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  • 10-Q (Nov 7, 2007)
  • 10-Q (Aug 8, 2007)
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  • 10-Q (Nov 8, 2006)
  • 10-Q (Nov 7, 2006)
  • 10-Q (Aug 15, 2006)

 
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Macrovision 10-Q 2006

Documents found in this filing:

  1. 10-Q/A
  2. Ex-31.01
  3. Ex-31.02
  4. Ex-32.01
  5. Ex-32.02
  6. Ex-32.02
Amendment No. 2 to Form 10-Q
Table of Contents

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


FORM 10-Q/A

 


(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2006

or

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission file number: 000-22023

 


Macrovision Corporation

(Exact name of registrant as specified in its charter)

 


 

Delaware   77-0156161

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

 

2830 De La Cruz Boulevard, Santa Clara, CA   95050
(Address of principal executive offices)   (Zip Code)

(408) 562-8400

(Registrant’s telephone number, including area code)

 


Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 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 whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.

Large accelerated filer  x    Accelerated filer  ¨    Non-accelerated filer  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

Class

 

Outstanding as of August 1, 2006

Common stock, $0.001 par value   52,890,682

 



Table of Contents

MACROVISION CORPORATION

FORM 10-Q/A

INDEX

 

         Page
PART I - FINANCIAL INFORMATION   
Item 1.   Financial Statements   
  Condensed Consolidated Balance Sheets as of June 30, 2006 and December 31, 2005    2
  Condensed Consolidated Statements of Income for the Three and Six Months Ended June 30, 2006 and 2005    3
  Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2006 and 2005    4
  Notes to Condensed Consolidated Financial Statements    5
Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations    27
Item 3.   Quantitative and Qualitative Disclosures about Market Risk    40
Item 4.   Controls and Procedures    41
PART II - OTHER INFORMATION   
Item 1.   Legal Proceedings    42
Item 1A.   Risk Factors    44
Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds    66
Item 3.   Defaults Upon Senior Securities    66
Item 4.   Submission of Matters to a Vote of Security Holders    67
Item 5.   Other Information    67
Item 6.   Exhibits    68
Signatures    69


Table of Contents

Amendment No. 2 to the Quarterly Report on Form 10-Q

For the Quarterly Period Ended June 30, 2006

EXPLANATORY NOTE

Macrovision Corporation (the “Company”) is filing this Amendment No. 2 on Form 10-Q/A (this “Amendment”) to its Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2006, which was originally filed on August 9, 2006 (the “Original Filing”), to amend and restate the Company’s condensed consolidated financial statements for the three and six months ended June 30, 2006. This Quarterly Report on Form 10-Q/A is being filed for the purpose of amending our condensed consolidated financial statements to record equity-based compensation adjustments related to the quarterly period ended June 30, 2006.

For the convenience of the reader, this Amendment sets forth the Original Filing in its entirety. However, this Amendment only amends and restates Items 1, 2 and 4 of Part I, in each case as a result of, and to reflect, the restatement and related matters. For a description of the restatement, see Note 2 “Restatement of Financial Statements” to the accompanying interim consolidated financial statements contained in this Amendment. No other information in the Original Filing is amended hereby. The foregoing items have not been updated to reflect other events occurring after the filing of the Original Filing or to modify or update those disclosures affected by subsequent events. In addition, pursuant to the rules of the SEC, Item 6 of Part II of the Original Filing has been amended to contain currently dated certifications from the Company’s Chief Executive Officer and Chief Financial Officer, as required by Sections 302 and 906 of the Sarbanes-Oxley Act of 2002. Except for the foregoing amended information, this Amendment continues to speak as of the date of the Original Filing and the Company has not updated the disclosure contained herein to reflect events that occurred as of a later date. Other events occurring after the filing of the Original Filing or other disclosures necessary to reflect subsequent events have been or will be addressed in the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2006, which will be filed after the filing of this Amendment, and any reports filed with the SEC subsequent to the date of this filing.

 

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Table of Contents

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

MACROVISION CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

(Unaudited)

 

    

June 30,

2006

(As Restated)

   

December 31,

2005

 

ASSETS

    

Current assets:

    

Cash and cash equivalents

   $ 120,441     $ 135,625  

Short-term investments

     126,024       99,039  

Accounts receivable, net of allowance for doubtful accounts of $1,465 and $3,715, respectively

     41,910       45,254  

Deferred tax assets

     2,474       2,504  

Prepaid expenses and other current assets

     6,876       5,004  
                

Total current assets

     297,725       287,426  

Long-term marketable investment securities

     26,966       15,040  

Restricted cash and investments

     12,000       12,000  

Property and equipment, net

     19,320       13,398  

Goodwill

     137,194       107,329  

Other intangibles from acquisitions, net

     31,553       32,755  

Deferred tax assets

     22,103       18,895  

Patents and other assets

     12,424       11,082  
                
   $ 559,285     $ 497,925  
                

LIABILITIES AND STOCKHOLDERS’ EQUITY

    

Current liabilities:

    

Accounts payable

   $ 3,933     $ 5,380  

Accrued expenses

     28,060       20,152  

Income taxes payable

     27,914       20,022  

Deferred revenue

     28,808       23,262  
                

Total current liabilities

     88,715       68,816  

Other non current liabilities

     2,944       959  
                

Total liabilities

     91,659       69,775  

Stockholders’ equity:

    

Common stock

     55       54  

Treasury stock, at cost

     (38,450 )     (38,450 )

Additional paid-in-capital

     353,616       330,912  

Deferred equity-based compensation

     —         (5,101 )

Accumulated other comprehensive income

     5,054       2,631  

Retained earnings

     147,351       138,104  
                

Total stockholders’ equity

     467,626       428,150  
                
   $ 559,285     $ 497,925  
                

See the accompanying notes to these condensed consolidated financial statements.

 

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MACROVISION CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share data)

(Unaudited)

 

    

Three Months Ended

June 30,

  

Six Months Ended

June 30,

 
    

2006

(As Restated)

   2005   

2006

(As Restated)

   2005  

Revenues:

           

Licenses

   $ 43,326    $ 36,104    $ 88,369    $ 80,221  

Services

     15,023      8,310      26,998      15,450  
                             

Total revenues

     58,349      44,414      115,367      95,671  

Cost of revenues:

           

License fees

     2,568      1,333      4,930      2,994  

Service fees*

     8,265      3,666      14,487      7,383  

Amortization of intangibles from acquisitions

     3,490      2,466      6,733      4,882  
                             

Total cost of revenues

     14,323      7,465      26,150      15,259  
                             

Gross profit

     44,026      36,949      89,217      80,412  

Operating expenses:

           

Research and development*

     13,615      7,925      26,330      16,622  

Selling and marketing*

     16,426      13,027      33,318      25,949  

General and administrative*

     8,475      7,461      17,293      15,887  
                             

Total operating expenses

     38,516      28,413      76,941      58,458  
                             

Operating income

     5,510      8,536      12,276      21,954  

Impairment losses on investments

     —        —        —        (5,822 )

Gains on strategic investments

     —        —        —        96  

Interest and other income, net

     2,106      974      4,155      1,911  
                             

Income before income taxes

     7,616      9,510      16,431      18,139  

Income taxes

     841      3,440      7,184      6,602  
                             

Net income

   $ 6,775    $ 6,070    $ 9,247    $ 11,537  
                             

Basic net earnings per share

   $ 0.13    $ 0.12    $ 0.18    $ 0.23  
                             

Shares used in computing basic net earnings per share

     52,262      50,502      51,985      50,426  
                             

Diluted net earnings per share

   $ 0.13    $ 0.12    $ 0.18    $ 0.22  
                             

Shares used in computing diluted net earnings per share

     53,090      51,263      52,679      51,298  
                             

           

*  Equity-based compensation by category is as follows:

           

Service fees

   $ 461    $ —      $ 915    $ —    

Research and development

   $ 1,557    $ —      $ 3,305    $ —    

Selling and marketing

   $ 1,858    $ —      $ 3,964    $ —    

General and administrative

   $ 1,536    $ —      $ 3,057    $ —    

See the accompanying notes to these condensed consolidated financial statements.

 

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MACROVISION CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 

    

Six Months Ended

June 30

 
    

2006

(As Restated)

    2005  

Cash flows from operating activities:

    

Net income

   $ 9,247     $ 11,537  

Adjustments to reconcile net income to net cash provided by operating activities:

    

Depreciation and amortization

     4,288       3,034  

Amortization of intangibles from acquisitions

     6,733       4,882  

Equity-based compensation

     11,241       —    

Deferred taxes from equity-based compensation

     (2,199 )     —    

Tax benefit from stock options exercises

     2,673       1,147  

Excess tax benefits from equity-based compensation

     (479 )     —    

Impairment losses on strategic investments

     —         5,822  

Gains on strategic investments

     —         (96 )

Deferred tax expense

     —         358  

Changes in operating assets and liabilities:

    

Accounts receivable, net

     5,943       6,941  

Deferred revenue

     4,265       4,365  

Other assets

     (5,612 )     (2,121 )

Other liabilities

     13,688       (3,943 )
                

Net cash provided by operating activities

     49,788       31,926  

Cash flows from investing activities:

    

Purchases of long and short-term investments

     (195,512 )     (117,534 )

Sales or maturities of long and short-term investments

     157,167       122,563  

Decrease (increase) in restricted cash and investments

     —         859  

Acquisition of eMeta, net of cash acquired

     (34,622 )     —    

Acquisition of property and equipment

     (8,784 )     (4,543 )

Payments for patents

     (858 )     (862 )

Proceeds from sale of strategic investments

     —         96  

Contingent consideration for Midbar acquisition

     —         (497 )

Acquisition of Zero G, net of cash acquired

     —         (9,558 )
                

Net cash used in investing activities

     (82,609 )     (9,476 )

Cash flows from financing activities:

    

Excess tax benefits from equity-based compensation

     479       —    

Proceeds from issuance of common stock from options and stock purchase plans

     16,565       5,729  
                

Net cash provided by financing activities

     17,044       5,729  

Effect of exchange rate changes on cash and cash equivalents

     593       (709 )
                

Net increase in cash and cash equivalents

     (15,184 )     27,470  

Cash and cash equivalents at beginning of period

     135,625       92,957  
                

Cash and cash equivalents at end of period

   $ 120,441     $ 120,427  
                

See the accompanying notes to these condensed consolidated financial statements.

 

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MACROVISION CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE 1 – BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements have been prepared by Macrovision Corporation and its subsidiaries (the “Company”) 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. However, the Company believes the disclosures are adequate to make the information not misleading. In the opinion of management, the accompanying unaudited condensed consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, which in the opinion of management are considered necessary to present fairly the results for the periods presented. This quarterly report on Form 10-Q/A should be read in conjunction with the audited financial statements and notes thereto and other disclosures, including those items disclosed under the caption “Risk Factors.”

The consolidated results of operations for the interim periods presented are not necessarily indicative of the results expected for the entire year ending December 31, 2006, for any future year, or for any other future interim period.

The accompanying condensed consolidated financial statements for 2005 contain certain reclassifications to conform to the 2006 presentation. This consists of a balance sheet reclassification of $12.0 million of certain short-term investments to restricted cash and investments, previously reported in short-term investments in 2005 and cash in 2004. The statement of cash flows for the six months ended June 30, 2005 also reflects this reclassification, shown as a reduction of $12.0 million, in cash and cash equivalents at the beginning and end of the period. The impact of this reclassification is not material to the December 31, 2005 balance sheet or the statement of cash flows for the six months ended June 30, 2005.

NOTE 2 – RESTATEMENT OF FINANCIAL STATEMENTS

As part of the Company’s financial close process during the third quarter of 2006, the Company determined that it had incorrectly calculated its equity-based compensation expense for the first and second quarters of 2006, resulting in an understatement of equity-based compensation of $0.9 million, before taxes, for the three months ended March 31, 2006 and an overstatement of equity-based compensation expense of $1.3 million, before taxes, for the three months ended June 30, 2006. As a result of these errors, the net impact on the six months ended June 30, 2006, was an overstatement of $0.5 million, before taxes. Specifically, the adjustments being made to the equity-based compensation expense for the three and six months ended June 30, 2006 relate to (i) expected forfeitures, (ii) the incremental value associated with the commencement of new offering periods under the Company’s employee stock purchase plan and (iii) the expected term assumptions used in calculating compensation associated with the Company’s employee stock purchase plan. There is no impact to any prior year financial statements. The Company determined to correct its equity-based compensation expense for the three months ended March 31, 2006 and June 30, 2006, and as a result, concluded to restate the Company’s financial statements for the quarterly periods ended March 31, 2006 and June 30, 2006.

The effect of the adjustments on the statement of income for the three months ended June 30, 2006 was a decrease in cost of revenues – service fees of $0.1 million, a decrease in research and development expense of $0.5 million, a decrease in sales and marketing expense of $0.6 million, a decrease in general and administrative expense of $0.1 million and an increase in tax expense of $0.8 million.

As discussed above, the Company also restated its previous financial statements for the three months ended March 31, 2006. As a result of these corrections, the effect of the adjustments on the statement of

 

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income for the six months ended June 30, 2006 was a decrease in cost of revenues – service fees of $0.1 million, a decrease in research and development expense of $0.2 million, a decrease in sales and marketing expense of $0.1 million, a decrease in general and administrative expense of $0.1 million and an increase in tax expense of $0.4 million. The impact of the restatement is an increase in net income of $0.5 million and $0.1 million, respectively, for the three and six months ended June 30, 2006 from amounts previously reported. The restatement increased reported basic and diluted earnings per share by $0.01 for the three months ended June 30, 2006 and increased reported diluted earnings per share by $0.01 for the six months ended June 30, 2006.

The effect of the adjustments on the balance sheet as of June 30, 2006 was an increase to taxes payable of $0.4 million, a decrease to additional-paid-in-capital of $0.5 million and an increase of $0.1 million to retained earnings.

The restatement did not impact reported operating, investing or financing cash flow activities for the three and six months ended June 30, 2006.

The following is a summary of the significant effects of the restatement on (i) the Company’s condensed consolidated balance sheet as of June 30, 2006; (ii) the Company’s condensed consolidated statements of income for the three and six months ended June 30, 2006; and (iii) the Company’s consolidated statement of cash flows for the six months ended June 30, 2006.

 

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MACROVISION CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEET

(in thousands)

 

     June 30, 2006     Adjustments     June 30, 2006  
     (as reported)           (as restated)  
ASSETS       

Current Assets

      

Cash and cash equivalents

   $ 120,441     $ —       $ 120,441  

Short-term investments

     126,024       —         126,024  

Accounts receivable, net

     41,910       —         41,910  

Deferred tax assets

     2,474       —         2,474  

Prepaid expenses and other current assets

     6,876       —         6,876  
                        

Total current assets

     297,725       —         297,725  

LT marketable investment securities

     26,966       —         26,966  

Restricted cash and investments

     12,000       —         12,000  

Property and equipment, net

     19,320       —         19,320  

Goodwill, net

     137,194       —         137,194  

Other intangibles from acquisitions, net

     31,553       —         31,553  

Deferred tax assets

     22,066       37       22,103  

Patents and other assets

     12,424       —         12,424  
                        
   $ 559,248     $ 37     $ 559,285  
                        
LIABILITIES AND STOCKHOLDERS’ EQUITY       

Current liabilities:

      

Accounts payable

   $ 3,933     $ —       $ 3,933  

Accrued expenses

     28,060       —         28,060  

Income taxes payable

     27,511       403       27,914  

Deferred revenue

     28,808       —         28,808  
                        

Total current liabilities

     88,312       403       88,715  

Other

     2,944       —         2,944  
                        
     91,256       403       91,659  

Stockholders’ equity:

      

Common stock

     55       —         55  

Treasury stock

     (38,450 )     —         (38,450 )

Additional paid-in capital

     354,081       (465 )     353,616  

Deferred stock-based compensation

     —         —         —    

Accumulated other comprehensive income

     5,054       —         5,054  

Retained earnings

     147,252       99       147,351  
                        

Total stockholders’ equity

     467,992       (366 )     467,626  
                        
   $ 559,248     $ 37     $ 559,285  
                        

 

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MACROVISION CORPORATION

CONDENSED CONSOLIDATED STATEMENT OF INCOME

(In thousands, except per share data)

 

    

Three months ended

June 30, 2006

   Adjustments    

Three months ended

June 30, 2006

     (as reported)          (as restated)

Net revenues

       

License revenue

   $ 43,326    $ —       $ 43,326

Services revenue

     15,023      —         15,023
                     

Total revenues

     58,349      —         58,349

Cost of revenues:

       

License fees

     2,568      —         2,568

Service fees

     8,379      (114 )     8,265

Amortization of intangibles from acquisitions

     3,490      —         3,490
                     

Total cost of revenues

     14,437      (114 )     14,323

Gross profit

     43,912      114       44,026

Operating expenses:

       

Research and development

     14,082      (467 )     13,615

Selling and marketing

     17,005      (579 )     16,426

General and administrative

     8,634      (159 )     8,475
                     

Total operating expenses

     39,721      (1,205 )     38,516
                     

Operating income

     4,191      1,319       5,510

Interest and other income, net

     2,106      —         2,106
                     

Income before income taxes

     6,297      1,319       7,616

Income taxes

     52      789       841
                     

Net income

   $ 6,245    $ 530     $ 6,775
                     

Basic net earnings per share

   $ 0.12    $ 0.01     $ 0.13

Shares used in computing basic net earnings per share

     52,262      52,262       52,262

Diluted net earnings per share

   $ 0.12    $ 0.01     $ 0.13

Shares used in computing diluted net earnings per share

     53,090      53,090       53,090

 

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MACROVISION CORPORATION

CONDENSED CONSOLIDATED STATEMENT OF INCOME

(In thousands, except per share data)

 

     Six months ended
June 30, 2006
   Adjustments     Six months ended
June 30, 2006
     (as reported)          (as restated)

Net revenues

       

License revenue

   $ 88,369    $ —       $ 88,369

Services revenue

     26,998      —         26,998
                     

Total revenues

     115,367      —         115,367

Cost of revenues:

       

License fees

     4,930      —         4,930

Service fees

     14,545      (58 )     14,487

Amortization of intangibles from acquisitions

     6,733      —         6,733
                     

Total cost of revenues

     26,208      (58 )     26,150

Gross profit

     89,159      58       89,217

Operating expenses:

       

Research and development

     26,524      (194 )     26,330

Selling and marketing

     33,471      (153 )     33,318

General and administrative

     17,353      (60 )     17,293
                     

Total operating expenses

     77,348      (407 )     76,941
                     

Operating income

     11,811      465       12,276

Interest and other income, net

     4,155      —         4,155
                     

Income before income taxes

     15,966      465       16,431

Income taxes

     6,818      366       7,184
                     

Net income

   $ 9,148    $ 99     $ 9,247
                     

Basic net earnings per share

   $ 0.18    $ —       $ 0.18

Shares used in computing basic net earnings per share

     51,985      51,985       51,985

Diluted net earnings per share

   $ 0.17    $ 0.01     $ 0.18

Shares used in computing diluted net earnings per share

     52,679      52,679       52,679

 

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MACROVISION CORPORATION

CONSOLIDATED STATEMENT OF CASH FLOW

(in thousands)

 

     Six months ended
June 30, 2006
    Adjustment     Six months ended
June 30, 2006
 
     (as reported)           (as restated)  

Cash flows from operating activities:

      

Net income

   9,148     99     9,247  

Adjustments to reconcile net income to net cash provided by operations:

      

Depreciation and amortization

   4,288     —       4,288  

Amortization of intangibles from acquisitions

   6,733     —       6,733  

Amortization of deferred stock-based compensation

   11,706     (465 )   11,241  

Deferred taxes from equity-based compensation

   (2,162 )   (37 )   (2,199 )

Tax benefit from stock options exercises

   2,673     —       2,673  

Excess tax benefits from equity-based compensation

   (479 )   —       (479 )

Changes in operating assets and liabilities, net of assets and liabilities acquired:

       —    

Accounts receivable, net

   5,943     —       5,943  

Deferred revenue

   4,265     —       4,265  

Other assets

   (5,612 )   —       (5,612 )

Other liabilities

   13,285     403     13,688  
                  

Net cash provided by operating activities

   49,788     —       49,788  
                  

Cash flows from investing activities:

      

Purchases of long and short term marketable investment securities

   (195,512 )   —       (195,512 )

Sales or maturities of long and short term marketable investments

   157,167     —       157,167  

Acquisition of eMeta, net of cash acquired

   (34,622 )   —       (34,622 )

Purchases of property and equipment

   (8,784 )   —       (8,784 )

Payments for patents

   (858 )   —       (858 )
                  

Net cash (used in) provided by investing activities

   (82,609 )   —       (82,609 )
                  

Cash flows from financing activities:

      

Excess tax benefits from equity-based compensation

   479     —       479  

Proceeds from issuance of common stock from options and stock purchase plans

   16,565     —       16,565  
                  

Net cash provided by (used in) financing activities

   17,044     —       17,044  
                  

Effect of exchange rate changes on cash

   593       593  

Net (decrease) increase in cash and cash equivalents

   (15,184 )   —       (15,184 )

Cash and cash equivalents at beginning of year

   135,625     —       135,625  
                  

Cash and cash equivalents at end of year

   120,441     —       120,441  
                  

 

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NOTE 3 – EQUITY-BASED COMPENSATION (As Restated)

Stock Options

Currently, the Company grants options from the 2000 Equity Incentive Plan (“2000 Plan”) and the 1996 Directors Stock Option Plan (the “Directors Plan”). The 2000 Equity Incentive Plan succeeded the 1996 Equity Incentive Plan (“1996 Plan”) in August 2000.

As of June 30, 2006, the Company had 18.3 million shares reserved and 5.6 million shares remained available for issuance under the 2000 Plan and 1996 Plan. The 2000 Plan provides for the grant of stock options, stock appreciation rights, and restricted stock awards by the Company to employees, officers, directors, consultants, independent contractors, and advisers of the Company. The 2000 Plan permits the grant of either incentive or nonqualified stock options at the then current market price. Option vesting periods are generally three years under the 2000 Plan where one-sixth vests in the first year, one-third vests in the second year and one-half vests in the third year. Option grants have contractual terms ranging from five to ten years. During the second quarter of 2006, the Company’s stockholders approved the amendment of the 2000 Plan to increase the number of shares reserved for issuance by 5.0 million shares.

As of June 30, 2006, the Company had 1.0 million shares reserved under the Directors Plan and 297,500 shares remained available for issuance. The Directors Plan provides for the grant of stock options to non-employee directors of the Company. The Directors Plan permits the grant of nonqualified stock options at the then current market price. Option vesting periods are generally one year under the Directors Plan. Option grants have terms ranging from five to ten years.

The Company recorded $4.2 million and $8.5 million of compensation expense relative to stock options in the three and six months ended June 30, 2006, respectively.

Restricted Stock

In November 2005, the Company’s board of directors approved the issuance of 340,975 shares of restricted stock, at an intrinsic value of $15.61 per share, to certain executives and key employees under the 2000 Plan. The restricted stock vests over four years and was considered outstanding at the time of grant.

As of June 30, 2006, 283,100 unvested restricted shares are outstanding. During the six months ended June 30, 2006, there were no new awards of restricted stock and 57,875 shares were forfeited. There were no shares of restricted stock that vested during the six months ended June 30, 2006.

Prior to the adoption of SFAS 123(R), the Company recognized the estimated compensation cost of restricted stock over the vesting term. The estimated compensation cost was based on the fair value of the Company’s common stock on the date of grant. The Company will continue to recognize the compensation cost, net of expected forfeitures over the vesting term. The Company evaluated the need to record a cumulative effect adjustment for estimated forfeitures upon the adoption of SFAS 123(R) and determined the amount to be immaterial.

The Company recorded $0.3 million and $0.9 million of compensation expense relative to restricted stock in the three and six months ended June 30, 2006, respectively.

Employee Stock Purchase Plan

The Company’s 1996 Employee Stock Purchase Plan (the “ESPP”) allows eligible employee participants to purchase shares of the Company’s common stock at a discount through payroll deductions.

 

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The ESPP consists of twenty-four-month offering periods with four six-month purchase periods in each offering period. Employees purchase shares in each purchase period at 85% of the market value of the Company’s common stock at either the beginning of the offering period or the end of the purchase period, whichever price is lower.

As of June 30, 2006, the Company had reserved 4.3 million shares of common stock for issuance under the ESPP and 2.8 million shares remained available for future issuance.

The Company recorded $0.9 million and $1.8 million of compensation expense relative to the ESPP in the three and six months ended June 30, 2006, respectively.

 

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Equity-Based Payments

Effective January 1, 2006, the Company adopted the provisions of, and accounts for equity-based compensation in accordance with, Statement of Financial Accounting Standards No. 123—revised 2004 (“SFAS 123(R)”), “Share-Based Payment” which replaced Statement of Financial Accounting Standards No. 123 (“SFAS 123”), “Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees.” In accordance with SFAS 123(R), equity-based compensation cost is measured at the grant date based on the fair value of the award. The Company elected the modified-prospective method. Under this transition method, equity-based compensation includes the amortized value of vesting equity-based payments granted prior to January 1, 2006 based on the grant date fair value as determined under SFAS 123 and those granted subsequently in accordance with SFAS 123(R). Results for prior periods have not been restated.

As a result of adopting SFAS 123(R), the Company’s income before taxes, net income and basic and diluted earnings per share for the three and six months ended June 30, 2006 were reduced by the amounts shown below (amounts in thousands except share data):

 

     Three Months Ended
June 30, 2006
(As Restated)
    Six Months Ended
June 30, 2006
(As Restated)
 

Total equity-based compensation, before tax

   $ 5,065     $ 10,311  

Tax effect

     (950 )     (1,933 )
                

Total equity-based compensation, net of taxes

   $ 4,115     $ 8,378  
                

Basic earnings per share

   $ 0.08     $ 0.16  
                

Diluted earnings per share

   $ 0.08     $ 0.16  
                

The adoption of SFAS 123(R) did not have a significant impact on the Company’s cash flows during the six months ended June 30, 2006.

  

The following table sets forth the pro forma amounts of net income and net income per share, for the three and six months ended June 30, 2005, that would have resulted if the Company had accounted for its employee stock plans under the fair value recognition provisions of SFAS 123 (amounts in thousands except share data):

   

     Three Months Ended
June 30, 2005
    Six Months Ended
June 30, 2005
 

Net income, as reported

   $ 6,070     $ 11,536  

Less: total equity-based employee compensation expenses determined under fair-value-based method for all rewards, net of tax

     (3,644 )     (6,496 )
                

Net income, pro forma

   $ 2,426     $ 5,040  
                

Basic net earnings per share

    

As reported

   $ 0.12     $ 0.23  

Adjusted pro forma

   $ 0.05     $ 0.10  

Diluted net earnings per share

    

As reported

   $ 0.12     $ 0.22  

Adjusted pro forma

   $ 0.05     $ 0.10  

 

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Valuation and Assumptions

The Company uses the Black-Scholes option pricing model to determine the fair value of stock options and employee stock purchase plan shares. The fair value of equity-based payment awards on the date of grant is determined by an option-pricing model using a number of complex and subjective variables. These variables include expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rate and expected dividends.

Estimated volatility of the Company’s common stock for new grants is determined by using a combination of historical volatility and implied volatility in market traded options. For grants prior to January 1, 2006, the estimated volatility was based only on historical volatility. The expected term was determined by analyzing past option experience. The risk-free interest rate used in the option valuation model is from U.S. Treasury zero-coupon issues with remaining terms similar to the expected term on the options. The Company does not anticipate paying any cash dividends in the foreseeable future and therefore uses an expected dividend yield of zero in the option valuation model. In accordance with SFAS123(R), the Company estimates forfeitures at the time of grant and revises those estimates in subsequent periods if actual forfeitures differ from those estimates. The Company uses historical data to estimate pre-vesting option forfeitures and record equity-based compensation expense only for those awards that are expected to vest. All equity-based payment awards granted after January 1, 2006 are amortized on a straight-line basis, net of expected forfeitures, over the vesting periods. In prior year periods, the Company applied accelerated amortization of equity-based compensation and will continue to do so for the remaining terms of these prior option grants.

The assumptions used to value equity-based payments are as follows:

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2006     2005     2006     2005  

Option Plans:

        

Dividends

   None     None     None     None  

Expected term

   3.5 years     2.4 years     3.3 years     2.4 years  

Risk free interest rate

   5.0 %   3.6 %   4.7 %   3.6 %

Volatility rate

   40.0 %   58.8 %   40.6 %   59.3 %

ESPP Plan:

        

Dividends

   None     None     None     None  

Expected term

   1.3 years     1.4 years     1.3 years     1.4 years  

Risk free interest rate

   4.6 %   3.1 %   4.6 %   3.1 %

Volatility rate

   41.0 %   61.3 %   41.0 %   61.3 %

Prior to the adoption of SFAS 123(R), tax benefits resulting from the exercise of stock options and disqualifying dispositions were presented as operating cash flows on our condensed consolidated statement of cash flows. SFAS 123(R) requires the benefits of tax deductions in excess of recognized compensation expense to be reported as a financing cash flow, rather than as an operating cash flow. This requirement reduces net operating cash flows and increases net financing cash flows. However, total cash flow remains unchanged from what would have been reported under prior accounting rules. During the six months ended June 30, 2006, $13.7 million was paid to the Company for options exercised, which will generate a potential tax deduction for the Company of $2.2 million.

 

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As of June 30, 2006, there was $25.6 million of unrecognized compensation cost, adjusted for estimated forfeitures, related to non-vested equity-based payments granted to employees. Total unrecognized compensation cost will be adjusted for future changes in estimated forfeitures and is expected to be recognized over a weighted average period of 1.2 years.

Activity under the Company’s stock option plans are as follows:

 

     Shares     Weighted-average
exercise price
   Weighted-average
remaining
contractual term
(years)
   Aggregate
Intrinsic
Value

Outstanding at December 31, 2005

   9,634,499     $ 20.89      

Granted

   1,368,351     $ 20.35      

Canceled

   (1,167,975 )   $ 23.99      

Exercised

   (867,410 )   $ 15.75      
              

Outstanding at June 30, 2006

   8,967,465     $ 20.92    3.9    $ 25,725
              

Exercisable and expected to become exercisable at June 30, 2006

   8,020,728     $ 21.18    3.9    $ 22,461
              

Exercisable at June 30, 2006

   3,700,358     $ 22.92    3.7    $ 10,916
              

The weighted average grant date fair value of options granted during the three months ended June 30, 2006 and 2005 was $7.81 and $8.43, respectively. The weighted average grant date fair value of options granted during the six months ended June 30, 2006 and 2005 was $7.01 and $8.51, respectively. The weighted average grant date fair value of an employee purchase share right options granted during the three and six months ended June 30, 2006 and 2005 was $7.60 and $10.87, respectively. The total intrinsic value of options exercised during the three months ended June 30, 2006 and 2005 was $3.1 million and $1.3 million, respectively. The total intrinsic value of options exercised during the six months ended June 30, 2006 and 2005 was $5.2 million and $2.2 million, respectively.

NOTE 4 – BUSINESS COMBINATION AND ASSET PURCHASES

eMeta Corporation

In February 2006, the Company acquired eMeta Corporation (“eMeta”), a privately held company based in New York, for $36.0 million of purchase consideration. eMeta provides software solutions that enable companies to manage and sell digital goods and services online. The acquisition of eMeta extends the Company’s reach from physical distribution into online digital distribution. eMeta results have been included in the Company’s Software Technologies segment. The condensed consolidated financial statements include the results of operations of eMeta since February 28, 2006, the effective date of the acquisition.

 

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The following is a summary of the estimated fair values of the tangible assets acquired and liabilities assumed at the date of the acquisition (in thousands):

 

    

As of

February 28,
2006

 

Cash and cash equivalents

   $ 5  

Accounts receivable

     2,357  

Other assets

     247  
        

Total tangible assets acquired

     2,609  
        

Accounts payable

     (87 )

Deferred revenue

     (1,247 )

Accrued liabilities

     (281 )
        

Total liabilities assumed

     (1,615 )
        

Net assets acquired

   $ 994  
        

The following is a summary of goodwill and identifiable intangible assets acquired in the acquisition of eMeta (in thousands):

 

    

As of

February 28, 2006

 

Cash paid

   $ 34,599  

Payable to shareholders

     1,438  

Net assets acquired

     (994 )
        

Total goodwill and intangible assets acquired

   $ 35,043  
        

 

Intangible Assets

        Amortization Period
in Years

Existing technology

   $ 4,300    3 – 4

Core technology

     500    3      

Customer Relationships

     560    3 – 4

Trade Name/Trademarks

     100    1      

Goodwill

     29,583    Not Applicable
         

Total

   $ 35,043   
         

As of June 30, 2006, the amount allocated to goodwill may be further adjusted during the year. The weighted average amortization period for amortizable eMeta intangible assets is 3.2 years.

 

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The amortization schedule for eMeta intangibles is as follows (in thousands):

 

Year ending:

   $

Remainder of 2006

   $ 895

2007

     1,707

2008

     1,690

2009

     523

2010

     48

2011 and thereafter

     —  
      

Total

   $ 4,863
      

Trymedia Systems, Inc.

In July 2005, the Company acquired Trymedia Systems, Inc. (“Trymedia”), a privately-held company based in San Francisco, California and in Spain, for $31.8 million of purchase consideration. Trymedia provided secure digital distribution services and was the operator of the largest distribution network for downloadable games. This acquisition expanded the Company’s games solution set by providing an online game distribution and promotion offering. Trymedia has been included in the Company’s Entertainment Technologies segment. The condensed consolidated financial statements include the results of operations of Trymedia since July 29, 2005, the effective date of the acquisition. As of March 31, 2006, the Company paid $31.5 million in cash and expects to pay an additional $0.4 million to Trymedia shareholders as they surrender the balance of their stock.

The following is a summary of the estimated fair values of the tangible assets acquired and liabilities assumed at the date of the acquisition (in thousands):

 

    

As of

July 29, 2005

 

Cash and cash equivalents

   $ 927  

Accounts receivable

     204  

Other assets

     779  
        

Total tangible assets acquired

     1,910  
        

Accounts payable

     (3,795 )

Deferred revenue

     (96 )

Accrued liabilities

     (2,225 )

Deferred tax liabilities, net

     (1,140 )

Notes payable

     (257 )
        

Total liabilities assumed

     (7,513 )
        

Net liabilities assumed

   $ (5,603 )
        

 

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Table of Contents

The following is a summary of goodwill and identifiable intangible assets acquired in the acquisition of Trymedia (in thousands):

 

Cash paid

   $ 31,481

Payable to shareholders

     365

Net liabilities assumed

     5,603
      

Total goodwill and intangible assets acquired

   $ 37,449
      

 

Intangible Assets

        Amortization Period
in Years

Existing technology

   $ 3,500    4

In-process technology

     500    —  

Core technology

     1,500    4

Trade Name/Trademarks

     600    5

Customer Relationships

     3,700    4

Goodwill

     27,649    Not Applicable
         

Total

   $ 37,449   
         

The weighted average amortization period for amortizable Trymedia intangible assets is 4.1 years. The in-process technology of $500,000 was charged to operations during the third quarter of 2005.

Zero G Software, Inc.

In June 2005, the Company acquired Zero G Software, Inc. (“Zero G”), a privately-held company based in San Francisco, California, for $10.6 million of purchase consideration, all of which has been paid in cash. Zero G provided software deployment and delivery solutions for multi-platform operating system environments. The acquisition increased the Company’s market for software value management solutions, added innovative technology and enhanced multi-platform products. Zero G has been included in the Company’s Software Technologies segment. The condensed consolidated financial statements include the results of operations of Zero G since June 9, 2005, the effective date of the acquisition.

 

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The following is a summary of the estimated fair values of the tangible assets acquired and liabilities assumed at the date of the acquisition (in thousands):

 

    

As of

June 9, 2005

 

Cash and cash equivalents

   $ 351  

Accounts receivable

     491  

Deferred tax assets

     3,175  

Other assets

     80  
        

Total tangible assets acquired

     4,097  
        

Accounts payable

     (721 )

Deferred revenue

     (590 )

Accrued liabilities

     (1,874 )

Notes payable

     (696 )
        

Total liabilities assumed

     (3,881 )
        

Net tangible assets acquired

   $ 216  
        

During the second quarter of 2006, the Company adjusted acquired deferred tax assets as of June 9, 2005 based on additional information from the final tax return as filed. This adjustment increased deferred tax assets by $1.2 million and decreased goodwill by $1.2 million.

The following is a summary of goodwill and identifiable intangible assets acquired in the acquisition of Zero G (in thousands):

 

Cash paid

   $  10,589  

Net tangible assets acquired

     (216 )
        

Total goodwill and intangible assets acquired

   $ 10,373  
        

 

Intangible Assets

   $    Amortization Period
in Years

Existing technology

   $ 2,000    4 – 5

Core technology

     600    5      

Trade Name/Trademarks

     200    5      

Customer Relationships

     700    5      

Goodwill

     6,873    Not Applicable
         

Total

   $ 10,373   
         

The weighted average amortization period for amortizable Zero G intangible assets is 4.7 years.

 

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Table of Contents

NOTE 5 – STRATEGIC INVESTMENTS

As of June 30, 2006 and December 31, 2005, the carrying value of the Company’s strategic investments totaled $12.4 million and $11.9 million, respectively. The Company’s strategic investments include public and non-public companies. Investments in public and non-public companies are classified on the condensed consolidated balance sheets as “Long-term marketable investment securities” and “Other assets,” respectively.

As of June 30, 2006, the carrying value of the Company’s strategic investments consisted solely of its investment in Digimarc, a publicly traded company. Additionally, the Company holds investments in a number of other privately held companies, which have no carrying value as of June 30, 2006.

For investments in public companies, at each quarter end, the Company compares its 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, a charge is recorded to the statement of income for the difference between the market price at period end and the current cost basis. During the quarter ended March 31, 2005, the Company recorded an other-than temporary impairment loss of $5.8 million on its investment in Digimarc. During the three and six months ended June 30, 2006 and the three months ended June 30, 2005, there were no other-than temporary impairment losses on strategic investments in public companies.

NOTE 6 – RESTRUCTURING

The Company has accounted for its restructuring charges and accruals in accordance with SFAS No. 146 Accounting for Costs Associated with Exit or Disposal Activities.

In October 2005, the Company’s board of directors approved a restructuring program, which included a worldwide workforce reduction and restructuring of certain business functions. The workforce reduction was announced on November 2, 2005 and resulted in the termination of 80 employees. All affected employees were informed of their termination prior to December 31, 2005. The Company recorded a charge of $2.5 million during the fourth quarter of 2005. The liability for restructuring costs is recorded in accrued expenses in the accompanying condensed consolidated balance sheet.

The following table summarizes the activity related to restructuring costs:

 

     Severance     Termination
Benefits
    Total  

Balance at December 31, 2005

   $ 1,166     $ 95     $ 1,261  

Cash payments

     (905 )     (95 )     (1,000 )
                        

Balance at June 30, 2006

   $ 261     $ —       $ 261  
                        

 

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NOTE 7 – EARNINGS PER SHARE

Basic net earnings per share (“EPS”) is computed using the weighted average number of common shares outstanding during the period. Diluted net EPS is computed using the weighted average number of common and dilutive potential common shares outstanding during the period except for periods of operating loss for which no potential common shares are included because their effect would be anti-dilutive. Dilutive potential common shares consist of common stock issuable upon exercise of stock options using the treasury stock method. The following is a reconciliation of the shares used in the computation of basic and diluted net EPS (in thousands, except per share data):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2006     2005     2006    2005  

Basic net EPS - weighted average number of common shares outstanding

     52,262       50,502       51,985      50,426  

Effect of dilutive potential common shares - stock options outstanding

     828       761       694      872  
                               

Diluted net EPS - weighted average number of common shares and potential common shares outstanding

     53,090       51,263       52,679      51,298  
                               

Anti-dilutive shares excluded

     5,676       4,800       6,353      3,553  
                               

Weighted average exercise price of anti-dilutive shares

   $ 24.77     $ 27.22     $ 24.25    $ 29.25  
                               
NOTE 8 – COMPREHENSIVE INCOME (As Restated)  

The components of comprehensive income, net of taxes, are as follows (in thousands):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
    

2006

(As Restated)

    2005    

2006

(As Restated)

   2005  

Net income

   $ 6,775     $ 6,070     $ 9,247    $ 11,537  

Other comprehensive income:

         

Unrealized gains (losses) on investments

     (1,589 )     (772 )     347      (1,202 )

Foreign currency translation adjustments

     1,875       (2,502 )     2,076      (3,544 )
                               

Comprehensive income

   $ 7,061     $ 2,796     $ 11,670    $ 6,791  
                               

NOTE 9 – RECENT ACCOUNTING PRONOUNCEMENT

In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 addresses the recognition and measurement of uncertain income tax positions taken or expected to be taken in a tax return using a “more-likely-than-not” threshold and introduces a number of new disclosure requirements. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is currently assessing the impact of the adoption of FIN 48.

 

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NOTE 10 – INCOME TAXES (As Restated)

The Company recorded income tax expense of $0.8 million and $7.2 million for the three and six months ended June 30, 2006. The Company calculates income tax expense based upon an annual effective tax rate forecast, including estimates and assumptions that could change during the year. The Company adjusted the annual effective rate forecast as of June 30, 2006 to reflect revised estimates of the geographic sources of revenue and operating profits expected to be earned for 2006. The income tax expense of $0.8 million recorded for the three months ended June 30, 2006 is the amount required to adjust total income tax expense for the six months June 30, 2006 to the revised effective tax rate for the year. The Company recorded $3.6 million during the first quarter of 2006 as a discrete item related to income tax accrued on an intercompany transfer of assets adjusted to reflect a change in estimates.

In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible, as well as tax planning strategies.

Based on projections of future taxable income over the periods in which the deferred tax assets are deductible and the history of the Company’s profitability, management believes that it is more likely than not that the Company will realize the benefits of these deductible differences, net of valuation allowances as of June 30, 2006. There were no adjustments to the valuation allowance balance in the three and six months ended June 30, 2006.

NOTE 11 – SEGMENT AND GEOGRAPHIC INFORMATION (As Restated)

The Company has two reportable segments: Entertainment Technologies and Software Technologies. Entertainment Technologies licenses digital content value management technology to video, music, and PC games content owners. The Entertainment Technologies products include content protection and rights management solutions for optical discs; videocassettes; digital set top boxes for cable/satellite TV; a variety of PC and consumer electronics video playback and record devices; digital distribution services for games; and peer-to-peer networks. The Video product group includes content protection and rights management solutions for optical discs, videocassettes and digital set top boxes. The Other product group of Entertainment Technologies includes content protection and rights management solutions for PC and consumer electronics video playback and record devices, digital distribution services for games and peer to peer networks. The Software Technologies products include the FLEXnet licensing platform, the InstallShield suite of software installation, repackaging, and update solutions, the Zero G software installation solutions and the eMeta software solutions enabling companies to manage and sell digital goods online.

 

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Revenue by Significant Product Group:

 

     Three Months Ended
June 30,
   Six Months Ended
June 30,
     2006    2005    2006    2005

Entertainment Technologies

           

Video

   $ 21,527    $ 20,215    $ 48,480    $ 43,327

Other

     3,252      1,927      7,218      3,621
                           

Total Entertainment Technologies

   $ 24,779    $ 22,142    $ 55,698    $ 46,948

Software Technologies

     33,570      22,272      59,669      48,723
                           

Total

   $ 58,349    $ 44,414    $ 115,367    $ 95,671
                           

Segment income:

Segment income is based on the reportable segment’s revenue less the respective segment’s cost of revenues, selling and marketing expenses and research and development expenses. The following table summarizes operating results for each reportable segment and further reconciled to pretax income (in thousands):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
    

2006

(As Restated)

    2005    

2006

(As Restated)

    2005  

Entertainment Technologies

   $ 7,256     $ 11,462     $ 19,592     $ 25,038  

Software Technologies

     6,729       4,535       9,977       12,804  
                                

Segment income

     13,985       15,997       29,569       37,842  

General and administrative

     (8,475 )     (7,461 )     (17,293 )     (15,888 )

Impairment losses on investments

     —         —         —         (5,822 )

Gains on strategic investments

     —         —         —         96  

Interest and other income, net

     2,106       974       4,155       1,911  
                                

Income before income taxes

   $ 7,616     $ 9,510     $ 16,431     $ 18,139  
                                
Information on Revenue by Geographic Areas:         
     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2006     2005     2006     2005  

United States

   $ 36,041     $ 24,234     $ 65,139     $ 53,739  

International

     22,308       20,180       50,228       41,932  
                                
   $ 58,349     $ 44,414     $ 115,367     $ 95,671  
                                

Geographic area information is based upon country of destination for products shipped and country of contract holder for royalties and license fees.

 

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NOTE 12 – COMMITMENTS AND CONTINGENCIES

Lease Commitments

The Company leases its facilities under noncancelable operating lease arrangements that expire at various dates through 2018.

In December 2004, the Company signed agreements that extended the lease for its corporate headquarters for an additional five years and committed to additional office space in an adjacent building. The term for the additional office space commenced February 2005. Both leases are operating leases and will expire in January 2017. The Company records rent expense on a straight-line basis based on contractual lease payments from January 2005 through January 2017. The Company occupied the new office space in April 2005.

The Company’s aggregate future minimum lease payments pursuant to these leases, pursuant to non-cancellable operating lease agreements as of June 30, 2006 were as follows (in thousands):

 

     Operating
Leases

Remainder of 2006

   $ 3,317

2007

     7,444

2008

     7,346

2009

     6,091

2010

     6,016

2011 and thereafter

     36,951
      

Total

   $ 67,165
      

Indemnifications

In the normal course of business, the Company provides indemnifications of varying scope to customers against claims of intellectual property infringement made by third parties arising from the use of the Company’s products. Historically, costs related to these indemnification provisions have not been significant and the Company is not able to estimate the maximum potential impact of these indemnification provisions on our future results of operations.

Restricted Cash and Investments

For one of our products, the Company has offered a maximum indemnity of $12.0 million to a collective group of customers under current contracts. Funds totaling $12.0 million have been segregated from the rest of the Company’s cash and investments and is restricted to use for customer claims under such indemnification provisions. (See Note 1.)

Legal Proceedings

The Company is involved in legal proceedings related to some of its intellectual property rights.

 

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USPTO Interference Proceedings Between Macrovision Corporation and Intertrust Technologies

A patent interference is declared by the United States Patent and Trademark Office (“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.

The Company received notice on September 4, 2003 that the USPTO had declared an interference between the Company’s U.S. Patent No. 5,845,281 (“the ‘281 patent”) together with two of its continuation applications, and a patent application from Intertrust Technologies Corporation (“Intertrust”). On or about December 28, 2005, the Board of Patent Appeals (“BPA”) issued its final ruling in the case, holding that the ‘281 patent had priority over the two Intertrust patent applications at issue, but also that the inventor of the ‘281 patent had committed inequitable conduct during the prosecution of that patent. As a result of this decision, the Company’s ‘281 patent was rendered unenforceable.

On December 19, 2003, the Company received notice from the USPTO declaring another interference, this time between two of the Company’s patent applications and four of Intertrust’s patents. On or about April 11, 2005, the BPA issued its final ruling, holding that the Intertrust patents had priority over the Company’s two applications at issue.

Intertrust and the Company filed lawsuits on July 28, 2006 and July 31, 2006, respectively, in the U.S. District Court for the Northern District of California against the other party, seeking to overturn the BPA’s rulings adverse to the parties in the two interference proceedings.

The Company has 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, not the international cases which have been granted or are proceeding to grant in Europe and Japan.

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. The Company 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 related 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 did not appear to implicate any current core InstallShield products. Further, Red Bend Software agreed to indemnify InstallShield and defend the suit for Macrovision. On or about June 6, 2006, the Company was advised that the court granted a motion to dismiss the lawsuit with prejudice against all defendants, including InstallShield.

Macrovision Corporation. vs. Sima Products Corporation, and Interburn Enterprises, Inc.

On June 14, 2005, the Company filed a lawsuit in the Southern District of New York against Sima Products Corporation and Interburn Enterprises, Inc., alleging that both companies manufacture, distribute or sell products that infringe the Company’s patented copy protection technology and also violate the U.S. Digital Millennium Copyright Act of 1998. The patents involved are: United States Patent No. 4,631,603 entitled “Method and apparatus for processing a video signal so as to prohibit the making of acceptable videotape recordings thereof,” and U.S. Patent No. 4,819,098 entitled “Method and apparatus for clustering modifications made to a video signal to inhibit the making of acceptable videotape recordings.” Interburn has entered into a stipulated judgment where they agreed not to further distribute their products. On April

 

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20, 2006, the Company was granted a preliminary injunction preventing Sima from distributing the products at issue in the lawsuit. On or about June 12, 2006, Sima filed an emergency motion with the United States Second Circuit Court of Appeals, asking that the injunction be stayed pending an appeal of the District Court’s issuance of the injunction. The injunction has been temporarily stayed while the Court of Appeals considers Sima’s motion. The Company is opposing Sima’s efforts to get the injunction overturned, and intends to continue to vigorously pursue this action to protect its patented copy protection technology.

InstallShield Software Corporation Liquidating Trust vs. Macrovision

On October 27, 2005, the Company received notice of an arbitration proceeding filed by InstallShield Software Corporation Liquidating Trust (the “Trust.”) The Trust is demanding arbitration of certain disputes between the Trust and the Company pursuant to Asset Purchase Agreement dated June 16, 2004 by and among InstallShield Software Corporation, the Company, Macrovision Europe Limited, and Macrovision International Holding L.P. (the “Agreement”). Under the Agreement, the Company may have been required to make an additional contingent payment of up to $20 million based on post-acquisition revenue performance through June 30, 2005. Based upon the revenue results through June 30, 2005, the Company concluded that no additional payment was required under the terms of the Agreement. The Trust alleges that the post-acquisition revenue performance targets were not reached due to the Company’s conduct in violation of the Agreement, and therefore is seeking the contingent payment in an amount exceeding $15 million. The Company denies these allegations and intends to vigorously defend itself in the arbitration proceeding.

Stock Option Inquiries

In addition to the aforementioned litigation matters, on June 13, 2006 and June 28, 2006, the Company announced that it had been contacted by the Securities and Exchange Commission (SEC) and had received a subpoena from the U.S. Attorney’s Office, respectively, each requesting information relating to the Company’s stock option practices. The Company has announced its intent to cooperate with the SEC and U.S. Attorney’s Office. The Company believes that this review of stock option practices has no material impact on the financial statements included in this report on Form 10-Q or on any previously issued financial statements.

As of June 30, 2006, for all the abovementioned 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, the Company has been involved in other disputes and legal actions arising in the ordinary course of business. In management’s opinion, none of these other disputes and legal actions is expected to have a material impact on the Company’s consolidated financial position, results of operation or cash flow.

 

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

The following commentary should be read in conjunction with the financial statements and related notes contained in our Annual Report on Form 10-K for the year ended December 31, 2005 as filed with the SEC. This 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, the failure of markets for home video, audio CDs, consumer or enterprise software valur management, or markets for the technological protection of copyrighted materials contained in such products, to continue, develop or expand, the failure of the changing demands of content or software providers and the impact of certain government reviews of our stock option practices and those additional factors set forth under Item 1A “Risk Factors” in this Quarterly Report for the period ended June 30, 2006 pursuant to the Securities Exchange Act of 1934, as amended (the “Exchange Act”). We specifically disclaim any obligation to update such forward-looking statements.

Overview

Macrovision Corporation, a Delaware corporation founded in 1983, enables businesses reliant on the deployment of software or content to secure, adapt and optimize their offering among digital distribution channels and destination devices. These digital lifecycle management solutions include anti-piracy and content protection technologies and services, digital rights management, embedded licensing technologies, usage monitoring for enterprises, access control and billing, and a host of related technologies and services from installation to update to back-office entitlement management. We market the FLEXnet licensing platform and the InstallShield suite of software installation, repackaging, and update solutions. We also operate Trymedia Systems, a distribution network for downloadable PC games. We acquired eMeta in February 2006, which provides software solutions for managing and selling digital goods and services online. Our customers consist of entertainment producers such as motion picture studios and music labels, software publishers, hardware manufacturers, consumer electronic firms, personal computer manufacturers, digital set-top box manufacturers, digital pay-per-view and video-on-demand network operators, publication companies and enterprise information technology organizations.

We report our revenues by our two segments: Entertainment Technologies and Software Technologies. Entertainment Technologies’ revenues derive from licensing various digital content management products and services to video, music, and PC games content owners. The Entertainment Technologies products include content protection and rights management solutions for optical discs; videocassettes; digital set top boxes for cable/satellite TV; a variety of PC and consumer electronics video playback and record devices; digital distribution services for games; and peer-to-peer networks. Software Technologies’ revenues are derived from licensing various software products and services to independent software vendors and enterprise IT departments. The Software Technologies products include the FLEXnet suite of electronic license management, electronic license delivery, and software asset management products, InstallShield Installer, Update Service, Admin Studio, InstallAnywhere and SolutionsArchitect products. We included the eMeta commerce, licensing and access control solutions in our Software Technologies segment.

 

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The following table provides revenue information by segment for the periods indicated (dollars in thousands):

 

     Three Months Ended
June 30,
           
     2006    2005    $ Change    % Change  

Entertainment Technologies

   $ 24,779    $ 22,142    $ 2,637    12 %

Software Technologies

     33,570      22,272      11,298    51 %
                       
   $ 58,349    $ 44,414    $ 13,935    31 %
                       
     Six Months Ended
June 30,
           
     2006    2005    $ Change    % Change  

Entertainment Technologies

   $ 55,698    $ 46,948    $ 8,750    19 %

Software Technologies

     59,669      48,723      10,946    22 %
                       
   $ 115,367    $ 95,671    $ 19,696    21 %
                       

The following table provides percentage of revenue information by segment for the periods indicated:

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2006     2005     2006     2005  

Entertainment Technologies

   42 %   50 %   48 %   49 %

Software Technologies

   58     50     52     51  
                        
   100 %   100 %   100 %   100 %
                        

Entertainment Technologies

Revenues from our Entertainment Technologies increased $2.6 million, or 12% from the second quarter of 2005 to the second quarter of 2006 primarily due to (i) $1.2 million from the growth in hardware licensing and (ii) $1.5 million increase in revenue as a result of the acquisition of Trymedia. Revenues from our Entertainment Technologies increased $8.8 million, or 19% from the six months ended June 30, 2005 to the six months ended June 30, 2006 primarily due to (i) $7.6 million increase from the growth in hardware licensing, including a significant set top box licensing transaction completed during the first quarter of 2006 resulting in $4.9 million of royalty fees for boxes manufactured in years earlier than 2006, and (ii) $3.0 million increase in revenue as a result of the acquisition of Trymedia, (iii) partially offset by the decrease in DVD revenue of $2.3 million caused by the decline in DVD volume and continued pricing pressures in our DVD copy protection business as the full impact of lower pricing in our contracts with MPAA studios take effect. Revenues from our video content protection technologies represented 37% and 46% and of our net revenues during the quarters ended June 30, 2006 and 2005, respectively and 42% and 45% of our net revenues for the six months ended June 30, 2006 and 2005.

We actively engage in intellectual property compliance and enforcement activities focused on identifying third parties that 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

 

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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 as we sign new contracts and generate more business for our products: Total Play; Hawkeye, RipGuard DVD™, and ActiveMARK, future revenues from our Entertainment Technologies will increase in absolute terms and continue to be a significant part of our revenues, but may vary as a percentage of our total revenues.

Software Technologies

Revenues from our Software Technologies increased $11.3 million, or 51% from the second quarter of 2005 to the second quarter of 2006 primarily due to (i) $8.3 million increase in existing software products primarily due to increased market penetration and a growing customer base and (ii) $3.0 million increase in revenue as a result of the acquisition of eMeta in February 2006. Revenues from our Software Technologies increased $11.0 million, or 22% from the six months ended June 30, 2005 to the six months ended June 30, 2006 primarily due to (i) $6.7 million increase in existing software products primarily due to increased market penetration and an increased customer base and (ii) $4.3 million increase in revenue as a result of ZeroG and eMeta acquisitions.

We believe that as we sign new contracts and generate more business for our existing and new products, revenues from our Software Technologies will increase in the future in absolute terms, but may vary as a percentage of our total revenues.

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. 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 for our Entertainment Technologies consists primarily of replicator fees, Hawkeye service costs, ActiveMARK service costs and patent related litigation expense. 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. Hawkeye and ActiveMARK service costs include customer support, hosting, bandwidth and equipment maintenance costs. Our cost of revenues for our Software Technologies 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 third party consultants for support and professional services. Cost of revenues also includes patent defense costs, amortization of intangibles from acquisitions and patent amortization. Our research and development expenses are comprised primarily of employee compensation and benefits, tooling and supplies and an allocation of

 

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overhead and facilities costs. Our selling and marketing expenses are comprised primarily of employee compensation and benefits, travel, advertising and an allocation of overhead and facilities costs. Our general and administrative expenses are comprised primarily of employee compensation and benefits, travel, advertising 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 condensed consolidated financial statements. These condensed consolidated financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission. 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 we believe 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.

Revenue Recognition

We recognize revenue in accordance with current U.S. generally accepted accounting principles that have been prescribed for the software industry under Statement of Position (“SOP”) 97-2, Software Revenue Recognition and with the guidelines of the SEC Staff Accounting Bulletin, or SAB, No. 101 as amended by SAB No. 104 “Revenue recognition in Financial Statements” for our hardware business. Revenue recognition requirements in the software industry are very complex and are subject to change. Our revenue recognition policy is one of our critical accounting policies because revenue is a key component of our results of operations and is based on complex rules which require us to make judgments and estimates. We generally recognize revenue when persuasive evidence of an arrangement exists, we have delivered the product or performed the service, the fee is fixed or determinable and collectibility is probable. However, determining whether and when some of these criteria have been satisfied often involves assumptions and judgments that can have a significant impact on the timing and amount of revenue we report. For example, for multiple element arrangements we must make assumptions and judgments in order to allocate the total price among the various elements we must deliver, to determine whether undelivered services are essential to the functionality of the delivered products and services, to determine whether vendor-specific evidence of fair value exists for each undelivered element. Also, we provide for returns on product sales in our channel business based on three month historical revenue trends and adjust such reserves as considered necessary. To date, there have been no significant sales returns.

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

 

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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, related cost of revenues and gross margin.

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 condensed consolidated financial statements.

Entertainment

Revenues from licensing video technology and trademarks are generated from licensing agreements primarily with motion picture studios that generally pay a per-unit royalty fee for videocassettes and DVDs replicated under those license agreements. Licensees generally report replication activity within 30 to 60 days after the end of the month or quarter in which such activity takes place. Consequently, we recognize revenue from these licensing agreements on an as earned basis, provided amounts are fixed or determinable and collection is reasonably assured. The Company relies on past experience and working relationship with these customers to reasonably and successfully estimate current period volume in order to calculate the quarter end revenue accrual. Any unusual or unanticipated replication volumes in a particular period can add significant fluctuations on the revenue reported.

If we change any of these assumptions or judgments, it could cause a material increase or decrease in the amount of revenue that we report in a particular period. Amounts for fees collected or invoiced and due relating to arrangements where revenue cannot be recognized are reflected on our balance sheet as deferred revenue and recognized when the applicable revenue recognition criteria are satisfied.

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. 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.

Equity-Based Compensation

We currently use the Black-Scholes option pricing model to determine the fair value of stock options and employee stock purchase plan shares. The fair value of equity-based payment awards on the date of grant is determined by using an option-pricing model using a number of complex and subjective variables. These variables include our expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rate and expected dividends. We estimate the volatility of our common stock by using a combination of historical volatility and implied volatility in market traded options.

The Black-Scholes option pricing model was developed for use in estimating the fair value of short-lived exchange traded options that have no vesting restrictions and are fully transferable. Existing valuation models, including the Black-Scholes and lattice binomial models, may not provide reliable measures of the fair values of our equity-based compensation. Consequently, there is a risk that our estimates of the fair

 

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values of our equity-based compensation awards on the grant dates may bear little resemblance to the actual values realized upon the exercise, expiration, early termination or forfeiture of those equity-based payments in the future. Certain equity-based payments, such as employee stock options, may expire worthless or otherwise result in zero intrinsic value as compared to the fair values originally estimated on the grant date and reported in our financial statements. Alternatively, value may be realized from these instruments that are significantly higher than the fair values originally estimated on the grant date and reported in our financial statements.

See Note 3 for further information regarding the SFAS 123(R) disclosures.

Valuation of Strategic Investments

As of June 30, 2006 and December 31, 2005, the carrying value of our strategic investments totaled $12.4 million and $11.9 million, respectively. Our strategic investments include public and non-public companies. As of June 30, 2006, the adjusted cost of our strategic investments consisted solely of our investment in Digimarc, a publicly traded company. Our investments in privately held companies had no carrying value as of June 30, 2006. The investment in Digimarc has been classified on the balance sheet as “Long-term marketable investment securities.”

We review our investments in 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 as a guideline to determine if an other-than-temporary impairment has occurred. If the six-month average is less than the current cost basis, it triggers a review of the investment to determine if an other-than temporary impairment has occurred. If we conclude that an other-than temporary impairment has occurred, we record an impairment 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 other-than temporary impairment losses on our investment in Digimarc of $5.8 million in the first quarter of 2005. There were no impairment losses recorded in the first half of 2006 or in the second quarter of 2005.

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.

There were no impairment charges related to our investments in non-public companies during the three and six months ended June 30, 2005 and 2006. As of June 30, 2006 and December 31, 2005, our investments in non-public companies had no remaining carrying value.

 

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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 the first half of 2006 and 2005, 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. We determine the fair value of each reporting unit using the discounted cash flow approach and the market multiple approach. 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. During the fourth quarter of 2005, we performed our most recent 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. We will perform our next annual impairment analysis during the fourth quarter of 2006.

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 2005, no impairment charges were recorded for long-lived assets. We will perform our next annual impairment analysis during the fourth quarter of 2006.

 

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Income Taxes

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 entity’s financial statements or tax returns. Management must make assumptions, judgments 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 net of valuation allowance. 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 not related to acquisitions 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. To the extent realization of the deferred tax assets related to certain acquisitions become probable, recognition of these acquired tax benefits would first reduce goodwill to zero, then reduce other non-current intangible assets related to the acquisition to zero with the remaining benefit reported as a reduction to income tax expense. 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.

Restatement of Financial Statements

As part of our financial close process during the third quarter of 2006, we determined that we had incorrectly calculated our equity-based compensation expense for the first and second quarters of 2006, resulting in an understatement of equity-based compensation of $0.9 million, before taxes, for the three months ended March 31, 2006 and an overstatement of equity-based compensation expense of $1.3 million, before taxes, for the three months ended June 30, 2006. As a result of these errors, the net impact on the six months ended June 30, 2006, was an overstatement of $0.5 million, before taxes. Specifically, the adjustments being made to the equity-based compensation expense for the three and six months ended June 30, 2006 relate to (i) expected forfeitures, (ii) the incremental value associated with the commencement of new offering periods under our employee stock purchase plan and (iii) the expected term assumptions used in calculating compensation associated with our employee stock purchase plan. There is no impact to any prior year financial statements. We determined to correct equity-based compensation expense for the three months ended March 31, 2006 and June 30, 2006, and as a result, concluded to restate our financial statements for the quarterly periods ended March 31, 2006 and June 30, 2006.

The effect of the adjustments on the statement of income for the three months ended June 30, 2006 was a decrease in cost of revenues – service fees of $0.1 million, a decrease in research and development expense of $0.5 million, a decrease in sales and marketing expense of $0.6 million, a decrease in general and administrative expense of $0.1 million and an increase in tax expense of $0.8 million.

As discussed above, we also restated our previously financial statements for the three months ended March 31, 2006. As a result of these corrections, the effect of the adjustments on the statement of income for the six months ended June 30, 2006 was a decrease in cost of revenues – service fees of $0.1 million, a decrease in research and development expense of $0.2 million, a decrease in sales and marketing expense of $0.1 million, a decrease in general and administrative expense of $0.1 million and an increase in tax expense of $0.4 million. The impact of the restatement is an increase in net income of $0.5 million and $0.1 million, respectively, for the three and six months ended June 30, 2006 from amounts previously reported. The restatement increased reported basic and diluted earnings per share by $0.01 for the three months ended June 30, 2006 and increased reported diluted earnings per share by $0.01 for the six months ended June 30, 2006.

 

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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:

 

     Three Months Ended
June 30,
            
    

2006

(As Restated)

   2005    $ Change     % Change  

Revenues:

          

Licenses

   $ 43,326    $ 36,104    $ 7,222     20 %

Services

     15,023      8,310      6,713     81  
                        

Total revenues

     58,349      44,414      13,935     31  

Cost of revenues:

          

License fees

     2,568      1,333      1,235     93  

Service fees

     8,265      3,666      4,599     126  

Amortization of intangibles from acquisitions

     3,490      2,466      1,024     42  
                        

Total cost of revenues

     14,323      7,465      6,858     92  
                        

Gross profit

     44,026      36,949      7,077     19  

Operating expenses:

          

Research and development

     13,615      7,925      5,690     72  

Selling and marketing

     16,426      13,027      3,399     26  

General and administrative

     8,475      7,461      1,014     14  
                        

Total operating expenses

     38,516      28,413      10,103     36  
                        

Operating income

     5,510      8,536      (3,026 )   (35 )

Interest and other income, net

     2,106      974      1,132     116  
                        

Income before income taxes

     7,616      9,510      (1,894 )   (20 )

Income taxes

     841      3,440      (2,599 )   (76 )
                        

Net income

   $ 6,775    $ 6,070    $ 705     12  
                        

 

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Six Months Ended

June 30,

             
     2006
(As Restated)
   2005     $ Change     % Change  

Revenues:

         

Licenses

   $ 88,369    $ 80,221     $ 8,148     10 %

Services

     26,998      15,450       11,548     75  
                         

Total revenues

     115,367      95,671       19,696     21  

Cost of revenues:

         

License fees

     4,930      2,994       1,936     65  

Service fees

     14,487      7,383       7,104     96  

Amortization of intangibles from acquisitions

     6,733      4,882       1,851     38  
                         

Total cost of revenues

     26,150      15,259       10,891     71  
                         

Gross profit

     89,217      80,412       8,805     11  

Operating expenses:

         

Research and development

     26,330      16,622       9,708     58  

Selling and marketing

     33,318      25,949       7,369     28  

General and administrative

     17,293      15,887       1,406     9  
                         

Total operating expenses

     76,941      58,458       18,483     32  
                         

Operating income

     12,276      21,954       (9,678 )   (44 )

Impairment losses on investments

     —        (5,822 )     5,822     100  

Gains on strategic investments

     —        96       (96 )   (100 )

Interest and other income, net

     4,155      1,911       2,244     117  
                         

Income before income taxes

     16,431      18,139       (1,708 )   (9 )

Income taxes

     7,184      6,602       582     9  
                         

Net income

   $ 9,247    $ 11,537     $ (2,290 )   (20 )
                         

License Revenues. Our license revenues increased $7.2 million or 20% from the second quarter of 2005 to the second quarter of 2006 primarily due to (i) $4.9 million increase from the organic growth of our existing software products due to increased market penetration and a growing customer base (ii) $1.6 million increase in software licensing revenue related to the acquisition of eMeta and (iii) $1.2 million increase from the growth in hardware licensing. License revenues increased $8.1 million or 10% from the six months ended June 30, 2005 to the six months ended June 30, 2006 primarily due to (i) $7.6 million increase from the growth in hardware licensing, including a significant set top box licensing transaction completed during the first quarter of 2006 resulting in $4.9 million of royalty fees for boxes manufactured in years earlier than 2006 and (iii) $2.7 million increase in software licensing revenue related to the acquisition of eMeta, (iv) partially offset by a decrease of $2.3 million in DVD royalty revenues caused by the decline in volume and continued pricing pressures in our DVD copy protection business as the full impact of lower pricing in our contracts with MPAA studios take effect.

Service Revenues. Our service revenues increased $6.7 million or 81% from the second quarter of 2005 to the second quarter of 2006 primarily due to (i) $3.4 million increase from the organic growth of our existing software products as the customer base continues to expand (ii) $2.9 million increase in service revenue as a result of the acquisitions of Trymedia and eMeta. Our service revenues increased $11.5 million or 75% from the six months ended June 30, 2005 to the six months ended June 30, 2006 primarily due to (i) $5.7 million increase in software services revenues primarily due to the growing customer base and (ii) $4.6 million increase as a result of the acquisition of Trymedia and eMeta.

Cost of Revenues – License Fees. Cost of revenues from license fees as a percentage of license revenues increased from 4% for the second quarter of 2005 to 6% for the second quarter of 2006,

 

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respectively, and increased from 4% for the six months ended June 30, 2005 to 6% for the six months ended June 30, 2006. Cost of revenues from license fees increased $1.2 million or 93% from the second quarter of 2005 to the second quarter of 2006, and increased $1.9 million or 65% from the six months ended June 30, 2005 to the six months ended June 30, 2006 primarily due to increased product costs associated with certain hardware products.

Cost of Revenues – Service Fees. Cost of revenues from service fees as a percentage of service revenues increased from 44% for the second quarter of 2005 to 55% for the second quarter of 2006, and increased from 48% for the six months ended June 30, 2005 to 54% for the six months ended June 30, 2006. Cost of revenues from service fees increased $4.6 million or 125% from the second quarter of 2005 to the second quarter of 2006 due primarily to (i) an increase of $2.7 million in support and service costs to support the growth in the customer base and strengthen the infrastructure and (ii) an increase of $1.5 million in costs related to operations acquired through eMeta and Trymedia. Cost of revenues from service fees increased $7.1 million or 96% for the six months ended June 30, 2005 to the six months ended June 30, 2006 due primarily to (i) an increase of $4.5 million in support and service costs to support the growth in the customer base and strengthen the infrastructure and (ii) an increase of $2.0 million in costs as a result of the acquisitions of eMeta and Trymedia. We anticipate our cost of revenues from service fees may increase as we continue to increase activity in our service products and expand our customer base.

Cost of Revenues – Amortization of Intangibles from Acquisitions. Cost of revenues from amortization of intangibles increased $1.0 million from the second quarter of 2005 to the second quarter of 2006, and increased $1.9 million from the six months ended June 30, 2005 to the six months ended June 30, 2006. The increase is primarily due to amortization of intangibles from the acquisitions of Zero G since June 2005, Trymedia since July 2005 and eMeta since February 2006.

In June 2005, we acquired Zero G, a privately held company based in San Francisco, California, for $10.6 million of purchase consideration, all of which has been paid in cash. As part of this acquisition, we acquired $3.5 million of intangibles subject to amortization.

In July 2005, we acquired Trymedia, a privately held company based in San Francisco, California and in Alicante, Spain, for $31.8 million of purchase consideration. As part of this acquisition, we acquired $9.3 million of intangibles subject to amortization.

In February 2006, we acquired eMeta, a privately held company based in New York City, New York, for $36.0 million of purchase consideration. As part of this acquisition, we acquired $5.5 million of intangibles subject to amortization.

Research and Development. Research and development expenses increased by $5.7 million or 72% from the second quarter of 2005 to the second quarter of 2006 primarily due to (i) an increase of $2.2 million of expenses related to recent acquisitions during 2006 and 2005 and (ii) an increase of $1.6 million related to equity based compensation. Research and development expenses increased $9.7 million or 58% from the six months ended June 30, 2005 to the six months ended June 30, 2006 primarily due to (i) an increase of $3.6 million of expenses to support products acquired in recent acquisitions and (ii) an increase of $3.3 million related to equity based compensation. Research and development expenses increased as a percentage of revenues from 18% in the second quarter of 2005 to 23% in the second quarter of 2006, and increased from 17% in the six months ended June 30, 2005 to 23.0% in the six months ended June 30, 2006. We expect research and development expenses to increase in absolute terms, but may vary as a percentage of revenues as a result of expected increases in research and development activity to support our new technologies.

 

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Selling and Marketing. Selling and marketing expenses increased by $3.4 million or 26% from the second quarter of 2005 to the second quarter of 2006 primarily due to (i) an increase of $2.0 million of expenses to related to products acquired in recent acquisitions during 2006 and 2005 and (ii) an increase of $1.9 million related to equity based compensation. Selling and marketing expenses increased $7.4 million or 28% from the six months ended June 30, 2005 to the six months ended June 30, 2006 primarily due to (i) an increase of $4.1 million of expenses to support products acquired in recent acquisitions during 2006 and 2005 and (ii) an increase of $4.0 million related to equity based compensation. Selling and marketing expenses as a percentage of revenues in the second quarter of 2005 were comparable to the second quarter of 2006, and increased from 27% for the six months ended June 30, 2005 to 29% for the six months ended June 30, 2006. Selling and marketing expenses are expected to increase in absolute terms and may vary as a percentage of revenues as we continue our efforts to increase our market share and grow our business.

General and Administrative. General and administrative expenses increased by $1.0 million or 14% from the second quarter of 2005 to the second quarter of 2006 primarily due to $1.5 million of equity-based compensation, partially offset by a decrease in Sarbanes Oxley compliance costs. General and administrative expenses increased $1.4 million or 9% from the six months ended June 30, 2005 to the six months ended June 30, 2006 primarily due to $3.1 million of equity-based compensation, partially offset by a decrease in Sarbanes Oxley compliance costs and legal costs. General and administrative expenses decreased as a percentage of revenues from 17% in the second quarter of 2005 to 15% in the second quarter of 2006 and decreased from 17% in the six months ended June 30, 2005 to 15% in the six months ended June 30, 2006. We expect our general and administrative expenses to increase in absolute terms next quarter as a result of increased costs related to information requests of our stock option practices from the SEC and U.S. Attorney’s Office.

Impairment losses on strategic investments. During the first quarter of 2005, we recorded charges totaling $5.8 million relating to an other-than-temporary impairment loss in our investment in Digimarc. There were no impairment charges during the first half of 2006 and in the second quarter of 2005.

Gains on strategic investments. In the first quarter of 2005, we received $96,000 in cash for our interests in a strategic investment that had been fully impaired. Accordingly, during the first quarter of 2005, we recorded a gain on strategic investments of $96,000.

Interest and Other Income, Net. Interest and other income increased $1.1 million, to $2.1 million in the second quarter of 2006 from $1.0 million in the second quarter of 2005 and increased $2.2 million from the six months ended June 30, 2005 to the six months ended June 30, 2006. This increase is primarily due to larger investment balances and higher interest rates earned in our investment portfolio.

Income Taxes. Income tax expense decreased $2.6 million, to $0.8 million in the second quarter of 2006 from $3.4 million in the second quarter of 2005. The Company calculates income tax expense based upon an annual effective tax rate forecast. The Company adjusted the annual effective rate forecast as of June 30, 2006 to reflect revised estimates of the geographic sources of revenue and operating profits expected to be earned for 2006. The decrease is primarily a result of a change in the estimate of the effective tax rate for 2006 that was made during the second quarter of 2006. The income tax expense of $0.8 million recorded in the three months ended June 30, 2006 is the amount required to adjust total income tax expense for the six months ended June 30, 2006 to the revised effective tax rate for the 2006 calendar year. Income tax expense increased $0.6 million, to $7.2 million for the six months ended June 30, 2006 from $6.6 million in the six months ended June 30, 2005. The increase is due to the net effect of the reduction in the annual expected effective tax rate for 2006 from 2005, as well as an amount of $3.6 million recorded during the first quarter ended March 31, 2006 as a discrete item related to income tax accrued on an intercompany transfer of assets adjusted to reflect a change in estimates.

 

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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 $49.8 million and $31.9 million for the six months ended June 30, 2006 and 2005, respectively. Cash provided by operating activities increased $17.9 million from the six months ended June 30, 2005 to the six months ended June 30, 2006, primarily due to the increase in liabilities.

Investing activities used net cash of $82.6 million and $9.5 million for the six months ended June 30, 2006 and 2005, respectively. Cash flow from investing activities decreased $73.1 million from the six months ended June 30, 2005 to the six months ended June 30, 2006, primarily due to the acquisition of eMeta and the increase in purchases of investments. We made capital expenditures of $8.8 million and $4.5 million during the first half of 2006 and 2005, respectively. Capital expenditures are primarily for computer software and hardware.

Net cash provided by financing activities was $17.0 million and $5.7 million for the six months ended June 30, 2006 and 2005, respectively. The net cash provided by financing activities 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 since 2002. If we consider repurchasing the remaining 2.0 million shares under this program in the future, we would seek re-approval from our Board of Directors.

At June 30, 2006, we had $120.4 million in cash and cash equivalents, $126.0 million in short-term investments, $12.0 million in restricted cash and investments and $27.0 million in long-term marketable investment securities, which includes $12.4 million in carrying value of our holdings in Digimarc. We anticipate that capital expenditures for the remainder of the year will not exceed $10.0 million. We also have future minimum lease payments of approximately $67.2 million under noncancelable 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 June 2005, we acquired Zero G for approximately $10.6 million. We paid cash of $9.9 million at closing and $0.7 million in subsequent quarters as Zero G shareholders surrendered the balance of their stock.

In July 2005, we acquired Trymedia for approximately $31.8 million of which $31.5 million was paid in cash. The remaining $0.3 million in cash is expected to be paid to Trymedia shareholders as they surrender the balance of their stock.

In February 2006, we acquired eMeta for approximately $36.0 million of which $34.6 million was paid in cash. The remaining $1.4 million in cash is expected to be paid in February 2007.

 

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Because a significant portion of our cash inflows historically have been 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 content value management and 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 Quarterly Report in Item 1 A.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

We are exposed to financial market risks, including changes in interest rates, foreign 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, cash equivalents, short-term investments and long-term marketable investment securities of $273.4 million as of June 30, 2006. 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 $211,000 decrease (approximately 0.1%) in the fair value of our fixed income available-for-sale securities as of June 30, 2006. Yield risk is also reduced by targeting a weighted average maturity of our portfolio at 12 months so that the portfolio’s yield regenerates itself as portions of the portfolio mature.

Foreign 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 United Kingdom, Japan operate in their local currency, which mitigates a portion of the exposure related to the respective currency royalties collected.

Strategic Investments. We currently hold minority equity interests in a number of companies. These investments, at book value totaling $12.4 million and $11.9 million, represented 2% of our total assets as of June 30, 2006 and December 31, 2005, respectively. As of June 30, 2006, 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 June 30, 2006. 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. During the first quarter of 2005, we charged $5.8 million of impairments that were other-than-temporary to operations. There were no impairment charges during the first half of 2006 or during the second quarter of 2005.

 

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Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures. As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with participation of management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act). In evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on their evaluation, our Chief Executive Officer and Chief Financial Officer concluded that as a result of the material weakness in internal control over financial reporting discussed below, our disclosure controls and procedures were not effective as of the end of the period covered by this report.

Material Weakness in Internal Control Over Financial Reporting. Our management made an assessment of the effectiveness of our internal control over financial reporting as of June 30, 2006. Based on this assessment, our management identified a deficiency in connection with the Company’s process for calculating its stock-based compensation expense pursuant to SFAS 123R for the period ended June 30, 2006. Specifically, the deficiency related to the Company’s process for reviewing stock-based compensation expense calculations, which resulted in incorrect calculations of (i) expected forfeitures; (ii) the incremental value associated with the commencement of new offering periods under the Company’s employee stock purchase plan and (iii) the expected term assumptions used in calculating compensation associated with the Company’s employee stock purchase plan. Management has concluded that, this deficiency constituted a material weakness in internal control over financial reporting as of June 30, 2006, as defined below. A material weakness is a significant deficiency, as defined in Public Company Accounting Oversight Board Auditing Standard No. 2, or a combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the Company’s annual or interim financial statements would not be prevented or detected by company personnel in the normal course of performing their assigned functions.

To date, subsequent to the filing of our 10-Q for the quarter ended June 30, 2006, the Company has taken steps to remediate this material weakness by implementing new review procedures and controls and by updating its stock administration software.

Changes in Internal Controls over Financial Reporting. During the quarter ended June 30, 2006, there have been no changes in our internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, these controls.

 

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

We are involved in legal proceedings related to some of our intellectual property rights.

USPTO Interference Proceedings Between Macrovision Corporation and Intertrust Technologies

A patent interference is declared by the United States Patent and Trademark Office (“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.

We received notice on September 4, 2003 that the USPTO had declared an interference between our U.S. Patent No. 5,845,281 (“the ‘281 patent”) together with two of our continuation applications, and a patent application from Intertrust Technologies Corporation (“Intertrust”). On or about December 28, 2005, the Board of Patent Appeals (“BPA”) issued its final ruling in the case, holding that the ‘281 patent had priority over the two Intertrust patent applications at issue, but also that the inventor of the ‘281 patent had committed inequitable conduct during the prosecution of that patent. As a result of this decision, our ‘281 patent was rendered unenforceable.

On December 19, 2003, we received notice from the USPTO declaring another interference, this time between two of our patent applications and four of Intertrust’s patents. On or about April 11, 2005, the BPA issued its final ruling, holding that the Intertrust patents had priority over our two applications at issue.

Intertrust and Macrovision filed lawsuits on July 28, 2006 and July 31, 2006, respectively, in the U.S. District Court for the Northern District of California against the other party, seeking to overturn the BPA’s rulings adverse to the parties in the two interference proceedings.

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, not the international cases which have been granted or are proceeding to grant in Europe and Japan.

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 related 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 did not appear to implicate any current core InstallShield products. Further, Red Bend Software agreed to indemnify InstallShield and defend the suit for us. On or about June 6, 2006, we were advised that the court granted a motion to dismiss the lawsuit with prejudice against all defendants, including InstallShield.

 

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Macrovision Corporation. vs. Sima Products Corporation, and Interburn Enterprises, Inc.

On June 14, 2005, we filed a lawsuit in the Southern District of New York against Sima Products Corporation and Interburn Enterprises, Inc., alleging that both companies manufacture, distribute or sell products that infringe our patented copy protection technology and also violate the U.S. Digital Millennium Copyright Act of 1998. The patents involved are: United States Patent No. 4,631,603 entitled “Method and apparatus for processing a video signal so as to prohibit the making of acceptable videotape recordings thereof,” and U.S. Patent No. 4,819,098 entitled “Method and apparatus for clustering modifications made to a video signal to inhibit the making of acceptable videotape recordings.” Interburn has entered into a stipulated judgment where they agreed not to further distribute their products. On April 20, 2006, we were granted a preliminary injunction preventing Sima from distributing the products at issue in the lawsuit. On or about June 12, 2006, Sima filed an emergency motion with the United States Second Circuit Court of Appeals, asking that the injunction be stayed pending an appeal of the District Court’s issuance of the injunction. The injunction has been temporarily stayed while the Court of Appeals considers Sima’s motion. We are opposing Sima’s efforts to get the injunction overturned, and intend to continue to vigorously pursue this action to protect our patented copy protection technology.

InstallShield Software Corporation Liquidating Trust vs. Macrovision

On October 27, 2005, we received notice of an arbitration proceeding filed by InstallShield Software Corporation Liquidating Trust (the “Trust.”) The Trust is demanding arbitration of certain disputes between the Trust and the Company pursuant to Asset Purchase Agreement dated June 16, 2004 by and among InstallShield Software Corporation, the Company, Macrovision Europe Limited, and Macrovision International Holding L.P. (the “Agreement”). Under the Agreement, we may have been required to make an additional contingent payment of up to $20 million based on post-acquisition revenue performance through June 30, 2005. Based upon the revenue results through June 30, 2005, we concluded that no additional payment was required under the terms of the Agreement. The Trust alleges that the post-acquisition revenue performance targets were not reached due to our conduct in violation of the Agreement, and therefore is seeking the contingent payment in an amount exceeding $15 million. We deny these allegations and intend to vigorously defend ourselves in the arbitration proceeding.

Stock Option Inquiries

In addition to the aforementioned intellectual property matters, on each of June 13, 2006 and June 28, 2006, we announced that we have been contacted by the Securities and Exchange Commission (SEC) and have received a subpoena from the U.S. Attorney’s Office, respectively, each requesting information relating to our stock option practices. We have announced our intent to cooperate with the SEC and U.S. Attorney’s Office. We believe that this review of stock option practices has no material impact on the financial statements included in this report on Form 10-Q or on any previously filed financial statements.

As of June 30, 2006, for all the abovementioned 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 management’s 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.

 

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ITEM 1A. RISK FACTORS

In addition to the other information contained in this Quarterly Report on Form 10-Q, you should consider carefully the following risks. If any of these risks occurs, our business, financial condition or operating results could be adversely affected.

Company Risks

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 significant percentage 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 PPV and 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.

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 due to a shift from physical media distribution to digital distribution or otherwise, 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.

Other factors that could affect our operating results include:

 

    The timing and number of releases of popular movies on videocassettes, DVDs or by digital PPV/VOD transmission;

 

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    The ability of the MPAA studios utilizing our content protection technology to produce one or more “blockbuster” titles on an annual basis;

 

    The acceptance of our content protection technologies by major motion picture studios and software companies;

 

    The amount by which theatrical content is being replaced by television content, and the extent to which entertainment producers decide to apply our protection technologies to television content;

 

    Expenses related to, and the financial impact of, possible acquisitions of other businesses and the integration of such businesses;

 

    The acceptance of our software solutions (electronic licensing, installation, update service, software asset management, packaging) solutions by software vendors and end-user organizations;

 

    The potential that we may not be in a position to anticipate a decline in revenues in any quarter until late in the quarter or after the quarter ends due to the delay inherent in reporting from certain licensees and closing of new sales agreements;

 

    The acceptance of our new music content protection technologies by major music labels in the U.S. market, Europe and Asia, and the impact of consumer activist organizations;

 

    The extent to which new content technologies or formats replace technologies to which our solutions are targeted;

 

    Adverse changes in the level of economic activity in the United States or other major economies in which we do business as a result of the threat of terrorism, military actions taken by the United States or its allies, or generally weak and uncertain economic and industry conditions;

 

    The timing and popularity of releases of computer software CD-ROM multimedia titles;

 

    The extent to which various hacking technologies are viewed by our customers to undermine and devalue our technologies; and

 

    The extent to which we are able to transition our market leading position in optical media (i.e., packaged media) content protection and our DRM patents into digital content value management via the Internet.

If our entertainment technologies customers decide to focus on other methods to inhibit piracy, the demand for our products may decrease and our business would be harmed.

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 or support legislative initiatives 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.

 

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As our entertainment technologies customers try to minimize costs, they may decrease their content protection usage or negotiate decreases in their usage fees, which may result in a substantial decline in our entertainment related revenues.

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, we have experienced a decline in our entertainment technologies’ revenues associated with DVDs in the last eighteen months and 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 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 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.

We depend on a small number of key customers for a high percentage of our entertainment-related revenues and the loss of a significant customer could result in a substantial decline in our revenues and profits.

Our customer base and our entertainment related revenues are 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 entertainment related business. Historically, we have derived the majority of our entertainment related revenues from a relatively small number of customers. No customer accounted for more than 10% of our net revenues in 2005 or 2004, and one customer accounted for 10.2% of our net revenues in 2003.

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 all or a substantial part of their videocassettes and/or DVDs in the U.S. These agreements expire at various times starting in late 2006, 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 entertainment related revenues and operating income, and our business would be harmed.

 

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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 subscription) license, the latter of which results in ratable recognition of the license fee over the term of the license, which is generally 12 months.

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 43%, 42% and 42% of our consolidated net revenues in 2005, 2004 and 2003, 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 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:

 

    foreign government regulation;

 

    changes in diplomatic and trade relationships;

 

    changes in, or imposition of, foreign laws and regulatory requirements;

 

    changes in, or weakening of copyright and intellectual property (patent) laws and support for content protection and DRM technologies;

 

    difficulty of effective enforcement of contractual provisions in local jurisdictions;

 

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    tariffs or taxes and other trade barriers and restrictions;

 

    fluctuations in our net effective income tax rate driven by changes in the percentage of revenues that we derive from international sources;

 

    changes in a specific country’s or region’s political or economic condition, including changes resulting from the threat of terrorism;

 

    difficulty in staffing and managing foreign operations; and

 

    fluctuations in foreign currency exchange rates.

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 digital content protection and lifecycle value management 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, the anticipated shift to high definition DVD or the transition from packaged media to Internet distribution. 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 and software lifecycle value management solutions and 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.

 

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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, RealNetworks, ContentGuard, IBM, Apple 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:

 

    substantial settlement or related costs, including indemnification of customers;

 

    diversion of management and technical resources;

 

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    either our customers discontinuing to use or ourselves discontinuing to sell infringing products;

 

    our expending significant resources to develop non-infringing technology; and

 

    our obtaining licenses to infringed technology.

In 2005, we entered into a new business for the protection and enablement of audio, video and software content on the Internet and P2P networks. There has been, and we believe that there 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.

Any legal or other enforcement action that we may initiate could be time-consuming to pursue, involve costly litigation, divert management’s attention from operations or may not be successful. See “Legal Proceedings.”

In the PC games copy protection market, 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 technologies that 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 TotalPlay 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 would like to license these patents to both content owners and hardware manufacturers, but in order to maintain strong customer relationships, we may not be able to monetize these patents. If we license these patents and they 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.

 

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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 continuously challenge 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:

 

    DVD and CD authoring facilities, mastering houses and replicators;

 

    DVD and CD authoring tools software companies and replicator test equipment suppliers;

 

    DVD and CD hardware manufacturers;

 

    videocassette duplicators;

 

    semiconductor and equipment manufacturers;

 

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    operators of digital PPV and VOD networks;

 

    consumer electronics, digital PPV/VOD set-top hardware manufacturers, and PC manufacturers;

 

    DRM suppliers, especially in the music business; and

 

    Internet portals and other digital distribution companies.

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 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 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:

 

    apply the various digital signature, formatting, and copy protection technology at licensed replication facilities; and

 

    allow replicators to run specialized quality assurance tests to confirm our technologies are applied.

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 123 of the world’s 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.

 

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We rely on our licensees and others to accurately prepare manufacturing reports in determining our entertainment related licensing revenue, and if these reports are inaccurate, our operating results could be materially adversely affected.

Our entertainment related 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. Although we generally have audit rights, audits are 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 entertainment related licensees.

Our quarterly operating results may fluctuate depending upon when we receive royalty reports from our entertainment related licensees. We recognize a portion of our entertainment related 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 entertainment related revenue is dependent upon the timing of our receipt of those reports, some of which are not delivered until late in the quarter or after the end of the quarter. This may put us in a position of being not able to anticipate a decline in revenues inany given quarter. 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 entertainment related 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 entertainment related licensing revenue from a licensee being recorded in a given quarter that is not necessarily indicative of the amounts of entertainment related licensing revenue to be received from that licensee in future quarters, thus causing fluctuations in our operating results and resulting in potential volatility in the price of our common stock.

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. Most recently, we completed the acquisition of Zero G Software Inc. in June 2005, Trymedia Systems, Inc. in July 2005 and eMeta Corporation in February 2006. We may not realize the anticipated benefits of these or any other companies we have acquired in the past and companies we acquire in the future, and 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.

 

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Acquisitions and other strategic investments involve numerous risks, including:

 

    problems integrating the purchased operations, technologies, personnel or products over geographically disparate locations, including most recently, San Francisco, California and Alicante, Spain;

 

    unanticipated costs, litigation and other contingent liabilities;

 

    adverse effects on existing business relationships with suppliers and customers;

 

    risks associated with entering into markets in which we have no, or limited, prior experience;

 

    incurrence of significant exit charges if products acquired in business combinations are unsuccessful;

 

    significant diversion of management’s attention from our core business and diversion of key employees’ time and resources;

 

    inability to retain key customers, distributors, vendors and other business partners of the acquired business; and

 

    potential loss of our key employees or the key employees of an acquired organization.

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 incur significant acquisition-related costs. In addition, 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. 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

 

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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. Since January 1, 2001, we have written off $40.2 million of strategic investments resulting from impairment that was other-than-temporary, and we may have to write off additional amounts in the future.

Our products could be susceptible to errors, defects, or unintended performance problems 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 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. Because our products are embedded in digital content and other software, our solutions’ performance could unintentionally jeopardize our customers’ product performance. Although we have had no such incidents to date, a recent situation with competitive music copy protection products demonstrated that certain ‘rootkit’ based design approaches resulted in unacceptable security and usability concerns to consumers. Any such defects, errors, or unintended performance problems 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

 

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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:

 

    The necessary communication and computer network technology underlying the Internet and other online service does not effectively support any expansion that may occur;

 

    New standards and protocols are not developed or adopted in a timely manner; or

 

    Concerns about security, reliability, cost, ease of use, accessibility, quality of service, or other factors results in the Internet not becoming established as a viable commercial marketplace, inhibiting the development of electronic commerce and reducing the need for and desirability of our products and services.

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.

We have a relatively limited operating history with our digital distribution business, which makes it difficult to evaluate its impact on our business.

We completed the acquisitions of Trymedia Systems, a digital distribution network for downloadable PC games, in July 2005 and eMeta Corporation, a provider of software solutions that enable companies to manage and sell digital goods and services online, in February 2006. We have a relatively limited history operating these businesses and as a result, we have limited financial results from these businesses on which to assess our future prospects. Our prospects must be considered in light of the risks, expenses and difficulties frequently encountered by companies in new and rapidly evolving businesses.

We have commenced a review of our historical stock option practices and have been contacted by the SEC and US Attorney’s Office to provide certain information relating to our stock options. These reviews may not be resolved favorably and have required, and may continue to require, a significant amount of management time and attention and accounting and legal resources, which could adversely affect our business, results of operations and cash flows.

The SEC and the US Attorney’s Office have each contacted the Company requesting information relating to our stock option practices from 1997 and 1995, respectively, to the present. We have announced that we intend to fully cooperate with them in connection with their requests. The period of time necessary to resolve the SEC and US Attorney’s Office reviews is uncertain, and these matters could require significant management and financial resources which could otherwise be devoted to the operation of our business. If we are subject to an adverse finding resulting from the reviews, we could be subject to investigations, be required to restate financial statements or to pay damages or penalties or have other remedies imposed upon us. The ongoing reviews and any negative outcome that may occur from these investigations could impact our relationships with customers and our ability to generate revenue. In addition, considerable legal and accounting expenses related to these matters have been incurred to date and significant expenditures may continue to be incurred in the future. The SEC and US Attorney’s reviews could adversely affect our business and operating results.

 

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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 have implemented 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.

For our business to succeed, we need to integrate new senior management into the organization.

In 2005 and 2006, we have had significant changes in our senior management team, including the hiring of a new chief executive officer and chief financial officer. The change of senior management can result in significant disruption to our ongoing operations, and new senior personnel must spend a significant amount of time learning our business and our systems in addition to performing their regular duties. Our future success depends on our ability to integrate new senior management personnel into the company. We do not have nor do we intend to obtain key person life insurance covering any of our personnel.

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:

 

    our own or licensed encryption and authentication technology, and access and security procedures, may be compromised, breached or otherwise be insufficient to ensure the security of customer information or intellectual property;

 

    we could experience unauthorized access, computer viruses, system interference or destruction, “denial of service” attacks and other disruptive problems, whether intentional or accidental, that may inhibit or prevent access to our websites or use of our products and services;

 

    someone could circumvent our security measures and misappropriate our, our partners’ or our customers’ proprietary information or content or interrupt operations, or jeopardize our licensing arrangements, which are contingent on our sustaining appropriate security protections; or

 

    our computer systems could fail and lead to service interruptions.

 

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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. 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 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. We have in the past, and may in the future, identify significant deficiencies in the design and operation of our internal controls, which have been or will in the future need to be remediated. Changes we make to our controls and processes may not 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, and changes in geographic operating results, 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 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.

 

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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.

Interpretation of existing laws that did not originally contemplate the Internet could harm our business and operating results.

The application of existing laws governing issues such as property ownership, copyright and other intellectual property issues to the Internet is not clear. Many of these laws were adopted before the advent of the Internet and do not address the unique issues associated with the Internet and related technologies. In many cases, the relationship of these laws to the Internet has not yet been interpreted. New interpretations of existing laws may increase our costs, require us or our customers to change business practices or otherwise harm our business.

We may be subject to market risk and legal liability in connection with the data collection capabilities of our products and services.

Many of our products are interactive Internet applications that by their very nature require communication between a computer system or network client and server to operate. To provide better consumer experiences and to operate effectively, our products send information to ours or our customers’ servers. Many of the services we provide also require that a user provide certain information to us. We post an extensive privacy policy concerning the collection, use and disclosure of user data involved in interactions between our client and server products. Any failure by us or our customers to comply with our posted privacy policy and existing or new legislation regarding privacy issues could impact the market for our products and services, subject us to litigation and harm our business.

We may be subject to legal liability for the provision of third-party products, services or content.

We periodically enter into arrangements to offer third-party products, services, content or advertising under our brands or via distribution on our websites or in our products or service offerings. We may be subject to claims concerning these products, services, content or advertising by virtue of our involvement in marketing, branding, broadcasting or providing access to them. Our agreements with these parties may not adequately protect us from these potential liabilities. It is also possible that, if any information provided directly by us contains errors or is otherwise negligently provided to users, third parties could make claims against us, including, for example, claims for intellectual property infringement. Investigating and defending any of these types of claims is expensive, even if the claims do not result in liability. If any of these claims results in liability, we could be required to pay damages or other penalties, which could harm our business and our operating results.

We may be subject to assessment of sales and other taxes for the sale of our products, license of technology or provision of services.

We do not currently collect sales or other taxes on the sale of our products, license of technology or provision of services in states and countries other than those in which we have offices or employees. Our business would be harmed if one or more states or any foreign country were able to require us to collect

 

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sales or other taxes from past sales of products, licenses of technology or provision of services, particularly because we would be unable to go back to customers to collect sales taxes for past sales and would likely have to pay such taxes out of our own funds.

Effective July 1, 2003, we began collecting Value Added Tax, or VAT, on sales of “electronically supplied services” provided to European Union residents, including software products, games, data, publications, music, video and fee-based broadcasting services. There can be no assurance that the European Union will not make further modifications to the VAT collection scheme, the effects of which could require significant enhancements to our systems and increase the cost of selling our products and services into the European Union. The collection and remittance of VAT subjects us to additional currency fluctuation risks.

The Internet Tax Freedom Act, or ITFA, which Congress extended until November 2007, among other things, imposed a moratorium on discriminatory taxes on electronic commerce. The imposition by state and local governments of various taxes upon Internet commerce could create administrative burdens for us and could decrease our future sales.

Industry Risks

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 TotalPlay 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. Adverse publicity, negative consumer reaction and lawsuits regarding competing copy protection technologies may impede adoption of our product, and our revenue may be adversely affected. 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 approximately 13 cable or satellite system operators in North America have activated copy protection for digital PPV or VOD programming.

 

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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; Intel’s High Definition Copy Protection (“HDCP”) encryption for both the Digital Display Working Group’s Digital Video Interfaces (“DVI”) and HDMI Licensing, LLC’s 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 instead of purchasing them. 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 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. Operating

 

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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. In addition to having more traditional competitors in various subcomponents of our offerings, such as SafeNet that has a license management offering and Altiris that has an installer offering, we may face new or increased competition from smaller and emerging companies such as XtreamLok, Softwrap and Reprise Software.

Our other software solutions, namely our InstallShield Installer, Update Service, InstallAnywhere and Admin Studio have other competitors, but none of these competitors have the breadth of software management solutions that we do. In the Installer business, Altiris’ Package Studio is the primary competition for our Admin Studio solution and Microsoft may be a competitor in the future. 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, Sony’s 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 (owned by Sony and Philips), Microsoft, Content Guard, Apple, 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;

 

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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 major software value management products include FLEXnet Publisher and FLEXnet InstallShield. FLEXnet Publisher is licensed to software publishers as a software 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 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 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 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.

Our software products are designed for the traditional software business model, and if the application service provider business model were to become the preferred model, our revenues may be adversely affected.

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 manage the software from within the enterprise. With the initial success of the software as a service (“SAaS”) business model, under which the software application is hosted in the software vendors’ remote servers and there is no server software resident in the enterprise, some industry experts have questioned whether the SAaS model will eventually replace the traditional application software business model. We believe it is too early to make this prediction, however, because our software solutions are mostly tailored for the traditional software model, if the SAaS 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. In 2004, we introduced our Hawkeye technology, which is designed to protect copyrighted content that is discovered being illicitly traded over the P2P file sharing networks, and in 2005, we introduced our RipGuard DVD technology, which is designed to be added to the DVD at the time of manufacture in order to prevent unauthorized ripping by PCs. These solutions may not achieve or sustain market acceptance, or may not meet, or

 

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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 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 another’s hard drives, all without securing licenses from content providers. Even though the U.S. Supreme Court ruled in 2005 that Internet peer-to-peer companies like Grokster Ltd. can be held liable for copyright infringement when individuals use their technology to download songs and movies illegally, the Court did not address the question of whether peer-to-peer file sharing technology is illegal in itself. 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.

Investment Risks

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:

 

    actual or anticipated fluctuations in operating results;

 

    announcements of technical innovations;

 

    new products or new contracts;

 

    competitors or their customers;

 

    governmental regulatory and copyright action;

 

    developments with respect to patents or proprietary rights;

 

    changes in financial estimates or coverage by securities analysts;

 

    changes in tax law or the interpretation of tax laws; and

 

    general market conditions.

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.

 

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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 company’s 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 non-GAAP reporting in our quarterly earnings press releases.

We publish non-GAAP financial measures in our quarterly earnings press releases along with a reconciliation of non-GAAP financial measures to those measures compiled in accordance with accounting principles generally accepted in the United States (“GAAP”). 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 more meaningful to investors in analyzing the results of operations and income generation as this is how the business is managed. We have not included any such non-GAAP financial measures or reconciliation to GAAP financial measures in this report. The market price of our stock may fluctuate based on future non-GAAP results if investors base their investment decisions upon such non-GAAP financial measures. 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 non-GAAP 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 use of non-GAAP financial measures in our quarterly earnings press releases, the market price of our stock could be affected if investors analyze our performance in a different manner.

If we continue to support broad-based employee stock option grants in the future, recent changes in 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. Prior to 2006, we accounted 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) Financial Accounting Standards Board (“FASB”) Interpretation No. 44 (“FIN 44”), “Accounting for Certain Transactions Involving Stock Compensation—an Interpretation of APB Opinion No. 25,” and complied with the disclosure provisions of (iii) Statement of Financial Accounting Standard (“SFAS”) No. 123, “Accounting for Stock-Based Compensation.”

Effective the first quarter of fiscal year 2006, the FASB required us to follow SFAS 123R, Share-Based Payment, which requires us to measure compensation expense for employee stock options using the fair value method. SFAS 123R applies to all outstanding stock options that are not vested at the effective date and grants of new stock options made subsequent to the effective date. As a result of SFAS 123R, we recorded higher levels of stock based compensation due to differences between the valuation methods of SFAS 123R and APB 25. If we continue to support broad-based employee stock option grants, employee stock-based compensation arrangements to be accounted for as an expense (in a manner different to APB No. 25 and FIN 44) may have a material, negative impact upon our future earnings. Alternatively, if we reduce the number of 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.

 

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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 management’s assessment of the effectiveness of internal control over financial reporting. 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 management’s 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.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

None.

Item 3. Defaults Upon Senior Securities

None.

 

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Item 4. Submission of Matters to a Vote of Security Holders

At our annual meeting of stockholders held on April 27, 2006, each of the following matters were voted on: (1) election of directors; (2) amendment of the 2000 Equity Incentive Plan; and (3) ratification and appointment of KPMG, LLP as our independent registered public accounting firm for the year ending December 31, 2006.

Each of the following individuals was elected to the board of directors to hold office until the 2007 annual meeting of stockholders, or until a successor is duly elected and qualified or the director’s earlier death, resignation or removal:

 

     Votes For    Votes Withheld

John O. Ryan

   46,811,519    1,629,381

Alfred J. Amoroso

   47,036,106    1,404,794

Donna S. Birks

   40,929,251    7,511,649

William N. Stirlen

   46,173,446    2,267,454

Steven G. Blank

   45,216,400    3,224,500

Robert J. Majteles

   46,830,454    1,610,446

The proposal to amend the 2000 Equity Incentive Plan was approved by the following vote:

 

Votes For

  

Votes Against

  

Abstentions

  

Broker non-votes

27,116,898

   14,826,625    865,261    4,217,393

The proposal to ratify the appointment of KPMG, LLP as our independent registered public accounting firm for the year ending December 31, 2006 was approved by the following vote:

 

Votes For

  

Votes Against

  

Abstentions

45,767,488

   1,130,792    127,896

Item 5. Other Information

None.

 

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Item 6. Exhibits

 

Exhibit
Number

  

Exhibit Description

   Incorporated by Reference   

Filed
Herewith

      Form    Date    Number   
10.01    2006 Company Incentive Plan    8-K    4/3/06    10.1   
10.02    Severance Agreement with Steven Weinstein dated June 14, 2006    8-K    6/19/06    10.01   
31.01    Certification of the Chief Executive Officer pursuant to Securities Exchange Act Rules 13a-15(e) and 15d-15(e) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.             X
31.02    Certification of the Principal Financial Officer pursuant to Securities Exchange Act Rules 13a-15(e) and 15d-15(e) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.             X
32.01    Certification of the Chief Executive Officer pursuant to 18 U.S.C Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.             X
32.02    Certification of the Principal Financial Officer pursuant to 18 U.S.C Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.             X

 

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SIGNATURES

In accordance with the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Macrovision Corporation

Authorized Officer:

 

Date: November 7, 2006   By:  

/s/ Alfred J. Amoroso

    Alfred J. Amoroso
    Chief Executive Officer

Principal Financial Officer and Principal Accounting Officer:

 

Date: November 7, 2006   By:  

/s/ James Budge

    James Budge
    Chief Financial Officer

 

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