UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

Commission File Number 000-26565

LIBERATE TECHNOLOGIES

(Exact name of registrant as specified in its charter)

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 ý  No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ý No o

105,752,099 shares of the Registrant’s common stock were outstanding as of December 31, 2004.

LIBERATE TECHNOLOGIES

FORM 10-Q

For The Quarterly Period Ended November 30, 2004

TABLE OF CONTENTS

Part I. Financial Information

Item 1. Financial Statements

LIBERATE TECHNOLOGIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

Unaudited

The accompanying notes are an integral part of these condensed consolidated financial statements.

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LIBERATE TECHNOLOGIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE LOSS

(In thousands, except per share data)

Unaudited

The accompanying notes are an integral part of these condensed consolidated financial statements.

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LIBERATE TECHNOLOGIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

Unaudited

The accompanying notes are an integral part of these condensed consolidated financial statements.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Unaudited

Note 1. Description of Business

Liberate Technologies (“Liberate,” “we,” “us,” or “our”), together with its wholly-owned subsidiaries, is a provider of software and services for digital cable television systems. Based on industry standards, our software enables cable operators to run multiple applications and services—including interactive programming guides, high definition television, video on demand, personal video recorders and games—on multiple platforms.

Liberate began operations in late 1995 as a division of Oracle. In April 1996, the company separately incorporated in Delaware as Network Computer, Inc., and on May 11, 1999, it changed its name to Liberate Technologies.

Our headquarters are located in San Mateo, California. As of November 30, 2004, we have a research and development center in Canada and sales and customer support offices in the U.K.

Note 2. Significant Accounting Policies

Basis of Presentation

These interim financial statements are unaudited and reflect all adjustments of a normal recurring nature, that we believe are necessary to provide a fair statement of the financial position and the results of operations for the interim periods in accordance with the rules of the Securities and Exchange Commission (“SEC”). These statements should be read in conjunction with the audited condensed consolidated financial statements and notes included in our annual report on Form 10-K for the fiscal year ended May 31, 2004. The results of operations for the interim periods reported do not necessarily indicate the results expected for the full fiscal year or for any future period.

In this report, we sometimes use the words “fiscal” or “FY” followed by a year to refer to our fiscal years, which end on May 31 of the specified year. We also sometimes use “Q1,” “Q2,” “Q3,” and “Q4” to refer to our fiscal quarters, which end on August 31, November 30, the last day of February, and May 31 of each fiscal year.

Principles of Consolidation

Our unaudited condensed consolidated financial statements include the accounts of Liberate and our subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation.

Bankruptcy Accounting

With the Chapter 11 bankruptcy case still pending at August 31, 2004, we prepared the unaudited condensed consolidated financial statements in accordance with the provisions of Statement of Position (“SOP”) 90-7, “Financial Reporting by Entities in Reorganization under the Bankruptcy Code” as of August 31, 2004 and for the three month period ended August 31, 2004. The provisions did not significantly change the application of accounting principles generally accepted in the United States. However, it required that the financial statements for periods including and subsequent to filing the Chapter 11 petition distinguish transactions and events that were directly associated with the reorganization from the ongoing operations of the business. On September 8, 2004, the bankruptcy court issued a ruling dismissing Liberate’s bankruptcy case. Hence, the unaudited condensed consolidated financial statements as of November 30, 2004 and for the three and six month periods ended November 30, 2004 are presented without the effects of SOP 90-7.

Use of Estimates

The preparation of unaudited condensed consolidated financial statements in conformity with

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generally accepted accounting principles in the United States requires management to make estimates and assumptions. These estimates affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.

Foreign Currency Translation and Re-measurement

During fiscal 2004, management determined that the conditions described in SFAS No. 52, “Foreign Currency Translation,” for the translation of the Canadian and U.K. operations using the local currency as the functional currency ceased to exist. Accordingly, starting in Q4 FY04, the functional currency of these subsidiaries’ operations is the U.S. dollar. The monetary assets and liabilities of these operations are re-measured into U.S. dollars at the exchange rate in effect at the balance sheet date and non-monetary assets and liabilities are re-measured at historical rates. Revenues, expenses, gains or losses are re-measured at the average exchange rate for the period, other than depreciation and amortization, which are re-measured at the respective historical rates as their related assets. The resulting re-measurement gains and losses of these operations as well as gains and losses from foreign currency transactions are included in the condensed consolidated statements of operations.

Translation gains or losses relating to prior periods have been recorded in “Accumulated Other Comprehensive Income (Loss),” a component of Stockholders’ Equity. As of November 30, 2004 and May 31, 2004, the cumulative translation losses in accumulated other comprehensive income was $1.9 million and $2.1 million, respectively.

Fair Value of Financial Instruments

Due to their short maturities, the carrying value of our financial instruments, including cash and cash equivalents, accounts receivable, restricted cash, accounts payable and accrued liabilities, approximates their fair value.

Concentration of Credit Risk

Financial instruments that potentially subject us to concentration of credit risk consist primarily of cash and cash equivalents and accounts receivable. Substantially all of our cash and cash equivalents are invested in high-quality money market instruments and securities of the U.S. government. While our customers are geographically dispersed, a substantial amount of our revenues has been generated from a small number of customers, whose receivables are generally unsecured. We mitigate our credit risk associated with accounts receivable by performing ongoing credit evaluations of our customers’ financial conditions, and we maintain an allowance for potential credit losses. Historically, we have not experienced significant losses related to the non-payment of accounts receivable.

The table below sets forth information relating to each customer that accounted for 10% or more of our total revenues during the periods ended November 30, 2004 and 2003:

*  Less than 10%

The above presentation includes the effects of the warrant amortization expense classified as a reduction of revenues. As a result, certain customers generated negative revenues, and the totals of the percentages for certain periods presented exceeds 100%.

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As of November 30, 2004 and May 31, 2004, each of three and four customers, respectively, accounted for 10% or more of our gross accounts receivable balance. Their respective receivable balances as a percentage of our gross accounts receivable balance were as follows:

*  Less than 10%

Property and Equipment

We record property and equipment at the lower of cost, net of accumulated depreciation, or net realizable value. We compute depreciation using the straight-line method over the estimated useful lives of the assets ranging from two to five years. We amortize leasehold improvements over the shorter of the remaining lease term or the estimated useful lives of the improvements using the straight-line method.

Deferred Costs Related to Warrants

In fiscal 1999, we issued warrants to several of our customers. We valued these warrants based on their estimated fair value using the Black-Scholes pricing model as of the earlier of the date that the warrants were earned or the date that it became likely that they would be earned. Under the requirements of Emerging Issues Task Force (“EITF”) 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services,” we continue to revalue warrants if appropriate. We record the value of warrants as deferred costs, a non-current asset on our condensed consolidated balance sheet. We amortize those deferred costs over the estimated economic life of the arrangements under which the warrants are issued. Under EITF 01-09, "Accounting for Consideration Given by a Vendor to a Customer,'' such amortization expense may be classified as an offset to associated revenues up to the amount of cumulative revenues recognized or to be recognized.

We periodically review warrants for impairment whenever events or changes in circumstances indicate that the carrying amount of the warrants may not be recoverable. Significant management judgment is required in assessing the useful life of our warrant assets and the need for a measurement of impairment. In fiscal 2002, we recorded an impairment charge of $44.8 million in connection with a review for impairment of the carrying value of deferred costs. In fiscal 2004, we recorded an impairment charge of $5.0 million as a result of our realignment of strategy to focus on the U.S. cable market and the resulting impairment of warrants issued to non-U.S. customers. These impairment charges reduced the carrying value of deferred costs to a level equal to the expected future revenues from the holders of those warrants during the amortization period of those warrants. For the three and six months ended November 30, 2004, we amortized $896,000 and $1.8 million, respectively, as a reduction of associated revenues up to the amount of cumulative revenues recognized or to be recognized from deferred revenues.

Stock-Based Compensation

We adopted the Financial Accounting Standards Board (“FASB”) SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure” in the fiscal year ended May 31, 2004. In December 2002, SFAS 148 amended SFAS 123, “Accounting for Stock-Based Compensation,” which provided alternate methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS 148 amends the disclosure requirements of SFAS 123 to require more prominent disclosures in both annual and interim financial statements about the method used on reported results. We have elected to continue to follow the intrinsic value method of accounting prescribed by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), to account for employee stock options. Under APB 25, no compensation expense is recognized upon the grant of an employee stock option unless the exercise price of the option is less than market price of the underlying stock at the date of grant.

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Under the provisions of APB 25, we record deferred stock-based compensation in connection with stock units based on the intrinsic value (fair market value) of the underlying shares at the date of grant. This value is then amortized over the vesting period of the stock unit as a compensation expense by functional classification of the award recipient. See Note 6.

The following information regarding net loss and loss per share prepared in accordance with SFAS 123 has been determined as if we had accounted for our employee stock options, stock units and shares issued under our 1999 Equity Incentive Plan using the fair value method prescribed by SFAS 123. The resulting effect on net loss and loss per share pursuant to SFAS 123 is not likely to be representative of the effects on net loss and loss per share pursuant to SFAS 123 in future periods, because future periods will include additional grants and periods of vesting.

The following table illustrates the effect on reported net loss and loss per share had we applied the fair value recognition provisions of SFAS 123 (in thousands, except per share data):

The following table shows the expense related to stock units, by functional classification (in thousands):

For the three and six months ended November 30, 2004, we granted 50,768 and 125,768 stock units to employees and non-employee directors, respectively, and we issued no stock options. For the three and six months ended November 30, 2003 we granted 223,528 stock units to employees and non-employee directors, and we issued 14,000 stock options.  For purposes of SFAS 123 the fair value of the stock based compensation issued under the 1999 Equity Incentive Plan for the quarter ended November 30, 2004 was estimated at the date of grant utilizing a Black-Scholes valuation model with the following weighted-average assumptions:

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Revenue Recognition

License and Royalty Revenues.  Liberate licenses its software through its direct sales force located in North America and Europe. License and royalty revenues consist primarily of fees earned from the licensing of its software, as well as royalty fees earned upon the shipment or activation of products that incorporate its software. In general, license revenues are recognized when a non-cancelable license agreement has been signed and the customer has acknowledged an unconditional obligation to pay, the software product has been delivered, there are no uncertainties surrounding product acceptance, the fees are fixed or determinable and collection is considered probable. Delivery is considered to have occurred when title and risk of loss have been transferred to the customer, which generally occurs when media containing the licensed programs are provided to a common carrier. In the case of electronic delivery, delivery occurs when the customer is given access to the licensed programs. If collectibility is not considered probable, revenue is recognized when the fee is collected.

Liberate recognizes revenue from software licensing arrangements using the residual method pursuant to the requirements of Statement of Position (SOP) No. 97-2, “Software Revenue Recognition”, as amended by SOP No. 98-9, “Software Revenue Recognition, With Respect to Certain Transactions” and the Securities and Exchange Commission’s Staff Accounting Bulletin No. 104, “Revenue Recognition.” Revenues recognized from multiple-element software arrangements are allocated to each element of the arrangement based on the fair values of the elements, such as licenses for software products, maintenance or consulting services. The determination of fair value is based on objective evidence, which is specific to Liberate. We limit our assessment of objective evidence for each element to either the price charged when the same element is sold separately or the price established by management having the relevant authority to do so, for an element not yet sold separately. If evidence of fair value of all undelivered elements exists but evidence does not exist for one or more delivered elements, then revenue is recognized under the residual method. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is recognized as revenue.

However, if such undelivered elements consist of services that are essential to the functionality of the software, we recognize license and services revenues using contract accounting, pursuant to SOP No. 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.” If license arrangements include the rights to unspecified future products, revenue is recognized ratably over the contractual or estimated economic term of the arrangement. We recognize royalty revenues when a network operator reports that it has shipped or activated products or its rights to deploy such products expire.

Deferred revenue primarily comprised of collections from and billings to customers for software arrangements, including new subscription arrangements, which does not qualify for revenue recognition under our revenue recognition policy.

We reduce license and royalty revenues by certain expenses as a result of the application of EITF No. 01-09, which generally requires that consideration, including warrants, issued to a customer should be classified in a vendor’s financial statements not as an expense, but as a reduction to revenues up

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to the amount of cumulative revenues recognized or likely to be recognized from that customer.

Service Revenues.  Service revenues consist of consulting, maintenance, and other services. We generally recognize consulting and other service revenues, including non-recurring engineering and training, as services are performed. Where consulting services are performed under a fixed-price arrangement, we generally recognize revenues on a percentage-of-completion basis. Maintenance services include both updates and technical support. Maintenance revenues are recognized ratably over the term of the maintenance agreement. The fees for maintenance arrangements range between 15% and 25% of the cumulative license fees and activation royalties incurred under the contract, depending upon the level of support being provided.

Service revenues also include reimbursable expenses billed to customers in accordance with EITF No. 01-14, “Income Statement Characterization of Reimbursements Received for ‘Out-of-Pocket’ Expenses Incurred,” which generally requires that a company recognize travel expenses and other reimbursable expenses billed to customers as revenue. With the adoption of EITF No. 01-14, we recognize reimbursable expenses as service revenues when there is an agreement to bill the customer for the expenses, the expenses have been incurred and billed, and collection is probable.

Restructuring Costs

As of January 1, 2003, we adopted SFAS No.146, “Accounting for Exit or Disposal Activities,” which addresses accounting for and reporting costs associated with exit or disposal activities and nullifies EITF No. 94-03 for restructuring activities initiated after December 31, 2002. For restructuring activities initiated prior to December 31, 2002, we continue to record restructuring costs in accordance with EITF No. 94-03, “Liability Recognition of Certain Employee Termination Benefits and Other Costs Incurred in a Restructuring,” and SAB No. 100, “Restructuring and Impairment Charges.” Severance costs include severance pay and employee benefit obligations to terminated employees. Our executive management approves the scope of any reductions in force. Other costs related to restructuring include the write-down of intangible assets and amounts expected to be paid in connection with terminated contracts.

Computation of Basic and Diluted Net Loss Per Share

Basic net loss per share is computed using the weighted average number of shares of common stock outstanding during the periods presented. Calculation of fully diluted shares is required when reporting net income per share and includes the weighted average number of shares of common stock, stock options, stock units and warrants outstanding. As we have recorded a net loss for all periods presented, the net loss per share on a diluted basis is equivalent to basic net loss per share because the effect of including all outstanding stock options, stock units and warrants in the earnings per share calculation would be anti-dilutive. Accordingly, we excluded from the calculation of net loss per share total potential dilutive common shares of 12,141,417 and 12,315,680, related to stock options, stock units and warrants, for the periods ended November 30, 2004 and November 30, 2003, respectively.

Recent Accounting Pronouncements

In December 2004, the FASB issued SFAS 123R, “Share-Based Payment.” SFAS 123R requires companies to expense the value of employee stock options and similar awards. It addresses the accounting for share-based payment transactions with employees. The fair value of the share-based payment will be expensed on the date that the company grants the awards to employees. The expense would be recognized over the vesting period for each option and adjusted for actual forfeitures that occur before vesting.  Although we do not expect to grant any options, the company is currently assessing the impact SFAS 123R will have on our financial statements.

Note 3. Discontinued Operations

In August 2002, we acquired the outstanding capital stock of Sigma Systems Group (Canada) (“Sigma Systems”). In accordance with SFAS No. 142, “Goodwill and Other Intangibles,” we determined that

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Sigma Systems had two reporting units, OSS and Bill-Care. Subsequently, in May 2003, we sold Bill-Care to a company owned by certain former shareholders of Sigma Systems, for the consideration of $1.0 million in cash, resulting in a loss of $177,000, which was recorded in the fourth quarter of fiscal 2003. In November 2003, we completed the sale of the OSS division and its assets to Sigma Software Solutions Inc. and affiliated entities. The price included $3.6 million in cash and the assumption of $7.4 million of lease obligations and other liabilities. In connection with the sale of the OSS division, we received a total of $7.1 million in cash, which consisted of the cash proceeds of $3.6 million and the return of escrow funds of $3.5 million, and we recorded a gain on the sale of discontinued operations of $9.0 million in the second quarter of fiscal 2004.

Computation of the gain on sale of the OSS division is as follows (in thousands):

Pursuant to the provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” amounts in the financial statements and related notes have been reclassified to reflect the discounted operations of both Bill-Care and OSS. Operating results for the discontinued operations are reported, net of tax, under “Loss from discontinued operations” on the condensed consolidated statement of operations. There was no impact of discontinued operations on the balance sheets as of November 30, 2004 and May 31, 2004. For the three month period ended November 30, 2004, there was no gain or loss recorded related to discontinued operations. For the six month period ended November 30, 2004, there was a gain recorded of $80,000 due to an unanticipated cash receipt related to the discontinued operations.

The following table reflects the impact of discontinued operations on certain statement of operations data for the three and six months ended November 30, 2003 (in thousands except per share information).

Note 4. Excess Facilities Charges and Related Asset Impairment

Our excess facilities charges consist primarily of costs associated with permanently vacating our facilities and the related asset impairments. In determining the charges for excess facilities, we were required to estimate future sublease income, future net operating expenses of the facilities, and other expenses. The most significant of these estimates relates to the timing and extent of future sublease income which reduces our reported lease obligations.  We based our estimates of sublease income on current market conditions and rental rates provided by an independent real estate consultant, an assessment of the

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time period over which reasonable estimates could be made, the status of negotiations with potential subtenants, and the location of the facility, among other factors.  Adjustments to the facilities accrual will be required if actual lease exit costs or sublease income differ from amounts currently expected. We review the status of activities on a quarterly basis and, if appropriate, record changes to our excess facilities obligations in current operations based on management’s most current estimates.

The liability for excess facilities as of May 31, 2004 did not include charges for additional space vacated in Q4 FY04 or potential savings related to the anticipated rejection of this lease under the U.S. Bankruptcy Code due to the uncertainty of the outcome of the bankruptcy proceeding. On September 8, 2004, the Bankruptcy Court issued a ruling dismissing our bankruptcy case. Pursuant to the dismissal of the bankruptcy case, which removed the uncertainty that existed at May 31, 2004, we recorded $4.4 million of excess facilities charges in Q1 FY05 based on revised estimates related to future sublease income and the additional space vacated in Q4 FY04. The $4.4 million excess facility charge consists of a $5.1 million charge related to additional space vacated in Q4 FY04, which was accounted for in accordance with SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities,” partially offset by an increase in estimates of sublease income of $640,000. In Q2 FY05 we recorded $1.2 million of excess facilities charges primarily related to lease payments made during the quarter, after the dismissal of the bankruptcy case, and an amendment of sublease income estimates (in accordance with SFAS 146). As of November 30, 2004 the total liability for excess facilities included in the condensed consolidated balance sheet was $26.1 million, which consisted of a long-term liability of $20.0 million and a short term liability of $6.1 million. We recorded $593,000 in excess facilities charges and related asset impairment expense for the three and six months ended November 30, 2003.

Note 5. Commitments and Contingencies

Operating Leases

We currently have various operating leases for our facilities, including our former offices in San Carlos, and certain office equipment that expire at various dates through fiscal 2009 and thereafter. Future minimum lease payments under these operating leases, including our former facilities in San Carlos, as of November 30, 2004 are as follows (in thousands):

Letters of Credit

We maintain various irrevocable letters of credit and bank guarantees as security deposits for the following facilities: our current headquarters in San Mateo, California, our former headquarters in San Carlos, California and our former U.K. offices. As of November 30, 2004, the aggregate outstanding balance of all letters of credit and bank guarantees was $10.3 million, of which $8.8 million was related to the letter of credit for our former headquarters in San Carlos, California. We vacated the San Carlos facility in March 2004 and ceased rent payment effective April 1, 2004. Our former landlord has since drawn against the letter of credit for the unpaid rent, net of sublease income from the facility, in the amount of $4.9 million, through November 30, 2004. The former landlord may draw up to the entire amount of the letter of credit in the event that Liberate does not make the payments required under the lease.

Employment Agreements

In March and April 2003, we entered into employee retention agreements with David Lockwood, Patrick Nguyen, Gregory Wood and Philip Vachon. Under the terms of the retention agreements, in the event of a change of control of Liberate that is followed within one year by the officer’s actual or

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constructive termination, the officer will receive a payment equal to twice his total taxable compensation for the prior fiscal year, with a minimum payment of $500,000 and a maximum payment of $750,000. We have other retention agreements with a small number of non-executive employees.

As part of our standard compensation package, certain employees and managers are eligible to participate in a variety of discretionary and non-discretionary bonus plans or commission plans. We accrue bonus and commission expense ratably over the fiscal year, based on expected payouts against those plans.

Indemnification Obligations

In November 2002, the FASB issued FIN 45 “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 requires that a guarantor recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee or indemnification. FIN 45 also requires additional disclosure by a guarantor in its interim and annual financial statements about its obligations under certain guarantees and indemnifications. The initial recognition and measurement provisions of FIN 45 are applicable for guarantees issued or modified after December 31, 2002. The disclosure requirements of FIN 45 are effective for financial statements of interim or annual periods ending after December 15, 2002. We adopted the recognition and measurement provisions of FIN 45 prospectively to guarantees issued or modified after December 31, 2002. The adoption of this standard did not have a material impact on our consolidated results of operations or financial position.

Our software license agreements typically provide for indemnification of customers for intellectual property infringement claims. To date, no material indemnification claims have been filed against us. We also warrant to customers that software products operate substantially in accordance with specifications. Historically, minimal costs have been incurred related to product warranties, and accordingly, we have not accrued warranty costs. In addition, we are obligated to indemnify our officers and directors under the terms of indemnity agreements entered into with them, as well as pursuant to our certificate of incorporation, bylaws, and applicable Delaware law. We are unable to quantify the charge that could result from officer and director indemnification.

Legal Matters

Restatement Class-Action Litigation.  On October 20, 2004, a Stipulation and Agreement of Settlement (the “Settlement”) was filed with the United States District Court for the Northern District of California in connection with the matter “In re Liberate Technologies Securities Litigation” (the “Class Action”).  The Class Action is based on the restatement of our financial statements for certain periods of fiscal 2002 and the revision of our preliminary financial results announced for the first quarter of fiscal 2003 (the “Restatement”).  The parties to the Settlement are: (i) the lead plaintiff in the Class Action, on behalf of himself and each of the class members; and (ii) defendants Liberate Technologies, Mitchell E. Kertzman, Nancy J. Hilker and Coleman Sisson.  Under the terms of the Settlement, Liberate agreed to pay or cause to be paid $13.8 million in settlement of the claims specified in the Class Action, and the lead plaintiff and each class member agreed to release Liberate and the other defendants from those claims.  The Settlement shall in no way be construed or deemed to be evidence of or an admission or concession on the part of Liberate or the other specified defendants with respect to any claim or any fault or liability or wrongdoing or damage whatsoever, or any infirmity in the defenses that the defendants have asserted.

The Settlement is subject to certain conditions and will be effective only if and when, among other things, the parties obtain final approval from the United States District Court for the Northern District of California following a settlement hearing currently scheduled for February 2005. If the proposed settlement does not become effective, the Class Action will continue, and possible resolution of this proceeding could include judgments against us or settlements that could require substantial payments by us, which could harm our financial condition, results of operations, or cash flows.

Termination of SEC Investigation.  On September 29, 2004, the staff of the SEC informed Liberate that the staff’s investigation into the events and circumstances that led to the Restatement has terminated as to Liberate and that the staff recommended no enforcement action against Liberate.  In

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February 2003, Liberate disclosed that the SEC had initiated a formal, non-public investigation to determine whether there had been any violations of the federal securities laws or regulations.  While the SEC staff’s investigation has terminated as to Liberate, the SEC announced that it has filed charges against two former Liberate employees for violations of the federal securities laws. The SEC also announced that one of these individuals has reached a settlement of the charges against him. Liberate terminated the employment of the two former officers in December 2002 and January 2003. 

Dismissal of Bankruptcy Case.  On April 30, 2004, Liberate filed a voluntary petition for reorganization under Chapter 11 of the United States Bankruptcy Code. The landlord of Liberate’s former headquarters in San Carlos, California filed a motion to dismiss the case, and on September 8, 2004, the bankruptcy court issued a ruling dismissing Liberate’s bankruptcy case. The bankruptcy court ruled that Liberate had cash well in excess of its liabilities and did not need bankruptcy protection to avoid wasteful liquidation of its assets. Liberate has appealed this ruling in the United States District Court for the Northern District of California and briefs on appeal have been submitted.  However, Liberate continues to await a decision and cannot predict the outcome or timing of the appellate process.  Unless the decision of the bankruptcy court is reversed on appeal, Liberate will not be able to realize savings or the other benefits of a Chapter 11 proceeding. 

Restatement Derivative Litigation.  On November 3, 2004, a Notice of Settlement in Principle (the “Notice”) was filed with the California Superior Court for the County of San Mateo in connection with the matter “In re Liberate Technologies Derivative Litigation” (the “Derivative Action”).  The Notice disclosed that Liberate has reached an agreement in principle to settle the Derivative Action on terms that, among other things, will provide for the dismissal with prejudice of all claims asserted by plaintiffs.  The agreement in principle to settle the Derivative Action is subject to the execution of a definitive stipulation of settlement and approval of such settlement stipulation by the California Superior Court for the County of San Mateo.  The Derivative Action is based on the Restatement and names Liberate as a nominal party and certain of our former officers and current or former directors as defendants (collectively, the “Derivative Defendants”). The Derivative Action generally alleges that the Derivative Defendants failed to adequately oversee our financial reporting, and thus are liable for breach of their fiduciary duties, abuse of control, gross mismanagement, and waste of corporate assets. The Derivative Action also alleges that the Derivative Defendants are liable for unjust enrichment and that certain named officers and directors are liable for violations of California Code Section 25402 and breach of fiduciary duty for insider selling and misappropriation of information. The Derivative Action seeks unspecified monetary damages and other relief.

Lease-Related Litigation.  On September 29, 2004, Circle Star Center Associates, L.P., the landlord of Liberate’s former offices in San Carlos, California, filed a complaint in the California Superior Court for the County of San Mateo alleging that Liberate had breached the office lease by, among other things, failing to pay rent for certain months of 2004 and applicable interest, failing to replenish the letter of credit and failing to reimburse the landlord for its attorneys’ fees in connection with Liberate’s bankruptcy proceeding.  The complaint also includes allegations of conversion and defamation.  The complaint seeks damages of approximately $3.9 million for the alleged breach and conversion and unspecified damages for the alleged defamation. In November 2004, Liberate filed motions challenging the legal basis for the landlord’s cause of action for defamation and claim for attorneys’ fees in connection with Liberate’s bankruptcy. Briefing has been completed on these motions, and the Superior Court heard oral argument on December 27, 2004. The matter is currently under submission.

In addition, on December 16, 2004, the landlord filed a further complaint for breach of lease against Liberate. The complaint seeks damages in the amount of not less than approximately $1.2 million, plus prejudgment interest, costs of suit and attorneys’ fees, alleging that Liberate breached the lease by failing to pay rent in November and December 2004.

While Liberate intends to vigorously defend these lawsuits, because litigation is by its nature uncertain, we are unable to predict the outcome or estimate the potential liability, if any, of this litigation.

Underwriting Litigation.  Beginning on May 16, 2001, a number of class-action lawsuits seeking monetary damages were filed in the United States District Court for the Southern District of New York

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against several of the firms that underwrote our initial public offering, naming Liberate and certain of our former officers and current or former directors as co-defendants. The suits allege that the underwriters received excessive and improper commissions that were not disclosed in our prospectus and that the underwriters artificially increased the price of our stock. The plaintiffs subsequently added allegations regarding our secondary offering, and named additional officers and directors as co-defendants. The suits were consolidated into one action that was coordinated for pretrial purposes with hundreds of virtually identical suits under a case captioned “In re Initial Public Offering Securities Litigation”, Civil Action No. 21-MC-92.  On February 19, 2003, the court denied in part and granted in part a motion to dismiss filed on behalf of the defendants, including Liberate.  The court’s order did not dismiss any claims against Liberate.  As a result, discovery may proceed.  The individual defendants have been dismissed without prejudice in this litigation. 

While we deny allegations of wrongdoing, we have agreed to enter into a global issuer settlement of plaintiffs’ claims.  In June 2004, a stipulation of settlement and release of claims against the issuer defendants, including Liberate, was submitted for preliminary approval by the court.  Under the settlement, the plaintiffs would dismiss and release all claims against the participating defendants, including Liberate, in exchange for a contingent payment undertaking by the insurance companies collectively responsible for insuring the issuer defendants in the coordinated action, and assignment or surrender to the plaintiffs of certain claims the issuer defendants may have against the underwriters.  Pursuant to the undertaking, the insurers would be required to pay the amount, if any, by which $1 billion exceeds the total amount ultimately collected by the plaintiffs from the non-settling defendants in the coordinated action.  The settlement is subject to a number of conditions, including certification of a class for settlement purposes and court approval.

We cannot predict the timing or ultimate outcome of this proposed settlement or estimate the amounts of, or potential range of loss with respect to, this litigation if a settlement is not approved. 

OpenTV Patent Litigation.  On February 7, 2002, OpenTV filed a lawsuit against Liberate in the United States District Court for the Northern District of California, alleging that Liberate is infringing two of OpenTV’s patents and seeking monetary damages and injunctive relief. We have filed an answer denying OpenTV’s allegations. Our counter-claim alleges that OpenTV infringes one of our patents for information retrieval systems. We are seeking to have OpenTV’s patents invalidated, requesting a finding that our technology does not infringe OpenTV’s patents, and seeking monetary damages and injunctive relief against OpenTV. The court has issued a claim construction ruling, but a trial date is not currently set. While we intend to vigorously defend this lawsuit and are confident in our technology and intellectual property, because litigation is by its nature uncertain, we are unable to predict the outcome of this litigation and whether we may face any material exposure for damages or the need to alter our software arising from this case. 

The cost of participating and defending against these actions is substantial and will require the continued diversion of management’s attention and corporate resources.  Because legal actions are inherently uncertain, we cannot predict or determine the outcome or resolution of these actions or estimate the amounts of, or potential range of, loss with respect to these proceedings. In addition, the timing of the final resolution of these proceedings is uncertain. The possible resolutions of these proceedings could include judgments against us or settlements that could require substantial payments by us, which could have a material adverse impact on our business, financial position, results of operations and cash flows.

We have notified our various insurance carriers of the Class Action, Derivative Action and other pending legal matters. Our primary carrier and one of our secondary carriers under our existing policies have disputed whether certain costs incurred in connection with the restatement-related litigation and the SEC investigation are covered under their respective policies. Our insurance may not cover all or portions of our defense costs, any settlement, any judgment rendered against us, or amounts we are required to pay to any indemnified person in connection with the Class Action or Derivative Action or any expenses incurred in connection with the SEC investigation or any other matter.

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Loss Contingencies

Of the $19.0 million of accrued liabilities on our condensed consolidated balance sheet approximately $6.6 million have been accrued to satisfy Liberate’s anticipated obligations resulting from settlement of the Class Action and the Derivative Action, after taking into account expected insurance proceeds. We have not accrued any amounts in connection with the Lease-Related Litigation, the OpenTV Litigation or the Underwriting Litigation (in the event that the proposed settlement is not approved). Management believes we have meritorious defenses to these claims and intends to defend these actions vigorously. However, we are unable to predict the outcome or resolution of these actions or estimate the amounts of, or potential range of, loss with respect to these actions.

Note 6. Offerings of Common Stock

Common Stock

In Q2 FY05 there were no exercises of stock options, and 24,264 stock units became vested (of which 4,467 vested units were withheld to satisfy employee withholding taxes, resulting in a net issuance of 19,797 shares to employees and non-employee directors). In the six months ended November 30, 2004, we issued 7,332 shares of common stock to employees upon the exercise of stock options and 337,879 stock units became vested (of which 108,058 vested units were withheld to satisfy employee withholding taxes, resulting in a net issuance of 229,821 shares to employees and non-employee directors). 

In Q2 FY04 and the six months ended November 30, 2003, we issued 863,758 shares of common stock to employees upon the exercise of stock options, 4,166 shares of common stock upon the vesting and settlement of stock units, and 103,000 shares of common stock to an executive officer.

Warrant Agreements

In fiscal 1999, we agreed to issue warrants to purchase up to 4,599,992 shares of our stock to certain network operators who satisfied specific milestones within specific time frames. We estimated the fair market value of the warrants using the Black-Scholes pricing model as of the earlier of the date the warrants were earned or the date that it became likely that they would be earned. Pursuant to the requirements of EITF No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services,” we will revalue the warrants if appropriate.

As of November 30, 2004, network operators had earned warrants to purchase 2,396,660 shares. Of this amount, warrants to purchase 552,774 shares had previously been exercised, warrants to purchase 163,890 shares were retired in connection with those exercises and warrants to purchase 879,998 shares expired unexercised. As of November 30, 2004, there were earned and outstanding warrants to purchase 799,998 shares with exercise prices of $4.80 and $6.90 per share and a weighted average exercise price of $6.64 per share. All outstanding warrants will expire by May 31, 2005.

We record amortization expense for deferred costs related to warrants in accordance with EITF No. 01-09. Under EITF No. 01-09, warrant amortization expense may be classified as a reduction to associated revenues up to the amount of cumulative revenues recognized or to be recognized. Such amortization expense was classified as follows (in thousands):

Stock-based Compensation – Stock Units

During fiscal 2004, we implemented a program to grant restricted stock units (“RSUs”) to certain employees and non-employee directors as part of our overall stock-based compensation. Each RSU entitles

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the holder to receive one share of Liberate common stock on the vesting date of the RSU. The RSUs granted to employees generally vest over a period of four years while those granted to non-employee directors generally vest over 12 months. Stock-based compensation representing the intrinsic value (fair market value) of the underlying shares at the date of grant of the RSUs is recognized evenly over the vesting period. On the vesting dates, the RSUs are settled by the delivery of shares of common stock to the participants. During the three months ended November 30, 2004, we granted 50,768 RSUs to employees. During the quarter 162,126 RSUs were cancelled due to employee terminations. As of November 30, 2004 there was a balance of $7.4 million in deferred stock-based compensation related to RSUs in stockholder’s equity and there were 2,094,302 RSUs outstanding and unvested. See Note 2 for the total expenses by functional classification incurred for the three and six months ended November 30, 2004 pertaining to the amortization of RSUs.

Note 7. Restructuring Costs

Restructuring costs include severance costs and other costs. Severance costs include severance pay and employee benefit obligations in connection with terminated employees. Other costs include the write-down of intangible assets, disposal of fixed assets and amounts paid in connection with terminated contracts.

For the three and six months ended November 30, 2004, there was no restructuring activity. For the three and six months ended November 30, 2003, we recorded $881,000 and $1.4 million, respectively, of restructuring expense related to severance payments for the termination of employees.

As of November 30, 2004, our restructuring liability was $37,000,  relating to severance payments.

Note 8. Segment Reporting and Geographic Information

We operate in one segment—providing digital infrastructure software and services for cable networks. We derive revenues for this one segment from licenses, royalties, and services, and our long-term assets are located primarily in the United States.

We classify our revenues by geographic region based on the country in which the sales order originates. Our North American region includes sales attributable to the United States and Canada. Our EMEA region includes sales attributable to Europe, the Middle East, and Africa. Our Asia Pacific region includes sales attributable to Asia (other than the Middle East) and Australia. The following table details the revenues from significant countries and regions (in thousands):

(1)   For all periods shown, warrant-related reductions of revenue are included. For the three and six months ended November 30, 2003, for Canada, the reductions exceeded the revenues, which resulted in negative revenues for those periods. The warrant-related reductions for Canada were $119,000 and $462,000, respectively for the three and six months ended November 30, 2003. For the six months ended November 30, 2003, the warrant-related reductions for the United States was $1.8 million.

International revenues consist of sales to customers outside of the United States and domestic revenues consist of sales to customers within the United States. International and domestic revenues as a percentage of our total revenues were as follows:

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(1)   For all periods shown, warrant-related reductions of revenue are included. For the six months ended November 30, 2003 the warrant-related reduction to domestic revenues was $1.8 million, which exceeded domestic revenues for that period.

Note 9. Subsequent Events

Insurance Coverage Litigation

On December 29, 2004, Federal Insurance Company, one of Liberate’s insurance carriers, filed a complaint for declaratory judgment, alleging that Liberate and other defendants are not entitled to coverage for costs and losses incurred in connection with the Class Action, Derivative Action, SEC investigation or other matters.  The complaint, filed in the U.S. District Court for the Northern District of California, names as defendants Liberate and certain former officers and current and former directors.  The policy at issue in this litigation has a limit of liability of $5 million.  Liberate intends to vigorously prosecute its rights under the policy.  However, litigation is by its nature uncertain and there can be no assurance that Liberate will be successful in securing coverage under this policy. 

Agreement for Sale of North American Business

On January 10, 2005, Liberate announced that it had reached agreement to sell substantially all of the assets of its North American business to Double C Technologies, LLC, a joint venture majority owned and controlled by Comcast Corporation with a minority investment by Cox Communications, Inc. Under the terms of the agreement, the joint venture will receive substantially all of the assets, including patents and other intellectual property, and will assume certain limited liabilities related to Liberate’s North American business.  Liberate will receive cash consideration of approximately $82 million. The parties will cross-license technology and intellectual property to one another following the closing for purposes of the continued conduct of their respective businesses.  As part of the transaction, the joint venture will make employment offers to approximately 130 employees, primarily located in London, Ontario, Canada. Liberate will retain its European business and will continue to service its European customers. In addition, concurrently with the effectiveness of the acquisition agreement, David Lockwood, the Chairman and CEO of Liberate Technologies, is entering into a voting agreement with the joint venture, under which he is agreeing to vote all shares of Liberate stock beneficially owned by him, comprising approximately 12% of the total outstanding shares of Liberate, in favor of the transaction. The agreement will not become effective until the dismissal of Liberate’s bankruptcy appeal, which Liberate has agreed to actively pursue. To that end, on January 10, 2005, Liberate is filing a motion in the U.S. District Court for the Northern District of California to dismiss the appeal of its bankruptcy case dismissal.  The agreement is also subject to Liberate shareholder approval, Hart-Scott-Rodino antitrust approval, and other customary closing conditions.

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

Overview

Liberate Technologies is a provider of software for digital cable television systems. Based on industry standards, our software enables cable operators to run multiple services—including interactive programming guides, high-definition television, video on demand, personal video recorders and games—on multiple platforms.

We operate in an industry sector that has experienced a significant downturn, and we believe that our future results of operations will continue to be subject to quarterly variations based upon a wide variety of factors as set forth in the “Risk Factors” below. Many of the companies operating in our industry have publicly reported decreased revenues and earnings, significant financial restructuring efforts and reduced capital expenditures, all of which affect their willingness to purchase our products and services.

The following discussion of the financial condition and results of operations of Liberate should be read in conjunction with the discussion contained in Liberate’s annual report on Form 10-K for the fiscal year ended May 31, 2004.  The discussion in this report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended.  All statements in this report, other than statements that are purely historical, are forward-looking statements.  Words such as “anticipates,” “expects,” “believes,” intends,” “plans,” “estimates” and similar expressions also identify forward-looking statements.  These forward-looking statements are not guarantees of future performance, and are subject to risks and uncertainties that could cause our actual results to differ materially from the results contemplated in the forward-looking statements.  Forward-looking statements in this report include, without limitation, those relating to future revenues, costs, expenses and other financial results, as well as future customer agreements or deployments, management strategies or the outcome of legal proceedings.

Risks and uncertainties that could cause actual results to differ materially include the emerging nature of our market, unknown revenue potential, a limited number of potential customers and the risks associated with legal proceedings, in addition to other risks identified below in “Risk Factors.”  Other factors and assumptions not identified above were also involved in the derivation of these forward-looking statements, and the failure of such other assumptions to be realized as well as other factors may also cause actual results to differ materially.  Most of these factors are difficult to predict accurately and are generally beyond our control.

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We assume no obligation to update any forward-looking statements, and we encourage you not to place undue reliance on forward-looking statements, which speak only as of the date of this report.  You are also encouraged to consider forward-looking statements in light of our condensed consolidated financial statements, related notes, and the cautionary statements and risk factors listed from time to time in our reports on Form 10-K, Form 10-Q and Form 8-K filed with the Securities and Exchange Commission (“SEC”).

New Subscription-based License Agreements

Beginning in fiscal 2004, we entered into agreements with several cable operators. These agreements provide for monthly subscription fees based on deployments of our software with cable customers. In some cases, we receive up-front fees at the inception of the license agreement. In addition, the agreements completed to date have provided for minimum periodic license fees for minimum subscriber levels. Pursuant to these agreements, we have invoiced our customers and amounts due have been paid.

To date, we have not recognized revenues under the agreements and all invoiced amounts of $8.1 million are included in deferred revenue on our balance sheet. We are in the process of assessing revenue recognition for these agreements, since the agreements provide for future delivery of products and specified annual updates of the product during the term of the agreements. While future annual product updates are contemplated and identified at the inception of the agreement, the details of the product releases will be discussed and agreed between us and the customers at future dates. During the quarter ended November 30, 2004, we collected $4.5 million non-refundable up-front fees and non-refundable monthly subscription fees from customers under these subscription license arrangements.

Dismissal of Bankruptcy Case

On April 30, 2004, Liberate filed a voluntary petition for reorganization under Chapter 11 of the United States Bankruptcy Code. The landlord of Liberate’s former headquarters in San Carlos, California filed a motion to dismiss the case, and on September 8, 2004, the bankruptcy court issued a ruling dismissing Liberate’s bankruptcy case.  The bankruptcy court ruled that Liberate had cash well in excess of its liabilities and did not need bankruptcy protection to avoid wasteful liquidation of its assets.  Liberate has appealed this ruling in the United States District Court for the Northern District of California and briefs on appeal have been submitted.  However, Liberate continues to await a decision and cannot predict the outcome or timing of the appellate process.  Unless the decision of the bankruptcy court is reversed on appeal, Liberate will not be able to realize savings or the other benefits of a Chapter 11 proceeding. 

Termination of SEC Investigation

On September 29, 2004, the staff of the SEC informed Liberate that the staff’s investigation into the events and circumstances that led to the Restatement has terminated as to Liberate and that the staff recommended no enforcement action against Liberate. While the SEC staff’s investigation has terminated as to Liberate, the SEC announced that it has filed charges against two former Liberate employees for violations of the federal securities laws. The SEC also announced that one of these individuals has reached a settlement of the charges against him. Liberate terminated the employment of the two former employees in December 2002 and January 2003.

Proposed Settlement of Class-Action Litigation

On October 20, 2004, a Stipulation and Agreement of Settlement (the “Settlement”) was filed with the United States District Court for the Northern District of California in connection with the matter “In re Liberate Technologies Securities Litigation” (the “Class Action”).  The Class Action is based on the restatement of our financial statements for certain periods of fiscal 2002 and the revision of our preliminary financial results announced for the first quarter of fiscal 2003 (the “Restatement”).  The parties to the Settlement are: (i) the lead plaintiff in the Class Action, on behalf of himself and each of the class members; and (ii) defendants Liberate Technologies, Mitchell E. Kertzman, Nancy J. Hilker and Coleman Sisson.  Under the terms of the Settlement, Liberate agreed to pay or cause to be paid $13.8 million in settlement of the claims specified in the Class Action, and the lead plaintiff and each class member agreed

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to release Liberate and the other defendants from those claims.  The Settlement shall in no way be construed or deemed to be evidence of or an admission or concession on the part of Liberate or the other specified defendants with respect to any claim or any fault or liability or wrongdoing or damage whatsoever, or any infirmity in the defenses that the defendants have asserted.

The Settlement is subject to certain conditions and will be effective only if and when, among other things, the parties obtain final approval from the United States District Court for the Northern District of California following a settlement hearing currently scheduled for February 2005. If the proposed settlement does not become effective, the Class Action will continue, and possible resolutions of this proceeding could include judgments against us or settlements that could require substantial payments by us, which could harm our financial condition, results of operations, or cash flows.

Critical Accounting Policies Update

There have been no material changes to our critical accounting policies as disclosed on our annual report on Form 10-K for the fiscal year ended May 31, 2004.

Results of Operations

Revenues

We generate license and royalty revenues by licensing our client and server software products, applications, and tools primarily to network operators that provide television services, and, in a small number of cases, to set-top box manufacturers. We generate service revenues from consulting, maintenance, and other services provided in connection with those licenses.

A portion of our revenues and of our deferred revenue balance as of November 30, 2004 arose from pre-payments we received in fiscal 1999 and 2000 from a limited number of North American network operators. In some cases, we recognized revenue upon termination of a customer’s right to credit these fees for software deployment or future services. Our revenues from these pre-payments (excluding any impact of warrant-related revenue reductions) were zero in Q2 FY05 and $113,000 in Q2 FY04. For the six months ended November 30, 2004 and November 30, 2003 revenues from these pre-payments were $275,000 and $134,000, respectively. We do not expect that our total revenues will equal or exceed prior levels until we receive significant new revenue commitments from existing or new customers.

Total revenues for the periods reported were as follows (in thousands):

International and domestic revenues as a percentage of our total revenues were as follows:

(1)   For all periods shown, warrant-related reductions of revenue are included, however for the six months ended November 30, 2003 the  reductions exceeded the revenues resulting in negative domestic revenues. The warrant-related reductions domestically were $1.8 million for the six months ended November 30, 2003.

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For the three months ended November 30, 2004 there was a shift in revenues from international to domestic. This was due to two major international customers that have transitioned from the up-front license model to the new monthly subscription model, under which we are not currently recognizing revenue. However, we anticipate international revenues will continue to represent a significant portion of total revenues.

License and Royalty Revenues. License and royalty revenues were as follows (in thousands):

License and royalty revenues increased from the three and six months ended November 30, 2003 to the three and six months ended November 30, 2004. This increase was primarily due to a revenue reserve of $1.2 million established in Q2 FY04 for a potential overpayment of royalties by one of the customers. The warrant-related reduction of revenue was higher in the three and six months ended November 30, 2003 by $119,000 and $484,000, respectively. In addition, two customers transitioned from the up-front license revenue model to the new monthly subscription revenues model (under which we have not taken any subscription revenues). These amounts are currently included in the deferred revenues on our condensed consolidated balance sheet. We expect license and royalty revenue will be less than recent historical levels unless and until we receive significant new revenue commitments from existing or new customers.

Service Revenues. Service revenues were as follows (in thousands):

Service revenues decreased significantly due to a decline in support revenue. Support revenue decreased by $996,000 from Q2 FY04 to Q2 FY05 and decreased by $2.7 million from the six months ended November 30, 2003 to the six months ended November 30, 2004. Revenues decreased because when two large customers transitioned to the new license agreements, we had fewer customers under traditional support agreements. Revenues from other services, which consist of training and consulting, increased by $233,000 from Q2 FY04 to Q2 FY05 and increased by $390,000 from the six months ended November 30, 2003 to the six months ended November 30, 2004. The increase is due to the completion of a services contract during the quarter ended November 30, 2004 and recognition of the revenue thereunder. We expect that service revenues will be less than historical levels unless we are able to obtain significant new customer commitments.

Cost of Revenues

Total cost of revenues was as follows (in thousands):

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Cost of License and Royalty Revenues. Cost of license and royalty revenues consists primarily of costs incurred for licenses and support of third-party technologies that are incorporated in our products. Cost of license and royalty revenues was as follows (in thousands):