Item 1. BUSINESS
Overview
We develop and market computer based tools:
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for creating digital audio and video titles in the CD-Audio and DVD-Video formats (and in related formats);
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for recording data files on CD recordable or DVD recordable disks in the CD-ROM and DVD-ROM formats; and
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for backing up the information contained on hard disks attached to computers.
Most of the products we sell consist entirely of computer software, though some of the tools we sell include “plug-in” computer hardware. We also license the software technology underlying our tools to other companies to incorporate in products they develop.
We divide our products into three categories:
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Professional Audio and Video Products - Our professional products consist of advanced DVD-Video creation tools which are intended for use by high-end professional customers. We sell a number of products in this category including DVD Creator (Macintosh based), Sonic Scenarist (Windows based), DVD Producer (Windows based), DVD Fusion (Macintosh based) and ReelDVD (Windows based). These products include elaborate applications software and, in some cases, plug-in hardware. Our customers use our professional products to prepare commercial quality DVD-Video titles, in many cases destined for mass replication and release to home video consumers.
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Desktop Products - Our desktop products include software-only DVD-Video creation tools and DVD-Video playback software intended for use by lower end professionals, by enthusiasts or “prosumers,” and by consumers. Our desktop products also include software-only CD-Audio, CD-ROM and DVD-ROM making tools, as well as data backup software. We sell and market these products through product bundling arrangements with OEM suppliers of related products, as well as through retail channels (both web-based and traditional “bricks and mortar” channels). We market a number of different desktop products under various trade names including RecordNow, Backup My PC, CinePlayer, DVDit! and MyDVD.
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Technology Products - This category includes software that we license to other companies for inclusion in their DVD or CD creation and recording products. We market most of this software under the trade names of AuthorScript and Primo SDK.
We often refer to our desktop products and our technology products collectively as our consumer products.
Quantities or results referred to as “to date” or “as of this date” mean as of or to March 31, 2003, unless otherwise specifically noted. References to “FY 2003” refer to the Company’s fiscal year ending on March 31 of the designated year. For example, “FY 2003” refers to the fiscal year ending March 31, 2003. References to years mean calendar years.
Please refer to our Company website at www.Sonic.com for the link to our Annual Report on Form 10-K.
DVD-Video and our Business
Many of our products involve the creation or playback of DVD-Video discs or related formats.
The DVD-Video optical disc format was introduced in 1996 and it offers high quality video, surround audio, and extensive interactivity on a Compact Disc-sized disc. DVD-Video is built upon the DVD-ROM standard, which specifies a disc capable of storing a significantly greater amount of digital information than the earlier Compact Disc format. A single-layer DVD-ROM disc holds 4.7 Gigabytes of data, while a CD-ROM holds approximately 650 Megabytes of data, or less than 15% of the capacity of the DVD format. DVD discs can be manufactured with two information layers on one side of the disc to store a total of 8.5 Gigabytes. They can also be manufactured with two information-carrying sides, for a maximum of 17.0 Gigabytes on a single disc (two sides, two layers on each side). The Compact Disc is limited to a single information layer on only one side of the disc. The DVD-Video format utilizes this large capacity to offer content publishers and video consumers a wide range of features and options:
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Video can be presented in the MPEG-1 or MPEG-2 compressed digital video format. A number of video streams may be presented in parallel so that, responding to user commands, the player may seamlessly jump from stream to stream. In the MPEG-2 format, at typical bit rates, the video will compare very favorably with broadcast “master” quality video - images will appear much better to consumers than the video they are used to seeing via TV broadcast from a standard VHS cassette tape.
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Audio can be presented in compressed digital stereo and “surround” formats. Up to eight audio streams may be presented simultaneously (and may also be selected for playback based on real-time user decisions) to support different language dialog tracks, or to allow stereo and surround versions of the same audio program. DVD titles, when presented in surround format, can give consumers the same kind of audio experience as a feature film in surround-equipped theatres.
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Chapter marks may be specified for random access into the video program. Subpictures (images overlaid on background video or still images) may be included and can be used in a number of ways, for example, to create animated “buttons” to facilitate user interaction, or to display language subtitles. Still pictures may be presented with audio and with subpictures. Extensive navigation capabilities are available to permit users to select from various program branches, to return to previous branch points or menus, etc.
Since its introduction, DVD-Video has been very popular with consumers. In fact, DVD-Video has proven to be the most rapidly adopted consumer electronics format of all time. By the end of 2002, almost 300 million DVD players were in use world-wide, including “set-top” players, video game console based players, and personal computer based players. In the United States more than 40 million homes had DVD players by the end of 2002, and during 2002 more than 650,000 billion DVD-Video discs were sold (both to end users and to companies who rent DVDs to consumers). During 2002 in the United States more than $20 billion was spent by consumers on DVD-Video discs.
Our products are used to encode video, audio and graphics elements in the particular formats supported by the DVD-Video specification, to prescribe and specify the disc navigation, that is, the interactive behavior of the DVD title in response to user commands, and then to weave or “multiplex” together the encoded elements and navigation information in the particular manner required by the DVD-Video format. Sometimes, particularly in professional settings, this process is referred to as “DVD Authoring.” In other settings, particularly in consumer settings, it is referred to as “DVD Creation.”
There are some other optical disc audio and video formats that are related to DVD-Video and that are supported by some of our products. Video CD (“VCD”) is a CD-ROM based format utilizing relatively low resolution MPEG-1 video. Super Video CD (“SVCD”) is a kind of compromise between DVD-Video and Video CD. It utilizes a CD-ROM carrier, and low-bit-rate MPEG-2 Video. DVD-Audio is a sister format to DVD-Video, emphasizing more audio-related features. To date, DVD-Audio has had only limited success, with a relatively small compatible player population (almost all of which also play standard DVD-Video discs) and only a limited number of titles (almost all of which include a standard DVD-Video title of the same content on the same physical disc).
Professional Products
We currently offer a number of professional product lines including DVD Creator, DVD Fusion, Sonic Scenarist, DVD Producer and Reel DVD. DVD Creator and DVD Fusion are designed to run on versions of the Macintosh personal computer manufactured by Apple Computer. Sonic Scenarist, DVD Producer, and Reel DVD are designed to run on personal computers equipped with versions of the Windows operating system manufactured by Microsoft Corporation.
Professional Customers
Our professional customers are mainly facilities that process and prepare audio, video and film programming and who provide DVD authoring services as part of their offering. Most of the titles authored by our professional customers involve entertainment, educational and/or business content.
Some of our professional customers are independent organizations that supply services to audio and video content holders and publishers, while some are in-house facilities that are owned by particular content holders or publishers. Our professional customers range in size from relatively small organizations with few employees to larger facilities with hundreds of employees. Among our customers are facilities that are independent, privately owned companies, as well as facilities which are part of much larger public, private, or non-profit organizations. While we have concluded corporate purchasing agreements with certain customer organizations that have multiple facilities, even within such organizations decisions to purchase and deploy our products are usually made at the facility level.
Professional DVD Production
Our tools enable professional customers to prepare DVD-Video titles. The tools we sell support some or all of the following processes:
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Video Encoding - The DVD-Video standard specifies MPEG-2 and MPEG-1 compressed digital video as the video formats to be used on DVD-Video discs. Many of our professional tools include a
hardware encoding system designed to support user control of the encoding process, and to facilitate the operation of the encoding system with standard professional video tape recorders and other typical peripherals.
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Audio Encoding - Our tools include the ability to encode audio into the formats supported by DVD-Video, including compressed formats such as MPEG-2 and Dolby Digital as well as uncompressed PCM audio. Many of our tools include a hardware encoding system which speeds the encoding process and permits encoding of advanced audio formats such as Dolby Digital 5.1 “surround” audio.
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Format Authoring - Our tools enable the customer to combine and organize individual compressed video, audio, graphics, still picture and subpicture elements along with navigation instructions specifying interactivity (i.e., the response a DVD disc will make based on user manipulation of DVD player front panel or remote control buttons). The output of the authoring step is an “asset list,” containing each of the individual elements, and a “script” describing how the assets are combined and accessed via user commands. Because of the large number of potential elements in a DVD title and the high level of interactivity possible, the authoring subsystem is a complex software package.
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Emulation - Our professional users require the ability to preview the results of their work before the time consuming step of producing a final output disc image. This is provided by a system that emulates the behavior of the finished disc in a player, but uses the original video, audio, picture and text elements stored on a computer’s hard disk.
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Formatting and Writing - Our tools take the output of an authoring session and then combine the navigation instructions together with the audio, video, text and graphic elements in the particular sequence required by the DVD-Video standard. This process, sometimes referred to as “multiplexing,” produces a finished DVD-Video disc image that can then be recorded to a recordable DVD disc, or to the particular tape format that can be read by the mastering systems at the replication plant that actually “cut” the disc master using high-powered lasers.
Professional Product Lines
We offer our professional products on both major PC platforms - Macintosh and Windows.
Macintosh Based Professional DVD Products: DVD Creator and DVD Fusion
We offer a range of professional DVD production tools for use on the Macintosh, under the DVD Creator and DVD Fusion trade names. Generally speaking, DVD Creator systems offer more extensive capabilities at a somewhat higher price points to more specialized professionals while DVD Fusion systems are designed for greater ease of use and are targeted at less specialized video professionals at somewhat lower price points. The two product lines share common technology and can perform most of the same functions. We offer both lines in many configurations so that customers can specify a system suited to their particular needs and style of operation.
DVD Creator
DVD Creator is a high-end professional DVD authoring system which we introduced in 1996. DVD Creator is intended for use by “Hollywood” class professionals. It offers superior audio and video encoding, a convenient and efficient workflow, and a high degree of creative control over the authoring process. It is designed to support a “mastering” model, where a piece of video content is completely finished and the main objective is to publish that content on as a DVD-Video disc. The archetypical project for DVD Creator is release of a major feature film on DVD. We also offer a number of software and some hardware options to our DVD Creator system packages.
DVD Fusion
DVD Fusion is a lower priced professional DVD authoring system. DVD Fusion is targeted at video professionals who serve corporate and multimedia applications. In most of these settings video content is sourced
and edited specifically for inclusion on a DVD-Video disc. Thus, DVD Fusion is designed to integrate with popular professional non-linear video editing systems provided by companies such as Avid and Media 100.
To date we have shipped a combined total of more than 11,000 DVD Creator and DVD Fusion systems to customers in various locations around the world.
Windows Based Professional DVD Products: Scenarist, ReelDVD, DVD Producer, DVD-Audio Creator
Scenarist
Scenarist is a tool for DVD-Video authoring targeted at “Hollywood” video professionals. Scenarist gives authoring professionals a great degree of control over the interactivity and feature set of DVD titles they produce. It offers extensive “scripting” capabilities that can be used by DVD-Video production facilities to automate much of the work involved in producing multiple versions of the same title. For example, it can be used release movie on DVD-Video that will be released in different parts of the world with different language audio and subtitle tracks. It can also be used in producing various DVD-Video titles that share a common “look and feel,” for example, a set of classic movie titles being released as part of a series.
In 2001, we acquired Scenarist which was the first commercially available DVD-Video authoring tool. It enjoys significant acceptance among high end authoring facilities. Because Scenarist’s formatting engine has the longest and broadest experience in the industry, the product is acknowledged by many professionals as the DVD-Video production industry’s “benchmark” for stable production of standard DVD-Video titles.
Generally speaking, Scenarist is targeted at the upper end of the same market targeted by DVD Creator. Since the introduction of Scenarist in 1996, to date, approximately 1,500 copies of Scenarist have been sold.
ReelDVD
ReelDVD is a DVD-Video authoring tool intended for video professionals who are not experts in the DVD-Video specification but who still need significant flexibility in utilizing the features of the DVD-Video specification. ReelDVD targets approximately the same video professional customer as DVDit!-PE (see below) or DVD Fusion.
ReelDVD is available as well in a system packaged with a hardware MPEG video encoder. In addition to selling ReelDVD to end users, we have marketed it through OEM agreements with other companies who include or “bundle” it with their products.
ReelDVD was introduced in 2000. Since its introduction, approximately 8,100 copies of ReelDVD have been shipped.
DVD Producer
DVD Producer is a new DVD-Video authoring tool which we introduced at the National Association of Broadcasters in April 2002. DVD Producer is intended for video professionals in the corporate and multimedia segments who wish to produce high quality professional-looking DVD-Video titles, but who need an easy-to-use system that supports a streamlined and efficient workflow. DVD Producer includes a number of Sonic technologies that make it unnecessary for customers to have deep knowledge of the DVD-Video specification, but still lets them author discs supporting advanced navigation capabilities consumers associate with Hollywood caliber titles.
DVD Producer is available also in a system packaged with a hardware MPEG video encoder.
DVD Producer began shipping in May of 2002. Approximately 350 copies of DVD Producer have been shipped to date.
DVD-Audio Creator
DVD-Audio is a sister format to DVD-Video. The DVD-Audio specification was developed between 1996 and 1999 by an industry group called DVD Forum in consultation with the music recording industry. The DVD Forum released Version 1.0 of the new DVD-Audio specification in April 1999. The first commercially released players compatible with the new format became available in late 1999. We announced support for this new specification in the fall of 1998, and began delivery of the first software packages supporting preliminary and limited DVD-Audio authoring early in 1999. We called this product DVD Audio Creator. In April 2001 we announced an agreement with Matsushita to integrate DVD-Audio authoring developed by them into DVD Audio Creator.
Professional DVD Market and Strategy
Market Segments for Professional DVD Production Systems
We divide the professional DVD production market into three segments:
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“Hollywood” Segment - This segment includes facilities that prepare film and video material for mass publication on DVD-Video discs. It includes:
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film and television studios,
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production companies and other content owners, and
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top flight independent video post production facilities which provide services to such content holders.
Customers in this segment tend to cluster in major film and video product centers including Hollywood/Los Angeles, New York City, Chicago, London, Paris, Tokyo, Taipei, etc. Customers in this segment demand the very highest quality in terms of processing output, strict adherence to standards, and are very concerned with the overall efficiency of production since projects are often produced on tight schedules. We estimate that there are a few thousand facilities and organizations in this segment worldwide.
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“Corporate” Segment - Customers in this segment prepare DVD-Video discs for publishing a variety of kinds of information for sales, training, and other communications purposes. The segment includes:
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“in-house” departments of corporate, industrial, non-profit or educational organizations, and
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independent facilities which specialize in assisting such organizations in preparing such material.
Customers in this segment are typically more budget constrained than customers in the “Hollywood” segment. In certain instances, however, production values and budgets equal or even exceed those typically encountered in the Hollywood segment. They tend to be geographically more dispersed. While efficiency of production is an important requirement of such customers, compatibility with other existing recording and post-production equipment is a major concern of customers in this segment. We estimate that there are potentially more than 100,000 facilities and organizations in this segment worldwide.
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“Multimedia” Segment - This segment includes developers of multimedia entertainment and educational titles intended for a mass audience. Customers in this segment tend to use DVD in conjunction with specialized computer software and accordingly their needs are more varied than those in the other segments. While relatively few organizations in this segment have moved to DVD, industry observers report a high level of interest in the DVD format. We estimate that there are approximately 15,000 organizations that might ultimately become involved in DVD-based production in this segment.
Competition
The DVD-Video format has generated significant interest among professional system suppliers. A number of companies currently provide MPEG-2 video encoding capabilities, audio encoding capabilities and authoring systems for the professional user. We believe that more companies will participate in this market in the future.
A number of companies produce products which compete with all or part of our professional product offerings. These companies include:
Adobe
Philips
Apple Computer
Pinnacle
Digital Vision
Sony
Dolby Laboratories
Toshiba
Mitsubishi
Ulead
Panasonic
A number of these companies have financial or organizational resources significantly greater than ours and/or greater familiarity with certain technologies involved in DVD pre-mastering solutions than we do.
Strategy
We expect that our professional DVD business will account for a significant portion of our overall business in the future. Our DVD strategy will continue to be based on the following elements:
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Focus on Professional Applications - Our DVD product and service offerings are focused on video and audio professionals whose primary concern is producing the highest quality DVD discs, in complete compliance with worldwide standards, with a high level of efficiency. We will continue to evolve DVD-related pre-mastering tools that are fully compatible with “industry-standard” input formats and typical professional video and audio equipment sets.
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High Performance Tools - Our DVD tools will offer professional users the highest levels of performance, both in terms of power and sophistication of processing, and in terms of maximizing production efficiency.
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Flexible Configurations - Because we market to a wide range of professional customers, we have engineered our professional products to incorporate modular audio, video and authoring subsystems to make it easy for facilities to re-arrange DVD workflow quickly, and to comply easily with changing demands of their customers. We plan to continue to implement this philosophy in future professional DVD product offerings.
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Range of Product Offerings - DVD has a number of potential uses, including applications in corporate and industrial settings, as well as in delivery of mass entertainment such as feature films, videos, and recorded music. That is why we have a broad range of professional products to meet the demands of varying professional applications and to fit the constraints of differing professional budgets.
Sales and Distribution
We sell our professional products through a field sales force in combination with a network of professional audio/video dealers. As of May 31, 2003 we employed 10 people in our field sales organization for professional products. Sales personnel are based in our headquarters office in Novato, California as well as in our offices in London (covering Europe) and in Tokyo (covering the Pacific Rim). We have other sales personnel based out of home offices in Chicago, Los Angeles, Utah, Washington and Taipei. Our field sales force includes sales managers and sales engineers. Most of our field sales personnel operate under compensation arrangements in which a substantial portion of their compensation is contingent upon performance relative to revenue targets.
The vast majority of our professional product sales involve one of our dealers. Dealers play an important role in our sales and support efforts. They stimulate demand in their regions, they prospect for and qualify potential new customers, they give product demonstrations, they close sales, and they assist in post-sale installation, training and support. Dealers very often sell peripheral equipment along with our products so that customers can obtain a complete workstation configuration from one source.
We have dealers for our professional products in most areas of the world. As of May 31, 2003, we had 51 dealers in the Americas, 44 in Europe, Africa and the Middle East and 22 dealers in the Pacific Rim. We generally do not grant contractual exclusivity to our dealers, though as a matter of practice, depending on the dealer’s territory and competence, we may maintain only one dealer in a particular region.
Recruiting and maintaining dealers can be a difficult process. Because our products are sophisticated, our dealers need to be technically proficient and very familiar with professional audio and video production work. Dealer organizations sometimes have limited financial resources, and may experience business reversals for reasons unrelated to our product lines. The attractive dealers in a region may also carry competing products.
Customer Support
Customer support is important to professional users. This is why we offer our customers the SonicCare™ maintenance program. Customers purchase annual SonicCare service contracts from us that may (depending on customer choice of options) provide for:
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ongoing software upgrades,
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telephone support,
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“swap” replacement hardware in case of hardware failure, and
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preferential access to new products and new versions of software.
Customers typically add a SonicCare option to their initial system purchase and a significant portion of customers renew SonicCare after their first year.
To administer SonicCare, we employ a staff of product support specialists at our Novato headquarters and in our field offices. We provide unlimited telephone support during scheduled support hours to all customers under SonicCare. Customer support calls also provide us with an important means of understanding customer requirements for future product enhancements. We also undertake customer calling programs in which customers are contacted by a customer support representative to assess their level of satisfaction and to acquaint them with new product offerings.
Outlook
While we expect our professional DVD creation products to continue to account for a significant portion of our revenues in the future, we do not expect this business to experience revenue growth in the near term. Professional DVD facilities began equipping to prepare DVD titles as early as 1997, and significant expansion of DVD creation capacity occurred during 1998, 1999 and 2000. While the number of DVD discs replicated will continue to grow in future years, we do not expect that the number of titles published will expand as dramatically, hence we do not expect increases in the rate of capacity expansion by DVD production facilities. This means that we do not expect significant increases in sales of our professional DVD creation products.
Professional Audio Products - SonicStudio Spin Off
For a number of years we developed and marketed a line of professional audio workstations under the SonicStudio trade name. On March 21, 2002, we executed an agreement to form a new company, SonicStudio LLC in partnership with a limited liability corporation controlled by two individuals - Eric Jorde and
Jeff Wilson. Under the terms of the agreement, we transferred our SonicStudio workstation business to SonicStudio LLC, and licensed them to utilize the technology underlying SonicStudio in the professional audio workstation market. The book value of net assets and liabilities transferred to the SonicStudio LLC, including receivables, inventory, fixed assets, and net of customer service liabilities was $235,661. Certain employees transferred from Sonic to join the SonicStudio LLC.
Under the terms of the agreement, SonicStudio LLC compensated us for the Sonic Studio business with a three year note for $500,000. The note, which does not carry interest, will be repaid to us with a percentage royalty based on sales received by SonicStudio LLC, plus any share of profits paid by them to us. Once the note is retired, Sonic will continue to retain a 15% interest in SonicStudio LLC.
As the present time, the book value of our investment in SonicStudio LLC is $68,897. We understand that the market for professional audio workstations designed for use by CD mastering engineers in the recording industry (the segment addressed by the SonicStudio product line) is currently quite depressed. If the business prospects for SonicStudio LLC deteriorates, we may find it necessary to write down the value of our investment in SonicStudio LLC, possibly to zero.
Desktop Products
Our desktop products are software tools that permit customers to combine audio, video and graphic elements to make regulation DVD-Video, DVD-ROM, CD-ROM, CD-Audio and Video CD discs. They also permit customers to play back DVD-Video discs on their computers, and to backup their PC data onto disc and tape backup devices. At the present time, we offer our desktop products under a variety of trade names, including RecordNow, Backup My PC, CinePlayer, DVDit! and MyDVD.
Recent Acquisitions
Ravisent License Agreement - CinePlayer, etc.
On May 24, 2002, we entered into an agreement with Axeda, under which Axeda licensed Ravisent’s DVD player software and other digital media technologies to us. Under the agreement, we paid Axeda a one-time fee of $2 million for the license and related agreements, and in return we obtained exclusive rights to deploy the Ravisent technologies in the personal computer market. As part of this agreement we acquired a revenue generating business, fixed assets, developed software and engineering employees.
We market the DVD player we acquired from Ravisent under the Sonic CinePlayer tradename. CinePlayer turns a Windows PC equipped with a device capable of reading a DVD-ROM into the full-featured DVD player.
Veritas DMD Acquisition - RecordNow, Backup My PC
On December 18, 2002, we acquired the business of the VERITAS Desktop Mobile Division (“DMD”) from VERITAS. DMD sold personal computer based CD-ROM, CD-Audio and DVD-ROM mastering software and personal computer backup software.
We acquired all the software and other intellectual property of VERITAS required to carry on development and marketing of products sold by the DMD business, and we assumed essentially all of the DMD business’s outstanding customer contracts and other contracts. Almost all the employees of the DMD business (approximately 40 individuals) joined Sonic. We also entered into a sublease agreement with VERITAS for the principal offices of the DMD business.
We issued 1,290,948 shares of Series F preferred stock, all of which has been converted into 1,290,948 shares of our common stock. We also provided registration rights for these shares.
The two principle end user products of the DMD business are RecordNow and Backup MyPC. RecordNow is a line of CD/DVD mastering software applications. Using RecordNow, users can transfer audio and data to recordable CDs or DVDs. Data is written in standard ISO-9660 or UDF formats, making the disc readable on virtually any computer system. Audio is written in standard CD-Audio format, making the discs produced playable on virtually every CD-Audio player in the world. We offer RecordNow in different versions, including a basic version intended for bundling with CD recorders and DVD/CD recorders, as well as an advanced version, RecordNow Max, intended for sale at retail. The enhanced version incorporates various additional features, for example, the ability to encode audio in the MP3 format for use in compatible players.
Backup MyPC is a data backup software application designed to assist computer users with preserving their valuable computer data in the event of a hardware failure or user error. Backup MyPC allows users to create backup discs or tapes, and to restore data to their PCs either selectively, or for a complete system restoration. The application incorporates a number of features to assist users in making backups an automatic process, and for making the backup process easier for users to deal with. We offer Backup MyPC in two versions: Simple Backup, which includes a limited feature set and which is oriented toward PC and drive OEMs who wish to bundle the software; and Backup MyPC, which includes a full feature set and is oriented toward retail purchasers.
DVD Creation Desktop Products
DVDit!
In April 1999 we introduced DVDit! - a simplified DVD-video creation tool.
DVDit! Positioning
DVDit! is designed to permit easy authoring of fully spec-compliant DVD titles by customers who do not have extensive knowledge of the DVD spec, and whose projects do not require the same specialized features required by “Hollywood” professional users. DVDit! is positioned to be purchased by consumers, “prosumers” and “desktop” professionals. We currently offer three different versions of DVDit!: DVDit!-LE (“Limited Edition”); DVDit!-SE (“Standard Edition”); and DVDit!-PE (“Professional Edition”).
DVDit! Customers
DVDit! is intended to address the needs of a broad range of customers who wish to create DVD-Video discs. Among DVDit!’s end user customers are:
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Consumers - Individuals who use DVDit! to make DVD-Video discs from home videos and the like for their personal enjoyment. We believe that this group of customers demands software that is easy to learn, and is reasonably priced.
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Prosumers - The term “prosumer” describes both video enthusiasts who make a significant investment of time and money in producing and preparing amateur videos, and professional and business people who use video in their work, but for whom video production is not a primary business activity. Compared to consumers, this customer group tends to be less price sensitive, and more concerned about a rich feature set, but is unlikely to have deep knowledge of DVD-Video.
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Desktop Professionals - This group of customers resembles in some ways the professional customers we described in discussing our professional products, except that they typically do not have frequent or constant use for DVD-Video authoring tools, and may not need some “Hollywood” level features.
MyDVD
We introduced MyDVD in the fall of 2000. MyDVD is specifically designed as a DVD creation tool for use by consumers.
MyDVD Positioning
MyDVD is designed to permit easy authoring of DVD titles by consumers who have virtually no knowledge of the DVD specification, but who wish to turn their videos into professional looking DVD titles. We currently offer three versions of MyDVD: a Bundle Version; MyDVD Plus and MyDVD Video Suite.
In late 2000 we first announced MyDVD and started shipping the product in November 2000. The initial version of MyDVD resembled DVDit! (but with a simplified feature set and user interface). In the summer of 2001 we introduced a new version of MyDVD with a significantly modified user interface and a feature set specifically designed for consumer use. Our belief is that as DVD recorders become widely available, consumers will begin to utilize DVD recording for a number of purposes, such as recording favorite home videos, recording favorite video broadcasts, creating highly convenient and portable copies of videos downloaded from the internet, and for copying videos published on VHS cassette or DVD. We do not advocate violation of copyright laws by our customers. None of our products contain software designed to circumvent the operation of encryption or other protection systems (for example the “CSS” encryption system commonly used by DVD-Video publishers to prevent digital copying of their published video content.)
Desktop Product Strategy
Our Desktop products are intended to take advantage of a number of trends in the PC and consumer electronics industries:
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Rapid Growth in DVD Playback Units - By the end of 2002, nearly 300 million DVD-Video playback units (including set-top players, game console based players and PCs equipped with
DVD readers) had been shipped worldwide. Industry observers expect that DVD players of all types will continue to be widely adopted with shipments of more than 200 million playback units expected to occur in 2003.
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Proliferation of MPEG Video Encoding on PCs - Due to certain introductions by chip and software makers, and a dramatic increase in the speed of standard PCs, relatively high quality real time MPEG encoding systems (some in hardware, some in software) are becoming widely available at very reasonable prices.
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Ubiquitous Digital Video - Relatively high quality digital video camera/recorders based on the DV format were introduced in the past three years aimed at professionals as well as consumers. Prices for consumer DV cameras began declining below $1,000 during 2000 and below $500 in 2001.
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Availability of Lower Cost DVD Recording; Mass Adoption of DVD-Recorders - Until recently DVD recorders were relatively highly priced. In early 2001, the first of a new generation of PC-attached DVD recorders was introduced by Pioneer at “street” prices under $1,000. Other manufacturers introduced DVD recorders during the rest of 2001, throughout 2002, and into 2003 and we expect new recorder introductions will continue for the balance of the current year and throughout 2004. We estimate that the average price for PC-attached DVD recorders was as low as $400 in calendar year 2002 (compared with an average price of around $700 in 2001), and we have already seen end user prices fall further this year. We anticipate that shipments of PC-attached DVD recorders will grow from approximately 4 million units in 2002 to over 10 million, and perhaps as many as 15 to 20 million units in 2003. These estimates are derived from DVD recorder manufacturer-level data - that is, they track shipments from the plants at which the DVD recorders are assembled. When we speak of DVD recorders we mean recording devices capable of producing highly compatible discs. By “compatible” we mean discs that can be played in standard living room set-top DVD players. This means that we exclude from our discussion disc formats such as DVD-RAM which, although it can be used to record video, does not result in a disc playable on most set-top DVD players. We do include in our discussion the DVD-RW and DVD+RW formats, both of which produce discs that are highly likely to be playable on standard DVD players. Note that virtually all PC attached DVD recorders are also CD recorders.
Based on these trends, we believe that manipulation of digital video, along with other digital media types such as digital audio, on PCs will become an important activity for many consumers. We believe that the availability of low cost DVD recording capabilities will accelerate this trend. DVDit! and MyDVD are designed to serve the needs of general consumers who require easy-to-use DVD creation software. The Ravisent and DMD products are intended to accompany our DVD creation products to form a suite of digital media software tools enabling a satisfactory consumer experience.
Sales and Distribution for Desktop Products
As of May 31, 2003, we had 12 sales and marketing professionals responsible for our Desktop Products, located at our headquarters in Novato as well as in field and home offices in various locations around the world. These professionals plan the development “road map” for our products, develop marketing materials to position the products, and develop and conclude agreements with the various channel partners we utilize to reach end users for our products.
We distribute our Desktop Products through four main channels: “bundling” arrangements with other companies; web store sales; specialized dealers and traditional “bricks and mortar” computer and electronics retail stores.
We believe that the vast majority of consumers will first become aware of DVD creation software when they purchase a video device, for example a CD recorder, video input plug-in card, or, especially, a DVD recorder, and when they begin to use the software that comes bundled with the device. These new users will then add to their software capabilities via upgrades, in most cases through web transactions. Later, when the DVD creation software category has become established, consumers who are now used to the concept of DVD creation will shop for DVD creation software in traditional retail channels.
OEM Bundling
Our primary channel for reaching customers with our desktop applications software is “bundling” arrangements with various other companies in which copies of DVDit!, MyDVD, CinePlayer, RecordNow, and/or Backup My PC are included or “bundled” with shipments of those companies’ products. These companies (we refer to them as “Bundle Partners”) are motivated to include our software as a value-added offering for their customers and they usually pay us a royalty on each copy of our software shipped with their products. We are motivated to enter into bundling arrangements because they generate revenue for us as well as create a large installed base of customers to whom we can sell upgraded or enhanced versions of our products (through our other channels, particularly through our Web Store).
We have bundling arrangements with a variety of Bundle Partners and product types. The products with which our software is bundled include professional video editing systems, professional video capture and display cards, consumers video capture and interface cards, DVD recorders, CD recorders, PC models including DVD recorders, PC models including CD recorders, and PC models positioned as “multimedia” PCs.
Most of our bundle deals permit us to capture customer registrations or to invite the customer to click to our web site. We usually do not provide end user support as part of our bundling arrangements, but rely on our Bundle Partners to support the end user customers. We typically do provide “second line” support to our Bundle Partners to enable them to provide “first line” support of our products to their consumer-customers.
The following are a representative list of companies with whom we have current bundling arrangements and/or with whom we bundled our software during the 2003 fiscal year:
Avid Technologies
Media 100
Canopus
Melco
Compaq(HP)
NEC
Dell
Panasonic
Easy Systems Japan
Pioneer
Fujitsu
Sharp
Hewlett-Packard
Sony
IBM
Interactual
IO-Data
Matrox
Web Store
We have established web-based retail stores for our Desktop Products (as well as some of our Professional Products, for example, ReelDVD, that are priced in a range that is typically sold over the web). Our Web Store is intended both to meet retail demand for our Desktop Products as well as to service upgrade orders for our products, in particular, upgrade orders for software distributed by our bundle partners.
We currently have separate Web Stores for Europe, North America and Japan. We currently “outsource” operations of parts of our Web Stores through arrangements we have with Digital River, Element Five, and Sanshin Denki. Under these arrangements, our outsource partners typically provide the servers which list our products and handle purchase transactions through their secure web sites.
Specialized Channel
We have a number of professional and semi-professional Audio-Video dealers who carry MyDVD, DVDit! and other products as part of their product lines. Very often these dealers also carry professional or semi-professional products with which basic versions of our desktop software are bundled or with which our products can be used. A few of these dealers also carry some of our professional DVD products, but most do not. At the current time we have 14 such dealers in the Americas, 16 in Europe, and 9 in the Pacific Rim.
“Bricks and Mortar” Channel
At the present time we have only limited distribution of our products through traditional “bricks and mortar” retail outlets for computer and consumer electronics products. In general we have chosen to pursue this channel through the use of publishing arrangements. Under such arrangements another company packages and sells our software applications to distributors and retailers, and we receive a royalty payment on each copy of our software that is shipped. We currently have a few such arrangements, with Stomp, Inc., Adaptec, Easy Systems Japan and Softbank.
Competition for Desktop Products
The market for our Desktop Products is a very competitive one. We believe that digital media creation is perceived as a very interesting and high growth area of the PC industry and, as such, will likely attract more competition in the future. Competitors of DVDit!, MyDVD, RecordNow, and/or Backup My PC include for example: Ahead, Apple Computer, BHA, Cyberlink, Dazzle (a division of SCM Microsystems), Intervideo Inc., MedioStream, NTI, Pinnacle, Roxio, and Ulead. Some of these competitors have significant technical and financial resources exceeding our own.
In April 2000, Apple Computer announced the acquisition of the DVD authoring business of Astarte Gmbh. Prior to the acquisition, Astarte sold a DVD authoring system that competed primarily with our DVD
Fusion product. In January 2001, Apple announced two new DVD authoring products, which we presume are based on Astarte’s technology. The first product, iDVD, is intended for consumer users and we believe will compete with MyDVD and DVDit! The second product, DVD Studio Pro, is intended for professional users, and competes with DVDit! PE, DVD Fusion and ReelDVD. Apple also announced the availability of aggressively priced DVD recorders with certain models of their Macintosh personal computer. In mid-2001, Apple purchased Spruce Technologies, a long-standing competitor of ours in the professional DVD market. In April 2003 Apple announced its intention to release DVD Studio Pro Version 2 in the summer of 2003. We presume that DVD Studio Pro Version 2 is based, at least in part, on technology deriving from the Spruce acquisition.
Technology Products
In the past three years we have begun to market our technology to permit other companies to build software products of their own. We market our technology products under the trade name “AuthorScript.”
AuthorScript is designed to make available to software product developers our “back-end” engines for producing DVD-Video discs (and related formats such as Video CD and Super Video CD), as well as DVD- ROMs, CD-ROMs, and CD-Audio discs. We include in AuthorScript the same processing software that underlies the authoring subsystems we provide in DVD Creator, DVD Fusion, DVDit!, MyDVD, and RecordNow. We package this software with an Application Programmer’s Interface (“API”) - that is, a top level mechanism permitting other companies’ software engineers to easily access our processing technology and integrate it with their own software applications.
We believe that AuthorScript will be both a revenue source and a point of strategic leverage for our Company. Once a software product is developed using one back-end technology, it is quite difficult and possibly de-stabilizing to switch to another product. We’ve consciously packaged AuthorScript in a way which is attractive to software developers, and we license it on terms that we believe are very reasonable. We anticipate that this will create a stable and growing base of AuthorScript licensees as digital media creation technology spreads.
Customers and Licenses for AuthorScript
We have licensed AuthorScript to a number of companies including: Adobe Systems, AOL, ArcSoft, Avid Technology, Hitachi, Intervideo, Microsoft, and Sony. Because the needs and situations of AuthorScript licensees vary greatly, there is no typical AuthorScript license. Some of the licenses we have concluded resemble a software bundling arrangement in which we receive a royalty on every unit shipped of software containing AuthorScript. Some of the licenses are broad, development relationships through which the license partner receives source-level access to AuthorScript, and rights to participate with us in our ongoing development program.
Additional Markets for AuthorScript
We believe that AuthorScript or products derived from it may be applicable to other application areas outside the PC software space. We have underway an active program to market our technology to consumer electronics device manufacturers. To date, we have revealed one such license of this type - a license to Sony for use in an advanced model of the CoCoon product family, released in Japan.
COMPANY OPERATIONS
Business Units
Since the middle of the 2002 fiscal year, we have organized Sonic using a matrix form of organization. In such an organization, most managers have dual reporting relationships. They report simultaneously to a senior functional manager (e.g., head of engineering, head of marketing, etc.) as well as to a business unit general manager.
We currently have three business units corresponding to our three product categories - professional products, desktop products and technology products. The following table shows an allocation of Sonic’s employees by major functional area and by business unit, as of March 31, 2003. Employees whose responsibilities span multiple business units are included in the “General” classification (e.g., corporate, accounting and, general services staff).
Marketing and Sales
Marketing and sales functions are handled by professional staff (50 in number as of March 31, 2003) who are dedicated to each of our business units. They are responsible for planning and monitoring the development road map of the products falling in their business unit, for preparing marketing materials to accompany the products, and for selling our products to end users or dealers, in the case of professional products, to bundle partners and channel participants in the case of desktop products, and to OEM developers in the case of technology products.
Sonic marketing and sales staff are located at our headquarters in Novato, our field offices in London, Tokyo, and Taipei, and in home offices in a number of locations around the world.
Engineering and Development
Our research and development staff includes a total of 141 hardware and software engineers and technicians and technical specialists. We tend to hire research and development personnel with backgrounds in digital audio signal processing, digital video image processing, distributed networking and computer systems design. Our development team exhibits a number of technology capabilities including the following that we believe are particularly important in light of our strategy and market position:
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Digital Signal Processing - This is the term used to describe the sophisticated mathematical processing by which aural and visual signals are processed in computer-based settings. Our engineering team includes individuals experienced at providing sophisticated digital signal processing solutions to meet the quality and performance requirements of audio and video professionals.
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Real Time Architectures - Our engineers are experienced in dealing with the requirements of high bandwidth, real time data in computer-based settings. We believe that has helped us to develop products that provide cost effective solutions for professional applications.
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Craft and Application Familiarity - Our engineers are experienced in the needs and work patterns of audio, film and video professionals and in the use of digital media by consumers and prosumers.
Our research and development staff is located principally at our headquarters in Novato and in our office in San Luis Obispo. Some of our engineers work remotely from their homes. We also have a small research and development installations in San Jose, California and in Wayne, Pennsylvania.
General and Administrative
General and administrative functions are handled by a staff of 20 people, all of whom are located at our corporate headquarters in Novato. Corporate management, accounting and financial management, information
services, and other services including manufacturing and shipping are all included in the general and administrative group.
Employees
To a very great degree our success in the future will depend on our ability to recruit, retain and motivate engineering, technical, sales, marketing and operations professionals. Recently, the U.S. labor market has been quite tight, and demand for technology professionals has been very strong. To make matters worse, our Company participates in what is perceived to be a “hot” area of the “high tech” industry. We have found that recruiting high caliber individuals is difficult and have had to expend considerable effort to do so.
No labor unions represent any of our employees. We have never experienced a work stoppage, slowdown or strike. We believe that our employee relations are good.
Revenue Concentration
During the fiscal years ended March 31, 2002 and 2003, sales to our Japanese distributor, Sanshin Electronics Company, amounted to 6% and 5%, respectively, of total revenues. Sanshin is a distributor of all of our products.
During fiscal 2003, approximately 26% of our revenue was derived from revenue recognized on development and licensing agreements from three customers as discussed in Note 10 of Notes to Financial Statements.
Apart from the revenue discussed above and in Note 10 of Notes to Financial Statements, no other single customer accounted for more than 10% of our total revenue during each of the past three fiscal years.
Backlog
In the case of professional products, we schedule our production based on our projections of customer demand. We generally ship products within a few days of acceptance of a customer purchase order so at any given time, we have little or no order backlog. With few exceptions, customers may cancel or delay orders with little or no penalty. Thus, even to the extent that we have backlog, we do not think that it is a reliable indicator of future revenue levels.
In the case of desktop products, sales through bundle partners depend on the bundle partners’ sales activities which are, for the most part, not under our influence or control. Generally, we recognize revenue from bundling arrangements based on the receipt of royalty reports we receive from our bundle partners. While we receive some royalty reports relating to a quarter’s activities within a short time after the end of a quarter, some bundle partners are slow in their reporting, which leads to a lag in our accounting for their activities (for instance, some bundle partner reports included in our March 31, 2003 quarterly report reflected bundle partner activity from December 1, 2002 through February 28, 2003). Sales of our Desktop Products on our Web Store or to dealers are recognized as shipped. Usually, there is no significant time interval between receipt of an order and its fulfillment via web download or via physical shipment. Thus, in the case of desktop products, we have no significant backlogs.
In the case of technology products, as we discussed above, some of our licenses resemble bundling arrangements and, as such have no backlog. Certain licenses, especially those of a broad nature, involve significant up-front payments or commitments by the OEM partner. Under such licenses, we oftentimes have certain delivery obligations to the OEM (for example, for customized changes to our software) . We account for revenue under such licenses in accordance with SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts,” whereby the revenue is recognized under the “percentage of
completion” method of contract accounting. Since these deliveries involve in most cases some degree of development activity, the outcome of which is inherently uncertain, it is incorrect to characterize these licenses as having a significant backlog associated with them.
Manufacturing and Suppliers
We manufacture various hardware components used in some of our professional products. We also manufacture or replicate copies of our software products on CDs when our customers require physical delivery of our products.
How We Manufacture
We have typically contracted with various electronics manufacturing and assembly houses to manufacture the hardware components of our products. Most of these contractors are located in the San Francisco Bay Area. Our staff performs some assembly, integration and testing at our Novato, California headquarters.
We also typically contract with outside duplication and fulfillment houses for replication of our software products on CDs. Again, most of these contractors are located in the San Francisco Bay Area. Our staff performs some assembly and logistical functions associated with our software products. Our staff also replicates some of our software products in-house in the case of certain short run length shipments.
Sole-Sourced Components
We utilize a number of components in our products that are available from only a single source. We purchase these sole-source components from time to time, that is, we do not carry significant inventories of these components and we have no guaranteed supply agreements for them. We have experienced shortages of some sole-sourced components in the past. We are likely to experience similar shortages at some point in the future. Such shortages can have a significant negative impact on our business.
Outsourcing
Over the past several years, we have shifted our hardware manufacturing to an “outsourcing” approach. Under outsourcing we contract with a single partner organization which takes responsibility for procuring parts, and for manufacturing them into complete, tested assemblies which are then released to us according to our instructions. Our current outsourcing arrangement is with Arrow-Bell Electronics, Inc. We believe that outsourcing provides us with increased flexibility to increase or decrease production, and allows us to operate our business with substantially reduced inventories thereby reducing financing requirements. During the 2003 fiscal year, we produced approximately 90% of our hardware via outsourcing. We plan to continue this outsourcing approach.
While we believe outsourcing is advantageous for Sonic, it makes us very dependent on a single production source. Financial, operational, or supply problems encountered by our outsourcing partner or its sub-contractors could seriously hamper or interrupt our ability to manufacture, sell and ship our products.
Proprietary Rights; Intellectual Property
General Approach
We rely on a combination of the following to protect our proprietary rights in our products:
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patents,
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trade secrets,
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copyright law,
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trademark law,
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contracts, and
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technical measures.
We generally sell our products subject to standard purchase and license agreements that restrict unauthorized disclosure of our proprietary software and designs, or copying for purposes other than the use intended when the product is sold.
Patents
We have applied in the United States for patents covering certain of our technologies and will probably apply for more in the future. We will probably also apply for foreign patents. We have been granted U.S. Patent No. 5,812,790: “Variable encoding rate plan generation” covering certain aspects of MPEG-2 Video encoding technology; and U.S. Patent No. 6,047,356: “Method of dynamically allocating network node memory’s partitions for caching distributed files” covering a distributed file system. We may be granted additional patents in the future. Of course, we can not be sure that our current or future patent applications will be granted, nor can we be certain that we can successfully prosecute claims against others based on our patents, or defend our patents against the claims of others. We believe that becoming involved in patent litigation can be quite expensive and is highly uncertain in terms of outcome.
The status of patent protection in our industry is not well defined particularly as it relates to software and signal processing algorithms. In the past several years there seems to have been a trend on the part of patent authorities to grant patents in audio and video processing techniques with increasing liberality. We believe that it is quite possible that some of our present or future products may infringe issued or yet to be issued patents. It is almost certain that we will be asked by patent holders to respond to infringement claims. If such patents were held to be valid, and if they covered a portion of our technology for which there was no ready substitute, we might suffer significant market and financial losses.
Our products involve the use of certain technologies in which the overall patent situation is acknowledged by most industry observers to be very unclear. For example, patent coverage and license availability for MPEG-2 video encoding and decoding is currently somewhat uncertain. While one group of companies has attempted to create a single licensing entity for this technology (called “MPEG LA”; see “Current Infringement Issues” below), not all relevant patent holding companies have joined this entity. We plan to continue to monitor this area and to act prudently to avoid needless litigation and entanglements while continuing to offer our products. We have been able to reduce our risk to some extent by means of contractual provisions. For example, in the case of low revenue-per-copy bundling agreements with OEM customers, we typically attempt to limit any indemnity we provide to our customers against the possibility that their use of our products will ultimately be held to be infringing.
Trade Secrets
We rely to a great extent on the protection the law gives to trade secrets to protect our proprietary technology. Our policy is to request confidentiality agreements from all of our employees and key consultants, and we regularly enter into confidentiality agreements with other companies with whom we discuss any of our proprietary technology.
Despite trade secret protection, we cannot be sure that third parties will not independently develop the same or similar technologies. Despite contract and procedural measures, we believe that it is practically impossible to guard against unauthorized disclosure or misuse of technology to which we have granted third parties access. We also have significant international operations. Many foreign countries, in law or in practice, do not extend the same level of protection to trade secrets as does U.S. law.
Current Infringement Issues
In the past we have been advised of various infringements of patents and trademarks. We do not believe that in any such situation currently known to us we are at risk of material loss or serious interruption of our business. We may be incorrect in this assessment, of course. We regularly accrue certain reserves relating to shipments of products based on our assessment of what we will ultimately pay in royalties to various patent holders. Our assessment in this regard may prove to be wrong, in which case we may be exposed to additional financial losses relating to patent infringements.
In May, 2003, we entered into a license agreement with MPEG LA. MPEG LA is a company set up to afford a convenient way for companies manufacturing products based on MPEG technology to license patents purportedly essential to such products. Currently the MPEG LA patent portfolio includes more than 500 patents held by more than 20 licensors. Under the terms of the agreement we provided MPEG LA with a payment covering products we have sold prior to entering into the agreement. We expect to continue to tender reports to MPEG LA and to make payments to MPEG LA based on those reports as we ship copies of our products in the future.
As noted above, MPEG LA’s patent portfolio does not cover all aspects of MPEG technology and there are many other areas of digital media and optical recording technology to which various patents may be applicable.
Geographic Exposure
We have for many years realized a significant proportion of our revenues from sales outside the United States. In some fiscal quarters, non-U.S. revenue has constituted as much as 50% of our revenues. In the fiscal year ended March 31, 2003, approximately 30% of our revenues came from sales outside the United States. We expect that a larger percentage of our revenues will derive from sales outside the United States in fiscal year 2004.
Because of our foreign sales, we are exposed to a number of factors that would not be relevant if our sales were largely made within the United States. Currency movements which make the U.S. dollar stronger relative to foreign currencies can effectively raise the price of our products to foreign customers, reducing demand for our products. Import restrictions, tariffs, and foreign product regulations (particularly those dealing with product safety and RF emissions) may also impede our ability to do business in foreign countries.
Item 2.
Item 2. PROPERTIES
Our principal administrative, sales and marketing, research and development and support facility is located at 101 Rowland Way in Novato, California and consists of approximately 30,000 square feet under a lease which expires in 2006.
We have additional research and development facilities in San Luis Obispo, CA; San Jose, CA; and Wayne PA.
We also have sales offices located in London and Tokyo.
Item 3.
Item 3. LEGAL PROCEEDINGS
We are not a party to any legal proceedings.
Item 4.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the fourth quarter of the fiscal year ended March 31, 2003, we did not submit any matters to a vote of our security holders.
Supplemental Item. EXECUTIVE OFFICERS OF THE REGISTRANT
Our executive officers and their ages as of March 31, 2003 are as follows:
Mr. Doris is married to Ms. Sauer. There are no other family relationships between any director or executive officer of the Company.
Robert J. Doris. Mr. Doris founded Sonic Solutions in 1986 and has served as President, Chief Executive Officer and Director of the Company since that time. Prior to 1986, he was President of The Droid Works, a subsidiary of Lucasfilm Ltd., which produced computer-based video and digital audio systems for the film and television post-production and music recording industries. Prior to founding The Droid Works, Mr. Doris was a Vice President of Lucasfilm and General Manager of the Lucasfilm Computer Division. Mr. Doris received B.A., J.D. and M.B.A. degrees from Harvard University.
Mary C. Sauer. Ms. Sauer founded Sonic Solutions in 1986 and has served as a Vice President and Director of the Company since that time. Ms. Sauer became Senior Vice President of Marketing and Sales in February 1993. Prior to 1986, Ms. Sauer was Vice President of Marketing for The Droid Works, and prior to joining The Droid Works, Ms. Sauer was Director of Marketing for the Lucasfilm Computer Division. Ms. Sauer received an M.B.A. in Finance and Marketing from the Wharton School of the University of Pennsylvania and a B.F.A. from Washington University in St. Louis.
A. Clay Leighton. Mr. Leighton joined Sonic Solutions in February 1993 as Vice President of Finance. In January, 1999, Mr. Leighton was named Senior Vice President of Worldwide Operations and Finance and Chief Financial Officer. Prior to joining Sonic, from January 1990 to July 1992 he was Vice President, Finance and CFO for RESNA Industries Inc., an environmental services firm, and from August 1988 to December 1989 he was Vice President, Finance and CFO for Command Data Systems, a software company specializing in software for the public safety market. Mr. Leighton has also worked as strategy consultant for the Boston Consulting Group. Mr. Leighton received a B.A. from Wesleyan University and an M.B.A. from the Amos Tuck School of Business Administration at Dartmouth College.
Christopher A. Kryzan. Mr. Kryzan joined Sonic Solutions in March 1996 as Vice President of Marketing. In January, 1999, Mr. Kryzan was named Senior Vice President of Marketing and Engineering. Prior to joining Sonic, from May 1994 through February 1996, he was an independent consultant specializing in Internet business and marketing strategy development. From July 1990 to April 1994, he was Director of Marketing at SuperMac Technology, a graphics and digital video technology firm, and General Manager of E-Machines, a subsidiary of SuperMac. From January 1986 to July 1990, he was Director of Product Marketing at Wyse Technology, a manufacturer of terminals and personal computers, and National Sales Manager of Amdek, a subsidiary of Wyse. Mr. Kryzan received a B.S. in Electrical Engineering from Northwestern University and an M.B.A. from Santa Clara University. Mr. Kryzan resigned as an executive officer of Sonic Solutions effective May 31, 2003. Mr. Kryzan acts as a consultant to Sonic Solutions through July 31, 2003 pursuant to an agreement dated May 31, 2003.
PART II
Item 5.
Item 5. MARKET FOR SONIC SOLUTIONS’ COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our Common Stock is listed on the Nasdaq National Market. As of March 31, 2003, there were approximately 154 registered holders of our Common Stock. We believe, however, that many beneficial holders of our Common Stock have registered their shares in nominee or street name, and that there are substantially more than 154 beneficial owners. The low price and high price of our Common Stock during the last eight quarters are as follows:
We have not paid any dividends on our Common Stock during the periods set forth above. It is presently the policy of the Board of Directors to retain earnings for use in expanding and developing our business. Accordingly, we do not anticipate paying any cash dividends on the Common Stock in the foreseeable future.
In December 2001, we issued 250,000 shares of Series E Convertible Preferred Stock to Sanshin Electronics Co., Ltd. in conjunction with their $1 million equity investment in Sonic Solutions. In addition to the equity investment, it was agreed that the distributor agreement by and between Sanshin and Sonic Solutions would be extended. Each share of Series E Convertible Preferred Stock is convertible into one share of Common Stock. These securities were exempt from registration pursuant to Section 4(2) of the Securities Act of 1933. These securities were sold to one investor which represented it was sophisticated and accredited. As of March 31, 2003, all shares of Series E Convertible Preferred Stock had been converted into 250,000 shares of our Common Stock.
In December 2002, we issued 1,290,948 shares of Series F Preferred Stock convertible into 1,290,948 shares of our common stock (subject to adjustment for stock splits and the like). Pursuant to the asset purchase agreement we entered into an amended and restated registration rights agreement with VERITAS under which we provided registration rights for these shares once they were converted into shares of our Common Stock. During March 2003, all shares of Series F Preferred Stock were converted into 1,290,948 shares of our Common Stock.
Item 6.
Item 6. SELECTED FINANCIAL DATA
The following selected financial data should be read in conjunction with the financial statements and related notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing elsewhere in this Form 10-K. The selected financial data presented below under the caption “Statement of Operations Data” and “Balance Sheet Data” for, and as of the end of, each of the years in the five-year period ended March 31, 2003, are derived from the financial statements of Sonic Solutions. The financial statements as of March 31, 2003 and 2002, and for each of the years in the three-year period ended March 31, 2003, and the report thereon, are included elsewhere in this Form 10-K.
Summarized quarterly financial information for fiscal years 2003 and 2002 is as follows:
Item 7.
Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW; CERTAIN FACTORS THAT MAKE FUTURE RESULTS DIFFICULT TO PREDICT; CERTAIN ITEMS TO REMEMBER WHEN READING OUR FINANCIAL STATEMENTS
Our quarterly and annual operating results vary significantly depending on the timing of new product introductions and enhancements by ourselves and by our competitors. Our results also depend on the volume and timing of our professional customer orders and on shipments of our OEM partners which are difficult to forecast. Because our professional customers generally order on an as-needed basis and we normally ship products within one week after receipt of an order, and because our OEM partners report shipments during or after the end of the period, we do not have an order backlog which can assist us in forecasting results. For all these reasons, our results of operations for any quarter or any year are a poor indicator of the results to be expected in any future quarter or year.
A large portion of our quarterly and annual professional product revenue is usually generated in the last few weeks of the quarter. Since our ongoing operating expenses are relatively fixed, and we plan our expenditures based primarily on sales forecasts, if professional revenue generated in the last few weeks of a quarter or year or if OEM partner shipments do not meet our forecast, operating results can be very negatively affected.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
We prepare our financial statements in conformity with U.S. generally accepted accounting principles. These accounting principles require management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements. Our management is also required to make certain judgments that affect the reported amounts of revenues and expense during the reporting period. We periodically evaluate our estimates including those relating to revenue recognition, the allowance for doubtful accounts, capitalized software, and other contingencies. We base our estimates on historical experience and various other assumptions that we believe to be reasonable based on the specific circumstances, the results of which form the basis for making judgments about the carrying value of certain assets and liabilities that are not readily apparent from other sources. Actual results could differ from these estimates.
We believe the following critical accounting policies impact the most significant judgments and estimates used in the preparation of our financial statements:
-Revenue Recognition
Revenue recognition rules for software companies are very complex. We follow very specific and detailed guidance in measuring revenue. Certain judgments, however, affect the application of our revenue recognition policy.
We have adopted Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” as amended by SOP 98-4 “Deferral of the Effective Date of a Provision of SOP 97-2,” and SOP 98-9, “Software Revenue Recognition,” with respect to certain arrangements and in certain instances in accordance with SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.” SOP 97-2 requires revenue earned on software arrangements involving multiple elements such as software products, hardware, upgrades, enhancements, maintenance and support, installation and training to be allocated to each element based on the relative fair values of the elements. The fair value of an element must be based on vendor-specific objective evidence.
We derive our software revenue primarily from licenses of our software products (including any related hardware components), development agreements and maintenance and support. Revenue recognized from
multiple-element software arrangements is allocated to each element of the arrangement based on the fair values of elements, for example, the license to use the software products versus maintenance and support for the software product. The determination of fair value is based on objective evidence specific to us. Objective evidence of fair values of all elements of an arrangement is based upon our standard pricing and discounting practices for those products and services when sold separately. Objective evidence of support services is measured by annual renewal rates. SOP 98-9 requires recognition of revenue using the “residual method” in a multiple element arrangement when fair value does not exist for one or more of the delivered elements in the arrangement. Under the “residual method,” the total fair value of the undelivered elements are deferred and subsequently recognized in accordance with SOP 97-2. The difference between the total software arrangement fee and the amount deferred for the undelivered elements is recognized as revenue related to the delivered elements.
Revenue from license fees is recognized when persuasive evidence of an arrangement exists, delivery of the product (including hardware) has occurred, no significant obligations with regard to implementation remain, the fee is fixed and determinable, and collectability is probable. In addition, royalty revenue from certain distributors that do not meet our credit standards and revenues from our distributor agreement with Daikin are recognized upon sell-through to the end-customer. We consider all arrangements with payment terms longer than one year not to be fixed and determinable. If the fee is not fixed or determinable, revenue is recognized as payments become due from the customer.
Revenue from development agreements, whereby the development is essential to the functionality of the licensed software, is recognized over the service period based on proportional performance. Under this method, management is required to estimate the number of hours needed to complete a particular project, and revenues and profits are recognized as the contract progresses to completion.
Deferred revenue includes amounts billed to customers for which revenues have not been recognized which results from the following: (1) deferred maintenance and support; (2) amounts billed to certain distributors for our products not yet sold through to the end-user customers; (3) amounts billed in excess of services performed to technology customers for license and development agreements; and (4) amounts billed to certain OEMs for products which contain one or more undelivered elements.
-Allowance for Doubtful Accounts
We maintain an allowance for doubtful accounts to reflect the expected non-collection of accounts receivable based on past collection history and specific risks identified in our portfolio of receivables. If the financial condition of our customers deteriorates resulting in an impairment of their ability to make payments, or if payments from customers are significantly delayed, additional allowances might be required.
-Capitalized Software
We capitalize a portion of our software development costs in accordance with Statement of Financial Accounting Standard No. 86 “Accounting for the Costs of Computer Software to be Sold, Leased, or otherwise Marketed.” Such capitalized costs are amortized to cost of revenue over the estimated economic life of the product, which is generally three years. Periodically, we compare a product’s unamortized capitalized cost to the product’s net realizable value. To the extent unamortized capitalized cost exceeds net realizable value based on the product’s estimated future gross revenues, reduced by the estimated cost of sales, the excess is written off. This analysis requires us to estimate future gross revenues associated with certain products, and the future cost of sales. If these estimates change, write-offs of capitalized software costs could result.
-Business Acquisitions; Valuation of Goodwill and Other Intangible Assets
Our business acquisitions typically result in the recognition of goodwill and other intangible assets, which affect the amount of current and future period charges and amortization expense. The determination of value of these components of a business combination, as well as associated asset useful lives, requires management to make various estimates and assumptions. Estimates using different, but each reasonable, assumptions could produce significantly different results.
On April 1, 2002 we adopted SFAS No. 142 “Accounting for Goodwill and Other Intangible Assets.” SFAS No. 142 addresses how goodwill and other intangible assets should be accounted for after they have been initially recognized in the financial statements. In accordance with SFAS No. 142, goodwill is no longer amortized over its estimated useful life, rather, goodwill will be subject to at least an annual assessment for impairment by applying a fair-value-based test. We continually review the events and circumstances related to our financial performance and economic environment for factors that would provide evidence of impairment of goodwill. We test goodwill for impairment in accordance with SFAS 142 at least annually and more frequently upon the occurrence of certain events, as defined in SFAS 142. Goodwill is tested for impairment annually in a two-step process. First, we determine if the carrying amount exceeds “fair value” based on quoted market prices of our common stock, which would indicate that goodwill may be impaired. If we determine that goodwill may be impaired, we will compare the “implied fair value” of the goodwill, as defined by SFAS 142, to its carrying amount to determine the impairment loss, if any. Goodwill has resulted from our Ravisent product business acquisition during the first quarter ended June 30, 2002, which was accounted for as a purchase, and from our DMD acquisition from VERITAS during the third quarter ended December 31, 2002, which was also accounted for as a purchase. As of March 31, 2003, no events have occurred that would lead us to believe that there has been any impairment.
-Stock Based Compensation
We follow Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees.” See Note 1 and 7 to our financial statements for March 31, 2001, 2002 and 2003 included elsewhere in this annual report for further discussion of our stock based compensation plans, including the illustration of the effect on net income and earnings per share as if we had applied the fair value recognition provisions of Statement of Financial Accounting Standards No. 123 “Accounting for Stock-Based Compensation” (SFAS 123).
-Impairment of Long-Lived Assets
On April 1, 2002, we adopted SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”), which supersedes certain provisions of APB Opinion No. 30 “Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions” and supersedes SFAS No. 121 “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of.” There was not a cumulative transition adjustment upon adoption. In accordance with SFAS 144, we evaluate long-lived assets, including intangible assets other than goodwill, for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable based on expected undiscounted cash flows attributable to that asset. The amount of any impairment is measured as the difference between the carrying value and the fair value of the impaired asset. We do not have any long-lived assets which we consider to be impaired as of March 31, 2003.
OTHER DISCLOSURES
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Investment in SonicStudio LLC
In March 2002, we executed an agreement to form a new company, SonicStudio LLC in partnership with a limited liability corporation controlled by two individuals. The book value of net assets and liabilities transferred to SonicStudio LLC, totaled $235,661. We account for this investment in SonicStudio LLC using the modified equity method. As of March 31, 2003, our investment in SonicStudio LLC totaled $68,897.
Under the terms of the agreement, SonicStudio LLC compensated us for the Sonic Studio business with a three year promissory note for $500,000. The promissory note, which does not carry interest, will be repaid to us with a percentage royalty based on sales received by SonicStudio LLC, plus any share of profits paid by them to us. When the note is retired, we expect to have a 15% interest in SonicStudio LLC.
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Other Contingencies
We are subject to various claims relating to products, technology, patent, shareholder and other matters. We are required to assess the likelihood of any adverse outcomes and the potential range of probable losses in these matters. The amount of loss accrual, if any, is determined after careful analysis of each matter, and is subject to adjustment if warranted. See the discussion under the Risk Factors titled “We may become involved in costly and time-consuming patent litigation.”
RESULTS OF OPERATIONS
The following table sets forth certain items from Sonic Solutions’ statements of operations as a percentage of net revenue for fiscal years 2001 through 2003:
COMPARISON OF FISCAL YEARS ENDED MARCH 31, 2003, 2002 and 2001
Net Revenue. Our net revenue increased from $16,519,000 in fiscal 2001 to $19,104,000 in fiscal 2002, representing an increase of 16% and increased to $32,718,000 in fiscal 2003, representing an increase of 71%. The increase in net revenue in fiscal 2002 was primarily due to the increase in sales of our consumer products which increased approximately 243% from fiscal 2001. The increase in sales was due to new OEM licensing agreements entered into during the fiscal year and the increase in volume of sales reported by the existing OEM partners. Included in consumer sales is revenue recognized on license development contracts entered into during fiscal 2002. This increase was offset in part by a decrease in our professional audio and video sales of approximately 24%. The increase in net revenue in fiscal 2003 was primarily due to the increase in sales, both from new and existing OEM partners, of our consumer products which increased approximately 174%. Included in consumer product sales is revenue recognized on new license development contracts which were entered into during the second half of fiscal 2002 and 2003. This increase was offset in part by a decrease in our professional audio and video sales of approximately 8%.
International sales accounted for 47%, of our net revenue in fiscal year 2001, 39% of our net revenue in fiscal year 2002 and 30% of our net revenue in fiscal year 2003. See Note 10 of Notes to Financial Statements. International sales have historically ranged from 30% to slightly less than 50% of our total sales, and we expect that they will continue to represent a significant percentage of future revenue. The percentage has decreased in fiscal year 2003 due to the increase in domestic OEM revenue from our consumer products.
Cost of Revenue. Our cost of revenue as a percentage of revenue decreased from 35.7% of net revenue in fiscal 2001 to 30.1% in fiscal 2002 to 22.8% in fiscal 2003. The decreases in cost of revenue as a percentage of revenue were primarily due to a shift in sales product mix towards higher margin consumer products (including software license and development contracts) and to the reduction of hardware as a percentage of revenue in our professional audio and video systems.
Marketing and Sales. Our marketing and sales expenses decreased from $8,710,000 in fiscal 2001 to $8,601,000 in fiscal 2002 and increased to $8,762,000 in fiscal 2003. Marketing and sales represented 52.7%, 45.0% and 26.8% of net revenue for fiscal 2001, 2002 and 2003, respectively. Our marketing and sales expenses decreased in fiscal 2002 primarily due to lower advertising and collateral expenses, which decreased approximately $200,000, and lower salary expense which decreased approximately $140,000, as a result of our reduction in headcount. These decreases were offset in part by an increase in commission expense due to the increase in sales. Our marketing and sales expenses increased in fiscal 2003 primarily due to an increase in salary expenses of approximately $575,000 relating to the increase in headcount. This increase was partially offset with changes in other expenses, primarily the decrease in dealer and employee commission expenses, due to increased OEM and direct sales, of approximately $570,000. Our marketing and sales headcount decreased from forty-nine at March 31, 2001 to forty-four at March 31, 2002 and increased to fifty at March 31, 2003. Dealer and employee commission expenses, as a percentage of net revenue increased from 4.4% in fiscal 2001 to 6.7% in fiscal 2002 and decreased to 5.9% in fiscal 2003.
Research and Development. Our research and development expenses increased from $5,148,000 in fiscal 2001 to $5,897,000 in fiscal 2002 to $10,625,000 in fiscal 2003. Our research and development expenses as a percentage of net revenue were 31.2% in fiscal 2001, 30.9% in fiscal 2002, and 32.5% in fiscal 2003. Our research and development expenses increased primarily due to higher salary expense associated with increases in headcount, which increased by approximately $250,000 and $3,070,000, for fiscal years ended March 31, 2002 and 2003, respectively. The increase in fiscal year 2003 was also due to an increase in consulting expense of approximately $690,000 and an increase in the allocation of occupancy expenses relating to the increase in headcount and the additional office locations. Our headcount increased from thirty-two at March 31, 2001 to forty-nine at March 31, 2002 to one hundred and forty-one at March 31, 2003. The increase in headcount during fiscal year 2003 is primarily the result of two acquisitions made during the fiscal year.
We capitalize a portion of our software development costs in accordance with Statement of Financial Accounting Standards No. 86. This means that a portion of the costs we incur for software development are not recorded as an expense in the period in which they are actually incurred. Instead, they are recorded as an asset on our balance sheet. The amount recorded on our balance sheet is then amortized to cost of revenue over the estimated life of the products in which the software is included. During fiscal year 2002 we capitalized approximately $514,000 and amortized approximately $1,511,000 (excluding amounts relating to the Daikin acquisition). During fiscal year 2003, we capitalized approximately $488,000 and amortized approximately $409,000 (excluding amounts relating to Daikin, Ravisent and DMD acquisitions). The Ravisent and DMD acquisitions are discussed under the heading “Acquisitions.”
General and Administrative. Our general and administrative expenses decreased from $2,514,000 in fiscal 2001 to $2,095,000 in fiscal 2002 and increased to $3,100,000 in fiscal 2003. These expenses represented 15.2% of net revenue in fiscal 2001, 11.0% of net revenue in fiscal 2002 and 9.4% of net revenue in fiscal 2003. General and administrative expenses decreased in fiscal 2002 primarily due to reduced legal fees and a reversal of previously recorded bad debt reserve which was no longer required due to our improvement in collections as a result of the continued shift in our customer base towards larger and more established OEM customers. General and administrative expenses increased in fiscal 2003 primarily due to increased rent, insurance, professional and other general expenses related to the overall increase in our headcount from one hundred and ten at March 31, 2002 to two hundred and eleven at March 31, 2003. We anticipate that general and administrative expenses may increase as our operations expand.
Business Integration Expense. In conjunction with the Daikin acquisition completed in February 2001 (fiscal year 2002), we incurred expenses to transition the business to our management. As such, these expenses did not exist during fiscal year 2003. Business integration expenses primarily consisted of engineering consulting expenses per the consulting agreement we entered into with Daikin dated February 27, 2001.
Other Income and Expense. Other income on our statement of operations includes the interest we earned on cash balances and short term investments. Interest income was approximately $129,000, $52,000 and $96,000 for the fiscal years ended March 31, 2001, 2002 and 2003, respectively. Other expense in fiscal year 2001 consists primarily of interest and other financing charges associated with the debt arrangements with Hambrecht & Quist. Other expense in fiscal years 2002 and 2003 primarily consist of write-downs of investments in other entities which totaled approximately $125,000 and $151,000, respectively, which was offset in part by the interest income discussed above.
Provision for Income Taxes. In accordance with Statement of Financial Accounting Standards No. 109, we made no provision for U.S. income taxes for our 2001, 2002 and 2003 years. For the 2002 and 2003 fiscal years foreign tax expense was recorded to reflect the taxes withheld by various Japanese customers and paid to the Japanese taxing authorities.
Acquisitions.
On February 27, 2001, we entered into an Asset Purchase Agreement with Daikin Industries, Ltd., a Japanese corporation, whereby on that date we acquired Daikin DVD. In return for the assets acquired, we issued 395,000 shares of Common Stock valued at approximately $593,000 and 700,000 shares of Preferred Stock valued at approximately $1,750,000. The acquisition was recorded using the purchase method of accounting and accordingly, the operating results have been included in our results of operations from the date of acquisition.
As a result of the acquisition, we acquired all the Daikin DVD related products and intellectual property rights which is included in purchased and internally developed software costs. Additionally, we acquired tangible assets such as furniture, computers and other electronic assets, some of which will continue to be used specifically in the acquired DVD software development business while others will be used in our general DVD authoring tool business.
On May 24, 2002, we entered into an agreement with Axeda, under which Axeda licensed Ravisent’s software DVD player and other digital media technologies to us. Under the agreement, we paid Axeda a one-time fee of $2,000,000 for the license and related agreements, and in return we obtained exclusive rights to deploy the Ravisent technologies in the personal computer market. As part of this agreement we acquired a revenue generating business, fixed assets, developed software and engineering employees. The accounting for this transaction was applied pursuant to the purchase accounting method.
On November 13, 2002, we entered into an agreement with VERITAS to acquire the business of the VERITAS Desktop Mobile Division (“DMD”), which sold personal computer based CD-ROM, CD-Audio and DVD-ROM mastering software and personal computer backup software. The transactions contemplated by the agreement were closed on December 18, 2002. We acquired the DMD business to expand our suite of CD and DVD mastering products.
Under this agreement with VERITAS we acquired all the software and other intellectual property required to carry on development and marketing of products sold by the DMD business, and we assumed essentially all of DMD businesses’ outstanding customers and other contracts. Under this agreement, almost all of the employees of the DMD business (approximately 40 individuals) joined Sonic.
Under the asset purchase agreement, we issued 1,290,948 shares of Series F preferred stock convertible into 1,290,948 shares of our common stock. The total purchase price was approximately $9,433,000 and the accounting for this transactions was applied pursuant to the purchase accounting method.
Liquidity and Capital Resources. Our operating activities have used cash of $848,000 in fiscal year 2001, generated cash of $5,708,000 in fiscal year 2002 and generated cash of $153,000 in fiscal year 2003. During fiscal year 2001, cash used in operations included a net loss of $5,855,000 including depreciation and amortization of $2,025,000 and interest expense amortization of $132,000. Cash used in operations was affected by changes in assets and liabilities including an increase in other assets of $177,000, and a decrease in accounts payable and accrued liabilities of $50,000, offset by decreases in accounts receivables of $2,215,000, inventory of $465,000 and an increase in deferred revenue and deposits of $219,000. In fiscal year 2001, net accounts receivables decreased 10% primarily due to lower revenues which decreased 21%. Inventory levels improved during the fiscal year, primarily due to better utilization of our outsourcing arrangement.
During fiscal year 2002, cash generated by operations included a net loss of $4,182,000 including depreciation and amortization of $1,880,000. Cash generated by operations was affected by changes in assets and liabilities including an increase in prepaid expenses and other current assets of $168,000 and an increase in other assets of $34,000, offset by decreases in accounts receivable of $1,042,000, inventory of $102,000 and increases in deferred revenue and deposits of $6,931,000 and in accounts payable and accrued liabilities of $135,000. In fiscal year 2002, net accounts receivables decreased by 25% primarily due to stronger collections and from prepayments and deposits received from OEM and licensing customers.
During fiscal year 2003, cash generated by operations included net income of $2,537,000 including depreciation and amortization of $2,396,000. Cash used in operations was affected by changes in assets and liabilities including a decrease in deferred revenue and deposits of 6,686,000 partially offset by an increase in accounts payable and accrued liabilities of $2,285,000. The decrease in accounts receivables was due to strong accounts receivable collections and the decrease in deferred revenue was the result of the revenue recognized on various OEM and development contracts.
During the fiscal years discussed above, our current ratio has fluctuated, primarily due to the increase in our deferred revenue and deposits. During fiscal year 2002, our current ratio increased over fiscal year 2001, primarily due to increase in cash from deposits and prepayments received from OEM and licensing customers which were offset in part by the increase in the deferred revenue account. During fiscal year 2003, our current ratio increased primarily due to the decrease in deferred revenue and deposits.
In addition to our operations, we utilized cash during the 2001, 2002 and 2003 fiscal years to purchase new fixed assets, and to fund the development of capitalized software. During the fiscal year 2003, cash of $2,275,000 was used to complete the acquisition of the Ravisent product line from Axeda and $962,000 was used to complete the acquisition of the DMD business from VERITAS.
We lease certain facilities and equipment under noncancelable operating leases. Rent expense under operating leases was approximately $1,011,000, $1,248,000 and $1,598,000 for the fiscal years ended March 31, 2001, 2002 and 2003, respectively. Future payments under operating leases that have initial remaining noncancelable lease terms in excess of one year are as follows (in thousands).
We believe that existing cash and cash equivalents and cash generated from operations will be sufficient to meet our cash requirements at least through the end of fiscal year 2004.
As of March 31, 2003, we had cash and cash equivalents of $9,708,000 and working capital of $8,004,000.
Off-Balance Sheet Arrangements. We do not have any off-balance sheet arrangements (as such term is defined in recently enacted SEC rules) that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors.
Risk Factors. You should carefully consider the risk factors set forth below as well as those in other documents we file with the Securities and Exchange Commission: The risks identified below could cause the value of our shares to decline. We cannot, however, estimate the likelihood that our shares may decline in value or the amount by which they may decline.
We have had losses in each of the past four fiscal years ending March 31, 2002.
We were unprofitable during each of the four fiscal years ending March 31, 2002. For example, in fiscal year 2002, we had a net loss of $4,182,000 and in fiscal year 2001 we had a net loss of $5,855,000. We were unprofitable during each quarter of the 2000 and 2001 fiscal years and during the first three quarters of the 2002 fiscal year. Although we were profitable in the fourth quarter of the 2002 fiscal year and each of the four quarters of the 2003 fiscal year, we may not maintain profitability and as a result our share price may decline. Although we have provided revenue and profitable earnings guidance for fiscal 2004, there are no assurances that we will meet such guidance and our inability to meet such guidance could cause our share price to decline.
During the fiscal year ended March 31, 2001 we had negative operating cash flows.
During the fiscal year ended March 31, 2001, we had a negative operating cash flow of $848,000. During the fiscal year ended March 31, 2002, we had a positive operating cash flow of $5,708,000. During the fiscal year ended March 31, 2003, we had a positive operating cash flow of $153,000. We may continue to report a negative operating cash flow in the future, and we may need to obtain additional financing to continue to operate. If we are unable to obtain such financing, then we may have to cease or significantly curtail operations.
If sources of financing are not available, we may not have sufficient cash to satisfy working capital requirements.
We believe that our current cash balances are sufficient to satisfy our working capital requirements for at least the next twelve months. We may need to obtain additional financing at that time or prior to that time if our plans change or if we expend cash sooner than anticipated. We currently do not have any commitments from third parties to provide additional capital. The risk to us is that at the time we will need cash, financing from other sources may not be available on satisfactory terms, if at all. Our failure to obtain financing could result in our insolvency and the loss to investors of their entire investment in our common stock.
Any failure to successfully integrate the DMD business we purchased from VERITAS could negatively impact us.
The acquisition of the DMD business involves risks related to the integration and management of the DMD business, which will be a complex, time-consuming and an expensive process and may disrupt our businesses if not completed in a timely and efficient manner. We may encounter substantial difficulties, costs and delays in integrating the DMD operations, including:
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potential conflicts between business cultures;
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adverse changes in business focus perceived by third-party constituencies;
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potential conflicts in distribution, marketing or other important relationships;
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an inability to implement uniform standards, controls, procedures and policies;
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an inability to integrate our research and development and product development efforts;
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the loss of current or future key employees and/or the diversion of management’s attention from other ongoing business concerns;
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undiscovered and unknown problems, defects or other issues related to the DMD products that become known to us only some time after the acquisition; and
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negative reactions from our resellers and customers.
The DMD business may not be a positive contributor to our operations but instead may constitute a drain on our resources. We may therefore not achieve the desired synergies and benefits of the DMD acquisition.
Other recent acquisitions may compromise our operations and financial results.
The Ravisent business line was not profitable when owned by Axeda. It is possible that the Ravisent technology and employees will not be a positive contributor to our operations and instead will constitute a drain on our resources.
Future acquisitions may compromise our operations and financial results.
As part of our efforts to enhance our existing products and introduce new products, we may pursue acquisitions of complementary companies, products and technologies. Acquisitions could adversely affect our operating results in the short term as a result of dilutive issuances of equity securities or usage of our cash and the incurrence of additional debt costs. The purchase price for an acquired company may exceed its book value, creating goodwill, possibly resulting in significant impairment write-downs charged to our operating results in future periods. We have limited experience in acquiring and integrating outside businesses and future acquisitions are likely to involve similar risks associated with our financial results and the integration of technology and employees.
The issuance of stock under our registration statement will dilute the relative ownership of existing common shareholders and could result in lower market price for our stock.
As part of the acquisition of the DMD business, we issued VERITAS 1,290,948 shares of our Series F convertible preferred stock. In March, 2003, VERITAS converted all of their shares of Series F Preferred Stock into 1,290,948 shares of our Common Stock which, based upon our common stock outstanding as of March 31, 2003, resulted in approximately a 7% dilution to our shareholders.
Our stock price has been volatile, is likely to continue to be volatile, and could decline substantially.
The price of our common stock has been, and is likely to continue to be, highly volatile. The price of our common stock could fluctuate significantly for some of the following reasons:
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future announcements concerning us or our competitors;
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quarterly variations in operating results;
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charges, amortization and other financial effects relating to our recent or future acquisitions;
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introduction of new products or changes in product pricing policies by us or our competitors;
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acquisition or loss of significant customers, distributors or suppliers;
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business acquisitions or divestitures;
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changes in earnings estimates by analysts;
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issuances of stock under our shelf registration statement;
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fluctuations in the economy or general market conditions;
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our failure to successfully integrate the DMD business; or
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the delay in delivery to market or acceptance of new DVD products (for example DVD recorders).
In addition, stock markets in general, and the market for shares of technology stocks in particular, have experienced extreme price and volume fluctuations in recent years which have frequently been unrelated to the operating performance of the affected companies. These broad market fluctuations may adversely affect the market price of our common stock. The market price of our common stock could decline below its current price and the market price of our stock may fluctuate significantly in the future. These fluctuations may be unrelated to our performance.
In the past, shareholders of various companies have often instituted securities class action litigation after periods of volatility in the market price of a company’s securities. If a shareholder files a securities class action suit against us, we would incur substantial legal fees and our management’s attention and resources would be diverted from operating our business in order to respond to the litigation.
If new digital formats are unsuccessful, it is unlikely that we will generate sufficient revenues to recover our development cost.
Our business involves new digital audio and video formats, such as DVD-Video and DVD-Audio, and, more recently, the new recordable DVD formats including DVD-RAM, DVD-R/RW and DVD+RW. If these formats prove to be unsuccessful or are not accepted for any reason, there will be only limited demand for our products.
Our reliance on outsourcing and single suppliers for our manufacturing and components makes us vulnerable to supplier operational problems.
Our outsourcing manufacturing program commits responsibility for almost all of our manufacturing activities to a single supplier - Arrow Bell Electronics. In addition, we often use components that are only available from a single source. Those components include, for example, Phillip’s Video Scaler and various Xilinx devices. Reliance on a single supplier for manufacturing or for certain manufacturing components makes us vulnerable to operating, financial and other problems encountered by those suppliers.
If we fail to protect our products’ intellectual property rights, such as trade secrets, we may not be able to market our products successfully.
Our products are based in large part on proprietary technology which we have sought to protect with patents, trademarks and trade secrets. For example, we have numerous patents and we have also filed applications for additional patents. We also registered trademarks for the following: DVDit!, MyDVD, DVD Creator, DVD Fusion, RecordNow, Backup MyPC, CinePlayer, AuthorScript, ReelDVD and Primo SKD among others. To the extent that we use patents to protect our proprietary rights, we may not be able to obtain needed patents or, if granted, the patents may be held invalid or otherwise indefensible. In addition, we make extensive use of trade secrets that we may not be able to protect. To the extent we are unable to protect our proprietary rights, competitors may enter the market offering products identical to ours, with a negative impact on sales of our products.
Other companies’ intellectual property rights may interfere with our current or future product development and sales.
We have never conducted a comprehensive patent search relating to the technology we use in our products. There may be issued or pending patents owned by third parties that relate to our products. If so, we could incur substantial costs defending against patent infringement claims or we could even be blocked from selling our products.
Other companies may succeed in obtaining valid patents covering one or more of the key techniques we utilize in our products. If so, we may be forced to obtain required licenses or implement alternative non-infringing approaches.
Our products are designed to adhere to industry standards, such as DVD-ROM, DVD-Video, DVD-Audio and MPEG video. A number of companies and organizations hold various patents that claim to cover various aspects of DVD and MPEG technology. We have entered into license agreements with certain companies relative to some of these technologies. For instance, we have entered into license agreements with Dolby Licensing Corporation covering Dolby Digital Audio and with Meridian Audio Limited covering Meridian Lossless Packing. Such license agreements may not be sufficient to grant all of the intellectual property rights to us necessary to market our products.
We may become involved in costly and time-consuming patent litigation.
Third parties could pursue us claiming that our products infringe various patents. Patent infringement litigation can be time consuming and costly. If the litigation resulted in an unfavorable outcome for us, we could be subject to substantial damage claims and a requirement that we obtain a royalty or license agreement to continue using the technology in issue. Such royalty or license agreements might not be available to us on acceptable terms, or at all, resulting in serious harm to our business.
For example, a group of companies have formed an organization called MPEG-LA to enforce the rights of holders of patents covering aspects of MPEG-2 video technology. Although we have entered into an agreement with MPEG-LA, that agreement may not prevent third parties from asserting that we infringe a patent covering the MPEG-2 technology.
Because a significant percentage of our professional DVD products operate only on Macintosh computers, the potential success of these products is tied to the success of this platform.
Several of our current professional DVD products, including DVD Creator and DVD Fusion, operate on Macintosh computers manufactured by Apple Computer. If the supply of Macintosh computers becomes limited, sales of these products will likely decline. If there is a decrease in the use of the Macintosh computing platform in the professional and corporate audio and video markets, there will likely be a decrease in demand for our products. If there are changes in the operating system or architecture of the Macintosh, it is likely that we will incur significant costs to adapt our products to the changes. Our Macintosh users generally demand that we maintain compatibility with the latest models of the Macintosh and the Macintosh OS. Currently our DVD Creator and DVD Fusion applications run only on OS 9. Macintosh OS X currently offers a “compatibility mode” which supports OS 9.x compatible applications, but we believe that we will soon have to modify our DVD Creator and DVD Fusion applications for them to continue to be able to run with the latest Macintosh models. Such a modification may be difficult to accomplish or infeasible and if it proves to be lengthy, our revenues could be significantly reduced in the interim.
Because a large portion of our net revenue is from OEM customers, the potential success of our products is tied to the success of their product sales.
Much of our consumer revenue is derived from sales to large OEM customers, which include Dell, Hewlett-Packard, Sony, Matrox and Avid. The revenue from many of these customers is recognized on a sell-thru basis. If these customers do not ship as many units as forecasted or if there is a decrease in their unit sales, our net revenue will be adversely impacted and we may be less profitable than forecasted or unprofitable.
Some of our competitors possess greater technological and financial resources than we do, may produce better or more cost-effective products than ours and may be more effective than we are in marketing and promoting their products.
There is a substantial risk that competing companies will produce better or more cost-effective products, or will be better equipped than we are to promote them in the marketplace. A number of companies have announced or are delivering products which compete with our products. These include Ahead, Apple Computer, CyberLink, Dazzle (a division of SCM Microsystems), Intervideo, Inc., MedioStream, Pinnacle, Roxio and
Ulead. See discussion entitled “Competition for Desktop Products” in the Business Section of Part I of this document. Most of these companies have greater financial and technological resources than ours.
Our reliance on outsourcing our Webstore makes us vulnerable to third party’s operational problems.
We have initiated a web-based retail store for our DVDit! and MyDVD products (as well as some of our professional products, for example, ReelDVD). We currently “outsource” our Webstore through an arrangement we have with Digital River. Under this arrangement, Digital River provides the servers which list our products and handle all purchase transactions through their secure web site.
Outsourcing means that we are dependent on a third party for smooth operation of our Webstore. Since our Webstore sales are a significant portion of our revenues, interruption of our Web Store could have a negative effect on our business.
We have little ability to reduce expenses to compensate for reduced sales.
We tend to close a number of sales in the last month or last weeks of a quarter, especially in our professional audio and video business, and we generally do not know until quite late in a quarter whether our sales expectations for the quarter will be met. For example, in recent quarters, as much as 65% of our professional sales have been procured in the last month of the quarter. Because most of our quarterly operating expenses and our inventory purchasing are committed prior to quarter end, we have little ability to reduce expenses to compensate for reduced sales.
Approximately 26% of our revenue derives from revenue recognized on development and licensing agreements from three customers for the fiscal year 2003.
During fiscal 2003, approximately 26% of our revenue was derived from revenue recognized on development and licensing agreements from three customers as discussed in Note 10 of Notes to Condensed Financial Statements. A decrease or interruption in any of the above mentioned businesses or their demand for our products or a delay in our development agreements could cause a significant decrease in our revenue.
A significant portion of our revenue derives from sales made to foreign customers located primarily in Europe and Japan.
Revenue derived from these customers accounted for approximately 47%, 39% and 30% of our revenues in fiscal years 2001, 2002 and 2003, respectively. These foreign customers expose us to the following risks, among others:
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currency movements in which the U.S. dollar becomes significantly stronger with respect to foreign currencies, thereby reducing relative demand for our products outside the United States;
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import and export restrictions and duties;
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foreign regulatory restrictions, for example, safety or radio emissions regulations; and
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liquidity problems in various foreign markets.
Item 7A.
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our exposure to market risk is limited. All of our international sales are denominated in U.S. dollars with the exception of the payments made to us by Daikin pursuant to the Distribution Agreement entered into on February 27, 2001 and payments made to Daikin by us pursuant to the Consulting Agreement entered into on February 27, 2001. See Note 13 of Notes to Condensed Financial Statements. We do not engage in any hedging activities.
We do not use derivatives or equity investments for cash investment purposes.
Cash equivalents consist of short-term, highly-liquid investments with original maturities of three months or less and are stated at cost which approximates market value. Cash equivalents consist of money market funds.
Item 8.
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Report of Independent Auditors, Financial Statements and Notes to Financial Statements follow.
INDEPENDENT AUDITORS’ REPORT
The Board of Directors
Sonic Solutions:
We have audited the accompanying balance sheets of Sonic Solutions as of March 31, 2003 and 2002, and the related statements of operations, shareholders’ equity and cash flows for each of the years in the three-year period ended March 31, 2003. In connection with our audits of the financial statements, we also have audited the financial statement schedule as listed in Item 15(a)2. These financial statements and financial statement schedule are the responsibility of Sonic Solutions’ management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. 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 financial statements referred to above present fairly, in all material respects, the financial position of Sonic Solutions as of March 31, 2003 and 2002 and the results of its operations and its cash flows for each of the years in the three-year period ended March 31, 2003, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
/s/ KPMG LLP
San Francisco, California
May 1, 2003
FINANCIAL STATEMENTS
SONIC SOLUTIONS
BALANCE SHEETS
(in thousands, except share and per share amounts)
See accompanying notes to financial statements
SONIC SOLUTIONS
STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
See accompanying notes to financial statements
SONIC SOLUTIONS
STATEMENTS OF SHAREHOLDERS’ EQUITY
(in thousands)
See accompanying notes to financial statements
SONIC SOLUTIONS
STATEMENTS OF CASH FLOWS
(in thousands)
See accompanying notes to financial statements
SONIC SOLUTIONS
NOTES TO FINANCIAL STATEMENTS
March 31, 2001, 2002 and 2003
(1) SUMMARY OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES
(a) Operations
We develop and market computer based tools that enable the creation of digital audio and video titles in the CD-Audio and DVD-Video formats, and in related formats. These tools are also used for recording data files on CD recordable or DVD recordable disks in the CD-ROM and DVD-ROM formats and for backing up the information contained on hard disks attached to computers. Most of the products we sell consist entirely of computer software, though some of the tools we sell include “plug-in” computer hardware. We also license the software technology underlying our tools to various other companies to incorporate in products they develop.
We divide our products into three categories:
•
Professional Audio and Video Products - Our professional products consist of advanced DVD-Video creation tools which are intended for use by high-end professional customers. We sell a number of products in this category including DVD Creator (Macintosh based), Sonic Scenarist (Windows based), DVD Producer (Windows based), DVD Fusion (Macintosh based) and ReelDVD (Windows based). These products include elaborate applications software and, in some cases, plug-in hardware. Our customers use our professional products to prepare commercial quality DVD-Video titles, in many cases destined for mass replication and release to home video consumers.
•
Desktop Products - Our desktop products include software-only DVD-Video creation tools and DVD-Video playback software intended for use by lower end professionals, by enthusiasts or “prosumers,” and by consumers. Our desktop products also include software-only CD-Audio, CD-ROM and DVD-ROM making tools, as well as data backup software. We sell and market these products through product bundling arrangements with OEM suppliers of related products, as well as through retail channels (both web-based and traditional “bricks and mortar” channels). We market a number of different desktop products under various trade names including RecordNow, Backup My PC, CinePlayer, DVDit! and MyDVD.
•
Technology Products - This category includes software that we license to other companies for inclusion in their DVD or CD creation and recording products. We market most of this software under the trade names of AuthorScript and Primo SDK.
On February 27, 2001, we entered into an Asset Purchase Agreement with Daikin Industries, Ltd., a Japanese corporation, whereby on that date we acquired The DVD Software Development Business of Daikin, also called “Daikin DVD.” In return for the assets acquired, we issued 395,000 shares of Common Stock valued at $593,000 and 700,000 shares of Preferred Stock valued at $1,750,000. The acquisition was recorded using the purchase method of accounting.
On March 21, 2002, we executed an agreement forming a new company, Sonic Studio LLC in partnership with a limited liability corporation controlled by two individuals - Eric Jorde and Jeff Wilson. Under the terms of the agreement, we transferred our SonicStudio workstation business to the SonicStudio LLC, and licensed them to utilize the technology underlying SonicStudio in the professional audio workstation market. The total amount of net assets and liabilities transferred to the SonicStudio LLC, including receivables, inventory, fixed assets, and net of customer service liabilities was $235,661. Certain employees transferred from Sonic to join the SonicStudio LLC.
Under the terms of the agreement, SonicStudio LLC compensated us for the Sonic Studio business with a three year note for $500,000. The note, which does not carry interest, will be repaid to us with a percentage
royalty based on sales received by SonicStudio LLC, plus any share of profits paid to us by them. Once the note is retired, Sonic will continue to retain a 15% interest in SonicStudio LLC.
On May 24, 2002, we entered into an agreement with Axeda, under which Axeda licensed Ravisent’s software DVD player and other digital media technologies to us. Under the agreement, we paid Axeda a one-time fee of $2 million for the license and related agreements, and in return we obtained exclusive rights to deploy the Ravisent technologies in the personal computer market. As part of this agreement we acquired a revenue generating business, fixed assets, developed software and engineering employees.
On November 13, 2002, we entered into an asset purchase agreement with VERITAS to acquire the business of the VERITAS Desktop Mobile Division (“DMD”), which sold personal computer based CD-ROM, CD-Audio and DVD-ROM mastering software and personal computer backup software . The transactions contemplated by the agreement were closed on December 18, 2002.
Under the agreement with VERITAS we acquired all the software and other intellectual property required to carry on development and marketing of products sold by the DMD business, and we assumed essentially all of the DMD business’ outstanding customer contracts and other contracts. Under this agreement almost all the employees of the DMD business (approximately 40 individuals) joined Sonic. Pursuant to this agreement we also entered into a sublease agreement with VERITAS for the principal offices of the DMD business.
Under the asset purchase agreement, we issued 1,290,948 shares of Series F Preferred Stock valued at $8,471,000 and convertible into 1,290,948 shares of our Common Stock (subject to adjustment for stock splits and the like). Pursuant to the asset purchase agreement we entered into an amended and restated registration rights agreement with VERITAS under which we provided registration rights for these shares once they were converted into shares of our Common Stock. In March, 2003, VERITAS converted all their shares of Series F Preferred Stock into shares of our Common Stock.
(b) Use of Estimates and Certain Concentrations
We prepare our financial statements in conformity with U.S. generally accepted accounting principles. These accounting principles require management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements. Our management is also required to make certain judgments that affect the reported amounts of revenues and expense during the reporting period. We periodically evaluate our estimates including those relating to revenue recognition, the allowance for doubtful accounts, capitalized software, and other contingencies. We base our estimates on historical experience and various other assumptions that we believe to be reasonable based on the specific circumstances, the results of which form the basis for making judgments about the carrying value of certain assets and liabilities that are not readily apparent from other sources. Actual results could differ from these estimates.
We are dependent on sole-source suppliers for certain key components used in our products. We purchase these sole-source components pursuant to purchase orders placed from time to time. We do not carry significant inventories of these components, and have no guaranteed supply agreements. Any extended future interruption or limitation in the supply of any of the components obtained from a single source could have a material adverse effect on our results of operations.
(c) Revenue Recognition
We recognize revenue in accordance with Statement of Position (“SOP”) 97-2, “Software Revenue Recognition”, as amended by SOP 98-4 “Deferral of the Effective Date of a Provision of SOP 97-2,” and SOP 98-9, “Software Revenue Recognition, with Respect to Certain Arrangements” and in certain instances in accordance with SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.” SOP 97-2 generally requires revenue earned on software arrangements involving multiple elements
such as software products, hardware, upgrades, enhancements, maintenance and support, installation and training to be allocated to each element based on the relative fair values of the elements. The fair value of an element must be based on vendor-specific objective evidence.
We derive our software revenue primarily from licenses of our software products (including any related hardware components), development agreements and maintenance and support. Revenue recognized from multiple-element software arrangements is allocated to each element of the arrangement based on the fair values of elements, for example, the license to use software products versus maintenance and support for the software product. The determination of fair value is based on objective evidence specific to us. Objective evidence of fair values of all elements of an arrangement is based upon our standard pricing and discounting practices for those products and services when sold separately. Objective evidence of support services is measured by annual renewal rates. SOP 98-9 requires recognition of revenue using the “residual method” in a multiple element arrangement when fair value does not exist for one or more of the delivered elements in the arrangement. Under the “residual method,” the total fair value of the undelivered element is deferred and subsequently recognized in accordance with SOP 97-2. The difference between the total software arrangement fee and the amount deferred for the undelivered elements is recognized as revenue related to the delivered elements.
Revenue from license fees is recognized when persuasive evidence of an arrangement exists (such as receipt of a signed agreement, purchase order or a royalty report), delivery of the product (including hardware) has occurred (generally F.O.B. shipping point), no significant obligations with regard to implementation remain, the fee is fixed and determinable, and collectibility is probable. In addition, royalty revenue from certain distributors that do not meet our credit standards and revenues from our distributor agreement with Daikin are recognized upon sell-through to the end-customer. We consider all arrangements with payment terms longer than one year not to be fixed and determinable. If the fee is not fixed or determinable, revenue is recognized as payments become due from the customer.
Revenue from development agreements, whereby the development is essential to the functionality of the licensed software, is recognized over the performance period based on proportional performance. Under this method, management is required to estimate the number of hours needed to complete a particular project, and revenues and profits are recognized as the contract progresses to completion.
Deferred revenue includes amounts billed to customers for which revenues have not been recognized which results from the following: (1) deferred maintenance and support; (2) amounts billed to certain distributors for our products not yet sold through to the end-user customers; (3) amounts billed to technology customers for license and development agreements in advance of recognizing the related revenue; and (4) amounts billed to certain OEMs for products which contain one or more undelivered elements.
(d) Cash Equivalents
Cash equivalents consist of short-term, highly-liquid investments with original maturities of three months or less and are stated at cost which approximates market value. Cash equivalents consist of money market funds.
(e) Inventory
Inventory is valued at the lower of cost, determined on a first-in, first-out basis, or market.
(f) Fixed Assets
Fixed assets consist of furniture and equipment and are recorded at cost less accumulated depreciation. Equipment under capital leases is stated at the present value of minimum lease payments at the inception of the lease. Depreciation of furniture and equipment is provided using the straight-line method over the estimated useful lives of the respective assets which are generally three to five years. Equipment held under capital leases is amortized over the shorter of the lease term or the estimated useful life of the asset.
(g) Purchased and Internally Developed Software Costs
Purchased software and software product development costs are capitalized when a product’s technological feasibility has been established and then are amortized over a future period. Amortization begins when a product is available for general release to customers. Amortization of capitalized software costs, for both internally developed and purchased software products, is computed on a straight- line basis over the estimated economic life of the product, which is generally three years, or on a basis using the ratio of current revenue to the total of current and anticipated future revenue, whichever is greater. All other research and development expenditures are charged to research and development expense in the period incurred.
(h) Income Taxes
We account for income taxes under the asset and liability method of accounting. Under the asset and liability method, deferred tax assets and liabilities are recognized based on the future tax consequences attributable to differences between the financial statement carrying amount of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using the tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized.
(i) Basic and diluted loss per share
The following table sets forth the computations of shares and net income (loss) per share, applicable to common shareholders used in the calculation of basic and diluted net income (loss) per share for the years ended March 31, 2001, 2002 and 2003 (in thousands, except per share data), respectively:
The following is a reconciliation of the number of shares used in the basic and diluted net income (loss) per share computations for the years ended March 31, 2001, 2002 and 2003 (in thousands, except per share data), respectively:
Potential dilutive common shares consist of shares issuable upon exercise of stock options. The impact of our stock options on the shares used for the diluted earnings per share computation is calculated based on the average share price of our common stock for each year using the treasury stock method.
We exclude all potentially dilutive securities from our diluted net income (loss) per share computation when their effect would be anti-dilutive. The following common stock equivalents were excluded from the earnings per share computation, as their inclusion would have been anti-dilutive (in thousands, except per share date), respectively:
(j) Concentrations of Risk
Financial instruments which potentially subject our Company to concentrations of credit risk are trade receivables. We manufacture and sell our products to customers who are primarily audio and video and graphic arts professionals who prepare sound, video and graphics for use in the music recording, video, film and broadcast and printing industries or for corporate in-house use and to dealers who support such customers. Management believes that any risk of credit loss is significantly reduced due to the diversity of its end users and their dispersion across many geographic sales areas. We maintain an allowance for doubtful accounts to provide against potential credit losses.
Cash equivalents consist of short-term, highly-liquid investments with original maturities of three months or less and are stated at cost which approximates market value. Cash equivalents consist of money market funds. At of March 31, 2003 and 2002, approximately $7,500,000 and $10,000,000, respectively, was invested in money market funds with one institution.
(k) Liquidity
In prior fiscal years we had incurred significant losses and negative cash flows from operations. As of March 31, 2003, we have an accumulated deficit of $26,339,000 and positive working capital of $8,004,000. We have primarily funded operations through private equity financing with Kingsbridge (see Note 6 to the Financial Statements).
(l) Stock-Based Compensation
Our Company has various stock-based compensation plans, as discussed in Note 7 to the Financial Statements. We have accounted for the effect of our stock based compensation plans under Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations. We have elected to adopt only the disclosure based requirements of Statement of Financial Accounting Standards (“SFAS”) No. 123 “Accounting for Stock-Based Compensation” and as such have disclosed the pro forma effects on net loss and net loss per share data as if we had elected to use the fair value approach to account for all our employee stock-based compensation plans.
Had compensation cost for our plans been determined in accordance with the fair value approach enumerated in SFAS No. 123, our net income (loss) and net income (loss) per share for the years ended March 31, 2001, 2002 and 2003 would have been adjusted as indicated below (in thousands, except per share data):
The fair value of options granted was estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 2001, 2002 and 2003; risk-free interest rate of 5.17%, 4.05% and 2.5%, respectively; expected life of 4 years; 110%, 125% and 112% expected volatility, respectively; and no dividends.
The effect of applying SFAS No. 123 for disclosing compensation costs may not be representative of the effects on reported net income (loss) for future years because pro forma net income (loss) reflects compensation costs only for stock options granted in fiscal 1996 through 2003 and does not consider compensation costs for stock options granted prior to April 1, 1995.
The Company accounts for options and warrants issued to nonemployees in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force (EITF) Issue No. 96-18, “Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling Goods or Services.” The Company uses the Black-Scholes option pricing model to value options granted to nonemployees. The related expense is recorded over the period in which the related services are received.
(m) Impairment of Long-Lived Assets
We evaluate long-lived assets, including intangible assets other than goodwill, for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable based on expected undiscounted cash flows attributable to that asset. The amount of any impairment is measured as the difference between the carrying value and the fair value of the impaired asset. We do not have any long-lived assets which we considered to be impaired during the fiscal year ended March 31, 2003.
(n) Recently Issued Accounting Pronouncements
In July 2001, the Financial Accounting Standards Board issued SFAS No. 141, “Business Combinations” and SFAS No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 141 requires that all business combinations be accounted for under the purchase method for business combinations initiated after June 30, 2001 and for which the date of acquisition is July 1, 2001 or later. Use of the pooling-of-interest method is no longer permitted. SFAS No. 141 also specifies criteria intangible assets acquired in a purchase method business combination must meet to be recognized and reported apart from goodwill. SFAS No. 142 addresses how goodwill and other intangible assets should be accounted for after they have been initially recognized in the financial statements. With the adoption of SFAS No. 142, goodwill is no longer subject to amortization over its estimated useful life; rather, goodwill will be subject to at least an annual assessment for impairment by applying
a fair-value-based test. We continually review the events and circumstances related to our financial performance and economic environment for factors that would provide evidence of impairment of goodwill. We test goodwill for impairment in accordance with SFAS 142 at least annually and more frequently upon the occurrence of certain events, as defined in SFAS 142. Goodwill is tested for impairment annually in a two-step process. First, we determine if the carrying amount exceeds “fair value” based on quoted market prices of our common stock, which would indicate that goodwill may be impaired. If we determine that goodwill may be impaired, we will compare the “implied fair value” of the goodwill, as defined by SFAS 142, to its carrying amount to determine the impairment loss, if any. Goodwill has resulted from our Ravisent product business acquisition during the first quarter ended June 30, 2002, which was accounted for as a purchase, and from our DMD acquisition from VERITAS during the third quarter ended December 31, 2002, which was also accounted for as a purchase. As of March 31, 2003, no events have occurred that would lead us to believe that there has been any impairment. If the benefit of an intangible asset is obtained through contractual or other legal rights, or if the intangible asset can be sold, transferred, licensed, rented or exchanged, an acquired intangible asset should be separately recognized. We adopted SFAS No. 142 effective April 1, 2002. The adoption of SFAS No. 141 and 142 did not have a material impact on our financial position or results of operations.
The Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 143, “Accounting for Asset Retirement Obligations” (“SFAS No. 143”), in August 2001, and Statement of Financial Accounting Standard No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”), in October 2001. SFAS No. 143 requires that the fair value of an asset retirement obligation be recorded as a liability in the period in which it incurs a legal obligation. SFAS No. 144 serves to clarify and further define the provisions of SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of.” SFAS No. 144 does not apply to goodwill and other intangible assets that are not amortized. SFAS No. 143 is effective for fiscal years beginning after June 15, 2002 and SFAS No. 144 is effective for fiscal years beginning after December 15, 2001. We adopted SFAS No. 143 effective April 1, 2003 and have adopted SFAS No. 144 effective April 1, 2002. The effect of adopting SFAS No. 143 did not have a material effect on our financial position or results of operations. The adoption of SFAS 144 did not have a material impact on our financial position or results of operations.
In April 2002, the Financial Accounting Standards Board issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” SFAS No. 145 rescinds Statement No. 4 “Reporting Gains and Losses from Extinguishment of Debt,” and an amendment of that Statement, No. 64 “Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements, and Statement No. 44 “Accounting for Intangible Assets of Motor Carriers. SFAS No. 145 also amends FASB Statement No. 13 “Accounting for Leases” to eliminate the required accounting for sale-leaseback transactions. We adopted SFAS No. 145 effective April 1, 2003. The adoption of SFAS No. 145 did not have a material effect on our financial position or results of operations.
In July 2002, the Financial Accounting Standards Board issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS No. 146 addresses how costs associated with an exit activity or with a disposal of long-lived assets are to be accounted for. SFAS No. 146 is effective for activities initiated after December 31, 2002, therefore, we adopted SFAS No. 146 effective January 1, 2003. The adoption of SFAS No. 146 did not have a material effect on our financial position or results of operations.
In November 2002, the Financial Accounting Standards Board issued FASB Interpretation (“FIN”) No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN No. 45 provides expanded accounting guidance surrounding liability recognition and disclosure requirements related to guarantees, as defined by this Interpretation. We adopted FIN No. 45 during the quarter ended December 31, 2002. In our ordinary course of business, we are not subject to potential obligations under guarantees that fall within the scope of FIN No.45 except for standard indemnification and warranty provisions that are contained within many of our customer license and service agreements, which give rise only to the disclosure requirements prescribed by FIN No. 45.
Indemnification and warranty provisions contained in our customer license and service agreements are generally consistent with those prevalent in our industry. The duration of our product warranties does not exceed 90 days following delivery of our products. We have not incurred significant obligations under customer indemnification or warranty provisions historically and do not expect to incur significant obligations in the future. Accordingly we do not maintain accruals for any potential customer indemnification or warranty-related obligations.
In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure.” This Statement amends SFAS No. 123, “Accounting for Stock-Based Compensation”, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. This statement also amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. We have adopted the annual disclosure requirements of SFAS No. 148 for the year ended March 31, 2003. We will adopt the interim disclosure requirements during the quarter ending June 30, 2003.
In January 2003, the FASB issued FIN No. 46, “Consolidation of Variable Interest Entities.” FIN No. 46 expands upon and strengthens existing accounting guidance that addresses when a company should include in its financial statements the assets, liabilities and activities of another entity. A variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN No. 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or is entitled to receive a majority of the entity’s residual returns or both. The consolidation requirements of FIN No. 46 apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements apply to older entities in the first fiscal year or interim period beginning after June 15, 2003. Certain disclosure requirements apply to any financial statements issued after January 31, 2003. The adoption of this statement did not have a significant impact on our financial position and results of operations.
In July 2002, the Financial Accounting Standards Board issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. We do not expect the adoption of SFAS No. 150 to have a material effect on our financial position or results of operations.
(o) Comprehensive Income (Loss)
We have no significant components of other comprehensive income (loss) and accordingly, comprehensive income (loss) equals net loss.
(p) Reclassifications
Certain prior period amounts have been reclassified to conform to the current period presentation.
(2) INVENTORY
The components of inventory consist of (in thousands):
(3) FIXED ASSETS
Fixed assets consist of (in thousands):
(4) PURCHASED, INTERNALLY DEVELOPED SOFTWARE COSTS, GOODWILL AND ACQUIRED INTANGIBLES
Capitalized software costs consist of (in thousands):
Amortization of capitalized software costs was $1,095,000, $602,000 and $468,000 for the years ended March 31, 2001, 2002 and 2003, respectively.
Acquired intangibles consist of (in thousands):
Amortization of acquired intangibles was $44,000, $910,000 and $963,000 for the years ended March 31, 2001, 2002 and 2003, respectively.
The following table represents accumulated amortization by class of acquired intangible as of the fiscal year ended March 31, 2003 (in thousands):
The estimated future amortization expense on the acquired intangibles is as follows (in thousands):
The following tables presents a rollforward of the goodwill and other intangibles, for the 2002 and 2003 fiscal years:
(1)
Includes technology acquired related to the Daikin acquisition as discussed in Note 13, “Daikin Acquisition”.
(2)
Amortization for intangibles in included in “Cost of Revenue” in our Statements of Operations for the fiscal year ended March 31, 2002.
(3)
Includes goodwill, technology acquired and customer lists acquired related to the Ravisent and DMD acquisitions as discussed in Note 11 “DMD Acquisition” and Note 12 “Ravisent Acquisition”.
(4)
Amortization for intangibles is included in “Cost of Revenue” in our Statements of Operations for the fiscal year ended March 31, 2003.
(5) ACCOUNTS PAYABLE AND ACCRUED LIABILITIES
Accounts payable and accrued liabilities consist of (in thousands):
(6) CREDIT FACILITIES AND DEBT RESTRUCTURING
On May 4, 2000, we entered into a new Private Equity Line Agreement (the “Agreement”) with Kingsbridge Capital. During the fourth quarter of fiscal year March 31, 2001, we drew $200,000 from the equity line for which we issued 211,416 shares of Common Stock. During the fiscal year March 31, 2002, we drew $2,400,000 from the equity line for which we issued 1,496,546 shares of Common Stock. During the fiscal year March 31, 2003, we drew $2,000,000 from the equity line for which we issued 269,360 shares of Common Stock. These amounts were recorded net of fees of $126,000 and $16,000 in fiscal years 2002 and 2003, respectively. The Agreement terminated by its terms on November 13, 2002.
Since December 1996, we have entered into two different financing arrangements with Hambrecht & Quist Guaranty Finance, including a $5,100,000 financing facility and a $7,000,000 equity-based line of credit. In March 1998, $3,000,000 of the $5,100,000 financing facility was restructured into $1,500,000 of convertible Preferred Stock (461,538 shares) and $1,500,000 of debt. The debt had an interest rate of 7.25% and was due in October 1999. As of the fiscal year ended March 31, 2001, all shares of the convertible Preferred Stock had been converted to Common Stock.
In October 1999, the $1,500,000 of debt due to Hambrecht and Quist Guaranty Finance was restructured into 153,846 shares of Series C Convertible Preferred Stock and $1,000,000 of debt. The unpaid balance at March 31, 2001 was $57,000. During the year ended March 31, 2001, all of the shares of Series C convertible Preferred Stock were converted to Common Stock. In connection with the debt restructuring, we issued warrants to purchase 120,000 common shares at an exercise price of $2.50, expiring on April 30, 2006. The fair value of the warrants was estimated using the Black-Scholes option pricing model and the following assumptions: volatility of .50, risk free interest rate of 6% and expected life equal to the contractual terms. These warrants expire on April 30, 2006 and are immediately exercisable. These warrants were exercised with respect to 70,000 shares at various times during fiscal years 2001 and 2002. During the first quarter ended June 30, 2002, warrants with respect to the remaining 50,000 shares were exercised.
(7) SHAREHOLDERS’ EQUITY
Convertible Preferred Stock - Series D
In February, 2001, we issued 700,000 shares of Series D Convertible Preferred Stock (the Preferred Stock) to Daikin Industries in conjunction with our purchase of Daikin DVD valued at $1,750,000 or $2.50 per share. During the quarter ended September 30, 2002, Daikin converted 350,000 shares of their Series D Convertible Preferred Stock into 350,000 shares of Common Stock and during the quarter ended December 31,
2002, Daikin converted all of their remaining shares of their Series D Convertible Preferred Stock into shares of Common Stock.
Convertible Preferred Stock - Series E
In December, 2001, we sold 250,000 shares of Series E Preferred Stock to Sanshin Electronic Co., Ltd. for $1,000,000. During the quarter ended September 30, 2002, Sanshin converted all of their Series E Preferred Stock into 250,000 shares of Common Stock.
Convertible Preferred Stock - Series F
On December 18, 2002 we sold 1,290,948 shares of Series F Preferred Stock to VERITAS Operating Corporation and its affiliates (“VERITAS”) in exchange for the Desktop and Mobile Division of VERITAS. The shares were sold pursuant to the exemption provided by Section 4(2) of the Securities Act of 1933. Each share of Series F Preferred Stock is convertible at the option of the holder into one share of common stock subject to adjustment for certain dilutive events, such as stock splits. In March 2003, VERITAS converted all of their Series F Preferred Stock into 1,290,948 shares of Common Stock.
Stock Options
Under our September 1989 Stock Option Plan (the “1989 Plan”), options to purchase up to an aggregate of 2,090,000 shares of Common Stock may be granted to key employees, directors and consultants. Grants of options to the directors of Sonic Solutions may not exceed 140,000 shares. The 1989 Plan provides for issuing both incentive stock options, which must be granted at fair market value at the date of grant, and nonqualified stock options, which must be granted at not less than 85% of fair market value of the stock. All options to date have been granted as incentive stock options. Options under the Plan generally vest over four years from the date of grant. The options generally expire ten years from the date of grant and are canceled three months after termination of employment. Our Board of Directors and Chief Executive Officer administer the 1989 Plan.
During 1995, we adopted the 1994 Non-Employee Directors Stock Option Plan (the “Non-Employee Plan”) which provides for the grant of stock options to Sonic Solutions’ non-employee directors. Under this plan, stock options are granted annually at the fair market value of Sonic Solutions’ Common Stock on the date of grant. The number of options so granted annually is fixed by the plan. Such options generally vest over four years from the grant date. The total number of shares to be issued under this plan may not exceed 100,000 shares. There were 12,000 options outstanding at March 31, 2003, at prices of $2.6560, $2.5625 and $1.6880 per share, all of which were exercisable. The Non-Employee Plan provides for issuing both incentive stock options, which must be granted at fair market value at the date of grant, and nonqualified stock options, which must be granted at not less than 85% of fair market value of the stock. All options to date have been granted as incentive stock options. Options under the Non-Employee Plan generally vest over four years from the date of grant. The options generally expire ten years from the date of grant and are canceled three months after termination of employment. Our Board of Directors and Chief Executive Officer administer the Non-Employee Plan.
In July, 1998, the Board of Directors adopted the Sonic Solutions 1998 Stock Option Plan (the “1998 Plan”) and the shareholder’s approved the 1998 Stock Option Plan in September, 1998. The 1998 Plan covers 1,000,000 shares of Common Stock, with an annual increase in the number of shares available for issuance under the 1998 Plan on the last day of each fiscal year; provided that the total number of shares issuable under the plan shall not exceed 2,000,000. The 1998 Plan provides for issuing both incentive stock options, which must be granted at fair market value at the date of grant, and nonqualified stock options, which must be granted at not less than 85% of fair market value of the stock. All options to date have been granted as incentive stock options. Options under the 1998 Plan generally vest over four years from the date of grant. The options generally expire ten years from the date of grant and are canceled three months after termination of employment. Our Board of Directors and Chief Executive Officer administer the 1998 Plan.
In July, 2000, the Board of Directors adopted the Sonic Solutions 2000 Stock Option Plan (the “2000 Plan”) and the shareholder’s approved the 2000 Plan in September, 2000. The 2000 Plan covers 3,000,000 shares of Common Stock with an annual increase in the number of shares available for issuance under the 2000 Plan on the last day of each fiscal year. Our Board of Directors and Chief Executive Officer administer the 2000 Plan.
A summary of Sonic Solutions’ option plans is presented below:
The following table summarizes information about stock options outstanding at March 31, 2003.
(8) INCOME TAXES
Income tax (benefit) expense for the year ended March 31, 2003 consists of:
Income tax (benefit) expense for the year ended March 31, 2002 consists of:
Income tax (benefit) expense for the year ended March 31, 2001 consists of:
The differences between income taxes computed using the statutory federal income tax rate of 34% and that shown in the statements of operations are summarized as follows (in thousands):
The components of deferred taxes are as follows (in thousands):
The net change in the valuation allowance for the year ended March 31, 2001, 2002 and 2003 was an increase of approximately $2,268,000, $2,696,000 and $138,000, respectively. Management believes that sufficient uncertainty exists regarding the future realization of certain deferred tax assets and thus a full valuation allowance is required.
As of March 31, 2003, we have cumulative federal and California net operating losses of approximately $24,938,000 and $10,923,000, respectively, which can be used to offset future income subject to taxes. The federal tax loss carryforwards will expire beginning in the year 2012 through 2023. The California tax loss carryforwards will expire beginning in the year 2002 through 2013.
California has imposed a moratorium on the utilization of loss carryforwards for the years 2002 and 2003.
As of March 31, 2003, we have cumulative unused research and development tax credits of approximately $3,011,000 and $1,707,000 which can be used to reduce future federal and California income taxes, respectively. We also have cumulative foreign tax credit of approximately $113,000. Federal credit carryforwards expire from 2009 through 2023; California credits will carryforward indefinitely.
As of March 31, 2003, we have federal minimum tax credit carryforwards of approximately $88,000 which are available to reduce federal regular income taxes, if any, over an indefinite period.
Utilization of our net operating loss carryforwards and tax credits may be subject to substantial annual limitations due to the ownership change limitations provided by the Internal Revenue Code and similar state provisions. Such an annual limitation could result in the expiration of the net operating loss carryforwards and tax credit carryforwards before utilization.
Amounts for the current year are based on estimates and assumptions as of the date of this report and could vary from amounts shown on the tax returns as filed. Accordingly, the variances from the amounts previously reported for the fiscal year 2002 are primarily a result of adjustments to conform to tax returns as filed.
(9) COMMITMENTS AND CONTINGENCIES
(a) Leases
We lease certain facilities and equipment under noncancelable operating leases. Future payments under operating leases that have initial remaining noncancelable lease terms in excess of one year are as follows (in thousands):
Rent expense under operating leases for the years ended March 31, 2001, 2002 and 2003 was approximately $1,011,000, $1,248,000 and $1,598,000, respectively.
(b) Benefit Plan
We sponsor a 401(k) savings plan covering most salaried employees. To date, no contributions have been made to this plan by us.
(c) Inventory Purchase Commitments
Under the terms of an agreement with an outside supplier, we have a commitment which requires us to purchase finished goods inventory from them subject to certain terms. At March 31, 2003, the amount was not significant.
(d) Other
We from time to time are subject to routine claims and litigation incidental to our business. We believe that the results of these matters will not have a material adverse effect on our financial condition and results of operations.
(10) SIGNIFICANT CUSTOMER INFORMATION AND SEGMENT REPORTING
Statement of Financial Accounting Standards (SFAS) No. 131, “Disclosures about Segments of an Enterprise and Related Information,” requires companies to report financial and descriptive information about its reportable operating segments, including segment profit or loss, certain specific revenue and expense items and segment assets, as well as information about the revenues derived from our products and services, the countries in which we earn revenue and hold assets, and major customers. The method for determining what information to report is based on the way that management organized the operating segments within our company for making operating decisions and assessing financial performance.
Our chief operating decision maker is considered to be our Chief Executive Officer (“CEO”). The CEO reviews financial information presented on a consolidated basis accompanied by desegregated information about revenue by product line and revenue by geographic region for purposes of making operating decisions and assessing financial performance. The consolidated financial information reviewed by the CEO is identical to the information presented in the accompanying statements of operations. Therefore, we operate in, and measure our results in a single operating segment. As such, we are required to disclose the following revenue by product line, revenue by geographic and significant customer information:
Revenues by Product Line:
Our accounting system does not capture meaningful gross margin and operating income (loss) information by product line, nor is such information used by the CEO for purposes of making operating decisions. Accordingly, such information has not been disclosed.
Revenues by Geographic Location:
We sell our products to customers categorized geographically by each customer’s country of domicile. We do not have any material investment in long lived assets located in foreign countries for any of the years presented.
Significant customer information:
Customer A is a current distributor of the Company.
Revenue recognized from Customers B and C is pursuant to development and licensing agreements for which amounts had been prepaid and previously included in deferred revenue.
Revenue recognized from Customer D is pursuant to development and licensing agreements.
(11) DMD ACQUISITION
On November 13, 2002, we entered into an agreement with VERITAS to acquire the business of the VERITAS Desktop Mobile Division (“DMD”), which sold personal computer based CD-ROM, CD-Audio and DVD-ROM mastering software and personal computer backup software. The transactions contemplated by the agreement were closed on December 18, 2002. The results of DMD’s operations have been included in our financials since December 18, 2002. We acquired the DMD business to expand our suite of CD and DVD mastering products.
Under this agreement with VERITAS we acquired all the software and other intellectual property required to carry on development and marketing of products sold by the DMD business, and we assumed essentially all of DMD businesses’ outstanding customers and other contracts. Under this agreement, almost all of the employees of the DMD business (approximately 40 individuals) joined Sonic. Pursuant to this agreement we also entered into a sublease agreement with VERITAS for the principal offices of the DMD business.
Under the asset purchase agreement, we issued 1,290,948 shares of Series F preferred stock convertible into 1,290,948 shares of our common stock (subject to adjustment for stock splits and the like). Pursuant to the asset purchase agreement, we entered into an amended restated registration rights agreement with VERITAS under which we provided registration rights for these shares once they are converted into shares of our common stock. The shares were convertible at the Company’s option three months following the effective registration of the shares. All of the stock was converted into common stock in March 2003. As the Company determined that the preferences associated with the preferred stock did not have significant value, the value of the 1,290,948 shares was determined based on the Average Market Price of our common shares over the two day period before and after the terms of the acquisition were agreed to and announced. The total purchase price of the DMD acquisition was approximately $9,433,000.
The accounting for this transaction was applied pursuant to the purchase accounting method. The amount and components of the purchase price along with the allocation of the purchase price are as follows (in thousands):
The acquired technology and customer relationships are being amortized on the straight-line method over a period of three (3) years.
The following unaudited pro forma results of operations for fiscal year 2002 and 2003 are as if the acquisition occurred on April 1, 2001. The pro forma information has been presented for illustrative purposes only and are not necessarily indicative of the combined financial position or results of operations for future periods or the results of operations or financial position that actually would have been realized had we been a combined company during the specified periods.
(12) RAVISENT LICENSE AGREEMENT
On May 24, 2002, we entered into an agreement with Axeda, under which Axeda licensed Ravisent’s software DVD player and other digital media technologies to us. Under the agreement, we paid Axeda a one-time fee of $2,000,000 for the license and related agreements, and in return we obtained exclusive rights to deploy the Ravisent technologies in the personal computer market. As part of this agreement we acquired a revenue generating business, fixed assets, developed software and engineering employees.
The accounting for this transaction was applied pursuant to the purchase accounting method. The amount and components of the purchase price along with the allocation of the purchase price are as follows (in thousands):
(13) DAIKIN DVD ACQUISITION
On February 27, 2001, we entered into an Asset Purchase Agreement with Daikin Industries, Ltd., a Japanese corporation, whereby on that date we acquired Daikin DVD. In return for the assets acquired, we issued 395,000 shares of Common Stock valued at approximately $593,000 and 700,000 shares of Preferred Stock valued at approximately $1,750,000.
The value of the common stock was determined based on the closing market price of our Common Stock on February 27, 2001. The estimated value of the Preferred Stock was determined based on the following considerations relative to Preferred Stock: (1) the Common Stock conversion feature; (2) the dividend rate; and (3) the stated liquidation preference associated with the Preferred Stock. The acquisition was recorded using the purchase method of accounting and accordingly, the operating results have been included in our results of operations from the date of acquisition.
A finder’s fee was paid of 100,000 shares of our Common Stock, valued at $150,000, in connection with the acquisition.
As a consequence of the acquisition, we acquired all the Daikin DVD related products and intellectual property rights which is included in purchased and internally developed software costs. Additionally, we acquired tangible assets such as furniture, computers and other electronic assets, some of which will continue to be used specifically in the acquired DVD software development business while others will be used in our general DVD authoring tool business. The costs of the acquisition have been allocated on the bases of the estimated fair market values of the assets and liabilities assumed.
We estimated fair value of the individual net tangible and intangible assets acquired exceeded the purchase price. As a result, the carrying values of the fixed assets and purchased software costs acquired were reduced by this excess. The amount and components of the purchase price along with the allocation of the purchase price are as follows (in thousands):
In connection with the Asset Purchase Agreement, we and Daikin entered into a fourteen month Distribution Agreement (the “Distribution Agreement”) whereby we appointed Daikin as our exclusive distributor in Japan. During the terms of the Distribution Agreement, Daikin committed to placing minimum purchase orders of 260,000,000 yen of Daikin acquired products. During the year ended March 31, 2001, Daikin paid us $595,210 relating to the Distribution Agreement. During the year ended March 31, 2002, Daikin paid us $1,522,434 relating to the Distribution Agreement. During the year ended March 31, 2003, we negotiated a new distribution agreement with Daikin, pursuant to which Daikin will continue to be a distributor in Japan.
(14) JOINT VENTURE - INVESTMENT IN SONICSTUDIO LLC
On March 21, 2002, we executed an agreement forming a new company, Sonic Studio LLC in partnership with a limited liability corporation controlled by two individuals - Eric Jorde and Jeff Wilson. Under this agreement, we transferred our SonicStudio workstation business to the new LLC, and licensed the LLC to use the technology underlying SonicStudio in the professional audio workstation market. The total amount of net assets and liabilities transferred to the new LLC, including receivables, inventory, fixed assets, and net of customer service liabilities was $235,661. We account for this investment in SonicStudio LLC using the modified equity method.
Under the agreement, the new LLC compensated us for the Sonic Studio business with a three year promissory note for $500,000. The promissory note, which does not carry interest, is being repaid to us with a royalty based on sales received by the new LLC, plus any share of profits paid to us by them. Once the promissory note is retired, Sonic will continue to retain a 15% interest in the new LLC. Certain employees transferred from Sonic to join the new LLC.
During fiscal year 2002, we recorded approximately $1,855,000 in revenues associated with our discontinued Sonic Studio audio business.
On January 15, 2002, we entered into an agreement with Sony Corporation (“Sony”) with respect to the development and creation of a multi-channel super-audio CD mastering editor on the “direct stream digital” format. The potential gross revenues under this agreement were $1 million. We assigned the work and the potential profits on this agreement to the new LLC. During our fiscal year 2003, we recognized all the revenue and costs in our financial statements.
During fiscal year 2003, we recorded $151,574 in other expense relating to the write-down of our investment in SonicStudio LLC which reflects our recording of the full amount of loss incurred by SonicStudio LLC for the year. We will continue to record the full amount of the loss incurred by SonicStudio LLC until our investment in SonicStudio LLC has been reduced to zero. At March 31, 2003, our investment in SonicStudio LLC totaled $68,897.
Item 9.
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
Item 10.
Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this Item with respect to executive officers is set forth in Part I of this Report and the information with respect to directors is incorporated herein by reference to the information set forth under the caption “Election of Directors” in the Proxy Statement for the year 2003 Annual Meeting of Shareholders.
Item 11.
Item 11. EXECUTIVE COMPENSATION
The information required by this Item is incorporated by reference to the information set forth under the caption “Executive Compensation” in the Proxy Statement for the year 2003 Annual Meeting of Shareholders.
Item 12.
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item is incorporated by reference to the information set forth under the caption “Security Ownership of Certain Beneficial Owners and Management” in the Proxy Statement for the year 2003 Annual Meeting of Shareholders.
Item 13.
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item is incorporated by reference to the information set forth under the caption “Certain Relationships and Related Transactions” in the Proxy Statement for the year 2003 Annual Meeting of Shareholders
Item 14.
Item 14. CONTROLS AND PROCEDURES
(a) An evaluation was performed under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures within 90 days before the filing date of this annual report. Based on that evaluation, our management, including the Chief Executive Officer and Chief Financial Officer, concluded that the Company’s disclosure controls and procedures were effective. There have been no significant changes in our internal controls or in other factors that could significantly affect internal controls subsequent to their evaluation.
(b) We intend to review and evaluate the design and effectiveness of our disclosure controls and procedures on an ongoing basis and to improve our controls and procedures over time and to correct any deficiencies that we may discover in the future. Our goal is to ensure that our senior management has timely access to all material financial and non-financial information concerning our business. While we believe the present design of our disclosure controls and procedures is effective to achieve our goal, future events affecting our business may cause us to significantly modify our disclosure controls and procedures.
PART IV
Item 15.
Item 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a)1.
Financial Statements.
Included in Part II of this report:
Report of Independent Auditors (page 37 of this Report).
Balance Sheets as of March 31, 2002 and March 31, 2003.
Statements of Operations for each of the years in the three year period ended March 31, 2003.
Statements of Shareholders’ Equity for each of the years in the three year period ended March 31, 2003.
Statements of Cash Flows for each of the years in the three year period ended March 31, 2003.
Notes to Financial Statements (pages 42 through 62 of this Report).
(a)2.
Financial Statements Schedule.
Included in Part IV of this report:
Schedule II Valuation and Qualifying Accounts
All other schedules are omitted because they are not required, or are not applicable, or the information is included in the financial statements.
(a)3.
Exhibits:
(1)
Incorporated by reference to exhibits to Registration Statement on Form S-1 (No. 33-72870) effective February 10, 1994.
(2)
Incorporated by reference to exhibits to Annual Report on Form 10-K for the Fiscal Year Ended March 31, 1996 (No. 33-72870).
(3)
Incorporated by reference to exhibits to Registration Statement on Form S-3 (No. 333-44347) effective January 30, 1998.
(4)
Incorporated by reference to exhibits to Registration Statement on Form S-3 (No. 333-50697) effective April 29, 1998.
(5)
Incorporated by reference to exhibits to Registration Statement on Form S-1 filed on May 27, 1999.
(6)
Incorporated by reference to exhibits to Registration Statement on Form S-3 filed on March 17, 2000.
(7)
Incorporated by reference to Appendix A to the Registrant’s Definitive Proxy Statement filed on July 21, 1998.
(8)
Incorporated by reference to exhibits to Registration Statement on Form S-1 filed with the Commission on May 21, 2001.
(9)
Incorporated by reference to exhibits of Form 8-K filed with the Commission on March 14, 2001.
(10)
Incorporated by reference to exhibits of Form 8-K filed with the Commission on December 19, 2001.
(11)
Incorporated by reference to exhibits to Current Report on Form 8-K filed on November 20, 2002
(12)
Incorporated by reference to exhibits to Current Report on Form 8-K filed on December 27, 2002
(b)
Reports on Form 8-K:
(i)
Sonic Solutions filed a report on Form 8-K with the Securities and Exchange Commission on November 20, 2002, making an Item 5 disclosure announcing that on November 13, 2002, it had entered into an Asset Purchase Agreement (the “Agreement”) with VERITAS Software Corporation, VERITAS Operating Corporation, VERITAS Software Global Corporation, VERITAS Software Holdings, Ltd., and VERITAS Software International Ltd. (collectively “VERITAS”), to acquire certain of the assets of VERITAS’s Desktop and Mobile Division (“DMD”) (the “Acquisition”).
(ii)
Sonic Solutions filed a report on Form 8-K with the Securities and Exchange Commission on December 30, 2002, making an Item 2 disclosure that on December 18, 2002, we announced the successful completion of our acquistion of the DMD of VERITAS Software Corporation.
(iii)
Sonic Solutions filed a report on Form 8-K/A with the Securities and Exchange Commission on February 12, 2003, making an Item 7 disclosure relating to the acquisition of the DMD to file the financial statements required by Item 7.
FINANCIAL STATEMENT SCHEDULE
SONIC SOLUTIONS
VALUATION AND QUALIFYING ACCOUNTS
Years Ended March 31, 2001, 2002 and 2003
(in thousands)
SIGNATURES
In accordance with Section 13 or 15(d) of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto, duly authorized on this 26th day of June, 2003.
SONIC SOLUTIONS
Date: June 26, 2003
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS that each person whose signature appears below constitutes and appoints Robert J. Doris and A. Clay Leighton, and each of them, his true and lawful attorney-in-fact, with full power of substitution and resubstitution, to act for him and in his name, place and stead, in any and all capacities to sign any and all amendments to this annual report on Form 10-K and to file the same, with all exhibits thereto, and all documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing which they, or any of them, may deem necessary or advisable to be done in connection with this annual report as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or any substitute or substitutes for any or all of them, may lawfully do or cause to be done by virtue hereof.
In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of Sonic Solutions and in the capacities and on the dates indicated.
CERTIFICATION
I, Robert J. Doris, President, certify that:
1. I have reviewed this annual report on Form 10-K of Sonic Solutions;
2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;
4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and
c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and
6. The registrant’s other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Date: June 26, 2003
/s/ Robert J. Doris
Robert J. Doris
President
CERTIFICATION
I, A. Clay Leighton, Senior Vice President of Worldwide Operations and Finance and Chief Financial Officer, certify that:
1. I have reviewed this annual report on Form 10-K of Sonic Solutions;
2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;
4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and
c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and
6. The registrant’s other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Date: June 26, 2003
/s/ A. Clay Leighton
A. Clay Leighton
Senior Vice President of Worldwide Operations and Finance and Chief Financial Officer