for software or digital media. The revenues we generate from these products depend on increased acceptance and use of the Internet as a medium of commerce, communications and delivery of software and digital media. Acceptance and use of the Internet may not continue to develop at historical rates, and a sufficiently broad base of business customers may not adopt or continue to use the Internet to conduct their operations. Demand and market acceptance for recently introduced services and products over the Internet are subject to a high level of uncertainty, and there are few proven services and products. Our business could be seriously harmed if:
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The necessary communication and computer network technology underlying the Internet and other online service does not effectively support any expansion that may occur; or
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New standards and protocols are not developed or adopted in a timely manner.
If use of the Internet for delivery of video programming increases, our business may suffer.
Our video packaged software copy protection products are designed to be applied to packaged media, and we receive royalties based on the number of units produced. If electronic delivery of such products using the Internet were to increase, our revenues from packaged media may be adversely affected and not replaced by Internet-based revenues. In this event, our business could be seriously harmed.
We have a relatively limited operating history with our digital distribution business, which makes it difficult to evaluate its impact on our business.
We completed the acquisitions of Trymedia, a digital distribution network for downloadable PC games, in July 2005 and eMeta, a provider of software solutions that enable companies to manage and sell digital goods and services online, in February 2006. We have a relatively limited history operating these businesses and as a result, we have limited financial results from these businesses on which to assess our future prospects. Our prospects must be considered in light of the risks, expenses and difficulties frequently encountered by companies in new and rapidly evolving businesses. We may not realize the anticipated benefits of these companies that we acquired as fast as we expect, or at all, and we may not be able to successfully incorporate any acquired services, products or technologies with our existing operations, in which case our business could be harmed.
We conducted a review of our historical stock option practices and provided the SEC and US Attorney’s Office with certain information relating to our stock options. While these reviews have been completed, negative publicity surrounding these reviews or further regulatory review may require a significant amount of accounting and legal resources, which could adversely affect our business, results of operations and cash flows.
The SEC and the US Attorney’s Office each contacted the Company in 2006 requesting information relating to our stock option practices from 1997 and 1995, respectively, to the present. We have cooperated with both of
these requests for information. We completed our internal review, which uncovered no evidence of fraud or intentional wrongdoing in our historical stock option granting practices. We reported this conclusion to the SEC and US Attorney’s Office. By letter dated October 24, 2006, the SEC informed us that its investigation had been terminated without enforcement action being recommended to the Commission. By letter dated January 11, 2007, the U.S. Attorney’s Office informed us that it withdrew its subpoena. The Internal Revenue Service has requested information relating to our stock option granting practices in connection with its current examination of our 2003 and 2004 federal tax returns. While we believe that this review of stock option practices has no material impact on the financial statements included in this report or on any previously issued financial statements, negative publicity surrounding these reviews could impact our relationships with customers or our stock price. In addition, considerable legal and accounting expenses related to the matter have been incurred to date and could be incurred in the future in responding to related inquiries.
For our business to succeed, we need to attract and retain qualified employees and manage our employee base effectively.
Our success depends on our ability to hire and retain qualified employees and to manage our employee base effectively. Because of the specialized nature of our business, our future success will depend upon our continuing ability to identify, attract, train and retain other highly skilled managerial, technical, sales and marketing personnel, particularly as we enter new markets. Competition for people with the skills that we require is intense, particularly in the San Francisco Bay area where our headquarters are located, and the high cost of living in this area makes our recruiting and compensation costs higher. In particular, due to the overall decline in technology market values and the resultant impact on our stock price, using stock options as an incentive to hire and retain employees may be less effective. If we are unable to hire and retain qualified employees, our business and operating results could be adversely affected.
Business interruptions could adversely affect our future operating results.
Several of our major business operations are subject to interruption by earthquake, fire, power shortages, terrorist attacks and other hostile acts, and other events beyond our control. The majority of our research and development activities, our corporate headquarters, our principal information technology systems, and other critical business operations are located near major seismic faults. Our operating results and financial condition could be materially harmed in the event of a major earthquake or other natural or man-made disaster that disrupts our business.
Our telephone and computer networks are subject to security and stability risks that could harm our business and reputation and expose us to litigation or liability.
Online business activities depend on the ability to transmit confidential information and licensed intellectual property securely over private and public networks. Any compromise of our ability to transmit such information and data securely or reliably, and any costs associated with preventing or eliminating such problems, could harm our business. Online transmissions are subject to a number of security and stability risks, including:
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our own or licensed encryption and authentication technology, and access and security procedures, may be compromised, breached or otherwise be insufficient to ensure the security of customer information or intellectual property;
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we could experience unauthorized access, computer viruses, system interference or destruction, “denial of service” attacks and other disruptive problems, whether intentional or accidental, that may inhibit or prevent access to our websites or use of our products and services;
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someone could circumvent our security measures and misappropriate our, our partners’ or our customers’ proprietary information or content or interrupt operations, or jeopardize our licensing arrangements, which are contingent on our sustaining appropriate security protections;
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our computer systems could fail and lead to service interruptions or down-time for our ecommerce web sites; or
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we may need to grow, reconfigure or relocate our data centers in response to changing business needs, which may be costly and lead to unplanned disruptions of service.
The occurrence of any of these or similar events could damage our business, hurt our ability to distribute products and services and collect revenue, threaten the proprietary or confidential nature of our technology, harm our reputation, and expose us to litigation or liability. Because some of our technologies and businesses are intended to inhibit use of or restrict access to our customers’ intellectual property, we may become the target of hackers or other persons whose use of or access to our customers’ intellectual property is affected by our technologies. We may be required to expend significant capital or other resources to protect against the threat of security breaches, hacker attacks or system malfunctions or to alleviate problems caused by such breaches, attacks or failures.
Our ecommerce web sites and our Internet-based product and service offerings rely on a variety of systems, networks and databases, many of which are maintained by us at our data centers. We do not have complete redundancy for all of our systems and we do not maintain real-time back-up of our data, so in the event of significant system disruption, particularly during peak periods, we could experience loss of data processing capabilities, which could cause us to lose customers and could harm our operating results. Notwithstanding our efforts to protect against “down time” for our ecommerce web sites and Internet-based products and services, we do occasionally experience unplanned outages or technical difficulties. In order to provide our Internet-based products and services, we must protect the security of our systems, networks, databases and software.
We will incur costs and demands upon management as a result of complying with the laws and regulations affecting public companies, which could affect our operating results.
We have incurred, and will continue to incur, significant legal, accounting and other expenses associated with corporate governance and public company reporting requirements, including requirements under the Sarbanes-Oxley Act of 2002, as well as rules implemented by the SEC and Nasdaq. As long as the SEC requires the current level of compliance for public companies of our size, we expect these rules and regulations to require significant our legal and financial compliance costs and to make some activities more time-consuming and costly. We do believe, however, that we will be able to fund these costs out of our available working capital. We also expect these new rules and regulations may make it more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage than was previously available. As a result, it may be more difficult for us to attract and retain qualified individuals to serve on our board of directors or as our executive officers.
If we fail to maintain proper and effective internal controls, our ability to produce accurate financial statements could be impaired, which could increase our operating costs and affect our ability to operate our business.
We have a complex business that is international in scope. Ensuring that we have adequate internal financial and accounting controls and procedures in place to help ensure that we can produce accurate financial statements on a timely basis is a costly and time-consuming effort that needs to be re-evaluated frequently. We are continually in the process of documenting, reviewing and, if appropriate, improving our internal controls and procedures in connection with Section 404 of the Sarbanes-Oxley Act of 2002, which requires annual management assessments of the effectiveness of our internal control over financial reporting and a report by our independent registered public accountants addressing these assessments. If we or our independent registered public accountants identify areas for further attention or improvement, implementing any appropriate changes to our internal controls may require specific compliance training of our directors, officers and employees, entail
substantial costs in order to modify our existing accounting systems, and take a significant period of time to complete. We have in the past, and may in the future, identify significant deficiencies in the design and operation of our internal controls, which have been or will in the future need to be remediated. For example, we made an assessment of the effectiveness of our internal control over financial reporting as of September 30, 2006. Based on this assessment, we identified a deficiency in our process for calculating our stock-based compensation expense pursuant to SFAS 123R for the periods ended March 31, 2006, June 30, 2006 and September 30, 2006. Specifically, the deficiency related to our process for reviewing stock-based compensation expense calculations, which resulted in incorrect calculations of (i) expected forfeitures; (ii) the incremental value associated with the commencement of new offering periods associated with our employee stock purchase plan and (iii) the expected term assumptions used in calculating compensation associated with our employee stock purchase plan. Management concluded that this deficiency constituted a material weakness in internal control over financial reporting as of September 30, 2006.
We have remediated this material weakness by implementing new review procedures and controls and by updating our stock administration software. However, changes we make to our controls and processes may not be effective in maintaining the adequacy of our internal controls, and any failure to maintain that adequacy, or consequent inability to produce accurate financial statements on a timely basis, could increase our operating costs and could materially impair our ability to operate our business.
Changes in, or interpretations of, tax rules and regulations, and changes in geographic operating results, may adversely affect our effective tax rates.
We are subject to income taxes in the U.S. and foreign tax jurisdictions. Our future effective tax rates could be unfavorably affected by changes in tax laws or the interpretation of tax laws, by changes in the amount of revenue or earnings that we derive from international sources in countries with high or low statutory tax rates, or by changes in the valuation of our deferred tax assets and liabilities. Unanticipated changes in our tax rates could affect our future results of operations.
In addition, we are subject to examination of our income tax returns by federal, state, and foreign tax jurisdictions, including a current examination of our 2003 and 2004 federal tax returns by the Internal Revenue Service. We regularly assess the likelihood of outcomes resulting from these examinations to determine the adequacy of our provision for income taxes. In making such assessments, we exercise judgment in estimating our provision for income taxes. While we believe our estimates are reasonable, we cannot assure you that the final determination from these examinations will not be materially different from that reflected in our historical income tax provisions and accruals. Any adverse outcome from these examinations may have an adverse effect on our business and operating results, which could cause the market price of our stock to decline.
We may be subject to market risk and legal liability in connection with the data collection capabilities of our products and services and the possession and use of personal customer information by our business.
Many of our products are interactive Internet applications that by their very nature require communication between a computer system or network client and server to operate. To provide better consumer experiences and to operate effectively, our products send information to ours or our customers’ servers. Many of the services we provide also require that a user provide certain information to us. We post an extensive privacy policy concerning the collection, use and disclosure of user data involved in interactions between our client and server products. Any failure by us or our customers to comply with our posted privacy policy and existing or new legislation regarding privacy issues could impact the market for our products and services, subject us to litigation and harm our business.
In addition, some of our customers use credit cards or automated payment systems to pay for our products and services and we may collect, use and retain personal customer information as part of that business. While we and our vendors use commercially available security procedures to safeguard customer information when taking
orders, a third party may be able to circumvent these security and business measures, and errors in the storage, use or transmission of personal information could result in a breach of customer privacy. A major breach of customer privacy or security by us or the third parties that hold and manage personal information could have serious negative consequences for our business, including the cost of a mandatory notification of data breach to customers, possible fines, penalties and damages, reduced customer demand for our services, harm to our reputation, regulation and oversight by federal or state agencies, and loss of our ability to accept and process customer credit card orders. We also have suffered losses, and may continue to suffer losses, as a result of Internet orders placed with fraudulent credit card or other payment data. The failure to detect or control payment fraud could have an adverse effect on our results of operations.
We may be subject to legal liability for the provision of third-party products, services or content.
We periodically enter into arrangements to offer third-party products, services, content or advertising under our brands or via distribution on our websites or in our products or service offerings. We may be subject to claims concerning these products, services, content or advertising by virtue of our involvement in marketing, branding, broadcasting or providing access to them. Our agreements with these parties may not adequately protect us from these potential liabilities. It is also possible that, if any information provided directly by us contains errors or is otherwise negligently provided to users, third parties could make claims against us, including, for example, claims for intellectual property infringement. Investigating and defending any of these types of claims is expensive, even if the claims do not result in liability. If any of these claims results in liability, we could be required to pay damages or other penalties, which could harm our business and our operating results.
We may be subject to assessment of sales and other taxes for the sale of our products, license of technology or provision of services.
We do not currently collect sales or other taxes on the sale of our products, license of technology or provision of services in states and countries other than those in which we have offices or employees. Our business would be harmed if one or more states or any foreign country were able to require us to collect sales or other taxes from past sales of products, licenses of technology or provision of services, particularly because we would be unable to go back to customers to collect sales taxes for past sales and would likely have to pay such taxes out of our own funds.
Effective July 1, 2003, we began collecting Value Added Tax, or VAT, on sales of “electronically supplied services” provided to European Union residents, including software products, games, data, publications, music, video and fee-based broadcasting services. There can be no assurance that the European Union will not make further modifications to the VAT collection scheme, the effects of which could require significant enhancements to our systems and increase the cost of selling our products and services into the European Union. The collection and remittance of VAT subjects us to additional currency fluctuation risks.
The Internet Tax Freedom Act, or ITFA, which Congress extended until November 2007, among other things, imposed a moratorium on discriminatory taxes on electronic commerce. The imposition by state and local governments of various taxes upon Internet commerce could create administrative burdens for us and could decrease our future sales.
We license technology for digital VOD and PPV copy protection, and if this market does not grow as anticipated or we are unable to serve this market effectively, our revenues may be adversely affected.
While our copy protection capability is embedded in more than 197 million digital set-top boxes manufactured by the leading digital set-top box manufacturers, only approximately 5 cable or satellite system operators in North America have activated copy protection for digital PPV or VOD programming. Our ability to expand our markets in additional home entertainment venues such as digital PPV or VOD will depend in large part on the support of the major motion picture studios in advocating the incorporation and activation of copy
protection technology in the hardware and network infrastructure required to distribute such video programming. If the MPAA studios do not require copy protection activation for PPV or VOD movies, or if PPV/VOD system operators do not specify our copy protection in their set-top boxes, or if the system operators do not activate copy protection in other digital PPV networks outside of Canada, Germany, Japan, Hong Kong or the United Kingdom, then our business may be harmed.
Further, consumers may react negatively to copy protected PPV or VOD programming because they may feel they are entitled to copy, having in the past routinely copied for later viewing analog cable and satellite-delivered subscription television and PPV programs, as well as free broadcast programming. In addition, when incoming video signals are routed through a VCR before reaching a TV set, the consumer may see impaired pictures while viewing a copy protected digital PPV program. If there is consumer dissatisfaction that cannot be managed, or if there are technical compatibility problems, our business could be harmed.
Pricing pressures on the content owners that incorporate our technologies into their products could limit the licensing fees we charge for our technologies, which could adversely affect our revenues.
The markets for the products in which our technologies are incorporated are intensely competitive and price sensitive. Retail prices for such products that include our technology, such as DVDs and CDs, have decreased significantly, and we expect prices to continue to decrease for the foreseeable future. In response, content owners have sought to reduce their product costs, which can result in downward pressure on the licensing fees we charge our customers who incorporate our technologies into the products they sell. A decline in the licensing fees we charge could materially and adversely affect our operating results.
If we are unable to compete effectively with existing or new competitors, we could experience price reductions, fewer customers, reduced margins or loss of market share.
We believe that our DVD digital-to-analog copy protection and videocassette copy protection systems currently have no competitors. It is possible, however, that competitive copy protection technologies could be developed in the future. Increased competition would be likely to result in price reductions and loss of market share, either of which could harm our business.
In the video market segment, there are a variety of supplemental copy protection and encryption systems that provide partial copy protection for digital links (the DTLA 5C encryption technology); the 4C pre-recorded media and recordable media copy protection systems; CSS, a content scrambling system for the DVD format; Intel’s High Definition Copy Protection (“HDCP”) encryption for both the Digital Display Working Group’s Digital Video Interfaces (“DVI”) and HDMI Licensing, LLC’s High Definition Multimedia Interface (“HDMI”). These systems are not directly competitive, as some apply to future products, but they are sometimes confused with our analog copy protection and may create uncertainty in the minds of customers, thereby reducing or delaying our licensing opportunities. Additionally, they may compete from the standpoint of content owners believing they have a limited budget for copy protection, and they may choose to spend their copy protection dollars on only a few technologies.
Our primary competition in the electronic license management market segment currently comes from our own prospective customers-those independent software vendors who believe they can develop their own electronic license management solutions instead of purchasing them. In the event that software vendors succeed with their internal developments, or forego the implementation of such applications, this would adversely affect our business. Other competitors include companies offering digital rights management, electronic licensing, or electronic software distribution technology, as well as companies that have historically offered hardware dongle products and are shifting to software-based protection. Operating system developers or microprocessor suppliers may choose to integrate rights management solutions into their products. Software resellers could also begin to develop their own electronic license management solutions. In addition to having more traditional competitors in
various subcomponents of our offerings, such as SafeNet that has a license management offering and Altiris that has an installer offering, we may face new or increased competition from smaller and emerging companies such as XtreamLok, Softwrap and Reprise Software.
Our other software solutions, namely our InstallShield Installer, Update Service, InstallAnywhere and Admin Studio experience competition from other products. In the installer business, Altiris’ Package Studio is the primary competition for our Admin Studio solution and Microsoft may be a competitor in the future. Update Service appears to have no competition other than from our customers.
There are a limited number of competitors in our SafeDisc Advanced consumer software copy protection market segment, including SecureRom, Sony’s DADC optical disk manufacturing subsidiary, and StarForce Technologies. However, it is possible that our own customers may develop software copy protection technologies, or that personal computer operating system and microprocessor companies may develop or license copy protection modules or systems that are internal to the PC or other consumer electronic devices.
In the consumer software product activation market segment, as in the enterprise software electronic license management market segment there is substantial competition from customer implemented internally developed solutions, as well as from small companies such as Australian company XtreamLok, and software e-commerce vendors like Digital River.
DRM solutions for consumer software, video, and audio have also attracted a number of companies and significant venture capital, including Intertrust Technologies (owned by Sony and Philips), Microsoft, Content Guard, Apple, and Real Networks. It is possible that companies with extensive financial resources may develop or acquire copy protection and rights management solutions that compete with our offerings, or may have a controlling patent position which would negatively impact our cost basis, or may give away their DRM technologies as in the case of the Windows Media Player.
In the connected device middleware market segment, there is competition from customer-implemented internally-developed solutions, as well as from companies such as DigiOn, BridgeCo, Syabas, Moxi and Oregan Networks.
New competitors or alliances among competitors may emerge and rapidly acquire significant market share in any of these areas. Our competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements than we do, which could reduce demand for our products or render them obsolete.
It may be more difficult for us, in the future, to have our technologies adopted as individual industry standards to the extent that entertainment industry participants collaborate on the development of industry standard technologies.
Increasingly, standards-setting organizations are adopting or establishing technology standards for use in a wide-range of consumer electronics products. As a result, it is more difficult for individual companies to have their technologies adopted wholesale as an informal industry standard. In addition, increasingly there are a large number of companies, including ones that typically compete against one another, involved in the development of new technologies for use in consumer entertainment products. As a result, these companies often license their collective intellectual property rights as a group, making it more difficult for any single company to have its technologies adopted widely as a de facto industry standard or to have its technologies adopted as an exclusive, explicit industry standard. Examples of this include MPEG-LA (DRM licensing); Advanced Access Control System (AACS) for next generation DVD encryption; HD-DVD and BluRay DVD (next generation DVD formats). If our technologies are not supported by these standards bodies or patent pools, it may be more difficult for us to grow our business in the future. Our major customers may have a large influence on industry standards and the widespread adoption of new technologies. The selection of alternative technologies to ours or to those on which our technologies operate would harm our business.
We have built a substantial business around the packaging, compliance, installation, deployment and monitoring of software licenses. We also enable our customers to protect, enhance and distribute their digital goods across channels to maximize revenue with focus on the video, gaming, information publishing and other entertainment industries.
Our major software licensing products include FLEXnet Publisher and FLEXnet InstallShield. FLEXnet Publisher is licensed to software publishers as a software product that enables these customers to offer multiple licensing models and automatically enforce compliance with license terms. FLEXnet InstallShield is also sold to software publishers as an automatic installer to help them with automatic and transparent installations of their software on most Windows and non-Windows PCs and servers. There is no assurance of our ability to grow and be successful with these products and if we are unsuccessful in the software licensing market, our business would be harmed.
Major software vendors have experienced deteriorating economic conditions as corporate customers have reduced capital expenditures. Demand for our software solutions is driven, to some degree, by end-user demand for software applications. If economic conditions for software vendors continue to be difficult, demand for our products could decline. This would result in lower revenues and operating income for this line of business.
In some cases, customers make a substantial capital investment when purchasing our software and commit additional resources to installation and deployment. Potential customers spend significant time and resources to determine which software to purchase. Selling our products sometimes requires an extensive sales effort because the decision to adopt our software solutions generally involves several customer executives in various functions and geographic areas. Due to these factors, our sales cycle is unpredictable, and the number of sales and amount of revenue generated from such sales varies from quarter to quarter.
Our software products are designed for the traditional software business model, and if the application service provider business model were to become the preferred model, our revenues may be adversely affected.
The traditional application software business model has been characterized by software vendors selling to enterprise IT departments who host the software on the enterprises’ servers and manage the software from within the enterprise. With the initial success of the software as a service (“SaaS”) business model, under which the software application is hosted in the software vendors’ remote servers and there is no server software resident in the enterprise, some industry experts have questioned whether the SaaS model will eventually replace the traditional application software business model. We believe it is too early to make this prediction, however, because our software solutions are mostly tailored for the traditional software model, if the SaaS model were to become very popular, it could harm our business.
We have entered the market for digital anti-ripper products and for peer-to-peer file sharing antipiracy products and we do not know if we will be successful in selling products for either application.
In August 2003, we acquired intellectual property and other assets, including patents and software that can be used to track and manage content in the peer-to-peer file sharing space. In 2004, we introduced our Hawkeye technology, which is designed to protect copyrighted content that is discovered being illicitly traded over the P2P file sharing networks, and in 2005, we introduced our RipGuard DVD technology, which is designed to be added to the DVD at the time of manufacture in order to prevent unauthorized ripping by PCs. These solutions may not achieve or sustain market acceptance, or may not meet, or continue to meet, the demands of the content owners. If the market for digital anti-ripper products or peer-to-peer antipiracy products fails to develop, or develops more slowly than expected, if our solutions do not achieve or sustain market acceptance or if there is significant and sustained consumer resistance to this technology, our business would be harmed.
Our business may be affected by peer-to-peer services on the Internet.
Our business may be affected by “free” peer-to-peer services, such as KaZaA, e-Donkey, Morpheus and a variety of other similar services that allow computer users to connect with each other and to copy/share many types of program files, including music and other media, from one another’s hard drives, all without securing licenses from content providers. Even though the U.S. Supreme Court ruled in 2005 that Internet peer-to-peer companies like Grokster Ltd. can be held liable for copyright infringement when individuals use their technology to download songs and movies illegally, the Court did not address the question of whether peer-to-peer file sharing technology is illegal in itself. Additionally, enforcement efforts against those in violation have not effectively shut down these services, and there can be no assurance that these services will ever be shut down. The ongoing presence of these “free” services substantially impairs the marketability of legitimate services and of technologies that shut down other unauthorized sources of the program file content, regardless of the ultimate resolution of their legal status. To the extent that consumers choose to utilize these peer-to peer services and do not purchase authentic packaged media or authorized DRM downloads, it may adversely affect our business for packaged media copy protection.
The price of our common stock may be volatile.
The market price of our common stock has been, and in the future could be, significantly affected by factors such as:
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actual or anticipated fluctuations in operating results;
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announcements of technical innovations;
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new products or new contracts;
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announcements by competitors or their customers;
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announcements by our customers;
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governmental regulatory and copyright action;
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developments with respect to patents or proprietary rights;
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announcements regarding litigation or regulatory matters;
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changes in financial estimates or coverage by securities analysts;
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changes in interest rates which affect the value of our investment portfolio;
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changes in tax law or the interpretation of tax laws; and
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general market conditions.
Announcements by the MPAA or its members, satellite television operators, cable television operators or others regarding motion picture production or distribution, consumer electronics or software vendor companies’ business combinations, evolving industry standards, consumer rights activists’ “wins” in government regulations or the courts, or other developments could cause the market price of our common stock to fluctuate substantially.
There can be no assurance that our historic trading prices and price/earnings ratios, or those of high technology companies in general, will be sustained. In the past, following periods of volatility in the market price of a company’s securities, some companies have been named in class action suits.
Further, the military conflict in Iraq, additional acts of terrorism and related political instability and economic uncertainty may adversely affect the global financial markets, which could cause the market price of our common stock to fluctuate substantially.
We have significant debt obligations.
We incurred $240 million of principal indebtedness from the sale of debentures in an August 2006 private placement. As a result of the sale of the debentures, we have substantially increased our principal and interest obligations. The degree to which we are leveraged could materially and adversely affect our ability to obtain additional financing and could make us more vulnerable to industry downturns and competitive pressures. Our ability to meet our debt service obligations will depend on our future performance, which will be subject to financial, business, and other factors affecting our operations, many of which are beyond our control.
We utilize non-GAAP reporting in our quarterly earnings press releases.
We publish non-GAAP financial measures in our quarterly earnings press releases along with a reconciliation of non-GAAP financial measures to those measures compiled in accordance with accounting principles generally accepted in the United States (“GAAP”). The reconciling items have adjusted GAAP net income and GAAP earnings per share for certain non-cash, non-operating or non-recurring items and are described in detail in each such quarterly earnings press release. We believe that this presentation may be more meaningful to investors in analyzing the results of operations and income generation as this is how the business is managed. The market price of our stock may fluctuate based on future non-GAAP results if investors base their investment decisions upon such non-GAAP financial measures. If we decide to curtail use of non-GAAP financial measures in our quarterly earnings press releases, the market price of our stock could be affected if investors analyze our performance in a different manner.
We are required to recognize expense for stock-based compensation related to employee stock options and employee stock purchases, and there is no assurance that the expense that we are required to recognize measures accurately the value of our share-based payment awards, and the recognition of this expense could decrease our GAAP earnings and cause our stock price to decline.
Effective the first quarter of fiscal year 2006, we adopted Statement of Financial Accounting Standards (“SFAS”) 123(R), Share-Based Payment, which requires us to measure compensation expense for employee stock options using the fair value method. SFAS 123(R) applies to all outstanding stock options that are not vested at the effective date and grants of new stock options made subsequent to the effective date. As a result, starting with fiscal 2006 of SFAS 123R, ,our operating results contain a charge for stock-based compensation expense related to employee stock options and employee stock purchases we recorded higher levels of stock based compensation due to differences between the valuation methods of SFAS 123R and APB 25. This charge is in addition to stock-based compensation expense we have recognized in prior periods related to acquisitions and investments. The application of SFAS 123(R) requires the use of an option-pricing model to determine the fair value of share-based payment awards. This determination of fair value is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, our expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise behaviors. Option-pricing models were developed for use in estimating the value of traded options that have no vesting or hedging restrictions and are fully transferable. Because our employee stock options have certain characteristics that are significantly different from traded options, and because changes in the subjective assumptions can materially affect the estimated value, in management’s opinion the existing valuation models may not provide an accurate measure of the fair value of our employee stock options. Although the fair value of employee stock options is determined in accordance with SFAS 123(R) and SAB 107 using an option-pricing model, that value may not be indicative of the fair value observed in a willing buyer/willing seller market transaction.
As a result of the adoption of SFAS 123(R), beginning with fiscal 2006, our earnings were lower than they would have been had we not been required to adopt SFAS 123(R). This will continue to be the case for future periods. We cannot predict the effect that this adverse impact on our reported operating results will have on the trading price of our common stock.
If our independent registered public accountants are unable to provide us with an unqualified report as to the adequacy of our internal control over financial reporting for future year-end periods as required by Section 404 of the Sarbanes-Oxley Act of 2002, investors could lose confidence in the reliability of our financial statements, which could result in a decrease in the value of our stock.
As directed by Section 404 of the Sarbanes-Oxley Act of 2002, the SEC adopted rules requiring public companies to include a report by management on our internal control over financial reporting in their annual reports on Form 10-K that contains an assessment by our management of the effectiveness of internal control over financial reporting. In addition, the public accounting firm auditing our financial statements must attest to and report on our management’s assessment of the effectiveness of internal control over financial reporting. While we continuously conduct a rigorous review of our internal control over financial reporting in order to comply with the Section 404 requirements, our independent registered public accountants may interpret the Section 404 requirements and the related rules and regulations differently from how we interpret them, or our independent registered public accountants may not be satisfied with our internal control over financial reporting or with the level at which these controls are documented, operated or reviewed in the future. In addition, the demand for competent audit resources has grown dramatically as a result of the requirements of Section 404, and such demand may exceed available supply. Finally, in the event we make a significant acquisition, or a series of smaller acquisitions, we may face significant challenges in implementing the required processes and procedures in the acquired operations. As a result, our independent registered public accountants may decline or be unable to attest to management’s assessment or may issue a qualified report in the future. This could result in an adverse reaction in the financial markets due to investors’ perceptions that our internal controls are inadequate or that we are unable to produce accurate financial statements, which could cause the market price of our shares to decline.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2. PROPERTIES
Our corporate headquarters consist of approximately 160,000 square feet located in Santa Clara, California. The leases for these premises expire on January 31, 2017. We also lease approximately 46,000 square feet in Schaumburg, Illinois pursuant to a lease that expires on January 31, 2009. As of December 31, 2006, we lease approximately 19,500 square feet in San Francisco, California pursuant to a lease that expires on July 31, 2013 and approximately 15,000 square feet in New York, New York pursuant to a lease that expires on May 31, 2016. Most U.S. sales, marketing and technical personnel for all product divisions are in these locations, with a small number of individuals operating out of their home offices. We believe that our existing facilities are adequate to meet current requirements and that additional or substitute space will be available as needed to accommodate any expansion of operations.
We also lease space for sales, marketing and technical staff in Maidenhead and Cheshire in the United Kingdom and in Tokyo, Japan; Seoul, Korea; Amsterdam, The Netherlands; Alicante, Spain; Hong Kong; Taipei, Taiwan; Tel Aviv, Israel; Paris, France and Frankfurt, Germany.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
We have not been required to pay a penalty to the Internal Revenue Service (“IRS”) for failing to make disclosures required with respect to any transaction that has been identified by the IRS as abusive or that has a significant tax avoidance purpose.
We are involved in legal proceedings related to some of our intellectual property rights.
USPTO Interference Proceedings Between Macrovision Corporation and Intertrust Technologies
A patent interference is declared by the United States Patent and Trademark Office (“USPTO”) when two or more parties claim the same patentable invention. In the United States, the party who can prove earliest inventorship is granted the patent.
We received notice on September 4, 2003 that the USPTO had declared an interference between our U.S. Patent No. 5,845,281 (“the ‘281 patent”) together with two of our continuation applications, and a patent application from Intertrust Technologies Corporation (“Intertrust”). On or about December 28, 2005, the Board of Patent Appeals (“BPA”) issued its final ruling in the case, holding that the ‘281 patent had priority over the two Intertrust patent applications at issue, but also that the inventor of the ‘281 patent had committed inequitable conduct during the prosecution of that patent. As a result of this decision, our ‘281 patent was rendered unenforceable.
On December 19, 2003, we received notice from the USPTO declaring another interference, this time between two of our patent applications and four of Intertrust’s patents. On or about April 11, 2005, the BPA issued its final ruling, holding that the Intertrust patents had priority over our two applications at issue.
Intertrust and Macrovision filed lawsuits on July 28, 2006 and July 31, 2006, respectively, in the U.S. District Court for the Northern District of California against the other party, seeking to overturn the BPA’s rulings adverse to the parties in the two interference proceedings. The parties are engaged in discovery.
We have a family of international patents and patent applications related to the U.S. cases involved in the interference. The U.S. patent interference affects only U.S. patents and U.S. pending patent applications, not the international cases which have been granted or are proceeding to grant in Europe and Japan.
Macrovision Corporation. vs. Sima Products Corporation and Interburn Enterprises, Inc.
On June 14, 2005, we filed a lawsuit in the Southern District of New York against Sima Products Corporation and Interburn Enterprises, Inc., alleging that both companies manufacture, distribute or sell products that infringe our patented copy protection technology and also violate the U.S. Digital Millennium Copyright Act of 1998. The patents involved are: United States Patent No. 4,631,603 entitled “Method and apparatus for processing a video signal so as to prohibit the making of acceptable videotape recordings thereof,” and U.S. Patent No. 4,819,098 entitled “Method and apparatus for clustering modifications made to a video signal to inhibit the making of acceptable videotape recordings.” Interburn has entered into a stipulated judgment whereby it agreed not to further distribute its products. On April 20, 2006, we were granted a preliminary injunction preventing Sima from distributing the products at issue in the lawsuit. On or about June 12, 2006, Sima filed an emergency motion with the United States Second Circuit Court of Appeals, asking that the injunction be stayed pending an appeal of the District Court’s issuance of the injunction. The emergency motion was denied by the Court of Appeals on or about August 26, 2006, resulting in the injunction being re-instated after it was stayed pending such motion. In February 2007, the parties resolved this dispute and Sima agreed to enter into a stipulated judgment whereby Sima has agreed not to further manufacture or sell the products at issue in the lawsuit and to pay us an undisclosed sum as settlement for its infringement of our patents.
InstallShield Software Corporation Liquidating Trust vs. Macrovision
On October 27, 2005, we received notice of an arbitration proceeding filed by InstallShield Software Corporation Liquidating Trust (the “Trust.”) The Trust has demanded arbitration of certain disputes between the Trust and Macrovision pursuant to the Asset Purchase Agreement dated June 16, 2004 by and among InstallShield Software Corporation, Macrovision Corporation, Macrovision Europe Limited, and Macrovision International Holding L.P. (the “Agreement”). Under the Agreement, we could have been required to make an additional contingent payment of up to $20 million based on post-acquisition revenue performance through June 30, 2005. Based upon the revenue results through June 30, 2005, we concluded that no additional payment was required under the terms of the Agreement. The Trust alleges that the post-acquisition revenue performance targets were not reached due to our conduct in violation of the Agreement, and therefore is seeking the contingent payment in an amount exceeding $15 million. We deny these allegations and intend to vigorously defend ourselves in the arbitration proceeding. The parties are engaged in discovery and no date has yet been set for the hearing.
Macrovision vs. Wise Solutions, Inc. and Altiris Inc.
On November 21, 2006, we filed a lawsuit in the United States District Court for the Northern District of California against Wise Solutions, Inc. and Altiris, Inc., alleging infringement of two of our patents. The patents involved are: U.S. Patent No. 5,671,412 entitled “License Management System for Software Applications” and U.S. Patent No. 5,390,297 entitled “System for Controlling the Number of Concurrent Copies of a Program in a Network Based on the Number of Available Licenses.” The lawsuit further alleges Wise and Altiris tortiously interfered with Macrovision’s economic relationships with its customers and seeks a declaratory judgment from the court that Macrovision does not infringe Wise’s U.S. Patent No. 7,028,019 (“the ‘019 patent”). On January 5, 2007, the defendants counterclaimed, alleging that Macrovision’s products infringe both the ‘019 patent and Altiris’ U.S. Patent No. 7,065,566. We deny these allegations and intend to vigorously defend ourselves in this litigation.
Stock Option Inquiries
In addition to the aforementioned intellectual property litigation matters, on June 13, 2006 and June 28, 2006, we announced that we had been contacted by the Securities and Exchange Commission (SEC) and had received a subpoena from the U.S. Attorney’s Office, respectively, each requesting information relating to our stock option practices. By letter dated October 24, 2006, the SEC informed us that its investigation into the matter had been terminated without enforcement action being recommended to the Commission. By letter dated January 11, 2007, the U.S. Attorney’s Office informed us that it withdrew its subpoena. The Internal Revenue Service has requested information relating to our stock option granting practices in connection with its current examination of our 2003 and 2004 federal tax returns. We believe that the findings of this review of stock option practices has no material impact on the financial statements included in this report or on any previously issued financial statements.
As of December 31, 2006, for all the abovementioned matters, it was not possible to estimate the liability, if any, in connection with the pending matters. Accordingly, no accruals for these contingencies have been recorded.
From time to time, we have been involved in other disputes and legal actions arising in the ordinary course of business. In management’s opinion, none of these other disputes and legal actions is expected to have a material impact on our consolidated financial position, results of operation or cash flow.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
We did not submit any matters to a vote of security holders during the quarter ended December 31, 2006.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Information and Holders
Our common stock has been listed on the Nasdaq National Market under the symbol “MVSN” since our initial public offering on March 13, 1997. The following table sets forth, for the periods indicated, the reported high and low closing prices for our common stock.
As of February 15, 2007, there were 79 holders of record of our common stock, based upon information furnished by American Stock Transfer & Trust Company, the transfer agent for our securities. We believe, based upon security positions listings, that there are approximately 5,077 beneficial owners of our common stock. As of February 15, 2007, there were 52,161,566 shares of common stock outstanding.
Stock Performance Graph
The graphs below shows a comparison of the cumulative total stockholder return on our common stock with the cumulative total return on the Nasdaq Composite Index (the “Nasdaq”), the S&P 500 Composite Index (the “S&P 500”) and the Russell 2000 Index (“Russell 2000”) over the five year period from December 31, 2001 through December 31, 2006. The graph assumes an investment of $100 in our common stock and in each of the market indices, and further assumes the reinvestment of all dividends. The comparisons in the graph below are based on historical data and are not intended to forecast the possible future performance of our common stock.
Dividend Policy
We have not declared or paid any cash dividends on our common stock since 1994. We do not anticipate paying any cash dividends on our common stock in the foreseeable future. At this time, we intend to retain all earnings for use in our business operations.
Stock Repurchase Authorization
In May 2002, our Board of Directors authorized a stock repurchase program, which allows us to purchase up to 5.0 million shares of common stock in the open market from time-to-time at prevailing market prices, through block trades or otherwise, or in negotiated transactions off the market, at the discretion of our management. In 2002, we repurchased 3.0 million shares of common stock under this program, which was recorded as treasury stock and resulted in a reduction of stockholders’ equity.
In August 2006, our Board of Directors authorized the purchase of up to $100 million of our common stock from time-to-time (inclusive of the stock repurchase program mentioned above). In connection with our offering of 2.625% Convertible Senior Notes due 2011, our Board authorized the purchase of up to $50 million of our common stock under this new stock repurchase program. In the year ended December 31, 2006, we repurchased approximately 2.3 million shares of common stock for $50.0 million, which was recorded as treasury stock and resulted in a reduction of stockholders’ equity. There were no shares repurchased during the fourth quarter of 2006. As of December 31, 2006, treasury stock consisted of 5.3 million shares of common stock that the Company had repurchased, with a cost basis of approximately $88.4 million.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth selected consolidated financial data and other operating information. The financial data does not purport to indicate results of operations as of any future date or for any future period. The financial data is derived from our consolidated financial statements and should be read in conjunction with the consolidated financial statements, related notes and other financial information included herein.
(1) See Note 1 of Notes to Consolidated Financial Statements. Cost of revenues includes $13.0 million, $11.0 million, $6.4 million, $3.3 million and $2.3 million of amortization of intangibles from acquisitions during 2006, 2005, 2004, 2003 and 2002, respectively.
(2) In connection with the acquisition of Midbar Tech (1998) Ltd. in November 2002, we allocated and expensed $6.0 million of the purchase price to in-process research and development projects. In connection with the acquisition of peer-to-peer assets in August 2003, we allocated and expensed $624,000 of the purchase price to in-process research and development projects. In connection with the acquisition of InstallShield in July 2004, we allocated and expensed $5.4 million of the purchase price to in-process research and development projects. In connection with the acquisition of Zero G in June 2005, we allocated and expensed $500,000 of the purchase price to in-process research and development projects.
(3) In October 2005, our board of directors approved a restructuring program, which included a worldwide workforce reduction and restructuring of certain business functions. We recorded a charge of $2.5 million during 2005.
(4) In August 2006, we issued $240.0 million in convertible senior notes which has been included in long-term liabilities.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following commentary should be read in conjunction with the Consolidated Financial Statements and related notes contained elsewhere in this Form 10-K.
Overview
Macrovision Corporation, a Delaware corporation founded in 1983, enables businesses reliant on the deployment of software or content to protect, enhance, or distribute their offering among digital distribution channels and destination devices. These digital lifecycle management solutions include anti-piracy and content protection technologies and services, digital rights management products and technologies, embedded licensing technologies, usage monitoring for enterprises, access control and billing, and several other related technologies and services from installation to update to back-office entitlement management. We market the FLEXnet licensing platform and the InstallShield suite of software installation, repackaging, and update solutions. We also operate a game network for digital distribution of downloadable PC games, and market our Rights products, which enable the sale and security of digital goods and services, such as text, audio, video, streaming media, games and applications. Our customers consist of entertainment content producers such as motion picture studios, software and PC games publishers, hardware manufacturers, consumer electronic firms, personal computer manufacturers, digital set-top box manufacturers, digital pay-per-view and video-on-demand network operators, publication companies and enterprise information technology organizations.
We report our revenues by our two segments: Entertainment Technologies and Software Technologies. Entertainment Technologies’ revenues derive from licensing various digital content management products and services to video and PC games content owners. The Entertainment Technologies products include content protection and rights management solutions for optical discs; videocassettes; digital set top boxes for cable/satellite TV; a variety of PC and consumer electronics video playback and record devices; digital distribution services for games; and peer-to-peer networks. Software Technologies’ revenues are derived from licensing various software products and services to independent software vendors and enterprise IT departments. The Software Technologies products include the FLEXnet suite of electronic license management, electronic license delivery, and software asset management products, InstallShield Installer, Update Service, Admin Studio, InstallAnywhere and SolutionsArchitect products. We include the eMeta commerce, licensing and access control solutions in our Software Technologies segment.
The following table provides revenue information by segment for the periods indicated (dollars in thousands):
The following table provides percentage of revenue information by segment for the periods indicated:
Entertainment Technologies
Our Entertainment Technologies generate revenues from the home video divisions of member companies of the MPAA, videocassette duplication and DVD replication companies and a number of “special interest” content owners, such as independent producers of exercise, sports, educational, documentary and corporate video programs. We typically receive per unit royalties based upon the number of copy-protected videocassettes or DVDs that are produced by MPAA studios or other content owners. Our Entertainment Technologies also generate revenues from licensing digital PPV and VOD content protection solutions to satellite and cable system operators and equipment manufacturers that supply cable and satellite industries. Most of our PPV content protection revenues are generated from royalties on digital set top boxes. We also receive one-time and annual license fees from set top box, DVD, and personal video recorder manufacturers. Support costs related to these one-time and annual licensing fee arrangements are not significant. We also receive transaction fees from PPV and VOD systems when they activate our technology to protect specific PPV or VOD programs. In addition, our Entertainment Technologies generate revenues from customers implementing our CD-ROM copy protection technology on PC games and peer to peer anti-piracy services. In July 2005, we acquired Trymedia Systems, a provider of secure digital distribution services and the operator of the largest distribution network for downloadable games. This acquisition has expanded our games solution set by providing an online game distribution and promotion offering. We have integrated Trymedia into our Entertainment Technologies revenues.
Revenues from our Entertainment Technologies increased $19.4 million, or 19% from 2005 to 2006. Revenues from our video content protection technologies represented 43.5%, 45.4% and 55.2% of our net revenues during 2006, 2005 and 2004, respectively. In absolute dollars, revenue from our video content protection technologies increased $15.4 million from 2005 to 2006, due primarily to the growth of our hardware licensing products and a full year of revenue from Trymedia operations. During 2006, we recognized approximately $0.9 million of revenue from set top box royalties on an as earned basis as a result of being able to estimate such royalties prior to year end. Previously, we had recognized royalties for these customers on an as reported basis.
We actively engage in intellectual property compliance and enforcement activities focused on identifying third parties who have under reported to us the amount of royalties owed under license agreements with us. As a result, from time to time, we may not receive timely replicator reports, and therefore, we may recognize revenues that relate to activities from prior periods. These royalty recoveries may cause revenues to be higher than expected during a particular reporting period and may not occur in subsequent periods. We cannot predict the amount or timing of such revenues.
We believe that as we sign new contracts and generate more business for our Hawkeye, RipGuard DVD™ and ActiveMARK products, future revenues from our Entertainment Technologies will increase in absolute terms and continue to be a significant part of our revenues, but may vary as a percentage of our total revenues.
Software Technologies
Our Software Technologies generate revenues from licensing software solutions and providing services related to the support and maintenance of this software. Revenues from our Software Technologies increased $25.0 million or 24.8% in 2006 as compared with 2005. The increase in our Software Technologies’ revenue is primarily due to increased sales of our existing license management solutions resulting from the impact of broad based product and marketing programs and the acquisition of eMeta since February 28, 2006. Software Technologies’ revenue includes Zero G since its acquisition on June 9, 2005 and eMeta since its acquisition on February 28, 2006. We believe that revenues from our Software Technologies will continue to increase in the future in absolute terms, but may vary as a percentage of our total revenues.
Seasonality of Business
We have experienced significant seasonality in our business, and our consolidated financial condition and results of operations are likely to be affected by seasonality in the future. We have typically experienced our highest revenues in the fourth quarter of each calendar year. We believe that this trend in our Entertainment Technologies business has been principally due to the tendency of certain of our customers to manufacture and release new video, audio, and PC games titles during the year-end holiday shopping season, while our operating expenses are incurred more evenly throughout the year. In our Software Technologies business, we have found that typical software and enterprise customers tend to spend up to one-third of their annual capital budgets in the fourth calendar quarter.
Costs and Expenses
Our cost of revenues for our Entertainment Technologies consists primarily of replicator fees, Hawkeye service costs, ActiveMARK service costs and patent related expense. Fees paid to licensed duplicators and replicators that produce videocassettes, DVDs, and CDs for content owners include fees paid to help offset costs of reporting copy protected volumes and costs of equipment used to apply our technology. Hawkeye and ActiveMARK service costs include customer support, hosting, bandwidth and equipment maintenance costs. Our cost of revenues for our Software Technologies includes software product support costs, direct labor and benefit costs of employees’ time spent on billable consulting or training, the cost of producing and shipping CDs containing our software and certain license fees paid to third parties. Cost of revenues also includes amortization of intangibles from acquisitions. Our research and development expenses are comprised primarily of employee compensation and benefits, tooling and supplies and an allocation of overhead and facilities costs. Our selling and marketing expenses are comprised primarily of employee compensation and benefits, travel, advertising and an allocation of overhead and facilities costs. Our general and administrative expenses are comprised primarily of employee compensation and benefits, travel, accounting and tax fees and an allocation of overhead and facilities costs.
Critical Accounting Policies and Use of Estimates
The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements. These consolidated financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, allowance for doubtful accounts, equity-based compensation, valuation of strategic investments, goodwill and intangible assets, impairment of long lived assets and income taxes. Our estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates.
We have identified the accounting policies below as critical to our business operations and the understanding of our results of operations.
Revenue Recognition
We recognize revenue in accordance with current U.S. generally accepted accounting principles that have been prescribed for the software industry and with the guidelines of the SEC Staff Accounting Bulletin, or SAB, No. 101 as amended by SAB No. 104 “Revenue recognition in Financial Statements” for our hardware business.
Software
Revenue recognition requirements in the software industry are very complex and are subject to change. Our revenue recognition policy is one of our critical accounting policies because revenue is a key component of our
results of operations and is based on complex rules which require us to make judgments and estimates. We generally recognize revenue when persuasive evidence of an arrangement exists, we have delivered the product or performed the service, the fee is fixed or determinable and collectibility is probable. However, determining whether and when some of these criteria have been satisfied often involves assumptions and judgments that can have a significant impact on the timing and amount of revenue we report. For example, for multiple element arrangements we must make assumptions and judgments in order to allocate the total price among the various elements we must deliver, to determine whether undelivered services are essential to the functionality of the delivered products and services, to determine whether vendor-specific evidence of fair value exists for each undelivered element. Also, we provide for returns on product sales in our channel business based on three month historical revenue trends and adjust such reserves as considered necessary. To date, there have been no significant sales returns.
When licenses are sold together with consulting and/or implementation services, license fees are recognized upon delivery of the product provided that: (1) the above criteria have been met; (2) payment of the license fees is not dependent upon performance of the consulting and implementation services; and (3) the services are not essential to the functionality of the software. For arrangements where services are essential to the functionality of the software, both the license and services revenue are recognized in accordance with the provisions of SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.” Arrangements that allow us to make reasonably dependable estimates relative to contract costs and the extent of progress toward completion are accounted for using the percentage-of-completion method. Arrangements that do not allow us to make reasonably dependable estimates of costs and progress are accounted for using the completed-contracts method. Because the completed-contracts method precludes recognition of performance under the contract as the work progresses, it does not reflect current financial performance when the contract extends beyond one accounting period, and it therefore may result in uneven recognition of revenue, related cost of revenues and gross margin.
We provide consulting and training services to our software vendor and enterprise customers. Revenue from such services is generally recognized as the services are performed, except in instances where services are included in an arrangement accounted for under SOP 81-1. Professional services revenues are included in services revenue in the accompanying condensed consolidated financial statements.
Entertainment
Revenues from licensing video technology and trademarks are primarily generated from licensing agreements that generally pay a per-unit royalty fee for DVDs and digital set-top boxes. Licensees generally report replication activity within 30 to 60 days after the end of the month or quarter in which such activity takes place. Consequently, we recognize revenue from these licensing agreements on an as earned basis, provided amounts are fixed or determinable and collection is reasonably assured. The Company relies heavily on past experience and working relationships with these customers to reasonably and successfully estimate current period volume in order to calculate the period end revenue accrual. Any unusual or unanticipated replication volumes in a particular period can add significant fluctuations on the revenue reported.
Amounts for fees collected or invoiced and due relating to arrangements where revenue cannot be recognized are reflected on our balance sheet as deferred revenue and recognized when the applicable revenue recognition criteria are satisfied.
Allowance for Doubtful Accounts
We estimate the collectibility of our accounts receivable on an account-by-account basis. We record an increase in the allowance for doubtful accounts when the prospect of collecting a specific account receivable becomes doubtful. We specifically analyze accounts receivable and historical bad debts experience, customer creditworthiness, current economic trends, international situations (such as currency devaluation), and changes in
our customer payment history when evaluating the adequacy of the allowance for doubtful accounts. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.
Equity-Based Compensation
We currently use the Black-Scholes option pricing model to determine the fair value of stock options and employee stock purchase plan shares. The fair value of equity-based payment awards on the date of grant is determined by using an option-pricing model using a number of complex and subjective variables. These variables include our expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rate and expected dividends. We estimate the volatility of our common stock by using a combination of historical volatility and implied volatility in market traded options.
The Black-Scholes option pricing model was developed for use in estimating the fair value of short-lived exchange traded options that have no vesting restrictions and are fully transferable. Existing valuation models, including the Black-Scholes and lattice binomial models, may not provide reliable measures of the fair values of our equity-based compensation. Consequently, there is a risk that our estimates of the fair values of our equity-based compensation awards on the grant dates may bear little resemblance to the actual values realized upon the exercise, expiration, early termination or forfeiture of those equity-based payments in the future. Certain equity-based payments, such as employee stock options, may expire worthless or otherwise result in zero intrinsic value as compared to the fair values originally estimated on the grant date and reported in our financial statements. Alternatively, value may be realized from these instruments that are significantly higher than the fair values originally estimated on the grant date and reported in our financial statements.
Valuation of Strategic Investments
As of December 31, 2006 and December 31, 2005, the adjusted cost of our strategic investments totaled $22.7 million and $11.9 million, respectively. Our strategic investments include public and non-public companies. In 2006, we made a $5.0 million investment in a privately-held digital watermarking company for strategic purposes. As of December 31, 2006, the adjusted cost of our strategic investments consisted of our investment in Digimarc, a publicly traded company, and an investment in the privately-held digital watermarking company. We hold investments in other privately held companies that have no carrying value as of December 31, 2006. The investments in Digimarc and the privately-held company have been classified on the balance sheet as “Long-term marketable investment securities” and “Prepaid and other current assets,” respectively.
We review our investments in public companies and estimate the amount of any impairment incurred during the current period based on specific analysis of each investment, considering the activities of and events occurring at each of the underlying portfolio companies during the period. For investments in public companies, at each quarter end, we compare our basis in the investment to the average daily trading prices of the security over the prior six months as a guideline to determine if an other-than-temporary impairment has occurred. If the six-month average is less than the current cost basis, it triggers a review of the investment to determine if an other-than temporary impairment has occurred. If we conclude that an other-than temporary impairment has occurred, we record an impairment charge to the statement of income for the difference between the market price at period end and the current cost basis. Based on such methods, we recorded other-than temporary impairment losses on our investment in Digimarc of $5.8 million and $5.3 million during the years ended December 31, 2005 and 2004, respectively. There were no other-than temporary impairment losses recorded during the year ended December 31, 2006.
For equity investments in non-public companies for which there is no market where their value is readily determinable, we review each investment for indicators of impairment on a regular basis based primarily on achievement of business plan objectives and current market conditions, among other factors. The primary business plan objectives we consider include, among others, those related to financial performance such as
liquidity, achievement of planned financial results or completion of capital raising activities, and those that are not primarily financial in nature such as the launching of technology or the hiring of key employees. If it is determined that an other-than-temporary impairment has occurred with respect to an investment in a portfolio company, an impairment charge is recorded. Future adverse changes in market conditions or poor operating results of underlying investments could result in losses or an inability to recover the current carrying value of the investments thereby requiring further impairment charges in the future. In the absence of quantitative valuation metrics, such as a recent financing round, management estimates the impairment and/or the net realizable value of the portfolio investment based on a hypothetical liquidation at book value approach as of the reporting date.
In 2005 and 2004, we received $174,000 and $1.2 million, respectively, in cash for our interests in strategic investments that had been fully impaired. Accordingly, we recorded gains on strategic investments of $174,000 and $1.2 million in 2005 and 2004, respectively. There were no gains recorded on strategic investments in the year ended December 31, 2006.
Goodwill and Other Intangible Assets
Goodwill represents the excess of cost over fair value of assets of businesses acquired. We account for goodwill under the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets.” Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but instead are tested for impairment at least annually in accordance with the provisions of SFAS No. 142. SFAS No. 142 also requires that intangible assets with estimable useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets.”
Goodwill and intangible assets not subject to amortization are tested annually for impairment, and are tested for impairment more frequently if events and circumstances indicate that the assets might be impaired. In 2006, 2005 and 2004, there were no triggering events that required us to test for impairment prior to our annual impairment analysis.
In connection with our impairment analysis performed annually in our fourth quarter, we are required to perform an assessment of whether there is an indication that goodwill is impaired. To accomplish this, we are required to determine the carrying value of each reporting unit by assigning the assets and liabilities, including the existing goodwill and intangible assets, to those reporting units. We determine the fair value of each reporting unit using the discounted cash flow approach and the market multiple approach. To the extent the carrying amount of a reporting unit exceeds its fair value, we would be required to perform the second step of the impairment analysis, as this is an indication that the reporting unit goodwill may be impaired. In this step, we compare the implied fair value of the reporting unit goodwill with the carrying amount of the reporting unit goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit to all of the assets (recognized and unrecognized) and liabilities of the reporting unit in a manner similar to a purchase price allocation, in accordance with SFAS No. 141, “Business Combinations.” The residual fair value after this allocation is the implied fair value of the reporting unit goodwill. To the extent the implied fair value of goodwill of each reporting unit is less than its carrying amount we would be required to recognize an impairment loss. During the fourth quarter of 2006, we performed our most recent annual impairment analyses of goodwill. Based on the results of the annual impairment analysis, we determined that no indicators of impairment existed for our reporting units and no impairment charges were recorded for goodwill. We will perform our next annual impairment analysis during the fourth quarter of 2007.
Impairment of Long-Lived Assets
In accordance with SFAS No. 144, long-lived assets, such as property and equipment, and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. Recoverability of assets to be held
and used is measured by a comparison of the carrying amount of an asset group to estimated undiscounted future cash flows expected to be generated by the asset group. If the carrying amount of an asset group exceeds its estimated future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset group exceeds the fair value of the asset group. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and would no longer be depreciated. The assets and liabilities of a disposal group classified as held for sale would be presented separately in the appropriate asset and liability sections of the balance sheet. In 2006, 2005 and 2004, no impairment charges were recorded for long-lived assets.
Income Taxes
We account for income taxes using the asset and liability method of SFAS 109, “Accounting for Income Taxes.” Under this method, income tax expense is recognized for the amount of taxes payable or refundable for the current year and for deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Tax contingencies are accounted for under SFAS 5, “Accounting for Contingencies.” Management must make assumptions, judgments and estimates to determine our current provision for income taxes and also our deferred tax assets and liabilities and any valuation allowance to be recorded against a deferred tax asset. Our judgments, assumptions and estimates relative to the current provision take into account current tax laws, our interpretation of current tax laws and possible outcomes of current and future audits conducted by foreign and domestic tax authorities. Changes in tax law or our interpretation of tax laws and the resolution of current and future tax audits could significantly impact the amount provided for income taxes in our consolidated financial statements.
Results of Operations
The following table sets forth selected consolidated statements of income data expressed as a percentage of net revenues for the periods indicated:
Comparison of Years Ended December 31, 2006 and 2005
License Revenues. Our license revenues for 2006 increased by $24.9 million or 15% compared to 2005 primarily due to (i) $16.4 million increase from the growth in hardware licensing due to strong demand from consumers, especially in international territories, for digital cable and digital satellite operators’ businesses (ii) $6.4 million increase from the growth of our existing software products due to increased market penetration and (iii) $4.5 million increase in software licensing revenue related to the acquisition of eMeta. During 2006, we recognized approximately $0.9 million of revenue from set top box royalties on an as earned basis as a result of being able to estimate such royalties prior to year end. Previously, we had recognized royalties for these customers on an as reported basis.
Service Revenues. Our service revenues for 2006 increased by $19.5 million or 53% compared to 2005, primarily due to (i) $8.8 million increase from the growth of our core software products and a growing customer base, (ii) $5.2 million increase in service revenue from the acquisition of eMeta, and (iii) $4.4 million increase in service revenue from the acquisition of Trymedia since August 2005.
Cost of Revenues-License Fees. Cost of revenues from license fees as a percentage of license revenues increased to 5.5% for 2006 from 3.6% for 2005. Cost of revenues from license fees increased $4.5 million to $10.4 million in 2006 from $5.9 million in 2005. The increase is primarily due to higher product costs associated with the increase in hardware revenue from our software segment.
Cost of Revenues-Service Fees. Cost of revenues from service fees as a percentage of service revenues increased to 56.8% for 2006 from 47.7% for 2005. Cost of revenues from service fees increased $14.4 million to $32.0 million in 2006 from $17.6 million in 2005. The increases were primarily due to (i) $4.6 million increase in support costs related to the growth of our software business, (ii) $4.9 million increase in support and service costs related to operations acquired through eMeta, (iii) $2.7 million increase in service costs to support the growth of our professional services organization related to the growth of our software business and (iv) $1.9 million increase from equity-based compensation. We anticipate our cost of revenues from service fees may increase as we continue to increase activity in our service products and expand our customer base.
Cost of Revenues-Amortization of Intangibles from Acquisitions. Cost of revenues from amortization of intangibles increased to $13.0 million in 2006 from $11.0 million in 2005. The increase was primarily due to the amortization of intangibles from the acquisitions of eMeta since February 2006, Trymedia since July 2005 and Zero G since June 2005.
In February 2006, we acquired eMeta, a privately-held company based in New York for $36.0 million of purchase consideration. As part of this acquisition, we acquired $5.5 million of intangibles subject to amortization. eMeta extends our reach from physical distribution into the online digital distribution segment and extended the breadth of our portfolio to include a broad spectrum of access control, usage entitlement, e-commerce and subscription management solutions.
In July 2005, we acquired Trymedia, a privately-held company based in San Francisco, California and in Alicante, Spain, for $31.8 million of purchase consideration. As part of this acquisition, we acquired $9.3 million of intangibles subject to amortization. Trymedia provides secure digital distribution services and operates the largest Internet distribution network for downloadable games. This acquisition expanded our games solution set by providing an online game distribution and promotion offering.
In June 2005, we acquired Zero G, a privately-held company based in San Francisco, California, for $10.6 million of purchase consideration, all of which was paid in cash. As part of this acquisition, we acquired $3.5 million of intangibles subject to amortization. Zero G provided software deployment and delivery solutions for multi-platform operating system environments. The acquisition increased our market for software solutions, added innovative technology and enhanced multi-platform products.
Research and Development. Research and development expenses increased by $18.5 million, or 53.7%, to $52.8 million in 2006 from $34.4 million in 2005, primarily due to (i) $6.2 million increase in additional research and development activities related to the acquisitions of Trymedia and eMeta and (ii) $6.0 million increase from equity-based compensation. Research and development expenses increased as a percentage of net revenues to 21% in 2006 from 17% in 2005. We expect research and development expenses to increase in absolute terms and decrease as a percentage of total revenues over the prior year period as a result of expected increases in research and development activity to support our new technologies.
Selling and Marketing. Selling and marketing expenses increased by $12.4 million, or 22%, to $68.5 million in 2006 from $56.1 million in 2005, primarily due to (i) $7.6 million increase in equity-based compensation and (ii) $2.4 increase in costs related to products acquired through the acquisitions of eMeta and Trymedia. Selling and marketing expenses, as a percentage of net revenues, remained consistent at 28% in 2006 and 2005. We expect selling and marketing expenses to increase in absolute terms and vary as a percentage of total revenues as we continue our efforts to increase our market share and grow our business.
General and Administrative. General and administrative expenses increased by $3.9 million, or 12%, to $36.8 million in 2006 from $32.9 million in 2005, primarily due to $6.7 million increase in equity-based compensation, partially offset by a decrease in Sarbanes Oxley compliance costs and legal costs. General and administrative expenses decreased as a percentage of net revenues to 15% in 2006 from 16% in 2005. We expect our general and administrative expenses to increase in absolute terms and vary as a percentage of total revenues as we continue to support the growth of the company.
Restructuring Charge. In October 2005, our board of directors approved a restructuring program, which included a worldwide workforce reduction and restructuring of certain business functions. The workforce reduction was announced on November 3, 2005 and resulted in the termination of 80 employees. All affected employees were informed of their termination prior to December 31, 2005. We recorded a charge of $2.5 million for the year ended December 31, 2005 in connection with this workforce reduction.
Impairment losses on strategic investments. During 2005, we recorded charges totaling $5.8 million relating to an other-than-temporary impairment loss in our investment in Digimarc. There were no impairment charges on strategic investments in 2006.
Interest and Other Income, Net. Interest and other income increased $4.3 million, or 88%, to $9.3 million in 2006 from $4.9 million in 2005. In August 2006, we issued $240 million in principal amount of 2.625% convertible senior notes due 2011 resulting in interest expense of $2.9 million for the year ended December 31, 2006. The increase in interest expense was offset by an increase in interest income, which increased $6.4 million due to higher invested balances and higher interest rates earned in our investment portfolio.
Income Taxes. We recorded income tax expense of $10.3 million and $19.5 million for 2006 and 2005, respectively. Income tax expense represents combined federal, foreign and state taxes at effective rates of 23.7% and 46.8% for 2006 and 2005, respectively. The change in effective tax rate in 2006 compared to 2005 was primarily due to the difference in tax charges for profits generated by our foreign operations, exempt interest income, equity-based compensation expense and tax charges for the distribution of foreign earnings under the American Jobs Creation Act of 2004.
Comparison of Years Ended December 31, 2005 and 2004
The following table provides revenue information by segment for the periods indicated (dollars in thousands):
License Revenues. Our license revenues for 2005 increased by $5.9 million or 3.7% compared to 2004 primarily due to higher revenue from our software products, partially offset by the decrease in video content protection revenues.
License revenue from our software products increased primarily due to the inclusion of InstallShield for the full year in 2005. InstallShield was acquired on July 1, 2004. To a lesser extent, the increase in our Software Technologies revenue was also due to increased sales of all of our license management solutions resulting from the impact of broad based market demand and product and marketing programs.
DVD content protection revenues were lower due to the impact of lower pricing in our contracts with MPAA studios. The decrease in video content protection revenues were partially offset by higher PPV and VOD revenues primarily from royalties and license fees from digital set top boxes due to strong demand from consumers, especially in international territories, for digital cable and digital satellite operators’ businesses. During 2004, we recognized $3.1 million in PPV revenue that was previously deferred until North American system operators activated the VOD system.
Service Revenues. Our service revenues for 2005 were higher by $15.2 million or 70.2%, primarily due to the increase in service contracts to support the growth in our software customer base. Service revenues also include revenue from the acquisition of Trymedia since July 2005.
Cost of Revenues-License Fees. Cost of revenues from license fees as a percentage of license revenues decreased to 3.6% for 2005 from 5.1% for 2004. Cost of revenues from license fees decreased $2.3 million to $5.9 million in 2005 from $8.2 million in 2004. The decrease was primarily due to lower replicator fees as a result of the decline in DVD content protection revenues.
Cost of Revenues-Service Fees. Cost of revenues from service fees as a percentage of service revenues increased to 47.7% for 2005 from 37.5% for 2004. Cost of revenues from service fees increased $9.5 million to $17.6 million in 2005 from $8.1 million in 2004. The increases were primarily due to the expansion of our customer support and professional services groups to support the growth of our software customer base. The increases were also due to costs incurred to maintain our peer to peer anti piracy service and digital distribution service.
Cost of Revenues-Amortization of Intangibles from Acquisitions. Cost of revenues from amortization of intangibles increased to $11.0 million in 2005 from $6.4 million in 2004. The increase was primarily due to amortization of intangibles from the acquisitions of Zero G and Trymedia in 2005 and InstallShield on July 1, 2004.
Research and Development. Research and development expenses increased by $5.7 million, or 20%, to $34.4 million in 2005 from $28.7 million in 2004. The increase was primarily due to additional research and development activities from the full year impact of our acquisitions of InstallShield in July 2004 and Zero G and Trymedia in mid 2005. Research and development expenses increased as a percentage of net revenues to 16.9% in 2005 from 15.8% in 2004.
Selling and Marketing. Selling and marketing expenses increased by $13.8 million, or 33%, to $56.1 million in 2005 from $42.3 million in 2004. The increases were primarily due to higher costs associated with the full year impact of additional personnel and infrastructure from our acquisitions of InstallShield in July 2004 and Zero G and Trymedia in mid 2005. Selling and marketing expenses increased as a percentage of net revenues to 27.6% in 2005 from 23.2% in 2004.
General and Administrative. General and administrative expenses increased by $7.3 million, or 29%, to $32.9 million in 2005 from $25.6 million in 2004. The increases were primarily due to increased headcount and related costs to support the overall growth of our business units and higher costs for compliance with the Sarbanes-Oxley Act of 2002. General and administrative expenses increased as a percentage of net revenues to 16% in 2005 from 14% in 2004.
In-process research and development. In connection with the acquisitions of Zero G in 2005, $500,000 was charged to in-process research and development in the year ended December 31, 2005. There were no in-process research and development charges related to the Trymedia acquisition in July 2005. In connection with the acquisition of InstallShield in July 2004, $5.4 million was charged to in-process research and development in the year ended December 31, 2004.
Impairment losses on strategic investments. During 2005, we recorded charges totaling $5.8 million relating to an other-than-temporary impairment loss in our investment in Digimarc. During 2004, we recorded charges totaling $5.5 million relating to other-than-temporary impairment losses in our investments in Digimarc and iVast.
Gains on strategic investments. For the years ended December 31, 2005 and 2004, we received $174,000 and $1.2 million, respectively, in cash for our interests in strategic investment that had been fully impaired. Accordingly, during the years ended December 31, 2005 and 2004, we recorded gains on strategic investments of $174,000 and $1.2 million, respectively.
Interest and Other Income, Net. Interest and other income increased $754,000, or 18%, to $4.9 million in 2005 from $4.2 million in 2004. This increase was primarily due to higher interest rates earned in our investment portfolio.
Income Taxes. We recorded income tax expense of $19.5 million and $20.7 million for 2005 and 2004, respectively. Income tax expense represented combined federal, foreign and state taxes at effective rates of 46.8% and 36.0% for 2005 and 2004, respectively. The change in effective tax rate in 2005 compared to 2004 was primarily due to increases in valuation allowance and tax charges for profits generated by our foreign operations, as well as tax charges for the distribution of foreign earnings under the American Jobs Creation Act of 2004.
Quarterly Results of Operations
The following table sets forth certain quarterly unaudited consolidated financial data for the periods indicated, as well as the percentage of our net revenues represented by such data. The data have been derived from our unaudited consolidated financial statements and, in the opinion of management, have been prepared on substantially the same basis as the audited consolidated financial statements, and include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of such data. Such data should be read in conjunction with our audited consolidated financial statements and notes thereto appearing elsewhere in this Form 10-K. The results of operations for any quarter are not necessarily indicative of the results to be expected for any future period.
(1) In October 2005, our board of directors approved a restructuring program, which included a worldwide workforce reduction and restructuring of certain business functions. We recorded a charge of $2.5 million during 2005.
(2) During the fourth quarters of 2006 and 2005, our effective tax rate increased as a result of an increase in the foreign tax differential on profits generated by our foreign operations.
Our operating results have fluctuated in the past, and are expected to continue to fluctuate in the future, on an annual and quarterly basis as a result of a number of factors. Such factors include the timing of release of popular titles on DVDs or by digital PPV transmission, the timing of release of popular computer games on CD-ROM, the timing of a small number of our electronic license management high-value perpetual licenses during any period, the degree of acceptance of our copy protection technologies by major motion picture studios and computer game publishers, the mix of products sold and technologies licensed, changes in product or license pricing, the seasonality of revenues, changes in our operating expenses, personnel changes, the development of our direct and indirect distribution channels, foreign currency exchange rates and general economic conditions. We may choose to reduce royalties and fees or increase spending in response to competition or new technologies or elect to pursue new market opportunities. Because a high percentage of our operating expenses are fixed, a small variation in the timing of recognition of revenues can cause significant variations in operating results from period to period.
Liquidity and Capital Resources
We have financed our operations primarily from cash generated by operations, principally our content protection products and our software products. Our operating activities provided net cash of $90.1 million, $55.2 million and $59.7 million in 2006, 2005 and 2004, respectively. Cash provided by operating activities increased $34.9 million from 2005 to 2006, primarily due to the increase in net income, adjusted for non-cash expenses such as depreciation, amortization and equity-based compensation. The availability of cash generated by our operations in the future could be affected by other business risks discussed in the “Risk Factor” section of this annual report.
Investing activities (used in) provided by net cash of $(273.2) million, $(23.0) million and $(10.7) million in 2006, 2005 and 2004, respectively. Cash from investing activities decreased $250.2 million from 2005 to 2006, primarily due to higher investment balances with $232.8 million in net proceeds from the issuance of convertible senior notes in August 2006, partially offset by $35.2 million for the acquisition of eMeta, and $40.2 million for advance payments for the acquisition of Mediabolic on January 1, 2007. We made capital expenditures of $14.2 million, $8.7 million and $4.8 million in 2006, 2005 and 2004, respectively. Capital expenditures were primarily for computer software and hardware.
In February 2006, we acquired eMeta Corporation (“eMeta”) for purchase consideration of $36.0 million, of which $35.2 million has been paid in cash. eMeta is a leading provider of software solutions that enable companies to control and sell digital goods and services online. eMeta is a privately held company based in New York. The acquisition of eMeta extends our reach from physical distribution into the online digital distribution segment.
In July 2005, we acquired Trymedia, a privately-held company based in San Francisco, California and in Spain, for $31.8 million of purchase consideration. As of December 31, 2006, we have paid an aggregate of $31.4 million in cash. Trymedia provided secure digital distribution services and is the operator of the largest distribution network for downloadable games. This acquisition expanded our games solution set by providing an online game distribution and promotion offering.
In June 2005, we acquired Zero G, a privately-held company based in San Francisco, California, for $10.6 million of purchase consideration, all of which has been paid in cash. Zero G provided software deployment and delivery solutions for multi-platform operating system environments. The acquisition increased our market for software, added innovative technology and enhanced multi-platform products
Net cash provided by financing activities was $206.4 million, $12.1 million and $15.2 million in 2006, 2005 and 2004, respectively. Net cash provided by financing activities increased $194.3 million from 2005 to 2006 primarily due to the issuance and sale, in a private offering, of $240.0 million in aggregate principal amount of 2.625% convertible senior notes due 2011 at par. The net proceeds to us from the offering of the notes, net of issuance costs, were $232.8 million. Concurrently with the issuance of the notes, we entered into a convertible bond call option, at a cost of $46.1 million, where we have options to purchase up to 7.96 million shares of our common stock at a price of $28.2829 per share. In addition, we sold warrants to purchase up to 7.96 million shares of our common stock at a price of $32.9248 per share and received $30.3 million in cash proceeds.
In May 2002, our Board of Directors authorized a stock repurchase program, which allows us to purchase up to 5.0 million shares of common stock in the open market from time-to-time at prevailing market prices, through block trades or otherwise, or in negotiated transactions off the market, at the discretion of our management. In 2002, we repurchased 3.0 million shares of common stock under this program, which have been recorded as treasury stock and resulted in a reduction of stockholders’ equity.
In August 2006, our Board of Directors authorized the purchase of up to $100 million of our common stock from time-to-time (inclusive of the stock repurchase program mentioned above). In connection with our offering of 2.625% Convertible Senior Notes due 2011, our Board authorized the purchase of up to $50 million of our common stock under this new stock repurchase program. In the year ended December 31, 2006, we repurchased approximately 2.3 million shares of common stock for $50.0 million, which was recorded as treasury stock and resulted in a reduction of stockholders’ equity. As of December 31, 2006, treasury stock consisted of 5.3 million shares of common stock that the Company had repurchased, with a cost basis of approximately $88.4 million.
At December 31, 2006, we had $159.7 million in cash and cash equivalents, $121.6 million in short-term investments, and $175.2 million in long-term marketable investment securities, which includes $17.7 million in fair market value of our holdings in Digimarc. We anticipate that capital expenditures for the next 12 months will aggregate approximately $13.0 million in order to support the growth of our business and strengthen our operations infrastructure.
In January 2007, we acquired Mediabolic, Inc. (“Mediabolic”) for cash consideration of $43.5 million. Mediabolic extends our capabilities in the delivery and enhancement of digital content through networking solutions to a wide variety of connected consumer electronics devices for the digital home. As of December 31, 2006, $40.2 million of such cash consideration was delivered to the paying agent for payment to Mediabolic stockholders upon the closing of the transaction.
We have future minimum lease payments of approximately $69.1 million under operating and capital leases. We believe that the current available funds and cash flows generated from operations will be sufficient to meet our working capital and capital expenditure requirements for the foreseeable future. We may also use cash to acquire or invest in additional businesses or to obtain the rights to use certain technologies in the future.
Because a significant portion of our cash inflows were generated by operations, our ability to generate positive cash flow from operations may be jeopardized by fluctuations in our operating results. Such fluctuations can occur as a result of decreases in demand for our copy protection products, our software products, or due to other business risks including, but not limited to, those factors set forth under the caption “Risk Factors” contained in this annual report.
Contractual Obligations
The following table summarizes Macrovision’s contractual obligations at December 31, 2006:
Recently Issued Accounting Pronouncements
In June 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement No. 109” (“FIN 48”), which is effective for fiscal years beginning after December 15, 2006. FIN 48 was issued to clarify the accounting for uncertainty in income taxes recognized in the financial statements by prescribing a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. We are evaluating the impact of this pronouncement on our financial statements.
In September 2006, the FASB issued Statement No. 157, “Fair Value” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 is effective in 2008. We are evaluating the impact of this pronouncement on our financial statements.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to financial market risks, including changes in interest rates, foreign currency exchange rates and security investments. Changes in these factors may cause fluctuations in our earnings and cash flows. We evaluate and manage the exposure to these market risks as follows:
Fixed Income Investments. We have an investment portfolio of fixed income securities, including those classified as cash equivalents, short-term investments and long-term marketable investment securities of $389.0 million as of December 31, 2006. These securities are subject to interest rate fluctuations. An increase in interest rates could adversely affect the market value of our fixed income securities.
We do not use derivative financial instruments in our investment portfolio to manage interest rate risk. We limit our exposure to interest rate and credit risk, however, by establishing and strictly monitoring clear policies and guidelines for our fixed income portfolios. The primary objective of these policies is to preserve principal while at the same time maximizing yields, without significantly increasing risk. A hypothetical 50 basis point increase in interest rates would result in an approximate $1.7 million decrease (approximately 0.4%) in the fair value of our fixed income available-for-sale securities as of December 31, 2006. Yield risk is also reduced by targeting a weighted average maturity of our portfolio at 12 months so that the portfolio’s yield regenerates itself as portions of the portfolio mature.
Foreign Currency Exchange Rates. Due to our reliance on international and export sales, we are subject to the risks of fluctuations in currency exchange rates. Because a substantial majority of our international and export revenues, as well as expenses, are typically denominated in U.S. dollars, fluctuations in currency exchange rates could cause our products to become relatively more expensive to customers in a particular country, leading to a reduction in sales or profitability in that country. Many of our subsidiaries operate in their local currency, which mitigates a portion of the exposure related to the respective currency collected.
Strategic Investments. We currently hold minority equity interests in a number of companies. These investments, at book value totaling $22.7 million and $11.9 million, represented 2.8% and 2.4% of our total assets as of December 31, 2006 and 2005, respectively. In 2006, we made a $5.0 million investment in a privately-held digital watermarking company for strategic purposes. As of December 31, 2006, the adjusted cost of our strategic investments consisted of our investment in Digimarc, a publicly traded company, and our investment in the privately-held digital watermarking company. In addition, we hold investments in a number of other privately held companies, which have no carrying value as of December 31, 2006. Digimarc is subject to price fluctuations based on the public market. Because there is no active trading market for the securities of privately held companies, our investments in them are illiquid. As such, we may never have an opportunity to realize a return on our investment in these private companies, and we may in the future be required to write off all or part of one or more of these investments. During 2005 and 2004, we wrote off $5.8 million and $5.5 million, respectively, of strategic investments resulting from impairment that was other-than-temporary. There were no other-than-temporary impairment charges in 2006. In 2005, the $5.8 million impairment was partially offset by gains of $174,000 related to gains on our interests in strategic investments that had been fully impaired. In 2004, the $5.5 million impairment loss was partially offset by a gain of $1.2 million related to the gain from the sale of InterActual Technologies.
Long-term Debt. The fair market value of the 2.625% convertible senior notes is subject to interest rate market price risk and equity risk due to the convertible feature of the notes and other factors. Generally the fair market value of fixed interest rate debt will increase as interest rates fall and decrease as interest rates rise. The fair market value of the notes will also increase as the market price of our stock rises and decrease as the market price of the stock falls. Interest rate and market value changes affect the fair market value of the notes but do not impact our financial position, cash flows or results of operations.
The notes may be converted, under certain circumstances, based on an initial conversion rate of 35.3571 shares of common stock per $1,000 principal amount of notes (which represents an initial conversion price of
approximately $28.28 per share), into an aggregate of 8.5 million shares. Prior to June 15, 2011, holders may convert their notes into cash and our common stock, at the applicable conversion rate, under any of the following circumstances: 1) during any fiscal quarter after the calendar quarter ending September 30, 2006, if the last reported sale price of our common stock for at least 20 trading days during the 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is greater than or equal to 120% of the applicable conversion price in effect on the last trading day of the immediately preceding fiscal quarter; 2) during the five business-day period after any ten consecutive trading-day period (the “measurement period”) in which the trading price per note for each day of such measurement period was less than 98% of the product of the last reported sale price of our common stock and the conversion rate on each such day; or 3) upon the occurrence of specified corporate transactions, as defined in the indenture. On and after June 15, 2011 until the close of business on the scheduled trading day immediately preceding the maturity date of August 15, 2011, holders may convert their notes into cash and shares of our common stock, if any, at the applicable conversion rate, at any time, regardless of the foregoing circumstances. In addition, in the event of a significant change in our corporate ownership or structure, the holders may require us to repurchase all or any portion of their notes for 100.00% of the principal amount.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by this item is submitted in a separate section of this report beginning on of this report.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our chief executive officer and our chief financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Exchange Act Rule 13a-15(e). Based on this evaluation, our chief executive officer and our chief financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this annual report.
Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining an adequate system of internal control over financial reporting. Our internal control over financial reporting includes those policies and procedures that:
•
pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets;
•
provide reasonable assurance that transactions are recorded as necessary to permit preparation of our financial statements in accordance with generally accepted accounting principles in the United States, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and
•
provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.
Our management assessed the effectiveness of our system of internal control over financial reporting as of December 31, 2006. In making this assessment, we used the framework in Internal Control-Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on our assessment and the criteria set forth by COSO, we believe that Macrovision maintained effective internal control over financial reporting as of December 31, 2006. Our assessment of the effectiveness of our internal control over financial reporting has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report which is included herein.
Inherent Limitations on Effectiveness of Controls
Our system of internal control over financial reporting was designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States.
All internal control systems, no matter how well designed and operated, can provide only reasonable assurance with respect to financial statement preparation and presentation. Our management does not expect that our disclosure controls and procedures will prevent all error and fraud. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues within the company have been detected, even with respect to those systems of internal control that are determined to be effective. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdown can occur because of simple error or mistake. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of these inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. Our system contains self monitoring mechanisms, and actions are taken to correct deficiencies as they are identified.
Audit Committee Oversight
The Audit Committee of the Board of Directors, which is comprised solely of independent directors, has oversight responsibility for our financial reporting process and the audits of our consolidated financial statements and internal control over financial reporting. The Audit Committee meets regularly with management and with our internal auditors and independent registered public accounting firm (collectively, the “accountants”) to review matters related to the quality and integrity of our financial reporting, internal control over financial reporting (including compliance matters related to our Code of Personal and Business Conduct and Ethics), and the nature, extent, and results of internal and external audits. Our accountants have full and free access and report directly to the Audit Committee. The Audit Committee recommended, and the Board of Directors approved, that the audited consolidated financial statements be included in this Annual Report on Form 10-K.
Changes in Internal Control Over Financial Reporting
During the quarter ended December 31, 2006, there have been no changes in our internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, these controls.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders of
Macrovision Corporation:
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A, that Macrovision Corporation (Macrovision) maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Macrovision’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of Macrovision’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that Macrovision maintained effective internal control over financial reporting as of December 31, 2006 is fairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework issued by COSO. Also, in our opinion, Macrovision maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by COSO.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Macrovision Corporation and subsidiaries as of December 31, 2006 and 2005 and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2006, and our report dated February 28, 2007 expressed an unqualified opinion on those consolidated financial statements.
/s/ KPMG LLP
Mountain View, California
February 28, 2007
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The information required by this item will be included in our proxy statement, which will be filed with the SEC in connection with the solicitation of proxies for our 2007 Annual Meeting of Stockholders to be held on April 26, 2007 (the “2007 Annual Meeting of Stockholders”), and that information is incorporated by reference herein.
In February 2004, we adopted a code of conduct and ethics applicable to all of our directors and employees, including the principal executive officer, principal financial officer and principal accounting officer. A copy of such code of conduct and ethics was filed as an Exhibit to our Annual Report on Form 10-K for the year ended December 31, 2003. If we make any substantive amendments to the code of conduct and ethics or grant any waiver, including implicit waiver, from a provision of the code of conduct and ethics to our principal executive officer, principal financial officer or principal accounting officer, we will disclose the nature of such amendment or waiver on our website at http:///www.macrovision.com or in a current report on Form 8-K that will be publicly filed.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item will be include in the proxy statement for the 2007 Annual Meeting of Stockholders and that information is incorporated by reference herein.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Except for the information about our equity plan shown below, the information required by this item will be included in the proxy statement for the 2007 Annual Meeting of Stockholders and that information is incorporated by reference herein.
Equity Compensation Plan Information
The following table gives information about our common stock that may be issued under our existing equity compensation plans as of December 31, 2006. Our 1996 Directors Stock Option Plan, as amended, 1996 Equity Incentive Plan, as amended, 1996 Employee Stock Purchase Plan, as amended and 2000 Equity Incentive Plan, as amended, were all approved by our stockholders. We do not have any non-stockholder approved equity compensation plans.
(1) No additional options may be granted under the 1996 Equity Incentive Plan, as amended. Excludes purchase rights accruing under the 1996 Employee Stock Purchase Plan. Under these plans, each eligible employee
may purchase shares of common stock with accumulated payroll deductions on the last business day in January and July of each year at a purchase price per share equal to 85% of the lower of (i) the closing market price per share of our common stock on the employee’s entry date into the two-year offering period in which that semi-annual purchase date occurs or (ii) the closing market price per share on the semi-annual purchase date.
(2) Includes 4,848,657 shares that remain available under the 2000 Equity Incentive Plan, 282,500 shares that remain available under the 1996 Directors Stock Option Plan and 2,618,592 shares that remain available under the 1996 Employee Stock Purchase Plan.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information required by this item will be included in the proxy statement for the 2007 Annual Meeting of Stockholders and that information is incorporated by reference herein.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this item will be included in the proxy statement for the 2007 Annual Meeting of Stockholders and that information is incorporated by reference herein.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) The following documents are filed as part of this report:
1. Financial Statements
Page
•
Report of Independent Registered Public Accounting Firm
•
Consolidated Balance Sheets
•
Consolidated Statements of Income
•
Consolidated Statements of Stockholders’ Equity and Comprehensive Income
•
Consolidated Statements of Cash Flows
•
Notes to Consolidated Financial Statements
2. Exhibits
(a) Exhibits
* Confidential treatment has been granted with respect to certain portions of this Exhibit. These portions have been omitted from this filing and have been filed separately with the Securities and Exchange Commission.
** Management contract or compensatory plan or arrangement.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant caused this report to be signed on its behalf by the undersigned thereunto duly authorized on this 28th day of February, 2007.
MACROVISION CORPORATION
By:
/s/ ALFRED J. AMOROSO
Alfred J. Amoroso
President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant, and in the capacities and on the date indicated.
MACROVISION CORPORATION
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
PAGE
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets
Consolidated Statements of Income
Consolidated Statements of Stockholders’ Equity and Comprehensive Income
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders of
Macrovision Corporation:
We have audited the accompanying consolidated balance sheets of Macrovision Corporation and subsidiaries (the Company) as of December 31, 2006 and 2005, and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2006. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Macrovision Corporation and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006 in conformity with U.S. generally accepted accounting principles.
As discussed in Note 8, to the consolidated financial statements, effective January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123(R), Share-Based Payment, applying the modified-prospective method.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the internal control over financial reporting of Macrovision Corporation as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 28, 2007 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
/s/ KPMG LLP
Mountain View, California
February 28, 2007
MACROVISION CORPORATION
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
See accompanying notes to consolidated financial statements.
MACROVISION CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share data)
See accompanying notes to consolidated financial statements.
MACROVISION CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME
(In thousands, except share data)
See accompanying notes to consolidated financial statements.
MACROVISION CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
See accompanying notes to consolidated financial statements
MACROVISION CORPORATION
Notes to Consolidated Financial Statements
December 31, 2006, 2005 and 2004
(1) The Company and Summary of Significant Accounting Policies
The Company
Macrovision Corporation, a Delaware corporation founded in 1983, enables businesses reliant on the deployment of software or content to protect, enhance, or distribute their offering among digital distribution channels and destination devices. These digital lifecycle management solutions include anti-piracy and content protection technologies and services, digital rights management, embedded licensing technologies, usage monitoring for enterprises, access control and billing, and a host of related technologies and services from installation to update to back-office entitlement management. The Company’s customers consist of entertainment producers such as motion picture studios and music labels, software publishers, hardware manufacturers, consumer electronic firms, personal computer manufacturers, digital set-top box manufacturers, digital pay-per-view and video-on-demand network operators, publication companies and enterprise information technology organizations.
Basis of Presentation
The accompanying consolidated financial statements include the accounts of Macrovision Corporation and its wholly owned subsidiaries after elimination of intercompany accounts and transactions.
The accompanying consolidated financial statements for 2005 contain certain reclassifications to conform to the 2006 presentation. This consists of a balance sheet reclassification of $12.0 million of certain short-term investments to restricted cash and investments, previously reported in short-term investments in 2005. The statement of cash flows for the year ended December 31, 2005 also reflects this reclassification, shown as a reduction of $12.0 million, in cash and cash equivalents at the beginning of the period and at the end of the period. The statement of cash flows for the year ended December 31, 2004 reflects this reclassification, shown as a reduction of $12.0 million, in cash and cash equivalents at the end of the period. The impact of this reclassification is not material to the December 31, 2005 balance sheet or the statement of cash flows for the years ended December 31, 2005 and 2004.
Use of Estimates
The preparation of consolidated financial statements in conformity with generally accepted accounting principles in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported results of operations during the reporting period. On an ongoing basis, the Company evaluates its estimates, including those related to revenue recognition, allowance for doubtful accounts, investments, equity-based compensation, goodwill and other intangible assets, long-lived assets and income taxes. Actual results could differ from those estimates under different assumptions or conditions.
Cash, Cash Equivalents, and Investments
The Company considers investments with maturities from date of purchase of three months or less to be cash equivalents. Cash and cash equivalents consist of cash on deposit with banks and money market funds. All other liquid investments with maturities over three months and less than 12 months are classified as short-term investments. Short-term investments consist primarily of U.S. and municipal securities, commercial paper, auction rate securities, corporate debt and equity securities. All marketable securities with maturities over one year or those for which the Company’s intent is to retain for the long-term are classified as long-term marketable investment securities.
The Company accounts for its publicly traded investments in accordance with Statement of Financial Accounting Standards (SFAS) No. 115, “Accounting for Certain Investments in Debt and Equity Securities” and complies with the disclosure provisions of Emerging Issues Task Force (EITF) 03-01, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” Management determines the appropriate classification of investment securities at the time of purchase and re-evaluates such designation as of each balance sheet date. As of December 31, 2006 and 2005, all investment securities were designated as “available-for-sale.” Available-for-sale securities are carried at fair value based on quoted market prices, with unrealized gains and losses reported in comprehensive income, as a separate component of stockholders’ equity.
Realized gains and losses and declines in value judged to be other-than-temporary for available-for-sale securities are reported in other income or expense as incurred. The cost of securities sold is based on the specific identification method. Interest and dividends on securities classified as available-for-sale are included in other income.
The following is a summary of available-for-sale securities (in thousands) as of December 31, 2006:
The following is a summary of available-for-sale securities (in thousands) as of December 31, 2005:
There were no recognized losses from other-than-temporary declines in the market value of marketable securities in 2006. In 2005 and 2004, we recognized $5.8 million and $5.3 million, respectively, from other-than-temporary losses in the market value of our equity securities (See Note 6-Strategic Investments).
In accordance with EITF 03-1, the following table summarizes the fair value and gross unrealized losses related to available-for-sale securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position as of December 31, 2006 and 2005 (in thousands):
Market values were determined for each individual security in the investment portfolio. The declines in value of these investments are primarily related to changes in interest rates and are considered to be temporary in nature.
As of December 31, 2006 and 2005, the unrealized gain (loss), net of taxes, was $3.0 million and $(0.4) million, respectively.
As of December 31, 2006, the weighted average contractual maturity for debt securities was approximately nine months.
Allowance for Doubtful Accounts
The Company maintains an allowance for doubtful accounts to reserve for potentially uncollectible trade receivables. The Company reviews its trade receivables by aging category to identify significant customers with known disputes or collection issues. For accounts not specifically identified, the Company provides reserves based on historical bad debt loss experience.
Property and Equipment
Property and equipment are stated at cost, net of accumulated depreciation and amortization. Depreciation and amortization is computed using the straight-line method over the estimated useful lives of the respective assets. Computer equipment and software are depreciated over three years. Furniture and fixtures are depreciated over five years. Leasehold improvements and assets recorded under capital leases are amortized on a straight-line basis over the shorter of the assets’ useful lives or lease terms.
Patents
Patent costs are amortized using the straight-line method over the shorter of the estimated useful life of the patent or a range of 7 to 10 years.
Deferred Revenue
Deferred revenue represents amounts received from customers under certain license, maintenance and service agreements for which the revenue earnings process has not been completed.
Comprehensive Income
Comprehensive income includes net income, foreign currency translation adjustments and other unrealized gains and losses on marketable investment securities that have been excluded from the determination of net income. The Company has reported the components of comprehensive income on its consolidated statements of stockholders’ equity.
Revenue Recognition
The Company’s revenue consists of royalty fees on copy-protected products on a per unit basis, licenses for its content protection technologies, licenses for its software value management products, and related maintenance and services revenues.
Royalty Revenues
Royalty revenue from the replication of videocassettes, DVDs, and CDs and PPV products is recognized when realized or realizable and earned. The Company relies on royalty reports from customers and/or third parties as the basis for revenue recognition, provided there is persuasive evidence of an arrangement and that collection of a fixed and determinable fee is considered probable. In the Company’s DVD, videocassette, PPV and PC games product lines, the Company has established significant experience and relationships with certain customers to reasonably estimate current period volume for purposes of making an accurate revenue accrual. Accordingly, royalty revenue from these customers is recognized as earned. Revenue from other customers is recognized as reported until such time that the Company can establish a basis for making reasonable estimates, in which case revenue is recognized on an as earned basis.
Technology Licensing Revenues
Technology licensing revenue, which applies principally to DVD and PC sub-assembly manufacturers; digital PPV, cable and satellite system operators and digital set-top decoder manufacturers, is recognized upon establishment of persuasive evidence of an arrangement, performance of all significant obligations and determination that collection of a fixed and determinable license fee is considered probable.
Entertainment Service Revenues
The Company provides peer to peer anti-piracy services and digital distribution services to entertainment industry customers. Revenue from such services is recognized as the services are performed. Entertainment technologies service revenues are included in services revenue in the accompanying consolidated financial statements.
Software Licensing Revenues
The Company sells software value management solutions through its direct sales force and through resellers. The Company recognizes revenue on software products in accordance with Statements of Position (“SOP”) 97-2, “Software Revenue Recognition,” as amended by SOP 98-9 “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions.” Revenue is recognized when all of the following criteria are met: persuasive evidence of an arrangement exists; delivery of the product has occurred; no significant obligations remain; the fee is fixed or determinable; and collectibility is probable. Resellers are offered the limited right of return on packaged products under certain policies and programs. The Company estimates and records reserves for product returns as an offset to revenue. The Company considers arrangements
with payment terms extending beyond six months not to be fixed or determinable and, accordingly, revenue is recognized as payments become due and payable from the customer under such arrangements. The Company assesses collectibility based on a number of factors, including the customer’s past payment history and current creditworthiness. If collectibility is not considered probable, revenue is recognized when the fee is collected from the customer.
Professional Services Revenues
The Company provides consulting and training services to its software vendor and enterprise customers. Revenue from such services is generally recognized as the services are performed, except in instances where services are included in an arrangement accounted for under SOP 81-1. Professional services revenues are included in services revenue in the accompanying consolidated statements of income.
Maintenance Revenues
Maintenance agreements generally call for the Company to provide technical support and unspecified software updates to customers. Maintenance revenue is deferred and recognized ratably over the maintenance contract period (generally one year) and is included in services revenue in the accompanying consolidated statements of income.
Cost of Revenues
License Fees
The Company has agreements with certain licensed duplicators, DVD and CD replicators, DVD authoring facilities and CD mastering facilities utilized by customers of the Company’s video copy protection and software copy protection technologies. The Company has agreed to pay these licensees on a specified fixed service fee or on a per unit basis when utilizing the Company’s copy protection technologies to help offset the cost of operating the Company’s copy protection equipment and reporting requirements of their contracts. Such amounts are charged to cost of revenues when incurred. Cost of revenues-license fees also includes items such as product costs, videocassette copy protection processor costs, royalty expense and software licensing fees. Cost of revenues-license fees also includes outside legal costs of $2.1 million, $1.7 million, and 1.9 million in 2006, 2005, and 2004, respectively, associated with litigation to enforce the Company’s patents. Amortization of patents is also included in cost of revenues-license fees.
Service Fees
Cost of revenues-service fees includes the cost of technical support for the Company’s software and service products. This primarily consists of customer support and professional services to software customers, as well as any third party consultants who provide such services on the Company’s behalf. Costs associated with the Company’s anti piracy and digital distribution of games services include customer support, hosting, bandwidth and equipment maintenance costs.
Amortization of Intangibles from Acquisitions
Cost of revenues-amortization of intangibles from acquisitions includes amortization of certain intangibles from acquisitions. This includes amortization from purchased existing technology, existing contracts, and patents and trademarks.
Equity-Based Compensation
Effective January 1, 2006, the Company adopted the provisions of, and accounts for equity-based compensation in accordance with, Statement of Financial Accounting Standards No. 123-revised 2004 (“SFAS
123(R)”), “Share-Based Payment” which replaced Statement of Financial Accounting Standards No. 123 (“SFAS 123”), “Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees.” In accordance with SFAS 123(R), equity-based compensation cost is measured at the grant date based on the fair value of the award. The Company elected the modified-prospective method. Under this transition method, equity-based compensation includes the amortized value of vesting equity-based payments granted prior to January 1, 2006 based on the grant date fair value as determined under SFAS 123 and those granted subsequently in accordance with SFAS 123(R). Results for prior periods have not been restated.
Income Taxes
Income taxes are accounted for under the asset and liability method of SFAS 109, “Accounting for Income Taxes.” Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The measurement of deferred tax assets is reduced, if necessary, by a valuation allowance for any tax benefits of which future realization is uncertain. Tax contingencies are accounted for under SFAS 5, “Accounting for Contingencies.”
Foreign Currency Translation and Transactions
The functional currency for the Company’s foreign subsidiaries is the applicable local currency. The translation of foreign currency denominated financial statements into United States dollars is performed for balance sheet accounts using current exchange rates in effect at the balance sheet date and for revenues and expense accounts using an average exchange rate for the respective periods. Adjustments resulting from such translation are included in comprehensive income. Gains or losses resulting from foreign currency transactions included in the consolidated statements of income were not material in any of the periods presented.
Business and Concentration of Credit Risk and Fair Value of Financial Instruments
The Company licenses its video copy protection, CD-ROM copy protection and electronic license management software to customers in the home videocassette, DVD, cable and satellite pay-per-view, corporate communication markets, multimedia software markets and business software markets primarily in the United States, Europe, Japan, and the Far East. In 2006, 2005, and 2004, 16%, 18%, and 30%, respectively, of the Company’s business was attributed to the licensing of its video content protection technology through MPAA movie studios. Accordingly, the ability of the Company to grow its video copy protection operations has been dependent on MPAA movie studios’ continued success in the production and distribution of movies utilizing the Company’s technology. The Company also licenses its digital PPV video content protection technologies to satellite and cable television operators and to the equipment manufacturers that supply the satellite and cable television industries. The Company licenses its CD-ROM copy protection to publishers of software in the multimedia and educational software and rights management application markets. With the acquisition of Globetrotter Software, Inc. the Company began its business in electronic software license management software. The Company licenses software technology solutions to software and hardware manufacturers and software asset management solutions to enterprise end-users. The Company also provides support, maintenance and consulting services. In addition, 45%, 43%, and 42%, of the Company’s sales in 2006, 2005, 2004, respectively, were from export or foreign operations.
Financial instruments that potentially subject the Company to significant concentrations of credit risk consist principally of cash, cash equivalents, marketable securities, trade accounts receivable and long-term investments. The Company places its cash and cash equivalents and marketable securities in deposits and money market funds with various high credit quality institutions. The carrying value of the Company’s financial instruments approximates fair market value due to the relatively short maturities of those instruments. For the
Company’s investments in public companies (Digimarc), the carrying value is the market price of shares as represented on a national exchange at period end.
The Company performs ongoing credit evaluations of its customers as necessary. The Company did not have any customers that were equal to or greater than 10% of net revenues for the years ended December 31, 2006, 2005 and 2004. At December 31, 2006 and 2005, the Company did not have any customers that were equal to or greater than 10% of accounts receivable.
Earnings Per Share
Basic EPS is computed using the weighted average number of common shares outstanding during the period. Diluted EPS is computed using the weighted average number of common and dilutive common equivalent shares outstanding during the period except for periods of operating loss for which no common share equivalents are included because their effect would be anti-dilutive. Dilutive common equivalent shares consist of common stock issuable upon exercise of stock options and restricted stock using the treasury stock method.
The following weighted average potential common shares were excluded from the computation of diluted net earnings per share as their effect would have been anti-dilutive:
(1) These employee stock options and restricted stock units were excluded from the computation of diluted net earnings per share because their impact is anti-dilutive.
(2) Potential common shares related to the convertible senior notes were excluded from the computation of diluted net income per share because the effective conversion price was higher than the average market price of our common stock during the period, and therefore the effect was anti-dilutive.
Goodwill and Other Intangibles from Acquisitions
In accordance with Statement of Financial Accounting Standards No. 142 (“SFAS 142”), “Goodwill and Other Intangible Assets,” goodwill is reviewed for impairment annually, or more frequently, if facts and circumstances warrant a review. The provisions of SFAS 142 require that a two-step test be performed to assess goodwill for impairment. First, the fair value of each reporting unit is compared to its carrying value. If the fair value exceeds the carrying value, goodwill is not impaired and no further testing is performed. The second step is performed if the carrying value exceeds the fair value. The implied fair value of the reporting unit’s goodwill must be determined and compared to the carrying value of the goodwill. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, an impairment loss equal to the difference will be recorded.
The Company performed its annual goodwill impairment test during the fourth quarter of fiscal 2006 and determined that the carrying amount of goodwill was not impaired.
SFAS 142 also requires that intangible assets with definite lives be amortized over their estimated useful life and reviewed for impairment in accordance with Statement of Financial Accounting Standards No. 144 (“SFAS 144”), “Accounting for the Impairment or Disposal of Long-Lived Assets.”
The Company amortizes acquired intangible assets with definite lives. Purchased technology and contracts are amortized over their useful lives, which are generally three to six years.
Software Development Costs
Capitalization of software development costs begins upon the establishment of technological feasibility, which is generally the completion of a working prototype that has been certified as having no critical bugs and is a release candidate or when alternative future use exists. To date, software development costs incurred between completion of a working prototype and general availability of the related product have not been material and have not been capitalized.
Research and Development
Expenditures for research and development are expensed as incurred. The Company had no capitalized research and development costs as of December 31, 2006.
Advertising Expenses
The Company expenses all advertising costs as incurred and classifies these costs under sales and marketing expense.
(2) Financial Statement Details
Property and Equipment, Net (in thousands):
Depreciation expense for the years ended December 31, 2006, 2005, and 2004 were $7.2 million, $4.8 million, and $3.2 million, respectively.
Patents, Net (in thousands):
Patent amortization for the years ended December 31, 2006, 2005, and 2004 were $2.1 million, $1.8 million, $1.6 million, respectively.
Accrued Expenses (in thousands):
Interest and Other Income, Net (in thousands):
Allowance for Doubtful Accounts (in thousands):
(3) Business Combinations and Asset Purchases
eMeta Corporation
In February 2006, the Company acquired eMeta Corporation (“eMeta”), a privately held company based in New York, for $36.0 million of purchase consideration. eMeta provided software solutions that enable companies to manage and sell digital goods and services online. The acquisition of eMeta extended the Company’s reach from physical distribution into online digital distribution. eMeta results have been included in the Company’s Software Technologies segment. The consolidated financial statements include the results of operations of eMeta since February 28, 2006, the effective date of the acquisition.
The following is a summary of the estimated fair values of the tangible assets acquired and liabilities assumed at the date of the acquisition (in thousands):
The following is a summary of goodwill and identifiable intangible assets acquired in the acquisition of eMeta (in thousands):
The weighted average amortization period for amortizable eMeta intangible assets is 3.2 years.
Trymedia Systems, Inc.
In July 2005, the Company acquired Trymedia Systems, Inc. (“Trymedia”), a privately-held company based in San Francisco, California and in Spain, for $31.8 million of purchase consideration. Trymedia provided secure digital distribution services and was the operator of the largest distribution network for downloadable games. This acquisition expanded the Company’s games solution set by providing an online game distribution and promotion offering. Trymedia has been integrated into the Company’s Entertainment Technologies segment. The consolidated financial statements include the results of operations of Trymedia since July 29, 2005, the effective date of the acquisition. As of December 31, 2006, the Company paid $31.4 million in cash and expects to pay an additional $0.4 million to Trymedia shareholders as they surrender the balance of their stock.
The following is a summary of the estimated fair values of the tangible assets acquired and liabilities assumed at the date of the acquisition (in thousands):
During 2006, the Company adjusted acquired deferred tax assets as of July 29, 2005 based on additional information from the final tax return as filed. This adjustment increased deferred tax assets and decreased goodwill by $3.3 million. The following is a summary of goodwill and identifiable intangible assets acquired in the acquisition of Trymedia (in thousands):
The weighted average amortization period for amortizable Trymedia intangible assets is 4.1 years. The in-process technology of $500,000 was charged to operations during the year ended December 31, 2005.
Zero G Software, Inc.
In June 2005, the Company acquired Zero G Software, Inc. (“Zero G”), a privately-held company based in San Francisco, California, for $10.6 million of purchase consideration, all of which has been paid in cash. Zero G provided software deployment and delivery solutions for multi-platform operating system environments. The acquisition increased the Company’s market for software value management solutions, added innovative technology and enhanced multi-platform products. Zero G has been integrated into the Company’s Software Technologies segment. The consolidated financial statements include the results of operations of Zero G since June 9, 2005, the effective date of the acquisition.
The following is a summary of the estimated fair values of the tangible assets acquired and liabilities assumed at the date of the acquisition (in thousands):
During 2006, the Company adjusted acquired deferred tax assets as of June 9, 2005 based on additional information from the final tax return as filed. This adjustment increased deferred tax assets by $1.2 million and decreased goodwill by $1.2 million. The following is a summary of goodwill and identifiable intangible assets acquired in the acquisition of Zero G (in thousands):
The weighted average amortization period for amortizable Zero G intangible assets is 4.7 years.
The following table shows supplemental unaudited information as if the acquisitions of ZeroG, Trymedia and eMeta had been completed as of January 1, 2005:
(4) Goodwill and Other Intangibles from Acquisitions
As of December 31, 2006, the goodwill balance relates to our acquisitions of CDilla Ltd., Productivity through Software, Midbar Tech (1998), peer-to-peer assets, InstallShield, Zero G, Trymedia and eMeta.
The following tables summarize the Company’s intangible assets from acquisitions subject to amortization as of December 31, 2006 and 2005 (in thousands):
The following table summarizes the Company’s estimated amortization expense through the year 2011 and thereafter (in thousands):
In accordance with SFAS 142, the Company has allocated goodwill to its reportable segments. The following table summarizes the Company’s goodwill by segment as of December 31, 2006 and 2005 (in thousands):
(5) Convertible Notes
In August 2006, the Company issued and sold, in a private offering, $240.0 million in aggregate principal amount of 2.625% Convertible Senior Notes due 2011 (the “Notes”) at par. The Notes may be converted, under certain circumstances described below, based on an initial conversion rate of 35.3571 shares of common stock per $1,000 principal amount of notes (which represents an initial conversion price of approximately $28.28 per share). The proceeds to the Company from the offering of the Notes, net of issuance costs, were $232.8 million.
Prior to June 15, 2011, holders may convert their notes into cash and the Company’s common stock, at the applicable conversion rate, under any of the following circumstances: 1) during any fiscal quarter after the calendar quarter ending September 30, 2006, if the last reported sale price of the Company’s common stock for at least 20 trading days during the 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is greater than or equal to 120% of the applicable conversion price in effect on the last trading day of the immediately preceding fiscal quarter; 2) during the five business-day period after any ten consecutive trading-day period (the “measurement period”) in which the trading price per note for each day of such measurement period was less than 98% of the product of the last reported sale price of the Company’s common stock and the conversion rate on each such day; or 3) upon the occurrence of specified corporate transactions, as defined in the indenture. On and after June 15, 2011 until the close of business on the scheduled trading day immediately preceding the maturity date of August 15, 2011, holders may convert their notes into cash and shares of the Company’s common stock, if any, at the applicable conversion rate, at any time, regardless of the foregoing circumstances.
Upon conversion, a holder will receive the conversion value of the Notes to be converted equal to the conversion rate multiplied by the volume weighted average price of the Company’s common stock during a specified period following the conversion date. The conversion value of each Note will be paid in: 1) cash equal to the lesser of the principal amount of the note or the conversion value, as defined, and 2) to the extent the conversion value exceeds the principal amount of the note, a combination of common stock and cash. In addition, upon a fundamental change at any time, as defined, the holders may require the Company to repurchase for cash all or a portion of their notes upon a “designated event” at a price equal to 100% of the principal amount of the notes being repurchased plus accrued and unpaid interest, if any.
The Company will pay cash interest at an annual rate of 2.625%, payable semi-annually on February 15 and August 15 of each year, beginning February 15, 2007. Note issuance costs of approximately $7.2 million are being amortized to interest expense over the term of the Notes and have been included in “Patents and Other Assets” on the consolidated balance sheet.
Concurrently with the issuance of the Notes, the Company entered into a convertible bond call option whereby the Company has options to purchase up to 7.96 million shares, subject to anti-dilution adjustments similar to those contained in the Notes, of the Company’s common stock at a price of $28.2829 per share. These options expire on August 15, 2011 and must be settled in net shares. The cost of the convertible bond call option was approximately $46.1 million and has been recorded as a reduction to stockholders’ equity in accordance with Emerging Issues Task Force Issue No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock,” (“EITF 00-19”.)
In addition, the Company sold warrants to purchase up to 7.96 million shares of its common stock at a price of $32.9248 per share. The warrants expire on various dates from August 16, 2011 through the 104th scheduled trading day following August 16, 2011, and must be settled in net shares. The Company received approximately $30.3 million in cash proceeds for the sales of these warrants and has been recorded as an increase to stockholders’ equity in accordance with EITF 00-19.
(6) Strategic Investments
As of December 31, 2006 and December 31, 2005, the adjusted cost of the Company’s strategic investments totaled $22.7 million and $11.9 million, respectively. The Company’s strategic investments include public and non-public companies. In 2006, the Company invested $5.0 million in a privately-held digital watermarking company for strategic purposes. As of December 31, 2006, the adjusted cost of the Company’s strategic investments consisted of its investment in Digimarc, a publicly traded company, and its investment in the privately-held digital watermarking company. The Company holds investments in other privately held companies, which had no carrying value as of December 31, 2006. The investments in Digimarc and the digital watermarking company have been classified on the balance sheet as “Long-term marketable investment securities” and “Prepaid expenses and other current assets,” respectively.
There were no impairment charges related to the Company’s strategic investments during the year ended December 31, 2006. During the years ended December 31, 2005 and 2004, the Company recorded other-than temporary impairment losses of $5.8 million and $5.3 million, respectively, on its investment in Digimarc.
The Company received $174,000 and $1.2 million during the years ended December 31, 2005 and 2004, respectively, in cash for its interest in InterActual Technologies, the assets of which were acquired by a third party during the year ended December 31, 2004. In fiscal year 2001, this strategic investment had been fully impaired. Accordingly, during the years ended December 31, 2005 and 2004, the Company recorded gains on strategic investments of $174,000 and $1.2 million, respectively.
(7) Recent Accounting Pronouncements
In June 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109” which is effective for fiscal years beginning after December 15, 2006. This interpretation was issued to clarify the accounting for uncertainty in income taxes recognized in the financial statements by prescribing a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The Company is evaluating the impact of this pronouncement on its financial statements.
In September 2006, the FASB issued Statement No. 157, “Fair Value” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 is effective in 2008. The Company is evaluating the impact of this pronouncement on our financial statements.
(8) Equity-based Compensation
Stock Options
Currently, the Company grants options from the 2000 Equity Incentive Plan (“2000 Plan”) and the 1996 Directors Stock Option Plan (the “Directors Plan”). The 2000 Equity Incentive Plan succeeded the 1996 Equity Incentive Plan (“1996 Plan”) in August 2000.
As of December 31, 2006, the Company had 18.6 million shares reserved and 4.8 million shares remained available for issuance under the 2000 Plan and 1996 Plan. The 2000 Plan provides for the grant of stock options, stock appreciation rights, and restricted stock awards by the Company to employees, officers, directors, consultants, independent contractors, and advisers of the Company. The 2000 Plan permits the grant of either incentive or nonqualified stock options at the then current market price. Option vesting periods are generally three years under the 2000 Plan where one-sixth vests in the first year, one-third vests in the second year and one-half vests in the third year. Option grants have contractual terms ranging from five to ten years. In 2006, the Company’s stockholders approved the amendment of the 2000 Plan to increase the number of shares reserved for issuance by 5.0 million shares.
As of December 31, 2006, the Company had 1.0 million shares reserved under the Directors Plan and 0.3 million shares remained available for issuance. The Directors Plan provides for the grant of stock options to non-employee directors of the Company. The Directors Plan permits the grant of nonqualified stock options at the then current market price. Option vesting periods are generally one year under the Directors Plan. Option grants have terms ranging from five to ten years.
The Company recorded $16.3 million of compensation expense relative to stock options during the year ended December 31, 2006.
Restricted Stock
In November 2005, the Company’s compensation committee of the board of directors approved the issuance of 340,975 shares of restricted stock, at an intrinsic value of $15.61 per share, to certain executives and key employees under the 2000 Plan. In 2006, the Company’s compensation committee of the board of directors approved the issuance of 527,950 shares of restricted stock at a weighted average intrinsic value of $21.50 per share to certain executives and key employees under the 2000 Plan. In 2006, 66,270 shares vested and 129,875 shares were forfeited. As of December 31, 2006, 672,780 unvested restricted shares are outstanding. Restricted stock generally vests over four years.
The Company recorded $3.0 million of compensation expense relative to restricted stock during the year ended December 31, 2006.
Employee Stock Purchase Plan
The Company’s 1996 Employee Stock Purchase Plan (the “ESPP”) allows eligible employee participants to purchase shares of the Company’s common stock at a discount through payroll deductions. The ESPP consists of twenty-four-month offering periods with four six-month purchase periods in each offering period. Employees purchase shares in each purchase period at 85% of the market value of the Company’s common stock at either the beginning of the offering period or the end of the purchase period, whichever price is lower.
As of December 31, 2006, the Company had reserved 4.3 million shares of common stock for issuance under the ESPP and 2.6 million shares remained available for future issuance.
The Company recorded $2.9 million of compensation expense relative to the ESPP during the year ended December 31, 2006.
As a result of adopting SFAS 123(R), the Company’s income before taxes, net income and basic and diluted earnings per share for the year ended December 31, 2006 were reduced by the amounts shown below (amounts in thousands except share data):
The adoption of SFAS 123(R) did not have a significant impact on the Company’s cash flows during the year ended December 31, 2006.
The following table sets forth the pro forma amounts of net income and net income per share, for the years ended December 31, 2005 and 2004, that would have resulted if the Company had accounted for its employee stock plans under the fair value recognition provisions of SFAS 123 (amounts in thousands except share data):
Valuation and Assumptions
The Company uses the Black-Scholes option pricing model to determine the fair value of stock options and employee stock purchase plan shares. The fair value of equity-based payment awards on the date of grant is determined by an option-pricing model using a number of complex and subjective variables. These variables include expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rate and expected dividends.
Estimated volatility of the Company’s common stock for new grants is determined by using a combination of historical volatility and implied volatility in market traded options. For grants prior to January 1, 2006, the estimated volatility was based only on historical volatility. The expected term was determined by analyzing past option experience. The risk-free interest rate used in the option valuation model is from U.S. Treasury zero-coupon issues with remaining terms similar to the expected term on the options. The Company does not anticipate paying any cash dividends in the foreseeable future and therefore uses an expected dividend yield of zero in the option valuation model. In accordance with SFAS 123(R), the Company estimates forfeitures at the time of grant and revises those estimates in subsequent periods if actual forfeitures differ from those estimates. The Company uses historical data to estimate pre-vesting option forfeitures and record equity-based compensation expense only for those awards that are expected to vest. All equity-based payment awards granted after January 1, 2006 are amortized on a straight-line basis, net of expected forfeitures, over the vesting periods. In prior year periods, the Company applied accelerated amortization of equity-based compensation and will continue to do so for the remaining terms of these prior option grants.
The assumptions used to value equity-based payments are as follows:
Prior to the adoption of SFAS 123(R), tax benefits resulting from the exercise of stock options and disqualifying dispositions were presented as operating cash flows on our condensed consolidated statement of cash flows. SFAS 123(R) requires the benefits of tax deductions in excess of recognized compensation expense, which has been calculated using the “long-haul” method, to be reported as a financing cash flow, rather than as an operating cash flow. This requirement reduces net operating cash flows and increases net financing cash flows. However, total cash flow remains unchanged from what would have been reported under prior accounting rules. During the year ended December 31, 2006, $33.8 million was paid to the Company for options exercised with an associated tax benefit of $0.8 million.
As of December 31, 2006, there was $25.3 million of unrecognized compensation cost, adjusted for estimated forfeitures, related to non-vested equity-based payments granted to employees. Total unrecognized compensation cost will be adjusted for future changes in estimated forfeitures and is expected to be recognized over a weighted average period of 3.3 years.
Activity under the Company’s stock option plans are as follows:
The weighted average fair value of options granted during the years ended December 31, 2006, 2005 and 2004 was $7.21, $7.49 and $9.35, respectively. The weighted average grant date fair value of an employee purchase share right granted during the years ended December 31, 2006, 2005 and 2004 was $4.80, $9.67 and $9.93, respectively. The total intrinsic value of options exercised during the years ended December 31, 2006, 2005 and 2004 was $11.4 million, $3.6 million and $8.1 million, respectively.
(9) Stock Repurchase Program
In May 2002, the Board of Directors authorized a stock repurchase program, which allowed the Company to purchase up to 5.0 million shares in the open market from time-to-time at prevailing market prices, through block trades or otherwise, or in negotiated transactions off the market, at the discretion of Company management. In 2002, the Company repurchased 3.0 million shares of common stock under this program, which was recorded as treasury stock and resulted in a reduction of stockholders’ equity. In August 2006, the Board of Directors authorized the purchase of up to $100.0 million of the Company’s common stock (inclusive of the aforementioned stock repurchase program and up to $50.0 million of the Company’s common stock in connection with the Notes offering described in Note 5-Convertible Notes.) In August 2006, the Company repurchased 2.3 million shares of common stock for $50.0 million, which was recorded as treasury stock and resulted in a reduction of stockholders’ equity. As of December 31, 2006 and 2005, treasury stock consisted of 5.3 million and 3.0 million shares, respectively, of common stock that the Company had repurchased, with a cost basis of approximately $88.4 million and $38.5 million, respectively.
(10) Income Taxes
The components of income before income taxes are as follows (in thousands):
Income tax expense for the years ended December 31, 2006, 2005 and 2004 consisted of the following (in thousands):
Income tax expense included charges in lieu of tax relating to stock option exercises of $0.8 million, $1.8 million and $3.9 million, for the years ended December 31, 2006, 2005 and 2004, respectively.
Income tax expense for the years ended December 31, 2006, 2005 and 2004 differed from the amounts computed by applying the U.S. federal income tax rate of 35% to pretax income as a result of the following (in thousands):
The tax effects of the temporary differences that give rise to significant portions of the deferred tax assets and liabilities are presented below (in thousands):
As of December 31, 2006, the Company had a valuation allowance of $5.1 million, $3.7 million of which related to deferred tax assets for capital loss carryforwards and $1.4 million related to foreign loss carryforwards for which sufficient uncertainty existed regarding its ability to recognize these deferred tax assets. During 2006, the Company released a $4.9 million valuation allowance on deferred tax assets related to acquisitions, concluding that it was more likely than not that these deferred tax assets would be realized, and reduced goodwill previously recorded for the acquisitions.
As of December 31, 2006, the Company had federal tax loss carryforwards of approximately $25.7 million, of which $7.9 million related to stock option deductions and are not included in deferred tax assets. The federal loss carryforwards will expire in 2012 through 2025. The Company has state net operating loss carryforwards of approximately $14.8 million as of December 31, 2006 of which $1.5 million are related to stock option deductions and are not included in deferred tax assets. The state loss carryforwards will expire in 2007 through 2015. Utilization of state and federal net operating loss carryforwards may be subject to limitations due to ownership changes.
On October 22, 2004, the American Jobs Creation Act (“AJCA”) was signed into law. The AJCA introduced a limited time 85% dividends received deduction on the repatriation of certain foreign earnings. In the fourth quarter of 2005, Macrovision’s foreign subsidiaries distributed $65 million to Macrovision Corporation. The distribution increased the provision for income taxes by $2.3 million and income taxes payable by $4.1 million. Except for the items described previously, U.S. income taxes have not been provided for approximately $39.0 million of cumulative undistributed earnings of non-U.S. subsidiaries. The Company intends to reinvest these earnings indefinitely in operations outside of the U.S.
The Company’s federal tax returns for tax years 2003 and 2004 are under examination by the Internal Revenue Service. The Company believes that adequate amounts of tax reserves have been provided for such years based on currently available information.
(11) Segment and Geographic Information
The Company has two reportable segments: Entertainment Technologies and Software Technologies. Entertainment Technologies licenses digital content value management technology to video, music, and PC games content owners. The Entertainment Technologies products include content protection and rights management solutions for optical discs; videocassettes; digital set top boxes for cable/satellite TV; a variety of PC and consumer electronics video playback and record devices; digital distribution services for games; and peer-to-peer networks. The Video product group includes content protection and rights management solutions for optical discs, videocassettes and digital set top boxes. The Other product group of Entertainment Technologies includes content protection and rights management solutions for PC and consumer electronics video playback and record devices, digital distribution services for games and peer to peer networks. The Software Technologies products include the FLEXnet licensing platform, the InstallShield and Zero G suites of software installation, repackaging, and update solutions and the eMeta software solutions enabling companies to manage and sell digital goods online.
The accounting policies of the reportable segments are the same as those described in Note 1-The Company and Summary of Significant Accounting Policies. With the exception of goodwill, the Company does not identify or allocate its assets by operating segment. See Note 4-Goodwill and Other Intangibles from Acquisitions for the allocation of goodwill by reportable segment.
Revenue by Significant Product Group:
Segment income:
Segment income is based on the reportable segment’s revenue less the respective segment’s cost of revenues, selling and marketing expenses and research and development expenses. The following table summarizes operating results for each reportable segment and further reconciled to pretax income (in thousands):
Information on Revenue by Geographic Areas:
Geographic area information is based upon country of destination for products shipped and country of contract holder for royalties and license fees.
Information on Long Lived Assets by Geographic Areas:
(12) Commitments and Contingencies
Lease Commitments
The Company leases its facilities and certain equipment pursuant to noncancelable operating lease agreements expiring through 2017. The Company leases its facilities and certain equipment pursuant to noncancelable operating lease agreements expiring through 2017. The Company’s corporate headquarters are located in Santa Clara, California and such leases expire in January 2017. The Company also leases office space, including those located in Illinois, New York, the United Kingdom and Japan, which expire at various dates from 2009 through 2016. The Company has recorded rent expense on a straight-line basis based on contractual lease payments. Allowances from lessors for tenant improvements have been included in the straight-line rent expense for applicable locations. Tenant improvements are capitalized and depreciated over the remaining life of the applicable lease. The Company also leases certain computer software under a capital lease agreement which expires on March 1, 2009. The current and long-term portions of the capital lease have been recorded in “Accrued expenses” and “Other non current liabilities,” respectively, on the consolidated balance sheet as of December 31, 2006. Amortization of assets recorded under the capital lease is included in depreciation expense.
Future minimum lease payments pursuant to these leases as of December 31, 2006 were as follows (in thousands):
Rent expense was $6.1 million, $5.9 million, and $5.4 million for the years ended December 31, 2006, 2005, and 2004, respectively.
Indemnifications
In the normal course of business, the Company provides indemnifications of varying scope to customers against claims of intellectual property infringement made by third parties arising from the use of the Company’s products. Historically, costs related to these indemnification provisions have not been significant and the Company is not able to estimate the maximum potential impact of these indemnification provisions on our future results of operations.
Restricted Cash and Investments
For one product, the Company has offered a maximum indemnity of $12.0 million to a collective group of customers under current contracts. Funds totaling $12.0 million have been segregated from the rest of the Company’s cash and investments and is restricted to use for customer claims under such indemnification provisions. (See Note 1.)
Employee Benefit Plans
The Company has a 401(k) plan that allows eligible employees to contribute up to 100% of their compensation, which contribution was limited to $15,000 in 2006 and $14,000 in 2005. Employee contributions vest immediately. The Company is not required to contribute to the 401(k) plan, but has made discretionary contributions. The Company made matching contributions to the 401(k) plan equal to 20% of each participating employee’s contribution, up to a maximum annual matching contribution of $3,000, $2,800, and $2,600 in 2006, 2005, and 2004, respectively. For employees 50 years of age or older, the contribution limit was $20,000 in 2006 and $18,000 in 2005. The Company’s maximum annual matching contribution for employees age 50 and older was $4,000 in 2006 and $3,600 in 2005.
Legal Proceedings
The Company has not been required to pay a penalty to the Internal Revenue Service (“IRS”) for failing to make disclosures required with respect to any transaction that has been identified by the IRS as abusive or that has a significant tax avoidance purpose.
The Company is involved in legal proceedings related to some of our intellectual property rights.
USPTO Interference Proceedings Between Macrovision Corporation and Intertrust Technologies
A patent interference is declared by the United States Patent and Trademark Office (“USPTO”) when two or more parties claim the same patentable invention. In the United States, the party who can prove earliest inventorship is granted the patent.
The Company received notice on September 4, 2003 that the USPTO had declared an interference between our U.S. Patent No. 5,845,281 (“the ‘281 patent”) together with two of our continuation applications, and a patent application from Intertrust Technologies Corporation (“Intertrust”). On or about December 28, 2005, the Board of Patent Appeals (“BPA”) issued its final ruling in the case, holding that the ‘281 patent had priority over the two Intertrust patent applications at issue, but also that the inventor of the ‘281 patent had committed inequitable conduct during the prosecution of that patent. As a result of this decision, the Company’s ‘281 patent was rendered unenforceable.
On December 19, 2003, the Company received notice from the USPTO declaring another interference, this time between two of its patent applications and four of Intertrust’s patents. On or about April 11, 2005, the BPA issued its final ruling, holding that the Intertrust patents had priority over the Company’s two applications at issue.
Intertrust and Macrovision filed lawsuits on July 28, 2006 and July 31, 2006, respectively, in the U.S. District Court for the Northern District of California against the other party, seeking to overturn the BPA’s rulings adverse to the parties in the two interference proceedings. The parties are engaged in discovery.
The Company has a family of international patents and patent applications related to the U.S. cases involved in the interference. The U.S. patent interference affects only U.S. patents and U.S. pending patent applications, not the international cases which have been granted or are proceeding to grant in Europe and Japan.
Macrovision Corporation. vs. Sima Products Corporation and Interburn Enterprises, Inc.
On June 14, 2005, the Company filed a lawsuit in the Southern District of New York against Sima Products Corporation and Interburn Enterprises, Inc., alleging that both companies manufacture, distribute or sell products that infringe its patented copy protection technology and also violate the U.S. Digital Millennium Copyright Act of 1998. The patents involved are: United States Patent No. 4,631,603 entitled “Method and apparatus for
processing a video signal so as to prohibit the making of acceptable videotape recordings thereof,” and U.S. Patent No. 4,819,098 entitled “Method and apparatus for clustering modifications made to a video signal to inhibit the making of acceptable videotape recordings.” Interburn has entered into a stipulated judgment whereby it has agreed not to further distribute its products. On April 20, 2006, the Company was granted a preliminary injunction preventing Sima from distributing the products at issue in the lawsuit. On or about June 12, 2006, Sima filed an emergency motion with the United States Second Circuit Court of Appeals, asking that the injunction be stayed pending an appeal of the District Court’s issuance of the injunction. The emergency motion was denied by the Court of Appeals on or about August 26, 2006, resulting in the injunction being re-instated after it was stayed pending such motion. In February 2007, the parties resolved this dispute and Sima agreed to enter into a stipulated judgment whereby Sima has agreed not to further manufacture or sell the products at issue in the lawsuit and to pay the Company an undisclosed sum as settlement for its infringement of our patents.
InstallShield Software Corporation Liquidating Trust vs. Macrovision
On October 27, 2005, the Company received notice of an arbitration proceeding filed by InstallShield Software Corporation Liquidating Trust (the “Trust.”) The Trust has demanded arbitration of certain disputes between the Trust and Macrovision pursuant to the Asset Purchase Agreement dated June 16, 2004 by and among InstallShield Software Corporation, Macrovision Corporation, Macrovision Europe Limited, and Macrovision International Holding L.P. (the “Agreement”). Under the Agreement, the Company could have been required to make an additional contingent payment of up to $20 million based on post-acquisition revenue performance through June 30, 2005. Based upon the revenue results through June 30, 2005, the Company concluded that no additional payment was required under the terms of the Agreement. The Trust alleges that the post-acquisition revenue performance targets were not reached due to the Company’s conduct in violation of the Agreement, and therefore is seeking the contingent payment in an amount exceeding $15 million. The Company denies these allegations and intends to vigorously defend itself in the arbitration proceeding. The parties are engaged in discovery and no date has yet been set for the hearing.
Macrovision vs. Wise Solutions, Inc. and Altiris Inc.
On November 21, 2006, the Company filed a lawsuit in the United States District Court for the Northern District of California against Wise Solutions, Inc. and Altiris, Inc., alleging infringement of two of our patents. The patents involved are: U.S. Patent No. 5,671,412 entitled “License Management System for Software Applications” and U.S. Patent No. 5,390,297 entitled “System for Controlling the Number of Concurrent Copies of a Program in a Network Based on the Number of Available Licenses.” The lawsuit further alleges Wise and Altiris tortiously interfered with Macrovision’s economic relationships with its customers and seeks a declaratory judgment from the court that Macrovision does not infringe Wise’s U.S. Patent No. 7,028,019 (“the ‘019 patent”). On January 5, 2007, the defendants counterclaimed, alleging that Macrovision’s products infringe both the ‘019 patent and Altiris’ U.S. Patent No. 7,065,566. The Company denies these allegations and intends to vigorously defend itself in this litigation.
Stock Option Inquiries
In addition to the aforementioned intellectual property litigation matters, on June 13, 2006 and June 28, 2006, the Company announced that it had been contacted by the Securities and Exchange Commission (SEC) and had received a subpoena from the U.S. Attorney’s Office, respectively, each requesting information relating to the Company’s stock option practices. By letter dated October 24, 2006, the SEC informed the Company that its investigation into the matter has been terminated without enforcement action being recommended to the Commission. By letter dated January 11, 2007, the U.S. Attorney’s Office informed the Company that it withdrew its subpoena. The Internal Revenue Service has requested information relating to the Company’s stock option granting practices in connection with its current examination of the Company’s 2003 and 2004 federal tax returns. The Company believes that the findings of this review of stock option practices has no material impact on the financial statements included in this report or on any previously issued financial statements.
As of December 31, 2006, for all the abovementioned matters, it was not possible to estimate the liability, if any, in connection with the pending matters. Accordingly, no accruals for these contingencies have been recorded.
From time to time, the Company has been involved in other disputes and legal actions arising in the ordinary course of business. In management’s opinion, none of these other disputes and legal actions is expected to have a material impact on the Company’s consolidated financial position, results of operations or cash flows.
(13) Unaudited Quarterly Consolidated Financial Data
(1) In October 2005, our board of directors approved a restructuring program, which included a worldwide workforce reduction and restructuring of certain business functions. We recorded a charge of $2.5 million during 2005.
(2) During the fourth quarters of 2006 and 2005, our effective tax rate increased as a result of an increase in the foreign tax differential on profits generated by our foreign operations. In addition, during the fourth quarter of 2005, our effective tax rate increased due to tax charges arising from the distribution of foreign earnings under the American Jobs Creation Act of 2004.
(14) Subsequent Events
Acquisitions
In January 2007, the Company acquired Mediabolic, Inc. (“Mediabolic”), a privately-held company based in San Mateo, California, for cash consideration of $43.5 million. Mediabolic is a provider of software solutions for connected consumer electronics devices, such as televisions, set-top boxes and digital video recorders. The acquisition of Mediabolic extends the Company’s capabilities in the delivery and enhancement of digital content to a wide variety of connected consumer electronics devices for the digital home. As of December 31, 2006, $40.2 million of such cash consideration was delivered to the paying agent for payment to Mediabolic stockholders upon the closing of the transaction.
Restructuring
In January 2007, the Company’s board of directors approved a restructuring program, which includes a workforce reduction and restructuring of certain business functions. The workforce reduction is expected to result in a charge of $2.0 million. All affected employees will be notified of their termination prior to March 31, 2007. In addition to the workforce reduction, the Company expects to record a charge of approximately $1.0 million on losses related to leases on abandoned facilities and assets.