Macrovision 10-K 2005
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
[X] ANNUAL REPORT PURSUANT TO SECTION 13
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004
[ ] TRANSITION REPORT PURSUANT TO SECTION 13
Commission File No. 000-22023
(Exact name of registrant as specified in its charter)
2830 De La Cruz Boulevard
Santa Clara, California 95050
(Address of principal executive offices) (Zip code)
(Registrants telephone number including area code)
Securities registered under Section 12(b) of the Exchange Act: None
Securities registered under Section 12(g) of the Exchange Act: Common Stock, $0.001 par value
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein and will not be contained, to the best of the Registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this form 10-K. [X]
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes [X] No [ ]
As of June 30, 2004, the aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant, based on the closing price for the registrants common stock on that day, was approximately $1,159,015,326.
As of March 1, 2005, there were 50,387,148 shares of the registrants common stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrants definitive proxy statement related to the 2005 annual meeting of stockholders, which will be filed with the Securities and Exchange Commission within 120 days of the fiscal year ended December 31, 2004, are incorporated by reference under Part III hereof.
Discussions of some of the matters contained in this Annual Report on Form 10-K for Macrovision Corporation (Macrovision, we or us) may constitute forward-looking statements within the meaning of the Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended, and as such, may involve risks and uncertainties. Some of these discussions are contained under the captions Item 1. Business and Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations. We have based these forward-looking statements on our current expectations and projections about future events, which include implementing our business strategy, developing and introducing new technologies, obtaining and expanding market acceptance of the technologies we offer, and competition in our markets.
In some cases, you can identify these forward-looking statements by terminology such as may, will, should, expect, plan, anticipate, believe, estimate, future, predict, potential, intend, or continue, and similar expressions. These statements are based on the beliefs and assumptions of our management and on information currently available to our management. Our actual results, performance and achievements may differ materially from the results, performance and achievements expressed or implied in such forward-looking statements. For a discussion of some of the factors that might cause such a difference, see Item 1. Business Risk Factors. We specifically disclaim any obligation to update such forward-looking statements.
Macrovision Corporation, a Delaware corporation founded in 1983, provides digital product value management offerings to entertainment producers, software publishers, and their customers. Value management solutions include anti-piracy technologies and services, embedded licensing technologies, usage monitoring for enterprises, and a host of related technologies and services from installation to update to back-office entitlement management. Our customers include: major Hollywood studios; independent video producers; hardware and software vendors; music labels; consumer electronic, PC and digital set-top box manufacturers; digital pay-per-view (PPV) and video-on-demand (VOD) network operators; and enterprise IT organizations.
Our content protection technologies are deployed on various media formats, distribution platforms, and hardware devices including: DVDs, videocassettes, music CDs, and games on CD-ROMs and DVDs, DVD players and digital video recorders (DVRs), digital set-top box and hard drive recorders, personal video recorders (PVRs), media center PCs, cable/satellite/telco networks and Internet Protocol delivery platforms. Most of our software value management solutions are incorporated into other software vendors products, and other products are sold as software asset management tools for enterprise IT organizations.
We own or have rights to various copyrights, trademarks and trade names used in our business. These include Macrovision®, ActiveReach, AdminStudio®, Cactus Data Shield, Colorstripe, FLEXbill, Flex Certified, FLEXenabled, FLEXlm®, FLEXnetTM,, GLOBEtrotter®, Hawkeye, InstallShield®, RipGuard, RipGuard DVD, SafeAudio, SafeAuthenticate®, SafeCast®, SafeDisc®, SafeDVD, SAFESTREAM, SafeWrite, SAMsuite and SOFTSUMMIT® and Update Service.
Content owners lose billions of dollars every year to casual copying and professional or bootleg piracy and Internet/P2P piracy. The latest data available from the Motion Picture Association of America (MPAA) estimated that the U.S. motion picture industry loses in excess of $3.5 billion annual due to packaged media piracy. In addition, the International Intellectual Property Alliance estimated that copyright piracy, not including Internet piracy, around the world inflicts $20$22 billion in annual losses to the U.S. copyright industries. According to the Business Software Alliance (BSA) and International Data Corporation (IDC) report of September 2004, worldwide PC software piracy accounts for approximately $29 billion in lost sales
annually. This problem is the focus of our technologies. Piracy prevention is one of many ways that content owners are looking to further monetize their digital products.
Consumers ability to make unauthorized copies of video, audio and software content has increased due to the proliferation of inexpensive, easy-to-use devices, such as VCRs, CD and DVD recorders, audio CD recorders (CD-Rs) and PC based hard drive recorders that allow in-home copying of videocassettes, DVDs, digital PPV/VOD programs, CD/DVD-ROMs, desktop software, and audio CDs. The industry shift towards digital media, PC-based entertainment platforms, digital portable devices, Internet downloads and the proliferation of peer-to-peer file sharing networks renders content and copyright owners increasingly vulnerable to unauthorized use of their content. As technological advances facilitate digital downloads and digital copying, motion picture studios, music labels, cable television program distributors and software games publishers have become more concerned with protecting their intellectual property. Amidst the backdrop of the race to digital media and digital hardware, the threat of analog copying does not diminish as the quality of digital-to-analog copies is very close to the original digital program. In fact, content owners face a triple threat of consumer piracy today which is sometimes characterized by three ‘holes into which they see their legitimate revenues disappear: analog; digital; and network holes. The analog hole refers to unauthorized content which is either in analog format to begin with, or is converted from digital to analog and is subsequently copied and then passed along in analog format or reconverted back to digital format. The digital hole refers to unauthorized content that is ‘ripped from an optic disc to a PC hard drive and then either uploaded to a P2P file sharing service or burned to a DVD-R or CD-R disc. The network hole refers to unauthorized content that is traded freely over P2P networks.
Independent software vendors and systems vendors are similarly concerned about unlicensed or illicit use of their application software, both in the enterprise environment (where license terms may be lost in the midst of corporate IT confusion or ignored) and at home (where PC software may be copied and redistributed). In the software industry, publishers are seeking ways to flexibly price and package their products in order to reach a larger share of the available market. Furthermore, as software complexity grows, publishers are seeking ways to simplify their customers software experience. Enterprise customers are particularly focused on reducing their total cost of ownership of software and reducing their support burden. Tools that provide a simple installation, activation and maintenance experience are winning favor with these enterprise customers.
We are organized into two business units, the Entertainment Technologies Group and the Software Technologies Group.
Entertainment Technologies Group
The Entertainment Technologies Group licenses digital content value management solutions that include content protection, authentication and digital rights management (DRM) technologies to video, music, and PC games content owners. Our Hawkeye peer-to-peer file sharing antipiracy service and our RipGuard content protection technologies that were introduced in 2004 are included in the Entertainment Technologies Group.
Motion picture studios wish to maximize the economic value from each feature film or other video program over its copyright life. According to the Digital Entertainment Group and Adams Media Research, consumers spent $24.5 billion in 2004 to own or rent movies, primarily on DVD in the United States. Understanding & Solutions Ltd. projects a 15% annual increase in DVD unit shipments to over 1.6 billion discs in 2005 in the United States and a 15% annual increase to over 2.48 billion discs in 2005 worldwide. The rapid growth of the DVD format presents major revenue opportunities for the studios, as well as serious copy protection concerns. Various consumer copying studies show that studios and video retailers lose theatrical, DVD, PPV, and VOD revenues when consumers make copies of movies, whether from VHS or
DVD rentals, PPV or VOD releases or downloads from peer-to-peer (P2P) file sharing networks. Any household that owns a DVD recorder (DVD-R), PVR, PC, media center or a VCR is capable of making unauthorized high quality digital and analog copies unless that content is properly copy protected against this variety of threats.
Our business originated in analog video copy protection, which continues to be the leading revenue generator for our Entertainment Technologies Group. Our analog copy protection (ACP) technology has been used to copy protect over 4.2 billion videocassettes worldwide since 1985 and over 4.3 billion DVDs worldwide since 1997. Most MPAA studios use our video content protection technology to protect some or all movie releases on videocassette or DVD. We believe that our technology is accepted as the de facto industry standard for analog video copy protection.
Recordable DVD Copy Protection. DVD-video recorders that allow recording onto DVD recordable blank media started selling to consumers in 2003, and sales of these DVD recorders and PC/DVD recorder/ re-recordable drives reached approximately 50 million units worldwide at the end of 2004. Our copy protection technology inhibits the duplication of DVDs using these devices. All DVD recording devices that we have tested to-date do not make a digital DVD copy from the analog video output of a Macrovision-enabled DVD playback device when playing a Macrovision copy-protected DVD disc. Because almost all the installed DVD playback devices are Macrovision-enabled and have only an analog output, our copy protection technology inhibits DVD-R copying in addition to VCR copying.
PC Ripping. Software that rips digital content from a Content Scramble System (CSS) protected optical disc to a PC hard drive is widely available in electronics stores and from Internet sites, with many of these products being available free-of-charge. This class of software technology, known as DeCSS rippers, breaks the CSS encryption code that is used on most movie DVDs, and often circumvents the Macrovision analog copy protection. Therefore, we believe such software packages are illegal because they either violate the U.S. Digital Millennium Copyright Act of 1998 (DMCA) or infringe our patents. Nevertheless many consumers acquire this type of software and add hacker software available on the Internet, and may engage in unauthorized ripping and copying activities. Our RipGuard DVD technology, which was introduced in the fourth quarter of 2004, can be added to the DVD at the time of manufacturer and is designed to inhibit ripping by PCs.
DVD-to-VHS Copy Protection. According to the Digital Entertainment Group, based on data from the Consumer Electronics Association, as of the end of 2004, approximately 127 million DVD playback devices are in American homes. The Digital Entertainment Group estimates that more than 80% of U.S. households will have at least one DVD player by the end of 2005. In addition, 90% of U.S. homes also have a VCR. Without effective copy protection, any VCR can, when combined with a DVD playback device, make VHS copies of a non-copy protected DVD. These copies are almost equal in quality to professionally prerecorded videocassettes. Virtually 100% of DVD playback devices in use since the DVD format introduction to the market in 1997 are designed to output Macrovision copy-protected analog video if the device plays a Macrovision copy-protected original DVD disc. Therefore, our copy protection technology can effectively inhibit DVD to VCR copying.
VHS Copy Protection. Even with the focus on digital media and growth in DVD, VCR sales remain strong as prices fall. With continued shipments of VCR devices to the market, we believe that VCRs will remain a home copying threat to video content owners for many years to come. Our copy protection technology still serves its original purpose of inhibiting VCR-to-VCR copying.
VOD and PPV Copy Protection. Digital PPV/VOD services enable consumers to purchase and view movies and other programming in their homes through cable or satellite systems, or Internet-based download services. Studios have realized the importance of copy protection in digital PPV/VOD networks because VHS and DVD-R recorders can be used to make high quality VHS and DVD copies from the source analog video signal. Most digital PPV/VOD system operators have implemented our copy protection capability in their digital set-top boxes at the request of the Hollywood studios.
Our technology enables consumers to view PPV/VOD programs but inhibits unauthorized copying or significantly distorts unauthorized copies of the program when copies are attempted by both DVD and VHS recording devices. To date, our copy protection technology has been embedded in over 145 million digital set-top boxes and DVRs worldwide, representing nearly 90% of total digital set-top boxes deployed. Our technology is dormant until it is activated by system operators for specific PPV or VOD movies. During the past five years, our video content protection technology has been activated by PPV system operators in Western Europe and Japan and in 2004, our technology was activated by a PPV system operator in Canada.
VOD is an emerging service, with approximately 20 million U.S. households currently enabled to view VOD, and an estimated total of 25 million U.S households expected to be VOD enabled by the end of 2005. We are working with several major MPAA studios and system operators to enable copy protection activation for VOD services in the U.S.
It has become common practice among many consumers to copy their DVD, PPV or VOD content onto PVRs and media center PCs. To protect content in such circumstances, Macrovision introduced ACPe, a derivative technology of our analog copy protection technology that is designed to inhibit the storage of protected content onto these hard drive devices or control content storage time to be in accordance with rules defined by copyright owners.
The music industry is at a digital crossroads. Music industry CD sales fell approximately 10% year-over-year from 2001 to 2003, according to the International Federation of Phonographic Industries (IFPI). In 2004, there has been a slight recovery in music sales, primarily due to the emergence of legitimate online music download stores. The continued decline in CD sales in various key music markets is attributed to the high penetration of personal computer-based CD-burners, proliferation of peer-to-peer file sharing services and the historical lack of commercial adoption of copy protection and DRM technologies. Approximately 30% of recordings sold worldwide are reportedly illegal copies, resulting in an estimated $4.5 billion of lost industry sales in 2003 alone, according to IFPIs Music Piracy Report 2004. In addition, peer-to-peer file sharing of music continues to be problematic. IFPI estimates there were approximately 100 million unauthorized music files on traditional web and file transfer protocol sites on the Internet and approximately 800 million unauthorized files on peer-to-peer networks at the end of 2003.
Consequently, the music industry is pursuing multiple initiatives to reverse the year-over-year sales declines, including CD copy protection and digital rights management technologies. Since early 2000, music labels have expressed interest in technology that would prevent the copying of music CDs to a PC or CD-R device, or downloading from peer-to-peer networks. We are developing and marketing technologies to address these needs.
Peer-to-Peer File Sharing Content Management Technology
Jupiter Research reported that in July 2004, 23.4 million people downloaded music, video and software files over free Internet peer-to-peer file sharing networks. Content owners believe they have been harmed by the free and unauthorized file sharing over these networks to such an extent that they have initiated lawsuits against several of the file sharing networks and even the individual consumers themselves. Our CDS-300
content protection technology is designed to inhibit unauthorized content from being made available over P2P networks. In addition, our new Hawkeye technology, which was introduced in the second quarter of 2004, is designed to protect copyrighted content from being traded over the P2P file sharing networks.
PC Games Technology
With the proliferation of inexpensive high capacity CD-ROM burners, and the increase in broadband Internet connections to the home and small office, individual consumers now have ready means for unauthorized copying and distribution of desktop software on a broad scale. In fact, unauthorized downloads of application and entertainment software frequently meet or exceed the volume of downloads of music from Internet file sharing services. As a result, application software and interactive entertainment (primarily games) software companies are facing an unprecedented loss of revenues due to unauthorized consumer copying of CD/DVD-ROM software and unauthorized file sharing over the Internet. Our SafeDisc Advanced technology addresses this problem.
Software Technologies Group
The Software Technologies Group develops and markets our software value management solutions to hardware and software vendors and their enterprise customers. Our InstallShield Installer, Update Service, and Admin Studio products that we acquired as a result of the purchase of the assets of InstallShield Software Corporation in 2004 have been added to our FLEXnet Publisher and FLEXnet Manager products within our Software Technologies Group.
Software and Hardware Manufacturers
Software and hardware manufacturers have access to a variety of tools with which to design and develop software. However, when such software needs to be delivered to customers, manufacturers have primarily relied on homemade solutions to handle electronic downloading, advanced installation, embedded licensing enforcement, automatic updates, and back-office tracking of entitlements. This not only places restrictions on the business models with which manufacturers can engage their customers, but also can lead to general business problems such as confusion as to which updates are needed and difficulty with installations.
BSA estimates that worldwide software piracy was roughly 29% for software sold in 2003, and a 2004 study by IDC found that only 4% of enterprises actively try to monitor their compliance with their software contracts. In 2003, IDC reaffirmed its estimate that license managed software would grow at almost twice the rate of the overall market. We believe that Macrovision is positioned to benefit from this market growth due to our current market leadership, installed base of customers and broad product set. IDC has said that Macrovisions core FLEXnet solutions benefit everyone in the industry from software publishers and their partners to their customers.
Enterprise IT teams are looking for ways to keep their software end-users as productive as possible while minimizing their support costs. Larger organizations that purchase significant volumes of software want to optimize those purchases, ensuring they purchase enough licenses to fulfill the needs of their end-users while at the same time ensuring they do not waste money by continuing to license unnecessary assets. These enterprises seek reporting software that can provide detailed usage information to guide them in their purchase decisions. Additionally, larger organizations that purchase significant volumes of software often have trouble complying with the purchase terms of their software. They desire automated solutions that help them stay within the bounds of their purchased licenses, and allow them to flexibly expand those bounds as needed (for example, via usage-based overdraft capabilities). Moreover, they seek management solutions that enable them to minimize the manual labor associated with managing large numbers of licenses and to maximize the reliability and availability of those licenses. Larger organizations also face significant challenges in rolling out
software products to their thousands of employees and need to ensure that software is deployed easily without productivity loss to the enterprise. Prior to deployment, they typically need to repackage their software to set preferred options and default locations, as well as to check for potential conflicts with their other software.
We develop and market a broad array of digital product value management technologies for each of our business lines. The rapid expansion of broadband Internet connections for consumers and small businesses and the continued tightening of enterprise IT budgets may result in the adoption of new licensing and distribution models for our solutions. We believe this has created a large market opportunity for our value management solutions.
Entertainment Technologies Group
Our ACP technologies allow consumers to view programming stored on prerecorded videocassettes and DVDs or transmitted as digital PPV or VOD programs via cable or satellite, but deter unauthorized consumer copying of such programming on both VCRs and recordable DVD devices. Videocassettes and DVDs are encoded with our video copy protection signal as they are manufactured. The result is that videocassettes and DVDs that are encoded with our copy protection signal will play normally on an analog TV set, but will cause generally unwatchable copies to be made on the vast majority of VCRs, and will shut down the analog-to-digital recording circuit of DVD recording devices, which include DVD-R devices and personal computers.
While our ACP technology addresses the analog hole, Macrovision has developed another video content protection technology, known as RipGuard DVD, to address the digital hole. This new hole was created by a class of piracy tools known as DeCSS rippers. Our RipGuard technology, which is applied to the DVD at the time of manufacture, is designed to prevent unauthorized optical disc copying (ripping) on PCs without requiring any modification to the PC. Together, ACP and RipGuard DVD are designed to close the analog and digital holes, and thus offer a comprehensive content protection solution.
In addition to our ACP solution for PPV/VOD applications, we have introduced our ACPe rights management solution, which allows content owners to both copy protect their PPV/VOD movies, as well as control the time that the content may be stored on personal video recorder hard drives, which are built into many digital set top boxes.
Our optic disc content protection technologies are licensed to 373 DVD and PC manufacturers, 382 DVD authoring houses, 123 replication facilities, 227 VHS commercial duplication facilities, 135 digital set-top box and hard drive recorder manufacturers and 65 semiconductor component suppliers worldwide.
We are actively involved in developing and marketing various technologies to meet the needs of emerging music delivery systems such as downloading and streaming via the Internet, as well as technologies to prevent the unauthorized copying of music CDs. Our music products combine the technologies that are the subject of patents developed internally, patents acquired from Midbar Tech (1998) Ltd. in November 2002 and patents acquired from TTR Technologies, Inc. in May 2003. Our CDS-300 v8 product provides music labels with passive copy protection that inhibits the consumer from copying music to a personal computer for subsequent redistribution on Internet based file sharing services. In addition, we utilize a proprietary active copy protection solution on the same CD that enables music files to be copied to a personal computer hard disk and be managed/played via Windows Media Player (or other DRM system) but controls (at the copyright owners option) subsequent transfer to portable devices, CD-Rs, and the Internet, and subsequent burning of copied CDs.
The CDS-100, CDS-200 and CDS-300 solutions have been used on over 400 million music CDs worldwide through 2004. Of the total number of copy protected CDs produced worldwide, approximately 60% were distributed in the Asia Pacific region (principally Japan), 35% in Western Europe, and 5% in North America, South America, and the rest of the world combined. The CDS-300 v8 product is currently being introduced by several of the major music labels in international territories. We believe that we are well positioned to develop and market unique solutions that meet the needs of the consumer, the artist, the publisher and the music label.
Peer-to-Peer File Sharing Content Management Technology
Our Hawkeye technology is designed to protect copyrighted content by making it difficult, if not impossible, to download Hawkeye-protected music and video files from P2P file sharing networks. Content owners are able to designate which music tracks, music albums or movies they want to protect, and our technology is activated as a service to find and protect those specific files on various file sharing networks.
PC Games Technology
Our SafeDisc Advanced technology is designed to prevent the copying of CD/DVD-ROM computer software by encrypting executable files, embedding an authenticating digital signature and adding multi-layered anti-hacking software. This is a proprietary software-based copy protection solution that does not require any changes to standard PC or CD/DVD-ROM hardware. Because SafeDisc Advanced is designed to operate while the disc is in the CD/DVD-ROM drive, it is ideally suited to PC games and education software and is not applicable for console games like Sony Playstation or Microsoft Xbox. The technology is licensed directly to software publishers, and to mastering and replication facilities that embed our patented digital signature in a CD/DVD-ROM during the manufacturing process. SafeDisc Advanced has been licensed to 132 replicators worldwide, and is estimated to have been used on more than 300 million CD/DVD-ROMs since 1998.
Software Technologies Group
Software and Hardware Manufacturers
We provide an extensive set of software value management solutions, ranging from installation technologies to license management to update services to packaging/distribution conflict management. By incorporating our technologies into their products, manufacturers are able to improve their ability to provide a standard and seamless installation and activation experience, simplify product-marketing strategies, reduce unpaid usage and lower costs associated with product development, distribution, and delivery. We also offer manufacturers back-office products to help them better manage the entitlements they have granted their customers, as well as a hosted update service that enables manufacturers to keep their deployed products up to date. Most of these offerings are marketed as modules of our FLEXnet Publisher platform.
As a result of our acquisition of the assets of InstallShield Software Corporation in July 2004, our product offerings have increased. Our InstallShield Installer product is a multi-platform installer solution that is incorporated into our customers software applications to allow them to build a simple, effective installation solution inside their own application. Our Update Service product allows software developers to message end-user PCs regarding updates and promotions, and also provides them with a mechanism to automatically deliver updates over the Internet.
Complementing our FLEXnet Publisher offerings for manufacturers, we offer FLEXnet Manager for enterprise customers, to help such customers better manage their FLEXenabled products. FLEXnet Manager captures and analyzes software usage data to help enterprises determine where to allocate their
software purchases and related costs and helps administer software access rights (electronic licenses) over global networks.
We also offer the AdminStudio family of products to help enterprise system administrators prepare various software applications and upgrades for deployment across the enterprise (via repackaging and patch impact management). It is used as a front-end preparation tool to assess whether there are any software application conflicts with other installed software prior to deploying to all the end user PCs.
The Macrovision Growth Strategy
Leverage Key Customer Relationships. We currently maintain relationships with customers in various industry and market segments, including:
We intend to build our business by capitalizing on these customer relationships and targeting them for delivery of our existing and future digital product value management technologies.
Introduce New Product Applications and Technologies. We intend to develop additional product value management solutions to sell to our extensive customer base. We have committed significant resources to expand our technology base, to enhance our existing products, to introduce additional products and to participate in industry standard-setting efforts and organizations. We intend to pursue opportunities in the following areas:
Expand and Protect Patent Position. We believe that our future success will depend on our ability to continue to introduce proprietary solutions for rights management and copy protection technologies that can be supplemented by enabling features that will incent consumers and users to pay for legitimate video, audio and software products, rather than trying to get them for free in an unauthorized fashion. We have patented many of these proprietary solutions, and our patents underpin our strong competitive position and financial model. We also have acquired key software rights management and copy protection patents. We use patents to limit the proliferation of devices that circumvent our video content protection technologies, and we have initiated legal actions relating to infringement of these patents. We intend to continue to obtain patents and to protect
and defend our patented technologies aggressively, including developing and obtaining patents covering a number of processes and devices that unauthorized parties could use to circumvent our DRM and copy protection technologies.
Continue To Make Strategic Acquisitions. We intend to continue to expand our technology portfolio by pursuing licensing arrangements, joint ventures and strategic acquisitions of companies whose technologies or proprietary rights complement our digital content value management or software value management technologies.
We have made a number of acquisitions since 1999. We acquired C-Dilla, Ltd. of the UK in June 1999 in order to enter the application software copy protection, license management and DRM business; in August 2000, we acquired Globetrotter Software, Inc., which facilitated our entry into enterprise electronic license management and software asset management business; in October 2000, we acquired Productivity through Software plc (PtS) of the UK, which was a distributor of our enterprise software solutions; in July 2001, we acquired the intellectual property and technology assets of AudioSoft, Inc., and in September 2001, we acquired the intellectual property and technology assets of MediaDNA, Inc., both of which provided us with significant intellectual property in the DRM business; in November 2002, we acquired the assets of Midbar Tech (1998) Ltd., which provided us with significant intellectual property and key personnel skilled in music copy protection and controlled disc burning applications; in May 2003, we acquired certain assets of TTR Technologies, Inc. to further enhance our intellectual property relating to music copy protection; in August 2003, we acquired intellectual property and other assets, including patents and software that can be used to track and manage content in the peer-to-peer file sharing space; and in July 2004, we acquired the intellectual property and assets of InstallShield Software Corporation, which provided us with the ability to expand our product portfolio in the software value management category and reach a large software developer customer base.
Technology Licensing, Sales and Marketing
Technology Licensing. We have built, and continue to add to, a large patent portfolio that helps differentiate our products and is important to our license driven business model. We generate recurring revenues from a variety of sources by licensing our portfolio of digital content value management and software value management technologies. We believe that content owners and software vendors utilize our solutions to secure their content or software and to ensure that their end-user customers pay them for the use of such content or software. We receive royalties and recurring revenues as follows:
Sales and Marketing. We market our digital content value management and software value management solutions directly to content owners and software vendors in both the video and software markets. We also license our software asset management solutions directly to end-user enterprise customers. We supplement our direct sales efforts with reseller programs and service partnerships among VHS, DVD, and CD duplicator, replicator and authoring organizations, and third party professional services, value added reseller, and systems integrator organizations in our enterprise software business. We also utilize a variety of marketing initiatives, including trade show participation, trade advertisements, industry education and newsletters. As part of our FLEXnet platform, we established alliances with several partner companies to extend the FLEXnet ecosystem to include other third-party services and solutions. We have a worldwide network of resellers who help us sell our InstallShield products.
Our primary locations for product development, business strategy, and operations are in our Santa Clara (California), Schaumburg (Illinois) and Maidenhead (United Kingdom) offices. We have sales and support operations through our U.S. sales force, and through our offices in the United Kingdom, Netherlands, Germany, France, Israel, Japan, Taiwan, Hong Kong, and Korea.
Entertainment Technologies Group
Video Content. We license our video content protection technology to the major motion picture studios and also to special interest customers that include independent video producers and corporations. Our copy protection technology for videocassettes and DVDs is used by the following leading major motion picture studios and home video suppliers:
No customer accounted for more than 10% of our net revenues in 2004. One customer accounted for more than 10% of our net revenues in each of 2003 and 2002.
PPV/VOD System Operators. There are 23 system operators who have licensed or specified Macrovisions digital PPV copy protection technology for incorporation into their networks, including:
These system operators have paid a one-time license fee to us and have entered into agreements with us pursuant to which we are entitled to transaction-based royalty payments at such time as copy protection for digital PPV or VOD programming is activated. Although 23 system operators have specified Macrovision technology for incorporation into their networks, only 13 international system operators have activated our copy protection in their networks, while the majority of U.S. systems operators have not yet activated copy
protection, even though the technology is included in their network infrastructure. In 2004, Shaw Cablesystems in Canada became the first North American cable operator to activate our PPV/VOD copy protection technology. We are in discussions with a number of major studios and system operators to activate VOD copy protection in the U.S.
Consumer Electronics Hardware Manufacturers. We believe that our DVD copy protection technology is universally utilized as the analog-to-analog and analog-to-digital copy protection solution that satisfies the principles established by the DVD licensing and standards group, and has been tested and accepted for compatibility with TV sets by leading consumer electronics companies. As of December 31, 2004, 373 companies that manufacture DVD players or PC/DVD-ROM drives had signed agreements with us to incorporate our DVD copy protection technology into their hardware, including both Sony and Microsoft for their DVD-based game consoles PlayStation®2 and Xbox.
Our PPV/VOD copy protection technology is embedded in more than 145 million digital set-top boxes currently in use worldwide, which we believe represents approximately 90% of all digital set-top boxes. We have licensed our copy protection technology for digital PPV/VOD to 107 set-top box and 28 DVR manufacturers, including:
We have also authorized 65 semiconductor companies to incorporate our digital PPV/VOD and DVD copy protection technologies into their semiconductor and reference designs. These companies generally pay us a one-time service fee to verify correct implementation of our video content protection technology in digital-to-analog application specific integrated circuits (ASICs) that are embedded in digital set-top boxes and DVD hardware. They are authorized to sell these Macrovision-capable ASICs to Macrovision-licensed DVD hardware manufacturers and to Macrovision-licensed digital set-top box and hard drive recorder (sometimes referred to as digital video recorder) manufacturers.
New Video Technologies. As of December 31, 2004, one of our customers began using our Hawkeye P2P services to protect select movies and several movie studios began testing our RipGuard DVD rip control solution.
CDS-100 and CDS-200 have been utilized on music CDs by all four major music labels (i.e., Universal, Warner, Sony/BMG, and EMI) in Europe and/or Japan, and by Avex, Pony Canyon and others in Japan. The CDS processor, which our customers use to apply our copy protection technologies to their CDs, has been installed in 56 manufacturing plants worldwide, including plants in North America, Europe and Japan. In 2004, we introduced our latest digital media management content protection solution, CDS-300 v8, which was tested by the studios in late 2004. CDS-300 v8 will be available in 2005.
PC Games Technology
Our copy protection technology for consumer software is used by leading software (primarily games) publishers, including the following:
Our consumer software customers have a wide choice of licensed replicators that they can use throughout the world and 132 mastering facilities and replicators have been licensed and have installed SafeDisc mastering and quality assurance systems from authorized suppliers of these systems.
Software Technologies Group
Software and Hardware Manufacturers
We believe that FLEXnet Publisher, our software value management product for manufacturers, is the industry leader. We have licensed our FLEXnet-related technologies in a range of market segments to more than 3,800 software and hardware manufacturers, including:
In addition, we believe that our InstallShield installer is the industry leader, having been sold to over 55,000 customers. All of the top 100 software publishers use InstallShield.
In addition we have licensed software asset management products to over 1,500 corporate end-users, enabling these end-users to deploy, manage, and track the software they have purchased from our software vendor customers. Examples of such corporate end-user customers include:
Similarly, we have licensed our AdminStudio line to over 4,000 enterprise customers, including:
Entertainment Technologies Group
Our technology was originally designed to prevent unauthorized copying of VHS and PPV/VOD programming to VCRs without impacting the original playback. We expanded this to inhibit unauthorized DVD-to-VHS copying. Hardware manufacturers have designed their DVD-R devices to recognize our copy protection signal to inhibit DVD-to-DVD copying as well. The majority of the recently introduced PVRs, DVD/VCR combo units, DVD recorders and PVR/DVD-R combo units comply with the DMCA, which requires that manufacturers must design their recording devices to sense widely used copy protection technologies, and, as a result, they recognize Macrovisions proprietary analog copy protection process and disable digital recording onto DVD discs.
DVD and Digital PPV/VOD Copy Protection. The DVD and digital PPV/VOD versions of our video content protection technologies employ proprietary electronic pulses placed in analog video streams and a second patented copy protection process called Colorstripe. Colorstripe affects the color playback circuit of a VCR causing colored horizontal stripes to appear in the picture of an unauthorized copy. The combination of the two processes provides a higher level of effectiveness than that provided by either process alone. In addition, Colorstripe is more effective against circumvention by most black box circumvention devices that were sold in the past. Copy protection is implemented in DVD and digital PPV/VOD applications by embedding a copy protection signal generator integrated circuit within the DVD player or digital set-top box. The copy protection circuits remain dormant until activated by data commands, which are either embedded in the DVD disc or sent along with the PPV movie transmission to the subscribers set-top box or hard drive recorder. The integrated circuit is activated by copy protection control codes, which are embedded into the DVD media or the PPV transmission. Once the integrated circuit is activated, it adds the copy protection signal to the analog output of the DVD player or digital set-top box. As with videocassette copy protection, consumers are able to see a clear picture on their television sets, but generally cannot make a usable videocassette copy on a VCR, and DVD recorders do not make DVD copies when they sense Macrovision copy protection signals at their analog inputs.
ACPe Content Management. Our ACPe technology can be used by content owners to control how long their PPV/VOD content may be stored on compliant digital set top box PVR units and home media center PC hard drives.
RipGuard DVD Rip Control Content Protection. RipGuard DVD is the digital copy protection counterpart of our ACP technology. It is designed to inhibit software ripper programs that operate on a consumers PC. It can be used in conjunction with ACP to give a combination analog and digital copy protection solution for optical discs. Ripguard DVD is a unilateral content protection solution, in that it is applied to the DVD disc at the time of manufacture, and is designed to have no impact on the quality of the displayed video and requires no hardware or special software on the PC or DVD player device.
In the audio CD market, CDS-100 and CDS-200 copy protection technologies were developed to inhibit consumer electronic device music files (standard, uncompressed music CD format) from being ripped by PCs. Each of the several CDS-100 and CDS-200 copy protection functions (e.g., coding, hiding and timing) is covered by pending patent applications. Our CDS-300 v8 product incorporates an active license manager solution that requires automatic transfer of software code from the CD to the PC hard drive, which is both consumer and rights owner friendly and can be used with any DRM.
Peer-to-Peer File Sharing Content Management Technology
Our Hawkeye technology can be used to protect copyrighted content by controlling the unauthorized file sharing of all types of digital content, including video and music, over P2P networks.
PC Games Technology
Each CD/DVD-ROM published with the patented SafeDisc Advanced technology is premastered with encrypted executable files and contains authenticating instructions and a unique SafeDisc digital signature. The digital signature, which is designed to prevent copying by CD recorders or transfer from a CD/DVD-ROM to a hard disc drive, is added to each original disc during the mastering/replication process. SafeDisc is a unilateral copy protection solution, which means that all of the copy protection technology resides on the CD/DVD-ROM and nothing has to be added to or changed in the PC. When a user inserts an original SafeDisc-protected disc in a CD/DVD-ROM drive, the authentication software reads the digital signature, allowing the program to be decrypted and run normally. The digital signature and authentication process is transparent to the user. If a consumer or pirate uses a CD recording device or professional mastering equipment to duplicate a CD/DVD-ROM and make an unauthorized copy, SafeDisc is designed to inhibit the transfer of the digital signature to the copy. If someone attempts to use such an unauthorized copy, the digital signature cannot be found, decryption will not take place and the copy will not run.
SafeDisc also contains anti-hacking technology which is designed to prevent the compromise of its security features. Because of our widespread penetration in the PC games market, hackers have targeted and cracked several versions of SafeDisc. For us to continue to be successful in this market, we must continually stay a step ahead of the hacker community. We have released new product versions approximately two to three times per year incorporating new anti-hacking features.
Software Technologies Group
Software and Hardware Manufacturers
FLEXnet Publisher enables software publishers and hardware manufacturers to price, package, and protect their software. Using FLEXnet Publisher, customers can electronically generate, track, and enforce their software licenses and guard against unauthorized use by implementing product activation or copy protection. FLEXnet Publisher also enables software publishers to generate additional revenue by offering their customers a broad choice of pricing and licensing models, including subscription- and usage-based models.
Software and hardware vendors integrate FLEXnet Publisher solutions into their products to monitor or control a customers compliance with a products license terms. Terms of the license are typically stored in an authenticated license file that resides either on the local computers hard disk drive or on a network-connected central server. Compliance with those license rights is automatically monitored. The software vendor may choose to block users from running a product if doing so violates or exceeds the license rights, or simply provide notification to the user or system administrator when product use has exceeded the customers license rights. This allows end user customers to buy software licenses using much more flexible license terms than traditional one-computer-one-license or site license approaches. These terms may include floating licenses
(where a specific number of licenses are shared over a network), product suites (where several product licenses are combined to be licensed as a single product) and demo licenses (where a prospective customer has full functional use of a product, but the right to use expires on a specific date or after a specific number of uses). With FLEXnet Publisher, software vendors can enable users to activate previously unlicensed copies of the software over the Internet, or by typing in a series of digits read over the phone. Electronic licensing can also record the use of licensed software into a transaction log, which is authenticated and encrypted so software vendors and customers can use this information as a basis for pay-per-use or other usage-based pricing or licensing.
Software and hardware vendors apply our InstallShield technology to their finished products, in effect wrapping the application for installation. When the end-user runs the installation program, it asks the user a number of questions and places the program files in the correct locations, configuring the program to run as requested.
Our Update Service technology is implemented as a program that resides on the end-users machine. It periodically checks the Internet for updates and downloads them as configured. End-users and/or their IT department system administration group can control how frequently (if at all) they want the service to check for updates, and what to do with those updates when available.
Macrovisions asset management software enables larger organizations to more effectively manage their licensed software, by providing interfaces to control licensed servers and set alerts to important licensing events. Moreover, this software can read and interpret the usage transaction logs described in the preceding section, enabling customers to better manage their FLEXenabled software assets and to allocate software-related costs to different departments or projects within the company. Our AdminStudio technology helps enterprise system administrators prepare various software applications and upgrades for deployment across the enterprise.
Research and Development
Our internal research and development efforts are focused on developing enhancements to existing products, new applications for our current technologies and new technologies related to our various digital product value management offerings. Our core competencies are in electronic license management and license delivery software, installer software, anti-hacking software, digital and analog video and audio engineering, copy protection engineering and optical media formats. We have acquired other companies and technologies to supplement our research and development expenditures. In 2004, 2003 and 2002, our expenses for research and development were $28.7 million, $17.2 million and $11.9 million, respectively.
Intellectual Property Rights
Patents Issued & Pending. We hold 100 U.S. patents and have 80 U.S. patent applications pending. Of the issued patents, 38 relate to our copy protection technologies, 24 relate to video scrambling, 12 relate to audio scrambling, seven relate to electronic license management and five relate to DRM technology (namely content usage control, tracking, and e-transactions). Of the pending patent applications, 40 relate to our copy protection technologies, six relate to video scrambling, 13 relate to audio scrambling, 10 relate to electronic license management and eight relate to DRM technology. The last of our issued U.S. patents expires in 2022. The last of our core group of analog copy protection patents expires in the year 2021. We also have 783 foreign patents issued and 336 foreign patent applications pending in 51 countries. Of the issued foreign patents, 499 relate to our copy protection technologies, 113 relate to video scrambling, 43 relate to audio scrambling, and 22 relate to electronic license management and DRM.
Circumvention Technology Patents. Included in the patents related to our copy protection technologies are 14 U.S. and 106 foreign patents covering a number of processes and devices that unauthorized parties could
use to circumvent our video content protection technologies. We also have three U.S. and 24 foreign circumvention technology patents pending. We have historically used these patents to limit the proliferation of devices intended to circumvent our video content protection technologies. We have initiated a number of patent infringement lawsuits against manufacturers and distributors of such devices. See Legal Proceedings.
Entertainment Technologies Group
Our video content protection technologies are proprietary and have broad U.S. and international patent coverage. We believe that there are currently no significant analog video copy protection competitors. We have the only analog copy protection scheme that has been widely deployed on commercial products that significantly distorts or inhibits copying by VHS VCRs, DVD recorders and hard drive recorders. Currently, our video content protection technology is embedded in nearly 100% of all DVD players and nearly 90% of digital set-top boxes worldwide. While it is possible that a competitive video content protection technology could be developed and deployed, we believe it would take years for the competitive technology to be tested and accepted by hardware manufacturers and ultimately to begin to be embedded into the consumer electronic devices. By the time this would happen, it is unlikely any other analog copy protection technology would displace our copy protection infrastructure and our extensive video copy protection ecosystem.
Our technology is designed to inhibit or prevent unauthorized consumer copying; it is not designed to prevent professional piracy. We believe that our customers are very concerned with professional piracy of their video, audio and software products. We believe that our customers assessment of the relative threats of professional versus consumer piracy may present a certain level of competition to our video copy protection business, to the extent that some content owners may decide to devote more of their resources to fighting professional video piracy instead of using our copy protection to deter unauthorized consumer copying.
With the increase in online movie and music distribution over the Internet, and with the continuing advance of digital content and high definition formats, our analog video content protection technologies that protect standard definition content on optical media and digital PPV/VOD signals may be viewed by our customers as being less important than the other digital and network copy protection solutions. As a result, other Internet-based digital content protection or DRM technologies may present significant competition to our video copy protection business, such as DRM offerings by Intertrust, Microsoft, RealNetworks, Contentguard and Sony. In addition, Sonys ARccOS product may present competition to our RipGuard DVD business. Competitors may also bundle their products with their own replication services, and by doing so, those competitors may be able to offer lower prices for the combined offering and therefore studios may switch to such replication facilities.
We believe that there are a limited number of direct competitors in the audio copy protection and rights management market, including SunnComm, Sony, First4Internet and Settec, with Sony having substantially greater financial and other resources than we have. To date, we believe we have a significant market share of the CDs produced worldwide to which audio CD copy protection has been applied. In 2004, only 180 million music CDs out of a total of approximately 2.3 billion music CDs produced included copy protection technology from any supplier, including Macrovision.
In January 2003, Microsoft announced the release of its Windows Media® Data Session Toolkit (WMDST) with a DRM solution that can to be deployed independently of our solutions. The announcement included SunnComm as the first company to integrate a third party music CD copy protection technology with Microsofts WMDST. We believe that SunnComm uses technology that is competitive with our CDS-100 and
CDS-200 technologies. It is possible that Microsoft may develop or acquire copy protection and rights management solutions that compete with our offerings. We have a non-exclusive agreement with Microsoft to allow their Windows Media Player and WMDST to interoperate with our CDS-300 solution.
Peer-to-Peer File Sharing Content Management Technology
We believe there are two primary competitors in the P2P file sharing content management market: MediaDefender and Loudeyes Overpeer Division. While these competitors were the first in this market and are very competitive in terms of pricing, we believe that our Hawkeye technology has the advantage of being able to more efficiently scale the solution to accommodate growing numbers of simultaneous titles/tracks that are copy protected.
PC Games Technology
We believe that there are a limited number of competitors in our SafeDisc Advanced consumer software copy protection market, including Sony SecuROM (developed and marketed by Sonys DADC optical disk manufacturing subsidiary), StarForce Technologies, Settec and Smarte Solutions.
Software Technologies Group
Publisher Value Management
Our primary competition in the publisher value management market comes from customers and prospects that develop their own homemade solutions. We have other more traditional competitors in various subcomponents of our offerings, including SafeNet (who acquired Rainbow Technologies, and has a small license management offering) and Altiris (who acquired Wise and has a small installer offering). There are other much smaller competitors as well, including companies such as XtreamLok and Softwrap. Operating system developers such as Microsoft, IBM and Sun already integrate limited license management and installation functionality into their products, and they could expand this functionality, which could pose an increased competitive threat. Similarly, microprocessor suppliers may choose to integrate rights management solutions into their products, and software resellers could also begin to develop their own electronic license management solutions.
Enterprise End-User Software Asset Management
Macrovision provides software asset management solutions to help end users monitor FLEXenabled applications. Because we encrypt the FLEXnet usage log files, we are the only ones authorized to read and interpret the FLEXnet usage log files for purposes of software asset management. We believe that there are currently no significant competitors in this particular software asset management area. In the larger market of software asset management in general, products such as CA Unicenter and IBM Tivoli offer related and sometimes overlapping functionality.
For our InstallShield heritage products, we believe our primary competitors are Altiris (for our AdminStudio and Windows installer business) and ZeroG (for our non-Windows installer business). Altiris acquired Wises PackageStudio product and we believe that PackageStudio currently outsells AdminStudio, in part due to historical distribution arrangements established before the Altiris acquisition. ZeroG is a small private company that focuses on non-windows-based deployment solutions.
Operations and Technical Support
We have technical support and certification operations to support our DVD manufacturer licensees, set-top box licensees, authorized semiconductor manufacturers, and our other hardware licensees. We provide technical support and professional services to our independent software vendor customers and end users during pre-sale, implementation and maintenance phases of our contracts.
We provide a variety of technical support to our content value management and software value management customers, including:
Our strategy is to license our technologies to third parties that manufacture products or software incorporating our technologies. For our InstallShield products, we contract with outside replicators to produce, package, and fulfill orders. Our manufacturing operations are limited to low volume video and audio copy protection processors used by third party replicators that require in-house system integration and quality control efforts.
Legislative and Regulatory Actions
A number of government and legislative initiatives have been enacted in recent years to encourage development and implementation of technologies that protect the rights and intellectual property of the content owners.
In the United States, Congress enacted the Digital Millennium Copyright Act (DMCA) in October 1998. This law required all VCRs to comply with analog copy protection technologies that are in widespread use, such as those covered in our patents, beginning in May 2000. The DMCA includes a clause that outlaws all circumvention devices and technologies that could be used to defeat widely used copy protection technologies. Based on our recent tests of new DVD recorder devices, we believe that manufacturers have designed them so they will not record analog input that is Macrovision copy-protected. Hence, our technology prevents copying on both VCRs and DVD-R devices. We also believe that software ripper products, when they include circumvention of copy protection or CSS encryption, are illegal under the law. In addition, we believe that software ripper companies who update their ripper products in order to circumvent RipGuard may be in violation of the anti-circumvention provisions of the DMCA. The U.S. law is based on a set of guidelines for amending basic copyright laws to deal with the protection of digital media. The guidelines were adopted in 1996 by the World Intellectual Property Organization, an agency of the United Nations.
Several countries in Europe have adopted a similar EU-wide copyright directive, which includes a provision aimed at controlling hardware and software circumvention devices and technologies. Individual countries legislatures are currently discussing these new copyright initiatives. The implementation of the Copyright Directive throughout Europe is continuing, with more countries enacting legislation. To date, Austria, Denmark, Germany, Greece, Italy and UK have implemented the Copyright Directive. The Directive brings into effect prohibitions on the manufacture, import, distribution, sale and marketing of circumvention devices and services. Macrovision has already taken action under the newly enacted German and UK Copyright Acts and obtained injunctions against a number of retailers to stop sales of devices that circumvent Macrovisions technology.
In Japan, a revision to the Japanese copyright law went into effect in October 1999 prohibiting the sale, manufacture, and import of circumvention devices. In addition, an industry directive that became effective in 1997 requires all digital recording devices to be responsive to analog copy protection technologies that utilize automatic gain control techniques, such as those covered by our patents.
We have made strategic investments in companies with complementary technologies and markets where we felt we could broaden our market reach or technology portfolio. The adjusted cost of our strategic investments as of December 31, 2004 was $18.8 million and consisted of investments in the following company:
Digimarc Corporation (Nasdaq: DMRC). In December 1997, we made our initial investment and signed a joint development agreement with Digimarc Corporation, a provider of patented digital watermarking technologies that allow digital code to be embedded in traditional and digital content, including movies, photographic images and documents such as financial instruments, passports and event tickets. We made two subsequent investments in June 1999 and October 2000, for a total of $25.3 million. Digimarc completed an initial public offering in December 1999. As of December 31, 2004, we owned approximately approximately 9.8% of Digimarc, which translated to a valuation of $18.8 million. During 2002, we determined that the decline in value of Digimarc stock was other-than-temporary and took a charge to earnings of $1.8 million as a result. There were no charges taken in 2003. During 2004, we determined that the decline in value of Digimarc stock was other-than-temporary and took a charge to earnings of $5.3 million as a result.
In addition to the above investment, we have made and hold strategic investments in other companies that have been written down and have no recorded value as of December 31, 2004.
Our strategic investments represented 4.1% and 7.0% of our total assets as of December 31, 2004 and 2003, respectively. In total, we wrote off $5.5 million, $4.8 million and $17.2 million for the years ended December 31, 2004, 2003 and 2002, respectively, related to impairments that were other-than-temporary, in an aggregate of eleven companies. In the future, we may continue to evaluate and make such minority investments for strategic purposes. We may never have an opportunity to realize a return on either current or future investments and may be required to write off all or part of these investments.
As of December 31, 2004, we had 606 full-time employees. Of these employees, 189 are based outside of the United States. We expect to hire additional employees in 2005, particularly in engineering, marketing, sales and support. None of our employees is covered by a collective bargaining agreement or is represented by a labor union. We have not experienced any organized work stoppages. We believe that our future success will depend in part upon the continued service of our key employees and on our continued ability to hire and retain qualified personnel. We may not be able to retain our key employees and may not be successful in attracting and retaining sufficient numbers of qualified personnel to conduct our business in the future. Our ability to hire and retain qualified personnel may be adversely affected if we decide not to offer broad-based stock options in response to Financial Accounting Standards Board (FASB) directives for stock option expensing.
Our Internet website is located at http://www.macrovision.com. We make available free of charge on our website our 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 Exchange Act, as soon as reasonably practicable after we electronically file such material with, or otherwise furnish it to, the Securities and Exchange Commission (the SEC). The reference to our Internet website does not constitute incorporation by reference of the information contained on or hyperlinked from our Internet website and should not be considered part of this document.
The public may also read and copy any materials we file with the SEC at the SECs 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 Rooms 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 SECs Internet website is located at http://www.sec.gov.
In addition to the other information contained in this Annual Report on Form 10-K, you should consider carefully the following risks. If any of these risks occurs, our business, financial condition or operating results could be adversely affected.
The success of our business depends on the continued use by major movie studios of our video content protection technology.
If major motion picture studios were to determine that the benefits of our technology do not justify the cost of licensing the technology, then demand for our technology would decline. Historically, we derive a majority of our net revenues and operating income from fees for the application of our patented video content protection technology to various video formats: prerecorded videocassettes, DVDs and digital pay-per-view or video-on-demand (PPV/VOD) programs.
Any future growth in revenues from these fees will depend on (a) growth in the various media formats, (b) increased use of our video content protection technology on a larger number of videocassettes, DVDs, digital PPV/VOD programs or PCs, or (c) increases in usage fees or royalties. To increase or maintain our market penetration, we must continue to persuade content owners that the cost of licensing the technology is outweighed by the increase in revenues that content owners and retailers gain as a result of using content protection, such as revenues from additional sales of the copy protected material or subsequent revenues from other distribution channels.
The retail prices of DVDs are falling. As retail prices drop, consumers trend toward purchases rather than rental of DVDs, therefore studios face substantial increases in marketing costs which creates increased pressure to trim manufacturing expenses. This includes cutting back in their content protection usage, as well as negotiated reductions in their usage fees. Recently, diminishing margins that studios have been experiencing have contributed to a reduction in the prices we can charge them to include our video content protection technology in their products. As such, although we have not experienced a decline in total revenue, we have seen our usage fees on a per unit basis decline over time. Even though we have contracts with minimum annual volume commitments, it is possible for some studios to copy protect a smaller percentage of their titles and still achieve their minimum volume commitments. In addition, some studios choose to copy protect selected titles, or choose to not use any copy protection, and their actions may influence other studios to do the same, which could harm our business.
We have been successful historically in licensing our content protection technologies to control unauthorized casual consumer copying. Other content piracy sources include camcorders in movie theaters,
peer-to-peer file sharing services and PC-based DVD copying software. To the extent that our customers spend money to prevent or litigate against these other piracy sources, they may reduce spending on our technology. Additionally, if our customers are unable to prevent their content from becoming available through these other piracy sources, they may consider our technology to be less valuable. In either event, our business would be harmed.
Any decline in demand for our video content protection technology, including a change of video content protection policy by the major motion picture studios, or a decline in sales of prerecorded videocassettes and DVDs that are encoded with our video content protection technology, or additional declines in our average unit royalties, would have a material adverse effect on our business. If several of the motion picture studios withdraw their support for our content protection technologies or otherwise determine not to copy protect a significant portion of prerecorded videocassettes, DVD or digital PPV/VOD programs, our business would be harmed.
Our operating results may fluctuate, which may adversely affect the price of our common stock.
Our quarterly and annual revenues, expenses and operating results could vary significantly in the future and period-to-period comparisons should not be relied upon as indications of future performance. Due to limited visibility in predicting software licensing revenues and, particularly, revenues that are generated from perpetual licenses (under which license fee revenue is recognized upfront on a one-time basis), we may experience volatility in revenues which may cause us to not be able to sustain our level of net revenues, or our rate of revenue growth, on a quarterly or annual basis. In addition, we may be required to delay or extend recognition of revenue on more complex licensing arrangements as required under generally accepted accounting principles in the United States. Fluctuations in our operating results may cause the price of our common stock to decline.
Further, we may not be in a position to anticipate a decline in revenues in any quarter until late in the quarter. This is primarily due to the delay inherent in reporting from certain licensees and closing of new sales agreements, resulting in potential volatility in the price of our common stock. Other factors that could affect our operating results include:
We experience seasonality in our operating results, which may affect the price of our common stock.
Because of the nature of the products that we offer, we have experienced significant seasonality in our business, and our business is likely to be affected by seasonality in the future. We have typically experienced our highest revenues in the fourth quarter of each calendar year followed by lower revenues and operating income in the first quarter, and at times in subsequent quarters, of the next year. We believe that this trend has been principally due to the tendency of our customers to release their more popular movies, games and music during the year-end holiday shopping season as well as the pronounced fourth quarter seasonality in the software business. Our revenues generally have tended to be lower in the summer months, particularly in Europe.
We depend on a small number of key customers for a high percentage of our revenues and the loss of a significant customer could result in a substantial decline in our revenues and profits.
Our customer base and our net revenues is highly concentrated among a limited number of customers, primarily due to the fact that the MPAA studios dominate the motion picture industry and the loss of any one customer would have a significant adverse impact on our business. Historically, we have derived the majority of our net revenues from a relatively small number of customers. No customer accounted for more than 10% of our net revenues in 2004, one customer accounted for 10.2% of our net revenues in 2003 and one customer accounted for 11.4% of our net revenues in 2002.
We expect that revenues from the MPAA studios will continue to account for a substantial portion of our net revenues for the foreseeable future. We have multi-year agreements with some of the major home video companies for copy protection of a substantial part of their videocassettes and/or DVDs in the U.S. These agreements expire at various times from 2005 to 2007, and may or may not be renewed, or, if renewed, may be at substantially reduced per unit prices and on other terms less favorable to us than the existing agreements. Changes in management, ownership or control of the MPAA studios could affect the renewal of their contracts with us. The failure of any one of these customers to renew its contract or to enter into a new contract with us on terms that are favorable to us would likely result in a substantial decline in our net revenues and operating income, and our business would be harmed.
We depend on signing and in some cases completing high-value license agreements during the reporting period from major software customers for our FLEXnet product and the inability to sign or complete these agreements could result in a decline or deferral of our revenues and profits.
Currently, a material portion of our FLEXnet revenues are generated from perpetual licenses, under which license fee revenue is generally recognized up front on a one-time basis, combined with an annual maintenance fee that is ratably recognized over the 12-month period. Failure to close a small number of high-value perpetual licenses during any period could result in a decline in our revenues and profits. We currently offer our customers the choice between a perpetual license and an annual (or time based) license, the latter of which results in ratable recognition of the license fee over the term of the license, which is generally 12 months.
Additionally, in the future, we believe an increasing portion of our FLEXnet revenues may be generated from custom software development projects and recognized when the projects are completed. We expect that as we pursue more independent software vendor customers in the mainstream enterprise software market, we
may engage in more custom software development projects, which may delay our revenue recognition by linking it to completion of software and formalized customer acceptance.
We have limited control over existing and potential customers and licensees decisions to include our technology in their product offerings.
In general we are dependent on our customers and licensees including producers and distributors of content for music, films, videos, software and games to incorporate our technology into their products. Although we have license agreements with many of these companies, many of these license agreements do not require any minimum purchase commitments, or are on a non-exclusive basis, or do not require incorporation of our technology in their products. Furthermore, while we may be successful in obtaining mandatory status for our technology in one or more industry standards, there is no guarantee that products associated with these standards will be successful in the market. Our licensees and other manufacturers might not utilize our technology in the future. If this were to occur, our business would be harmed.
A significant portion of our revenues is derived from international sales. Economic, political, regulatory and other risks associated with our international business could have an adverse effect on our operating results.
International and export sales together represented 42.2%, 42.2% and 34.2% of our consolidated net revenues in 2004, 2003 and 2002, respectively. We expect that international and export sales will continue to represent a substantial portion of our net revenues for the foreseeable future. Our future growth will depend to a large extent on worldwide acceptance and deployment of our content protection and DRM solutions for music CDs, digital PPV networks, DVDs, and consumer software. Worldwide adoption of our FLEXnet software value management solutions will also be an important driver of future growth.
To the extent that foreign governments impose restrictions on importation of programming, technology or components from the U.S., the requirement for content protection and rights management solutions in these markets could diminish. In addition, the laws of some foreign countries may not protect our intellectual property rights to the same extent as do the laws of the U.S., which increases the risk of unauthorized use of our technologies and the ready availability or use of circumvention technologies. Such laws also may not be conducive to copyright protection of digital content and software, which may make our content protection technology less effective and reduce the demand for it.
Because we sell our products worldwide, our business is subject to the risks associated with conducting business internationally, including:
Our business could be materially adversely affected if foreign markets do not continue to develop, if we do not receive additional orders to supply our technologies or products for use in foreign prerecorded video, music, PPV and other applications requiring our content protection solutions or if regulations governing our international businesses change. For example, our products are eligible for export under the U.S. Export Administration Act and U.S. export regulations. We have implemented a program to comply with these laws and regulations, but cannot guarantee that any particular product can be exported to any particular location at any particular time. Any changes to the statute or the regulations with respect to export of encryption technologies could require us to redesign our products or technologies or prevent us from selling our products and licensing our technologies internationally.
If we fail to develop and deliver innovative technologies in response to changes in the entertainment industry, our business could decline.
The markets for our products and technologies are characterized by rapid change and technological evolution. We will need to continue to expend considerable resources on research and development in the future in order to continue to design and deliver enduring, innovative entertainment products and technologies. Despite our efforts, we may not be able to develop and effectively market new products, technologies and services that adequately or competitively address the needs of the changing marketplace. In addition, we may not correctly identify new or changing market trends at an early enough stage to capitalize on market opportunities. At times such changes can be dramatic, such as the shift from VHS videocassettes to DVDs for consumer playback of movies in homes and elsewhere. Our future success depends to a great extent on our ability to develop and deliver innovative technologies that are widely adopted in response to changes in the entertainment industry and that are compatible with the technologies or products introduced by other entertainment industry participants. If we are unsuccessful in developing and delivering new technologies, our business would be harmed.
Our success is heavily dependent upon our proprietary technologies.
We believe that our future success will depend on our ability to continue to introduce proprietary solutions for digital content value management and software value management technologies that can be supplemented by enabling features that will incent consumers and users to pay for legitimate video, audio and software products, rather than trying to get them for free in an unauthorized fashion. We rely on a combination of patent, trademark, copyright and trade secret laws, nondisclosure and other contractual provisions, and technical measures to protect our intellectual property rights. Our patents, trademarks or copyrights may be challenged and invalidated or circumvented. Our patents may not be of sufficient scope or strength or be issued in all countries where products incorporating our technologies can be sold. The last of our core group of analog copy protection patents expire in the year 2017. In many cases, we have filed applications to expand our patent claims and for improvement patents to extend the current expiration dates, however, expiration of some of our patents may harm our business. If we are not successful in protecting our intellectual property, our business would be harmed.
Others may develop technologies that are similar or superior to our technologies, duplicate our technologies or design around our patents. A number of companies with extensive financial resources have developed intellectual property in the digital rights management field, including InterTrust, Philips, Sony, ContentGuard, IBM and Microsoft. Such competitive threats could harm our business.
Effective intellectual property protection may be unavailable or limited in some foreign countries. Despite efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise use aspects of processes and devices that we regard as proprietary. Policing unauthorized use of our proprietary information is difficult, and the steps we have taken may not prevent misappropriation of our technologies.
We may initiate patent infringement or patent interference actions or other litigation to protect our intellectual property, which could be costly and harm our business.
Litigation may be necessary in the future to enforce our patents and other intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. For a description of our current legal proceedings, see Legal Proceedings.
We, and many of our current and potential competitors, dedicate substantial resources to protection and enforcement of intellectual property rights, especially patents in the area of digital rights management technologies. We believe that companies will continue to take steps to protect these technologies, including, but not limited to, seeking patent protection. As a result, disputes regarding the ownership of these technologies and the associated rights are likely to arise in the future and may be very costly. Companies in the technology and content-related industries have frequently resorted to litigation regarding intellectual property rights. We may be forced to litigate to determine the validity and scope of other parties proprietary rights. Any such litigation could be very costly and could distract our management from focusing on operating our business. The existence and/or outcome of such litigation could harm our business.
We may be subject to intellectual property infringement claims or other litigation, which are costly to defend and could limit our ability to use certain technologies in the future.
From time to time we receive claims and inquiries from third parties alleging that our internally developed technology, technology we have acquired or technology we license from third parties may infringe other third parties proprietary rights, especially patents. Third parties have also asserted and most likely will continue to assert claims against us alleging infringement of copyrights, trademark rights or other proprietary rights, or alleging unfair competition or violations of privacy rights. We could be required to spend significant amounts of time and money to defend ourselves against such claims. If any of these claims were to prevail, we could be forced to pay damages, comply with injunctions, or stop distributing our products and services while we re-engineer them or seek licenses to necessary technology, which might not be available on reasonable terms or at all. We could also be subject to claims for indemnification resulting from infringement claims made against our customers and strategic partners, which could increase our defense costs and potential damages. Any of these events could require us to change our business practices and harm our business.
Litigation could harm our business and result in:
We are entering into a new business for the protection and enablement of audio, video and software content on the Internet and P2P networks. We believe that there is and will continue to be an increasing level of litigation to determine the applicability of current laws to, and impact of new technologies on, the use and distribution of content over the Internet and P2P networks and through new devices, especially as it relates to the music, motion picture and software industries. P2P network providers and consumer activist groups have been very active in litigation against attempts to restrict the free use and distribution of content over the Internet and P2P networks. As we develop products and services that protect, provide or enable the provision of content in such ways, the risk of litigation against us may increase.
It may be time-consuming and costly to enforce our patents against devices and hacking techniques that attempt to circumvent our content protection technology, and our failure to control them could harm our business.
We use our patents to limit the proliferation of devices and technologies intended to circumvent our video content protection technologies. In the past, we have initiated a number of patent infringement disputes against manufacturers and distributors of these devices and software. In the event of an adverse ruling in such litigation, the value of our video protection technology may decline due to the legal availability of such a circumvention device, or we may have to obtain rights to the offending devices to protect the value of our technology. The legal availability of circumvention devices could result in the increased proliferation of devices that defeat our content protection technology and a decline in demand for our technologies, which could have a material adverse effect on our business.
A limited number of DVD manufacturers may build products that either do not contain our content protection technology, or include features that allow consumers to bypass content protection. Although we believe this is in contravention of the DMCA, as well as the basic DVD CSS license, proliferation of these products could cause a decline in demand for our technologies, which could harm our business.
Any legal or other enforcement action that we may initiate could be time-consuming to pursue, involve costly litigation, divert managements attention from operations or may not be successful. See Legal Proceedings.
In the PC games copy protection segment, a number of individuals have developed and posted SafeDisc Advanced hacks on the Internet, or CD cloning software. If we are not able to develop frequent SafeDisc Advanced software releases and new digital signatures, which deter the hackers from developing circumvention or cloning techniques, our customers could reduce their usage of our technology because it was compromised. We expect to encounter similar challenges with our CDS-300 music content protection product, our Ripguard DVD anti-ripper product and our Hawkeye P2P file sharing antipiracy service.
CGMS-A is an alternative analog copy protection technology for which we have patents that apply in the United States. We believe this technology has applicability in protecting digital content within home media centers, Internet downloads, and digital PPV/VOD broadcasts. We plan to license these patents to both content owners and hardware manufacturers. If our patents are contested, we may find that the cost in terms of litigation expense, management diversion, and reduced customer goodwill may offset the revenue potential and could harm our business.
Legislative initiatives seeking to weaken copyright law or new governmental regulation and resulting legal uncertainties could harm our business.
Consumer rights advocates and other constituencies are challenging copyright law, notably the U.S. Digital Millennium Copyright Act of 1998, through both legislative and judicial actions. Legal uncertainties surrounding the application of the DMCA may adversely affect our business. If copyright law is compromised, or devices that can circumvent our technology are permitted by law and become prevalent, this could result in reduced demand for our technologies, and our business would be harmed.
Many laws and regulations are pending and may be adopted in the United States, individual states and local jurisdictions and other countries with respect to the Internet. These laws may relate to many areas that impact our business, including copyright and other intellectual property rights and digital rights management. These types of regulations are likely to differ between countries and other political and geographic divisions. Other countries and political organizations are likely to impose or favor more and different regulation than that which has been proposed in the United States, thus furthering the complexity of regulations. In addition, state and local governments may impose regulations in addition to, inconsistent with, or stricter than federal regulations. Changes to or the interpretation of these laws could expose us to increased litigation risk, substantial defense costs and other liabilities. It is not possible to predict whether or when such legislation
may be adopted, and the adoption of such laws or regulations, and uncertainties associated with their validity, interpretation, applicability and enforcement, could materially and adversely affect our business.
Our relationships with entertainment industry participants are particularly important to our businesses, and if we fail to maintain such relationships our business could be materially harmed.
If we fail to maintain and expand our relationships with a broad range of participants throughout the entertainment industry, including motion picture studios, broadcasters, video game designers, music producers and manufacturers of consumer electronics products, our business and prospects could be materially harmed. Relationships have historically played an important role in the entertainment industries that we serve. If we fail to maintain and strengthen these relationships, these entertainment industry participants may not purchase and use our technologies, which could materially harm our business and prospects. In addition to directly providing a substantial portion of our revenue, these relationships are also critical to our ability to have our technologies adopted as industry standards. Moreover, if we fail to maintain our relationships, or if we are not able to develop relationships in new markets in which we intend to compete in the future, including markets for new technologies and expanding geographic markets, our business, operating results and prospects could be materially and adversely affected. In addition, if major industry participants form strategic relationships that exclude us, our business and prospects could be materially adversely affected.
We must establish and maintain licensing relationships with companies other than content owners or software publishers to continue to build and support a worldwide content value management ecosystem and to expand our business, and failure to do so could harm our business prospects.
Our future success will depend upon our ability to establish and maintain licensing relationships with companies in related business fields, including:
Substantially all of our license agreements are non-exclusive, and therefore our licensees are free to enter into similar agreements with third parties, including our competitors. Our licensees may develop or pursue alternative technologies either on their own or in collaboration with others, including our competitors.
Some of our third party license arrangements will require that we license others technologies and/or integrate our solutions with others. As an example, our customers will expect that our music copy protection, authentication, and controlled burning technologies will be integrated with various DRM solutions. In addition, we rely on third parties to report usage and volume information to us. Delays, errors or omissions in this information could harm our business. If these third parties choose not to support integration efforts or delay the integration, our business could be harmed.
We must continue to provide satisfactory support and maintenance services to our software value management customers.
Our future success will depend on our ability to provide adequate software support and maintenance services to our independent software vendor electronic license management customers. As they release new applications or modify their software to run on new platforms, it is important that their businesses not be disrupted as a result of inadequate support from us. Failure to deliver such services could harm our business.
We depend on third parties to implement and support our SafeDisc Advanced, our CDS-300 music copy protection, and our Ripguard DVD anti-ripper software modules within their optic disc encoding and quality assurance equipment.
We rely on third party vendors such as DCA, Eclipse, Media Morphics and CD Associates to develop and incorporate software modules that will:
Our operations could be disrupted if our relationships with third party vendors are disrupted or if their products are defective, not available or not accepted by licensed replicators. This could result in a loss of customer orders and revenue.
Our various digital content value management solutions are available in more than 132 of the worlds largest mastering and replication facilities, and are designed to be fully compatible with standard CD manufacturing processes. Nevertheless, we rely on such third parties to properly apply these technologies to optical media-based content on behalf of our customers and to properly perform quality assurance testing with respect to such content. Any improper application of the technology or improper quality assurance testing by such third party mastering and replication facilities may result in content that does not contain our copy protection technology or may result in other defects in the rights holders content, and may therefore, result in a loss of revenue or a claim against us by the content owner.
We rely on our licensees and others to accurately prepare manufacturing reports in determining our licensing revenue, and if these reports are inaccurate, our operating results could be materially adversely affected.
Our licensing revenue is generated primarily from content owners who license our technologies and incorporate them in their products. Under our existing arrangements, these licensees typically pay us a per-unit licensing fee based on the number of units of product they manufacture that incorporates our technologies. We depend on third party replicators to properly apply our content protection technology to content on behalf of our customers, to properly perform quality assurance testing with respect to such content and to accurately report the number of copy protected units manufactured. In collecting our license fees, preparing our financial reports, projections and budgets and directing our sales and product development efforts, we rely on those manufacturing reports from our customers and their replicators. However, it is often difficult for us to independently determine whether or not our licensees are reporting shipments accurately and audits are generally expensive and time consuming and initiating audits could harm our customer relationships. To the extent that our licensees understate or fail to report the number of products incorporating our technologies that they ship, we will not collect and recognize revenue to which we are entitled, which could adversely affect our operating results. To the extent that these same parties improperly report and overstate the number of products incorporating our technologies that they ship, we may have to issue credits for past revenue, which could adversely affect our operating results.
Our operating results may fluctuate depending upon when we receive manufacturing reports from our licensees.
Our quarterly operating results may fluctuate depending upon when we receive royalty reports from our licensees. We recognize a portion of our license revenue only after we receive royalty reports from our licensees regarding the manufacture of their products that incorporate our technologies. As a result, the timing of our revenue is dependent upon the timing of our receipt of those reports. In addition, it is not uncommon for royalty reports to include corrective or retroactive royalties that cover extended periods of time. Furthermore, there have been times in the past when we have recognized an unusually large amount of licensing revenue from a licensee in a given quarter because not all of our revenue recognition criteria were met in prior periods. This can result in a large amount of licensing revenue from a licensee being recorded in a given quarter that is not necessarily indicative of the amounts of licensing revenue to be received from that licensee in future quarters, thus causing fluctuations in our operating results.
We are exposed to risks associated with expanding our technology base through strategic acquisitions and investments.
We have expanded our technology base in the past through strategic acquisitions and investments in companies with complementary technologies or intellectual property and intend to do so in the future. Acquisitions always hold special challenges in terms of successful integration of technologies, products and employees. For companies we have acquired in the past and companies we acquire in the future, we may not be able to incorporate any acquired services, products or technologies with our existing operations, or integrate personnel from the acquired businesses, in which case our business could be harmed.
Negotiating or completing any potential future acquisitions, and integrating past and potential future assets and acquisitions, could cause significant diversions of management time and resources. Financing for future acquisitions may not be available on favorable terms, or at all. If we identify an appropriate acquisition candidate for any of our businesses, we may not be able to negotiate the terms of the acquisition successfully, finance the acquisition or integrate the acquired business, products, technologies or employees into our existing business and operations. Future acquisitions may not be well-received by the investment community, which may cause our stock price to fall. We have not entered into any agreements regarding any future acquisitions and cannot ensure that we will be able to identify or complete any acquisition in the future.
If we acquire businesses, new products or technologies in the future, we may be required to amortize significant amounts of identifiable intangible assets and we may record significant amounts of goodwill that will be subject to annual testing for impairment. We have in the past and may in the future be required to write off all or part of one or more of these investments that could harm our business. If we consummate one or more significant future acquisitions in which the consideration consists of stock or other securities, our existing stockholders ownership could be significantly diluted. If we were to proceed with one or more significant future acquisitions in which the consideration included cash, we could be required to use a substantial portion of our available cash. Acquisition activities could also cause operating margins to fall depending upon the financial models of the businesses acquired.
Our strategic investments may involve joint development, joint marketing, or entry into new business ventures, or new technology licensing. Any joint development efforts may not result in the successful introduction of any new products by us or a third party, and any joint marketing efforts may not result in increased demand for our products. Further, any current or future strategic acquisitions and investments by us may not allow us to enter and compete effectively in new markets or enhance our business in any current markets.
We currently hold minority equity interests in a number of companies, including Digimarc, a public corporation. These strategic investments, totaling $18.8 million, represented 4.1% of our total assets as of December 31, 2004. Other than Digimarc, our strategic investments are in privately held companies. There is no active trading market for the securities of privately held companies and our investments in them are illiquid at best.
We have written off all of our investments in such privately held companies and we may never have an opportunity to realize any return on our investments in them. Through December 31, 2001, we had invested an aggregate of $53.3 million in strategic investments. Since December 31, 2001, we have not made any additional strategic investments. During 2004, 2003 and 2002, we wrote off $5.5 million, $4.8 million and $17.2 million, respectively, of strategic investments resulting from impairment that was other-than-temporary.
Our products could be susceptible to errors or defects that could result in lost revenues, liability or delayed or limited market acceptance.
We offer and develop a series of complex content value management and software value management solutions, which we license to customers. The performance of these products typically involves working with sophisticated software, computing and communications systems. Due to the complexity of these products offered and developed, and despite our quality assurance testing, the products may contain undetected defects or errors that may affect the proper use or application of such products by the customer. Any such defects or errors in existing or new products, and any inability to meet customer expectations in a timely manner, could result in loss of revenue or market share, failure to achieve market acceptance, diversion of development resources, injury to our reputation, increased insurance costs and increased service, any of which could materially harm our business.
In addition, we rely on the customer and third party replicators to properly use our products to protect the software and applications to which our technology may be applied. Any improper use or application of the software by the customer or the third party replicators may render our technologies useless and result in losses from claims arising out of such improper use of the products.
Because customers rely on our products for copy protection and digital rights management of their software and applications, defects or errors in our products may discourage customers from purchasing our products. These defects or errors could also result in product liability or warranty claims. Although we attempt to reduce the risk of losses resulting from these claims through warranty disclaimers and limitation of liability clauses in our agreements, these contractual provisions may not be enforceable in every instance. Furthermore, although we maintain errors and omissions insurance, this insurance may not adequately cover these claims. If a court refused to enforce the liability-limiting provisions of our contracts for any reason, or if liabilities arose that were not contractually limited or adequately covered by insurance, our business could be materially harmed.
In protecting copyrights and other intellectual property rights of our customers, our products affect consumer use of our customers products. Consumers may view this negatively and discontinue or threaten to discontinue purchase or use of our customers products unless our customers stop using our technologies. This may cause a decline in demand for our products or legal actions against us by our customers or consumers.
If use of the Internet for delivery of software does not increase as we anticipate, our business may suffer.
Some of our products are designed to support using the Internet to deliver, install, deploy, activate, update or pay for software or digital media. The revenues we generate from these products depend on increased acceptance and use of the Internet as a medium of commerce, communications and delivery of software and digital media. Acceptance and use of the Internet may not continue to develop at historical rates, and a sufficiently broad base of business customers may not adopt or continue to use the Internet to conduct their operations. Demand and market acceptance for recently introduced services and products over the Internet are subject to a high level of uncertainty, and there are few proven services and products. Our business could be seriously harmed if:
If use of the Internet for delivery of video and audio programming increases, our business may suffer.
Some of our products, such as video, audio and packaged software copy protection, are designed to be applied to packaged media, and we receive royalties based on the number of units produced. If electronic delivery of such products using the Internet were to increase, our revenues from packaged media may be adversely affected and not replaced by Internet-based revenues. In this event, our business could be seriously harmed.
For our business to succeed, we need to attract and retain qualified employees and manage our employee base effectively.
Our success depends on our ability to hire and retain qualified employees and to manage our employee base effectively. Because of the specialized nature of our business, our future success will depend upon our continuing ability to identify, attract, train and retain other highly skilled managerial, technical, sales and marketing personnel, particularly as we enter new markets. We are implementing a senior management succession program in order to effectively plan for changes in our executive officers over time but there can be no guarantee that we will find appropriate candidates. Competition for people with the skills that we require is intense, particularly in the San Francisco Bay area where our headquarters are located, and the high cost of living in this area makes our recruiting and compensation costs higher. In particular, due to the overall decline in technology market values and the resultant impact on our stock price, using stock options as an incentive to hire and retain employees may be less effective. If we are unable to hire and retain qualified employees, our business and operating results could be adversely affected.
Calamities or terrorist attacks in Silicon Valley, the U.K. or other countries in which our offices are located could disrupt our business and adversely affect our operations.
Our headquarters office facilities in Santa Clara, California are in areas of seismic activity near active earthquake faults. Any earthquake, fire or other calamity affecting our facilities may disrupt our business and substantially affect our operations. A terrorist attack targeting Silicon Valley, the U.K. or other countries in which our offices are located could disrupt our business and substantially affect our operations.
Our telephone and computer networks are subject to security and stability risks that could harm our business and reputation and expose us to litigation or liability.
Online business activities depend on the ability to transmit confidential information and licensed intellectual property securely over private and public networks. Any compromise of our ability to transmit such information and data securely or reliably, and any costs associated with preventing or eliminating such problems, could harm our business. Online transmissions are subject to a number of security and stability risks, including:
The occurrence of any of these or similar events could damage our business, hurt our ability to distribute products and services and collect revenue, threaten the proprietary or confidential nature of our technology, harm our reputation, and expose us to litigation or liability. Because some of our technologies and businesses are intended to inhibit use of or restrict access to our customers intellectual property, we may become the target of hackers or other persons whose use of or access to our customers intellectual property is affected by our technologies. We may be required to expend significant capital or other resources to protect against the threat of security breaches, hacker attacks or system malfunctions or to alleviate problems caused by such breaches, attacks or failures.
We will incur increased costs and demands upon management as a result of complying with the laws and regulations affecting public companies, which could affect our operating results.
We have incurred, and will continue to incur, significant legal, accounting and other expenses associated with recently adopted corporate governance and public company reporting requirements, including requirements under the Sarbanes-Oxley Act of 2002, as well as new rules implemented by the SEC and the Nasdaq. The expenses incurred by public companies generally for reporting and corporate governance purposes have been increasing. As long as the SEC requires the current level of compliance for public companies of our size, we expect these rules and regulations to increase our legal and financial compliance costs and to make some activities more time-consuming and costly, although we are unable to currently estimate these costs with any degree of certainty. We do believe, however, that we will be able to fund these costs out of our available working capital. We also expect these new rules and regulations may make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage than was previously available. As a result, it may be more difficult for us to attract and retain qualified individuals to serve on our board of directors or as our executive officers.
If we fail to maintain proper and effective internal controls, our ability to produce accurate financial statements could be impaired, which could increase our operating costs and affect our ability to operate our business.
We have a complex business that is international in scope. Ensuring that we have adequate internal financial and accounting controls and procedures in place to help ensure that we can produce accurate financial statements on a timely basis is a costly and time-consuming effort that needs to be re-evaluated frequently. We are continually in the process of documenting, reviewing and, if appropriate, improving our internal controls and procedures in connection with Section 404 of the Sarbanes-Oxley Act of 2002, which requires annual management assessments of the effectiveness of our internal control over financial reporting and a report by our independent registered public accountants addressing these assessments. If we or our independent registered public accountants identify areas for further attention or improvement, implementing any appropriate changes to our internal controls may require specific compliance training of our directors, officers and employees, entail substantial costs in order to modify our existing accounting systems, and take a significant period of time to complete. Such changes may not, however, be effective in maintaining the adequacy of our internal controls, and any failure to maintain that adequacy, or consequent inability to produce accurate financial statements on a timely basis, could increase our operating costs and could materially impair our ability to operate our business.
Changes in, or interpretations of, tax rules and regulations may adversely affect our effective tax rates.
We are subject to income taxes in the U.S. and foreign tax jurisdictions. Our future effective tax rates could be unfavorably affected by the changes in tax laws or the interpretation of tax laws, by changes in the amount of revenue or earnings that we derive from international sources in countries with low statutory tax rates, or by changes in the valuation of our deferred tax assets and liabilities. Unanticipated changes in our tax rates could affect our future results of operations.
In addition, we are subject to examination of our income tax returns by the Internal Revenue Service and other domestic and foreign tax jurisdictions. We regularly assess the likelihood of outcomes resulting from these examinations to determine the adequacy of our provision for income taxes. In making such assessments, we exercise judgment in estimating our provision for income taxes. While we believe our estimates are reasonable, we cannot assure you that the final determination from these examinations will not be materially different from that reflected in our historical income tax provisions and accruals. Any adverse outcome from these examinations may have an adverse effect on our business and operating results, which could cause the market price of our stock to decline.
If consumer reaction to music copy protection and digital rights management technologies is unfavorable, our revenue potential may be adversely affected.
We entered the market for music CD copy protection and rights management through the acquisition of the assets of Midbar Tech (1998) Ltd. and TTR Technologies, Inc. in 2002 and 2003, respectively. Patents we acquired from both Midbar and TTR cover first session copy protection and controlled burning two technologies that we believe are fundamental to success in the music copy protection business. Our CDS-300 product incorporates an active license manager solution that requires automatic transfer of software code from the CD to the PC hard drive. The consumer must ‘opt in to this action if they want to listen to the CD on their PC. A number of competitors have developed similar or alternative music copy protection solutions. The solution we are marketing may not achieve or sustain market acceptance, or may not meet, or continue to meet, the demands of the music industry.
It is possible that there could be significant consumer resistance to audio copy protection, as consumers may feel that copy protection degrades the sound quality of the original or that they are entitled to freely copy audio CDs, because no technology has been used in the past to prevent copying. It is not clear whether the major music labels will deploy any copy protection solutions if there is sustained consumer resistance. To date, we have seen limited acceptance of our technology in Europe and Japan. We believe that the major music labels have not moved to deploy the technology in the U.S. because they are concerned about playability issues and negative consumer reaction. If the music labels conclude that shipping increasingly meaningful volumes of CDs that include our technologies generate unacceptable consumer backlash, our revenue potential may be adversely affected. If the market for music CD copy protection fails to develop, or develops more slowly than expected, if our solution does not achieve or sustain market acceptance or if there is significant and sustained consumer resistance to this technology, our business would be harmed.
We license technology for digital VOD and PPV copy protection, and if this market does not grow as anticipated or we are unable to serve this market effectively, our revenues may be adversely affected.
While our copy protection capability is embedded in more than 145 million digital set-top boxes manufactured by the leading digital set-top box manufacturers, only 13 cable or satellite system operators have activated copy protection for digital PPV or VOD programming. Our ability to expand our markets in additional home entertainment venues such as digital PPV or VOD will depend in large part on the support of the major motion picture studios in advocating the incorporation and activation of copy protection technology in the hardware and network infrastructure required to distribute such video programming. If the MPAA studios do not require copy protection activation for PPV or VOD movies, or if PPV/VOD system operators
do not specify our copy protection in their set-top boxes, or if the system operators do not activate copy protection in other digital PPV networks outside of Canada, Germany, Japan, Hong Kong or the United Kingdom, then our business may be harmed.
Further, consumers may react negatively to copy protected PPV or VOD programming because they may feel they are entitled to copy, having in the past routinely copied for later viewing analog cable and satellite-delivered subscription television and PPV programs, as well as free broadcast programming. In addition, when incoming video signals are routed through a VCR before reaching a TV set, the consumer may see impaired pictures while viewing a copy protected digital PPV program. If there is consumer dissatisfaction that cannot be managed, or if there are technical compatibility problems, our business could be harmed.
Pricing pressures on the content owners that incorporate our technologies into their products could limit the licensing fees we charge for our technologies, which could adversely affect our revenues.
The markets for the products in which our technologies are incorporated are intensely competitive and price sensitive. Retail prices for such products that include our technology, such as DVDs and CDs, have decreased significantly, and we expect prices to continue to decrease for the foreseeable future. In response, content owners have sought to reduce their product costs, which can result in downward pressure on the licensing fees we charge our customers who incorporate our technologies into the products they sell. A decline in the licensing fees we charge could materially and adversely affect our operating results.
If we are unable to compete effectively with existing or new competitors, we could experience price reductions, fewer customers, reduced margins or loss of market share.
We believe that our DVD digital-to-analog copy protection and videocassette copy protection systems currently have no competitors. It is possible, however, that competitive copy protection technologies could be developed in the future. Increased competition would be likely to result in price reductions and loss of market share, either of which could harm our business.
In the video market, there are a variety of supplemental copy protection and encryption systems that provide partial copy protection for digital links (the DTLA 5C encryption technology); the 4C pre-recorded media and recordable media copy protection systems; CSS, a content scrambling system for the DVD format; Intels High Definition Copy Protection (HDCP) encryption for both the Digital Display Working Groups Digital Video Interfaces (DVI) and HDMI Licensing, LLCs High Definition Multimedia Interface (HDMI). These systems are not directly competitive, as some apply to future products, but they are sometimes confused with our analog copy protection and may create uncertainty in the minds of customers, thereby reducing or delaying our licensing opportunities. Additionally, they may compete from the standpoint of content owners believing they have a limited budget for copy protection, and they may choose to spend their copy protection dollars on only a few technologies.
Our primary competition in the electronic license management market currently comes from our own prospective customers those independent software vendors who believe they can develop their own electronic license management solutions. In the event that software vendors succeed with their internal developments, or forego the implementation of such applications, this would adversely affect our business. Other more traditional competitors include companies offering digital rights management, electronic licensing, or electronic software distribution technology, as well as companies that have historically offered hardware dongle products and are shifting to software-based protection. In addition, operating system developers or microprocessor suppliers may choose to integrate rights management solutions into their products. Software resellers could also begin to develop their own electronic license management solutions.
Our other software value management solutions, namely our InstallShield Installer, Update Service, and Admin Studio have other competitors, but none of these competitors have the breadth of software value management solutions that we do. In the Installer business, ZeroG and Altiris/Wise are competitors and
Altiris Package Studio is the primary competition for our Admin Studio solution. Update Service appears to have no competition other than from our customers who believe they can develop their own solutions.
There are a limited number of competitors in our SafeDisc Advanced consumer software copy protection market, including SecureRom, Sonys DADC optical disk manufacturing subsidiary, and StarForce Technologies. However, it is possible that our own customers may develop software copy protection technologies on their own, or that personal computer operating system and microprocessor companies may develop or license copy protection modules or systems that are internal to the PC or other consumer electronic devices.
In the consumer software Product Activation market, as in the enterprise software electronic license management market there is substantial competition from customer implemented internally developed solutions, as from small companies such as Australian company XtreamLok, and software e-commerce vendors like Digital River.
DRM solutions for consumer software, video, and audio have also attracted a number of companies and significant venture capital, including Intertrust Technologies (recently acquired by Sony and Philips), Microsoft, Content Guard, and Real Networks. It is possible that companies with extensive financial resources may develop or acquire copy protection and rights management solutions that compete with our offerings, or may have a controlling patent position which would negatively impact our cost basis, or may give away their DRM technologies as in the case of the Windows Media Player.
Several of our competitors in the audio copy protection and rights management market, including SunnComm, Sony, Settec and First4Internet have participated in early market trials with one or more major record labels. New competitors or alliances among competitors may emerge and rapidly acquire significant market share in any of these areas. Our competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements than we do, which could reduce demand for our products or render them obsolete.
It may be more difficult for us, in the future, to have our technologies adopted as individual industry standards to the extent that entertainment industry participants collaborate on the development of industry standard technologies.
Increasingly, standards-setting organizations are adopting or establishing technology standards for use in a wide-range of consumer electronics products. As a result, it is more difficult for individual companies to have their technologies adopted wholesale as an informal industry standard. In addition, increasingly there are a large number of companies, including ones that typically compete against one another, involved in the development of new technologies for use in consumer entertainment products. As a result, these companies often license their collective intellectual property rights as a group, making it more difficult for any single company to have its technologies adopted widely as a de facto industry standard or to have its technologies adopted as an exclusive, explicit industry standard. Examples of this include MPEG-LA (DRM licensing); Advanced Access Control System (AACS) for next generation DVD encryption; HD-DVD and BluRay DVD (next generation DVD formats). If our technologies are not supported by these standards bodies or patent pools, it may be more difficult for us to grow our business in the future. Our major customers may have a large influence on industry standards and the widespread adoption of new technologies. The selection of alternative technologies to ours or to those on which our technologies operate would harm our business.
We have built a substantial business in the software value management space, and market conditions are different from the entertainment digital product value management space.
Our Software Technologies Groups major products include FLEXnet Publisher and FLEXnet InstallShield. FLEXnet Publisher is licensed to software publishers as a software value management product that enables these customers to offer multiple licensing models and automatically enforce compliance with license terms. FLEXnet InstallShield is also sold to software publishers as an automatic installer to help them
with automatic and transparent installations of their software on most Windows and non-Windows PCs and servers. There is no assurance of our ability to grow and be successful with these products and if we are unsuccessful in the software value management market, our business would be harmed.
Major software vendors have experienced deteriorating economic conditions as corporate customers have reduced capital expenditures. Demand for our software value management solutions is driven, to some degree, by end-user demand for software applications. If economic conditions for software vendors continue to be difficult, demand for our products could decline. This would result in lower revenues and operating income for this line of business.
In some cases, customers make a substantial capital investment when purchasing our software and commit additional resources to installation and deployment. Potential customers spend significant time and resources to determine which software to purchase. Selling our products sometimes requires an extensive sales effort because the decision to adopt our software value management solutions generally involves several customer executives in various functions and geographic areas. Due to these factors, our sales cycle is unpredictable, and the number of sales and amount of revenue generated from such sales varies from quarter to quarter.
The traditional application software business model has been characterized by software vendors selling to enterprise IT departments who host the software on the enterprises servers and managed the software from within the enterprise. With the initial success of the application service provider (ASP) business model, under which the software application is hosted in remote servers and there is no server software resident in the enterprise, some industry experts have questioned whether the ASP model will eventually replace the traditional application software business model. We believe it is too early to make this prediction, however, because our software value management solutions are mostly tailored for the traditional software model, if the ASP model were to become very popular, it could harm our business.
We have entered the market for digital anti-ripper products and for peer-to-peer file sharing antipiracy products and we do not know if we will be successful in selling products for either application.
In August 2003, we acquired intellectual property and other assets, including patents and software that can be used to track and manage content in the peer-to-peer file sharing space. Our Hawkeye technology, introduced in the second quarter of 2004, is designed to protect copyrighted content that is discovered being traded over the P2P file sharing networks. Our RipGuard DVD technology, introduced in the fourth quarter of 2004, is designed to be added to the DVD at the time of manufacture in order to prevent ripping by PCs. These solutions may not achieve or sustain market acceptance, or may not meet, or continue to meet, the demands of the content owners. If the market for digital anti-ripper products or peer-to-peer antipiracy products fails to develop, or develops more slowly than expected, if our solutions do not achieve or sustain market acceptance or if there is significant and sustained consumer resistance to this technology, our business would be harmed.
Our business may be affected by peer-to-peer services on the Internet.
Our business may be affected by free peer-to-peer services, such as KaZaA, e-Donkey, Morpheus, Grokster and a variety of other similar services that allow computer users to connect with each other and to copy/share many types of program files, including music and other media, from one anothers hard drives, all without securing licenses from content providers. The legal status of these free services is uncertain, because although some courts have found that these services violate copyright laws, other services have been found to not violate any copyright laws, particularly in the case of Grokster, which has been appealed by the content owners to the U.S. Supreme Court. Additionally, enforcement efforts against those in violation have not effectively shut down these services, and there can be no assurance that these services will ever be shut down. The ongoing presence of these free services substantially impairs the marketability of legitimate services and of technologies that shut down other unauthorized sources of the program file content, regardless of the ultimate resolution of their legal status. To the extent that consumers choose to utilize these peer-to peer
services and do not purchase authentic packaged media or authorized DRM downloads, it may adversely affect our business for packaged media copy protection.
The price of our common stock may be volatile.
The market price of our common stock has been, and in the future could be, significantly affected by factors such as:
Announcements by the MPAA or its members, satellite television operators, cable television operators or others regarding motion picture production or distribution, consumer electronics or software vendor companies business combinations, evolving industry standards, consumer rights activists wins in government regulations or the courts, or other developments could cause the market price of our common stock to fluctuate substantially.
There can be no assurance that our historic trading prices and price/earnings ratios, or those of high technology companies in general, will be sustained. In the past, following periods of volatility in the market price of a companys securities, some companies have been named in class action suits.
Further, the military conflict in Iraq, additional acts of terrorism and related political instability and economic uncertainty may adversely affect the global financial markets, which could cause the market price of our common stock to fluctuate substantially.
We utilize pro forma reporting in our quarterly earnings press releases.
We publish pro forma results in our quarterly earnings press releases along with a reconciliation of pro forma earnings to earnings compiled in accordance with accounting principles generally accepted in the United States (GAAP). Pro forma earnings are non-GAAP financial measurements. The reconciling items have adjusted GAAP net income and GAAP earnings per share for certain non-cash, non-operating or non-recurring items and are described in detail in each such quarterly earnings press release. We believe that this presentation may be useful to the investment community in analyzing the results of operations. We have not included any such pro forma earnings or reconciliation to GAAP earnings in this annual report. The market price of our stock may fluctuate based on future pro forma results. However, we urge investors to carefully review the GAAP financial information included as part of our Quarterly Reports on Form 10-Q and our Annual Reports on Form 10-K that are filed with the SEC, as well as our quarterly earnings releases, and compare the GAAP financial information with the pro forma financial results disclosed in our quarterly earnings releases and investor calls, as well as in some of our other reports. If we decide to curtail this pro forma presentation in our quarterly earnings press releases, the market price of our stock could be affected.
If we continue to support broad-based employee stock option grants in the future, recently adopted accounting standards that require companies to expense stock options will decrease our GAAP earnings and our stock price may decline.
We believe that employee stock options are an important element of total compensation. Effective July 1, 2005, the FASB has adopted new accounting rules that will require expensing of stock options. Currently, we account for employee stock-based compensation arrangements in accordance with the provisions of (i) Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, (ii) FASB Interpretation No. 44 (FIN 44), Accounting for Certain Transactions Involving Stock Compensation an Interpretation of APB Opinion No. 25, and comply with the disclosure provisions of (iii) Statement of Financial Accounting Standard (SFAS) No. 123, Accounting for Stock-Based Compensation. If we continue to support broad-based employee stock option grants after the July 1, 2005 change in GAAP which requires employee stock-based compensation arrangements to be accounted for as an expense (in a manner different to APB No. 25 and FIN 44), the result may have a material, negative impact upon our future earnings. Alternatively, if we cut back on employee stock option grants, we may lose an important benefit that impacts the recruiting and retention of quality employees, and our business could be harmed. If we replace broad based employee option grants with other types of performance based incentives, or restricted stock, we also will be required to report these incentives as expenses. Any of these consequences could cause the market price of our stock to decline.
If our independent registered public accountants are unable to provide us with an unqualified report as to the adequacy of our internal control over financial reporting for future year-end periods as required by Section 404 of the Sarbanes-Oxley Act of 2002, investors could lose confidence in the reliability of our financial statements, which could result in a decrease in the value of our stock.
As directed by Section 404 of the Sarbanes-Oxley Act of 2002, the SEC adopted rules requiring public companies to include a report by management on our internal control over financial reporting in their annual reports on Form 10-K that contains an assessment by our management of the effectiveness of internal control over financial reporting. In addition, the public accounting firm auditing our financial statements must attest to and report on our managements assessment of the effectiveness of internal control over financial reporting. This requirement first applies to our annual report on Form 10-K for the fiscal year ending December 31, 2004. While we continuously conduct a rigorous review of our internal control over financial reporting in order to comply with the Section 404 requirements, our independent registered public accountants may interpret the Section 404 requirements and the related rules and regulations differently from how we interpret them, or our independent registered public accountants may not be satisfied with our internal control over financial reporting or with the level at which these controls are documented, operated or reviewed in the future. In addition, the demand for competent audit resources has grown dramatically as a result of the requirements of Section 404, and such demand may exceed available supply. Finally, in the event we make a significant acquisition, or a series of smaller acquisitions, we may face significant challenges in implementing the required processes and procedures in the acquired operations. As a result, our independent registered public accountants may decline or be unable to attest to managements assessment or may issue a qualified report in the future. This could result in an adverse reaction in the financial markets due to investors perceptions that our internal controls are inadequate or that we are unable to produce accurate financial statements, which could cause the market price of our shares to decline.
Our corporate headquarters consist of approximately 160,000 square feet located in Santa Clara, California. The leases for these premises expire on January 31, 2017. We also lease approximately 42,000 square feet in Schaumburg, Illinois pursuant to a lease that expires on January 31, 2009. Most U.S. sales, marketing and technical personnel for all product divisions are in these locations, with a small number of individuals operating out of their home offices or a leased sales office in Burlington, Massachusetts. We
believe that our existing facilities are adequate to meet current requirements and that additional or substitute space will be available as needed to accommodate any expansion of operations.
We also lease space for sales, marketing and technical staff in Maidenhead, Cheshire and Bristol in the United Kingdom and in Tokyo, Japan; Seoul, Korea; Amsterdam, The Netherlands; Hong Kong; Taipei, Taiwan; and Tel Aviv, Israel.
We are involved in legal proceedings related to some of our intellectual property rights.
Macrovision Corporation v. ViTec Audio and Video GmbH
We initiated a patent infringement lawsuit in the District Court of Dusseldorf in March 1999 against ViTec Audio und Video GmbH, a German company that manufactures what we believe to be a video copy protection circumvention device. ViTec filed a reply brief arguing that its product does not infringe our patents. The case was heard in the District Court of Dusseldorf, Germany and the Court ruled adversely against us. We appealed the District Courts ruling in July 2000 to the Court of Appeal in Dusseldorf. Following a series of hearings, the submission of a technical opinion from a Court appointed expert witness and briefs by both parties, the Court of Appeals rendered a decision on January 20, 2005 rejecting Macrovisions appeal and dismissing the case. The Court further ordered Macrovision to pay the costs of the appeal, which are estimated to be 35,000 Euros. In view of the adverse ruling, we may incur a corresponding decline in demand for our video content protection technology, which could harm our business in Germany.
USPTO Interference Proceedings Between Macrovision Corporation and InterTrust Technologies
We received notice on September 4, 2003 from the United States Patent and Trademark Office (USPTO) declaring an interference between our U.S. Patent No. 5,845,281 (the ‘281 patent) together with two of its continuation applications, and a patent application determined to be from InterTrust Technologies Corporation. On December 19, 2003, we received notice from the USPTO declaring an additional interference between two continuation applications related to the ‘281 patent and four issued U.S. patents of InterTrust. The ‘281 patent and its continuation applications are in the field of digital rights management, and are not associated with our existing copy protection business.
An interference is declared by the USPTO when two or more parties claim the same patentable invention. In the United States, the party who can prove earliest inventorship is granted the patent. An interference proceeding has commenced to determine the rightful inventorship of the involved U.S. patents and patent applications. The ‘281 patent and its U.S. continuation applications have a priority filing date of February 1, 1995. The InterTrust patents and patent application have a priority filing date of February 13, 1995. The Administrative Patent Judge (APJ) has decided to proceed with the second interference first. Because our filing date is prior to InterTrusts filing date, we have been designated the senior party in the interference. InterTrust submitted its proof of inventorship in a brief filed on June 24, 2004. We responded with our brief filed on July 14, 2004. Interference procedural rules allow each party to file rebuttals to the other partys brief, cross-examine witnesses offered up by the other party and file various motions and objections during this pre-hearing phase of the interference. This pre-hearing phase continued for several months. Following the close of this pre-hearing phase, both parties had an opportunity for an oral hearing, which occurred on January 6, 2005. Following the oral hearing, we anticipate that the APJ will issue a decision in the second interference case in the second quarter of 2005.
In the first patent interference case, InterTrust had also brought an inequitable conduct motion against us alleging misconduct during the original prosecution of the ‘281 patent. The APJ initially dismissed the motion, but then gave InterTrust an opportunity to re-file the motion. In the fourth quarter of 2004, InterTrust re-filed its inequitable conduct motion and we filed a rebuttal brief. On December 9, 2004, the parties presented their arguments on the inequitable conduct motion before the APJ. We anticipate the APJ will render a decision on
the inequitable conduct motion in the second quarter of 2005. We believe we have meritorious defenses to the motion asserted against us and intend to vigorously defend against the inequitable conduct motion.
We have a family of international patents and patent applications related to the U.S. cases involved in the interference. The U.S. patent interference affects only U.S. patents and U.S. pending patent applications. The international cases are proceeding to grant in Europe and Japan. A corresponding patent has already issued in Sweden (Patent No. 9500355) and a European patent application was recently allowed and is expected to be granted in the second quarter of 2005. These international cases have the benefit of the early February 1, 1995 priority date and the broad patent claim coverage ultimately expected to issue in the U.S. following resolution of the interference action.
Macrovision vs. 321 Studios LLC
On January 7, 2004, we initiated a lawsuit in the Southern District of New York against 321 Studios LLC, a producer of cloning software products, alleging that 321 Studios infringes our patented copy protection technology and also violates the U.S. Digital Millennium Copyright Act of 1998. On May 11, 2004, we were granted a preliminary injunction barring 321 Studios from selling various versions of its DVD copying software. On June 4, 2004, 321 Studios filed a notice of interlocutory appeal, which we opposed. We have notified various large retailers and other resellers of 321 Studios products of the issuance of the preliminary injunction and requested removal of 321 Studios products enjoined by the preliminary injunction. 321 Studios has announced cessation of its operations and has claimed to have discontinued sales and/or distribution of enjoined products. We are awaiting the issuance of findings of fact and conclusions of law by the court, which is expected by the second quarter of 2005. We intend to vigorously pursue this action to protect our patented copy protection technology.
BIS Advanced Software Systems, Ltd. vs. InstallShield Software Corporation et. al.
On September 9, 2004, BIS Advanced Software Systems, Ltd. filed a patent infringement lawsuit against a small group of companies, including InstallShield. We acquired the operations and certain assets of InstallShield on July 1, 2004. InstallShield was served with the complaint on September 27, 2004. The BIS patent (6,401,239) allegedly relates to a vBuild product that InstallShield licensed from Red Bend Software and sold as an add-on product. InstallShield discontinued sales of this product in early 2004 and the patent does not appear to implicate any current core InstallShield products. Further, Red Bend Software has agreed to indemnify InstallShield and defend the suit for Macrovision. We are monitoring the progress of the suit and the actions taken by Red Bend on our behalf.
As of December 31, 2004, for all the above mentioned matters, it was not possible to estimate the liability, if any, in connection with the pending matters. Accordingly, no accruals for these contingencies have been recorded.
From time to time we have been involved in other disputes and legal actions arising in the ordinary course of business. In our opinion, none of these other disputes and legal actions is expected to have a material impact on our consolidated financial position, results of operation or cash flow.
We did not submit any matters to a vote of security holders during the quarter ended December 31, 2004.
Price Range of Common Stock
Our common stock has been listed on the Nasdaq National Market under the symbol MVSN since our initial public offering on March 13, 1997. The following table sets forth, for the periods indicated, the reported high and low closing prices for our common stock.
As of March 1, 2005, there were 93 holders of record of our common stock, based upon information furnished by American Stock Transfer & Trust Company, the transfer agent for our securities. We believe, based upon security positions listings, that there are approximately 6,733 beneficial owners of our common stock. As of March 1, 2005, there were 50,387,148 shares of common stock outstanding.
We have not declared or paid any cash dividends on our common stock since 1994. We do not anticipate paying any cash dividends on our common stock in the foreseeable future. We intend to retain all earnings for use in our business operations and in expansion.
The following table sets forth selected consolidated financial data and other operating information. The financial data does not purport to indicate results of operations as of any future date or for any future period. The financial data is derived from our consolidated financial statements and should be read in conjunction with the consolidated financial statements, related notes and other financial information included herein.
ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following commentary should be read in conjunction with the Consolidated Financial Statements and related notes contained elsewhere in this Form 10-K. The discussion contains forward-looking statements that involve risks and uncertainties. These statements relate to future events or our future financial performance. In some cases, you can identify these forward-looking statements by terminology such as may, will, should, expect, plan, anticipate, believe, estimate, future, predict, potential, intend, or continue, and similar expressions. These statements are only predictions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of a variety of factors, including, but not limited to, those set forth under Risk Factors and elsewhere in this Form 10-K. We specifically disclaim any obligation to update such forward-looking statements.
Macrovision Corporation, a Delaware corporation founded in 1983, provides digital product value management offerings to entertainment producers, software publishers, and their customers. Our customers include major Hollywood studios, independent video producers, hardware and software vendors, music labels, consumer electronic, PC and digital set-top box manufacturers; digital PPV and VOD network operators and enterprise IT organizations. We provide content owners with the means to market, distribute, manage and protect video, software and audio content.
Our content protection technologies are deployed on various media formats, distribution platforms, and hardware devices including: DVDs, videocassettes, music CDs, and games on CD-ROMs and DVDs, DVD players and recorders, digital set-top box and hard drive recorders, PVRs, media center PCs, cable/satellite/telco networks and Internet Protocol delivery platforms. Most of our software value management solutions are incorporated into other software vendors products, and other products are sold as software asset management tools for enterprise IT organizations.
We are organized in two business units, the Entertainment Technologies Group and the Software Technologies Group. The Entertainment Technologies Group licenses digital content value management
technology to video, music, and PC games content owners. Our Hawkeye peer-to-peer file sharing antipiracy service that was introduced in the second quarter of 2004 is also included in the Entertainment Technologies Group. The Software Technologies Group develops and markets our software value management solutions which include the FLEXnet suite of electronic license management, electronic license delivery, and software asset management products, as well as the recently acquired InstallShield Installer, Update Service, and Admin Studio products. Revenues have been reclassified for prior periods to conform to the current period presentation.
The following table provides revenue information by business unit for the periods indicated (dollars in thousands):
The following table provides percentage of revenue information by business unit for the periods indicated:
Entertainment Technologies Group
Our Entertainment Technologies Group generates revenue from the home video divisions of member companies of the MPAA, videocassette duplication and DVD replication companies and a number of special interest content owners, such as independent producers of exercise, sports, educational, documentary and corporate video programs. We typically receive per unit royalties based upon the number of copy-protected videocassettes or DVDs that are produced by MPAA studios or other content owners. Our Entertainment Technologies Group also generates revenues from licensing digital PPV and video-on-demand (VOD) content protection solutions to satellite and cable system operators and equipment manufacturers that supply cable and satellite industries. Most of our PPV content protection revenues are generated from royalties on digital set top boxes. We also receive one-time and annual license fees from set top box, DVD, and personal video recorder manufacturers. In addition, our Entertainment Technologies Group generates revenues from customers implementing our CD-ROM copy protection technology on PC games, as well as customers in the music industry who implement our copy technology on compact discs.
Revenues from our Entertainment Technologies Group increased $19.3 million, or 21.2% from 2003 to 2004. Revenues from our video content protection technologies represented 55.2%, 63.3% and 63.1% of our net revenues during 2004, 2003 and 2002, respectively. The increases in our video content protection technologies revenues are primarily due to the increase in numbers of DVDs sold and continued strong demand for our DVD copy protection solution, despite declining unit royalties over the past two years and to a lesser extent, the increases in revenue are also due to an increase in PPV and VOD revenues. During 2004, we recognized approximately $2.2 million of revenue from studio volume replicated during 2003. We were not able to record these revenues in the year in which the volumes were replicated due to prolonged contract negotiations. During 2003, DVD copy protection revenues included approximately $917,000 in revenue from the resolution of one customers over reporting claim.
We actively engage in intellectual property compliance and enforcement activities focused on identifying third parties who have under reported to us the amount of royalties owed under license agreements with us. As a result, from time to time, we may not receive timely replicator reports, and therefore, we may recognize revenues that relate to activities from prior periods. These royalty recoveries may cause revenues to be higher than expected during a particular reporting period and may not occur in subsequent periods. We cannot predict the amount or timing of such revenues.
We believe that total revenues from our Entertainment Technologies Group in the future will increase in absolute terms and continue to be a significant part of our revenues, although our video copy protection per unit royalties may continue to decline.
Software Technologies Group
Our software products generate revenue from licensing software value management solutions and providing services related to the support and maintenance of this software. Revenues from our Software Technologies Group increased $34.4 million or 93.1% in 2004 as compared with 2003. The increase in our Software Technologies Group revenue is due to the inclusion of $17.7 million of revenues from our InstallShield operations since July 1, 2004 and increased sales of our FLEXnet Publisher license management solutions resulting from the impact of broad based product and marketing programs and the efforts of sales personnel added during the year. We believe that revenues from our Software Technologies Group will continue to increase in the future in absolute terms and as a percentage of our total revenues due to increased sales of our FLEXnet and InstallShield solutions.
Seasonality of Business
We have experienced significant seasonality in our business, and our consolidated financial condition and results of operations are likely to be affected by seasonality in the future. We have typically experienced our highest revenues in the fourth quarter of each calendar year followed by lower revenues and operating income in the first quarter of the following year, and at times in subsequent quarters. We believe that this trend in our Entertainment Technologies business has been principally due to the tendency of certain of our customers to manufacture and release new video, audio, and PC games titles during the year-end holiday shopping season, while our operating expenses are incurred more evenly throughout the year. In our Software Technologies business, we have found that typical software and enterprise customers tend to spend up to one-third of their annual capital budgets in the fourth calendar quarter. In addition, revenues generally have tended to be lower in the summer months, particularly in Europe.
Costs and Expenses
Our cost of revenues in our Entertainment Technologies Group consists primarily of service fees and patent related litigation expense. Service fees paid to licensed duplicators and replicators that produce videocassettes, DVDs, and CDs for content owners include fees paid to help offset costs of reporting copy protected volumes and costs of equipment used to apply our technology. In addition, our cost of revenues in our Software Technologies Group includes software product support costs, direct labor and benefit costs of employees time spent on billable consulting or training, the cost of producing and shipping CDs containing our software and certain license fees paid to third parties. Cost of revenues also includes patent defense costs, amortization of licensed technologies and amortization of certain intangibles from acquisitions and patent amortization. Our research and development expenses are comprised primarily of employee compensation and benefits, consulting and recruiting fees, tooling and supplies and an allocation of overhead and facilities costs. Our selling and marketing expenses are comprised primarily of employee compensation and benefits, consulting and recruiting fees, travel, advertising and an allocation of overhead and facilities costs. Our general and administrative expenses are comprised primarily of employee compensation and benefits, consulting and recruiting fees, travel, professional fees and an allocation of overhead and facilities costs.
Critical Accounting Policies and Use of Estimates
The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements. These consolidated financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures, normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America, have been condensed or omitted in accordance with such rules and regulations. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, allowance for doubtful accounts, valuation of strategic investments, intangible assets and income taxes. Our estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates.
We have identified the accounting policies below as critical to our business operations and the understanding of our results of operations.
Our revenue consists of royalty fees on copy-protected products on a per unit basis, licenses for our content protection technologies, licenses for our software value management products, and related maintenance and services revenues.
Royalty revenue from the replication of videocassettes, DVDs, and CDs is recognized when realized or realizable and earned. We rely on royalty reports from our customers and/or third parties as our basis for revenue recognition. In our DVD, videocassette, and PC games product lines, we have established significant experience with certain customers to reasonably estimate current period volume for purposes of making an accurate revenue accrual. Accordingly, royalty revenue from these customers is recognized as earned, provided there is persuasive evidence of an arrangement and that collection of a fixed or determinable fee is considered probable. Revenue from our PPV and music technology products is recognized only as reported, due to the timing of receipt of reports in PPV, and the embryonic stage and volume volatility of the market for our music technology products. Advanced royalty fees attributable to minimum guaranteed quantities of licensed units or royalties based on a percentage of licensed product sales are deferred until earned. In the case of agreements with minimum guaranteed royalty payments with no specified volume, revenue is recognized on a straight-line basis over the life of the agreement.
Technology Licensing Revenues
Technology licensing revenue, which applies principally to DVD and PC sub-assembly manufacturers; digital PPV, cable and satellite system operators; digital set-top decoder manufacturers; and content owners who utilize our Hawkeye peer-to-peer antipiracy service is recognized upon establishment of persuasive evidence of an arrangement, performance of all significant obligations and determination that collection of a fixed and determinable license fee is considered probable.
Software Licensing Revenues
We sell our software value management solutions through our direct sales force and through resellers. We recognize revenue on our software products in accordance with Statements of Position (SOP) 97-2, Software Revenue Recognition, as amended by SOP 98-9 Modification of SOP 97-2. We recognize revenue when all of the following criteria are met: persuasive evidence of an arrangement exists; delivery of the product has occurred; no significant obligations remain; the fee is fixed or determinable; and collectibility is probable. We offer resellers the right of return on our packaged products under certain policies and programs. We estimate and record reserves for product returns as an offset to revenue. We consider
arrangements with payment terms extending beyond six months not to be fixed or determinable and, accordingly, revenue is recognized as payments become due and payable from the customer under such arrangements. We assess collectibility based on a number of factors, including the customers past payment history and current creditworthiness. If collectibility is not considered probable, revenue is recognized when the fee is collected from the customer.
For license agreements in which non-standard customer acceptance clauses are a condition to earning the license fees, revenue is not recognized until acceptance occurs. For arrangements containing multiple elements, such as software license fees, consulting services and maintenance, or multiple products and where vendor-specific objective evidence (VSOE) of fair value exists for all undelivered elements, we account for the delivered elements in accordance with the residual method. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is recognized as revenue. For arrangements containing multiple elements where VSOE of fair value does not exist for all undelivered elements, all revenue is deferred until such time as VSOE of fair value for all undelivered elements is evidenced or all elements of the arrangement have been delivered, or if the only undelivered element is maintenance where VSOE of fair value exists, maintenance revenue is recognized pro rata over the maintenance contract period. We also enter into term license agreements in which the license fee is recognized ratably over the term of the license period (generally one year).
When licenses are sold together with consulting and implementation services, license fees are recognized upon delivery of the product provided that: (1) the above criteria have been met; (2) payment of the license fees is not dependent upon performance of the consulting and implementation services; and (3) the services are not essential to the functionality of the software. For arrangements where services are essential to the functionality of the software, both the license and services revenue are recognized in accordance with the provisions of SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. Arrangements that allow us to make reasonably dependable estimates relative to contract costs and the extent of progress toward completion are accounted for using the percentage-of-completion method. Arrangements that do not allow us to make reasonably dependable estimates of costs and progress are accounted for using the completed-contracts method. Because the completed-contracts method precludes recognition of performance under the contract as the work progresses, it does not reflect current financial performance when the contract extends beyond one accounting period, and it therefore may result in uneven recognition of revenue and gross margin. For each of the years ended December 31, 2003 and 2004, we used the completed-contracts method for all such arrangements. For the year ended December 31, 2002, there were no such arrangements.
Professional Services Revenues
We provide consulting and training services to our software vendor and enterprise customers. Revenue from such services is generally recognized as the services are performed, except in instances where services are included in an arrangement accounted for under SOP 81-1. Professional services revenues are included in services revenue in the accompanying consolidated financial statements.
Maintenance agreements generally call for us to provide technical support and unspecified software updates to customers. Maintenance revenue is deferred and recognized ratably over the maintenance contract period (generally one year) and is included in services revenue in the accompanying consolidated financial statements.
Valuation of Strategic Investments
As of December 31, 2004 and 2003, the adjusted cost of our strategic investments totaled $18.8 million and $27.0 million, respectively. This included our investments in public and non-public companies. Our investments in public and non-public companies are classified on the balance sheet as Long-term marketable investment securities and Other assets, respectively.
We review our investments in non-public companies and estimate the amount of any impairment incurred during the current period based on specific analysis of each investment, considering the activities of and events occurring at each of the underlying portfolio companies during the period. For investments in public companies, at each quarter end, we compare our basis in the investment to the average daily trading prices of the security over the prior six months to determine if an other-than-temporary impairment has occurred. If the six-month average is less than the current cost basis, we record a charge to the statement of income for the difference between the market price at period end and the current cost basis. Based on such methods, we recorded an other-than temporary impairment of $5.3 million on our investment in Digimarc during the twelve months ended December 31, 2004 and $5.6 million during the twelve months ended December 31, 2002 relating to Digimarc and TTR.
For equity investments in non-public companies for which there is no market where their value is readily determinable, we review each investment for indicators of impairment on a regular basis based primarily on achievement of business plan objectives and current market conditions, among other factors. The primary business plan objectives we consider include, among others, those related to financial performance such as liquidity, achievement of planned financial results or completion of capital raising activities, and those that are not primarily financial in nature such as the launching of technology or the hiring of key employees. If it is determined that an other-than-temporary impairment has occurred with respect to an investment in a portfolio company, an impairment charge is recorded. Future adverse changes in market conditions or poor operating results of underlying investments could result in losses or an inability to recover the current carrying value of the investments thereby requiring further impairment charges in the future.
In the absence of quantitative valuation metrics, such as a recent financing round, management estimates the impairment and/or the net realizable value of the portfolio investment based on a hypothetical liquidation at book value approach as of the reporting date.
Based on these measurements, $180,000, $4.8 million and $11.6 million of other-than-temporary impairment losses from investments in non-public companies were recorded during the years ended December 31, 2004, 2003 and 2002, respectively. As of December 31, 2004, our investments in non-public companies had no remaining carrying value.
In 2004, we received $1.2 million in cash for our interest in InterActual Technologies, which was acquired by a third party during the period. In fiscal year 2001, this strategic investment had been fully impaired. Accordingly, we recorded a gain on strategic investments of $1.2 million in 2004. Also, in 2003, we recorded $395,000 of realized gains from the surrender of our stock in TTR.
Goodwill and Other Intangible Assets
Goodwill represents the excess of cost over fair value of assets of businesses acquired. We account for goodwill under the provisions of SFAS No. 142, Goodwill and Other Intangible Assets. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but instead are tested for impairment at least annually in accordance with the provisions of SFAS No. 142. SFAS No. 142 also requires that intangible assets with estimable useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS No. 144, Accounting for Impairment or Disposal of Long-Lived Assets.
Goodwill and intangible assets not subject to amortization are tested annually for impairment, and are tested for impairment more frequently if events and circumstances indicate that the assets might be impaired. In 2004, 2003 and 2002, there were no triggering events that required us to test for impairment prior to our annual impairment analysis.
In connection with our impairment analysis performed annually in our fourth quarter, we are required to perform an assessment of whether there is an indication that goodwill is impaired. To accomplish this, we are required to determine the carrying value of each reporting unit by assigning the assets and liabilities, including the existing goodwill and intangible assets, to those reporting units. To the extent the carrying amount of a
reporting unit exceeds its fair value, we would be required to perform the second step of the impairment analysis, as this is an indication that the reporting unit goodwill may be impaired. In this step, we compare the implied fair value of the reporting unit goodwill with the carrying amount of the reporting unit goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit to all of the assets (recognized and unrecognized) and liabilities of the reporting unit in a manner similar to a purchase price allocation, in accordance with SFAS No. 141, Business Combinations. The residual fair value after this allocation is the implied fair value of the reporting unit goodwill. To the extent the implied fair value of goodwill of each reporting unit is less than its carrying amount we would be required to recognize an impairment loss. In October 2004, 2003 and 2002, we completed our annual impairment analyses of goodwill. Based on the results of the annual impairment analysis, we determined that no indicators of impairment existed for our reporting units and no impairment charges were recorded for goodwill during the years ended December 31, 2004, 2003 and 2002.
Impairment of Long-Lived Assets
In accordance with SFAS No. 144, long-lived assets, such as property and equipment, and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset group to estimated undiscounted future cash flows expected to be generated by the asset group. If the carrying amount of an asset group exceeds its estimated future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset group exceeds the fair value of the asset group. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and would no longer be depreciated. The assets and liabilities of a disposal group classified as held for sale would be presented separately in the appropriate asset and liability sections of the balance sheet. In 2004, 2003 and 2002, no impairment charges were recorded for long-lived assets.
Allowance For Doubtful Accounts
We estimate the collectibility of our accounts receivable on an account-by-account basis. We record an increase in the allowance for doubtful accounts when the prospect of collecting a specific account receivable becomes doubtful. In addition, we establish a non-specific reserve, using a specified percentage of the outstanding balance of all such accounts based on historical bad debt loss experience. We specifically analyze accounts receivable and historical bad debts experience, customer creditworthiness, current economic trends, international situations (such as currency devaluation), and changes in our customer payment history when evaluating the adequacy of the allowance for doubtful accounts. 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 account for income taxes using the asset and liability method. Under this method, income tax expense is recognized for the amount of taxes payable or refundable for the current year and for deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entitys financial statements or tax returns. Management must make assumptions, judgements and estimates to determine our current provision for income taxes and also our deferred tax assets and liabilities and any valuation allowance to be recorded against a deferred tax asset. Our judgments, assumptions and estimates relative to the current provision take into account current tax laws, our interpretation of current tax laws and possible outcomes of current and future audits conducted by foreign and domestic tax authorities. Changes in tax law or our interpretation of tax laws and the resolution of current and future tax audits could significantly impact the amount provided for income taxes in our consolidated financial statements.
Our assumptions, judgments and estimates relative to the value of a deferred tax asset take into account predictions of the category and amount of future taxable income. We believe that it is more likely than not that the results of future operations will generate sufficient taxable income to utilize these deferred tax assets. While we have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for any valuation allowance, in the event we were to determine that we will be able to realize our deferred tax assets in the future in the excess of the net recorded amount, an adjustment to the valuation allowance would increase income in the period such determination was made. Deferred tax assets, related valuation allowances and deferred tax liabilities are determined separately by tax jurisdiction. Should we determine that we would not be able to realize all or part of our net deferred tax asset in the future, an adjustment to the valuation allowance would be charged to income in the period such determination was made.
Our effective tax rate is directly affected by the relative proportions of domestic and international revenue and income before taxes, the estimated level of annual pre-tax income, and any of the assumptions, judgments and estimates mentioned above.
Results of Operations
The following table sets forth selected consolidated statements of income data expressed as a percentage of net revenues for the periods indicated:
Comparison of Years Ended December 31, 2004 and 2003
The following table provides revenue information by business unit for the periods indicated (dollars in thousands):
License Revenues. Our license revenues for 2004 increased by $45.6 million or 39.7% compared to 2003 primarily due to higher revenue from our video content protection and software products. The increase in license revenues is also due to $12.8 million in revenue from the inclusion of InstallShield product revenue since July 1, 2004.
Video content protection revenues are higher due to the increase in numbers of DVDs sold and continued growth in demand of the DVD format, continued high penetration among Hollywood studio customers, a strong hit release schedule that more than offset modest declines in our average unit royalties and decreased usage by certain Hollywood studios. Video content protection revenues also increased due to higher PPV and VOD revenues primarily from royalties and license fees from digital set top boxes due to strong demand from consumers, especially in international territories, for digital cable and digital satellite operators businesses. During 2004, we recognized approximately $2.2 million of revenue from studio volume replicated during 2003. We were not able to record these revenues in the year in which the volumes were replicated due to prolonged contract negotiations. In 2003, DVD copy protection revenues included approximately $917,000 in revenue from the resolution of one customers over reporting claim. During 2004, we recognized $3.1 million in PPV revenue that was previously deferred until North American system operators activated the VOD system.
Excluding the inclusion of InstallShield since July 1, 2004, the increases in license revenue from our Software Technologies Group are primarily due to increased sales of our FLEXnet Publisher license management solutions resulting from the impact of broad based product and marketing programs and additional sales personnel in our Software Technologies Group.
Service Revenues. Our service revenues for 2004 increased $8.1 million or 60.0% to $21.7 million compared to $13.5 million in 2003, primarily due to the growth of our professional services practice which has generated higher consulting revenue and our increased market penetration has resulted in higher maintenance revenue. The increase in service revenues is also due to $4.9 million from the inclusion of InstallShield since July 1, 2004.
Cost of Revenues License Fees. Cost of revenues from license fees as a percentage of license revenues increased to 5.1% for 2004 from 4.3% for 2003. Cost of revenues from license fees increased $3.2 million to $8.2 million in 2004 from $5.0 million in 2003. The increases are primarily due to higher patent defense costs and higher patent amortization costs. Cost of revenues includes items such as product costs, duplicator and replicator fees, video copy protection processor costs, patent amortization on internally developed patents, patent defense costs, licensing expenses and the cost of producing and shipping CDs containing our software.
Cost of Revenues Service Fees. Cost of revenues from service fees as a percentage of service revenues increased to 37.3% for 2004 from 23.3% for 2003. Cost of revenues from service fees increased $4.9 million to $8.1 million in 2004 from $3.2 million in 2003. The increases are primarily due to the expansion of our professional services group to support additional consulting and implementation projects for our FLEXnet solutions. The increase is also due to $3.2 million in costs associated with additional personnel and infrastructure from our acquisition of InstallShield since July 1, 2004. We anticipate our cost of revenues
from service fees may increase as we continue to increase activity in our consulting practice and seek to expand our customer base.
Cost of Revenues Amortization of Intangibles from Acquisitions. Cost of revenues from amortization of intangibles increased to $6.4 million in 2004 from $3.3 million in 2003. The increase is primarily due to amortization of intangibles from the acquisition of InstallShield in July 2004.
We acquired the net assets of InstallShield in July 2004 for approximately $77.1 million in cash, including related acquisition costs. In addition, we have agreed to an additional maximum payout of $20.0 million contingent on post-acquisition performance through June 30, 2005. The transaction was accounted for as a purchase and approximately $28.8 million of the purchase price was allocated to existing technology, existing contracts, patents and trademarks. In addition, we recorded $43.1 million of goodwill from this transaction and recorded a $5.4 million charge in 2004 for purchased in-process research and development. We amortize intangibles, with the exception of goodwill, relating to the acquisition of net assets of InstallShield on a straight-line basis over three to six years based on the expected useful lives of existing technology, existing contracts, patents and trademarks.
Research and Development. Research and development expenses increased by $11.4 million or 66.4% to $28.7 million in 2004 from $17.2 million in 2003. The increase is primarily due to increased research and development activities for our video technology, music technology, peer-to-peer antipiracy and software value management products resulting in higher costs. The increases are also due to $4.5 million in costs associated with additional personnel and infrastructure from our acquisition of InstallShield since July 1, 2004. Research and development expenses increased as a percentage of net revenues to 15.7% in 2004 from 13.4% in 2003. We expect research and development expenses to increase in absolute terms and as a percentage of revenues over the prior year periods as a result of expected increases in research and development activity to support customer/market demand for new technologies from our Entertainment Technologies Group and Software Technologies Group.
Selling and Marketing. Selling and marketing expenses increased by $15.2 million, or 56.4%, to $42.2 million in 2004 from $27.0 million in 2003. The increases are due to higher costs from increased business development activities for our entertainment and software technologies products on an overall basis as well as increased commission costs associated with higher revenue levels. The increases are also due to $6.0 million in costs associated with additional personnel and infrastructure from our acquisition of InstallShield since July 1, 2004. Selling and marketing expenses increased as a percentage of net revenues to 23.2% in 2004 from 21.0% in 2003. Selling and marketing expenses are expected to increase in absolute terms and as a percentage of revenues as we continue to invest in additional sales personnel and expand our efforts to increase our market share and grow our business.
General and Administrative. General and administrative expenses increased by $6.1 million, or 31.6%, to $25.5 million in 2004 from $19.4 million in 2003. The increases are primarily due to increased headcount and related costs to support the overall growth of our business units and higher costs for compliance with the Sarbanes-Oxley Act of 2002. To a lesser extent, the increase is also due to costs associated with additional personnel and infrastructure from our acquisition of InstallShield since July 1, 2004. General and administrative expenses decreased as a percentage of net revenues to 14.0% in 2004 from 15.1% in 2003. We expect our general and administrative expenses to increase in absolute terms and remain flat as a percentage of revenues as we continue to support the expansion of our business, to integrate the administrative and systems infrastructure between InstallShield and Macrovision, and to comply with the requirements of the Sarbanes-Oxley Act of 2002.
Amortization of Deferred Stock-Based Compensation. In connection with the acquisition of Globetrotter in 2000, approximately 783,742 Globetrotter employee stock options were exchanged for Macrovision stock options, resulting in a deferred stock-based compensation charge of approximately $37.9 million. The amortization of the deferred stock-based compensation for 2004 and 2003 was $185,000 and $2.7 million,
respectively. The expense associated with amortization of this stock-based compensation ended in the first quarter of 2004.
In-process research and development. In connection with the acquisition of InstallShield in July 2004, $5.4 million was charged to in-process research and development in the year ended December 31, 2004. In connection with the acquisition of intellectual property and other assets in the peer-to-peer file sharing space in August 2003, $624,000 was charged to in-process research and development in 2003.
Impairment losses on strategic investments. During 2004 and 2003, we recorded charges totaling $5.5 million and $4.8 million, respectively, relating to other-than-temporary impairment of certain strategic investments. During 2004, we recorded $5.3 million and $180,000 in charges relating to other-than-temporary impairments in our investments in Digimarc and iVast, respectively. During 2003, we recorded $4.8 million in charges relating to an other-than-temporary impairment in our investment in iVast.
Gains on strategic investments. For the year ended December 31, 2004, we received $1.2 million in cash for our interest in InterActual Technologies, the assets of which were acquired by a third party during the first quarter of 2004. In fiscal year 2001, this strategic investment had been fully impaired. Accordingly, during the year ended December 31, 2004, we recorded a gain on strategic investments of $1.2 million. During 2003, we recorded a realized gain of $395,000 from the surrender of 1,880,937 shares of TTR common stock, which was used to acquire patents and other assets of TTR, a public company strategic investment, and a realized gain of $57,000 for distributions received in excess of its book value for our investment in NTRU Cryptosystems, a private company.
Interest and Other Income, Net. Interest and other income increased $321,000, or 8.3%, to $4.2 million in 2004 from $3.9 million in 2003. This increase is primarily due to foreign exchange gains. As the Euro grew strong against the US Dollar in 2004, we recorded a gain on our Euro bank balances where the functional currency was the US Dollar. This increase was partially offset by a decrease in interest income due to a decline in our investment balances. The decline in our investment balances was due to the acquisition of InstallShield.
Income Taxes. We recorded income tax expense of $20.7 million and $22.6 million for 2004 and 2003, respectively. Income tax expense represents combined federal and state taxes at effective rates of 36.0% and 45.6% for 2004 and 2003, respectively. The change in effective tax rate in 2004 compared to 2003 was primarily due to the increase in valuation allowance and the higher portion of profits generated by our foreign operations.
Comparison of Years Ended December 31, 2003 and 2002
The following table provides revenue information by business unit for the periods indicated (dollars in thousands):
License Revenues. Our license revenues for 2003 increased by 24.9% compared to 2002 primarily due to increases in our revenues derived by our video content protection technology products, primarily in the DVD copy protection area. This was offset by decreases in our copy protection revenues for videocassettes. During 2003, the increase in video content protection revenues included approximately $917,000 in revenue as a partial resolution of this customer reporting claim. Our video content protection revenues in 2002 were also reduced by a $2.3 million refund resulting from a customers self-reporting errors detected in 2002, which revenue was previously recognized upon cash receipt. We also had increases in license revenues from our
Software Technologies Group primarily due to an increase in licensing and maintenance volume and the increased market acceptance of our technology by major software vendors.
Service Revenues. Our service revenues for 2003 increased by 31.2% compared to 2002 primarily due to increases in maintenance revenues and, to a lesser extent, an increase in consulting revenues.
Cost of Revenues License Fees. Cost of revenues from license fees as a percentage of license revenues decreased to 4.3% for 2003 from 6.6% for 2002. Cost of revenues from license fees decreased $1.1 million to $5.0 million in 2003 from $6.1 million in 2002. This decrease was primarily due to decreased patent defense costs relating to the Rainbow litigation. Cost of revenues includes items such as product costs, duplicator and replicator fees, video copy protection processor costs, patent amortization on internally developed patents, patent defense costs and licensing expenses.
Cost of Revenues Service Fees. Cost of revenues from service fees as a percentage of service revenues increased to 23.3% for 2003 from 18.5% for 2002. Cost of revenues from service fees increased $1.2 million to $3.2 million in 2003 from $1.9 million in 2002. This increase was primarily due to increased activity in our enterprise software consulting practice.
Cost of Revenues Amortization of Intangibles from Acquisitions. Cost of revenues from amortization of intangibles increased to $3.3 million in 2003 from $2.3 million in 2002. The increase is primarily due to amortization of intangibles from the Midbar acquisition that was completed in November 2002.
We acquired the net assets of Midbar in November 2002 for approximately $17.8 million in cash. In addition, we have agreed to an additional maximum payout of $8.0 million based on a percentage of the net revenues of the music technology division through December 31, 2004. The transaction was accounted for as a purchase and approximately $4.9 million of the purchase price was allocated to existing technology, existing contracts, patents and trademarks. In addition, we recorded $6.9 million of goodwill from this transaction and recorded a $6.0 million charge in 2002 for purchased in-process research and development. In 2003, we recorded additional goodwill of approximately $1.2 million for the contingent payment obligation based on sales of our music technology products through December 31, 2003. We amortize intangibles, with the exception of goodwill, relating to the acquisition of net assets of Midbar on a straight-line basis over three to five years based on the expected useful lives of existing technology, existing contracts, patents and trademarks.
In August 2003, we acquired intellectual property and other assets, including patents and software that can be used to track and manage content in the peer-to-peer file sharing space. We paid $720,000 in cash, $80,000 of acquisition costs and an additional payment of $80,000 will be due on the first anniversary of the closing date for a total purchase price of $880,000. In addition, we have agreed to a maximum payment of $140,000 if certain milestones are achieved by May 28, 2004. The purchase price was allocated to in-process research and development, core technology and employment agreements. The in-process research and development of $624,000 was expensed in 2003, and the balance of the purchase price has been allocated among the other intangible assets and is being amortized on a straight-line basis over two to six years based on the expected useful lives of the intangibles.
Research and Development. Research and development expenses increased by $5.3 million or 44.9% to $17.2 million in 2003 from $11.9 million in 2002. The increase is primarily due to increased research and development activities for our video technology, music technology and software technology product lines. Research and development expenses increased as a percentage of net revenues to 13.4% in 2003 from 11.6% in 2002.
Selling and Marketing. Selling and marketing expenses increased by $6.3 million or 30.3% to $27.0 million in 2003 from $20.7 million in 2002. This increase was primarily due to increased business development activities for our enterprise licensing and music technology product lines and increased commission costs associated with higher revenue levels. Selling and marketing expenses increased as a percentage of net revenues to 21.0% in 2003 from 20.3% in 2002.
General and Administrative. General and administrative expenses increased by $4.4 million or 28.9% to $19.4 million in 2003 from $15.0 million in 2002, primarily due to higher compensation expense, increased headcount and increased costs associated with the compliance with Sarbanes-Oxley requirements. General and administrative expenses increased as a percentage of net revenues to 15.1% in 2003 from 14.7% in 2002.
Amortization of Intangibles from Acquisitions. Amortization of intangibles from acquisitions, other than those included in cost of revenues, decreased from $273,000 in 2002 to $0 in 2003 as the covenant not to compete in connection with the purchase of PtS was fully amortized during 2002. There was no amortization of intangibles from acquisitions in operating expenses during 2003.
Amortization of Deferred Stock-Based Compensation. In connection with the acquisition of Globetrotter in 2000, approximately 783,742 Globetrotter employee stock options were exchanged for Macrovision stock options, resulting in a deferred stock-based compensation charge of approximately $37.9 million. The amortization of the deferred stock-based compensation for 2003 and 2002 was $2.7 million and $6.3 million, respectively. The expense associated with amortization of this stock-based compensation will end in the first quarter of 2004.
In-process research and development. In connection with the acquisition of intellectual property and other assets in the peer-to-peer file sharing space in August 2003, $624,000 was charged to in-process research and development in 2003. In connection with the acquisition of Midbar in November 2002, $6.0 million was charged to in-process research and development in 2002.
Impairment losses and gains on strategic investments. During 2003 and 2002, we recorded net charges totaling $4.4 million and $17.2 million, relating to other-than-temporary impairment of certain strategic investments. During 2003, we determined that the decline in value of our iVAST stock was other-than-temporary and took a charge to earnings of $4.8 million as a result. This was partially offset by a gain of $395,000 related to the surrender of 1,880,937 shares of TTR common stock, which was used to acquire patents and other assets of TTR.
Interest and Other Income, Net. Interest and other income decreased $3.5 million or 47.4% to $3.9 million in 2003 from $7.3 million in 2002, primarily from declining interest rates.
Income Taxes. We recorded income tax expense of $22.6 million and $9.8 million for 2003 and 2002, respectively. Income tax expense represents combined federal and state taxes at effective rates of 45.6% and 44.8% for 2003 and 2002, respectively. The increase in the effective tax rate was primarily due to changes in tax jurisdictions where our income was earned and the composition of our expenses, including the reduction in amortization of deferred stock-based compensation.
Quarterly Results of Operations
The following table sets forth certain quarterly unaudited consolidated financial data for the periods indicated, as well as the percentage of our net revenues represented by such data. The data have been derived from our unaudited consolidated financial statements and, in the opinion of management, have been prepared on substantially the same basis as the audited consolidated financial statements, and include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of such data. Such data should be read in conjunction with our audited consolidated financial statements and notes thereto appearing elsewhere in this Form 10-K. The results of operations for any quarter are not necessarily indicative of the results to be expected for any future period.
Our operating results have fluctuated in the past, and are expected to continue to fluctuate in the future, on an annual and quarterly basis as a result of a number of factors. Such factors include the timing of release of popular titles on videocassettes or DVDs or by digital PPV transmission, the timing of release of popular computer games on CD-ROM, the timing of a small number of our electronic license management high-value perpetual licenses during any period, the degree of acceptance of our copy protection technologies by major motion picture studios and computer game publishers, the mix of products sold and technologies licensed, any change in product or license pricing, the seasonality of revenues, changes in our operating expenses, personnel changes, the development of our direct and indirect distribution channels, foreign currency exchange rates and general economic conditions. We may choose to reduce royalties and fees or increase spending in response to competition or new technologies or elect to pursue new market opportunities. Because a high percentage f our operating expenses are fixed, a small variation in the timing of recognition of revenues can cause significant variations in operating results from period to period.
Liquidity and Capital Resources
We have financed our operations primarily from cash generated by operations, principally our copy protection products and our software value management products. Our operating activities provided net cash of $59.7 million, $58.9 million and $55.1 million in 2004, 2003 and 2002, respectively. Cash provided by operating activities increased $0.8 million from $58.9 million in 2003 to $59.7 million in 2004. This increase was primarily due to the increase in net income partially offset by the increase in accounts receivable. In addition, the availability of cash generated by our operations could be affected by other business risks discussed in the Risk Factor section of this annual report.
Investing activities provided (used) net cash of $1.3 million, $(137.2) million and $51.8 million in 2004, 2003 and 2002, respectively. Cash provided by (used in) investing activities increased $138.5 million from ($137.2) million in 2003 to $1.3 million in 2004. The increase is primarily due to a decline in amounts invested as we used approximately $77.1 to acquire the operations and assets of InstallShield in July 2004. We made capital expenditures of $4.8 million, $2.8 million and $3.9 million in 2004, 2003 and 2002, respectively. Capital expenditures are primarily for computer software and hardware. We also paid $1.1 million, $6.3 million and $761,000 in 2004, 2003 and 2002, respectively, related to patents during those periods.
In July 2004, we acquired the operations and certain assets of InstallShield Software Corporation (InstallShield) for approximately $77.1 million in cash, including related acquisition costs. We also assumed certain liabilities as part of the acquisition. An additional contingent payment of up to $20.0 million may be required to be made by us based on post-acquisition revenue performance through June 30, 2005. Any additional contingent consideration would be required to be paid in the third quarter of 2005. InstallShield is a leading provider of software installation tools. The acquisition of InstallShield expands our product portfolio in the software value management category and enables us to reach InstallShields large software developer customer base. InstallShields personnel, operations, and products have been integrated into our Software Technologies Group.
Net cash provided by (used in) financing activities was $15.2 million, $6.8 million and $(34.6) million in 2004, 2003 and 2002, respectively. The increase in net cash provided by financing activities from $6.8 million in 2003 to $15.2 million in 2004 is primarily from proceeds of stock option exercises and employee stock purchase plan purchases. In May 2002, our Board of Directors authorized a share repurchase program, which allows us to purchase up to 5.0 million shares in the open market from time-to-time at prevailing market prices, through block trades or otherwise, or in negotiated transactions off the market, at the discretion of our management. In 2002, we repurchased 3.0 million shares of common stock under this program, which have been recorded as treasury stock and resulted in a reduction of stockholders equity. We did not repurchase any shares of common stock in 2003 or 2004.
At December 31, 2004, we had $105.0 million in cash and cash equivalents, $101.3 million in short-term investments, and $47.4 million in long-term marketable investment securities, which includes $18.8 million in fair market value of our holdings in Digimarc. We anticipate that capital expenditures for the next 12 months will aggregate approximately $9.9 million in order to support the expansion of our office space and our operations infrastructure.
We also have future minimum lease payments of approximately $50.9 million under operating leases. We believe that the current available funds and cash flows generated from operations will be sufficient to meet our working capital and capital expenditure requirements for the foreseeable future. We may also use cash to acquire or invest in additional businesses or to obtain the rights to use certain technologies in the future.
In November 2002, we acquired the assets and operations of Midbar for approximately $17.8 million in cash and related acquisition costs. In addition, we are subject to an additional maximum payout of $8.0 million based on a percentage of revenues derived from our sales of music technology products through December 31, 2004. During 2004 and 2003, we paid $1.1 million and $480,000, respectively, of such contingent consideration in cash.
In August 2003, we acquired intellectual property and other assets, including patents and software that can be used to track and manage content in the peer-to-peer file sharing space for $720,000 in cash, $80,000 of acquisition costs and an additional payment of $80,000 due on the first anniversary of the closing date for total consideration of $880,000. In addition, we agreed to a maximum payment of $140,000 if certain milestones were achieved by May 28, 2004.
Because a significant portion of our cash inflows were generated by operations, our ability to generate positive cash flow from operations may be jeopardized by fluctuations in our operating results. Such
fluctuations can occur as a result of decreases in demand for our copy protection products, our software value management products, or due to other business risks including, but not limited to, those factors set forth under the caption Risk Factors contained in this annual report.
We lease facilities and certain equipment pursuant to non-cancelable operating lease agreements. Future minimum lease payments pursuant to these leases as of December 31, 2004 were as follows (in thousands):
Recently Issued Accounting Pronouncements
In December 2003, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities An Interpretation of Accounting Research Bulletin No. 51 (FIN 46R). FIN 46R requires an investor with a majority of the variable interests (primary beneficiary) in a variable interest entity (VIE) to consolidate the entity and also requires majority and significant variable interest investors to provide certain disclosures. A VIE is an entity in which the voting equity investors do not have a controlling financial interest, or the equity investment at risk is insufficient to finance the entitys activities without receiving additional subordinated financial support from other parties. Application of FIN 46R is required in financial statements of companies that have interests in variable interest entities or potential variable interest entities commonly referred to as special purpose entities for periods ending after December 15, 2003. Application by companies for all other types of entities is required in financial statements for periods ending after March 15, 2004. We had no investments in VIEs as of December 31, 2004.
In December 2003, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition. SAB No. 104 updates interpretive guidance in the codification of staff accounting bulletins to provide consistent accounting guidance on revenue recognition. The principal revisions relate to the deletion of interpretive material no longer necessary because of private sector developments in generally accepted accounting principles in the United States of America, and the incorporation of certain sections of the SECs Revenue Recognition in Financial Statements Frequently Asked Questions and Answers document. The adoption of SAB No. 104 has had no material impact on our financial position or results of operations.
In December 2003, the FASB issued SFAS No. 132 (revised 2003), Employers Disclosures about Pensions and Other Postretirement Benefits. SFAS No. 132 (revised 2003) revises employers disclosures about pension plans and other postretirement benefit plans. It does not change the measurement or recognition of those plans required by SFAS No. 87, Employers Accounting for Pensions, No. 88, Employers Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits, and No. 106, Employers Accounting for Postretirement Benefits Other Than Pensions. This statement retains the disclosure requirements contained in SFAS No. 132, Employers Disclosures about Pensions and Other Postretirement Benefits, which it replaces. It requires additional disclosures to those in the original SFAS No. 132 about the assets, obligations, cash flows, and net periodic benefit cost of defined benefit pension plans and other defined benefit postretirement plans. The required information should be provided
separately for pension plans and for other postretirement benefit plans. SFAS No. 132 (revised 2003) is effective for financial statements with fiscal years ending after December 15, 2003. We had no pension plans or other postretirement benefit plans covered by SFAS No.132 as of December 31, 2004.
In March 2004, the FASB issued EITF Issue No. 03-1 (EITF 03-1) The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. EITF 03-1 provides new guidance for assessing impairment losses on investments. Additionally, EITF 03-1 includes new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB delayed the accounting provisions of EITF 03-1; however the disclosure requirements remain effective for annual periods ending after June 15, 2004. We have adopted the disclosure requirements under EITF 03-1 by the year ended December 31, 2004. We will evaluate the impact of EITF 03-1 once final guidance is issued.
In July 2004, the FASB issued EITF Issue No. 02-14 (EITF 02-14) Whether an Investor Should Apply the Equity Method of Accounting to Investments Other Than Common Stock. EITF 02-14 includes new guidance for determining whether the equity method of accounting applies when an investor does not have an investment in voting common stock of an investee but exercises significant influence through other means, how the equity method should be applied to investments other than common stock, and for securities with a readily determinable fair market value, how the scope provisions of APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock, and FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, interact. The accounting guidance provided in EITF 02-14 is effective for reporting periods beginning after September 15, 2004. We adopted the accounting guidance effective October 1, 2004. The adoption of EITF 02-14 has had no material impact on our financial position or results of operations.
In December 2004, the FASB issued SFAS No. 123 (revised 2004), or SFAS 123R, Share-Based Payment. This statement replaces SFAS 123, Accounting for Stock-Based Compensation and supersedes Accounting Principles Boards Opinion No. 25 (ABP 25), Accounting for Stock Issued to Employees. SFAS 123R will require us to measure the cost our employee stock-based compensation awards granted after the effective date based on the grant date fair value of those awards and to record that cost as compensation expense over the period during which the employee is required to perform services in exchange for the award (generally over the vesting period of the award). SFAS 123R addresses all forms of share-based payments awards, including shares issued under employee stock purchase plans, stock option, restricted stock and stock appreciation rights. In addition, we will be required to record compensation expense (as previous awards continue to vest) for the unvested portion of previously granted awards that remain outstanding at the date of adoption. SFAS 123R is effective for fiscal periods beginning after June 15, 2005. Therefore, we are required to implement the standard no later than our third fiscal quarter which begins on July 1, 2005. SFAS 123R permits public companies to adopt its requirements using the following methods: (1) a modified prospective method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS 123R for all share-based payments granted after the effective date and (b) based on the requirements of SFAS 123 for all awards granted to employees prior to the effective date of SFAS 123R that remain unvested on the effective date; or (2) a modified retrospective method which includes the requirements of the modified prospective method described above, but also permits entities to restate their financial statement based on the amounts previously recognized under SFAS 123 for purposes of pro forma disclosures for either (a) all prior periods presented or (b) prior interim periods of the year of adoption.
We are currently evaluating the alternative methods of adoption as described above. As permitted by SFAS 123, we currently account for share-based payments to employees using APB 25s intrinsic value method and, as such, generally recognize no compensation cost for employee stock options. Accordingly, the adoption of SFAS 123Rs fair value method will have a significant impact on our result of operations, although it will have no negative impact on our cash flow. The impact of adoption of SFAS 123R cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. See Note 1 The Company and Summary of Significant Accounting Policies for information related to the pro
forma effects on our reported net income and net income per share of applying the fair value recognition provisions of the previous SFAS 123 to stock-based employee compensation.
In December 2004, the FASB issued Financial Staff Position (FSP) No. FAS 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004 (FSP 109-2). On October 22, 2004, the American Jobs Creation Act of 2004 (the Act) was signed into law. The Act creates a temporary incentive for U.S. corporations to repatriate accumulated income earned abroad by including an 85 percent deduction for certain foreign earnings that are repatriated, as defined in the Act, at an effective federal tax cost of 5.25 percent. FSP 109-2 is effective immediately and provides accounting and disclosure guidance for the repatriation provision. FSP 109-2 allows companies additional time to evaluate the effects of the law on its unremitted earnings for the purpose of applying the indefinite reversal criteria under APB 23, Accounting for Income Taxes Special Areas, and requires explanatory disclosures from companies that have not yet completed the evaluation. We are in the process of evaluating whether it will repatriate any foreign earnings under the Act and, if so, the amount that it will repatriate. However, we do not expect to be able to complete this evaluation until after Congress or the Treasury Department provides additional clarifying language on key elements of the provision. Based on our preliminary analysis, the range of possible amounts that we are considering for repatriation under this provision is between zero and $30 million. The related potential range of income tax is between zero and approximately $2 million. We expect to determine the amounts and sources of foreign earnings to be repatriated, if any, during 2005.
We are exposed to financial market risks, including changes in interest rates, foreign currency exchange rates and security investments. Changes in these factors may cause fluctuations in our earnings and cash flows. We evaluate and manage the exposure to these market risks as follows:
Fixed Income Investments. We have an investment portfolio of fixed income securities, including those classified as cash equivalents, short-term investments and long-term marketable investment securities of $195.3 million as of December 31, 2004. These securities are subject to interest rate fluctuations. An increase in interest rates could adversely affect the market value of our fixed income securities.
We do not use derivative financial instruments in our investment portfolio to manage interest rate risk. We limit our exposure to interest rate and credit risk, however, by establishing and strictly monitoring clear policies and guidelines for our fixed income portfolios. The primary objective of these policies is to preserve principal while at the same time maximizing yields, without significantly increasing risk. A hypothetical 50 basis point increase in interest rates would result in an approximate $359,000 decrease (approximately 0.2%) in the fair value of our fixed income available-for-sale securities as of December 31, 2004. Yield risk is also reduced by targeting a weighted average maturity of our portfolio at 12 months so that the portfolios yield regenerates itself as portions of the portfolio mature.
Foreign Currency Exchange Rates. Due to our reliance on international and export sales, we are subject to the risks of fluctuations in currency exchange rates. Because a substantial majority of our international and export revenues, as well as expenses, are typically denominated in U.S. dollars, fluctuations in currency exchange rates could cause our products to become relatively more expensive to customers in a particular country, leading to a reduction in sales or profitability in that country. Our subsidiaries in the U.K., Japan and Israel operate in their local currency, which mitigates a portion of the exposure related to the respective currency collected.
Strategic Investments. We currently hold minority equity interests in a number of companies. These investments, at book value totaling $18.8 million, $27.0 million and $28.7 million, represented 4.1%, 7.0% and 8.9% of our total assets as of December 31, 2004, 2003 and 2002, respectively. As of December 31, 2004, the adjusted cost of our strategic investments consisted of our investment in Digimarc, a publicly traded company. In addition, we hold investments in a number of other privately held companies, which have no
carrying value as of December 31, 2004. Digimarc is subject to price fluctuations based on the public market. Because there is no active trading market for the securities of privately held companies, our investments in them are illiquid. As such, we may never have an opportunity to realize a return on our investment in these private companies, and we may in the future be required to write off all or part of one or more of these investments. During 2004, 2003 and 2002, we wrote off $5.5 million, $4.8 million and $17.2 million, respectively, of strategic investments resulting from impairment that was other-than-temporary. In 2004, the $5.5 million impairment loss was partially offset by a gain of $1.2 million related to the gain from the sale of InterActual Technologies. In 2003, the $4.8 million impairment loss was partially offset by a gain of $395,000 related to the surrender of 1,880,937 shares of TTR common stock, which was used to acquire patents and other assets of TTR.
The information required by this item is submitted in a separate section of this report beginning on F-1 of this report.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES
Evaluation of Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our chief executive officer and our chief financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Exchange Act Rule 13a-15(e). Based on this evaluation, our chief executive officer and our chief financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this annual report.
Managements Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining an adequate system of internal control over financial reporting. Our internal control over financial reporting includes those policies and procedures that:
Our management assessed the effectiveness of our system of internal control over financial reporting as of December 31, 2004. In making this assessment, we used the framework in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on our assessment and the criteria set forth by COSO, we believe that Macrovision maintained effective internal control over financial reporting as of December 31, 2004. Our assessment of the effectiveness of our internal control over financial reporting has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report which is included herein.
Inherent Limitations on Effectiveness of Controls
Our system of internal control over financial reporting was designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States.
All internal control systems, no matter how well designed and operated, can provide only reasonable assurance with respect to financial statement preparation and presentation. Our management does not expect that our disclosure controls and procedures will prevent all error and fraud. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues within the company have been detected, even with respect to those systems of internal control that are determined to be effective. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdown can occur because of simple error or mistake. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of these inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. Our system contains self monitoring mechanisms, and actions are taken to correct deficiencies as they are identified.
Internal Control Over Financial Reporting Associated With the InstallShield Acquisition
We completed the acquisition of the assets of InstallShield Software Corporation on July 1, 2004. Our management has not completed an assessment of the internal control over financial reporting of our InstallShield operations as it was not possible to conduct a full assessment of InstallShields internal control over financial reporting in the period between the completion of the acquisition and the date of our managements assessment of our internal control over financial reporting. Our conclusion in this Annual Report on Form 10-K regarding the effectiveness of our internal control over financial reporting as of December 31, 2004 does not include the internal control over financial reporting of InstallShield and its subsidiaries. The total revenues from the InstallShield operations since July 1, 2004 represented approximately 9.7% of the related consolidated financial statement amounts for the year ended December 31, 2004. Total assets from InstallShield represented approximately 2.8% of the related consolidated financial statement amounts as of December 31, 2004.
Audit Committee Oversight
The Audit Committee of the Board of Directors, which is comprised solely of independent directors, has oversight responsibility for our financial reporting process and the audits of our consolidated financial statements and internal control over financial reporting. The Audit Committee meets regularly with management and with our internal auditors and independent registered public accounting firm (collectively, the accountants) to review matters related to the quality and integrity of our financial reporting, internal control over financial reporting (including compliance matters related to our Code of Personal and Business Conduct and Ethics), and the nature, extent, and results of internal and external audits. Our accountants have full and free access and report directly to the Audit Committee. The Audit Committee recommended, and the Board of Directors approved, that the audited consolidated financial statements be included in this Annual Report on Form 10-K.
Changes in Internal Control Over Financial Reporting
In the course of auditing our 2004 financial statements, we identified that at the end of 2003, we did not maintain adequate controls over the review of our tax provision related to U.S. taxation on income earned outside of the United States, which impacted the income tax expense in the fourth quarter of 2003. Therefore, we decided to restate our financial statements for the year ended 2003. The financial statement impact of the adjustment was confined to the fourth quarter of 2003 and did not have any effect on subsequently reported quarterly financial results. We remediated this weakness in internal control over financial reporting in the fourth quarter of 2004, by improving our review of our intercompany tax records and tax accrual position, and changing our methods of recordkeeping of intercompany entries that relate to U.S. taxation on income earned outside the United States. We also hired a full-time tax director to lead this function and we have engaged new external tax advisors. We believe that these corrective actions taken as a whole, have mitigated the control weakness with respect to the review of our tax provision and that these measures have been effective to ensure that information required to be disclosed in this Annual Report on Form 10-K for 2004 has been recorded, processed, summarized and reported correctly.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders of
We have audited managements assessment, included in the accompanying Managements Report on Internal Control Over Financial Reporting, that Macrovision Corporation (‘Macrovision) maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Macrovisions 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 managements assessment and an opinion on the effectiveness of Macrovisions 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 managements 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 companys 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 companys 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 companys 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.
In our opinion, managements assessment that Macrovision Corporation maintained effective internal control over financial reporting as of December 31, 2004 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, Macrovision Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
Macrovision Corporation completed the acquisition of the assets of InstallShield Software Corporation on July 1, 2004, and management excluded from its assessment of the effectiveness of Macrovision Corporations internal control over financial reporting as of December 31, 2004, InstallShields internal control over financial reporting which represented approximately 2.8% of total consolidated assets and approximately 9.7% of total consolidated revenues as of and for the year ended December 31, 2004. Our audit of internal control over financial reporting of Macrovision also excluded an evaluation of the internal control over financial reporting of InstallShield and its subsidiaries.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Macrovision Corporation and subsidiaries as of December 31, 2004 and 2003 and the related consolidated statements of income, stockholders equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2004; and our report dated March 31, 2005 expressed an unqualified opinion on those consolidated financial statements.
/s/ KPMG LLP
Mountain View, California
The information required by this item is incorporated by reference from the information under the sections Information About Directors, Information About our Executive Officers and Proposal 1: Election of Directors, to be contained in our proxy statement, which will be filed with the SEC in connection with the solicitation of proxies for our 2005 Annual Meeting of Stockholders to be held on May 24, 2005 (the 2005 Annual Meeting of Stockholders).
In February 2004, we adopted a code of conduct and ethics applicable to all of our directors and employees, including the principal executive officer, principal financial officer and principal accounting officer. A copy of such code of conduct and ethics was filed as an Exhibit to our Annual Report on Form 10-K for the year ended December 31, 2003. If we make any substantive amendments to the code of conduct and ethics or grant any waiver, including implicit waiver, from a provision of the code of conduct and ethics to our principal executive officer, principal financial officer or principal accounting officer, we will disclose the nature of such amendment or waiver on our website at http:///www.macrovision.com or in a current report on Form 8-K that will be publicly filed.
The information required by this item is incorporated by reference to the information under the section Executive Compensation to be contained in the proxy statement for the 2005 Annual Meeting of Stockholders.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required by this item is incorporated by reference to the information under the section Security Ownership of Certain Beneficial Owners and Management and Equity Plan Information to be contained in the proxy statement for the 2005 Annual Meeting of Stockholders.
The information required by this item is incorporated by reference to the information under the section Certain Relationships and Related Transactions to be contained in the proxy statement for the 2005 Annual Meeting of Stockholders.
The information required by this item is incorporated by reference to the information under the caption Principal Auditor Fees and Services to be contained in the proxy statement for the 2005 Annual Meeting of Stockholders.