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RNWK > SEC Filings for RNWK > Form 10-K on 18-Mar-2013All Recent SEC Filings

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Form 10-K for REALNETWORKS INC


18-Mar-2013

Annual Report


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

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; 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; and within our Games segment, revenue is derived primarily from subscriptions and license fees. 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 2012 our consolidated revenue declined by $76.8 million compared with 2011. We experienced declines in revenue in all three of our segments, with the largest declines occurring in 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. Our Emerging Products segment is experiencing declines in revenue as a result of market saturation related to third-party software products we distribute. In our Games segment and in the general games market, consumer's game play continues to shift from downloadable PC 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. 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 to Intel Corporation. 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 in the statement of operations. This gain accounts for the material improvement in our operating income (loss) and net income (loss) for 2012, compared with 2011. 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 second 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 contributed to the recording of restructuring charges totaling $15.2 million in 2012. Summary of Results
Consolidated results of operations were as follows (dollars in thousands):


                                                                2012-2011        %         2011-2010         %
                        2012          2011          2010         Change        Change        Change        Change
Total revenue        $ 258,842     $ 335,686     $ 401,733     $ (76,844 )       (23 )%   $ (66,047 )        (16 )%
Cost of revenue        103,731       126,637       144,723       (22,906 )       (18 )%     (18,086 )        (12 )%
Impairment of
deferred costs               -        19,962             -       (19,962 )      (100 )%      19,962          100  %
Gross profit           155,111       189,087       257,010       (33,976 )       (18 )%     (67,923 )        (26 )%
Gross margin                60 %          56 %          64 %           4 %                       (8 )%
Sale of patent
assets and other
technology assets,
net of costs           116,353             -             -       116,353         100  %
Total operating
expenses               215,901       226,697       291,537       (10,796 )        (5 )%     (64,840 )        (22 )%
Operating income
(loss)               $  55,563     $ (37,610 )   $ (34,527 )   $  93,173         248  %   $  (3,083 )         (9 )%

2012 compared with 2011
Revenue decreased by $76.8 million, or 23%. The reduction in revenue resulted from a decline of $42.0 million in our Core Products segment, a decline of $30.8 million in our Games segment, and a decline of $4.0 million in our Emerging Products segment, due to the factors described above. Cost of revenue decreased by $22.9 million compared with the year earlier period due primarily to the decline in revenue, partially offset by a decrease of $5.5 million in royalty expense in the year prior, due to a change in estimates of our accrued royalties. Operating expenses improved by $10.8 million due primarily to reduced personnel and related costs of $20.3 million and reduced marketing expenses of $6.7 million, due to our ongoing work to align our operating expenses with our revenue profile. These declines were partially offset by an increase of $10.5 million in restructuring costs and losses on excess office facilities, in addition to a benefit in 2011 of $6.4 million related to an insurance reimbursement for previously settled litigation that reduced expenses during the quarter ended March 31, 2011.
2011 compared with 2010
Revenue decreased by $66.0 million, or 16%. Approximately half, or $35.7 million of the decline was due to the deconsolidation of Rhapsody on March 31, 2010 in addition to declines of $35.1 million in our Core Products and Games segments. The deconsolidation of Rhapsody is described in detail in Note 3, Rhapsody Joint Venture. Cost of revenue decreased by $18.1 million compared with the year earlier period due primarily to lower costs of $21.9 million from the deconsolidation of the Rhapsody joint venture. We recorded impairments of deferred costs of $20.0 million in the fourth quarter of 2011 related to certain contracts with carrier customers for which the total estimated costs exceeded the total estimated revenues expected to be recognized. Operating expenses improved by $64.8 million due primarily to reduced personnel and related costs of $31.6 million, $13.9 million resulting from the Rhapsody deconsolidation, and lower restructuring charges and losses on excess office facilities totaling $11.8 million.

Segment Reporting
Core Products
The Core Products segment primarily generates revenue and incurs costs from the
sales of SaaS services, such as ringback tones, intercarrier 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):
                                                                  2012-2011       %        2011-2010        %
                          2012          2011          2010         Change       Change       Change       Change
Total revenue          $ 149,211     $ 191,240     $ 212,845     $ (42,029 )     (22 )%   $ (21,605 )      (10 )%
Cost of revenue           70,796        83,696        83,733       (12,900 )     (15 )%         (37 )        -  %
Impairment of
deferred costs                 -        19,329             -       (19,329 )    (100 )%      19,329        100  %
Gross profit              78,415        88,215       129,112        (9,800 )     (11 )%     (40,897 )      (32 )%
Gross margin                  53 %          46 %          61 %           7 %                    (15 )%
Total operating
expenses                  64,960        75,188        86,217       (10,228 )     (14 )%     (11,029 )      (13 )%
Operating income
(loss)                 $  13,455     $  13,027     $  42,895     $     428         3  %   $ (29,868 )      (70 )%

2012 compared with 2011
Total Core Products revenue decreased by $42.0 million, or 22%. This decrease was primarily due to reduced revenue from our SaaS offerings of $29.1 million. The decline in SaaS revenue was due primarily to a $24.3 million decline in our


ringback tone, intercarrier messaging and video on demand revenues due to both fewer subscribers and lower contract prices. In addition, subscription revenue, mainly from our SuperPass product, decreased $8.9 million due to a decline in subscribers, and revenue from systems integration declined $4.0 million. Gross margin increased primarily due to the impairments of deferred costs of $19.3 million within the year ended December 31, 2011, related to certain contracts with carrier customers for which the total estimated costs exceeded the total estimated revenues expected to be recognized. Slightly offsetting this was a decrease in gross margin as a result of higher costs of $1.9 million in the current year, related to a reduction in royalty expense in the prior year from a change in estimates of our accrued royalties related to our SuperPass product. Operating expenses decreased by $10.2 million primarily due to reductions in personnel and related costs that resulted from our restructuring efforts.
2011 compared with 2010
Revenue decreased by $21.6 million, or 10%. SaaS revenue decreased by $14.2 million primarily due to lower intercarrier messaging contract prices that contributed $8.8 million to the decline, and a $5.2 million decline in revenues from our tone business primarily due to a decline in subscribers. In addition, subscription revenue, mainly from our SuperPass product, declined by $5.3 million during the year ended December 31, 2011, compared with the same period in 2010 due primarily to a decline in the number of subscribers.
Gross margin decreased primarily due to the 2011 impairments of deferred costs as well as lower SaaS intercarrier messaging contract prices, with no corresponding decreases in cost of revenue. The 2011 impairments of deferred costs of $19.3 million related to certain contracts with carrier customers for which the total estimated costs exceeded the total estimated revenues expected to be recognized. Operating expenses decreased by $11.0 million primarily due to reductions in personnel and related costs that resulted from our restructuring efforts.
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 RealPlayer Plus 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):

                                                               2012-2011        %        2011-2010        %
                          2012         2011         2010         Change       Change       Change       Change
Total revenue          $ 42,576     $ 46,590     $ 41,761     $   (4,014 )      (9 )%   $   4,829         12  %
Cost of revenue           7,965       11,879        7,123         (3,914 )     (33 )%       4,756         67  %
Impairment of
deferred costs                -          633            -           (633 )    (100 )%         633        100  %
Gross profit             34,611       34,078       34,638            533         2  %        (560 )       (2 )%
Gross margin                 81 %         73 %         83 %            8 %                    (10 )%
Total operating

expenses 30,809 36,011 28,053 (5,202 ) (14 )% 7,958 28 % Operating income
(loss) $ 3,802 $ (1,933 ) $ 6,585 $ 5,735 297 % $ (8,518 ) (129 )%

2012 compared with 2011
Emerging Products revenue decreased by $4.0 million, or 9%. This decrease was due in part to the decline of revenue related to the distribution of third-party software of $2.2 million, due to fewer units distributed. In addition, revenue related to advertising decreased by $1.9 million. Cost of revenue decreased $3.9 million, primarily due to the elimination in 2012 of certain advertising agreements that occurred in 2011, in addition to lower revenue. Operating expenses decreased by $5.2 million, due in part to reductions in personnel and related costs of $7.5 million, which resulted from our ongoing work to align our operating expenses with our revenue profile. Partially offsetting these decreases was increased marketing spend to drive the distribution of our premium, paid version of RealPlayer of $2.5 million.

2011 compared with 2010
Revenue increased by $4.8 million, or 12%. Higher unit sales of our RealPlayer Plus software contributed approximately $3.9 million to the increase during the period, due to increased marketing efforts. Cost of revenue increased $4.8 million mainly due to increases related to certain advertising agreements and increased support costs for the distribution of RealPlayer and other products. Operating expenses increased by $8.0 million primarily due to increased marketing expense to drive the distribution of RealPlayer and related third-party software.
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):

                                                                    2012-2011        %        2011-2010        %
                              2012         2011         2010          Change       Change       Change       Change
Total revenue              $ 67,055     $ 97,856     $ 111,394     $ (30,801 )      (31 )%   $ (13,538 )      (12 )%
Cost of revenue              21,613       30,646        29,071        (9,033 )      (29 )%       1,575          5  %
Gross profit                 45,442       67,210        82,323       (21,768 )      (32 )%     (15,113 )      (18 )%
Gross margin                     68 %         69 %          74 %          (1 )%                     (5 )%
Total operating expenses     49,804       60,633        78,275       (10,829 )      (18 )%     (17,642 )      (23 )%
Operating income (loss)    $ (4,362 )   $  6,577     $   4,048     $ (10,939 )     (166 )%   $   2,529         62  %

2012 compared with 2011
Games revenue decreased by $30.8 million, or 31%. Lower revenue from license sales and our subscription products contributed $13.9 million and $10.2 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 $4.9 million, as well as lower sales of mobile games of $4.8 million. Lower subscription revenue was a result of fewer subscribers compared with the year-earlier period. Further contributing to the decline was lower revenue from advertising of $4.9 million. Cost of revenue decreased by $9.0 million, or 29%. This decrease was primarily due to the decrease in partner royalties expense, which has a direct correlation with the decrease in Games revenue. Operating expenses decreased by $10.8 million, or 18%. The decrease was primarily due to reductions in marketing expenses of $7.2 million, primarily related to our non-social games, in addition to reductions in personnel and related costs of $2.4 million.
2011 compared with 2010
Revenue decreased by $13.5 million, or 12%. The decline was due to lower license revenue of $4.8 million primarily due to a decrease in the number of games sold through our games syndication services. Further contributing to the decline was lower revenue from our subscription products of $4.8 million as a result of fewer subscribers. In addition, distribution of third party software declined by $3.7 million due to reduced traffic for our games properties. Cost of revenue increased by $1.6 million, or 5%. The increase was due primarily to higher costs associated with distribution of third party games as well as increased delivery costs for our games products and services. Gross margins decreased due to lower subscription revenue and lower distribution of third party software, both of which are higher-margin revenues. Operating expenses decreased by $17.6 million, or 23%. The decrease was primarily due to reductions in personnel and related costs of approximately $8.7 million. Further, we reduced our spending on marketing and related activities by approximately $3.4 million in 2011. In addition, depreciation expense related to our Games technology platform decreased by $3.1 million.
Music
We currently own approximately 45% of Rhapsody, which provides products and services that enable consumers to have unlimited access to digital music content anytime from a variety of devices. Rhapsody currently generates revenue primarily in the U.S. through subscriptions to its music services, and sales of tracks and advertising.
As described in detail in Note 3, Rhapsody Joint Venture, on March 31, 2010, we completed the restructuring of Rhapsody, which at that time, resulted in our ownership interest in Rhapsody decreasing to approximately 47% and the loss of our operating control over Rhapsody. Our revenue and operating results for the first quarter of 2010 includes results from Rhapsody's operations, as during that time we owned 100% of Rhapsody and their results were included in our financial statements. Beginning with the second quarter of 2010, Rhapsody's revenue and other operating results are no longer consolidated within our financial statements and we have not been recording any operating or other financial results for the Music segment. Starting with the second quarter of 2010, we account for our investment in Rhapsody using the equity method of accounting for investments. Our share of Rhapsody's accounting losses for the years ended December 31, 2012 and 2011 were $5.7 million and $7.9 million. Our share of Rhapsody's losses for the nine-month period from April 1, 2010 to December 31, 2010, was $14.2 million.
For the three month period ending March 31, 2010, during which we owned 100% of Rhapsody, our Music segment results of operations was as follows (dollars in thousands):


                                  2010
Total revenue                  $ 35,733
Cost of revenue                  21,864
Gross profit                     13,869
Gross margin                         39 %
Total operating expenses         13,911
Operating income (loss)        $    (42 )

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):
                                                                   2012-2011        %       2011-2010       %
                           2012         2011          2010          Change       Change      Change       Change
Cost of revenue         $  3,357     $     416     $   2,932     $     2,941       707 %   $  (2,516 )     (86 )%
Gain on sale of
patents and other
technology assets,
net of costs             116,353             -             -         116,353       100 %           -         -  %
Total operating
expenses                  70,328        54,865        85,081          15,463        28 %     (30,216 )     (36 )%
Operating income
(loss)                  $ 42,668     $ (55,281 )   $ (88,013 )   $    97,949       177 %   $  32,732        37  %

2012 compared with 2011
Cost of revenue increased by $2.9 million. The increase was due primarily to a reduction in expense in the prior year from a change in estimates of our accrued royalties on our historical music business of approximately $3.6 million. The net gain from the sale of patents and other technology assets to Intel Corporation of $116.4 million in 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 $15.5 million, or 28%. The increase compared with the prior period was primarily due to increased restructuring costs and losses on excess office facilities totaling $10.5 million, and to the impact of a benefit in 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 $2.4 million in 2012, which resulted from our ongoing work to align our operating expenses with our revenue profile. 2011 compared with 2010
Cost of revenue declined by $2.5 million, or 86%. The majority of the decline was the result of a change of estimates in our accrued royalties, which resulted in a reversal of approximately $3.6 million in royalty expense primarily associated with our historical music business.
Operating expenses decreased by $30.2 million, or 36%. The decrease was due in part to lower restructuring charges and loss on excess office facilities of approximately $11.8 million as well as a reduction in personnel and related costs and professional services expense of approximately $11.5 million. The remaining decrease in operating expenses was due in part to a benefit in 2011 from an insurance reimbursement of $6.4 million related to previously settled litigation, which was accounted for as a reduction to operating expenses. Operating Expenses
Research and Development
Research and development expenses consist primarily of salaries and related costs of research and development personnel, expense associated with stock-based compensation, and consulting fees associated with product development. To date, all research and development costs have been expensed as incurred because technological feasibility for software products is generally not established until substantially all development is complete.
Research and development costs were as follows (dollars in thousands):


                                                              2012-2011        %         2011-2010        %
                        2012         2011         2010         Change        Change       Change        Change
Research and
Development          $ 63,194     $ 70,212     $ 100,955     $  (7,018 )       (10 )%   $ (30,743 )       (31 )%
As a percent of
revenue                    24 %         21 %          25 %

2012 compared with 2011
Research and development expenses, including non-cash stock-based compensation, decreased by $7.0 million, or 10%, primarily due to a decrease in personnel and related costs of $6.1 million.
2011 compared with 2010
Research and development expenses, including non-cash stock-based compensation, decreased by $30.7 million, or 31%. The decline was primarily due to a decrease in personnel and related costs of approximately $18.5 million as well as a decrease in depreciation expense related to our Games technology platform of $3.1 million. In addition, the removal of Rhapsody's operating expenses from our consolidated financial results beginning April 1, 2010, contributed approximately $3.8 million to the decline. Further contributing to the decline was the reduction of $5.7 million of professional services costs due primarily to reduced development work in our SaaS business. The decrease in research and development expenses as a percentage of total revenue from 25% in 2010 to 21% in 2011 was due primarily to our ongoing cost-containment efforts. Sales and Marketing
Sales and marketing expenses consist primarily of salaries and related costs for sales and marketing personnel, sales commissions, amortization of certain intangible assets capitalized in our acquisitions, credit card fees, subscriber acquisition costs, consulting fees, trade show expenses, advertising costs and costs of marketing collateral.
Sales and marketing costs were as follows (dollars in thousands):

                                                                    2012-2011        %         2011-2010         %
                             2012         2011          2010         Change        Change       Change        Change
Sales and Marketing       $ 90,301     $ 111,300     $ 118,543     $ (20,999 )       (19 )%   $  (7,243 )        (6 )%
As a percent of revenue         35 %          33 %          30 %

2012 compared with 2011
Sales and marketing expenses, including non-cash stock-based compensation, decreased by $21.0 million, or 19%. The decrease was due primarily to a decrease in personnel and related costs of $13.4 million. Further contributing to the decline in sales and marketing costs was reductions in marketing expenses of $7.1 million, primarily related to our non-social games. 2011 compared with 2010
Sales and marketing expenses, including non-cash stock-based compensation, decreased by $7.2 million, or 6%. The decrease was due primarily to the removal of Rhapsody's operating expenses of $8.8 million from our consolidated financial results beginning April 1, 2010. Also contributing to the overall decrease of sales and marketing expenses was a decrease in personnel and related costs of approximately $5.7 million due to our restructuring activities and reduced third-party sales commissions of $1.6 million. These decreases in sales and marketing costs were partially offset by an increase in marketing expenses for RealPlayer of $8.1 million, as well as higher professional services expense of $2.4 million.
General and Administrative
General and administrative expenses consist primarily of salaries and related personnel costs, fees for professional and temporary services and contractor costs, stock-based compensation, and other general corporate costs. General and administrative costs were as follows (dollars in thousands):

                                                              2012-2011         %         2011-2010        %
                        2012         2011         2010         Change         Change       Change        Change
General and
Administrative       $ 43,891     $ 37,181     $ 51,217     $     6,710          18 %    $ (14,036 )       (27 )%
As a percent of
revenue                    17 %         11 %         13 %

2012 compared with 2011
General and administrative expenses, including non-cash stock-based compensation, increased by $6.7 million, or 18%. This increase was primarily due 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.

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