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Business
Overview
We are one of the world’s leading providers of software, applications and professional services for interactive and enhanced television. We have traditionally provided the core software and related technologies that permit cable, satellite and digital terrestrial operators, which we refer to as “network operators,” television programmers and advertisers to offer viewers interactive and enhanced television experiences. As of December 31, 2005, we had deployed our software solutions with 36 network operators, and more than 63 million digital set-top boxes embedded with our software and technologies had been shipped worldwide.
Our software and applications allow our customers to differentiate their video service offerings from their competitors, enabling them to attract and retain viewers. We believe our software and applications will also help enable the use of television for gaming, commerce, information retrieval, entertainment services and similar purposes. Our international footprint, with the millions of set-top boxes in which our software is deployed, should also provide us, over time, with a strong foundation to develop revenue generating applications and other products that leverage off of that embedded software. In addition, as we witness the distribution of digital content across multiple platforms, we have begun to extend our products, technologies and applications beyond the network operators with whom we have been traditionally engaged. For example, we are developing technologies for Internet protocol television, or IPTV, for broadband network operators, including telecommunications and cable operators. We are also creating technology that enables our customers to distribute content and applications to consumers’ set-top boxes, home networks and other devices, including portable and wireless devices.
Our basic technologies enable network operators to manage the creation and delivery of advanced digital television services to their subscribers across multiple models of set-top boxes and within numerous network infrastructures. We provide our technologies, interactive content and applications and professional services in more than 96 countries. Major set-top box manufacturers incorporate our software directly into over 115 different set-top box models, which allows our solutions to be easily activated by network operators upon deployment. Our “core” technology platform, which we refer to as “middleware,” permits network operators to maintain a consistent user experience for their subscribers irrespective of the set-top box or boxes that may be deployed within a subscriber’s home and the source of the video signal transmitted to that subscriber’s home, whether transmitted by cable, satellite or terrestrial means, or, even, most recently, over IPTV. Our middleware also allows our customers, including programmers and advertisers, to develop applications once,
without the need to rewrite those applications for different hardware environments, and offers network operators many other efficiencies in managing their business. We continue to evolve our middleware to enhance the features that we offer. We have developed enhancements to our personal video recorder, or PVR, solutions that retain interactive content for future playback simultaneously with the recorded broadcast. We have also developed PVR enhancements that will enable recording of high definition television and are developing solutions for distribution of protected content to other devices in the home network. In addition, we offer solutions that allow network operators to manage the trafficking and billing of their commercials, provide targeted and addressable advertising solutions and research technologies that detail how viewers engage and interact with programs and advertisements, and enable viewers to engage in commerce transactions, retrieve information such as weather reports and sports updates, and other interactive services. We also provide interactive gaming services, such as play-for-prizes and fixed odds gaming, subject to local laws and regulations.
As part of our business, we also offer professional engineering and consulting services to help implement and coordinate the launch, integration and customization of the technologies and products that we provide. We can manage entire digital television launch projects, with complete end-to-end digital programming solutions, or simply provide assistance with discrete integration projects or development activities. We believe that our extensive experience in the digital television sector makes these services especially attractive to our customers as they seek to leverage our institutional knowledge and practical perspective.
We have invested significant resources in developing our software solutions and believe that our patent portfolio protects many of the key elements necessary to support digital interactive and enhanced television and certain other methods of distribution. We believe that we have established an industry leading technology position, and, as of December 31, 2005, had 94 patents issued in the United States, 370 patents issued outside of the United States and 558 patent applications pending throughout the world.
As of December 31, 2005, based on the number of our outstanding ordinary shares, Liberty Media Corporation beneficially owned an approximately 30.6% economic interest in our company, which because of its ownership of approximately 99.6% of our super-voting Class B ordinary shares, provided it with an approximate 77.6% voting interest in our company. As a result of that voting power, Liberty Media has the ability to elect all of the members of our board of directors and, subject to applicable law and stockholder agreements, the right to approve or disapprove all matters presented to a vote of our stockholders. Liberty Media is a holding company, which, through its ownership of interests in subsidiaries and other companies, is primarily engaged in the electronic retailing, media, communications and entertainment industries. In addition, companies in which Liberty Media owns interests are engaged in, among other things, (i) interactive commerce via the Internet, television and telephone, (ii) domestic cable and satellite broadband distribution services and (iii) telephony and other technology ventures. From time to time, we have entered into commercial relationships with Liberty Media affiliates and expect to continue to do so in the future if advantageous opportunities become available.
We are incorporated in the British Virgin Islands.
Recent Events
As of December 31, 2005, Sun Microsystems, Inc. beneficially owned 7,594,796 shares of Class B common stock of our subsidiary OpenTV, Inc., which is not publicly traded. In January 2006, Sun exercised its right to exchange those Class B shares in OpenTV, Inc. for the same number of Class B ordinary shares of OpenTV Corp. As a result of the exchange, as of February 28, 2006, Sun’s ownership of our Class B ordinary shares represented approximately 5.6% of the economic interest and 15.8% of the voting power of our ordinary shares, and Liberty Media Corporation’s beneficial ownership of our Class A and Class B ordinary shares represented approximately 28.9% of the economic interest and 65.4% of the voting power of our ordinary shares. Sun has the right, at any time, to convert its Class B ordinary shares into our Class A ordinary shares on a one-for-one basis; in the event that Sun determined to sell its interest in the public markets, we would expect Sun to convert its Class B ordinary shares into Class A ordinary shares, which are publicly traded.
On February 10, 2006, our board of directors (including each of our independent directors), in accordance with the laws of the British Virgin Islands, unanimously approved a proposal to amend and restate our memorandum of association. The amended and restated memorandum of association provides, among other things, for the following changes that affect our Class B ordinary shares. These changes have:
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eliminated a restriction formerly contained in our memorandum of association that prohibited us from issuing additional Class B ordinary shares or options, rights or warrants to subscribe for additional Class B ordinary shares; and
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deleted provisions formerly contained in our memorandum of association that required each Class B ordinary share to automatically convert into a Class A ordinary share under certain circumstances, including upon the transfer of any Class B ordinary shares to a person who was not a stockholder, or an affiliate of such stockholder, prior to the initial public offering of our Class A ordinary shares, and the procedures relating to that automatic conversion.
In connection with, and as a condition to, the adoption of our amended and restated memorandum of association, we entered into a letter agreement with Liberty Media. Under that agreement, Liberty Media agreed that if it (or any of its affiliates) sells or otherwise transfers any of our Class B ordinary shares to a third party and the aggregate sale proceeds received by Liberty Media in that transaction exceed, on a per share basis, the trading price of our Class A ordinary shares as determined in accordance with an agreed formula, then Liberty Media will contribute to us, generally in the same form it receives as consideration for its shares, a proportionate percentage of that aggregate premium, reflecting Liberty Media’s relative economic (not voting) ownership in us. As a result of that commitment, in a sale of its Class B ordinary shares, Liberty will retain only that portion of any premium that is equal to its relative equity ownership, based on the number of outstanding Class A and Class B ordinary shares at the time of any such sale.
Our Operating Businesses
We manage our businesses geographically and along several product and technology lines. From a geographical standpoint, we group customers within the following regions: Americas; Europe, Middle East and Africa; and Asia Pacific. From a product and technology standpoint, we manage our reporting units within the following general categories: middleware and integrated technologies; and applications. Because of the nature of its business, we also, to a large extent, manage BettingCorp, our subsidiary that offers interactive gaming services, on a standalone basis. Financial information related to our operating segments and according to geographic area can be found in Note 15 of our Consolidated Financial Statements contained in Part IV of this report.
Middleware and Integrated Technologies
Our middleware and integrated technologies provide a common platform for network operators, set-top box manufacturers and manufacturers of other consumer electronics devices, programmers, content producers, advertisers and interactive application developers to create, deliver and manage interactive advanced digital television services across the various digital television environments and network architectures. Our middleware software enables advanced digital television services to run on cable, satellite and digital terrestrial networks, and, with the development of our IPTV solution, the networks of telecommunications and other broadband companies that use Internet protocol for distribution purposes. It also allows network operators to cost effectively deploy consistent advanced digital television services across set-top boxes and through other products manufactured by a multitude of vendors.
We have generally derived nearly all of our revenues from the licensing of our middleware and integrated technologies. We have historically realized revenues through one-time royalty payments and ongoing license fees. In early January 2006, we announced a new licensing agreement with an India-based satellite and cable television provider that will pay us under a subscription-based model, pursuant to which we are paid a monthly fee for each set-top box that is deployed by the network operator for so long as that set-top box remains in use by the end-user. In the future, we expect to structure additional licensing agreements in this manner so that we are able to derive more of our revenues from subscriber-based fee or revenue sharing arrangements.
As of December 31, 2005, we had deployed our middleware software solutions and technologies to 36 network operators throughout the world, and more than 63 million digital set-top boxes embedded with our middleware software and technologies had been shipped worldwide.
In addition to the software and technologies that we integrate on set-top boxes, we also offer technologies that are deployed at the network operator’s headend. We provide enterprise solutions that more effectively integrate the software in a set-top box with the operator’s, programmer’s and advertiser’s back-end systems. Additionally, we have development tools that permit users to create, test and deliver interactive content and applications.
Our middleware and integrated technologies consist of the following solutions:
OpenTV Core Middleware. This set-top box embedded software technology for advanced digital television services is our primary offering. OpenTV Core supports a wide range of services including electronic program guides, video-on-demand, personal video recording, customer care, and interactive and enhanced applications. The latest version of OpenTV’s Core Middleware is OpenTV Core 2.0.
The following features and functions are supported by OpenTV Core:
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Basic and Advanced Set-top Boxes. OpenTV Core can operate with the relatively limited processing power and memory found in most mass-market digital set-top boxes currently deployed by network operators. OpenTV Core is also suitable for more advanced digital set-top boxes expected to be deployed in the future, which contain increased processing power and memory. This capability permits us to offer technical solutions that address the limited capabilities of many set-top boxes that are currently deployed by various network operators, while simultaneously offering a solution that will position network operators to take advantage of more powerful set-top boxes in the future.
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Digital/ Personal Video Recording. Our OpenTV PVR is an extension to OpenTV Core that allows network operators to deliver advanced personal video recording services to their subscribers, including the ability to record multiple broadcast or on-demand programs simultaneously and play back those programs using VCR-style controls such as pause, fast forward and rewind, on set-top boxes that contain internal hard drives. We are developing PVR technology to enable both series recording and the recording of an interactive TV broadcast that retains interactive content for future playback simultaneously with the recorded broadcast.
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Video-on-Demand. OpenTV Core also supports video-on-demand, or VOD, services. It enables media rich user interfaces for browsing VOD titles and underlying protocols to establish sessions and control streams with VCR-style controls.
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HTML Applications. Our OpenTV HTML Package is an extension to OpenTV Core, which allows network operators to deliver existing Web-based HTML and JavaScript content to their subscribers through a digital set-top box.
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Connectivity. OpenTV Core provides solutions for broadcast or point-to-multipoint networks as well as high bandwidth, bi-directional, point-to-point networks. OpenTV Core includes modules that support common digital television-related communication protocols, including the DOCSIS communications protocol, which provides a data return channel for cable modem set-top boxes that enables viewers to retrieve information from the Internet at broadband speed.
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Localization. OpenTV Core supports text input and presentation of substantially all languages in common use, including double byte Asian languages, and allows for localization of interactive television services for different countries.
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OpenTV Measure. OpenTV Core has been extended to enable network operators, programmers and advertisers to collect information and data regarding viewer preferences, viewing habits and other analytical information that helps to assess the efficacy of programming and advertising.
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OpenTV IPTV Solution. OpenTV is developing an IPTV solution based on the OpenTV Core 2.0 and PVR platforms for cable, satellite and telecommunications operators. OpenTV Core 2.0 for IPTV will
be an extension to OpenTV Core that allows cable, satellite and telecommunications operators to deliver existing digital television services via two-way broadband IP networks, including broadcast TV programming, on-demand programming, PVR services, interactive TV services and downloadable applications. The IPTV extension to OpenTV Core will provide cable television operators the ability to seamlessly extend their existing digital TV services to new broadband IP customers using the same broadcast, video-on-demand, billing and conditional access systems already in place, and will provide telecommunications operators the ability to enter the digital TV market with a stand-alone IPTV solution.
OpenTV Device Mosaic. OpenTV Device Mosaic is a customizable, HTML browser designed specifically for information appliances other than personal computers. OpenTV Device Mosaic is deployed independently from OpenTV Core. OpenTV Device Mosaic supports the key Internet standards, and is optimized and designed for advanced digital television services. A version of OpenTV Device Mosaic, known as the OpenTV Integrated Browser, has been developed for the Japanese consumer electronics market with support for Broadcast Markup Language, or BML. The OpenTV Integrated Browser was developed in partnership with Matsushita Electric Company, one of Japan’s largest consumer electronics companies, and has been incorporated into certain models of Panasonic-branded digital television sets shipped within Japan since September 2003.
OpenTV Enterprise Solutions. OpenTV Enterprise Solutions are software components that are installed at a network operator’s broadcast facility, cable headend or back office to enable the creation, management and delivery of advanced digital television services to OpenTV enabled set-top boxes.
OpenTV Development Tools and Support for Third Party Application Developers. We encourage content developers to design and create applications on OpenTV enabled networks by offering a series of application development tools and support tool sets enabling them to develop and market applications directly to network operators. The tools can be used alone or in combination with other third party tools to meet virtually any interactive television development need, such as creating virtual channels, building interactive advertisements, enhancing existing programs with interactive features and testing interactive television content through a simulated broadcast environment.
Applications Business
We develop and provide interactive applications that:
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permit targeted and addressable advertising;
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provide traffic and billing solutions for the delivery of advertisements by network operators;
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facilitate purchase and sales transactions through a viewer’s remote control;
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facilitate requests for information from advertisers or programmers in real-time as the viewer sees the advertisement or television program; and
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provide audience and media research capabilities to determine viewing preferences.
We have also developed and operated branded interactive television channels that are distributed by network operators utilizing OpenTV Core or interactive television middleware platforms provided by third parties. We generally realize revenues through license and other fees, as well as revenue sharing arrangements from the use of our services.
We believe that the worldwide deployment of set-top boxes embedded with our software solutions provides us with a strong foundation to develop applications and other products that leverage off of that platform.
Our applications business consists of the following solutions:
OpenTV Advanced Advertising Solutions. We provide software solutions to enable the sales, integration, delivery and management of addressable and interactive advertising for digital television systems.
OpenTV Advanced Advertising Solutions are being developed to provide our customers with an integrated solution to address emerging challenges in the advertising market. Technology advancements are changing the way viewers watch television. Personal video recorders and video-on-demand are services that allow viewers to time-shift programming and receive programming in an on-demand and commercial-free manner; those types of services have changed the television viewing experience and created new advertising opportunities. These advancements are expediting the need for advertising that is more relevant to individual viewers and for advertising that more deeply engages viewers. Our addressable advertising products are intended to offer advertisers the ability to target advertisements with more relevancy to viewers based on a variety of demographic and other information. Our interactive advertising technologies will also enable television viewers to interact with advertisements, including, for example, requesting brochures and finding local retail outlets. Our sales and inventory management solutions offer operators the ability to sell, manage, bill and deliver multiple advertisements across an operator’s network. The market for these types of solutions remains undeveloped, and there are many issues that will need to be resolved over time, including issues of privacy, before these solutions become extensively deployed.
OpenTV Advanced Advertising Solutions currently consist of the following technologies and services:
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OpenTV AdVision and OpenTV Eclipse. Both OpenTV AdVision and OpenTV Eclipse are advertising sales and inventory management systems, or traffic and billing systems, that manage various media platforms and outlets, simultaneously providing network operators the tools to manage local cable television, cable networks, and proprietary broadband networks by scheduling and monitoring the display of advertising, and billing the advertisers based upon such monitoring. In September 2005, we acquired CAM Systems, which developed the Eclipse advertising sales and inventory management system and was a leading provider of services in this sector. That acquisition helped us significantly extend our market share in the advertising sales and inventory management segment. Our solutions are currently deployed in 15 of the top 25 U.S. cable television markets. We believe sales and inventory management systems, such as our Advision and Eclipse solutions, will be critical to addressing the ongoing changes in the advertising market. Neither OpenTV AdVision nor OpenTV Eclipse is dependent on a network operator deploying OpenTV’s middleware solutions.
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OpenTV SpotOn. OpenTV SpotOn enables network operators to offer addressable advertising that can be delivered to particular households based on individual profiles. OpenTV SpotOn is not dependent on a network operator deploying OpenTV’s middleware solutions. Advertisers have the ability to develop different ads for the same product or service that are designed for specific audiences. This ability helps ensure that the message appeals to all of the audience for the commercial. Different advertising messages can be simultaneously targeted to households through the use of technology that permits set-top boxes to seamlessly jump between video signals. With this technology, a network operator can, for example, deliver an advertisement for a pick-up truck to one household while simultaneously delivering an advertisement, in the same interval, for a sedan or sports coupe to a different household based on demographic profiles. The network operator can also measure and track each addressable spot and receive valuable aggregate viewer data, enabling advertisers to build profiles, and help drive improved analysis and research for future marketing and planning. We carefully review and assess, with our customers, the privacy issues associated with this type of product, and expect to deploy this product in a manner that addresses the various privacy laws, regulations and practices that are evolving in the sector.
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OpenTV Inject. OpenTV Inject is a post-production video editing tool that enables producers to easily insert “triggers” into an analog or digital video stream. The trigger is detected by a set-top box when the video plays. An on-screen prompt is automatically displayed, alerting the viewer that additional interactive content is available.
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OpenTV NMI. OpenTV National Marketing Interconnect is an end-to-end managed service that operates as a national interconnect for cable system operators, managing promotional inventory and certain advanced advertising applications.
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OpenTV Ad Producer. OpenTV Ad Producer is a template-based tool that allows a third party, an ad agency for example, to create interactive advertising content by assembling graphic assets following a step-by-step process. OpenTV Ad Producer guides the user through the application creation process, based on the chosen template, and is designed specifically for users with minimal interactive television production software experience. OpenTV Ad Producer outputs Extensible Markup Language, or XML, that can be easily interpreted by the OpenTV Ad Manager system.
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OpenTV Ad Manager. OpenTV Ad Manager is a Windows-based software tool that enables cable and satellite operators to take the XML file generated by the OpenTV Ad Producer and preview it, verify the content, authenticate the content, transcode the content to binary code that each set-top box can interpret and schedule the application for broadcast.
OpenTV Enhanced Content. We provide interactive applications for programmers and network operators that deliver enhanced content. In November 2004, for example, we extended a multi-year agreement with iN DEMAND to produce 72 NASCAR races through NASCAR In Car on iN DEMAND. NASCAR In Car is a multi-channel television package that uses a mix of digital compression technology, real-time telemetry data and superior graphics to give subscribers seven in-car camera channels, and live team audio, data and driver statistics. iN DEMAND distributes this programming on a pay-per-view basis through certain digital cable systems in the United States. In February 2006, we launched CNN Enhanced TV on EchoStar Communication’s DISH Network. Developed with Turner Broadcasting System, Inc., CNN Enhanced TV is a content-rich interactive news service that delivers the latest headlines and images from CNN.com on the same screen with CNN programming. It offers DISH Network subscribers the ability to view graphically rich headlines and stories, vote in polls, and review on-air schedules through an intuitive user interface that is displayed simultaneously with the CNN broadcast.
PlayJam. PlayJam is one of the world’s first multi-platform interactive television entertainment and games channels. We offer a library of more than 800 different single- or multi-player games that can run on PlayJam. These include quizzes, arcade-style games, puzzles, adult-theme games, and competition and editorial games. A wide selection of these games can be customized and used as unique branding vehicles.
Launched in early 2001 on BSkyB’s network in the United Kingdom, PlayJam currently is available to over 20 million subscribers through distribution on BSkyB, cable operators NTL Group Ltd. and Telewest Broadband in the United Kingdom, Multichoice Africa in Africa, and satellite operator EchoStar Communications in the United States. PlayJam runs on the OpenTV platform as well as those provided by other middleware providers.
In the United Kingdom, PlayJam charges a service fee, via a premium rate telephone call using the telephone or the remote control, for membership registration, game score registration for the chance to win prizes, and for access to pay-per-play content. We have also sold advertising and sponsorship space from time to time on PlayJam games. In the United States, PlayJam is offered as a subscription-based service on EchoStar, for which we receive a revenue share.
BettingCorp Business
We acquired BettingCorp in 2003. BettingCorp provides a branded interactive television gaming service in the United Kingdom under the name “PlayMonteCarlo” and also offers play-for-prizes and casino games. Subject to local laws and regulations and based on the licenses BettingCorp holds, we are able to offer fixed-odds and casino gaming services. PlayMonteCarlo is one of the world’s first interactive television play-for-prizes and gaming channels. BettingCorp also developed the Ultimate One platform described below that now forms the backbone for our Participation TV product offering.
Ultimate One Platform. With our Ultimate One technology platform, we can enable network operators, programmers, wireless carriers and others to offer various games and products across multiple media platforms, including television, Internet and wireless networks, using a single, integrated back-end management system. Ultimate One also provides an integrated back-end management system that enables operators to monitor usage of the games, tailor promotions on an individual basis and evaluate usage and other metrics
in real-time. This platform, for example, allows a subscriber to initiate an account through a cable operator, play games through that cable operator’s network, and then sign-off and reinitiate that same game, in the same state, on a mobile telephone with single account sign-on.
Participation TV. In 2005, we began marketing a new product called OpenTV Participate, which is based on the Ultimate One technology platform described above. We believe that OpenTV Participate will help to extend our interactive and participation offerings beyond the television environment, and will enable us to offer customers a seamless interactive platform for their subscribers.
Professional Services and Support
To complement our various businesses, we provide a comprehensive suite of professional engineering and consulting services on a worldwide basis to network operators, set-top box manufacturers and content and application developers in support of our product offerings. The services that we provide include interactive television business consulting, middleware porting and integration, application customization and localization, launch management and technology training services. These services allow us to manage various interactive television projects, from discrete integration or development assignments to complete end-to-end digital programming solutions for network operators. Our services include maintenance and support for our products after they have been installed and commercially deployed by our network operators and set-top box manufacturers, including the provision of product updates. Services are generally provided on a paid engagement basis and are either executed on a time and materials or fixed price contract basis, except that maintenance and support is generally subject to an annual fee.
Customer and Industry Relationships
We have established significant relationships with many of the leading network operators, set-top box manufacturers, chipset manufacturers, programming networks and conditional access providers around the world. Our customer and industry relationships include the following:
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Network Operators. Over 36 network operators in 96 countries around the world have launched our middleware platform, including Austar Entertainment Pty Ltd. and FOXtel in Australia, Bell ExpressVu in Canada, BSkyB in the United Kingdom, Dong Fang Cable Network Co. Ltd. in China, EchoStar’s DISH Network in the United States, Multichoice in Africa, TPS in France, Sky Italia in Italy, Liberty Global in Europe and Viasat in Sweden. In January 2006, we also announced a licensing agreement with India’s largest cable and satellite operator, Essel Group. The number of network operators that have deployed our software may change from year to year as network operators continue to consolidate or merge.
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Set-top Box Manufacturers. Our software has been ported by 38 manufacturers on over 115 models of set-top boxes, including models produced by Advanced Digital Broadcast, Amstrad, Matsushita Electric, Motorola, Inc., Phillips, Pace Micro Technology, Sagem, Samsung, Scientific-Atlanta, Inc., Thomson and UEC Technologies (Pty) Ltd.
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Chipset Manufacturers. OpenTV middleware has been ported to most of the major chipset vendors for set-top boxes, including Broadcom, Connexant, NEC and ST Microelectronics. OpenTV middleware is currently being ported to the latest generation of chipsets supporting MPEG4/AVC.
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Programming Networks. We have worked with numerous programming networks including American Broadcasting Company, Turner Broadcasting System, Inc., Discovery Communications, Inc., QVC Shopping Network, Playboy Enterprises, Inc. and Showtime Networks, Inc. to enhance programming content and advertising on their networks.
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Conditional Access Providers: We have integrated our middleware with conditional access software provided by Irdeto, Motorola, Nagravision, NDS Group plc, Scientific-Atlanta and Viaccess.
Sky Italia accounted for approximately 12% of our revenues during 2005 in the form of royalties and licenses and services and other. BSkyB, directly and indirectly, accounted for approximately 19% of our
revenues during 2005 in the form of set-top box royalties and licenses paid for by its manufacturers and services and other, which include consumer use of our PlayJam services on BSkyB. EchoStar accounted for approximately 17% of our revenues during 2005 in the form of royalties and licenses and services and other.
Sales and Marketing
We promote and sell the majority of our products and services through our direct sales organization to corporate enterprises, including network operators, programmers, advertisers and set-top box manufacturers. We have regional operating groups that are responsible for customers within their geographic areas: Americas; Europe, Middle East and Africa; and Asia Pacific.
Competition
The markets in which we compete are intensely competitive and rapidly changing. Current and potential competitors in one or more aspects of our business include digital television technology companies and companies developing interactive television content and applications. The principal competitive factors in our industry include product functionality, speed of product integration, breadth of network and platform coverage, scalability, price, possession of adequate intellectual property rights and sales and marketing efforts. The following is a competitive analysis of our business segments.
Middleware and Integrated Technologies
Our competitors offering advanced digital television-enabling technology include NDS Group, Microsoft Corporation, Osmosys, ACCESS Co., Ltd. and Scientific-Atlanta, Inc., which was recently acquired by Cisco Systems, Inc. NDS Group historically provided conditional access and limited interactive application technologies to its customers. In 2003, NDS extended its interactive services offerings with its acquisition of MediaHighway from Thomson Multimedia and today offers solutions that are directly competitive with many of those that we offer. NDS Group is controlled by The News Corporation. The News Corporation maintains a controlling stake in Hughes Electronics, the parent of DirecTV, one of the two largest satellite operators in the United States. The News Corporation also controls BSkyB, the largest satellite operator in the United Kingdom, and Sky Italia, the largest satellite operator in Italy, which are two of our most significant customers. It also controls other satellite operators throughout the world. While we continue to work with, and provide technology and services to many affiliates of, The News Corporation, including BSkyB, FOXtel and Sky Italia, The News Corporation’s control of NDS Group, and the extension by NDS Group of its product offering, may significantly increase competitive pressures and affect the willingness of other News Corporation affiliates to work with us or to obtain products or services from us. We cannot, therefore, be certain of the long-term implications related to The News Corporation’s control of NDS Group or the effects that such control may have upon our relationships and opportunities to work with the many satellite operators throughout the world that are controlled by The News Corporation.
In April 2005, Double C Technologies, LLC, a joint venture between Comcast Corporation and Cox Communications, acquired substantially all of the North American assets of Liberate Technologies, which included technologies that compete with ours. It remains uncertain whether Double C Technologies will only develop those technologies for the benefit of Comcast and Cox or whether it will attempt to sell those technologies and related products to other cable operators in competition with OpenTV.
Scientific-Atlanta, Inc., in the form of PowerTV, develops and markets operating system and middleware software products for the advanced digital interactive cable television markets. Scientific-Atlanta is also a major manufacturer of set-top boxes, and many of our customers or potential customers may seek to deploy set-top boxes manufactured by Scientific-Atlanta. Cisco Systems, Inc. acquired Scientific Atlanta in February 2006. We have historically competed with Scientific-Atlanta in certain market segments, and expect that we will continue to do so in the future as it operates under Cisco’s control.
For several years, Microsoft Corporation has been working to create interactive television solutions. Microsoft has several deployments of its interactive television solution, and, in particular, its IPTV solutions,
and we expect that Microsoft may become a strong competitor in the market for advanced digital television solutions.
In the IPTV market, we expect to face competition from other middleware providers who have partnered with leading systems integrators and telecommunications equipment manufacturers to provide end-to-end IPTV solutions for cable, satellite and telecommunications operators. Our competition includes Microsoft and Alcatel, who have entered into a joint development, integration and marketing agreement to deliver IPTV solutions worldwide. Other competitive IPTV offerings that deliver middleware solutions or IPTV solutions through partnerships include those from Myrio which was acquired by Siemens in April 2005, and Orca Interactive, who has signed IPTV partnership agreements with both Lucent Technologies and Hewlett-Packard.
The primary competition for OpenTV PVR comes from other middleware vendors including Microsoft, NDS Group, Guideworks LLC, a joint venture of Comcast and Gemstar-TV Guide International, Osmosys, Digeo and Motorola, who include PVR functionality either with their electronic program guide, or EPG, or as an additional feature. Other PVR technology providers targeting the integrated PVR space include set-top box manufacturers Pioneer, Pace, Humax, UEC, Motorola and Scientific-Atlanta, and dedicated PVR solution providers including TiVo and ReplayTV.
Applications
In the markets for enhanced television technology and services, addressable and interactive advertising technology, and advertising traffic and billing solutions, our primary competition comes from companies such as Visible World Corporation, NDS Group, Invidi Corporation, Tandberg Television and Harris Corporation. Addressable and interactive technology is in its initial stages, and we expect additional competitors to appear as the market continues to develop. Visible World provides a suite of services enabling a media outlet to develop and deliver content and advertising that can be geographically and demographically customized as well as dynamically updated based on business parameters, market trends and demands.
Our interactive applications face competition from numerous parties. Companies that compete with our efforts to develop and launch applications on our middleware platform include dedicated applications providers such as Gemstar-TV Guide International, NDS Group, Visiware, and Tandberg Television, which last year acquired Goldpocket, and TVWorks, a wholly owned subsidiary of Double C Technologies, LLC, independent third parties that develop and provide applications for our middleware platform, and other middleware providers such as Microsoft. We expect competition in the interactive content and applications area to intensify as the general market for interactive television services further develops, particularly in the case of independent third parties that have the ability to develop applications for our middleware platform at relatively modest expense through the use of our applications development tools.
BettingCorp
While interactive television betting and gaming may provide a future source of potential growth, we also expect to face intense competition in jurisdictions in which we are permitted to deploy those product offerings. Companies with which we expect to compete include BSkyB and Fancy a Flutter. Because this aspect of interactive television remains nascent, we cannot be certain as to how competition will develop or the precise nature of the competitors that we may expect to encounter. Because of the significant regulatory issues affecting this sector and the benefits derived from operating under that regulatory framework over a long period, we may also face competition in the future from more traditional casino companies with long histories in the betting and gaming sector.
Regulations
The telecommunications, media, broadcast and cable television industries are subject to extensive regulation by governmental agencies around the world. These governmental agencies continue to oversee and adopt legislation and regulation over these industries, particularly in the areas of user privacy, consumer protection, the online distribution of content and the characteristics and quality of online products and
services, which may affect our business, the development of our products, the decisions by market participants to adopt our products and services or the acceptance of interactive television by the marketplace in general.
If, and to the extent that, we continue to develop applications for the gaming and betting market, we also expect to become subject to additional regulatory oversight. The laws and regulations in this market are quickly evolving and changing. To adequately address the legal and regulatory issues inherent in that market, we will need to dedicate significant resources to those matters and maintain effective controls to monitor changes in applicable laws and the effects on our business.
Intellectual Property and Research and Development
As of December 31, 2005, we had 94 patents issued in the United States, 370 patents issued outside of the United States, and 558 patent applications pending throughout the world. We believe that our patent portfolio protects many of the key elements necessary to support digital interactive television. Our research and development expenses, excluding in-process research and development charges related to acquisitions, and amortization of share-based compensation, for the years ended December 31, 2005, 2004 and 2003 were $33.9 million, $29.8 million and $23.0 million, respectively.
Employees
As of December 31, 2005, we had 433 full-time employees, with 234 in the Middleware and Integrated Technologies business, 109 in the Applications business, 42 in the BettingCorp business, and 48 employed in corporate and administrative functions.
Available Information
Our Internet website is located at http://www.opentv.com, but the information contained on our website is not deemed to be incorporated herein. We make available free of charge on the investor relations page of our website this annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission, or SEC.
The public may also read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also maintains an Internet website that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC. The SEC’s Internet site is located at http://www.sec.gov.
Item 1A.
Item 1A.
Risk Factors
Factors That May Affect Future Results
In addition to the other information contained in this 2005 Annual Report on Form 10-K, you should consider carefully the following factors in evaluating OpenTV and our business.
We have a history of net losses, and we may continue to experience net losses in the future.
We have incurred significant net losses since our inception. Our net losses for the years ended December 31, 2005, 2004 and 2003 were approximately $8.5 million, $22.0 million and $54.1 million, respectively. While we have recently narrowed our net losses, we, nonetheless, expect to continue to incur significant sales and marketing, product development and administrative expenses. It is, therefore, likely that we will continue to suffer net losses in the near term. We will need to generate significant revenue to achieve and maintain profitability. We cannot be certain that we will achieve, sustain or increase profitability in the future. Any failure to significantly increase revenue as we implement our product and distribution strategies would adversely affect our business, financial condition and operating results.
We have historically derived a significant percentage of our revenues from licensing our middleware to network operators. Our opportunities for future revenue growth with middleware are limited by the actual number of worldwide network operators and by technology decisions they make from time to time.
We have, on a historic basis, derived a significant percentage of our total revenues from royalties associated with the deployment of our middleware and integrated technologies and fees charged for services rendered in support of those deployments. While we continue to seek deployments within the United States, we already have a significant number of customers outside of the United States that have deployed our middleware. In most cases, the number of network operators in any particular country is relatively small, and to the extent that we have already achieved deployments in those countries, the opportunities for future growth of our middleware and integrated technologies business may be limited.
Our capacity to generate future revenues associated with our middleware may also be limited due to a number of reasons, including:
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network operators that have selected our middleware may switch to another middleware platform for the provision of interactive services, reduce their pace of set-top box deployment or stop deploying set-top boxes enabled with our middleware, decrease or stop their use of our support services, or choose not to upgrade or add additional features to the version of our middleware running on their networks;
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network operators that have not selected our middleware may choose another middleware platform for the provision of interactive services, which could include the selection of standards-based solutions such as MHP or OCAP in various countries; or
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a meaningful opportunity to deploy our middleware in the markets that have not yet adopted interactive television on a large scale may never develop or may develop at a very slow pace.
Any of these eventualities would have an adverse effect on our results of operations.
We offer volume discounts to certain customers, which may, over time, depress our average pricing. While deployments of our software may continue to grow, those discounts, as they are triggered, may limit the rate of our royalty growth in the future.
In certain instances, we provide volume discounts to customers based on the number of copies of our software that they deploy. As a result, although we may experience continued growth in middleware deployments, the average price for each copy licensed to certain customers may decline over time, which could limit the growth of our royalty payments in the future. We experienced this effect in 2005, as our royalty and license revenues from Sky Italia declined by $3.3 million compared to 2004 because of volume discounts. We have historically provided various types of volume discounts to our customers and expect that we will continue to do so in the future. Unless we are able to offset anticipated discounts through a change in product mix, upgrades to our software or other methods that typically enable us to charge higher fees, we may experience slower royalty growth as discounting is triggered.
We expect a more significant portion of our revenue growth in the future to be derived from interactive applications that we develop and market. If we are not successful in developing and marketing interactive applications, our future revenue growth may be limited.
We expect over the next several years to develop extensive interactive applications, including advanced advertising solutions and participation television applications. The market for interactive applications is still nascent and evolving. Historically, we have derived only a relatively small percentage of our total revenue from these offerings. We cannot be certain that the demand for, or the market acceptance of, interactive applications will develop as we anticipate, and even if they do, we cannot be certain that we will be able to market those applications effectively. In addition, our ability to market those products will be affected to a large degree by network operators. If network operators determine that our interactive applications do not meet their business or operational expectations, they may choose not to offer our applications to their customers. To the extent that network operators fail to renew or enter into new or expanded contracts with us for provision of interactive content, such as our enhanced television service, and applications, such as the
PlayJam channel, we will be unable to maintain or increase the level of distribution of our interactive applications and the associated revenue from those offerings. Moreover, due to global economic conditions, network operators may slow down their deployment of new content and applications offerings, and such actions would negatively impact our revenue. Accordingly, our ability to generate substantial revenues from our interactive content and applications offerings is uncertain.
Two of our potential North American cable customers, Cox Communications and Comcast Corporation, joined together in early 2005 to acquire certain assets from Liberate Technologies, one of our direct competitors in the middleware business. That acquisition, which closed in April 2005, is likely to eliminate Cox and Comcast as potential customers for our middleware, which could adversely affect our ability to grow.
In April 2005, Double C Technologies, a joint venture formed by Cox Communications and Comcast Corporation, acquired substantially all of the assets of Liberate’s North American business. Our middleware competes directly with the middleware software included within those assets transferred by Liberate. To date, while we have licensed certain of our technologies to Comcast, and expect to pursue additional applications opportunities with both Cox and Comcast, we have not licensed to either of these companies our middleware solutions. Based on our current understanding of the circumstances, we would not expect Cox or Comcast, in light of the assets that they acquired from Liberate, to license middleware or related solutions from us. As a result, our opportunity to license our middleware in the United States to cable operators may have been materially diminished and our future revenue growth adversely affected. In addition, it is unclear whether Double C Technologies will only develop that technology for the benefit of Comcast and Cox or whether it will attempt to sell that technology and related products to other cable operators in competition with OpenTV.
A significant percentage of our revenues are currently provided by entities affiliated with The News Corporation, which also controls companies that compete with us in certain market segments. Those circumstances may make it more difficult for us, over the long-term, to sell products, technologies or services to News Corporation affiliates in market segments in which other News Corporation affiliates offer competing products.
The News Corporation currently controls NDS Group and Gemstar-TV Guide International, Inc., each of which competes with us in certain respects. The News Corporation also controls, directly or indirectly, or exerts significant influence over, a number of our customers, including BSkyB, Sky Italia and FOXtel. For the year ended December 31, 2005, BSkyB, Sky Italia and FOXtel, accounted, in the aggregate, for 34% of our revenues. While we believe that our relationships with each of these customers is good, and we have multi-year contracts with each, the long-term implications of The News Corporation owning technology companies that directly compete with us in certain respects is difficult to assess. We may be at a disadvantage in selling certain of our products, technologies or services to The News Corporation affiliates over the long-term when in direct competition with other companies in which The News Corporation maintains a significant ownership interest.
We have concluded that our internal control over financial reporting and disclosure controls were not effective as of December 31, 2005. If we do not properly address identified weaknesses and implement additional controls to remedy those weaknesses, the reliability of our financial statements could be implicated and, ultimately, our financial results and our stock price could suffer.
Section 404 of the Sarbanes-Oxley Act of 2002 requires companies to do a comprehensive evaluation of their internal control over financial reporting and their disclosure controls. To comply with this new statute, our management assessed our internal control over financial reporting and our disclosure controls. We identified certain weaknesses in our internal control over financial reporting as of December 31, 2005 that we have discussed in a separate report included as part of our Annual Report. Those weaknesses related to ineffective control over our account analysis for certain financial statement accounts, including accruals, long-term other assets and deferred tax assets, and our lack of sufficient internal personnel with adequate technical expertise to analyze effectively, and review in a timely manner, our accounting for revenue and income taxes. Based on those findings, we concluded that our internal control over financial reporting was not effective as of December 31, 2005. We also concluded that, as a result of those material weaknesses, our disclosure controls,
as of December 31, 2005, were not effective. We also identified material weaknesses in our report for 2004 that was included in our Annual Report on Form 10-K for 2004. While we were able to remediate aspects of the weaknesses we identified in 2004, there is a certain overlap in several of the weaknesses we identified in 2004 and 2005. The fact that we have not been able to remediate fully the weaknesses we identified in 2004, and that we have identified other weaknesses in 2005, may raise questions regarding our ability to implement effective internal control over financial reporting.
Our efforts to comply with Section 404 have required significant managerial time, and we have incurred substantial costs in undertaking those efforts. If our efforts to remedy the weaknesses we identified are not successful, the reliability of our financial statements could be impaired, which could adversely affect our stock price and could also affect our company in other adverse ways. In addition, the ongoing costs associated with implementing such additional controls and procedures, and otherwise complying with the requirements of Sarbanes-Oxley, are not immaterial, and while we would expect those costs to decline over the next several years they did not materially decrease from 2004 to 2005.
We may be unable in the future to raise additional capital required to support our operating activities.
We expect to be able to fund our capital requirements for at least the next twelve months by using existing cash balances and short-term and long-term marketable debt securities, if our assumptions about our revenues, expenses and cash commitments are generally accurate. Nevertheless, we have incurred to date and we expect that we will continue to incur in the near term significant expenses. As of December 31, 2005, we had $64.5 million of cash, cash equivalents and marketable debt securities. We generated cash from operating activities of $2.4 million for the year ended December 31, 2005. That was a significant improvement from 2004, when we used approximately $16.2 million in cash for operating activities. While we continue to monitor our operating expenses and seek to bring them in line with our revenues, there can be no assurance that we will continue to be successful in doing so or that we will be able to generate cash from operating activities on a consistent basis. If we are not successful in those endeavors, we might need to raise additional capital in the future.
To the extent we are required to raise additional capital, we may not be able to do so at all or we may be able to do so only on unacceptable terms. If we cannot raise additional capital on acceptable terms, we may not be able to develop or enhance our products and services, take advantage of future opportunities or respond to competitive pressures or unanticipated requirements, any of which could have an adverse effect on our business, results of operations or future prospects.
We realize a percentage of our revenue from revenue sharing and subscription-based arrangements, especially in our applications business. We are not certain that those revenue models will be generally acceptable to our customers over the long-term or that they will offer us significant opportunities for revenue growth, which could adversely affect the growth opportunities for our applications business.
We have historically generated a substantial portion of our revenue from one-time royalty and licensing fees related to the licensing of our middleware products and from fees for professional services that we provide. We believe that our capacity to generate future revenues in this manner may be limited, and if we are unsuccessful in evolving our revenue model, our opportunities for future revenue growth, particularly outside of the United States, may be limited. While we currently generate a moderate percentage of our revenues from revenue sharing arrangements with network operators, programmers and advertisers, and from subscriber-based arrangements, we cannot be certain that those revenue models will be accepted by our customers over the long-term, or that our customers will allow us to participate in their revenue streams on those bases. If our efforts to identify other sources of revenue, in addition to the licensing of our middleware are unsuccessful, then our future results of operations will be adversely affected.
The market for our products and services is subject to significant competition, which could adversely affect our business.
We face competition from a number of companies, including many that have significantly greater financial, technical and marketing resources and better recognized brand names than we do. Current and potential competitors in one or more aspects of our business include interactive technology companies, companies developing interactive television content and entertainment, and, in the professional services area, third party system integrators and internal information technology staffs at our network operator customers. Some of our customers or their affiliates offer products or services that compete with our products and services. For example, as we noted above, Double C Technologies, a joint venture between Cox and Comcast, acquired the North American assets of Liberate Technologies, which included its middleware business. In addition to our PlayJam and PlayMonteCarlo applications, BSkyB also offers its own competitive gaming and gambling applications through its broadcast network. If any of these competitors achieves significant market penetration or other significant success within the markets upon which we rely as a significant source of revenue, or in new markets that we may enter in the future, our ability to maintain market share and sustain our revenues may be materially and adversely affected.
The trend of consolidation among industry participants may adversely impact our business, results of operations and future prospects.
There has been a worldwide trend of consolidation in the cable, direct broadcast satellite and telecommunications industries. We believe this trend is likely to continue due to economic and competitive concerns. This trend appears to be expanding to include other companies involved with the interactive television industry. For example, in addition to the acquisition of Liberate Technologies by a joint venture between Cox and Comcast discussed above, Comcast and Gemstar-TV Guide International Inc., a media and technology company, formed a joint venture called Guideworks to develop an interactive programming guide for the cable television industry. Tandberg Television acquired Goldpocket towards the end of 2005, and Cisco Systems, Inc. acquired Scientific-Atlanta in February 2006. We expect additional consolidation to occur throughout the industry.
While the full impact of this trend is uncertain at the present time, we will need to adapt to changing relationships with industry participants and address competitive concerns that may arise as companies consolidate. If we are unable to successfully manage these changing relationships and address these competitive concerns, our business and results of operations may be adversely affected.
Unanticipated fluctuations in our quarterly operating results could affect our stock price.
We believe that quarter-to-quarter comparisons of our financial results are not necessarily meaningful indicators of our future operating results and should not be relied on as an indication of future performance. If our quarterly operating results fail to meet the expectations of analysts, the market price of our publicly-traded securities could be negatively affected. Our quarterly operating results have varied substantially in the past and they may vary substantially in the future depending upon a number of factors described below, including many that are beyond our control.
Our operating results may vary from quarter to quarter as a result of a number of factors, including:
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Changes in the rate of capital spending and the rollout of interactive television-related products and services by network operators;
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The number, size and scope of network operators deploying OpenTV-enabled interactive services and the associated rollout to subscribers;
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Increased competition in general and any changes in our pricing policies that may result from increased competitive pressures;
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Potential downturns in our customers’ businesses or in the domestic or international markets for our products and services;
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The ability to generate applications-related revenue from existing and potential customers;
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Changes in technology, whether or not developed by us;
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Our ability to develop and introduce on a timely basis new or enhanced versions of our products that can compete favorably in the marketplace; and
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The timing of revenue recognition associated with major licensing and services agreements.
Because a high percentage of our expenses, particularly compensation, is fixed in advance of any particular quarter, any of the factors listed above could cause significant variations in our earnings on a quarter-to-quarter basis. You should not rely on the results of prior periods as an indication of our future performance. Any decline in revenues or a greater than expected loss for any quarter could cause the market price of our publicly-traded securities to decline.
We depend upon key personnel, including our senior executives and technical and engineering staff, to operate our business effectively, and we may be unable to attract or retain such personnel.
Our future success depends largely upon the continued service of our senior executive officers and other key management and technical personnel. If certain of our senior executives were to leave the company, we may be placed at a competitive disadvantage. In addition, we may also need to increase our technical, consulting and support staff to support new customers and the expanding needs of our existing customers. We have, in the past, experienced difficulty in recruiting qualified personnel. If we are not successful in those efforts, our business may be adversely affected.
We continue to evaluate our business operations and may implement structural and other changes that affect the conduct of our worldwide business operations. As we continue to align our resources appropriately with our evolving business, we may face unintended consequences or suffer adverse effects on our operations or personnel.
We review our operations on an ongoing basis with a view towards improving our business performance. We may, from time to time, initiate efforts to consolidate our operations, close and relocate various offices around the world and divest non-strategic assets. There is a risk that, as new business strategies and administrative processes are developed and implemented, the changes we adopt will be unduly disruptive or less effective than our old strategies and processes. This may adversely affect our business, results of operations and future prospects.
Interactive television remains an emerging business and it may not attract widespread market acceptance or demand.
Our success will depend upon, among other things, the broad acceptance of interactive television by industry participants, including operators of broadcast and pay television networks, network operators and manufacturers of televisions and set-top boxes, as well as by television viewers and advertisers. Because the market for interactive television remains an emerging market, the potential size of the market opportunity and the timing of its development are uncertain. The growth and future success of our business will depend in part upon our ability to penetrate new markets and convince network operators, television viewers and advertisers to adopt and maintain their use of our products and services.
Because much of our success and value lie in our ownership and use of our intellectual property, our failure to protect our intellectual property and develop new proprietary technology may negatively affect us.
Our ability to effectively conduct our business will be dependent in part upon the maintenance and protection of our intellectual property. We rely on patent, trademark, trade secret and copyright law, as well as confidentiality procedures and licensing arrangements, to establish and protect our rights in and to our technology. We have typically entered into confidentiality or license agreements with our employees, consultants, customers, strategic partners and vendors, in an effort to control access to, and distribution of, our software, related documentation and other proprietary information. Despite these precautions, it may be
possible for a third party to copy or otherwise obtain and use our software and other proprietary information without authorization.
Policing unauthorized use of our software and proprietary information will be difficult. The steps we take may not prevent misappropriation of our intellectual property and the agreements we enter into may not be enforceable in some instances. In addition, effective patent, copyright, trademark and trade secret protection may be unavailable or limited in certain foreign countries or, alternatively, such protection may be difficult to enforce. Litigation may be necessary in the future to enforce or protect our intellectual property rights or to determine the validity and scope of our intellectual property rights and the proprietary rights of others. Any such litigation could cause us to incur substantial costs and diversion of resources, which in turn could adversely affect our business.
Intellectual property infringement claims may be asserted against us, which could have the effect of disrupting our business.
We may be the subject of claims by third parties alleging that we infringe their intellectual property. The defense of any such claims could cause us to incur significant costs and could result in the diversion of resources with respect to the defense of any claims brought, which could adversely affect our financial condition and operating results. As a result of such infringement claims, a court could issue an injunction preventing us from distributing certain products, which could adversely affect our business. If any claims or actions are asserted against us, we may seek to obtain a license under a third party’s intellectual property rights in order to avoid any litigation. However, a license under such circumstances may not be available on commercially reasonable terms, if at all.
We grant certain indemnification rights to our customers when we license our software technologies. We may, therefore, become subject to third party infringement claims through those commercial arrangements. In addition, the damages to which we are subject may be increased by the use of our technologies in our customers’ products.
Many of our and our subsidiaries’ agreements with customers contain an indemnification obligation, which could be triggered in the event that a customer is named in an infringement suit involving their products or involving the customer’s products or services that incorporate or use our products. If it is determined that our products infringe any of the asserted claims in such a suit, we may be prevented from distributing certain of our products and we may incur significant indemnification liabilities, which may adversely affect our business, financial condition and operating results.
In addition, while damages claims in respect of an alleged infringement may, in many cases, be based upon a presumed royalty rate that the patent holder would have otherwise been entitled to, it is possible that our liability may increase as a result of the incorporation of our technology with our customer’s products. In some cases, potential damages against us could be based on the profits derived from a product that infringes through the use of our software even though we receive a relatively moderate economic benefit from the licensing arrangement.
The adoption of industry-wide standards for interactive television, such as the OpenCable initiative in North America, could adversely affect our ability to sell our products and services or place downward pressure on our pricing.
Ongoing efforts to establish industry-wide standards for interactive television software include a commitment by cable network operators in the United States to deploy a uniform platform for interactive television based on a jointly developed specification known as the OpenCable Applications Platform and an initiative by European television industry participants to create a similar platform called Multimedia Home Platform. The establishment of these standards or other similar standards could adversely affect the pricing of our products and services, significantly reduce the value of our intellectual property and the competitive advantage our proprietary technology provides, cause us to incur substantial expenditures to adapt our
products or services to respond to these developments, or otherwise hurt our business, particularly if our products require significant redevelopment in order to conform to the newly established standards.
Our failure to participate in certain industry standards setting organizations, including CableLabs, may adversely affect our ability to sell products or services to network operators or other potential customers that are members of those organizations
We have not, to date, joined CableLabs, the research and development consortium managing the OpenCable initiative, and certain other standards setting organizations. While we continually assess our position with respect to any relevant standards setting organizations, and have joined several of them, our failure to participate in certain organizations may affect the willingness of their respective members to conduct business with us. If that were the case, our ability to continue to grow our business might be adversely affected.
The adoption of incompatible standards by our industry and rapid technological advances could render our products and services obsolete or non-competitive.
The migration of television from analog to digital transmission, the convergence of television, the Internet, communications and other media, and other emerging trends, such as the deployment of high definition television and multicasting, are creating a dynamic and unpredictable environment in which to operate. Our ability to anticipate trends and adapt to new technologies and evolving standards is critical to our success.
The deployment of new digital television applications, such as high-definition television and multicasting multiple television programs through a single channel, may compete directly with our products and services for broadcast distribution capacity. To the extent that such capacity cannot accommodate all of the applications that a cable or direct broadcast satellite system operator wants to distribute, then there is a risk that other applications will be deployed to the exclusion of our content and applications. If this occurs, our results of operations could be adversely affected.
Any delay or failure on our part to respond quickly, cost-effectively and sufficiently to these developments could render our products and services obsolete or non-competitive and have an adverse effect on our business, financial condition and operating results. In addition, we must stay abreast of cutting-edge technological developments and evolving service offerings to remain competitive and increase the utility of our services, and we must be able to incorporate new technologies into our products in order to address the increasingly complex and varied needs of our customer base. There can be no assurance that we will be able to do so successfully, and any failure to do so may adversely affect us.
Government regulations may adversely affect our business.
The telecommunications, media, broadcast and cable television industries are subject to extensive regulation by governmental agencies. These governmental agencies continue to oversee and adopt legislation and regulation over these industries, particularly in the areas of user privacy, consumer protection, the online distribution of content and the characteristics and quality of online products and services, which may affect our business, the development of our products, the decisions by market participants to adopt our products and services or the acceptance of interactive television by the marketplace in general. In particular, governmental laws or regulations restricting or burdening the exchange of personally identifiable information could delay the implementation of interactive services or create liability for us or any other manufacturer of software that facilitates information exchange. These governmental agencies may also seek to regulate interactive television directly. Future developments relating to any of these regulatory matters may adversely affect our business.
Changes to current accounting policies or in how such policies are interpreted or applied to our business could have a significant effect on our reported financial results or the way in which we conduct our business and could make it difficult for investors to assess properly our financial condition or operating results.
We prepare our financial statements in conformity with accounting principles generally accepted in the United States, which are subject to interpretation by the American Institute of Certified Public Accountants, the Public Company Accounting Oversight Board, the Securities and Exchange Commission and various other bodies formed to interpret and create appropriate accounting policies. A change in these policies or in how such policies are interpreted or applied to our business could have a significant effect on our reported results and may even retroactively affect previously reported transactions. Our accounting policies that recently have been or may in the future be affected by changes in the accounting rules are as follows:
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Revenue recognition;
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Accounting for share-based compensation;
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Accounting for income taxes; and
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Accounting for business combination, related goodwill and other intangible assets.
As a software company, our revenue recognition policy, in particular, is a key component of our results of operations and is based on complex rules that require us to make judgments and estimates. In applying our revenue recognition policy, we must determine what portions of our revenue are recognized currently and which portions must be deferred. As a result, we may receive cash from a customer, or bill that customer, but not be able to recognize the revenue associated with that cash, or billing, for some period of time under applicable accounting rules. This results in our recording the cash as “deferred revenue” on our balance sheet. There are also complex accounting rules associated with the treatment of internal development costs, and whether those costs should be capitalized or expensed as incurred. A determination whether to capitalize or expense certain costs may materially affect our financial presentation. Because different contracts may require different accounting treatment, it may be difficult for investors to properly assess our financial condition or operating results unless they carefully review all of our financial information, including our statement of operations, our balance sheet and our statement of cash flows.
In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123R which requires the measurement of all employer share-based payments to employees, including grants of employee stock options, using a fair-value-based method and the recording of such expense in our Consolidated Statements of Operations. In April 2005, the SEC adopted a rule that amends the compliance dates of SFAS No. 123R. Under the revised compliance dates, we will be required to adopt the provisions of SFAS No. 123R no later than the first interim period of fiscal 2006. While management continues to evaluate the impact of SFAS No. 123R on our Consolidated Financial Statements, we currently believe that the expensing of stock-based compensation will most likely affect our Consolidated Statements of Operations in a manner generally consistent with our pro forma disclosure under SFAS No. 123, as amended.
Through the use of our technology, we have the ability to collect personal and confidential information from set-top boxes. If we fail to protect this information from security breaches or misuse this information, then our operations could be disrupted and we could be subject to litigation and liability under privacy laws.
Through the technology that we license for use in set-top boxes, we have the ability, when requested by our customers, to collect and store personal information from users of our applications. Subject to applicable laws, and the agreement of our customers and consumers, we may also seek to use such information to help develop addressable and targeted advertising businesses. Storage and use of such information is subject to laws and regulations and may also subject us to privacy claims relating to its use and dissemination. In addition, a third party might be able to breach our security measures and gain unauthorized access to our servers where such information is stored and misappropriate such information or cause interruptions to our business operations. We may be required to expend significant capital and other resources to monitor the laws
applicable to privacy matters, to protect against security breaches or to deal with the consequences of any breach. A breach of privacy rights by us, network operators or others could expose us to liability. Any compromise of security or misuse of private information could materially and adversely affect our business, reputation, operating results and financial condition and expose us to costly litigation and regulatory action. Concerns over the security of personal information transmitted through our applications and the potential misuse of such information might also inhibit market acceptance of our applications, and if this occurs, our business and operating results will be adversely affected.
If we continue to develop and seek to market gaming and gambling applications, we must assess the legality of these types of activities in different jurisdictions. Our inability to launch these applications legally, the uncertain regulatory landscape for these applications and the significant costs associated with ongoing evaluations regarding the state of gaming and gambling laws around the world may adversely affect our business.
We develop and market gaming and gambling applications for interactive television based on technologies and know-how that we acquired through BettingCorp. In many jurisdictions throughout the world, the laws regulating gaming and gambling, particularly through media such as interactive television and the Internet, are highly uncertain and subject to frequent change. The penalties in many jurisdictions include both civil and criminal penalties. While we continually assess the laws and regulations regarding gaming and gambling ventures, and engage special outside legal counsel to assist in that process, we cannot be certain that our interpretation of, or the advice that we receive from outside professionals with respect to, those laws will necessarily be the only possible interpretation. The costs associated with that evaluative process are not, and will not be, insignificant. In the event that we are incorrect in our interpretation of certain laws or regulations, we may be subject to penalties. Moreover, we may be required to make significant changes to our business, if those laws or regulations change in ways that we do not anticipate or expect. The uncertainty inherent in these matters, the changing nature of these laws and regulations, and the significant costs associated with our ongoing evaluation of those laws and regulations, may adversely affect our business over time. If we do not believe that we can legally and effectively launch gaming and gambling applications, our future growth may be impaired.
Our multinational operations expose us to special risks that could increase our expenses, adversely affect our operating results and require increased time and attention of management.
We derive a substantial portion of our revenue from customers located outside of the United States and have significant operations in a number of countries around the world. Our international operations are subject to special risks, including:
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differing legal and regulatory requirements and changes in those requirements;
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potential loss of proprietary information due to piracy, misappropriation or weaker laws regarding intellectual property protection;
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export and import restrictions, tariffs and other trade barriers;
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currency fluctuations and devaluations;
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difficulties in staffing and managing offices as a result of, among other things, distance, language and cultural differences;
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longer payment cycles and problems in collecting accounts receivable;
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political and economic instability; and
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potentially adverse tax consequences.
Any of these factors could have an adverse effect on our business, financial condition and operating results.
Our software products may contain errors, which could cause us to lose revenue and incur unexpected expenses.
Software development is an inherently complex process, which frequently results in products that contain errors, as well as defective features and functions. Moreover, our technology is integrated into other products and services deployed by our network operator customers. Accordingly, a defect, error or performance problem with our technology could cause the systems of our network operator customers to fail for a period of time or to be impaired in certain respects. Any such failure could subject us to damage claims and claims for indemnification by our customers and result in severe customer relations problems and harm to our reputation.
While our agreements with customers typically contain provisions designed to limit or exclude our exposure to potential liability claims in those circumstances, those provisions may not be effective, in all respects, under the laws of some jurisdictions. As a result, we could be required to pay substantial amounts of damages in settlement or upon the determination of any of these types of claims.
The interests of our majority owner may differ from yours and may result in OpenTV acting in a manner inconsistent with your general interests.
Liberty Media Corporation beneficially owned Class A and Class B ordinary shares representing approximately 30.6% of the economic interest and 77.6% of the voting power of our ordinary shares outstanding as of December 31, 2005. As a result of its ownership of our ordinary shares, Liberty Media has sufficient voting power, without the vote of any other stockholder, to determine the outcome of any action presented to a vote of our stockholders, including amendments of our memorandum of association and articles of association for any purpose (which could include increasing or reducing our authorized capital or authorizing the issuance of additional shares). The interests of Liberty Media may diverge from your interests, and Liberty Media may be in a position, subject to general fiduciary obligations, to cause or require us to act in a way that is inconsistent with the general interests of the holders of our Class A ordinary shares.
Because we are controlled by Liberty Media, we are exempt from certain listing requirements of the Nasdaq National Market relating to corporate governance matters.
Over the past several years, the National Association of Securities Dealers has adopted certain listing requirements for the Nasdaq National Market System designed to enhance corporate governance standards of the companies who are listed thereon. As a result of Liberty Media’s beneficial ownership of our Class A and Class B ordinary shares, we are not subject to some of these requirements, including the requirement that a majority of our board of directors be “independent” under the guidelines established by the National Association of Securities Dealers and certain requirements regarding the determination of our Chief Executive Officer’s compensation and our director nominees. While we do not believe that our exemption from those requirements affects the manner and method by which we manage and operate the company, investors should be aware that we are not subject to those provisions and may have no obligation to comply with those requirements in the future unless our ownership profile changes.
Because we are a British Virgin Islands company, you may not be able to enforce judgments against us that are obtained in United States courts.
We are incorporated under the laws of the British Virgin Islands. As a result, it may be difficult for investors to effect service of process upon us within the United States or to enforce against us judgments obtained in the United States courts, including judgments predicated upon the civil liability provisions of the federal securities laws of the United States.
We have been advised by our British Virgin Islands counsel, Harney Westwood Riegels, that judgments of United States courts predicated upon the civil liability provisions of the federal securities laws of the United States may be difficult to enforce in British Virgin Islands courts and that there is doubt as to whether British Virgin Islands courts will enter judgments in original actions brought in British Virgin Islands courts predicated solely upon the civil liability provisions of the federal securities laws of the United States.
Because we are a British Virgin Islands company, your rights as a stockholder may be less clearly established as compared to the rights of stockholders of companies incorporated in other jurisdictions.
Our corporate affairs are governed by our amended and restated memorandum of association and articles of association and by the International Business Companies Act of the British Virgin Islands. Principles of law relating to such matters as the validity of corporate procedures, the fiduciary duties of management and the rights of our stockholders may differ from those that would apply if we were incorporated in the United States or another jurisdiction. The rights of stockholders under British Virgin Islands law are not as clearly established as are the rights of stockholders in many other jurisdictions. Thus, our stockholders may have more difficulty protecting their interests in the face of actions by our board of directors or our controlling stockholder than they would have as stockholders of a corporation incorporated in another jurisdiction.
Certain provisions contained in our charter documents could deter a change of control of us.
Certain provisions of our amended and restated memorandum of association and articles of association may discourage attempts by other companies to acquire or merge with us, which could reduce the market value of our Class A ordinary shares. For example, in February 2006, we amended and restated our memorandum of association to eliminate a restriction that previously prohibited us from issuing additional super voting Class B ordinary shares. The amended and restated memorandum of association also deleted provisions that previously caused each Class B ordinary share to automatically convert into a Class A ordinary share under certain circumstances, including upon the transfer of any Class B ordinary shares to a person who was not a stockholder, or an affiliate of a stockholder, prior to our initial public offering. The comparatively low voting rights of our Class A ordinary shares as compared to our Class B ordinary shares, approximately 99.6% of which were beneficially owned by Liberty Media as of December 31, 2005, as well as other provisions of our amended and restated memorandum of association and articles of association, may delay, deter or prevent other persons from attempting to acquire control of us.
Item 1B.
Item 1B.
Unresolved Staff Comments
None.
Item 2.
Item 2.
Properties
Our corporate headquarters and principal executive offices are presently located at 275 Sacramento Street, San Francisco, California, 94111, where we occupy 60,458 square feet of space under a lease that expires on January 31, 2010. In addition to the corporate headquarters, we have leased regional office space elsewhere in the United States, Europe, Asia and Australia.
Item 3.
Item 3.
Legal Proceedings
OpenTV, Inc. v. Liberate Technologies, Inc. On February 7, 2002, OpenTV, Inc., our subsidiary, filed a lawsuit against Liberate Technologies, Inc. alleging patent infringement in connection with two patents held by OpenTV, Inc. relating to interactive technology. The lawsuit is pending in the United States District Court for the Northern District of California. On March 21, 2002, Liberate Technologies filed a counterclaim against OpenTV, Inc. for alleged infringement of four patents allegedly owned by Liberate Technologies. Liberate Technologies has since dismissed its claims of infringement on two of those patents. In January 2003, the District Court granted two of OpenTV, Inc.’s motions for summary judgment pursuant to which the court dismissed Liberate Technologies’ claim of infringement on one of the remaining patents and dismissed a defense asserted by Liberate Technologies to OpenTV, Inc.’s infringement claims, resulting in only one patent of Liberate Technologies remaining in the counterclaim. The District Court issued a claims construction ruling for the two OpenTV patents and one Liberate patent remaining in the suit on December 2, 2003.
In April 2005, Liberate sold substantially all of the assets of its North American business to Double C Technologies, a joint venture between Comcast Corporation and Cox Communications, Inc. In connection with that transaction, Liberate and Double C Technologies indicated in a filing with the United States District
Court that Double C Technologies had assumed all liability related to this litigation. A stay of these proceedings has been granted to the parties through May 15, 2006 to allow for settlement discussions.
We continue to believe that our lawsuit is meritorious and intend to continue vigorously pursuing prosecution of our claims. In addition, we believe that we have meritorious defenses to the counterclaims brought against OpenTV, Inc. and will defend ourselves vigorously. No provision has been made in our Consolidated Financial Statements for this matter. We are unable to predict the likelihood of a favorable outcome or estimate our potential liability, if any, in respect of any potential counterclaims if litigated to conclusion.
Initial Public Offering Securities Litigation. In July 2001, the first of a series of putative securities class actions, Brody v. OpenTV Corp., et al., was filed in United States District Court for the Southern District of New York against certain investment banks which acted as underwriters for our initial public offering, us and various of our officers and directors. These lawsuits were consolidated and are captioned In re OpenTV Corp. Initial Public Offering Securities Litigation. The complaints allege undisclosed and improper practices concerning the allocation of our initial public offering shares, in violation of the federal securities laws, and seek unspecified damages on behalf of persons who purchased OpenTV Class A ordinary shares during the period from November 23, 1999 through December 6, 2000. The Court has appointed a lead plaintiff for the consolidated cases. On April 19, 2002, the plaintiffs filed an amended complaint. Other actions have been filed making similar allegations regarding the initial public offerings of more than 300 other companies, including Wink Communications as discussed in greater detail below. All of these lawsuits have been coordinated for pretrial purposes as In re Initial Public Offering Securities Litigation, 21 MC 92 (SAS). Defendants in these cases filed an omnibus motion to dismiss on common pleading issues. Oral argument on the omnibus motion to dismiss was held on November 1, 2002. All claims against our officers and directors have been dismissed without prejudice in this litigation pursuant to the parties’ stipulation approved by the Court on October 9, 2002. On February 19, 2003, the Court denied in part and granted in part the omnibus motion to dismiss filed on behalf of defendants, including us. The Court’s Order dismissed all claims against us except for a claim brought under Section 11 of the Securities Act of 1933. Plaintiffs and the issuer defendants, including us, have agreed to a stipulation of settlement, in which plaintiffs will dismiss and release their claims in exchange for a guaranteed recovery to be paid by the insurance carriers of the issuer defendants and an assignment of certain claims. The stipulation of settlement for the claims against the issuer-defendants, including us, has been submitted to the Court. On February 15, 2005, the Court preliminarily approved the settlement contingent on specified modifications. On August 31, 2005, the Court entered an order confirming its preliminary approval of the settlement. A hearing on the fairness of the settlement to the shareholder class is set for April 24, 2006. There is no guarantee that the settlement will become effective, as it is subject to a number of conditions which cannot be assured. If the settlement does not occur, and the litigation against us continues, we believe that we have meritorious defenses to the claims asserted against us and will defend ourselves vigorously. No provision has been made in our Consolidated Financial Statements for this matter. We are unable to predict the likelihood of an unfavorable outcome or estimate our potential liability, if any.
In November 2001, a putative securities class action was filed in United States District Court for the Southern District of New York against Wink Communications and two of its officers and directors and certain investment banks which acted as underwriters for Wink Communications’ initial public offering. We acquired Wink Communications in October 2002. The lawsuit is now captioned In re Wink Communications, Inc. Initial Public Offering Securities Litigation. The operative amended complaint alleges undisclosed and improper practices concerning the allocation of Wink Communications’ initial public offering shares in violation of the federal securities laws, and seeks unspecified damages on behalf of persons who purchased Wink Communications’ common stock during the period from August 19, 1999 through December 6, 2000. This action has been consolidated for pretrial purposes as In re Initial Public Offering Securities Litigation. On February 19, 2003, the Court ruled on the motions to dismiss filed by all defendants in the consolidated cases. The Court denied the motions to dismiss the claims under the Securities Act of 1933, granted the motion to dismiss the claims under Section 10(b) of the Securities Exchange Act of 1934 against Wink Communications and one individual defendant, and denied that motion against the other individual defendant. As described above, a stipulation of settlement for the claims against the issuer defendants has been submitted to
and preliminarily approved by the Court. There is no guarantee that the settlement will become effective, as it is subject to a number of conditions, including approval of the Court, which cannot be assured. If the settlement does not occur, and the litigation against Wink Communications continues, we believe that Wink Communications has meritorious defenses to the claims brought against it and that Wink Communications will defend itself vigorously. No provision has been made in our Consolidated Financial Statements for this matter. We are unable to predict the likelihood of an unfavorable outcome or estimate our potential liability, if any.
Litigation Relating to the Acquisition of ACTV, Inc. On November 18, 2002, a purported class action complaint was filed in the Court of Chancery of the State of Delaware in and for the County of New Castle against ACTV, Inc., its directors and us. The complaint generally alleges that the directors of ACTV breached their fiduciary duties to the ACTV shareholders in approving the ACTV merger agreement pursuant to which we acquired ACTV on July 1, 2003, and that, in approving the ACTV merger agreement, ACTV’s directors failed to take steps to maximize the value of ACTV to its shareholders. The complaint further alleges that we aided and abetted the purported breaches of fiduciary duties committed by ACTV’s directors on the theory that the merger could not occur without our participation. No proceedings on the merits have occurred with respect to this action, and the case is dormant. We believe that the allegations are without merit and intend to defend against the complaint vigorously. No provision has been made in our Consolidated Financial Statements for this matter. We are unable to predict the likelihood of an unfavorable outcome or estimate our potential liability, if any.
Broadcast Innovation Matter. On November 30, 2001, a suit was filed in the United States District Court for the District of Colorado by Broadcast Innovation, L.L.C., or BI, alleging that DIRECTV, Inc., EchoStar Communications Corporation, Hughes Electronics Corporation, Thomson Multimedia, Inc., Dotcast, Inc. and Pegasus Satellite Television, Inc. are infringing certain claims of United States patent no. 6,076,094, assigned to or licensed by BI. DIRECTV and certain other defendants settled with BI on July 17, 2003. We are unaware of the specific terms of that settlement. Though we are not currently a defendant in the suit, BI may allege that certain of our products, possibly in combination with the products provided by some of the defendants, infringe BI’s patent. The agreement between OpenTV, Inc. and EchoStar includes indemnification obligations that may be triggered by the litigation. If liability is found against EchoStar in this matter, and if such a decision implicates our technology or products, EchoStar has notified OpenTV, Inc. of its expectation of indemnification, in which case our business performance, financial position, results of operations or cash flows may be adversely affected. Likewise, if OpenTV, Inc. were to be named as a defendant and it is determined that the products of OpenTV, Inc. infringe any of the asserted claims, and/or it is determined that OpenTV, Inc. is obligated to defend EchoStar in this matter, our business performance, financial position, results of operations or cash flows may be adversely affected. On November 7, 2003, BI filed suit against Charter Communications, Inc. and Comcast Corporation in United States District Court for the District of Colorado, alleging that Charter and Comcast also infringe the ’094 patent. The agreements between Wink Communications and Charter Communications include indemnification obligations of Wink Communications that may be triggered by the litigation. While reserving all of our rights in respect of this matter, we have conditionally reimbursed Charter for certain legal reasonable expenses that it incurred in connection with this litigation. On August 4, 2004, the District Court found the ’094 patent invalid. After various procedural matters, including interim appeals, in November 2005, the United States Court of Appeals for the Federal Circuit remanded the case back to the District Court for disposition. The District Court has tentatively scheduled a trial in this matter for September 2006, although counsel for the defendants expects that, prior to the trial date, the District Court may review and issue its opinion on various pending summary judgment motions for dismissal. In addition, on March 8, 2006, the defendants filed a writ of certiorari in this matter with the Supreme Court of the United States to review the decision of the United States Court of Appeals for the Federal Circuit, which had overturned the District Court’s order for summary judgment in favor of the defendants. Based on the information available to us, we have established a reserve for costs and fees that may be incurred in connection with this matter. That reserve is an estimate only and actual costs may be materially different.
Personalized Media Communications, LLC. On December 4, 2000, a suit was filed in the United States District Court for the District of Delaware by Pegasus Development Corporation and Personalized Media Communications, LLC alleging that DIRECTV, Inc., Hughes Electronics Corp., Thomson Consumer Electronics and Philips Electronics North America, Inc. are willfully infringing certain claims of seven U.S. patents assigned or licensed to Personalized Media Communications. Based on publicly available information, we believe that the case has been stayed in the District Court pending re-examination by the United States Patent and Trademark Office. Though Wink Communications is not a defendant in the suit, Personalized Media Communications may allege that certain products of Wink Communications, possibly in combination with products provided by the defendants, infringe Personalized Media Communication’s patents. The agreements between Wink Communications and each of the defendants include indemnification obligations that may be triggered by this litigation. If it is determined that Wink Communications is obligated to defend any defendant in this matter, and/or that the products of Wink Communications infringe any of the asserted claims, our business performance, financial position, results of operations or cash flows may be adversely affected. No provision has been made in our Consolidated Financial Statements for this matter. We are unable to estimate our potential liability, if any.
Other Matters. From time to time in the ordinary course of our business, we are also party to other legal proceedings or receive correspondence regarding potential or threatened legal proceedings. While we currently believe that the ultimate outcome of these other proceedings, individually and in the aggregate, will not have a material adverse effect on our financial position or overall trends in our results of operations, legal proceedings are subject to inherent uncertainties.
The estimate of the potential impact on our financial position or overall results of operations for any of the legal proceedings described in this section could change in the future.
Item 4.
Item 4.
Submission of Matters to a Vote of Security Holders
At our 2005 Annual Meeting of Stockholders held on November 10, 2005, each of the following individuals was elected to our board of directors to hold office until the next annual meeting of stockholders or until their successors are duly elected and qualified:
The following proposals were also approved at our annual meeting of stockholders:
No other matters were submitted to stockholders for a vote.
PART II
Item 5.
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market Information
Our Class A ordinary shares trade on the Nasdaq National Market under the symbol “OPTV.” Our Class B ordinary shares are not publicly traded.
The following table lists the high and low sales prices for our Class A ordinary shares on the Nasdaq National Market for the periods indicated.
Holders
As of February 28, 2006, there were approximately 751 holders of record of our Class A ordinary shares and four holders of record of our Class B ordinary shares. Banks, brokers and other institutions hold many of our Class A ordinary shares on behalf of our stockholders.
Dividends
We have never paid any cash dividends on our ordinary shares. We anticipate that any earnings in the foreseeable future will be retained to finance our business, and we have no current intention to pay cash dividends on our ordinary shares. The payment of dividends is within the discretion of our board of directors and will be dependent upon, among other factors, our results of operations, financial condition, capital requirements, legal requirements and any restrictions imposed by financing arrangements.
Certain Aspects of British Virgin Islands Law
There are no governmental laws, decrees or regulations in the British Virgin Islands that restrict the export or import of capital, including, but not limited to, foreign exchange controls, or that affect the remittance of dividends or other payments to holders of our ordinary shares who are not residents of the British Virgin Islands. In particular, the British Virgin Islands does not impose a withholding tax on dividends paid by companies such as us that are incorporated under the International Business Companies Act of the British Virgin Islands.
Under the International Business Companies Act of the British Virgin Islands, a holder of our ordinary shares who is not a resident of the British Virgin Islands is exempt from British Virgin Islands income tax on dividends paid on our ordinary shares and no holders of our ordinary shares are liable to the British Virgin Islands for income tax on gains realized during any taxable year on sale or disposal of our ordinary shares. There are no capital gains, gift or inheritance taxes levied by the British Virgin Islands on the holders of our
ordinary shares. In addition, our ordinary shares are not subject to transfer taxes, stamp duties or other similar charges as a matter of British Virgin Islands law.
There is no income tax treaty or convention currently in effect between the United States and the British Virgin Islands. If we were to be classified as a passive foreign investment company under applicable United States tax regulations, for the prior, current, or subsequent taxable years, stockholders who are U.S. taxpayers could be subject to adverse tax consequences.
Securities Authorized for Issuance Under Equity Compensation Plans
The following table presents information about our equity compensation plans as of December 31, 2005:
Equity Compensation Plan Information
As a result of our stockholders’ approval of our 2005 Incentive Plan (the “2005 Plan”), on November 10, 2005, no further awards will be granted under the following plans:
•
our Amended and Restated 1999 Share Option/ Share Issuance Plan (the “1999 Plan”);
•
our 2001 Nonstatutory Stock Option Plan (the “2001 Plan”); and
•
our 2003 Incentive Plan (the “2003 Plan”).
Our board of directors has suspended offering periods under our Amended and Restated 1999 Employee Stock Purchase Plan (the “ESPP”) and no options or purchase rights are currently outstanding under the ESPP. In the event our board elects to commence offering periods under our ESPP in the future, the number of Class A ordinary shares issuable under the ESPP will, pursuant to the terms of the ESPP, be reset at 500,000 each successive December 31 through calendar year 2008, in each case for issuance during the following year.
(1)
Represents (i) 3,363,549 Class A ordinary shares issuable upon the exercise of options outstanding under the 1999 Plan, (ii) 95,628 Class A ordinary shares issuable upon the exercise of outstanding options assumed in connection with our acquisition of Spyglass, Inc. in July 2000, (iii) 4,770,882 Class A ordinary shares issuable upon the exercise of options outstanding under the 2003 Plan, (iv) 1,883,665 Class A ordinary shares issuable upon the exercise of outstanding options, assumed in connection with our acquisition of ACTV, Inc. in July 2003, and (v) 3,000 Class A ordinary shares issuable upon the exercise of options outstanding under the 2005 Plan.
(2)
Represents (i) 5,997,000 Class A ordinary shares available for future issuance under the 2005 Plan and (ii) 500,000 Class A ordinary shares available for future issuance under the ESPP.
(3)
Represents (i) 146,986 Class A ordinary shares issuable upon exercise of outstanding stock options granted under the 2001 Plan, and (ii) 744,428 Class A ordinary shares issuable upon the exercise of exchange rights granted under our 2000 Exchange Plan, or the Exchange Plan.
(4)
Does not include information regarding weighted-average exercise price of Class A ordinary shares issuable under the Exchange Plan because such issuances do not involve the payment of an exercise price or the provision of other monetary consideration.
2000 Exchange Plan
Exchange rights granted under the Exchange Plan enable the holder to exchange, generally on a one for one basis, shares of the common stock of our majority-owned subsidiary OpenTV, Inc. (including shares of OpenTV, Inc. common stock that may be acquired pursuant to the exercise of options outstanding under OpenTV, Inc.’s Amended and Restated 1998 Stock Purchase/ Stock Issuance Plan, or the 1998 Plan) for our Class A ordinary shares. Although 800,868 Class A ordinary shares were reserved for future issuance under the Exchange Plan as of December 31, 2005, only 744,428 shares of OpenTV, Inc. common stock (62,000 of which were underlying options to purchase shares of OpenTV, Inc. common stock previously granted under the 1998 Plan at a weighted-average exercise price of $4.64) were actually eligible for exchange under the Exchange Plan as of that date. We no longer grant options under the 1998 Plan.
2001 Nonstatutory Stock Option Plan
Our board of directors adopted the 2001 Nonstatutory Stock Option Plan, or the 2001 Plan, in October 2001. As of November 10, 2005, the date our stockholders approved the 2005 Plan, no further awards will be granted under the 2001 Plan. The 2001 Plan did not require the approval of our stockholders, and no stockholder approval was obtained or sought. The material features of the 2001 Plan are summarized below.
Share Reserve. Options to purchase 146,986 Class A ordinary shares were outstanding under the 2001 Plan as of December 31, 2005. No further awards will be granted under the 2001 Plan and any previously issued options under 2001 Plan that are forfeited, cancelled or otherwise terminated without being exercised will not become available for future grants. As of December 31, 2005, no Class A ordinary shares had been issued upon the exercise of options granted under the 2001 Plan.
Administration. The compensation committee of our board of directors administers the 2001 Plan. The compensation committee has complete discretion to make all decisions relating to the administration, interpretation and operation of the 2001 Plan.
Eligibility. The following groups of individuals are eligible to participate in the 2001 Plan:
•
employees (other than employees who are executive officers); and
•
consultants.
Structure of Plan. The 2001 Plan permits the grant of options to purchase Class A ordinary shares to eligible participants. Options to purchase our Class A ordinary shares that may be granted under the 2001 Plan are non-statutory options and do not qualify for the favorable tax treatment afforded incentive options under Section 422 of the Code. The exercise price and other terms of non-statutory options granted under the 2001 Plan will be determined by the compensation committee. The compensation committee may provide that non-statutory options will be transferable.
Corporate Transaction. Options granted under the 2001 Plan will automatically vest in full upon the occurrence of certain change of control events, if such options are not assumed or exchanged for equivalent rights by the successor entity in accordance with the terms of the 2001 Plan. In the event of a corporate transaction that does not result in the automatic vesting of options and other awards, the board of directors or the compensation committee has discretion to accelerate vesting of such options and other awards.
Amendment and Termination. The board of directors may amend the 2001 Plan at any time. If our board of directors amends the 2001 Plan, stockholder approval will be sought if required by applicable law. The 2001 Plan will terminate upon the earliest of (i) ten years after its adoption by our board, or (ii) such earlier date as determined by our board of directors.
Recent Sales of Unregistered Securities
Except in connection with our acquisition of certain assets of CAM Systems, L.L.C. as previously reported in our Current Report on Form 8-K filed with the Securities and Exchange Commission on September 9, 2005, we did not sell any securities during the year ended December 31, 2005 that were not registered under the Securities Act of 1933, as amended.
Item 6.
Item 6.
Selected Financial Data
The selected consolidated financial data set forth below should be read in conjunction with Item 7.
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis provides information concerning our financial condition and results of operations for the year ended December 31, 2005. This discussion should be read in conjunction with our Consolidated Financial Statements and the notes thereto. Segment information appearing below in this discussion and analysis, and in Note 15 of our Consolidated Financial Statements, is presented in accordance with SFAS 131, “Disclosures about Segments of an Enterprise and Related Information.”
Overview
We are one of the world’s leading providers of software and solutions for interactive and enhanced television.
We derive our revenues from the licensing of our core software and related technologies, the licensing and distribution of our content and applications and the delivery of professional services. We typically receive one-time royalty fees from manufacturers of set-top boxes or from network operators once a set-top box, which incorporates our software, has been shipped to, or activated by, the network operator. In January 2006, we announced a subscription-based licensing agreement under which we would receive monthly payments for each set-top box embedded with our software that our customer deployed, for so long as those set-top boxes remain active. As we pursue additional subscription-based pricing, our revenue model may change over time. We also receive ongoing licensing fees for various other software products that we sell. In addition, we receive professional services fees from consulting, engineering and training engagements, fees for the maintenance and support of our products and fees from revenue sharing arrangements related to the use of our interactive content and applications.
As of December 31, 2005, Liberty Media Corporation’s total ownership represented approximately 30.6% of the economic interest and 77.6% of the voting interest of our ordinary shares on an undiluted basis.
Recent Events
In January 2006, Sun Microsystems exchanged its 7,594,796 Class B shares of our subsidiary, OpenTV Inc., for the same number of Class B ordinary shares of OpenTV Corp. As of February 28, 2006, Sun’s ownership of our Class B ordinary shares, therefore, represented approximately 5.6% of the economic interest and 15.8% of the voting power of our ordinary shares, and Liberty Media’s beneficial ownership of our Class A and Class B ordinary shares represented approximately 28.9% of the economic interest and 65.4% of the voting power of our ordinary shares. Sun has the right, at any time, to convert its Class B ordinary shares into our Class A ordinary shares on a one-for-one basis; in the event that Sun determined to sell its interest in the public markets, we would expect Sun to convert its Class B ordinary shares into Class A ordinary shares, which are publicly traded.
We also amended and restated our memorandum of association in February 2006. Among the changes we made, we eliminated a restriction that had prohibited us from issuing additional Class B ordinary shares or options, rights or warrants to subscribe for additional Class B ordinary shares. We also deleted provisions that formerly required each Class B ordinary share to automatically convert into a Class A ordinary share, with only one vote per share, under certain circumstances, including sales of those Class B ordinary shares to persons who were not stockholders prior to our initial public offering. And, finally, in connection with, and as a condition to, those amendments, we entered into a letter agreement with Liberty Media. In that agreement, Liberty Media generally agreed that if it sells any of our Class B ordinary shares to a third party for a sales price above the trading price of our Class A ordinary shares, then Liberty Media will contribute to us a proportionate percentage of any premium it receives from that sale, which reflects Liberty Media’s relative economic (not voting) ownership in us. We provided a more complete description of these events in our Current Report on Form 8-K that we filed with the Securities and Exchange Commission on February 13, 2006.
Critical Accounting Policies and Estimates
Our discussion and analysis of our financial condition and results of operations is based upon our Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. In preparing these Consolidated Financial Statements, we made our best estimates and judgments, which are normally based on knowledge and experience with regard to past and current events and assumptions about future events, giving due consideration to materiality. Actual results could differ materially from these estimates under different assumptions or conditions.
We believe the following critical accounting polices and estimates have the greatest potential impact on our Consolidated Financial Statements: revenue recognition, valuation allowances, specifically the allowance for doubtful accounts and deferred tax assets, valuation of investments in privately-held companies, impairment of goodwill and long-lived assets, and restructuring costs. All of these accounting policies, estimates and assumptions, as well as the resulting impact to our financial statements, have been discussed with our audit committee.
Revenue Recognition
We recognize revenue in accordance with current generally accepted accounting principles, or GAAP, that have been prescribed for the software industry, the principal policies of which are reflected in American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) 97-2, “Software Revenue Recognition”, SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts” and Securities and Exchange Commission Staff Accounting Bulletin No. 104 (SAB 104), “Revenue Recognition.” Revenue recognition requirements in the software industry are very complex and are subject to change. Our revenue recognition policy is one of our critical accounting policies because revenue is a key component of our results of operations and is based on complex rules that require us to make judgments and estimates. The application of SOP 97-2 requires judgment, including whether a software arrangement includes multiple elements, and if so, whether vendor-specific objective evidence (VSOE) of fair value exists. In applying our revenue recognition policy, we must determine which portions of our revenue to recognize currently and which portions to defer. In order to determine current and deferred revenue, we make judgments and estimates with regard to future deliverable products and services and the appropriate valuation for those products and services. Our assumptions and judgments regarding future products and services could differ from actual events.
As indicated, we provide a comprehensive suite of professional engineering and consulting services on a worldwide basis in support of our product offerings. Such services may include one or more of the following: middleware porting, customization, implementation and integration; the design, development or construction of software and systems; and system maintenance and support. Professional services from software development contracts, customization services and implementation support are recognized generally on the percentage of completion basis in accordance with the provisions of SOP 81-1. If a contract involves the provision of multiple elements, total estimated contract revenues are allocated to each element based on the relative fair value of each element. In the event that fair value is not determinable for each service element of a multiple-element contract, the contract is considered to be one accounting unit. If it is reasonably assured that no loss will be incurred under the arrangement, we recognize service revenues using the percentage of completion method using a zero-profit methodology until the contract accounting services are complete. If the arrangement includes the future delivery of specified future software products, we recognize revenue on the completed contract method, upon delivery of the services and such specified deliverables. If total costs are estimated to exceed the relative fair value for the arrangement, then a provision for the estimated loss is made in the period in which the loss first becomes apparent.
For fixed bid contracts under the percentage of completion method, the extent of progress towards completion is measured based on actual costs incurred to total estimated costs. The actual results could differ from the percentage estimates by the time a project is complete.
The recognition of revenues is partly based on our assessment of the probability of collection of the resulting accounts receivable balance. As a result, the timing or amount of revenue recognition may have been different if other assessments of the probability of collection of accounts receivable had been made at the time the transactions were recorded in revenue.
Valuation Allowances
We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.
We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. We consider our potential future taxable income and ongoing prudent and feasible tax planning strategies in assessing the amount of our valuation allowance. Currently, we maintain a partial valuation allowance on deferred tax assets. Adjustments may be required in the future if it becomes more likely than not that an amount of deferred tax assets is realizable.
Valuation of Investments in Privately-Held Companies
We have invested in equity and debt instruments of privately-held companies for business and strategic objectives, and typically we do not attempt to reduce or eliminate the inherent market risks of these investments. We perform periodic reviews of these investments for impairment. Our investments in privately-held companies are considered impaired when a review of the investee’s operations and other indicators of impairment indicate that there has been a decline in the fair value that is other than temporary and that the carrying value of the investment is not likely to be recoverable. Such indicators include, but are not limited to, limited capital resources, need for additional financing, and prospects for liquidity of the related securities. Impaired investments in privately-held companies are written down to estimated fair value, which is the amount we believe is recoverable from the investment.
Impairment of Goodwill and Long-lived Assets
Our long-lived assets include goodwill, property and equipment, other assets and other intangible assets, which are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable and in the case of goodwill, annually. In estimating the fair value of our reporting units and assessing the recoverability of our long-lived assets, we consider changes in economic conditions and make assumptions regarding estimated future cash flows and other factors. The biggest assumption impacting estimated future cash flows is revenue. Estimates of future cash flows are highly subjective judgments that can be significantly impacted by changes in global and local business and economic conditions, operating costs, competition and demographic trends. If our estimates or underlying assumptions change in the future, we may be required to record additional impairment charges.
Restructuring Costs
We monitor our organizational structure and associated operating expenses periodically. Depending upon events and circumstances, actions may be taken to restructure the business, including terminating employees, abandoning excess lease space and incurring other exit costs. Any resulting restructuring costs include numerous estimates made by us based on our knowledge of the activity being affected, the cost to exit existing commitments and fair value estimates. These estimates could differ from actual results. We monitor the initial estimates periodically and record an adjustment for any significant changes in estimates.
Recent Accounting Pronouncements
In December 2004, the FASB issued SFAS No. 123 (revised 2004) (SFAS No. 123R), “Share-Based Payment.” SFAS No. 123R requires that the cost resulting from all share-based payment transactions be recognized in the financial statements using a fair-value-based method. The statement replaces SFAS No. 123, supersedes APB No. 25, and amends SFAS No. 95, “Statement of Cash Flows.”
In March 2005, the SEC released Staff Accounting Bulletin No. 107, “Share-Based Payment,” which provides the views of the staff regarding the interaction between SFAS No. 123R and certain SEC rules and regulations for public companies. In April 2005, the SEC adopted a rule that amends the compliance dates of SFAS No. 123R. Under the revised compliance dates, we will be required to adopt the provisions of SFAS No. 123R no later than the first interim period of fiscal 2006. While management continues to evaluate the impact of SFAS No. 123R on our Consolidated Financial Statements, we currently believe that the expensing of share-based compensation will most likely affect our Consolidated Statements of Operations in a manner generally consistent with our pro forma disclosure under SFAS No. 123, as amended.
In March 2004, the FASB ratified the measurement and recognition guidance and certain disclosure requirements for impaired securities as described in Emerging Issues Task Force (EITF) Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” In June 2005, the FASB directed its staff to issue proposed FASB Staff Position (FSP) EITF 03-1-a, “Implementation Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1,” as final. The FASB plans to retitle this FSP as FSP FAS 115-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” The final FSP will supersede EITF Issue No. 03-1 and EITF Topic D-44, “Recognition of Other-Than-Temporary Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value.” The final FSP will replace the guidance set forth in paragraphs 10 through 18 of EITF Issue No. 03-1 with references to existing other-than-temporary impairment guidance. In September 2005, the FASB decided to retain the paragraph in the proposed FSP pertaining to the accounting for debt securities subsequent to an other-than-temporary impairment and added a footnote to clarify that the proposed FSP does not address when a debt security should be designated as non-accrual or how to subsequently report income on a non-accrual debt security. The FASB decided that the transition would be applied prospectively and the effective date would be reporting periods beginning after December 15, 2005. Although management is currently evaluating the potential effects that adoption of the measurement and recognition guidance in FSP FAS 115-1 will have on our Consolidated Financial Statements, we do not currently anticipate that adoption of FSP FAS 115-1 will materially affect our Consolidated Financial Statements.
In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections - A Replacement of APB Opinion No. 20 and FASB Statement No. 3.” SFAS No. 154 changes the requirements for the accounting and reporting of a change in accounting principle. Under previous guidance, changes in accounting principle were recognized as a cumulative effect in the net income of the period of the change. The new statement requires retroactive application of changes in accounting principle, limited to the direct effects of the change, to prior periods’ financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. Additionally, this Statement requires that a change in depreciation, amortization or depletion method for long-lived, non-financial assets be accounted for as a change in accounting estimate affected by a change in accounting principle, and that the correction of errors in previously issued financial statements should be termed a “restatement.” SFAS No. 154 is effective for accounting changes and the correction of errors made in fiscal years beginning after December 15, 2005. Management does not believe the adoption of SFAS No. 154 will have a material impact on our Consolidated Financial Statements.
Management’s Assessment of Internal Control Over Financial Reporting and Disclosure Controls
In connection with the preparation of our year-end financial statements, we have prepared a report, as required by the Sarbanes-Oxley Act of 2002, which evaluates our internal control over financial reporting as of December 31, 2005. That complete report, as well as our conclusions regarding the effectiveness of our
disclosure control and our remediation efforts, is included under Item 9A of this Annual Report on Form 10-K, which investors should read in its entirety.
We are required to establish and maintain adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. Those controls are designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP. And while those controls may be expected to provide reasonable assurances regarding the reliability of our financial reporting, we do not expect that such controls will prevent all error and fraud. We monitor our controls and maintain those controls as dynamic systems that change (including improvements and corrections) as conditions warrant.
We also maintain a system of disclosure controls that have been designed with the objective of ensuring that information required to be disclosed in the reports we file under the Securities Exchange Act, including this Annual Report on Form 10-K, is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission.
As we assessed our internal control over financial reporting, we have sought to identify various deficiencies or weaknesses that we may have and to correct those deficiencies or weaknesses as promptly as practicable. We are required to disclose any material weaknesses that we have identified. The Public Company Accounting Oversight Board, which was established under the Sarbanes-Oxley Act, defines a “material weakness” as a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.
We identified certain material weaknesses in our internal control over financial reporting as of December 31, 2005. Those weaknesses generally related to ineffective control over our account analysis for certain financial statement accounts, including accruals, long-term other assets and deferred tax assets, and our lack of sufficient internal personnel with adequate technical expertise to analyze effectively, and review in a timely manner, our accounting for revenue and income taxes. Based on those findings, we concluded that our internal control over financial reporting was not effective as of December 31, 2005. We also concluded that, as a result of those material weaknesses, our disclosure controls, as of December 31, 2005, were not effective. We also identified material weaknesses in our report for 2004 that was included in our Annual Report on Form 10-K for 2004. While we were able to remediate aspects of the weaknesses we identified in 2004, there is a certain overlap in several of the weaknesses we identified in 2004 and 2005, as described more fully in Item 9A of this Annual Report.
Years Ended December 31, 2005, 2004, and 2003
Revenues
In 2005, we simplified our revenue classifications to present revenues from licensed products under the line item “Royalties and licenses,” and revenues from services under the line item, “Services and other.” In light of that change, we have also reclassified line items for 2004 and 2003 to provide a consistent presentation. These reclassifications did not affect our financial results or financial position in any of the periods presented.
Revenues for the year ended December 31, 2005 were $87.4 million, an increase of $10.2 million, or 13%, from $77.2 million in 2004. Revenues for the year ended December 31, 2004 were $77.2 million, an increase of $13.0 million, or 20%, from $64.2 million in 2003. Royalties and licenses accounted for 63% of revenues in 2005, 63% in 2004, and 45% in 2003. Revenues by line item were as follows (in millions):
Royalties and licenses. We generally derive royalties from the sale of set-top boxes and other products that incorporate our software. Royalties are paid by either the set-top box manufacturer or by the network
operator depending upon our payment arrangements with those customers. We recognize royalties upon notification of unit shipments or activation of our software by manufacturers or network operators. Royalty reports are generally received one quarter in arrears. For non-refundable prepaid royalties, we recognize revenues upon delivery of the software, provided all the criteria of SOP 97-2 and related accounting principles have been met. While we have historically realized revenues through one-time royalty payments and ongoing license fees, we recently signed a licensing agreement with an India-based satellite and cable television provider that will pay us under a subscription-based model, pursuant to which we are paid a monthly fee for each set-top box that is deployed by the network operator for so long as that box remains in use by the operator. We expect, in the future, to seek additional licensing arrangements of this nature, which, if we are successful, may affect our revenues over a period of time. We also derive license fees from the licensing of other software products, such as OpenTV Streamer and OpenTV Software Developers Kit. License fees are generally one-time purchases by our customers and can vary significantly from quarter to quarter.
Our royalties usually result from several different types of arrangements. These may include: initial deployments by new customers, the activation of new subscribers by existing customers, the shipment of additional set-top boxes as replacements for older set-top boxes, for defective set-top boxes or for purposes of simply upgrading existing set-top boxes, or sales of new products or services by the network operators that require new or updated set-top boxes. As we discuss in more detail below, we have historically provided various types of volume discounts to our customers and expect that we will continue to do so in the future. Unless we are able to offset anticipated discounts through a change in product mix, upgrades to our software or other methods which typically enable us to charge higher fees, we may experience slower royalty growth as discounting is triggered. Specific royalty trends associated with set-top box deployments by our customers are difficult to discern in many cases, as we do not control or directly influence actual deployment schedules of our customers.
Royalties and licenses for 2005 increased 13% to $55.1 million compared to 2004. Royalties and licenses for Europe, Middle East and Africa decreased by $0.9 million from 2004 to $25.9 million in 2005, principally as a result of $3.3 million less in royalties and licenses revenues from Sky Italia in 2005. The decrease in revenues from Sky Italia resulted from a reduction in the royalty rate paid by Sky Italia over the course of 2005, which related to volume discounts we offered Sky Italia when it became a customer. The decrease from Sky Italia was partially offset by an increase of $1.8 million in royalties and licenses revenue for BSkyB, primarily as a result of increased set-top box shipments by the four manufacturers who manufacture set-top boxes for BSkyB, and an increase of $0.6 million in royalties and licenses revenues from other customers in the region. Royalties and licenses in the Americas region increased by $5.2 million to $20.6 million in 2005. Approximately $2.7 million of that increase was realized from EchoStar, with the remaining $2.5 million realized from other customers. Despite this increase in the amortization of EchoStar payments during 2005, total revenues from EchoStar were affected, in part, by a reduction in EchoStar set-top box shipments in 2005 compared to 2004. Royalty payments we receive from EchoStar are amortized over the seven-year term of our EchoStar agreements because EchoStar has a right to receive a limited number of unspecified future applications developed by us. Until we are able to recognize the full royalty revenue reported by EchoStar, which would occur upon expiration of the seven-year agreement term, a portion of the amounts that we invoice to EchoStar are recorded as deferred revenue on our balance sheet and amortized over the remaining life of the agreement. Royalties and licenses in the Asia Pacific region increased by $1.9 million to $8.6 million in 2005. Royalties and licenses from shipments of our integrated browser in certain digital TV sets distributed within Japan accounted for $0.2 million of this increase, while other customers accounted for the remaining $1.7 million.
Royalties and licenses for 2004 increased 71% to $48.9 million compared to 2003. Royalties and licenses for Europe, Middle East and Africa increased by $14.6 million from 2003 to $26.8 million in 2004. Royalties and licenses from Sky Italia accounted for $12.6 million of this increase, with the remaining $2.0 million accounted for by other customers. Royalties and licenses in the Americas region increased by $3.2 million from 2003 to $15.3 million in 2004. Increased shipments and amortization of EchoStar payments accounted for an increase of approximately $3.6 million, which was partially offset by decreased royalty and license revenue of $0.4 million attributable to other customers. Royalties and licenses in the Asia Pacific region
increased by $2.4 million from 2003 to $6.7 million in 2004. Increased shipments of our integrated browser in certain digital TV sets distributed within Japan accounted for $2.9 million of this increase, which was partially offset by decreased royalty and license revenue of $0.5 million attributable to other customers.
Services and Other. Services and other revenues consist primarily of professional services, maintenance and support, training, service usage fees and revenue shares and programming fees. Professional service revenues are generally derived from consulting engagements for set-top box manufacturers, network operators and system integrators. Maintenance, support and training revenues are generally realized as services are provided to set-top box manufacturers and network operators. The decision by a set-top box manufacturer to purchase maintenance and support from us largely depends on whether such manufacturer is actively shipping set-top boxes with our software or reasonably expects to do so in quantities large enough to justify payment of these amounts, which, in both cases, is dependent upon such manufacturer’s supply contracts with network operators and set-top box demand by the network operator. Service usage fees and revenue shares are generally derived from our PlayJam games channels, our betting and gaming channels, and revenue shares for advertising and other interactive services. We also derive programming fees from our NASCAR agreement and from other programmers.
Services and other revenue for 2005 increased by 14% to $32.3 million compared to 2004. We experienced an increase of $1.7 million in net betting and gaming fees from customers of our wholly-owned subsidiary, BettingCorp, due to increased service usage on BSkyB. We also realized an increase of $1.2 million in advertising related service revenue from our acquisition of CAM Systems in September 2005, as further described in Note 3 of our Consolidated Financial Statements, which was partially offset by decreased advertising related service revenues of $0.3 million from other advertising customers. In 2004, we did not recognize any programming fees for NASCAR. As described in Note 8 of our Consolidated Financial Statements, we renegotiated our NASCAR agreement in 2004, and, as a result, we recognized $1.8 million of additional revenue from providing these programming services in 2005. We also realized an increase of $3.0 million in services from other customers to which we provided professional services. These increases were partially offset by a decrease of $1.9 million in PlayJam games channel fees resulting from increased competition and a reduction of service on our PlayJam games channel in France that we initiated. We also experienced a decrease of $1.5 million in consulting work for Motorola in 2005.
Service and other revenue for 2004 decreased by 20% to $28.3 million compared to 2003. We experienced a decrease of $6.6 million in our consulting service engagements, including a $4.7 million reduction in work from Motorola, for which certain minimum commitments expired in the first quarter of 2004, and a decrease of $1.1 million in maintenance and support fees, due to certain customers not renewing their maintenance agreements. In addition, our advertising and programming fees from our Wink product offering accounted for a decline of $1.1 million and our PlayJam games channel fees decreased by $0.3 million due to competitive pressures, which offset favorable currency exchange rates. These decreases were partially offset by an increase of $1.7 million in net betting and gaming fees from customers of BettingCorp, due to the inclusion of its results for the full year of 2004 compared with five months of 2003, and an increase of $0.2 million from revenue shares for various other product offerings.
Individuals who play games on the PlayJam games channel in the United Kingdom make payments to their telecommunications provider, which provides a “return path” to enable the games to be interactive. We receive revenues from the payment intermediary. During 2004, we changed our payment intermediary from Digital Interactive Television Group, or DITG, to BSkyB. In 2005, the fees paid by BSkyB to us for these services were $6.5 million. In 2004, the fees paid by BSkyB to us were $5.1 million and the fees paid by DITG to us were $2.8 million. The fees paid by DITG to us in 2003 were $7.4 million. In the United States, we receive a revenue share from EchoStar in connection with its distribution of our PlayJam games channel.
Operating Expenses
Our total operating expenses, which include cost of revenues, were $100.3 million for the year ended December 31, 2005, $101.8 million for the year ended December 31, 2004, and $117.7 million for the year ended December 31, 2003. Operating expenses by line item were as follows (in millions):
Cost of Royalties and Licenses. Cost of royalties and licenses consist primarily of materials and shipping costs, patent-related legal costs and amortization of developed technology and patents.
Cost of royalties and licenses for 2005 decreased 22% from 2004 to $6.4 million. As a percentage of revenues, cost of royalties and licenses decreased to 7% in 2005 compared to 11% in 2004, primarily due to a $1.0 million decrease in patent-related legal costs and a $0.7 million decrease in the amortization of developed technologies as a result of fully amortizing certain developed technologies.
Cost of royalties and licenses for 2004 decreased 23% from 2003 to $8.2 million. As a percentage of revenues, cost of royalties and licenses decreased to 11% in 2004 compared to 17% in 2003. The decrease in 2004 was primarily due to a $5.6 million decrease in the amortization of developed technologies and patents as a result of fully amortizing certain developed technologies and patents. That decrease in 2004 was partially offset by an increase of $2.5 million in patent-related legal costs in 2004, and a $0.5 million increase in the amortization of developed technologies attributable to the inclusion of BettingCorp’s financial information for a full year.
Cost of Services and Other. Cost of services and other consist primarily of headcount and headcount-related costs associated with maintenance and support and professional services engagements, consulting and subcontractor costs, third party material costs, depreciation and network infrastructure and bandwidth costs of our interactive games and betting channels.
Cost of services and other for 2005 decreased 9% from 2004 to $28.4 million. As a percentage of revenues, cost of services and other decreased to 33% in 2005 compared to 40% in 2004. A reduction in headcount-related costs accounted for $2.5 million of the decrease, and a reduction in depreciation expense as a result of fully depreciating certain fixed assets accounted for a decrease of $1.0 million. In addition, in 2004 we had recorded a provision of $3.5 million for remaining future commitments under the terms of a Sun Java license agreement. These decreases were partially offset by an increase of $3.1 million in consulting and subcontractor costs and third party material costs associated with billable professional services engagements, and a net increase of $1.2 million in network infrastructure and bandwidth costs.
Cost of services and other for 2004 decreased 22% from 2003 to $31.1 million. As a percentage of revenues, cost of services and other decreased to 40% in 2004 compared to 62% in 2003. In 2004, there was a significant decrease in operations costs, including a transfer of some personnel to research and development
functions, and in payments made in connection with the distribution of our Wink products, which accounted for a decrease of $8.0 million. BettingCorp accounted for an increase of $2.2 million as a result of its inclusion for the full year. In 2004, we had recorded a provision of $3.5 million for remaining future commitment under the terms of a Sun Java license agreement. All other items accounted for a net decrease of $6.3 million.
NASCAR Amendment. During the second quarter of 2004, we renegotiated an existing contract that our subsidiary, ACTV, had with iNDEMAND relating to the production of interactive programming for the 2004 NASCAR season and beyond. As a result of this renegotiation, we reduced the estimated loss for that contract by $4.6 million from the amount which had been accrued by ACTV in 2003 prior to our acquisition of ACTV. This item was shown as a separate line item in our Consolidated Statement of Operations for the year ended December 31, 2004. No revenue or expenses were recorded prior to the renegotiation in 2004 as a result of the overall estimated losses expected under the assumed relationship.
Research and Development. Research and development expenses consist primarily of headcount and headcount-related overhead costs incurred for both new product development and enhancements to our range of software and application products.
We believe that research and development spending is critical to remain competitive in the marketplace. We will continue to focus on the timely development of new and enhanced interactive television products for our customers, and we plan to continue investing at levels that are adequate to develop our technologies and product offerings.
Research and development expenses for 2005 increased 14% from 2004 to $33.9 million. The increase was primarily a result of $4.3 million of additional headcount and headcount-related overhead costs associated with increased staffing. As a percentage of revenues, research and development expenses were 39% in both 2005 and 2004.
Research and development expenses for 2004 increased 29% from 2003 to $29.7 million. As a percentage of revenues, research and development expenses increased to 39% in 2004 compared to 36% in 2003. The increases were attributable to increased headcount and headcount-related overhead costs and $1.2 million attributable to the inclusion of BettingCorp financial information for a full year.
Sales and Marketing. Sales and marketing expenses consist primarily of advertising and other marketing-related expenses, headcount and headcount-related overhead costs, and travel costs.
Sales and marketing expenses for 2005 decreased 24% from 2004 to $11.5 million. As a percentage of revenues, sales and marketing expenses decreased to 13% in 2005 compared to 20% in 2004. The decrease in 2005 is primarily attributable to a decrease in headcount, which reduced headcount and headcount-related overhead costs by $2.9 million, and a decrease in marketing costs of $0.7 million.
Sales and marketing expenses for 2004 increased 9% from 2003 to $15.1 million. As a percentage of revenues, sales and marketing expenses decreased to 20% in 2004 compared to 21% in 2003. As a result of the expiration of our Wink agreement with DirecTV in December 2003, we reversed, in 2003, a $3.8 million accrual that we had made for development funds which we were not required to incur, resulting in a credit of that amount. Excluding this credit, sales and marketing expenses for 2004 decreased by $2.5 million from 2003. In 2004, we reduced marketing and trade show expenditures for our Wink products, which were offset by an increase of $0.8 million attributable to the inclusion of BettingCorp financial information for the full year.
General and Administrative. General and administrative expenses consist primarily of headcount and headcount-related overhead costs, fees for professional services, including litigation costs, and provision for doubtful accounts.
General and administrative expenses for 2005 decreased 11% from 2004 to $15.9 million. As a percentage of revenues, general and administrative expenses decreased to 18% in 2005 compared to 23% in 2004. That decrease resulted from a decrease in litigation fees of $3.9 million, a decrease in facilities expenses and outside services costs of $1.7 million and a reduction in depreciation expenses of $0.9 million. The decrease was mostly offset by an increase in headcount-related overhead costs of $4.5 million.
General and administrative expenses for 2004 increased 3% from 2003 to $17.9 million. As a percentage of revenues, general and administrative expenses decreased to 23% in 2004 compared to 27% in 2003. In 2004, there was an increase in litigation expenses of $1.8 million, resulting principally from patent litigation. This increase was partially offset by expense reductions of $1.3 million, of which $0.7 million was a reversal of accruals relating to acquisitions from prior years and $0.3 million was a reduction of the provision for doubtful accounts.
Restructuring and Impairment Costs. During the last three years we undertook several initiatives to reduce operating expenses around the world. As a result of these actions, seven employees were included in termination plans in 2005, 22 employees in 2004 and 79 employees in 2003. Provision was also made for excess office space and the write-down of leasehold improvements and other property and equipment that was abandoned.
During 2005, we recorded restructuring charges of $2.5 million, which included a first quarter restructuring and impairment provision of $0.4 million related to the closure of our Lexington, Massachusetts facility, a second quarter restructuring provision of $1.7 million for excess office space in New York, and a third quarter restructuring provision of $0.4 million for a workforce reduction in the United States and Switzerland.
The provision in 2004 of $0.9 million included restructuring charges of $2.4 million which were offset by $1.5 million in reversals of excess accruals. The provision in 2003 of $6.6 million included restructuring charges of $7.7 million, which were offset by $1.1 million in reversals of excess accruals relating to prior year provisions.
Impairment and Amortization of Intangible Assets
Intangible assets are amortized on a straight-line basis over the estimated useful life of two to 13 years. As noted above, cost of revenues includes amounts relating to the amortization of developed technologies and patents. Amortization of remaining other intangible assets was $1.7 million for 2005, $3.5 million for 2004 and $4.9 million for 2003. These decreases of $1.8 million and $1.4 million were due primarily to the expiration of the amortization period for certain intangibles. In the fourth quarter of 2003, we determined that an impairment of $1.5 million had occurred in the value of patents related to our acquisition of Cablesoft due to the absence of any current or future expected cash flow associated with the Cablesoft technologies.
Interest Income
As a result of increased interest rates and a small overall increase in our investment portfolio and cash position, interest income for 2005 was $1.7 million compared with $0.9 million for 2004. In 2004, due to a decrease in our investment portfolio, interest income was $0.9 million, compared with $1.6 million for 2003.
Other Income and Expense Items
For 2005, net other income of $3.8 million primarily included a gain of $3.1 million from the sale of a cost investment, and a gain of $0.5 million related to a contract amendment with Sun Microsystems for use of its Java technology in our products. That amendment reduced our payment obligation to Sun to an amount that was $0.5 million less than the amount we had previously accrued as a charge in 2004 in respect of that agreement.
For 2004, net other income of $0.5 million primarily included a gain of $0.6 million from the settlement of certain litigation, offset by certain other expense items. For 2003, net other expenses of $1.1 million primarily included a charge of $0.9 million for the settlement of a dispute we assumed in connection with our acquisition of Wink.
Minority Interest
In November 2000, we established Spyglass Integration, Inc., a co-owned venture with Motorola. We recorded a gain with respect to Motorola’s share of losses in this venture of $0.1 million for 2005, $0.5 million for 2004 and $0.2 million for 2003.
Income Taxes
We estimate that we had United States federal tax loss carryforwards of approximately $319 million at the end of 2005, although our ability to make use of those tax loss carryforwards may be limited under applicable tax regulations. The calculation of those tax loss carryforwards is a complex matter and may require a reassessment from time to time, which could result in changes to that estimate. Notwithstanding those federal tax loss carryforwards, we are subject to income taxes in certain state and foreign jurisdictions and we have foreign taxes withheld from certain royalty payments. Our income tax expense of $1.1 million for 2005 was primarily attributable to foreign and state taxes of $1.4 million. These were offset by a benefit resulting from a reduction in our valuation allowance for Swiss deferred tax assets where management believes it is more likely than not that the benefit will be realized.
Our income tax benefit was $0.8 million for 2004, which included credits of $1.9 million primarily due to tax refunds in the United Kingdom, a favorable settlement of a tax audit in France, and the reversal of a federal and state tax liability previously recorded by an acquired company following the expiration of the statute of limitations, offset by a provision of $1.1 million for foreign and state taxes. Income tax expense was $1.3 million for 2003.
Business Segment Results
Our chief operating decision maker is our Chief Executive Officer. In 2004, we replaced our Chief Executive Officer and appointed several new senior executives. As part of that management change, we reorganized our reporting units to provide management with better information for allocating the company’s resources and assessing performance in accordance with the new management team’s strategic focus. Our management assesses our results and financial performance, and prepares our internal budgeting reports, on the basis of three segments: the middleware and integrated technologies business, the applications business, and the BettingCorp business. We have prepared this segment analysis in accordance with Statement of Financial Accounting Standards No. 131, “Disclosure about Segments of an Enterprise and Related Information.”
Our middleware and integrated technologies business includes our middleware products and the related technologies that are customarily integrated as “extensions” of that middleware. Our applications business includes our PlayJam, advanced advertising and NASCAR products and related technologies. Our BettingCorp business includes our fixed-odds and other wagering gaming applications, the development and operation of our “Ultimate One” platform and the marketing of our evolving Participation TV product that is based on the Ultimate One technology.
Our management reviews and assesses the “contribution margin” of each of these segments, which is not a financial measure calculated in accordance with GAAP. We define “contribution margin,” for these purposes, as segment revenues less related, direct or indirect, allocable costs, including headcount and headcount-related overhead costs, consulting and subcontractor costs, travel, marketing and network infrastructure and bandwidth costs. There are significant judgments management makes with respect to the direct and indirect allocation of costs that may affect the calculation of contribution margins. While management believes these and other related judgments are reasonable and appropriate, other persons could assess such matters in ways different than the company’s management. Contribution margin is a non-GAAP financial measure which excludes unallocated corporate overhead, interest, taxes, depreciation and amortization, amortization of intangible assets, share-based compensation, impairment of goodwill, impairment of intangibles, other income, minority interest, restructuring provisions, and unusual items such as contract amendments that mitigated potential loss positions. These exclusions, including unallocated corporate overhead costs, income tax and interest, result in a definition of “contribution margin” that does not take into
account the substantial costs of doing business. Management believes that segment contribution margin is a helpful measure in evaluating operational performance for our company. Unallocated corporate overhead costs include headcount and headcount-related overhead costs, consulting and subcontractor costs, travel, legal and audit costs not considered directly allocable to individual business segments. While we may consider “contribution margin” to be an important measure of comparative operating performance, this measure should be considered in addition to, but not as a substitute for, loss from operations, net loss, cash flow and other measures of financial performance prepared in accordance with accounting principles generally accepted in the United States that are otherwise presented in our financial statements. In addition, our calculation of “contribution margin” may be different from the calculation used by other companies and, therefore, comparability may be affected.
Because these segments reflect the manner in which management reviews our business, they necessarily involve judgments that management believes are reasonable in light of the circumstances under which they are made. These judgments may change over time or may be modified to reflect new facts or circumstances. Segments may also be changed or modified to reflect technologies and applications that are newly created, or that change over time, or other business conditions that evolve, each of which may result in reassessing specific segments and the elements included within each of those segments.
Revenues by segment were as follows (in millions):
Middleware and Integrated Technologies
Revenues from the middleware and integrated technologies business for 2005 increased 8% from 2004 to $68.3 million. In 2004, revenues from the middleware and integrated technologies business increased 27% from 2003 to $63.1 million. In 2005 and 2004, increased royalties and licenses offset a decline in services and other revenues. Royalties and licenses from set-top box shipments and other product sales accounted for 80% of segment revenues in 2005, 77% in 2004 and 56% in 2003. Royalties and licenses from the middleware and integrated technologies business account for the majority of our overall royalties and licenses, and increased in 2005 and 2004 due to the additional shipments and amortization described under “Royalties and licenses” above.
Services and other consists primarily of professional services consulting engagements for set-top box manufacturers, network operators and system integrators and maintenance, support and training. This category accounted for 20% of segment revenues in 2005, a decrease from 23% in 2004, and a decrease from 44% in
2003. The decrease was due to fewer professional services projects, primarily due to the discontinuance of ongoing services to Motorola in 2004.
Applications
Revenues from the applications business for 2005 increased 17% to $14.1 million. In 2004, revenues from the applications business decreased 15% to $12.1 million. For 2005, PlayJam games fees accounted for 65% of segment revenues, a decrease from 91% in 2004. We experienced a decrease of $1.9 million in PlayJam games channel fees in 2005 as a result of competitive pressures and a reduction of our PlayJam games offerings in France that we initiated in 2005. Advertising revenue increased $1.6 million in 2005, of which $0.7 million was attributable to increased royalties and licenses and $0.9 million was attributable to increased services and other revenue. Nearly all of that $1.6 million increase was due to the acquisition of CAM Systems in September 2005, as further described in Note 3 of our Consolidated Financial Statements. We did not recognize any programming fees for NASCAR in 2004. As described above, we renegotiated our NASCAR production agreement in 2004 and, as a result, recognized $1.8 million of additional revenue for this service in 2005. Revenues from the applications business for 2004 were $12.1 million, a decrease of $2.2 million, or 15%, from $14.3 million in 2003. For 2004, PlayJam games channel fees accounted for 91% of the applications segment revenues. Our PlayJam games channel fees decreased by $0.3 million from 2003 to 2004 due to competitive pressures, which offset favorable currency exchange rates. In addition, there were decreases in revenue related to the customers acquired with the 2002 acquisition of Wink.
BettingCorp
Revenues from the BettingCorp business for 2005 increased 150% to $5.0 million. This increase was primarily due to increased service usage on BSky and due to increases in professional services from other customers. Revenues from the BettingCorp business for 2004 were $1.7 million higher than in 2003, primarily as a result of including financial information for BettingCorp for the full year in 2004.
Contribution Margins by Segment
Total contribution margin by segment, as reconciled to net loss on a GAAP basis, was as follows (in millions):
Middleware and Integrated Technologies
Total contribution margin for the middleware and integrated technologies business increased in both 2005 and 2004, primarily as a result of higher revenues in each year, which were only partially offset by increased costs in that segment. Middleware and integrated technology costs consist primarily of headcount and headcount-related overhead costs and consulting and subcontractor costs associated with billable professional services engagements.
Applications
Total contribution loss for the applications business improved in 2005, primarily as a result of increased revenues, including revenues from our acquisition of CAM Systems, as described above. Contribution loss for the applications business improved significantly from 2003 to 2004 due mostly to reduced operating expenses.
BettingCorp
Total contribution loss for the BettingCorp business increased in 2005. Although revenue increased as described above, associated bandwidth and revenue shares increased proportionately, in addition to other operating expenses. Contribution loss for the BettingCorp business increased from 2003 to 2004 as a result of BettingCorp’s inclusion in our financial results for the full year in 2004.
Deferred Revenue
When we apply our revenue recognition policy, we must determine what portions of our revenue are recognized currently and which portions must be deferred, principally in terms of SOP 97-2, SOP 81-1 and SAB 104. In order to determine current and deferred revenue, we make judgments and estimates with regard to future deliverable products and services and the appropriate valuation for those products and services.
Beginning in 2004, we entered into multiple-element arrangements for products and services with customers including UGC (which has been acquired by Liberty Global), FOXtel, Austar, PartiTV and Comcast. Portions of the amounts that we have invoiced to UGC, FOXtel and Austar under those agreements have been deferred and will be included as revenue over time in our Middleware and Integrated Technologies business. Portions of those amounts that we have invoiced to Comcast under our agreement with Comcast will be included as revenue over time in our Applications business. Portions of the amounts that we have invoiced to PartiTV under our agreements with them will be included as revenue over time in our BettingCorp business.
The arrangements with these customers included maintenance and support, for which evidence of fair value did not exist. In addition, several of these arrangements provided for the delivery of specified future products, for which evidence of fair value also did not exist. All revenues under arrangements for which we are obligated to provide specified future products are initially deferred. Upon final delivery of all specified products under each arrangement, we will recognize revenue either over the remaining contractual period of support or over the remaining period during which maintenance and support is expected to be provided. As we noted above in our discussion of royalties, our EchoStar royalty revenues, which are included as revenues in
our Middleware and Integrated Technologies business, are also being amortized over the seven-year term of our EchoStar agreements, with a portion of those reported royalty amounts currently reflected in our deferred revenue amounts.
As of December 31, 2005, we recorded $22.6 million in deferred revenue compared with $17.1 million at the end of 2004. Of that total deferred amount at December 31, 2005, $17.7 million, or 78%, was deferred as a result of the arrangements with EchoStar, UGC, FOXtel, Austar, PartiTV and Comcast described in the preceding paragraphs. These deferred amounts as of December 31, 2005 do not reflect any additional future middleware deployments or additional license sales. The remaining $4.9 million, or 22%, of our deferred revenue as of December 31, 2005 was principally attributable to other maintenance and support and professional services arrangements with other customers, which are typically short-term in nature.
Based on our current estimates of final delivery for all specified products, we expect the following recognition of the $18.7 million of unearned revenue at December 31, 2005 resulting from the EchoStar, UGC, FOXtel, Austar, PartiTV and Comcast arrangements:
As noted in our critical accounting policies, our assumptions and judgments regarding future products and services could differ from actual events. As a result, the actual revenue recognized from these arrangements, and the timing of that recognition, may differ from the amounts identified in this table. While management believes that this information is a helpful measure in evaluating the company’s performance, investors should understand that unless, and until, the company is actually able to recognize these amounts as revenue in accordance with GAAP, there can be no assurance that the conditions to recording that revenue will be satisfied.
Liquidity and Capital Resources
We expect to be able to fund our operating and capital requirements for at least the next twelve months by using existing cash balances and short-term and long-term marketable debt securities, if our assumptions about our revenues, expenses and cash commitments are generally accurate. Because we cannot be certain that our assumptions about our business or the interactive television market in general will prove to be accurate, our funding requirements may differ from our current expectations.
As of December 31, 2005, we had cash and cash equivalents of $47.2 million, which was an increase of $11.6 million from the prior year. Cash and cash equivalents as of December 31, 2004 and 2003 were $35.6 million and $47.7 million, respectively. Taking into account short-term and long-term marketable debt securities of $17.3 million, our cash, cash equivalents and marketable debt securities were $64.5 million as of December 31, 2005 compared to $63.0 million as of December 31, 2004 and $73.5 million as of December 31, 2003. The mix of cash and short-term and longer-term securities may change in the future as we make decisions regarding the composition of our investment portfolio. Our primary source of cash is receipts from revenue. The primary uses of cash are payroll, general operating expenses and cost of revenues.
Our cash balances as of December 31, 2005 were positively affected by a $9.7 million increase in cash from investing activities, which included $7.1 million in cash received from the sale of a private cost investment and by net cash generated from operating activities of $2.4 million. Our cash balances as of December 31, 2004, were positively affected by $4.1 million in cash from the sale by the former owners of BettingCorp of OpenTV shares they had received in the acquisition of BettingCorp at a price above that which the company had guaranteed, and the release from escrow of $6.9 million that had previously secured our obligations under that price guarantee we had provided BettingCorp.
Cash generated from operating activities was $2.4 million for 2005, compared with cash used in operating activities of $16.2 million for 2004 and $42.5 million for 2003. Increased revenues and reduced operating expenses resulted in a significantly reduced net loss for 2005. In addition, favorable working capital movements also improved operating cash flows by $4.1 million, primarily as a result of increased deferred revenues of $6.0 million which offset other working capital changes of $1.9 million. In 2004 and 2003, cash uses were primarily for our continuing operating losses, including restructuring payments.
For 2005, net cash provided from investing activities was $9.7 million. In the fourth quarter of 2005, we received $7.1 million from the sale of a private cost investment. In addition, net sales of marketable debt securities of $10.1 million were used to fund the $4.2 million cash portion of our acquisition costs for the cable TV advertising assets of CAM Systems, and to also fund capital equipment expenditures for our company. For 2004, net cash provided from investing activities was $0.3 million. In the fourth quarter of 2004, we received $4.1 million from the BettingCorp liquidity guarantee described above. In 2004, $2.1 million was used for capital expenditures. Cash provided from investing activities was $48.2 million for 2003, primarily due to the sale of marketable debt securities. In 2003, uses of cash included $10.1 million for acquisitions and $2.9 million for capital expenditures.
For 2004, cash provided from financing activities was $3.5 million due to proceeds from the exercise of stock options. For 2003, cash provided from financing activities was $3.3 million due to proceeds from the exercise of stock options and a capital contribution to fund management retention payments from our former controlling stockholder, MIH Limited.
We use professional investment management firms to manage most of our invested cash. The portfolio consists of highly liquid, high-quality investment grade securities of the United States government and agencies, corporate notes and bonds and certificates of deposit that predominantly have maturities of less than three years. All investments are made in accordance with our written investment policy, which has been approved by our Board of Directors.
Commitments and Contractual Obligations
Information as of December 31, 2005 concerning the amount and timing of required payments under our contractual obligations is summarized below (in millions):
We have the right to terminate, without penalty, two of our operating leases prior to their scheduled expiration. If we exercised those early termination rights, our future minimum lease commitments would be reduced by an aggregate of $6.4 million over the current remaining life of those leases, beginning in 2006. We have not yet made any determination as to whether we intend to exercise any of those rights. If we did exercise any such rights, while our commitments under those specific leases would be reduced, we might also be required to lease additional space to conduct our business and we cannot be certain, at this time, whether any such actions would possibly result in a net increase in our future minimum lease commitments.
In the ordinary course of business, we enter into various arrangements with vendors and other business partners for bandwidth, marketing, and other services. Future minimum commitments under these arrangements as of December 31, 2005 were $2.1 million and $0.1 million for the years ending December 31, 2006 and 2007 respectively. In addition, we also have arrangements with certain parties that provide for revenue-sharing payments.
As of December 31, 2005, we had three standby letters of credit aggregating approximately $2.0 million that were issued to landlords and sublessee at two of our leased properties, against which two certificates of deposit aggregating $2.0 million and approximately $0.5 million of restricted cash were pledged as collateral.
On September 7, 2005, we acquired substantially all of the cable TV advertising inventory management assets of CAM Systems, L.L.C. and its affiliates in a transaction accounted for as a purchase. Under the terms of that acquisition, the sellers and we agreed to adjust the number of shares issued under specified circumstances. As of the date of this Annual Report on Form 10-K, we have determined that no adjustments will be required to the purchase price based on the trading value of our Class A ordinary shares through the adjustment period.
Indemnification
In the normal course of our business, we provide indemnification to customers, subject to limitations, against claims of intellectual property infringement made by third parties arising from the use of our products. Historically, costs related to these indemnification provisions have not been significant and we are unable to estimate the maximum potential impact of these indemnification provisions on our future results of operations, although our liabilities in those arrangements are customarily limited in various respects, including monetarily. As permitted under the laws of the British Virgin Islands, we have agreed to indemnify our officers and directors for certain events or occurrences while the officer or director is, or was serving, at our request in such capacity. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have director and officer insurance coverage that limits our exposure and enables us to recover a portion of any future amounts paid. We believe the estimated fair value of these indemnification agreements in excess of applicable insurance coverage is not material.
Item 7A.
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
We are exposed to financial market risks. This exposure relates to our holdings of fixed income investment securities, investments in privately-held companies and assets and liabilities denominated in foreign currencies.
Fixed Income Investment Risk
We own a fixed income investment portfolio with various holdings, types and maturities. These investments are generally classified as available-for-sale. Available-for-sale securities are recorded on the balance sheet at fair value with unrealized gains or losses, net of tax, included as a separate component of the balance sheet line item titled “accumulated other comprehensive income (loss).”
Most of these investments consist of a diversified portfolio of highly liquid United States dollar-denominated debt securities classified by maturity as cash equivalents, short-term investments or long-term investments. These debt securities are not leveraged and are held for purposes other than trading. Our investment policy limits the maximum maturity of securities in this portfolio to three years and weighted-average maturity to 15 months. Although we expect that market value fluctuations of our investments in short-term debt obligations will not be significant, a sharp rise in interest rates could have a material adverse effect on the value of securities with longer maturities in the portfolio. Alternatively, a sharp decline in interest rates could have a material positive effect on the value of securities with longer maturities in the portfolio. We do not currently hedge interest rate exposures.
Our investment policy limits investment concentration in any one issuer (other than with respect to United States treasury and agency securities) and also restricts this part of our portfolio to investment grade obligations based on the assessments of rating agencies. There have been instances in the past where the assessments of rating agencies have failed to anticipate significant defaults by issuers. It is possible that we could lose most or all of the value in an individual debt obligation as a result of a default. A loss through a default may have a material impact on our earnings even though our policy limits investments in the obligations of a single issuer to no more than five percent of the value of our portfolio.
The following table presents the hypothetical changes in fair values in our portfolio of investment securities with original maturities greater than 90 days as of December 31, 2005 using a model that assumes immediate sustained parallel changes in interest rates across the range of maturities (in thousands):
The modeling technique used in the above table estimates fair values based on changes in interest rates assuming static maturities. The fair value of individual securities in our investment portfolio is likely to be affected by other factors including changes in ratings, market perception of the financial strength of the issuers of such securities and the relative attractiveness of other investments. Accordingly, the fair value of our individual securities could also vary significantly in the future from the amounts indicated above.
Foreign Currency Exchange Rate Risk
We transact business in various foreign countries. We incur a substantial majority of our expenses, and earn most of our revenues, in United States dollars. A majority of our worldwide customers are invoiced and make payments in United States dollars, with the remainder invoiced by our non-United States business units under contracts that require payments to be remitted in local currency.
We have a foreign currency exchange exposure management policy. The policy permits the use of foreign currency forward exchange contracts and foreign currency option contracts and the use of other hedging procedures in connection with hedging foreign currency exposures. The policy requires that the use of derivatives and other procedures qualify for hedge treatment under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” We regularly assess foreign currency exchange rate risk that results from our global operations. We did not use foreign currency forward exchange contracts, options in hedging foreign currency exposures, or other hedging procedures, during 2005. We expect over time, however, that a more significant number of our European customers may seek to pay us in Euros, which may affect our risk profile and require us to make use of appropriate hedging strategies. While we anticipate a certain portion of our revenues in 2006 will be paid to us in Euros, we do not believe that such payments will require a material change in our existing hedging policies.
Item 8.
Item 8.
Financial Statements and Supplementary Data
The Consolidated Financial Statements and Supplementary Data required by this Item are set forth at the pages indicated in Item 15(a).
Item 9.
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Not Applicable
Item 9A.
Item 9A.
Controls and Procedures
a. Management’s Annual Report on Internal Control over Financial Reporting as of December 31, 2005.
Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting (“Internal Control”) as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”).
A material weakness is a significant deficiency (within the meaning of Public Company Accounting Oversight Board Auditing Standard No. 2), or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. Management assessed the effectiveness of the Company’s Internal Control as of December 31, 2005 using the criteria issued by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO) in Internal Control-Integrated Framework and identified the following material weaknesses as of December 31, 2005:
•
The Company’s financial reporting process did not provide for effective account analysis for certain financial statement accounts. Specifically, the accounting for accruals, long-term other assets, and deferred-tax assets was not adequately analyzed. This material weakness resulted in errors, which were material in the aggregate, in the Company’s preliminary 2005 financial statements.
•
The Company did not have sufficient personnel with adequate technical expertise to analyze effectively, and review in a timely manner, its accounting for revenue and income taxes. These material weaknesses resulted in material errors in the Company’s accounting for: (a) certain complex multiple-element software license and professional service arrangements; and (b) income taxes and related financial statement note disclosures.
Based on the material weaknesses described above, management has concluded that, as of December 31, 2005, the Company’s Internal Control was not effective.
KPMG LLP, the Company’s independent registered public accounting firm, has issued an auditors’ report on management’s assessment of the Company’s Internal Control, which begins on page 50 of this Annual Report on Form 10-K.
b. Correction of Material Errors in Consolidated Financial Statements.
Management corrected all material errors prior to the issuance of the Company’s 2005 audited financial statements. None of the errors referred to in the Company’s report in Item 9A.a. above required a change in any of the Company’s prior Consolidated Financial Statements.
c. Evaluation of Disclosure Controls and Procedures.
We maintain disclosure controls and procedures (“Disclosure Controls”), as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act that are designed to ensure that information required to be disclosed in our Exchange Act reports, including the Company’s Annual Report on Form 10-K, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
In designing and evaluating the Disclosure Controls, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
As required by Rule 13a-15(b) and 15d-15(b) under the Exchange Act, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. As described in our report on Internal Control over Financial Reporting set forth above, we have identified material weaknesses as of December 31, 2005. The Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as a result of the material weaknesses identified, the Company’s Disclosure Controls, as of December 31, 2005, were not effective.
d. Changes in Internal Control Over Financial Reporting
We identified the material weaknesses set forth below in our Annual Report on Form 10-K for the year ended December 31, 2004 (the “2004 10-K”). In response to those material weaknesses, we initiated certain changes in our Internal Control during 2005, and in the fourth quarter of 2005, we continued to implement the specific changes described below. Those changes included the introduction of additional procedures to ensure a more thorough review of financial data in the financial reporting and close process. To help effect those changes, the Company hired a new Chief Financial Officer in May 2005, added additional staff to its financial
department and also appointed a new Controller in the summer of 2005. We believe that we have improved overall controls and procedures based on the foregoing changes, although we have not been able to remediate all of the deficiencies identified in 2004 as described below.
1) Certain Duties within the Company’s Financial Group were not Properly Segregated
As we noted in our 2004 10-K, the Company’s controller had the ability to direct other personnel within the finance group to initiate and enter manual journal entries in the Company’s books and records without authorization or review by other members of the financial organization. We implemented new procedures during 2005 that require the Company’s Chief Financial Officer, or another senior financial officer within our finance department, to perform a detailed review of any and all non-recurring manual journal entries above a certain dollar threshold and also to review all journal entries that are directed by the Company’s Controller. The Company’s Chief Financial Officer was also charged with responsibility for undertaking a reasonable review of all other non-recurring journal entries, to ensure that all such entries are fully and properly authorized and reviewed. As a result of the foregoing changes in Internal Control, management believes that it had remediated this material weakness as of December 31, 2005.
2) Certain Controls Associated with the Financial Reporting and Close Process were not Effective
As we noted in our 2004 10-K:
•
Management’s review of certain year-end accruals was not effective in 2004. Specifically, this review did not identify that an accrual was not adequately supported by reasonable assumptions and sufficient documentation. We implemented new procedures during 2005 that require the Company’s financial group to collect, analyze and monitor all necessary and relevant supporting documentation for accrual balances and any adjustments. We also introduced additional procedures to ensure a more thorough review of financial data in the financial reporting and close process. As noted above in Item 9A.a., management has identified a material weakness as of December 31, 2005 related to its analysis of certain financial statement accounts in connection with the financial reporting process. Management has concluded that it had not remediated the deficiency described in this paragraph as of December 31, 2005.
•
Management’s ineffective review of certain detailed schedules prepared in connection with the Company’s financial reporting process for 2004 to support the Company’s financial statements and related note disclosures led to errors in the statement of cash flows, lease commitments and tax notes and required modification of those notes as included in the our 2004 audited financial statements. We implemented certain changes in our Internal Control during 2005, including the introduction of additional procedures to ensure a more thorough review of financial data in the financial reporting and close process. As a result of the foregoing changes in Internal Control, management believes that it had remediated this material weakness as of December 31, 2005.
•
The Company did not have sufficient internal personnel and technical expertise to properly apply accounting principles to certain non-routine matters. As a result, the Company inappropriately applied the provisions of Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangibles (SFAS No. 142) in conducting its annual analysis for potential impairment that led to an error in the accounting for goodwill that was identified and subsequently corrected. The Company hired a new Chief Financial Officer in May 2005, added additional staff to its financial department and also appointed a new Controller in the summer of 2005. Management did not identify any errors associated with the application of SFAS 142 in 2005. As noted above in Item 9A.a., however, management has identified the lack of sufficient internal personnel with adequate technical expertise to analyze effectively, and review in a timely manner, its accounting with respect to certain complex multiple-element software license and professional service arrangements and income taxes and related financial statement note disclosures as a material weakness at December 31, 2005. Management has concluded that it had not remediated the deficiency described in this paragraph as of December 31, 2005.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders
OpenTV Corp.:
We have audited management’s assessment, included in the accompanying “Management’s Annual Report on Internal Control over Financial Reporting as of December 31, 2005” (Item 9A.a.), that OpenTV Corp. did not maintain effective internal control over financial reporting as of December 31, 2005, because of the effect of the material weaknesses identified in management’s assessment, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). OpenTV Corp.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weaknesses have been identified and included in management’s assessment as of December 31, 2005:
•
The Company’s financial reporting process did not provide for effective account analysis for certain financial statement accounts. Specifically, the accounting for accruals, long-term other assets, and deferred-tax assets was not adequately analyzed. This material weakness resulted in errors, which were material in the aggregate, in the Company’s preliminary 2005 financial statements.
•
The Company did not have sufficient personnel with adequate technical expertise to analyze effectively, and review in a timely manner, its accounting for revenue and income taxes. These material weaknesses resulted in material errors in the Company’s accounting for: (a) certain complex multiple-element software license and professional service arrangements; and (b) income taxes and related financial statement note disclosures.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of OpenTV Corp. and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of operations, stockholders’ equity and comprehensive loss and cash flows for each of the years in the three-year period ended December 31, 2005. The aforementioned material weaknesses were considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2005 consolidated financial statements, and this report does not affect our report dated March 30, 2006 which expressed an unqualified opinion on those consolidated financial statements.
In our opinion, management’s assessment that OpenTV Corp. did not maintain effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, because of the effect of the material weaknesses described above on the achievement of the objectives of the control criteria, OpenTV Corp. has not maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
/s/ KPMG LLP
San Francisco, California
March 30, 2006
Item 9B.
Item 9B.
Other Information
None.
PART III
Item 10.
Item 10.
Directors and Executive Officers of OpenTV
The information regarding our directors and executive officers required by this Item is incorporated by reference to the information set forth in the section entitled “Election of Directors” and “Executive Officers” in the definitive proxy statement for our 2006 annual meeting of stockholders to be filed with the SEC pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this Form 10-K (the “Proxy Statement”).
Information required by the Item with respect to compliance with Section 16(a) of the Securities Act of 1934 is incorporated by reference to the information set forth in the section entitled “Section 16(a) Beneficial Ownership Reporting Compliance” in the Proxy Statement.
Item 11.
Item 11.
Executive Compensation
The information required by this Item is incorporated by reference to the information set forth in the section entitled “Executive Compensation” in the Proxy Statement.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required by this Item regarding security ownership of certain beneficial owners is incorporated by reference to the information set forth in the section entitled “Stock Ownership of Certain Beneficial Owners and Management” in the Proxy Statement.
Item 13.
Item 13.
Certain Relationships and Related Transactions
The information required by this Item is incorporated by reference to the information set forth in the section entitled “Certain Relationships and Related Transactions” in the Proxy Statement.
Item 14.
Item 14.
Principal Accounting Fees and Services
The information required by this Item is incorporated by reference to the information set forth in the section entitled “Fees for Independent Auditors” in the Proxy Statement.
PART IV
Item 15.
Item 15.
Exhibits and Financial Statement Schedules
(a)(1)
Financial Statements Included in Part II of this Report:
(2)
Financial Statement Schedule
Schedule II - Valuation and Qualifying Accounts
(3)
Exhibits
*
Filed Herewith
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
OPENTV CORP.
/s/ James A. Chiddix
James A. Chiddix
Chairman and Chief Executive Officer
Dated: March 30, 2006
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated.
PART IV
OPENTV CORP.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
OpenTV Corp.:
We have audited the accompanying consolidated balance sheets of OpenTV Corp. and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of operations, stockholders’ equity and comprehensive loss, and cash flows for each of the years in the three-year period ended December 31, 2005. In connection with our audits of the consolidated financial statements, we also have audited the accompanying financial statement schedule. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of OpenTV Corp. and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of OpenTV Corp.’s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 30, 2006 expressed an unqualified opinion on management’s assessment of, and an adverse opinion on the effective operation of, internal control over financial reporting.
/s/ KPMG LLP
San Francisco, California
March 30, 2006
OPENTV CORP.
CONSOLIDATED BALANCE SHEETS
(In thousands, except share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
OPENTV CORP.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except share and per share amounts)
(1)
Inclusive of $10, $52 and $1,107 of related party revenue for the years ended December 31, 2005, 2004 and 2003, respectively.
(2)
Inclusive of $8, $25 and $55 of share-based compensation for the years ended December 31, 2005, 2004 and 2003, respectively.
(3)
Inclusive of $0, $1 and $59 of share-based compensation for the years ended December 31, 2005, 2004 and 2003, respectively.
(4)
Inclusive of $0, $0 and $24 of share-based compensation for the years ended December 31, 2005, 2004 and 2003, respectively.
(5)
Inclusive of $0, $0 and $33 of share-based compensation for the years ended December 31, 2005, 2004 and 2003, respectively.
The accompanying notes are an integral part of these consolidated financial statements.
OPENTV CORP.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY AND COMPREHENSIVE LOSS
(In thousands, except share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
OPENTV CORP.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
The accompanying notes are an integral part of these condensed consolidated financial statements.
OPENTV CORP.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005
Note 1.
Ownership and Business of OpenTV
We were formed as an international business company incorporated under the International Business Companies Act of the British Virgin Islands in September 1999 to act as a holding company for OpenTV, Inc., which then became our principal operating subsidiary.
On August 27, 2002, Liberty Media Corporation and one of its subsidiaries (collectively, “Liberty Media”) completed a transaction in which Liberty Media acquired a controlling interest in us. As of December 31, 2005, Liberty Media’s total ownership represented approximately 30.6% of the economic interest and approximately 77.6% of the voting power of our ordinary shares on an undiluted basis.
We provide software, content and applications, and professional services for interactive and enhanced television.
Note 2.
Summary of Significant Accounting Policies
Principles of Consolidation and Basis of Presentation
The accompanying consolidated financial statements include the accounts of our majority-owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.
Certain amounts in the consolidated financial statements for 2004 and 2003 have been reclassified to conform to the 2005 presentation.
Management Estimates
The preparation of financial statements and related disclosures in conformity with GAAP in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Estimates are used for, but not limited to, revenues, the accounting for the allowance for doubtful accounts, depreciation and amortization, investment valuation, goodwill and long-lived assets valuation, restructuring accruals, taxes and contingencies. Actual results could differ from these estimates.
Cash and Cash Equivalents
Cash and cash equivalents are stated at cost, which approximates fair value. We consider all highly liquid instruments with original or remaining maturities of three months or less at the date of purchase and money market funds to be cash equivalents.
Marketable Debt Securities
Our policy is to minimize risk by investing in investment grade securities which earn returns based on current interest rates.
We classify all marketable debt securities as available-for-sale in accordance with Statement of Financial Accounting Standards (SFAS) No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” Accordingly, our marketable debt securities are carried at fair value as of the balance sheet date. Short-term marketable debt securities are those with remaining maturities at the balance sheet date of one year or less. Long-term marketable debt securities have remaining maturities at the balance sheet date of greater than one year.
Unrealized gains and losses are reported as accumulated other comprehensive income (loss) in the statement of shareholders’ equity. Additionally, realized gains and losses on sales of all such investments are reported in results of operations and computed using the specific identification cost method. It is our policy to
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
review our marketable debt securities classified as short-term and long-term investments on a regular basis to evaluate whether or not any security has experienced an other-than-temporary decline in fair value. If we believe that an other-than-temporary decline exists in one of our marketable debt securities, it is our policy to write down these debt investments to the market value and record the related write-down as an investment loss on our consolidated statements of operations.
Fair Value of Financial Instruments
The reported amounts of our financial instruments, including cash and cash equivalents, short-term marketable debt securities, accounts receivable (net of the allowance for doubtful accounts), accounts payable and accrued liabilities, approximate fair value due to their short maturities.
Concentration of Credit Risk
Financial instruments that potentially subject us to a concentration of credit risk consist principally of cash and cash equivalents, accounts receivable and short-term and long-term marketable debt securities. Cash and cash equivalents are primarily invested in a diverse portfolio of money market securities and money market funds in accordance with our investment policy. With respect to accounts receivable, our customer base is dispersed across many geographic areas and we generally do not require collateral. We analyze historic collection experience, customer credit-worthiness, current economic trends in each country where our customers are located, and customer payment history when evaluating the adequacy of the allowance for doubtful accounts.
Property and Equipment
Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is computed using the straight-line method over the estimated useful lives of three to seven years. Leasehold improvements are amortized on a straight-line basis over the life of the lease, or the estimated useful life of the asset, whichever is shorter.
Major additions and improvements are capitalized, while replacements, maintenance, and repairs that do not improve or extend the life of the assets are charged to expense. In the period assets are retired or otherwise disposed of, the costs and related accumulated depreciation and amortization are removed from the accounts, and any gain or loss on disposal is included in results of operations.
Long-Term Private Equity Investments
We invest in equity and debt instruments of privately-held companies for business and strategic objectives, and typically we do not attempt to reduce or eliminate the inherent market risks of these investments. These investments are included in other assets and are accounted for under the cost method when we do not have the ability to exercise significant influence over operations. When we have the ability to exercise significant influence over operations, investments are accounted for under the equity method. We perform periodic reviews of these investments for impairment. Our investments in privately-held companies are considered impaired when a review of the investee’s operations and other indicators of impairment indicate that there has been a decline in the fair value that is other than temporary and that the carrying value of the investment is not likely to be recoverable. Such indicators include, but are not limited to, limited capital resources, need for additional financing and prospects for liquidity of the related securities. Impaired investments in privately-held companies are written down to estimated fair value, which is the amount we believe is recoverable from the investment.
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Goodwill and Intangible Assets
In accordance with Statement of Financial Accounting Standards No. 142 (SFAS 142), “Goodwill and Other Intangible Assets,” we review our goodwill for impairment annually, or more frequently, if facts and circumstances warrant a review. The provisions of SFAS 142 require that a two-step test be performed to assess goodwill for impairment. First, the fair value of each reporting unit is compared to its carrying value. If the fair value exceeds the carrying value, goodwill is not impaired and no further testing is performed. The second step is performed if the carrying value exceeds the fair value. The implied fair value of the reporting unit’s goodwill must be determined and compared to the carrying value of the goodwill. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, an impairment loss equal to the difference will be recorded.
We completed our annual goodwill impairment test during the fourth quarter of fiscal 2005 and determined that the carrying amount of goodwill was not impaired.
SFAS 142 also requires that intangible assets with definite lives be amortized over their estimated useful life and reviewed for impairment in accordance with Statement of Financial Accounting Standards No. 144 (SFAS 144), “Accounting for the Impairment or Disposal of Long-Lived Assets.”
Intangible assets are stated at cost less accumulated amortization. Amortization of intangible assets is computed on a straight-line basis over the estimated benefit periods. The estimated benefit period ranges from two to thirteen years.
Long-Lived Assets
We account for long-lived assets under SFAS No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets,” which requires us to review for the impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying amount of an asset might not be recoverable. When such an event occurs, we estimate the future cash flows expected to result from the use of the asset and its eventual disposition. If the undiscounted expected future cash flows are less than the carrying amount of the asset, an impairment loss is recognized for the difference between the asset’s fair value and its carrying value.
Revenue Recognition
We derive revenue from two primary sources: (i) royalties and licenses and (ii) services and other.
Royalties and licenses. In accordance with Statement of Position (SOP) 97-2, we generally recognize royalties upon notification of shipment or activation of our software in set-top boxes and other products by licensees if a signed contract exists, delivery has occurred, the fee is fixed or determinable and collection of the resulting receivable is probable. For non-refundable prepaid royalties, we recognize revenue upon delivery of software provided that all other requirements of SOP 97-2 have been met. In accordance with SOP 97-2, we recognize license fees if a signed contract exists, delivery has occurred, the fee is fixed or determinable and collection of the resulting receivable is probable.
Services and other. Professional services from software development contracts, customization services and implementation support are recognized generally on the percentage of completion basis in accordance with the provisions of SOP 81-1. If a contract involves the provision of multiple service elements, total estimated contract revenues are allocated to each element based on the relative fair value of each element. In the event that fair value is not determinable for each service element of a multiple-element contract, the contract is considered to be one accounting unit. If it is reasonably assured that no loss will be incurred under the arrangement, we recognize service revenues using the percentage of completion method using a zero-profit methodology until the contract accounting services are complete. If the arrangement includes the future delivery of specified future software products, we recognize revenue on the completed contract method, upon
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
delivery of the services and such specified deliverables. If total costs are estimated to exceed the relative fair value for the arrangement, then a provision for the estimated loss is made in the period in which the loss first becomes apparent.
We also receive services fees from the use of our PlayJam games channel, interactive advertising fees, net betting and gaming transactions and revenue shares received for advertising and other interactive services. These revenues are recognized in accordance with Securities and Exchange Commission Staff Accounting Bulletin No. 104 (SAB 104), “Revenue Recognition.” Revenue is recognized only when the price is fixed or determinable, persuasive evidence of an arrangement exists, the service is performed and collectability of the resulting receivable is reasonably assured.
For contracts with multiple obligations (e.g. maintenance and other services), and for which vendor-specific objective evidence of fair value for the undelivered elements exists, we recognize revenue for the delivered elements based upon the residual method as prescribed by SOP No. 98-9, “Modification of SOP No. 97-2 with Respect to Certain Transactions.” Generally, we have vendor-specific objective evidence of fair value for the maintenance element of software arrangements based on the renewal rates for maintenance in future years as specified in the contracts. In such cases, we defer the maintenance revenue at the outset of the arrangement and recognize it ratably over the period during which the maintenance is to be provided, which generally commences on the date the software is delivered. Payments for maintenance and support fees are generally made in advance and are non-refundable. Vendor-specific objective evidence of fair value for the service element is determined based on the price charged when those services are sold separately. For revenue allocated to consulting services and for consulting services sold separately, we recognize revenue as the related services are performed.
In the normal course of business, we act as or use an intermediary or agent in executing transactions with third parties. The determination of whether revenue should be reported as gross or net is based on an assessment of whether we are acting as the principal or acting as an agent in the transaction. In determining whether we serve as principal or agent, we follow the guidance in Emerging Issues Task Force (EITF) 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent”.
Under the PlayJam brand, we derive revenue as consumers interact with our games channels in the United Kingdom, France and the United States. We receive fees primarily from premium rate telephone calls that are placed by consumers in the UK and France using either the telephone or the remote control, for membership registration, game score registration for the chance to win prizes, and for access to pay-per-play content. Premium rate telephony charges are recorded as revenue upon notification from the telecommunications companies. In the United States, we receive a revenue share from EchoStar in connection with its distribution of our PlayJam games channel.
Net betting and gaming fees are derived from customers wagering on casino games offered on our casino channel. Incentives and jackpots are deducted to arrive at net betting and gaming revenues.
We also enter into arrangements whereby our licensees pay us a percentage of the interactive revenues they earn from their customers. When we have delivered all of the software under the arrangement, we recognize the revenue as the licensee reports to us our revenue share, which is done generally on a quarterly basis.
Advertising fees are recognized as the advertisements are delivered or ratably over the contract period, where applicable, and when collection of the resulting receivable is reasonably assured.
Other Revenue Accounting Policies
Under multiple-element arrangements where the customer receives rights for unspecified products or services when they are made available, we recognize the entire arrangement fee ratably over the term of the
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
arrangement, in the appropriate respective revenue categories. Under multiple-element arrangements where the customer receives rights for specified future products and vendor-specific objective evidence of fair value does not exist, we defer all revenue until the earlier of the point at which sufficient vendor-specific evidence exists for all undelivered elements, or until all elements of the arrangement have been delivered.
Under multiple-element arrangements where the only undelivered element is maintenance and support and vendor-specific objective evidence does not exist, the entire arrangement fee is recognized ratably over either the contractual maintenance and support period, or the period during which maintenance and support is expected to be provided.
In November 2001, the EITF reached consensus on EITF No. 01-09, “Accounting for Consideration Given by a Vendor to a Customer or Reseller of the Vendor’s Products.” In accordance with EITF No. 01-09, we account for cash consideration given to customers, for which we do not receive a separately identifiable benefit and cannot reasonably estimate fair value, as a reduction of revenue rather than as an expense.
Deferred Revenue
Deferred revenue consists primarily of billings for royalties, services and licenses to customers with multiple-element arrangements where vendor-specific objective evidence of fair value from certain elements does not exist, and for undelivered products or services, which are generally amortized over the term of the arrangement or as such products or services are delivered.
Research and Development
Costs incurred in the research and development of new software products are expensed as incurred until technological feasibility is established. Development costs are capitalized beginning when a product’s technological feasibility has been established and ending when the product is available for general release to customers, in accordance with SFAS No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed.” To date, software development costs incurred between completion of a working prototype and general availability of the related product have not been material and have not been capitalized.
Advertising
Costs related to advertising and promotion of products are charged to sales and marketing expense as incurred. Advertising expense for the years ended December 31, 2005, 2004, and 2003 was $0.4 million, $1.4 million and $0.7 million, respectively.
401(k) Plan
Employees based in the United States participate in a 401(k) plan which provides retirement benefits through tax-deferred salary deductions for all eligible employees meeting certain age and service requirements. Participating employees may contribute an amount of their eligible compensation, subject to an annual limit. We, at the discretion of our board of directors, may make discretionary matching contributions on behalf of our employees. We made contributions to the plan in the amounts of $0.6 million, $0.6 million and $0.7 million for the years ended December 31, 2005, 2004 and 2003, respectively.
Employee Bonus
For the years ended December 31, 2005, 2004 and 2003, the compensation committee of the Board of Directors approved a bonus plan that provided for the issuance of shares to employees based on corporate and individual performance objectives. Due to legal restrictions in certain foreign jurisdictions related to the issuance of shares or the costs associated with implementing such a program, certain employee bonuses were
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
paid in cash. In addition, applicable withholding taxes were netted from certain employees’ gross bonus in the United States and the United Kingdom. During 2005, 1,162,180 shares were issued pursuant to the 2004 bonus plan. During 2004, 578,917 shares were issued pursuant to the 2003 bonus plan. The estimated amount recorded as an expense was $5.5 million for the year ended December 31, 2005. The amount recorded as an expense was $4.8 million and $3.7 million, respectively, for each of the years ended December 31, 2004 and 2003. The shares for the 2005 bonus will be calculated and issued in 2006.
Operating Leases
The Company leases office space under operating lease agreements with original lease periods up to nine years. Certain of the lease agreements contain rent holidays and rent escalation provisions. Rent holidays and rent escalation provisions are considered in determining straight-line rent expense to be recorded over the lease term. The lease term begins on the date of initial possession of the lease property for purposes of recognizing lease expense on a straight-line basis over the term of the lease. Lease renewal periods are considered on a lease-by-lease basis and are generally not included in the initial lease term.
Income Taxes
We account for income taxes using an asset and liability approach which requires the recognition of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in our financial statements or tax returns. The measurement of current and deferred tax liabilities and assets is based on provisions of the enacted tax law. The measurement of deferred tax assets is reduced, if necessary, by a valuation allowance if it is more likely than not that a deferred benefit will not be realized.
Share-Based Compensation
We account for share-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and comply with the disclosure provisions of SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure,” which was effective for the year ended December 31, 2003. Under APB No. 25 compensation expense is based on the difference, if any, on the date of the grant, between the fair value of our shares and the exercise price of the option or purchase right. Had compensation cost for options plans been determined based on the fair value at the grant dates for the awards under a method prescribed by SFAS 148, our net loss would have been increased to the pro-forma amounts indicated below (amounts in millions, except per share amounts):
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
During the year ended December 31, 2003, there was a net reversal of share-based employee compensation expense determined under a fair value-based method for all awards of $1.5 million due to the termination of certain employees.
These pro-forma amounts may not be representative of the effects on reported net loss for future years as options vest over several years and additional awards are generally made each year.
We calculated the fair value of each option grant on the date of the grant using the Black-Scholes option pricing model with the following assumptions:
The weighted average fair value of options granted during 2005, 2004 and 2003 was $2.76, $3.06 and $2.52, respectively.
Comprehensive Income (loss)
We adopted the provisions of SFAS No. 130, “Reporting Comprehensive Income.” This statement requires companies to classify items of comprehensive income by their nature in the consolidated financial statements and display the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in capital in the equity section of the consolidated balance sheets. Accordingly, we reported foreign currency translation adjustments and the unrealized gain (loss) on marketable securities in comprehensive income (loss).
Foreign Currency Translation
The functional currency of our foreign subsidiaries is generally the local currency. Assets and liabilities are translated into U.S. dollars at the balance sheet date exchange rate. Revenues and expenses are translated at the average exchange rate prevailing during the period. The related gains and losses from translation are recorded as a translation adjustment in a separate component of shareholders’ equity. Foreign currency transaction gains and losses are included in results of operations.
Net Loss Per Share
Basic and diluted net loss per share were computed using the weighted-average number of ordinary shares outstanding during the periods presented. The following items as of December 31 were not included in the computation of diluted net loss per share because the effect would be anti-dilutive:
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Had such items been included in the calculation of diluted net loss per share, shares used in the calculation would have been increased by approximately 9.5 million, 10.1 million and 9.7 million in the years ended December 31, 2005, 2004, and 2003, respectively.
Recent Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123 (revised 2004) (SFAS No. 123R), “Share-Based Payment.” SFAS No. 123R requires that the cost resulting from all share-based payment transactions be recognized in the financial statements using a fair-value-based method. The statement replaces SFAS No. 123, supersedes APB No. 25, and amends SFAS No. 95, “Statement of Cash Flows.”
In March 2005, the SEC released Staff Accounting Bulletin No. 107, “Share-Based Payment,” which provides the views of the staff regarding the interaction between SFAS No. 123R and certain SEC rules and regulations for public companies. In April 2005, the SEC adopted a rule that amends the compliance dates of SFAS No. 123R. Under the revised compliance dates, we will be required to adopt the provisions of SFAS No. 123R no later than the first interim period of fiscal 2006. While management continues to evaluate the impact of SFAS No. 123R on our consolidated financial statements, we currently believe that the expensing of share-based compensation most likely affect our consolidated statements of operations in a manner generally consistent with our pro forma disclosure under SFAS No. 123, as amended.
In March 2004, the FASB ratified the measurement and recognition guidance and certain disclosure requirements for impaired securities as described in EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” In June 2005, the FASB directed its staff to issue proposed FASB Staff Position (FSP) EITF 03-1-a, “Implementation Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1,” as final. The FASB plans to retitle this FSP as FSP FAS 115-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” The final FSP will supersede EITF Issue No. 03-1 and EITF Topic D-44, “Recognition of Other-Than-Temporary Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value.” The final FSP will replace the guidance set forth in paragraphs 10 through 18 of EITF Issue No. 03-1 with references to existing other-than-temporary impairment guidance. In September 2005, the FASB decided to retain the paragraph in the proposed FSP pertaining to the accounting for debt securities subsequent to an other-than-temporary impairment and added a footnote to clarify that the proposed FSP does not address when a debt security should be designated as nonaccrual or how to subsequently report income on a nonaccrual debt security. The FASB decided that transition would be applied prospectively and the effective date would be reporting periods beginning after December 15, 2005. Management does not believe the adoption of EITF 03-01 will have a material impact on our consolidated financial statements.
In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections - A Replacement of APB Opinion No. 20 and FASB Statement No. 3.” SFAS No. 154 changes the requirements for the accounting and reporting of a change in accounting principle. Under previous guidance, changes in accounting principle were recognized as a cumulative effect in the net income of the period of the change. The new statement requires retrospective application of changes in accounting principle, limited to the direct effects of the change, to prior periods’ financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. Additionally, this statement requires that a change in depreciation, amortization or depletion method for long-lived, nonfinancial assets be accounted for as a change in accounting estimate affected by a change in accounting principle and that correction of errors in previously issued financial statements should be termed a “restatement.” SFAS No. 154 is effective for accounting changes and correction of errors made in fiscal years beginning after December 15, 2005. Management does not believe the adoption of SFAS No. 154 will have a material impact on our consolidated financial statements.
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Note 3.
Acquisitions
ACTV Acquisition
On July 1, 2003, we acquired ACTV, Inc. Each outstanding share of common stock of ACTV was converted into the right to receive 0.73333 of our Class A ordinary shares, and we, therefore, became obligated to issue 41,648,399 Class A ordinary shares with a value of $54.6 million. These shares were valued at a per share value of $1.31, which was equal to the average last sale prices for our Class A ordinary shares for the trading-day period two days before and after September 26, 2002, the date the merger was agreed upon and announced. In addition, we reserved 6,750,103 Class A ordinary shares for issuance upon the exercise of options that formerly represented a right to purchase ACTV common stock that we assumed in the merger. The fair value of these outstanding stock options of ACTV was $3.9 million and was determined by estimating the fair value as of the acquisition date using the Black-Scholes option pricing model. The acquisition was accounted for as a purchase. We also issued 675,676 Class A ordinary shares in September 2003 as deferred consideration for ACTV’s purchase of a minority interest in one of its subsidiaries.
Tangible assets acquired from ACTV included cash and cash equivalents, short-term marketable debt securities, accounts receivable, property and equipment and other assets. Liabilities assumed from ACTV included accounts payable, accrued liabilities and deferred revenue. The total purchase price, including transaction costs of $3.2 million, was allocated based upon an appraisal as follows (in millions):
The patents are being amortized over their estimated useful life of 13 years. In the allocation of the purchase price, we included an adjustment to accrued liabilities of $4.5 million for estimated severance and $0.2 million for excess facilities to be incurred in connection with a restructuring of ACTV’s operations.
The following presents our operating results for the year ended December 31, 2003 on a pro-forma basis as if the acquisition of ACTV had been consummated as of January 1, 2003 (in millions, except per share amounts):
Included in pro-forma operating results for the year ended December 31, 2003 are approximately $1.8 million of revenue reported by ACTV resulting from the amortization of deferred revenues associated with a marketing arrangement with Ascent Media Group (formerly Liberty Livewire), a related party. The deferred revenues were adjusted to a fair value of zero in the allocation of the purchase price and, accordingly, such revenue recognition will not recur in future periods. The foregoing operating results have been prepared for comparative purposes only and do not necessarily reflect the results that would have occurred had the acquisition actually been consummated at January 1, 2003 or the results that may occur in the future.
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
BettingCorp Acquisition
On August 15, 2003, we acquired substantially all of the assets of BettingCorp Limited in a transaction accounted for as a purchase. The purchase price consisted of $3.1 million of cash and the issuance of 3,225,063 of our Class A ordinary shares with a value of $6.9 million. The shares were valued at a per share value of $2.15, which was equal to the average market price of our Class A ordinary shares for the three trading days before the acquisition date. Of the Class A ordinary shares issued, 2,580,050 were issued directly to the seller and 645,013 were deposited in an escrow fund established for the purpose of securing the payment of indemnification obligations arising out of our asset purchase.
The total purchase price, including transaction costs of $1.4 million, was allocated based upon an appraisal as follows (in millions):
The identifiable intangible assets are being amortized over 2-5 years.
Under the terms of a liquidity agreement, we guaranteed that the seller would realize net proceeds of approximately $6.9 million (or $2.15 per share), plus interest, upon the disposition of the shares they received in the transaction. The seller sold the shares during 2004 and the amount in excess of the guarantee was $4.1 million, which was credited to additional paid-in capital in the consolidated balance sheet.
CAM Systems Acquisition
On September 7, 2005, we acquired substantially all of the cable TV advertising inventory management assets of CAM Systems, L.L.C. and its affiliates in a transaction accounted for as a purchase. For financial reporting purposes, the purchase price was recorded as approximately $17.5 million, consisting of $4.2 million in cash, 5,221,462 of our Class A ordinary shares with an estimated fair value of $13.1 million, as determined under EITF 97-15 (which reflected the “floor” for the pricing collar in the transaction), and direct transaction expenses of approximately $0.2 million. Of the 5,221,462 Class A ordinary shares issued, 900,252 shares were deposited in an escrow account established for the purpose of securing the payment of indemnification obligations of CAM Systems arising out of our purchase.
The total purchase price, including expenses, was allocated based upon a third party appraisal as follows (in millions):
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The intangible assets consist of customer contracts and relationships, developed technology and trademarks, and have been assigned estimated useful lives of 5 years, 3 years and 4 years, respectively.
Under the terms of that acquisition, the sellers and we agreed to adjust the number of shares issued under specified circumstances. As of March 7, 2006, we determined that no adjustments would be required to the purchase price based on the trading value of our Class A ordinary shares.
The acquired businesses provide an integrated traffic and billing software system designed and operated to manage local advertising inventory for cable system operators and a sales management software solution designed to assist in the creation of customer proposals, rate card management, local advertising research and other related customer relationship services for the local advertising market. They also provide an end-to-end managed service that operates as a national interconnect for a cable system operator and manages promotional inventory and certain advanced advertising applications. We currently intend to continue marketing, developing and supporting these products.
Note 4.
Balance Sheet Components (in thousands)
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
As of December 31, 2004, we had a private equity investment, which was assumed in connection with the acquisition of ACTV and was accounted for under the cost method. During 2005, we sold this cost investment with cash proceeds of $7.1 million. The related gain was $3.1 million.
As of December 31, 2005 and 2004, we had in other assets $0.5 million of restricted cash pledged as collateral against a standby letter of credit of approximately $0.5 million that was issued to the landlord at one of our leased properties.
Note 5.
Marketable Debt Securities
The following is a summary of marketable debt securities as of December 31 (in thousands):
As of December 31, 2005, there were two certificates of deposit aggregating $2.0 million, included in long-term marketable debt securities, pledged as collateral against two standby letters of credit aggregating $1.5 million that were issued to the landlord and sublessee at two of our leased properties.
In accordance with EITF 03-01, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”, the following table summarizes the fair value and gross unrealized losses
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
related to available-for-sale securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, as of December 31, 2005:
Fair values were determined for each individual security in the investment portfolio, the declines in value of these investments are primarily related to changes in interest rates and are considered to be temporary in nature.
Note 6.
Goodwill
As of December 31, 2005, our goodwill balance related to our acquisitions of Wink Communications, Inc., ACTV, BettingCorp and CAM Systems. As required by SFAS 142, we have allocated goodwill to our reportable segments. Below is our goodwill reported by segment as of December 31, 2005 and 2004 (in millions):
Changes in the carrying amount of goodwill during the years ended December 31, were as follows (in millions):
During the third quarter of 2005, $9.4 million of goodwill was recorded as a result of the acquisition of CAM Systems. During the third quarter of 2003, $25.2 million of goodwill was recorded as a result of the acquisitions of ACTV and the assets of BettingCorp. See Note 3.
Minority shareholders of OpenTV, Inc., which is a subsidiary of ours, have the ability, under certain arrangements, to exchange their shares of OpenTV, Inc. for our shares, generally on a one-for-one basis. As
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
the shares are exchanged, they are accounted for at fair value. This accounting effectively provides that at each exchange date, the exchange is accounted for as a purchase of a minority interest in OpenTV, Inc., valued at the number of our Class A ordinary shares issued to effect the exchange multiplied by the market price of a Class A ordinary share on that date. As a result of applying purchase accounting to the exchanges, we recorded additional amounts of goodwill in the periods presented.
In the fourth quarter of 2003, we changed the annual goodwill impairment testing date under SFAS 142 from September 30 to December 31. We believe that this change in accounting principle is preferable because it conforms with the methodology applied by our controlling shareholder, Liberty Media. This change had no impact on our financial position or results of operations. Based on the results of our impairment testing, we determined that there was no impairment of goodwill for 2005, 2004 or 2003.
Note 7.
Intangible Assets, Net
The components of intangible assets, excluding goodwill, were as follows (in millions):
During the fourth quarter of 2003, we determined that an impairment had occurred with respect to the value of the patents related to our acquisition of CableSoft Corporation in 2000 due to the absence of any current or future expected cash flow associated with CableSoft technologies. In accordance with SFAS 144, we recorded an impairment charge for the unamortized balance of $1.5 million.
The intangible assets are being amortized on a straight-line basis over their estimated useful lives. Amortization of intangible assets was $5.7 million, $8.2 million, and $14.7 million for the years ended December 31, 2005, 2004, and 2003, respectively (of which $4.0 million, $4.7 million, and $9.8 million for the years ended December 31, 2005, 2004 and 2003, respectively, were reported in cost of revenues). The future annual amortization expense is expected to be as follows (in millions):
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Note 8.
NASCAR Amendment
During 2004, we renegotiated an existing contract that our subsidiary, ACTV, had with iN DEMAND relating to the production of interactive programming for the 2004 NASCAR season. As a result of this renegotiation, we reduced the estimated loss for that contract by $4.6 million from the remaining amount of $6.4 million which had been accrued by ACTV in 2003 prior to its acquisition by us. This item has been shown as a separate line in our consolidated statement of operations.
Note 9.
Restructuring and Impairment Costs
We monitor our organizational structure and associated operating expenses periodically. Depending upon events and circumstances, actions may be taken to restructure the business, including terminating employees, abandoning excess lease space and incurring other exit costs. Restructuring costs are recorded in accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Any resulting restructuring accrual includes numerous estimates made by management, which are developed based on management’s knowledge of the activity being affected and the cost to exit existing commitments. These estimates could differ from actual results. We monitor the initial estimates periodically and record an adjustment for any significant changes in estimates.
In the first quarter of 2003, we announced the termination of approximately 70 employees located in France, the reduction of excess office space and the write-down of certain property and equipment. In the third quarter of 2003, we reduced the management of our Static UK operations by nine employees. The employee costs included severance payments and certain employee benefit obligations estimated at $4.9 million. Facilities consolidation charges for the reduction of excess office space were estimated to be $1.5 million. These costs included a lease buyout and shut-down costs. Asset write-offs of $0.5 million were incurred in connection with leasehold improvements and other property and equipment that was abandoned. During the third and fourth quarters of 2003 we reversed excess accruals from prior restructuring provisions of $1.1 million because our actual costs were lower than our original estimates.
On July 1, 2003, we acquired ACTV, Inc. In the allocation of the purchase price, we included an adjustment to accrued liabilities of $4.5 million for estimated severance and $0.2 million for excess facilities to be incurred in connection with a restructuring of ACTV’s operations.
During the second quarter of 2004, we reduced the workforce of our PlayJam operations in France by five people, resulting in a restructuring provision of $0.3 million for severance and $0.1 million for excess facilities. During the second and third quarters of 2004, we also reversed $0.6 million of excess accruals from prior restructuring provisions for severance and benefits and $0.9 million of excess accruals for excess facilities because our actual costs were lower than our original estimates. In the fourth quarter of 2004, we announced the termination of approximately 20 employees located in our office in Lexington, Massachusetts and the reduction of excess office space and the write down of certain property and equipment. The employee costs included severance payments of $0.1 million. Facilities consolidations charges for the reduction of excess office space were estimated to be $0.9 million, net of estimated sublease income. Asset write-offs of $1.0 million were incurred in connection with leasehold improvements and other property and equipment that was abandoned.
In the first quarter of 2005, we recorded a restructuring and impairment provision of $0.5 million, in consideration of the final settlement of our outstanding liabilities relating to our Lexington, Massachusetts facility. This provision consisted of $0.2 million additional restructuring charges to terminate and buy-out the lease, and an impairment of $0.3 million in respect of certain equipment transferred as part of the settlement arrangement. That $0.5 million amount was in addition to the $1.3 million restructuring and impairment provision remaining from our initial provision for this matter of $2.0 million that we recorded during the third
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quarter of 2002. In the second quarter of 2005, we recorded a restructuring provision of $1.7 million relating to a reduction of excess office space in New York City, net of estimated sub-lease income and existing reserves. This lease was acquired through our acquisition of ACTV in 2003. At the time of acquisition, we recorded a reserve for the estimated fair value of this lease. As of the cease-use date, we had a remaining reserve of $0.5 million, which was reclassified to our restructuring reserve. In the third quarter of 2005, we recorded a restructuring provision of $0.4 million related to the termination plan to terminate seven employees in our United States and Switzerland operations.
The following sets forth the activity relating to these restructuring activities (in millions):
The outstanding accrual for excess facilities relates to operating lease obligations that continue through 2016.
Note 10.
Shareholders’ Equity
Authorized share capital
•
500,000,000 Class A ordinary shares
•
200,000,000 Class B ordinary shares
•
500,000,000 preference shares - none outstanding
Voting
The holders of Class A ordinary shares and Class B ordinary shares are generally entitled to vote as a single class on all matters upon which holders of ordinary shares have a right to vote, subject to the requirements of any applicable laws. Each Class A ordinary share entitles its holder to one vote, and each Class B ordinary share entitles its holder to ten votes. Unless otherwise required by law, and so long as their rights are not adversely affected, the holders of Class A ordinary shares and Class B ordinary shares are not
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entitled to vote on any amendment to our Articles of Association and Memorandum of Association that relates solely to the terms of one or more outstanding series of preference shares.
Dividends and Other Distributions
Subject to the preferential and other dividend rights of any outstanding series of preference shares, the holders of Class A ordinary shares and Class B ordinary shares are entitled to equal dividends per share when, as and if declared by our board of directors, except that all dividends payable in ordinary shares will be paid in the form of Class A ordinary shares to holders of Class A ordinary shares and in the form of Class B ordinary shares to holders of Class B ordinary shares. Neither Class A ordinary shares nor Class B ordinary shares may be split, divided or combined unless the other class is proportionally split, divided or combined. In the event we are liquidated, the holders of our Class A ordinary shares and Class B ordinary shares will be treated equally on a per share basis and will be entitled to receive all of our remaining assets following distribution of the preferential and/or other amounts to be distributed to the holders of our preference shares.
Merger
In the event of a merger, the holders of Class A ordinary shares and Class B ordinary shares will be entitled to receive the same per share consideration, if any, except that if such consideration includes voting securities (or the right to acquire voting securities or securities exchangeable for or convertible into voting securities), we may (but are not required to) provide for the holders of Class B ordinary shares to receive voting securities (or rights to acquire voting securities) entitling them to ten times the number of votes per share as the voting securities (or rights to acquire voting securities) being received by holders of Class A ordinary shares.
Conversion of Class B Ordinary Shares
Each Class B ordinary share is convertible, at the option of the holder thereof, into Class A ordinary shares on a share-for-share basis
In the event of a transaction where Class A ordinary shares are converted into or exchanged for one or more other securities, cash or other property (a “Class A Conversion Event”), a holder of Class B ordinary shares thereafter will be entitled to receive, upon the conversion of such Class B ordinary shares, the amount of such securities, cash and other property that such holder would have received if the conversion of such Class B ordinary shares had occurred immediately prior to the record date or effective date, as the case may be, of the Class A Conversion Event.
Exchangeable Share Arrangements
Pursuant to our 2000 Exchange Plan and the Exchange Agreement between us, OpenTV, Inc. and Sun TSI Subsidiary, Inc. dated October 23, 1999, the minority shareholders of OpenTV, Inc. have the ability to exchange their shares of OpenTV, Inc. for shares of us, generally on a one-for-one basis. As the minority shareholders are not responsible to fund the losses of OpenTV, Inc., we have recorded 100% of the loss in excess of the cost basis of the minority shareholders.
As the shares are exchanged, they are accounted for at fair value. Exchange rights granted under our 2000 Exchange Plan expire on the fifteenth anniversary of the date of grant, and the exchange right granted under the Exchange Agreement with Sun TSI Subsidiary is perpetual.
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Shares Reserved
As of December 31, 2005, the following Class A ordinary shares were reserved:
Pursuant to the Exchange Agreement between us, OpenTV, Inc. and Sun TSI Subsidiary, Inc., 7,594,796 Class B ordinary shares were reserved for issuance upon exchange of shares of OpenTV, Inc. Class B common stock. See Note 16 for subsequent event information relating to the exchange of these shares in 2006.
Warrants
In October 1998, General Instrument acquired warrants to purchase shares of Spyglass. These warrants were assumed by us in connection with the acquisition of Spyglass and expired in December 2003.
Agreements with General Instrument and Motorola
In November 2000, we entered into a series of definitive agreements with General Instrument Corporation and Motorola, Inc. dedicated to accelerating interactive television deployments worldwide. One of the agreements provided for the establishment of a co-owned venture to provide integration and testing services for cable and satellite operators. At December 31, 2005 and 2004, the carrying value of Motorola’s minority interest in the venture was $0.5 million and $0.6 million, respectively.
Share-based Compensation
The share-based compensation amounts are being amortized in accordance with FIN 28 over the vesting period of the options. Share-based compensation expense was nominal in the years ended December 31, 2005 and 2004. Share-based compensation expense was $0.2 million in the year ended December 31, 2003. As of December 31, 2005, we had a nominal amount of total unamortized deferred share-based compensation, which will be fully amortized in 2006. During the year ended December 31, 2003, total deferred compensation was reduced by $0.1 million and additional paid-in capital was credited by a similar amount due to the termination of certain employees.
Note 11.
Option Plans
Options are currently outstanding under the following plans: (i) the Amended and Restated OpenTV Corp. 1999 Share Option/ Share Issuance Plan, or the 1999 Plan, (ii) the Amended and Restated OpenTV, Inc. 1998 Option/ Stock Issuance Plan, or the 1998 Plan, (iii) the OpenTV Corp. 2001 Nonstatutory Stock Option Plan, or the 2001 Plan, (iv) the OpenTV Corp. 2003 Incentive Plan, or the 2003 Plan, (v) the OpenTV Corp. 2005 Incentive Plan, or the 2005 Plan, (vi) option plans relating to outstanding options assumed in connection with the Spyglass merger (collectively, the “Assumed Spyglass Options”), and (vii) option plans relating to outstanding options assumed in connection with the ACTV merger (collectively, the “Assumed ACTV Options”). Options have been issued to employees, directors and consultants.
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As a result of our shareholders’ approval of our 2005 Plan on November 10, 2005, no further awards will be granted under our 1999 Plan, 2001 Plan or 2003 Plan. The 1999 Plan, 2001 Plan and 2003 Plan will remain in existence for the sole purpose of governing the outstanding options until such time as such options have been exercised or cancelled. Options or shares awarded under the 1999 Plan, 2001 Plan or 2003 Plan that are forfeited or cancelled will no longer be available for future issuance.
We issue options from the 2005 Plan. The compensation committee of our board of directors administers the 2005 Plan. The compensation committee has the discretion to determine grant recipients, the number and exercise price of stock options, and the number of stock appreciation rights, restricted stock or stock units issued under the 2005 Plan. The options may be incentive stock options or non-statutory stock options. Consistent with the foregoing, options under the 2005 Plan have been granted at an exercise price equal to the fair market value on the date of grant and vest 25% after one year from the date of grant and 1/48 th over each of the next 36 months. The term of the options generally is 10 years from the date of grant. Unexercised options generally expire ninety days after termination of employment with us and are then returned to the pool and available for reissuance. A total of 6,000,000 Class A ordinary shares have been reserved for issuance under the 2005 Plan since its inception, and as of December 31, 2005, options to purchase 3,000 Class A ordinary shares were outstanding under the 2005 Plan.
As discussed above, we no longer issue options from the 1999 Plan. The options outstanding may be incentive stock options or non-statutory options. Consistent with the foregoing, options that have been issued under the plan have generally been granted at an exercise price equal to the fair market value on the date of grant and vest 25% after 12 months of continuous service with us and 1/48 th over each of the next 36 months. The term of the options generally is 10 years from the date of grant. Unexercised options generally expire three months after termination of employment with us. A total of 8,980,000 Class A ordinary shares have been reserved for issuance under the 1999 Plan since its inception, and as of December 31, 2005, options to purchase 3,363,549 Class A ordinary shares were outstanding under the 1999 Plan.
Effective as of October 23, 1999, options to purchase 5,141,114 shares of Class A common stock of OpenTV, Inc. under the 1998 Plan were assigned to and assumed by us and these options thereafter represented the right to purchase under the 1999 Plan an identical number of our Class A ordinary shares. The remainder of the options then outstanding under the 1998 Plan were not assigned to and assumed by us. OpenTV, Inc. no longer issues options from the 1998 Plan. The 1998 Plan will remain in existence for the sole purpose of governing those remaining options until such time as such options have been exercised and the underlying shares have become transferable by the holders. Options or shares awarded under the 1998 Plan that are forfeited or cancelled will no longer be available for issuance. As of December 31, 2005, options to purchase 62,000 shares of OpenTV, Inc.’s Class A common stock were outstanding under the 1998 Plan.
As discussed above, we no longer issue options from the 2001 Plan. Only non-statutory options were granted. A total of 500,000 Class A ordinary shares had been reserved for issuance under the 2001 Plan, and as of December 31, 2005, options to purchase 146,986 Class A ordinary shares were outstanding under the 2001 Plan.
As discussed above, we no longer issue options from the 2003 Plan. The options outstanding are either incentive stock options or non-statutory stock options. Consistent with the foregoing, options under the 2003 Plan have generally been granted at an exercise price equal to the fair market value on the date of grant and, for grants made through the end of 2004, had vested 25% after two years from the date of grant and 25% yearly thereafter for the following three years. In 2005, we revised the vesting schedule so that it is consistent with the schedule generally applicable under the 1999 Plan. The term of the options generally is 10 years from the date of grant. Unexercised options generally expire ninety days after termination of employment with us. A total of 5,000,000 Class A ordinary shares had been reserved for issuance under the 2003 Plan since its inception, and as of December 31, 2005, options to purchase 4,770,882 Class A ordinary shares were outstanding under the 2003 Plan.
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
All of the Assumed Spyglass Options were converted as a result of the Spyglass acquisition into options to purchase our Class A ordinary shares. As of December 31, 2005, there were outstanding Assumed Spyglass Options to purchase 95,628 Class A ordinary shares.
All of the Assumed ACTV Options were converted as a result of the ACTV acquisition into options to purchase our Class A ordinary shares. As of December 31, 2005, there were outstanding Assumed ACTV Options to purchase 1,883,665 Class A ordinary shares.
Assumed Spyglass Options and Assumed ACTV Options that are forfeited or cancelled will no longer be available for issuance, and no new options will be granted under the option plans relating to the Assumed Spyglass Options and Assumed ACTV Options.
Activity under the Plans was as follows:
The above table includes OpenTV, Inc. options issued pursuant to the 1998 Plan of which 20,000 shares were exercised in 2003.
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table summarizes information with respect to options outstanding at December 31, 2005:
At December 31, 2005, 2004 and 2003, vested options to purchase 4,205,047 ordinary shares, 4,316,187 ordinary shares and 7,016,486 ordinary shares, respectively, were unexercised.
Note 12. Income Taxes
The components of loss before income taxes were as follows (in thousands):
Income tax expense (benefit) was comprised of the following (in thousands):
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The tax benefit for the year ended December 31, 2004 was primarily attributable to the release of contingency reserves due to the expiration of the statute of limitations and the closing of a foreign income tax audit.
Income tax expense (benefit) differs from the amount computed by applying the statutory United States federal income tax rate to loss before income taxes as follows (in thousands):
The components of the net deferred tax assets and liabilities were as follows (in thousands):
We provided a partial valuation allowance on deferred tax assets as of December 31, 2005. Because of our limited operating history and cumulative losses, management believes it is more likely than not that substantially all of the deferred tax asset will not be realized. We did recognize an asset in 2005 for Swiss deferred tax assets as management believes it is more likely than not that the deferred tax asset will be realized. The 2004 deferred tax amounts have been adjusted to reflect the company’s best estimate of future deductions and liabilities. These adjustments were reflected as a reclassification to net operating loss carryover or valuation allowance with no balance sheet or income statement impact.
At December 31, 2005, we estimated that we had approximately $319 million, $162 million and $38 million, respectively, of federal, state and foreign net operating losses. These carryforwards expire between 2009 and 2025 for federal tax purposes and 2006 and 2015 for state tax purposes, if not utilized. The use of our net operating losses is subject to certain limitations and may be subject to further limitations as a result of changes in ownership as defined by federal and state tax law. In addition, approximately $52.3 million of the federal net operating loss results from deductions attributable to stock option exercises. The benefit of the use
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
of the net operating loss related to stock option exercises will be credited to equity when realized. The portion of our valuation allowance related to acquired deferred tax assets is creditable to goodwill.
The Company has not recognized a deferred tax liability related to foreign subsidiary earnings that the Company intends to permanently reinvest in the respective foreign jurisdiction. As of December 31, 2005, we have not determined the potential amount of tax liability.
Note 13.
Commitments and Contingencies
Operating Leases
We lease our facilities from third parties under operating lease agreements or sublease agreements in the United States, Europe and Asia Pacific. These leases expire between January 2006 and May 2012. Total rent expense was $4.5 million, $5.5 million and $5.8 million for the years ended December 31, 2005, 2004 and 2003, respectively.
Future minimum payments under non-cancelable operating leases as of December 31, 2005 were as follows (in millions):
We have the right to terminate, without penalty, two of our operating leases prior to their scheduled expiration. If we exercised those early termination rights, our future minimum lease commitments would be reduced by an aggregate of $6.4 million over the current remaining life of those leases, beginning in 2006. We have not yet made any determination as to whether we intend to exercise any of those rights. If we did exercise any such rights, while our commitments under those specific leases would be reduced, we might also be required to lease additional space to conduct our business and we cannot be certain, at this time, whether any such actions would possibly result in a net increase in our future minimum lease commitments.
Other Commitments
In the ordinary course of business we enter into various arrangements with vendors and other business partners for bandwidth, marketing, and other services. Future minimum commitments under these arrangements as of December 31, 2005 were $2.1 million and $0.1 million for the years ending December 31, 2006 and 2007, respectively. In addition, we also have arrangements with certain parties that provide for revenue-sharing payments.
As of December 31, 2005, we had three standby letters of credit aggregating approximately $2.0 million that were issued to landlords and sublessee at two of our leased properties, against which two certificates of deposit aggregating $2.0 million and approximately $0.5 million of restricted cash were pledged as collateral.
In March 1998, we entered into a licensing and distribution agreement with Sun Microsystems, Inc. under which Sun Microsystems granted us a non-exclusive, non-transferable license to develop and distribute products based upon Sun Microsystems’ Java technology. Subsequent amendments extended our license
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
through December 2006. As amended, the agreement required us to make a payment of $4.0 million to Sun Microsystems in February 2007, less any amounts previously paid for support and royalty fees. During 2004, we evaluated our commitment and decided to record a provision of $3.5 million to reflect our estimate of the remaining future commitment we had under the terms of this license. During 2005, a contract amendment with Sun Microsystems for this license reduced our payment obligation to Sun by $0.5 million and extended the term of the license until March 2010. The remaining $3.0 million was paid off during 2005.
Contingencies
OpenTV, Inc. v. Liberate Technologies, Inc. On February 7, 2002, OpenTV, Inc., our subsidiary, filed a lawsuit against Liberate Technologies, Inc. alleging patent infringement in connection with two patents held by OpenTV, Inc. relating to interactive technology. The lawsuit is pending in the United States District Court for the Northern District of California. On March 21, 2002, Liberate Technologies filed a counterclaim against OpenTV, Inc. for alleged infringement of four patents allegedly owned by Liberate Technologies. Liberate Technologies has since dismissed its claims of infringement on two of those patents. In January 2003, the District Court granted two of OpenTV, Inc.’s motions for summary judgment pursuant to which the court dismissed Liberate Technologies’ claim of infringement on one of the remaining patents and dismissed a defense asserted by Liberate Technologies to OpenTV, Inc.’s infringement claims, resulting in only one patent of Liberate Technologies remaining in the counterclaim. The District Court issued a claims construction ruling for the two OpenTV patents and one Liberate patent remaining in the suit on December 2, 2003.
In April 2005, Liberate sold substantially all of the assets of its North American business to Double C Technologies, a joint venture between Comcast Corporation and Cox Communications, Inc. In connection with that transaction, Liberate and Double C Technologies indicated in a filing with the United States District Court that Double C Technologies had assumed all liability related to this litigation. A stay of these proceedings has been granted to the parties through May 15, 2006 to allow for settlement discussions.
We continue to believe that our lawsuit is meritorious and intend to continue vigorously pursuing prosecution of our claims. In addition, we believe that we have meritorious defenses to the counterclaims brought against OpenTV, Inc. and will defend ourselves vigorously. No provision has been made in our consolidated financial statements for this matter. We are unable to predict the likelihood of a favorable outcome or estimate our potential liability, if any, in respect of any potential counterclaims if litigated to conclusion.
Initial Public Offering Securities Litigation. In July 2001, the first of a series of putative securities class actions, Brody v. OpenTV Corp., et al., was filed in United States District Court for the Southern District of New York against certain investment banks which acted as underwriters for our initial public offering, us and various of our officers and directors. These lawsuits were consolidated and are captioned In re OpenTV Corp. Initial Public Offering Securities Litigation. The complaints allege undisclosed and improper practices concerning the allocation of our initial public offering shares, in violation of the federal securities laws, and seek unspecified damages on behalf of persons who purchased OpenTV Class A ordinary shares during the period from November 23, 1999 through December 6, 2000. The Court has appointed a lead plaintiff for the consolidated cases. On April 19, 2002, the plaintiffs filed an amended complaint. Other actions have been filed making similar allegations regarding the initial public offerings of more than 300 other companies, including Wink Communications as discussed in greater detail below. All of these lawsuits have been coordinated for pretrial purposes as In re Initial Public Offering Securities Litigation, 21 MC 92 (SAS). Defendants in these cases filed an omnibus motion to dismiss on common pleading issues. Oral argument on the omnibus motion to dismiss was held on November 1, 2002. All claims against our officers and directors have been dismissed without prejudice in this litigation pursuant to the parties’ stipulation approved by the Court on October 9, 2002. On February 19, 2003, the Court denied in part and granted in part the omnibus motion to dismiss filed on behalf of defendants, including us. The Court’s Order dismissed all claims against us except for a claim
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
brought under Section 11 of the Securities Act of 1933. Plaintiffs and the issuer defendants, including us, have agreed to a stipulation of settlement, in which plaintiffs will dismiss and release their claims in exchange for a guaranteed recovery to be paid by the insurance carriers of the issuer defendants and an assignment of certain claims. The stipulation of settlement for the claims against the issuer-defendants, including us, has been submitted to the Court. On February 15, 2005, the Court preliminarily approved the settlement contingent on specified modifications. On August 31, 2005, the Court entered an order confirming its preliminary approval of the settlement. A hearing on the fairness of the settlement to the shareholder class is set for April 24, 2006. There is no guarantee that the settlement will become effective, as it is subject to a number of conditions which cannot be assured. If the settlement does not occur, and the litigation against us continues, we believe that we have meritorious defenses to the claims asserted against us and will defend ourselves vigorously. No provision has been made in our consolidated financial statements for this matter. We are unable to predict the likelihood of an unfavorable outcome or estimate our potential liability, if any.
In November 2001, a putative securities class action was filed in United States District Court for the Southern District of New York against Wink Communications and two of its officers and directors and certain investment banks which acted as underwriters for Wink Communications’ initial public offering. We acquired Wink Communications in October 2002. The lawsuit is now captioned In re Wink Communications, Inc. Initial Public Offering Securities Litigation. The operative amended complaint alleges undisclosed and improper practices concerning the allocation of Wink Communications’ initial public offering shares in violation of the federal securities laws, and seeks unspecified damages on behalf of persons who purchased Wink Communications’ common stock during the period from August 19, 1999 through December 6, 2000. This action has been consolidated for pretrial purposes as In re Initial Public Offering Securities Litigation. On February 19, 2003, the Court ruled on the motions to dismiss filed by all defendants in the consolidated cases. The Court denied the motions to dismiss the claims under the Securities Act of 1933, granted the motion to dismiss the claims under Section 10(b) of the Securities Exchange Act of 1934 against Wink Communications and one individual defendant, and denied that motion against the other individual defendant. As described above, a stipulation of settlement for the claims against the issuer defendants has been submitted to and preliminarily approved by the Court. There is no guarantee that the settlement will become effective, as it is subject to a number of conditions, including approval of the Court, which cannot be assured. If the settlement does not occur, and the litigation against Wink Communications continues, we believe that Wink Communications has meritorious defenses to the claims brought against it and that Wink Communications will defend itself vigorously. No provision has been made in our consolidated financial statements for this matter. We are unable to predict the likelihood of an unfavorable outcome or estimate our potential liability, if any.
Litigation Relating to the Acquisition of ACTV, Inc. On November 18, 2002, a purported class action complaint was filed in the Court of Chancery of the State of Delaware in and for the County of New Castle against ACTV, Inc., its directors and us. The complaint generally alleges that the directors of ACTV breached their fiduciary duties to the ACTV shareholders in approving the ACTV merger agreement pursuant to which we acquired ACTV on July 1, 2003, and that, in approving the ACTV merger agreement, ACTV’s directors failed to take steps to maximize the value of ACTV to its shareholders. The complaint further alleges that we aided and abetted the purported breaches of fiduciary duties committed by ACTV’s directors on the theory that the merger could not occur without our participation. No proceedings on the merits have occurred with respect to this action, and the case is dormant. We believe that the allegations are without merit and intend to defend against the complaint vigorously. No provision has been made in our consolidated financial statements for this matter. We are unable to predict the likelihood of an unfavorable outcome or estimate our potential liability, if any.
Broadcast Innovation Matter. On November 30, 2001, a suit was filed in the United States District Court for the District of Colorado by Broadcast Innovation, L.L.C., or BI, alleging that DIRECTV, Inc., EchoStar Communications Corporation, Hughes Electronics Corporation, Thomson Multimedia, Inc., Dot-
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cast, Inc. and Pegasus Satellite Television, Inc. are infringing certain claims of United States patent no. 6,076,094, assigned to or licensed by BI. DIRECTV and certain other defendants settled with BI on July 17, 2003. We are unaware of the specific terms of that settlement. Though we are not currently a defendant in the suit, BI may allege that certain of our products, possibly in combination with the products provided by some of the defendants, infringe BI’s patent. The agreement between OpenTV, Inc. and EchoStar includes indemnification obligations that may be triggered by the litigation. If liability is found against EchoStar in this matter, and if such a decision implicates our technology or products, EchoStar has notified OpenTV, Inc. of its expectation of indemnification, in which case our business performance, financial position, results of operations or cash flows may be adversely affected. Likewise, if OpenTV, Inc. were to be named as a defendant and it is determined that the products of OpenTV, Inc. infringe any of the asserted claims, and/or it is determined that OpenTV, Inc. is obligated to defend EchoStar in this matter, our business performance, financial position, results of operations or cash flows may be adversely affected. On November 7, 2003, BI filed suit against Charter Communications, Inc. and Comcast Corporation in United States District Court for the District of Colorado, alleging that Charter and Comcast also infringe the ’094 patent. The agreements between Wink Communications and Charter Communications include indemnification obligations of Wink Communications that may be triggered by the litigation. While reserving all of our rights in respect of this matter, we have conditionally reimbursed Charter for certain reasonable legal expenses that it incurred in connection with this litigation. On August 4, 2004, the District Court found the ’094 patent invalid. After various procedural matters, including interim appeals, in November 2005, the United States Court of Appeals for the Federal Circuit remanded the case back to the District Court for disposition. The District Court has tentatively scheduled a trial in this matter for September 2006, although counsel for the defendants expects that, prior to the trial date, the District Court may review and issue its opinion on various pending summary judgment motions for dismissal. In addition, on March 8, 2006, the defendants filed a writ of certiorari in this matter with the Supreme Court of the United States to review the decision of the United States Court of Appeals for the Federal Circuit, which had overturned the District Court’s order for summary judgment in favor of the defendants. Based on the information available to us, we have established a reserve for costs and fees that may be incurred in connection with this matter. That reserve is an estimate only and actual costs may be materially different.
Personalized Media Communications, LLC. On December 4, 2000, a suit was filed in the United States District Court for the District of Delaware by Pegasus Development Corporation and Personalized Media Communications, LLC alleging that DIRECTV, Inc., Hughes Electronics Corp., Thomson Consumer Electronics and Philips Electronics North America, Inc. are willfully infringing certain claims of seven U.S. patents assigned or licensed to Personalized Media Communications. Based on publicly available information, we believe that the case has been stayed in the District Court pending re-examination by the United States Patent and Trademark Office. Though Wink Communications is not a defendant in the suit, Personalized Media Communications may allege that certain products of Wink Communications, possibly in combination with products provided by the defendants, infringe Personalized Media Communication’s patents. The agreements between Wink Communications and each of the defendants include indemnification obligations that may be triggered by this litigation. If it is determined that Wink Communications is obligated to defend any defendant in this matter, and/or that the products of Wink Communications infringe any of the asserted claims, our business performance, financial position, results of operations or cash flows may be adversely affected. No provision has been made in our consolidated financial statements for this matter. We are unable to estimate our potential liability, if any.
Indemnification
In the normal course of our business, we provide indemnification to customers, subject to limitations, against claims of intellectual property infringement made by third parties arising from the use of our products. Historically, costs related to these indemnification provisions have not been significant and we are unable to
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
estimate the maximum potential impact of these indemnification provisions on our future results of operations, although our liabilities in those arrangements are customarily limited in various respects, including monetarily. As permitted under the laws of the British Virgin Islands, we have agreed to indemnify our officers and directors for certain events or occurrences while the officer or director is, or was serving, at our request in such capacity. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have director and officer insurance coverage that limits our exposure and enables us to recover a portion of any future amounts paid. We believe the estimated fair value of these indemnification agreements in excess of applicable insurance coverage is not material.
Note 14.
Related Party Transactions
The table below reflects transactions involving the following current and former related parties during the periods indicated (in thousands). Other than Liberty Media, none of the parties referred to in the table below held an equity interest, as of December 31, 2005, in our company that exceeded five percent.
Commencing in August 2002, Liberty Broadband Interactive Television, a subsidiary of Liberty Media, provided certain management services for us. This relationship was terminated in February 2004. We reimbursed Liberty Broadband for services based on the estimated percentage of time that its employees dedicated to the performance of services for us. In addition, we also reimbursed Liberty Broadband and Liberty Media for an allocated portion of its travel and administrative costs and certain specific costs related to performing services for OpenTV. Total management and other charges from Liberty Broadband and Liberty Media were $0.4 million and $2.4 million for the years ended December 31, 2004 and 2003, respectively.
Since January 2004, we have participated in the Liberty Media benefits program for employees in the United States at a cost of $2.0 million and $1.9 million for the years ended December 31, 2005 and 2004, respectively. We believe that this participation provides us with better economic terms than we would otherwise be able to achieve independent of Liberty Media.
On March 23, 2004, in consideration for the issuance by Liberty Media to James Chiddix of options to purchase 50,000 shares of Liberty Media Series A common stock as an inducement to Mr. Chiddix agreeing to serve as Chairman of our Board of Directors, we issued to Liberty Media an aggregate of 76,982 of our Class A ordinary shares. The number of our Class A ordinary shares issued to Liberty Media was determined by multiplying the Black-Scholes value per option to purchase a share of Liberty Media Series A common stock ($4.603495) by 50,000 and dividing the resulting number by the closing sale price of our Class A ordinary share on the Nasdaq National Market on March 23, 2004 ($2.99). We accounted for the issuance of our shares to Liberty Media as a dividend equal to the fair value of the shares of $0.2 million.
In June 2000, we entered into an employment agreement with James Ackerman, our former Chief Executive Officer and a member of our Board of Directors, pursuant to which we agreed, among other things, (a) to provide an interest-free loan of approximately $2.4 million to be forgiven in annual installments over a period of four years and (b) to issue Class A ordinary shares having an aggregate fair market value of approximately $0.6 million in annual installments over the same four-year period. The Class A ordinary shares
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
issued were 43,662 and 121,402 during the years ended December 31, 2004 and 2003, respectively. The amounts forgiven annually and the annual grants of ordinary shares were reported as compensation expense. In May 2004, we and Mr. Ackerman agreed not to renew his employment agreement and Mr. Ackerman stepped down as Chief Executive Officer.
Note 15.
Segment Information
Our chief operating decision maker is our Chief Executive Officer. In 2004, we replaced our Chief Executive Officer and appointed several new senior executives. As part of that management change, we reorganized our reporting units to provide management with better information for allocating the company’s resources and assessing performance in accordance with the new management team’s strategic focus. Our management assesses our results and financial performance, and prepares our internal budgeting reports, on the basis of three segments: the middleware and integrated technologies business, the applications business, and the BettingCorp business. We have prepared this segment analysis in accordance with Statement of Financial Accounting Standards No. 131, “Disclosure about Segments of an Enterprise and Related Information.”
Our middleware and integrated technologies business includes our middleware products and the related technologies that are customarily integrated as extensions of that middleware. Our applications business includes our PlayJam, advanced advertising and NASCAR products and related technologies. Our BettingCorp business includes our fixed-odds and other wagering gaming applications, the development and operation of our “Ultimate One” platform and the marketing of our evolving Participation TV product that is based on the Ultimate One technology.
Our management reviews and assesses the “contribution margin” of each of these segments, which is not a financial measure calculated in accordance with GAAP. We define “contribution margin,” for these purposes as segment revenues less related, direct or indirect, allocable costs, including headcount and headcount-related overhead costs, consulting and subcontractor costs, travel, marketing and network infrastructure and bandwidth costs. There are significant judgments management makes with respect to the direct and indirect allocation of costs that may affect the calculation of contribution margins. While management believes these and other related judgments are reasonable and appropriate, other persons could assess such matters in ways different than company’s management. Contribution margin is a non-GAAP financial measure which excludes unallocated corporate overhead, interest, taxes, depreciation and amortization, amortization of intangible assets, share-based compensation, impairment of goodwill, impairment of intangibles, other income, minority interest, restructuring provisions, and unusual items such as contract amendments that mitigated potential loss positions. These exclusions, including unallocated corporate overhead costs, income tax and interest result in a definition of “contribution margin” that does not take into account the substantial cost of doing business. Management believes that segment contribution margin is a helpful measure in evaluating operational performance for our company. Unallocated corporate overhead costs include headcount and headcount-related overhead costs, consulting and subcontractor costs, travel, legal and audit costs not considered directly allocable to individual business segments. While we may consider “contribution margin” to be an important measure of comparative operating performance, this measure should be considered in addition to, but not as a substitute for, loss from operations, net loss, cash flow and other measures of financial performance prepared in accordance with accounting principles generally accepted in the United States that are otherwise presented in our financial statements. In addition, our calculation of “contribution margin” may be different from the calculation used by other companies and, therefore, comparability may be affected.
Because these segments reflect the manner in which management reviews our business, they necessarily involve judgments that management believes are reasonable in light of the circumstances under which they are made. These judgments may change over time or may be modified to reflect new facts or circumstances.
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Segments may also be changed or modified to reflect technologies and applications that are newly created, or that change over time, or other business conditions that evolve, each of which may result in reassessing specific segments and the elements included within each of those segments.
Summarized information by segment was as follows (in millions):
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Our revenues by geographic area based on the location of customers were as follows (in millions):
Four major customers accounted for the following percentages of revenues:
British Sky Broadcasting, or BSkyB, directly and indirectly accounted for 19%, 17% and 11% of total revenues for the years ended December 31, 2005, 2004 and 2003, respectively, taking into account the royalties which are paid by four manufacturers who sell set-top boxes to BSkyB and by customers transacting on our PlayJam service on BSkyB channels.
Two customers accounted for 18% and 11% of net accounts receivable as of December 31, 2005. One customer accounted for 36% of net accounts receivable as of December 31, 2004.
Additional summarized information by geographic area was as follows (in millions):
(*) Long-lived assets include property and equipment, and other assets.
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Note 16.
Subsequent Events
As of December 31, 2005, Sun Microsystems, Inc. beneficially owned 7,594,796 shares of Class B common stock of our subsidiary OpenTV, Inc., which is not publicly traded. In January 2006, Sun exercised its right to exchange those Class B shares in OpenTV, Inc. for the same number of Class B ordinary shares of OpenTV Corp. As a result of the exchange, as of February 28, 2006, Sun’s ownership of our Class B ordinary shares represented approximately 5.6% of the economic interest and 15.8% of the voting power of our ordinary shares, and Liberty Media Corporation’s beneficial ownership of our Class A and Class B ordinary shares represented approximately 28.9% of the economic interest and 65.4% of the voting power of our ordinary shares. Sun has the right, at any time, to convert its Class B ordinary shares into our Class A ordinary shares on a one-for-one basis; in the event that Sun determined to sell its interest in the public markets, we would expect Sun to convert its Class B ordinary shares into Class A ordinary shares, which are publicly traded.
On February 10, 2006, our Board of Directors (including each of our independent directors), in accordance with the laws of the British Virgin Islands, unanimously approved a proposal to amend and restate our memorandum of association. The amended and restated memorandum of association provides, among other things, for the following changes that affect our Class B ordinary shares. These changes have:
•
eliminated a restriction formerly contained in our memorandum of association that prohibited us from issuing additional Class B ordinary shares or options, rights or warrants to subscribe for additional Class B ordinary shares; and
•
deleted provisions formerly contained in our memorandum of association that required each Class B ordinary share to automatically convert into a Class A ordinary share under certain circumstances, including upon the transfer of any Class B ordinary shares to a person who was not a stockholder, or an affiliate of such stockholder, prior to the initial public offering of our Class A ordinary shares, and the procedures relating to that automatic conversion.
In connection with, and as a condition to, the adoption of our amended and restated memorandum of association, we entered into a letter agreement with Liberty Media. Under that agreement, Liberty Media agreed that if it (or any of its affiliates) sells or otherwise transfers any of our Class B ordinary shares to a third party and the aggregate sale proceeds received by Liberty Media in that transaction exceed, on a per share basis, the trading price of our Class A ordinary shares as determined in accordance with an agreed formula, then Liberty Media will contribute to us, generally in the same form it receives as consideration for its shares, a proportionate percentage of that aggregate premium, reflecting Liberty Media’s relative economic (not voting) ownership in our company. As a result of that commitment, Liberty Media will retain only that portion of any premium that is equal to its relative equity ownership, based on the number of outstanding Class A and Class B ordinary shares at the time of any such sale.
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Note 17.
Quarterly Consolidated Financial Data (Unaudited)
The following table presents our operating results for each of the eight quarters in the period ended December 31, 2005. The information for each of these quarters is unaudited, has been prepared on a basis generally consistent with our audited consolidated financial statements, except for the absence of notes thereto or as otherwise described in our consolidated financial statements. In the opinion of management, all necessary adjustments (consisting only of normal recurring and other adjustments) have been included to present fairly the unaudited consolidated quarterly results. These operating results are not necessarily indicative of the results of any future period. The quarterly information was as follows (in thousands, except for share and per share amounts):
The quarter ended December 31, 2005 included a gain of $3.1 million from the sale of a cost investment (see Note 4). The quarter ended June 30, 2004 included a credit of $4.6 million for the NASCAR amendment (see Note 8).
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SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS