Summary of SONIC SOLUTIONS/CA/

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of the Company's financial condition and results of operations should be read in conjunction with its Consolidated Financial Statements and the related notes included elsewhere in this Annual Report. In addition to historical consolidated financial information, the following discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions as described under the "Forward-Looking Statements" section that appears earlier in this Annual Report. The Company's actual results could differ materially from those anticipated by these forward-looking statements as a result of many factors, including those discussed under "Item 1A: Risk Factors" and elsewhere in this Annual Report.

Overview

The Company is a leading developer of products and services that enable the creation, management, and enjoyment of digital media content across a wide variety of technology platforms. The Company's products and services offer innovative technologies to consumers, original equipment manufacturers ("OEMs"), enterprises, high-end professional DVD authoring experts and developers. The Company distributes its products and services through retailers and distributors, personal computer ("PC") and consumer electronics ("CE") OEMs, Internet websites including www.roxio.com, and other channels. The Company also licenses core technology and intellectual property to other software companies and technology manufacturers for integration into their own products and services. Sonic software is intended for use with Microsoft Windows and Apple Mac operating systems, as well as some Linux environments and proprietary platforms.

Sonic products and services are used to accomplish a wide variety of tasks, including creating and distributing digital audio and video content in a variety of formats; renting, purchasing and enjoying Hollywood movies and other premium content; producing digital media photo and video shows for sharing online and via television, PCs and CE devices; recording and playback of digital content on DVD, BD, other storage media and portable devices; managing digital media on PCs and CE devices; and backing up and preserving digital information, both to local storage devices and on the Internet.

The Company differentiates between digital media content that is created by consumers (sometimes referred to herein as "personal" content) and digital content that is professionally created for mass consumption (sometimes referred to herein as "premium" content). Accordingly, the Company now organizes its business into two reportable operating segments targeted at these different forms of content: the "Roxio Consumer" segment, which offers products and services related to personal content, and the "Premium Content" segment, which offers products and services related to premium content. These segments reflect the Company's internal organizational structure, as well as the processes by which management makes operating decisions, allocates resources and assesses performance.

Roxio Consumer Segment

The Company's Roxio Consumer segment creates software and services that enable consumers to easily create, manage, and share personal digital media content on and across a broad range of connected devices. A wide array of leading technology companies and developers rely on Roxio products, services and technologies to bring innovative digital media functionality to PCs and next-generation CE devices and platforms. Roxio offers products and services under a variety of names, including BackonTrack, Backup MyPC, CinePlayer, Crunch, Easy VHS to DVD, Just!Burn, MyDVD, MyTV To Go, PhotoShow, PhotoSuite, Popcorn, RecordNow, Roxio Copy & Convert, Roxio Creator, Toast, VideoWave, WinOnCD, and others. Most Roxio products are sold in a number of different versions and languages. The Company distributes Roxio products through various channels, including "bundling" arrangements with OEMs, volume licensing programs, its web store, and third party web-based and "bricks and mortar" retail stores. The Company also markets the same "under the hood" technology that powers Roxio products to other companies who wish to build their own PC software products.

Premium Content Segment

The Company's Premium Content segment offers a range of products and services related to the creation, distribution and enjoyment of premium content. Within this segment, the Professional Products Group reporting unit offers software under the Scenarist, CineVision, and DVDit product names and Sonic and Roxio Professional brands to major motion picture studios, high-end authoring houses and other professional customers. CinemaNow, also part of this segment, sells, rents and distributes premium entertainment content to consumers over the Internet. The Company also develops software components that it licenses to CE companies to enable their devices to offer premium content to consumers, licenses intellectual property through its Qflix initiative, and licenses patents.

Recent Trends & Events

Due to the proliferation of computer technology, broadband Internet connectivity and personal electronic devices of all kinds, digital media content is now everywhere. Sonic's products and services enable people to create, manage, enjoy and distribute premium and personal digital content, allowing them to organize and share their digital lives and memories in new and innovative ways. The Company's strategy is to utilize its technology, expertise and competitive positioning to deliver exciting products and services to enhance the value of digital media in people's lives, capitalizing on evolving trends in the technology industry, including:

· Optical Disc Playback Evolution - Optical disc technologies have enjoyed tremendous growth and extremely widespread consumer adoption. For example, DVD playback units (including set-top players, game consoles and PCs) have been one of the fastest growing consumer technologies in history, and multiple DVD players are now present in most households. Similarly, sales of BD units and players grew during 2008 at a rate comparable to that of standard definition DVD at the equivalent time period in its life cycle, implying that BD is positioned to grow dramatically over the next several years.

· Growth of Digital Distribution of Premium Content - Content owners, such as Hollywood studios, are increasingly offering sell-through and rental of premium content through digital distribution. Simultaneously, a growing number of consumers are enjoying and taking advantage of the benefits of digital distribution of premium content. As more Internet-enabled electronic devices offer delivery of premium content, the rate of adoption and number of title offerings should continue to scale.

· Digital Phone, Portable and Gaming Devices - The consumer adoption rate of mobile phones, gaming consoles and portable CE devices, particularly those with high-end digital media capabilities, continues to increase worldwide. The growing popularity of portable devices leads to greater demand for software products and services, such as those offered by Sonic, that provide digital media management and functionality.

· Growth of Online Social Networks - Online social networks, such as Facebook and MySpace, increasingly feature personal digital photo, video and audio content, and these networks function as distribution platforms for sharing and enjoying digital media content. The rising popularity of these networks and their platforms creates an increased demand for products and services that can capture, create, edit and manage digital media.

During fiscal 2009, the Company acquired the assets of Simple Star, Inc., a software products and online service provider based in San Francisco, California. Simple Star is the developer of PhotoShow, a comprehensive multimedia story telling platform and online community that enables consumers to quickly and easily turn personal photos and video clips into entertaining shows that can be enjoyed and shared on PCs, TVs, and handheld devices, or published to popular social media sites. PhotoShow is broadly distributed through a network of major partners, including online photo providers, photofinishing service providers, cable operators and others. One of the major initiatives underway at Roxio has been to embrace web services as an important part of its consumer business.

During fiscal 2009, the Company acquired the assets of CinemaNow, Inc., a privately held online entertainment provider based in Marina Del Rey, California. CinemaNow is at the forefront of digital video distribution, offering a wide selection of high-quality Hollywood movies, TV shows and music videos to users across multiple platforms. The company has relationships with numerous content providers, including all major Hollywood studios, and supplies premium entertainment services to a host of PC and CE device manufacturers. The addition of the CinemaNow assets helps expand Sonic's products and services across the entire premium entertainment supply chain, from creation to distribution to consumption. The Company plans to increase the number of premium content titles available for rental and sell-through, increase the number of titles that are enabled for Qflix burning, and continue to expand the number of CinemaNow relationships it has with PC and CE OEMs and retail partners.

During fiscal 2009, the Company initiated restructuring plans to reorganize operations, optimize its engineering and development efforts, reduce workforce, consolidate divisions into a single reporting segment, unify its OEM licensing efforts, and eliminate organizational redundancies. For more information see Note 8, "Restructuring," to the Consolidated Financial Statements included in this Annual Report.

Strategic Objectives

Enable Consumers to Buy and Play Premium Content Anywhere and at Anytime. The Company believes that digital distribution of premium content will grow dramatically over the next few years, and that ultimately industry revenue from the digital distribution of premium content may surpass revenue from the sale and rental of premium content on optical media such as DVD and BD. As the digital content ecosystem continues to expand and evolve, the Company aims to makes its products and services available through an increasing range of platforms, devices and partners, with the goal that Sonic technology will represent a symbol of compatibility and a common point of interaction for consumers who want to enjoy Hollywood movies and other premium digital content anywhere and at anytime.

Develop and strengthen Roxio-branded products and services. The Company seeks to build on the brand strength of its Roxio products and services by strengthening its relationships with OEMs and retail partners, while deepening its relationship with consumers by adding new products and services. The Company plans to continue to enhance its Web-based offerings, add innovative solutions to its consumer product portfolio and extend the reach of the Roxio brand to a new audience of online users.

Improve Operational Efficiencies and Cash Flow Performance. Management's goal for fiscal 2010 is to achieve operational efficiencies and improve cash flow through revenue growth and cost management. In fiscal 2009, the Company engaged in restructuring activities designed to achieve its efficiency goals, and will continue to focus on aligning its cost structure and business initiatives.

Outlook

While the current global economic downturn has resulted in a decline in overall consumer and corporate spending, impacting the Company's business and financial results in fiscal 2009, the Company believes it is well positioned to capitalize on its strong brand, consumer market position, OEM relationships and evolving premium content business models and opportunities. The Company made significant strategic and financial progress during fiscal 2009 to bring costs in line with revenues while positioning the Company for revenue growth and margin improvement.

Critical Accounting Policies and Estimates

The Company prepares its Consolidated Financial Statements in conformity with U.S. generally accepted accounting principles ("GAAP"). In preparing its Consolidated Financial Statements, the Company makes estimates, judgments, and assumptions that can significantly affect the amounts reported in its consolidated financial statements. The Company bases its estimates on historical experience and various other assumptions that it believes to be reasonable under the circumstances. Actual results could differ from these estimates. The Company regularly evaluates its estimates, judgments, and assumptions and makes changes accordingly. The Company believes the following accounting policies and estimates are the most critical and significant to understanding and evaluating its financial condition and results of operations.

Use of estimates

On an ongoing basis, the Company evaluates estimates used, including those related to the valuation of goodwill and other intangible assets, valuation of stock options, valuation of investment instruments, useful lives of intangible assets and equipment and leasehold improvements, inventory valuation allowances, revenue recognition, the estimated allowances for sales returns and doubtful accounts and income tax accruals. The following accounting policies require management to make estimates, judgments and assumptions and are critical in fully understanding and evaluating the Company's reported financial results:

· Revenue recognition

· Allowances for product returns and doubtful accounts

· Goodwill, intangible assets and other long-lived assets

· Share-based compensation

· Income tax and deferred tax asset valuation

· Valuation of acquired businesses, assets and liabilities

· Accrued liabilities

· Contingencies

Revenue Recognition

The Company derives its revenue primarily from licenses of its software products, software development agreements and maintenance and support. The Company also sells and licenses patents and patented technology. The Company recognizes software-related revenue in accordance with American Institute of Certified Accountants ("AICPA") Statement of Position ("SOP") 97-2, Software Revenue Recognition ("SOP No. 97-2") as amended by SOP No. 98-9, Software Revenue Recognition With Respect to Certain Transactions ("SOP No. 98-9"), and Staff Accounting Bulletin ("SAB") 104, Revenue Recognition in Financial Statements ("SAB No. 104"). The Company recognizes revenue when the following criteria have been met:

· Persuasive evidence of an arrangement exists,

· Delivery has occurred or services have been rendered,

· The arrangement fees are fixed or determinable, and

· Collection is considered probable.

If the Company determines that any of the above criteria has not been met, the Company will defer recognition of the revenue until all the criteria have been met.

The Company generally considers arrangements with payment terms longer than six months from the time of delivery not to be fixed or determinable, and recognizes the related revenue as payments become due from the customer, provided all other revenue recognition criteria have been met. If the Company determines that collection of a fee is not probable, it will defer the fees and recognize revenue upon cash receipt, provided all other revenue recognition criteria have been met.

The Company follows Emerging Issues Task Force ("EITF") 99-19, Reporting Revenue Gross as Principal versus Net as an Agent ("EITF No. 99-19"). Generally, the Company records revenue at gross and records costs related to a sale in cost of revenue. In those cases where the Company is not the primary obligor or merchant of record and/or does not bear credit risk, or where it earns a fixed transactional fee, the Company records revenue under the net method. When the Company records revenues at net, revenue is reported at the net amount received and retained by the Company.

Multiple Element Arrangements - In arrangements that include multiple elements (e.g., software, specified upgrades, support services, installation services, and/or training), the Company allocates the total revenue to be earned under the arrangement to the elements based on their relative fair value, as determined by vendor-specific objective evidence of fair value ("VSOE"). VSOE is generally the price charged when that element is sold separately or, in the case of support services, annual renewal rates.

In arrangements where VSOE exists only for the undelivered elements, the Company uses the "residual method" under SOP No. 98-9, under which it defers the full fair value of the undelivered elements and recognizes the difference between the total arrangement fee and the amount deferred for undelivered items as revenue. If VSOE does not exist for all elements but the only undelivered element is maintenance and support, the Company recognizes revenue from the arrangement ratably over the maintenance and support period. If VSOE does not exist for undelivered elements that are specified products or upgrades, the Company defers revenue until the earlier of the delivery of all elements or the point at which it determines VSOE for these undelivered elements.

Product Sales - Except in the case of consignment arrangements, the Company recognizes revenue from the sale of its packaged software products when title transfers to the distributor or retailer. When the Company sells packaged software products to distributors and retailers on a consignment basis, it recognizes revenue upon sell through to an end customer.

The Company's distributor arrangements often provide distributors with certain product rotation rights. In such situations, the Company recognizes product sales in accordance with SFAS No. 48, Revenue Recognition When Right of Return Exists ("SFAS No. 48"). The Company estimates returns based on its historical return experience and other factors such as channel inventory levels and the introduction of new products. These allowances are recorded as a reduction of revenues and as an offset to accounts receivable to the extent the Company has legal right of offset, otherwise they are recorded in accrued expenses and other current liabilities. If future returns patterns differ from past returns patterns, for example due to reduced demand for the Company's product, it may be required to increase these allowances in the future and may be required to reduce future revenues.

In accordance with EITF No. 01-09, Accounting for Consideration Given by a Vendor to a Customer or a Reseller of the Vendor's Product ("EITF No. 01-09"), the Company accounts for cash consideration (such as sales incentives) that it gives to its customers or resellers as a reduction of revenue rather than as an operating expense unless the Company receives a benefit that is separate from the customer's purchase from the Company and for which it can reasonably estimate the fair value.

Software License Arrangements - Provided all other revenue recognition criteria have been met, the Company recognizes revenue from software licensing arrangements upon delivery, or, in the case of per-unit royalty arrangements, upon sell through to an end user as evidenced by the receipt of a customer royalty report.

Software Development Arrangements - For arrangements that include development or other services that are essential to the functionality of the licensed software, the Company recognizes revenue in accordance with SOP No. 81-1, Accounting for Performance of Construction Type and Certain Production Type Contracts ("SOP No. 81-1"), using the percentage-of-completion method. Under the percentage-of-completion method, management estimates the number of hours needed to complete a particular project, and revenues are recognized as the contract progresses to completion. Changes in estimates are recognized in the period in which they are known.

In certain instances, a development agreement may include additional undelivered elements, such as maintenance and support, or a specified upgrade or other deliverable, and VSOE of fair value may not exist for the undelivered elements, or the Company may not have sufficient experience with either the type of project or the customer involved to be able to make reliable estimates towards completion. If the Company cannot reliably estimate total profitability under the agreement but is reasonably assured that no loss will be realized on the agreement, the Company recognizes revenue using the zero gross margin method. Under the zero gross margin method, revenue recognized under the contract equals costs incurred under the contract and any profit is deferred until development is complete. The Company recognizes the deferred gross profit over the remaining contractual service period (for example, the initial maintenance period).

In addition, the Company receives prepayments of certain usage-based services and offers certain products and services on a subscription basis. Subscription revenue is recognized ratably over the related subscription period. Prepaid revenue is deferred and recognized over the usage period.

Allowance for Product Returns and Doubtful Accounts

The Company's distributors and retail arrangements provide for certain product rotation rights and permit certain product returns. The Company estimates reserves for these rights of return based on historical return rates, timing of new product releases, and channel inventory levels.

The Company maintains an allowance for doubtful accounts to reserve for potentially uncollectible accounts based on past collection history and specific risks identified in its portfolio of receivables. If the financial condition of the Company's distributors or other customers deteriorates, resulting in an impairment of their ability to make payments, or if payments from distributors or other customers are significantly delayed, additional allowances may be required.

Impairment of Goodwill, Intangible Assets and Long-Lived Assets

The Company accounts for goodwill and other intangible assets in accordance with SFAS No. 142, Goodwill and Other Intangible Assets ("SFAS No. 142"). SFAS No. 142 classifies intangible assets into three categories: (1) intangible assets with definite lives subject to amortization; (2) intangible assets with indefinite lives not subject to amortization; and (3) goodwill. For goodwill and identifiable intangible assets with indefinite useful lives the Company tests for impairment at least annually, in the Company's fourth fiscal quarter, or more frequently if events and circumstances warrant.

The Company evaluates goodwill and indefinite life intangible assets for impairment by comparing the fair value of each of its reporting units to its carrying value including the goodwill allocated to that reporting unit. A reporting unit is an operating segment or one level below an operating segment. To determine the reporting unit's fair value, the Company uses the income approach under which it evaluates estimated discounted future cash flows of that unit. The Company bases its cash flow assumptions on historical and forecasted revenue and operating costs.

In accordance with SFAS No.144, Accounting for the Impairment or Disposal of Long-Lived Assets ("SFAS No. 144"), long-lived assets are reviewed for impairment at least annually or whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. The Company evaluates long-lived assets, including intangible assets with finite useful lives, for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. The determination of recoverability of long-lived assets and intangible assets with finite lives is based on an estimate of the undiscounted future cash flows resulting from the use of that asset and its eventual disposition.

Share-Based Compensation

In accordance with SFAS No. 123(R), Share-Based Payment ("SFAS No. 123(R)"), the Company measures compensation cost for share-based award at fair value and recognizes compensation over the requisite service period for awards expected to vest. Estimating the portion of share-based award that will ultimately vest requires judgment, and to the extent actual results or updated estimates differ from the Company's current estimates, such amounts are recorded in the period estimates are revised. The Company considers several factors when estimating expected forfeitures, including types of awards, employee class, and historical experience. The Company also considers several factors when estimating expected volatility and expected life of the option.

Income Taxes

The Company accounts for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes ("SFAS No. 109"). The provision for income taxes is calculated using the liability method of accounting. Under the liability method, deferred tax assets and liabilities are recognized based on the future tax consequences attributable to differences between the financial statement carrying amount of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using the tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. In assessing net deferred tax assets, management considers whether it is more likely than not that some or all of the deferred tax assets will not be realized. When the Company does not believe realization of a deferred tax asset is likely, it records a valuation allowance. The valuation allowance is evaluated at the end of each year, considering positive and negative evidence about whether the deferred tax assets will be realized.

The Company is subject to income taxes in the U.S. and certain foreign jurisdictions. Significant judgment is required in evaluating the Company's uncertain tax positions and determining its provision for income taxes. Effective April 1, 2007, the Company adopted Financial Accounting Standards Board ("FASB") Financial Interpretation Number ("FIN") 48, Accounting for Income Tax Uncertainties ("FIN No. 48"), an interpretation of SFAS No. 109, Accounting for Income Taxes ("SFAS No. 109"). FIN No. 48 contains a two-step approach to recognize and measure uncertain tax positions accounted for in accordance with SFAS No. 109. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount that is more than fifty percent likely of being realized upon settlement.

The Company adjusts these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the refinement of an estimate. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the provision for income taxes in the period in which such determination is made. The provision for income taxes includes the impact of reserve provisions as well as related interest and penalties.

Recent Accounting Pronouncements

The following represents a summary of recent authoritative pronouncements that could impact or have impacted the Company's accounting, reporting, and/or disclosure of financial information.

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