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RNWK > SEC Filings for RNWK > Form 10-Q on 8-Nov-2012All Recent SEC Filings

Show all filings for REALNETWORKS INC

Form 10-Q for REALNETWORKS INC


8-Nov-2012

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q and the documents incorporated herein by reference contain forward-looking statements that have been made pursuant to the provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on current expectations, estimates, and projections about RealNetworks' industry, products, management's beliefs, and certain assumptions made by management. Words such as "anticipates," "expects," "intends," "plans," "believes," "seeks," "estimates," and similar expressions are intended to identify forward-looking statements. All statements contained in this report that do not relate to matters of historical fact should be considered forward-looking statements. Forward-looking statements include statements with respect to:
future revenues, operating expenses, income and other taxes, tax benefits, net income (loss) per diluted share available to common shareholders, acquisition costs and related amortization, and other measures of results of operations;

the effects of our past acquisitions and expectations for future acquisitions and divestitures;

the effect on our businesses of the sale of certain patent assets and next generation codec assets to Intel Corporation;

plans, strategies and expected opportunities for future growth, increased profitability and innovation;

the prospects for creation and growth of strategic partnerships and the resulting financial benefits from such partnerships;

the expected financial position, performance, growth and profitability of, and investment in, our businesses and the availability of resources;

our involvement in potential claims, legal proceedings and government investigations, the expected course and costs of existing claims, legal proceedings and government investigations, and the potential outcomes and effects of both existing and potential claims, legal proceedings and governmental investigations on our business, prospects, financial condition or results of operations;

the expected benefits and other consequences from the 2010 restructuring of Rhapsody and from our other strategic initiatives;

our expected introduction of new and enhanced products, services and technologies across our businesses;

the effects of legislation, regulations, administrative proceedings, court rulings, settlement negotiations and other factors that may impact our businesses;

the continuation and expected nature of certain customer relationships;

impacts of competition and certain customer relationships on the future financial performance and growth of our businesses;

the effects of U.S. and foreign income and other taxes on our business, prospects, financial condition or results of operations; and

the effect of economic and market conditions on our business, prospects, financial condition or results of operations.

These statements are not guarantees of future performance and actual actions or results may differ materially. These statements are subject to certain risks, uncertainties and assumptions that are difficult to predict, including those noted in the documents incorporated herein by reference. Particular attention should also be paid to the cautionary language in Item 1A of Part II entitled "Risk Factors." RealNetworks undertakes no obligation to update publicly any forward-looking statements as a result of new information, future events or otherwise, unless required by law. Readers should, however, carefully review the risk factors included in other reports or documents filed by RealNetworks from time to time with the Securities and Exchange Commission, particularly the Quarterly Reports on Form 10-Q and any Current Reports on Form 8-K. Overview
We manage our business and report revenue and profit (loss) in three segments:
(1) Core Products, (2) Emerging Products and (3) Games. Within Core Products, our revenue is derived primarily from the sale of our software as a service (SaaS) offerings, and within Emerging Products, our revenue is derived primarily from the sale of our RealPlayer media player software and from the associated distribution of third-party products. We report common corporate overhead expenses, including finance, legal, headquarters facilities and stock compensation costs, in the aggregate as Corporate results. Our most


significant expenses relate to cost of revenue, compensating employees, and selling and marketing our products and services.
In the quarter and nine months ended September 30, 2012, our consolidated revenue declined by $25.3 million and $63.9 million, respectively, compared with the comparable periods in 2011. The declines in both the quarter and nine-month periods were principally the result of declines in revenue in both our Core Products and Games segments.

Our SaaS business within Core Products continues to experience competitive pricing pressure from carriers and the proliferation of smartphone applications and services, some of which do not depend on our carrier customers for distribution to consumers. In addition, we are still experiencing pricing pressure from carriers for our intercarrier messaging services, which prevents this revenue from rising in spite of increased usage of our services. In our Games segment, consumer's game play continues to shift from downloadable PCs games and online game subscriptions, where we currently generate 85% of overall Games revenues, to social networks and mobile devices. Since 2011, we have been focusing on developing social games and monetizing social game play experiences. However, the revenue we currently generate from social games is not a significant portion of our Games revenue. Our Emerging Products segment is experiencing declines in revenue as a result of market saturation related to third-party software products we distribute.

We continue to focus on aligning our operating expenses with our revenue profile, and in the third quarter of 2012 we announced we would be eliminating approximately 160 positions worldwide, with the reductions expected to be completed by the end of the first quarter of 2013. In the third quarter of 2012 we also assigned two of our existing domestic carrier service contracts for ringback tone, ring tone, and music on demand services to a third party. These actions resulted in the recording of restructuring charges totaling $10.7 million in the third quarter of 2012. Of the total 160 positions being eliminated, approximately one-third of the impacted individual employees could be reassigned to another position within the Company. Because of this uncertainty, no severance expense was recorded for this group as of September 30, 2012, however, to the extent that we are unable to reassign any of these individuals, we expect to record additional severance charges.
In the second quarter of 2012 we completed the sale of certain patents, patent applications and related rights and assets relating to our Next Generation Video codec technologies pursuant to the Asset Purchase Agreement with Intel Corporation dated January 26, 2012. We received gross cash consideration of $120.0 million from the sale, and reported the sales proceeds, net of related direct costs, as a gain on the statement of operations. This gain accounts for the material improvement in our operating income (loss) and net income (loss) for nine months ended September 30, 2012, compared with the 2011 prior year period.
Condensed consolidated results of operations were as follows (dollars in thousands):

                             Quarters Ended September 30,                         Nine Months Ended September 30,
                     2012          2011       $ Change     % Change       2012          2011        $ Change      % Change
Total revenue     $  59,088     $ 84,414     $ (25,326 )      (30 )%   $ 191,578     $ 255,467     $ (63,889 )      (25 )%
Cost of revenue      25,244       31,816        (6,572 )      (21 )%      78,633        94,548       (15,915 )      (17 )%
Gross profit         33,844       52,598       (18,754 )      (36 )%     112,945       160,919       (47,974 )      (30 )%
Gross margin             57 %         62 %                                    59 %          63 %
Sale of patent
assets and other
technology
assets, net of
costs                     -            -             -          -  %     116,353             -       116,353        100  %
Operating
expenses             57,019       56,081           938          2  %     166,847       174,852        (8,005 )       (5 )%
Operating income
(loss)            $ (23,175 )   $ (3,483 )   $ (19,692 )     (565 )%   $  62,451     $ (13,933 )   $  76,384        548  %

In the third quarter of 2012, our total consolidated revenue declined by $25.3 million, compared with the year-earlier period. The reduction in revenue resulted from a decline of $16.6 million in our Core Products segment and a decline of $8.1 million in our Games segment, due to the factors described above. Gross margin declined to 57% from 62% for the year earlier quarter as a result of a decrease of $4.2 million in royalty expense in the prior year, due to a change in estimates in our accrued royalties.
Operating expenses increased by $0.9 million in the quarter ended September 30, 2012, compared with the prior year primarily due to increased restructuring costs of $10.3 million. This increase was partially offset by reduced personnel and related costs of $7.3 million, and reduced marketing expenses of $1.7 million, due in turn to our ongoing work to align our operating expenses with our revenue profile.
For the nine months ended September 30, 2012, our total consolidated revenue declined by $63.9 million, compared with


the year-earlier period. The reduction in revenue resulted from a decline of $34.5 million in our Core Products segment, a decline of $25.0 million in our Games segment, and a decline of $4.4 million in our Emerging Products segment, due to the factors described above. Gross margin declined to 59% from 63% compared with the year-earlier period as a result of a decrease of $5.5 million in royalty expense in the prior year, due to a change in estimates in our accrued royalties.
Operating expenses improved by $8.0 million for the nine months ended September 30, 2012, compared with the prior year period due primarily to reduced personnel and related costs of $16.1 million, and reduced marketing expenses of $5.0 million, due in turn to our ongoing work to align our operating expenses with our revenue profile. These declines were partially offset by an increase in restructuring costs totaling $6.0 million, and expenses we recorded of $1.3 million in the nine months ended September 30 2012, associated with the investigation by the Washington State Attorney General's Office, which was resolved through a consent decree entered into in the quarter ended June 30, 2012. In addition, operating expenses in the nine months ended September 30, 2011 were favorably impacted by a benefit of $6.4 million related to an insurance reimbursement for previously settled litigation that reduced expenses during the quarter ended March 31, 2011.
The gain from the sale of patents and other technology assets to Intel Corporation of $117.9 million in the second quarter of 2012 reflects the cash proceeds of $120.0 million less $2.1 million of direct expenses incurred in that quarter. We incurred $1.6 million of direct expenses in the first quarter of 2012, resulting in a net gain of $116.4 million for the nine months ended September 30, 2012.
See "Segment Operating Results" below for more information and discussion regarding changes in the operating results for each of our reporting segments. Segment Operating Results
Core Products
The Core Products segment primarily generates revenue and incurs costs from the sales of SaaS services, such as ringback tones, inter-carrier messages, music on demand and video on demand; professional services and system integration services to carriers and mobile handset companies; sales of licenses of our software products such as Helix for handsets; and consumer subscriptions such as SuperPass and international radio subscriptions.
Core Products segment results of operations were as follows (dollars in thousands):

                             Quarters Ended September 30,                          Nine Months Ended September 30,
                     2012         2011       $ Change      % Change        2012          2011        $ Change      % Change
Revenue           $ 34,078     $ 50,705     $ (16,627 )      (33 )%     $ 110,025     $ 144,547     $ (34,522 )      (24 )%
Cost of revenue     17,323       22,492        (5,169 )      (23 )%        52,832        62,829        (9,997 )      (16 )%
Gross profit        16,755       28,213       (11,458 )      (41 )%        57,193        81,718       (24,525 )      (30 )%
Gross margin            49 %         56 %                                      52 %          57 %
Operating
expenses            15,575       19,398        (3,823 )      (20 )%        50,072        57,958        (7,886 )      (14 )%
Operating income
(loss)            $  1,180     $  8,815     $  (7,635 )      (87 )%     $   7,121     $  23,760     $ (16,639 )      (70 )%

Total Core Products revenue decreased by $16.6 million in the quarter ended September 30, 2012, compared with the year-earlier period, primarily due to reduced revenue from our SaaS offerings of $9.7 million. The decline in SaaS revenue was due primarily to a $7.4 million decline in our ringback tone, music on demand and intercarrier messaging revenues due to both fewer subscribers and lower contract prices. Revenue from systems integration declined $3.6 million, and revenues on our SuperPass product decreased $2.4 million due to a decline in subscribers.
Total Core Products revenue decreased by $34.5 million for the nine months ended September 30, 2012, compared with the year-earlier period, primarily due to reduced revenue from our SaaS offerings of $23.7 million. The decline in SaaS revenue was due primarily to a $19.6 million decline in our ringback tone, intercarrier messaging and video on demand revenues due to both fewer subscribers and lower contract prices. Revenue from our SuperPass product decreased $5.0 million due to a decline in subscribers, and revenue from systems integration declined $4.3 million.
Cost of revenue decreased during the quarter and the nine months ended September 30, 2012 by $5.2 million and $10.0 million, respectively, compared with the year-earlier periods. During the quarter and nine months ended, costs related to our SaaS offerings decreased by $2.9 million and $6.8 million, respectively. In addition, costs related to systems integration sales decreased during the quarter and nine months ended by $2.5 million and $3.2 million, respectively. Partially offsetting these decreases was an increase in costs compared to the prior year periods due to a reduction in royalty expense from a change in


estimates of our accrued royalties related to our SuperPass product during the quarter and nine months ended September 30, 2011, of $1.3 million and $1.9 million, respectively.
Operating expenses declined by $3.8 million and $7.9 million for the quarter and nine months ended September 30, 2012, respectively, compared with the year-earlier periods, primarily due to reductions in personnel and related costs that resulted from our ongoing work to align our operating expenses with our revenue profile.
Emerging Products
The Emerging Products segment primarily generates revenue and incurs costs from sales of RealPlayer and its related products, such as the distribution of third-party software products, advertising on RealPlayer websites, and sales of RealPlayerPlus software licenses to consumers. Also included within the Emerging Products segment is the cost to build and develop new product offerings for consumers and business customers.
Emerging Products segment results of operations were as follows (dollars in thousands):

                             Quarters Ended September 30,                       Nine Months Ended September 30,
                     2012         2011       $ Change     % Change        2012         2011       $ Change     % Change
Revenue           $ 10,134     $ 10,764     $   (630 )       (6 )%     $ 30,206     $ 34,616     $ (4,410 )      (13 )%
Cost of revenue      2,041        3,913       (1,872 )      (48 )%        5,946        8,431       (2,485 )      (29 )%
Gross profit         8,093        6,851        1,242         18  %       24,260       26,185       (1,925 )       (7 )%
Gross margin            80 %         64 %                                    80 %         76 %
Operating
expenses             8,245        8,884         (639 )       (7 )%       22,883       28,144       (5,261 )      (19 )%
Operating income
(loss)            $   (152 )   $ (2,033 )   $  1,881         93  %     $  1,377     $ (1,959 )   $  3,336        170  %

Total Emerging Products revenue decreased by $0.6 million and $4.4 million in the quarter and nine months ended September 30, 2012, respectively, compared with the year-earlier periods. These decreases were primarily due to lower revenue from advertising during the quarter and nine months ended, of $0.6 million and $2.0 million, respectively. In addition, revenue related to the distribution of third-party software declined during the nine months ended September 30, 2012 by $2.7 million, due to fewer units distributed. Cost of revenue decreased by $1.9 million and $2.5 million for the quarter and nine months ended September 30, 2012, respectively, primarily due to the cost impacts of certain advertising agreements that occurred in 2011.
Operating expenses decreased by $0.6 million and $5.3 million for the quarter and nine months ended September 30, 2012, respectively, compared with the year-earlier periods. The decreases were due in part to reductions in personnel and related costs that resulted from our ongoing work to align our operating expenses with our revenue profile, during the quarter and nine months ended, of $1.8 million and $6.6 million, respectively. Partially offsetting these decreases was increased marketing spend to drive the distribution of RealPlayer, during the quarter and nine months ended, of $1.3 million and $1.6 million, respectively.
Games
The Games segment primarily generates revenue and incurs costs from the creation, distribution and sales of games licenses, online games subscription services, advertising on game sites and social network sites, games syndication services, and microtransactions from online and social games, and sales of mobile games.
Games segment results of operations were as follows (dollars in thousands):

                            Quarters Ended September 30,                      Nine Months Ended September 30,
                     2012         2011       $ Change    % Change       2012         2011       $ Change     % Change
Revenue           $ 14,876     $ 22,945     $ (8,069 )      (35 )%   $ 51,347     $ 76,304     $ (24,957 )      (33 )%
Cost of revenue      4,936        7,197       (2,261 )      (31 )%     17,169       23,771        (6,602 )      (28 )%
Gross profit         9,940       15,748       (5,808 )      (37 )%     34,178       52,533       (18,355 )      (35 )%
Gross margin            67 %         69 %                                  67 %         69 %
Operating
expenses            11,648       14,159       (2,511 )      (18 )%     38,171       46,184        (8,013 )      (17 )%
Operating income
(loss)            $ (1,708 )   $  1,589     $ (3,297 )     (207 )%   $ (3,993 )   $  6,349     $ (10,342 )     (163 )%


Total Games revenue decreased by $8.1 million in the quarter ended September 30, 2012, compared with the year-earlier period. Lower revenue from license sales and our subscription products contributed $3.2 million and $2.9 million, respectively, to the decline during the period. The decrease in license revenue reflected a decrease in the number of games sold through our games syndication services of $0.9 million, as well as lower sales of mobile games of $1.3 million. Lower subscription revenue was a result of fewer subscribers compared with the year-earlier period.
Total Games revenue decreased by $25.0 million for the nine months ended September 30, 2012, compared with the year-earlier period. Lower revenue from license sales and our subscription products contributed $10.9 million and $8.4 million, respectively, to the decline during the period. The decrease in license revenue included a decrease in the number of games sold through our games syndication services of $4.4 million, as well as lower sales of mobile games of $3.6 million. Lower subscription revenue was a result of fewer subscribers compared with the year-earlier period.
Cost of revenue decreased by $2.3 million and $6.6 million in the quarter and nine months ended September 30, 2012, respectively, compared with the year-earlier periods. These decreases were primarily due to the decrease in partner royalties expense, which has a direct correlation with the decrease in Games revenue.
Operating expenses declined by $2.5 million and $8.0 million for the quarter and nine months ended September 30, 2012, respectively, compared with the year-earlier periods. The decreases were mainly due to reductions in marketing expenses of $2.1 million and $5.6 million, primarily related to our non-social games, in the quarter and nine months ended September 30, 2012, respectively. Corporate
Certain corporate-level activity is not allocated to our segments, including costs of: human resources, legal, finance, information technology, procurement activities, litigation, corporate headquarters, legal settlements and contingencies, stock compensation, restructuring costs and losses on excess office facilities.

Corporate segment results of operations were as follows (dollars in thousands):

                              Quarters Ended September 30,                         Nine Months Ended September 30,
                     2012          2011        $ Change      % Change        2012         2011        $ Change     % Change
Cost of revenue   $     944     $  (1,786 )   $   2,730        153  %     $  2,686     $    (483 )   $   3,169        656 %
Gain on sale of
patent assets and
other technology
assets, net of
costs                     -             -             -          -  %      116,353             -       116,353        100 %
Operating
expenses             21,551        13,640         7,911         58  %       55,721        42,566        13,155         31 %
Operating income
(loss)            $ (22,495 )   $ (11,854 )   $ (10,641 )      (90 )%     $ 57,946     $ (42,083 )   $ 100,029        238 %

Cost of revenue increased during the quarter and nine months ended September 30, 2012 by $2.7 million and $3.2 million, respectively, primarily due to a reduction in expense in the prior year periods from a change in estimates of our accrued royalties on our historical music business of approximately $2.8 million and $3.6 million during the quarter and nine months ended September 30, 2011, respectively.
The net gain from the sale of patents and other technology assets to Intel Corporation of $116.4 million in the nine months ended September 30, 2012 reflects the cash proceeds of $120.0 million in the second quarter, less $3.6 million of direct transaction expenses incurred during the first and second quarters.
Operating expenses increased by $7.9 million in the quarter ended September 30, 2012, compared with the year-earlier period. The increase compared with the prior period was primarily due to an increase in restructuring costs of $10.3 million. This increase was partially offset by reductions in personnel and related costs of $2.3 million, which resulted from our ongoing work to align our operating expenses with our revenue profile.
Operating expenses increased by $13.2 million for the nine months ended September 30, 2012, compared with the year-earlier period. The increase compared with the prior period was primarily due to increased restructuring costs and losses on excess office facilities totaling $6.4 million, and to the impact of a benefit in the first quarter of 2011 of $6.4 million related to an insurance reimbursement for previously settled litigation that reduced expense in the prior year. These increases were partially offset by reductions in personnel and related costs of $1.7 million in the nine months ended September 30, 2012, which resulted from our ongoing work to align our operating expenses with our revenue profile.
Consolidated Operating Expenses


Consolidated operating expenses consist primarily of salaries and related personnel costs including stock based compensation, consulting fees associated with product development, sales commissions, amortization of certain intangible assets capitalized in our acquisitions, professional service fees, advertising costs, restructuring and related charges, and losses on excess office facilities. Operating expenses were as follows (dollars in thousands):

                            Quarters Ended September 30,                       Nine Months Ended September 30,
                     2012         2011       $ Change    % Change       2012          2011        $ Change     % Change
Research and
development       $ 15,321     $ 16,496     $ (1,175 )       (7 )%   $  49,167     $  54,200     $ (5,033 )       (9 )%
Sales and
marketing           21,972       28,625       (6,653 )      (23 )%      68,462        85,958      (17,496 )      (20 )%
General and
administrative       8,759       10,522       (1,763 )      (17 )%      35,103        27,018        8,085         30  %
Restructuring and
other charges       10,724          438       10,286      2,348  %      13,872         7,850        6,022         77  %
Loss (gain) on
excess office
facilities             243            -          243        100  %         243          (174 )        417        240  %
Total
consolidated
operating
expenses          $ 57,019     $ 56,081     $    938          2  %   $ 166,847     $ 174,852     $ (8,005 )       (5 )%

Research and development expenses decreased by $1.2 million in the quarter ended September 30, 2012, compared with the year-earlier period. The decline was primarily due to a decrease in personnel and related costs of $1.1 million resulting from our ongoing work to align our operating expenses with our revenue profile.
Research and development expenses decreased by $5.0 million for the nine months ended September 30, 2012, compared with the year-earlier period. The decline was primarily due to a decrease in personnel and related costs of $4.1 million resulting from our ongoing work to align our operating expenses with our revenue profile.
Sales and marketing expenses decreased by $6.7 million in the quarter ended September 30, 2012, compared with the year-earlier period. The decline was primarily due to a decrease in personnel and related costs of $4.5 million resulting from our ongoing work to align our operating expenses with our revenue profile and to lower expenses for marketing and related activities of $1.7 million.
Sales and marketing expenses decreased by $17.5 million for the nine months ended September 30, 2012, compared with the year-earlier period. The decline was primarily due to a decrease in personnel and related costs of $11.3 million resulting from our ongoing work to align our operating expenses with our revenue . . .

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