Q3 10Q 2014


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
(Mark One)
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 30, 2014
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 0-23137
 
 RealNetworks, Inc.
 
 
(Exact name of registrant as specified in its charter)
 
Washington
 
91-1628146
(State of incorporation)
 
(I.R.S. Employer
Identification Number)
 
 
 
 
 
1501 First Avenue South, Suite 600
Seattle, Washington
 
98134
(Address of principal executive offices)
 
(Zip Code)
 
(206) 674-2700
 
 
(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  ý    No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ý    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
 
¨
  
Accelerated filer
ý
 
 
 
 
Non-accelerated filer
 
¨  (Do not check if a smaller reporting company)
  
Smaller reporting company
¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No   ý
The number of shares of the registrant’s Common Stock outstanding as of October 31, 2014 was 36,034,025.



TABLE OF CONTENTS
 
 
Page
 
 

2


PART I. FINANCIAL INFORMATION
Item 1.
Financial Statements
REALNETWORKS, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share data)
 
September 30,
2014
 
December 31,
2013
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
114,073

 
$
151,235

Short-term investments
63,948

 
74,920

Trade accounts receivable, net of allowances
17,679

 
24,613

Deferred costs, current portion
1,023

 
1,601

Deferred tax assets, net, current portion
296

 
306

Prepaid expenses and other current assets
8,382

 
9,124

Total current assets
205,401

 
261,799

Equipment, software, and leasehold improvements, at cost:
 
 
 
Equipment and software
83,230

 
86,721

Leasehold improvements
3,616

 
3,482

Total equipment, software, and leasehold improvements, at cost
86,846

 
90,203

Less accumulated depreciation and amortization
68,392

 
67,031

Net equipment, software, and leasehold improvements
18,454

 
23,172

Restricted cash equivalents and investments
3,000

 
3,000

Equity method investment
10,000

 
12,473

Available for sale securities
2,848

 
7,181

Other assets
2,925

 
2,332

Deferred costs, non-current portion
913

 
946

Deferred tax assets, net, non-current portion
1,424

 
1,409

Other intangible assets, net
10,954

 
12,993

Goodwill
17,615

 
17,476

Total assets
$
273,534

 
$
342,781

LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
18,155

 
$
19,987

Accrued and other current liabilities
25,885

 
41,893

Deferred tax liabilities, net, current portion
768

 
899

Deferred revenue, current portion
6,908

 
7,498

Total current liabilities
51,716

 
70,277

Deferred revenue, non-current portion
143

 
166

Deferred rent
1,293

 
1,318

Deferred tax liabilities, net, non-current portion
1,805

 
1,556

Other long-term liabilities
563

 
483

Total liabilities
55,520

 
73,800

Commitments and contingencies

 

Shareholders’ equity:
 
 
 
Preferred stock, $0.001 par value, no shares issued and outstanding:
 
 
 
Series A: authorized 200 shares
—

 
—

Undesignated series: authorized 59,800 shares
—

 
—

Common stock, $0.001 par value authorized 250,000 shares; issued and outstanding 36,034 shares in 2014 and 35,833 shares in 2013
36

 
36

Additional paid-in capital
616,260

 
610,167

Accumulated other comprehensive loss
(53,778
)
 
(47,695
)
Retained deficit
(344,504
)
 
(293,527
)
Total shareholders’ equity
218,014

 
268,981

Total liabilities and shareholders’ equity
$
273,534

 
$
342,781

See accompanying notes to unaudited condensed consolidated financial statements.

3


REALNETWORKS, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE INCOME (LOSS)
(In thousands, except per share data)
 
Quarters Ended
September 30,
 
Nine Months Ended
September 30,
 
2014
 
2013
 
2014
 
2013
Net revenue (A)
$
34,157

 
$
48,958

 
$
120,706

 
$
155,601

Cost of revenue (B)
18,928

 
18,990

 
58,500

 
59,015

Extinguishment of liability (See Note 10)
—

 
—

 
(10,580
)
 
—

Gross profit
15,229

 
29,968

 
72,786

 
96,586

Operating expenses:
 
 
 
 
 
 
 
Research and development
12,784

 
15,707

 
40,110

 
45,951

Sales and marketing
13,283

 
19,427

 
51,022

 
59,830

General and administrative
7,723

 
9,869

 
25,617

 
28,506

Restructuring and other charges
2,048

 
1,877

 
3,805

 
4,075

Lease exit and related charges
154

 
—

 
703

 
3,066

Loss on legal settlements
—

 
11,525

 
—

 
11,525

Total operating expenses
35,992

 
58,405

 
121,257

 
152,953

Operating income (loss)
(20,763
)
 
(28,437
)
 
(48,471
)
 
(56,367
)
Other income (expenses):
 
 
 
 
 
 
 
Interest income, net
80

 
166

 
396

 
992

Gain (loss) on sale of available for sale securities, net
—

 
—

 
2,371

 
—

Equity in net loss of Rhapsody investment
(1,530
)
 
(2,629
)
 
(4,170
)
 
(6,209
)
Other income (expense), net
325

 
(118
)
 
153

 
(146
)
Total other income (expenses), net
(1,125
)
 
(2,581
)
 
(1,250
)
 
(5,363
)
Income (loss) before income taxes
(21,888
)
 
(31,018
)
 
(49,721
)
 
(61,730
)
Income tax expense (benefit)
290

 
357

 
1,256

 
(210
)
Net income (loss)
$
(22,178
)
 
$
(31,375
)
 
$
(50,977
)
 
$
(61,520
)
Basic net income (loss) per share
$
(0.62
)
 
$
(0.88
)
 
$
(1.42
)
 
$
(1.73
)
Diluted net income (loss) per share
$
(0.62
)
 
$
(0.88
)
 
$
(1.42
)
 
$
(1.73
)
Shares used to compute basic net income (loss) per share
36,003

 
35,670

 
35,912

 
35,490

Shares used to compute diluted net income (loss) per share
36,003

 
35,670

 
35,912

 
35,490

Comprehensive income (loss):
 
 
 
 
 
 
 
Unrealized investment holding gains (losses), net of reclassification adjustments
$
(323
)
 
$
(1,043
)
 
$
(3,936
)
 
$
(28
)
Foreign currency translation adjustments, net of reclassification adjustments
(2,338
)
 
1,235

 
(2,147
)
 
(391
)
Total other comprehensive income (loss)
(2,661
)
 
192

 
(6,083
)
 
(419
)
Net income (loss)
(22,178
)
 
(31,375
)
 
(50,977
)
 
(61,520
)
Comprehensive income (loss)
$
(24,839
)
 
$
(31,183
)
 
$
(57,060
)
 
$
(61,939
)
(A) Components of net revenue:
 
 
 
 
 
 
 
License fees
$
5,925

 
$
10,503

 
$
21,168

 
$
33,494

Service revenue
28,232

 
38,455

 
99,538

 
122,107

 
$
34,157

 
$
48,958

 
$
120,706

 
$
155,601

(B) Components of cost of revenue:
 
 
 
 
 
 
 
License fees
$
2,044

 
$
2,062

 
$
6,426

 
$
6,377

Service revenue
16,884

 
16,928

 
52,074

 
52,638

 
$
18,928

 
$
18,990

 
$
58,500

 
$
59,015

See accompanying notes to unaudited condensed consolidated financial statements.

4


REALNETWORKS, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
 
Nine Months Ended
September 30,
 
2014
 
2013
Cash flows from operating activities:
 
 
 
Net income (loss)
$
(50,977
)
 
$
(61,520
)
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
 
 
 
Depreciation and amortization
8,876

 
15,045

Stock-based compensation
4,158

 
5,671

Equity in net loss of Rhapsody
4,170

 
6,209

Deferred income taxes, net
(64
)
 
(1,238
)
Gain on sale of available for sale securities
(2,371
)
 
—

Realized translation gain
(48
)
 
(35
)
Extinguishment of liability
(10,580
)
 
—

Other
—

 
51

Net change in certain operating assets and liabilities:
 
 
 
Trade accounts receivable
6,553

 
6,466

Prepaid expenses and other assets
1,353

 
4,772

Accounts payable
(1,606
)
 
26

Accrued and other liabilities
(5,106
)
 
(3,750
)
Net cash provided by (used in) operating activities
(45,642
)
 
(28,303
)
Cash flows from investing activities:
 
 
 
Purchases of equipment, software, and leasehold improvements
(2,054
)
 
(5,798
)
Proceeds from sale of available for sale securities
2,754

 
—

Purchases of short-term investments
(63,574
)
 
(85,670
)
Proceeds from sales and maturities of short-term investments
74,546

 
110,359

Decrease (increase) in restricted cash equivalents and investments, net
—

 
5,000

Acquisitions of businesses, net of cash acquired
(733
)
 
(22,480
)
Other
(467
)
 
—

Net cash provided by (used in) investing activities
10,472

 
1,411

Cash flows from financing activities:
 
 
 
Proceeds from issuance of common stock (stock options and stock purchase plan)
641

 
408

Tax payments from shares withheld upon vesting of restricted stock
(403
)
 
(911
)
Payment of contingent consideration
(696
)
 
(828
)
Net cash provided by (used in) financing activities
(458
)
 
(1,331
)
Effect of exchange rate changes on cash and cash equivalents
(1,534
)
 
(96
)
Net increase (decrease) in cash and cash equivalents
(37,162
)
 
(28,319
)
Cash and cash equivalents, beginning of period
151,235

 
163,198

Cash and cash equivalents, end of period
$
114,073

 
$
134,879

Supplemental disclosure of cash flow information:
 
 
 
Cash received from income tax refunds
$
292

 
$
8,354

Cash paid for income taxes
$
1,457

 
$
2,988

Non-cash investing activities:
 
 
 
Increase (decrease) in accrued purchases of equipment, software, and leasehold improvements
$
(371
)
 
$
1,096

See accompanying notes to unaudited condensed consolidated financial statements.


5


REALNETWORKS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Quarters and Nine Months Ended September 30, 2014 and 2013
Note 1. Description of Business and Summary of Significant Accounting Policies
Description of Business. RealNetworks, Inc. and subsidiaries is a leading global provider of network-delivered digital media applications and services that make it easy to manage, play and share digital media. The Company also develops and markets software products and services that enable the creation, distribution and consumption of digital media, including audio and video.
Inherent in our business are various risks and uncertainties, including a limited history of certain of our product and service offerings. RealNetworks' success will depend on the acceptance of our technology, products and services and the ability to generate related revenue.
In this Quarterly Report on Form 10-Q (10-Q or Report), RealNetworks, Inc. and Subsidiaries is referred to as “RealNetworks”, the “Company”, “we”, “us”, or “our”. “RealPlayer”, “LISTEN” and other trademarks of ours appearing in this report are our property.       
Basis of Presentation. The unaudited condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. Intercompany balances and transactions have been eliminated in consolidation.
The unaudited condensed consolidated financial statements reflect all adjustments, consisting only of normal, recurring adjustments that, in the opinion of the Company’s management, are necessary for a fair presentation of the results of operations for the periods presented. Operating results for the quarter and nine months ended September 30, 2014 are not necessarily indicative of the results that may be expected for any subsequent period or for the year ending December 31, 2014. Certain information and disclosures normally included in financial statements prepared in conformity with accounting principles generally accepted in the United States of America (GAAP) have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission (SEC).
These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2013 (the 10-K).
Use of Estimates. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, 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 those estimates. In addition, current economic conditions may require the use of additional estimates, and certain estimates we make are subject to a greater degree of uncertainty as a result of the current economic conditions.
Note 2. Recent Accounting Pronouncements
        
In August 2014, the Financial Accounting Standards Board (FASB) issued a new standard, "Disclosure of Uncertainties About an Entity's Ability to Continue as a Going Concern". This standard provides guidance around management's responsibility to evaluate whether there is substantial doubt about an entity's ability to continue as a going concern and to provide related footnote disclosures. The new guidance is effective for all annual and interim periods ending after December 15, 2016. We do not expect the adoption of this standard to have a material effect on our consolidated financial statements.
In May 2014, the FASB issued new revenue recognition guidance. The guidance will require an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The new guidance will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. The new guidance is effective for us on January 1, 2017. Early application is not permitted. The guidance permits the use of either the retrospective or cumulative effect transition method. We are evaluating the effect that the guidance will have on our consolidated financial statements and related disclosures. We have not yet selected a transition method nor determined the effect of the standard on our ongoing financial reporting.     
In April 2014, the FASB issued new guidance related to discontinued operations. The guidance changes the criteria for reporting discontinued operations and modifies the related disclosure requirements. Under the new guidance, a discontinued operation is defined as a disposal of a component or group of components that represents a strategic shift that has, or will have, a major effect on an entity's operations and financial results.  The new guidance is effective for us on January 1, 2016. We are evaluating the impact that this guidance may have on our consolidated financial statements and related disclosures.

6


There have been no other recent accounting pronouncements or changes in accounting pronouncements to be implemented that are of significance or potential significance to RealNetworks.
Note 3. Acquisitions
In the quarter ended June 30, 2013, we acquired 100% of the voting interests in Slingo, Inc., a social casino games company based in the U.S., for total cash consideration of $15.6 million. The tangible and intangible assets and liabilities recognized are reported within the Games segment. The identifiable intangible assets associated with the acquisition totaled $8.0 million. Of this total, $4.5 million was related to tradenames and trademarks determined to have indefinite useful lives and will be evaluated annually in our fourth quarter for impairment, or more frequently, if circumstances indicate an impairment may exist. The remaining $3.5 million includes developed game technology and existing customer relationships with finite lives, and is being amortized over their useful lives. We recorded a net deferred tax liability of $2.7 million related to the intangible assets acquired. Goodwill totaling $9.9 million was recorded, representing the excess of purchase consideration over the fair value of net acquired assets, and was primarily related to the assembled workforce and expected synergies in the rapidly growing social casino games market. The goodwill is not deductible for income tax purposes. We expect this acquisition to enhance our footprint in the social casino games arena.
In the quarter ended September 30, 2013, we acquired 100% of the voting interests in Muzicall Limited, a ringback tone company based in London, for total cash consideration of $6.7 million. The tangible and intangible assets and liabilities recognized are reported in the Mobile Entertainment segment. The identifiable intangible assets associated with the acquisition totaled $5.4 million, and include tradenames and trademarks, developed technology, user base and carrier relationships. All identifiable intangible assets from this acquisition have finite lives, and are being amortized over their useful lives. We recorded a net deferred tax asset of $3.4 million related to the assets acquired, and a full valuation allowance. Goodwill totaling $1.3 million was recorded, representing the excess of purchase consideration over the fair value of net acquired assets acquired, and was primarily related to the assembled workforce and expected synergies in the ringback tone industry. The goodwill is not deductible for income tax purposes. This acquisition is intended to accelerate our growth initiatives within the Mobile Entertainment segment.
Note 4. Stock-Based Compensation
Total stock-based compensation expense recognized in our consolidated statements of operations includes amounts related to stock options, restricted stock units, and employee stock purchase plans and was as follows (in thousands):
 
 
Quarters Ended
September 30,
 
Nine Months Ended
September 30,
 
2014
 
2013
 
2014
 
2013
Total stock-based compensation expense
$
1,148

 
$
1,613

 
$
4,158

 
$
5,671

The fair value of options granted determined using the Black-Scholes model used the following weighted-average assumptions:
 
 
Quarters Ended
September 30,
 
Nine Months Ended
September 30,
 
2014
 
2013
 
2014
 
2013
Expected dividend yield
0
%
 
0
%
 
0
%
 
0
%
Risk-free interest rate
1.30
%
 
0.96
%
 
1.20
%
 
0.82
%
Expected life (years)
4.5

 
3.8

 
3.9

 
4.0

Volatility
42
%
 
48
%
 
40
%
 
48
%

The total stock-based compensation amounts for 2014 and 2013 disclosed above are recorded in their respective line items within operating expenses in the consolidated statement of operations. As of September 30, 2014, we had $12.1 million of total unrecognized compensation cost, net of estimated forfeitures, related to stock awards. The unrecognized compensation cost is expected to be recognized over a weighted-average period of approximately 3 years.
Note 5. Rhapsody Joint Venture
As of September 30, 2014 we owned approximately 45% of the issued and outstanding stock of Rhapsody and account for our investment using the equity method of accounting.

7


Rhapsody was initially formed in 2007 as a joint venture between RealNetworks and MTV Networks, a division of Viacom International Inc. (MTVN), to own and operate a business-to-consumer digital audio music service known as Rhapsody. Prior to March 31, 2010, we held a 51% interest in Rhapsody and MTVN owned the remaining 49%. On March 31, 2010, restructuring transactions involving Rhapsody were completed, and as a result, effective March 31, 2010 RealNetworks owned approximately 47% of Rhapsody. Subsequent to the restructuring transaction, we have accounted for our investment in Rhapsody using the equity method of accounting.
As part of the 2010 restructuring transactions, RealNetworks contributed $18.0 million in cash, the Rhapsody brand and certain other assets, including content licenses, in exchange for shares of convertible preferred stock of Rhapsody, carrying a $10.0 million preference upon certain liquidation events.
Subsequent to the 2010 restructuring transactions, RealNetworks provided certain operational transition services to Rhapsody. These transition services were completed in 2013, and RealNetworks has no further obligations or liabilities pursuant to the support services agreement.
We recorded our share of losses of Rhapsody of $1.5 million and $4.2 million for the quarter and nine months ended September 30, 2014, respectively. Because of the $10.0 million liquidation preference on the preferred stock we hold in Rhapsody, under the equity method of accounting we do not record any share of Rhapsody losses that would reduce our carrying value of Rhapsody, which is impacted by Rhapsody equity transactions, below $10.0 million, unless Rhapsody's book value is reduced below $10.0 million. The carrying value of our Rhapsody investment was $12.5 million as of December 31, 2013 and as of September 30, 2014 was $10.0 million.
Our share of the losses of Rhapsody for the quarter and nine months ended September 30, 2013 were $2.6 million and $6.2 million, respectively.
Summarized financial information for Rhapsody, which represents 100% of their financial information (in thousands):
 
 
Quarters Ended
September 30,
 
Nine Months Ended
September 30,
 
2014
 
2013
 
2014
 
2013
Net revenue
$
44,148

 
$
35,190

 
$
128,578

 
$
103,831

Gross profit
7,739

 
7,800

 
24,730

 
24,412

Net loss
(7,965
)
 
(5,621
)
 
(14,312
)
 
(14,812
)
Note 6. Fair Value Measurements
Items Measured at Fair Value on a Recurring Basis
The following table presents information about our financial assets that have been measured at fair value on a recurring basis as of September 30, 2014 and December 31, 2013, and indicates the fair value hierarchy of the valuation inputs utilized to determine such fair value (in thousands).

 
Fair Value Measurements as of
 
Amortized Cost as of
 
September 30, 2014
 
September 30, 2014
 
Level 1
 
Level 2
 
Level 3
 
Total
 
 
Cash and cash equivalents:
 
 
 
 
 
 
 
 
 
Cash
$
28,213

 
$
—

 
$
—

 
$
28,213

 
$
28,213

Money market funds
—

 
5,092

 
—

 
5,092

 
5,092

Corporate notes and bonds
—

 
80,768

 
—

 
80,768

 
80,768

Total cash and cash equivalents
28,213

 
85,860

 
—

 
114,073

 
114,073

Short-term investments:
 
 
 
 
 
 
 
 
 
Corporate notes and bonds
—

 
53,246

 
—

 
53,246

 
53,195

U.S. government agency securities
10,702

 
—

 
—

 
10,702

 
10,701

Total short-term investments
10,702

 
53,246

 
—

 
63,948

 
63,896

Restricted cash equivalents and investments
—

 
3,000

 
—

 
3,000

 
3,000

Equity investment in publicly traded securities
2,848

 
—

 
—

 
2,848

 
428

Total
$
41,763

 
$
142,106

 
$
—

 
$
183,869

 
$
181,397


8



 
Fair Value Measurements as of
 
Amortized Cost as of
 
December 31, 2013
 
December 31, 2013
 
Level 1
 
Level 2
 
Level 3
 
Total
 
 
Cash and cash equivalents:
 
 
 
 
 
 
 
 
 
Cash
$
46,978

 
$
—

 
$
—

 
$
46,978

 
$
46,978

Money market funds
1

 
26,913

 
—

 
26,914

 
26,914

Corporate notes and bonds
—

 
77,043

 
—

 
77,043

 
77,044

U.S. government agency securities
—

 
300

 
—

 
300

 
300

Total cash and cash equivalents
46,979

 
104,256

 
—

 
151,235

 
151,236

Short-term investments:
 
 
 
 
 
 
 
 
 
Corporate notes and bonds
—

 
59,766

 
—

 
59,766

 
59,713

U.S. government agency securities
14,077

 
1,077

 
—

 
15,154

 
15,159

Total short-term investments
14,077

 
60,843

 
—

 
74,920

 
74,872

Restricted cash equivalents and investments
—

 
3,000

 
—

 
3,000

 
3,000

Equity investment in publicly traded securities
7,181

 
—

 
—

 
7,181

 
842

Total
$
68,237

 
$
168,099

 
$
—

 
$
236,336

 
$
229,950


Restricted cash equivalents and investments amounts as of September 30, 2014, and December 31, 2013 relate to cash pledged as collateral against a letter of credit in connection with a lease agreement.
Realized gains or losses on sales of short-term investment securities for the quarters and nine months ended September 30, 2014 and 2013 were not significant. Gross unrealized gains and gross unrealized losses on short-term investment securities as of September 30, 2014 and December 31, 2013 were not significant.
Investments with remaining contractual maturities of five years or less are classified as short-term because the investments are marketable and highly liquid, and we have the ability to utilize them for current operations. Contractual maturities of short-term investments as of September 30, 2014 (in thousands):
 
 
Estimated
Fair Value
Within one year
$
47,671

Between one year and five years
16,277

Total short-term investments
$
63,948

Our equity investment in a publicly traded company as of September 30, 2014 and December 31, 2013 consisted of J-Stream Inc., a Japanese media services company. This equity investment is accounted for as available for sale. In March 2014 we sold a portion of the J-Stream shares we held, resulting in cash proceeds of $2.8 million and a pre-tax gain of $2.4 million.
Items Measured at Fair Value on a Non-recurring Basis
Certain of our assets and liabilities are measured at estimated fair value on a non-recurring basis, using Level 3 inputs. These instruments are subject to fair value adjustments only in certain circumstances (for example, when there is evidence of impairment). During the nine months ended September 30, 2014 and 2013, we did not record any impairments on those assets required to be measured at fair value on a non-recurring basis.
Note 7. Allowance for Doubtful Accounts Receivable and Sales Returns
Activity in the allowance for doubtful accounts receivable and sales returns (in thousands):
 

9


 
Allowance For
 
Doubtful
Accounts
Receivable
 
Sales
Returns
Balances, December 31, 2013
$
966

 
$
569

Addition (reduction) to allowance
403

 
(185
)
Amounts written off
—

 
(5
)
Foreign currency translation
(54
)
 
(1
)
Balances, September 30, 2014
$
1,315

 
$
378

One customer accounted for 17% of trade accounts receivable and one other customer accounted for 14% of trade accounts receivable, as of September 30, 2014. One customer accounted for 17% of trade accounts receivable as of December 31, 2013.
One customer accounted for 24% and 20% of consolidated revenue, or $8.2 million and $24.6 million, during the quarter and nine months ended September 30, 2014, and is reflected in our Mobile Entertainment segment. One customer accounted for approximately 12% and 14% of consolidated revenue, or $6.0 million and $21.1 million, during the quarter and nine months ended September 30, 2013, and is reflected in our RealPlayer Group and Games segments. One additional customer accounted for approximately 14%, or $6.8 million, and 11% or $17.3 million, of consolidated revenue during the quarter and nine months ended September 30, 2013, respectively, and is reflected in our Mobile Entertainment segment.
Note 8. Other Intangible Assets
Other intangible assets (in thousands):
 
 
 
 
September 30, 2014
 
December 31, 2013
 
 
 
Gross
Amount
 
Accumulated
Amortization
 
Net
 
Gross
Amount
 
Accumulated
Amortization
 
Net
Amortizing intangible assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
Customer relationships
 
$
34,876

 
$
32,372

 
$
2,504

 
$
35,156

 
$
31,262

 
$
3,894

 
Developed technology
 
28,871

 
25,922

 
2,949

 
29,097

 
25,039

 
4,058

 
Patents, trademarks and tradenames
 
3,945

 
3,624

 
321

 
4,021

 
3,627

 
394

 
Service contracts
 
6,426

 
5,746

 
680

 
5,679

 
5,532

 
147

 
 
 
74,118

 
67,664

 
6,454

 
73,953

 
65,460

 
8,493

Non-amortizing intangible assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
Trademarks and tradenames
 
4,500

 
—

 
4,500

 
4,500

 
—

 
4,500

 
Total
 
$
78,618

 
$
67,664

 
$
10,954

 
$
78,453

 
$
65,460

 
$
12,993


In the second quarter of 2014 a small acquisition of a business related to our RealPlayer Group resulted in an intangible asset of $0.8 million being recorded.

No impairments of other intangible assets were recognized in either of the nine months ended September 30, 2014 or 2013.
Note 9. Goodwill
Changes in goodwill (in thousands):
 
Balance, December 31, 2013
$
17,476

Increases due to current year acquisitions
460

Effects of foreign currency translation
(321
)
Balance, September 30, 2014
$
17,615


Goodwill by segment (in thousands):
 

10


 
September 30,
2014
RealPlayer Group
$
1,003

Mobile Entertainment
2,073

Games
14,539

Total goodwill
$
17,615


In the second quarter of 2014 a small acquisition of a business related to our RealPlayer Group resulted in goodwill of $0.5 million being recorded.

No impairment of goodwill was recognized in either of the nine months ended September 30, 2014 or 2013.

Note 10. Accrued and Other Current Liabilities
Accrued and other current liabilities (in thousands):
 
 
September 30, 2014
 
December 31, 2013
Royalties and other fulfillment costs
$
4,537

 
$
16,467

Employee compensation, commissions and benefits
8,086

 
10,060

Sales, VAT and other taxes payable
6,644

 
7,237

Other
6,618

 
8,129

Total accrued and other current liabilities
$
25,885

 
$
41,893

During the quarter ended March 31, 2014, certain accrued royalty liabilities of $10.6 million associated with our historical music business, which had originally been recorded based on statutory rates, were extinguished.
Note 11. Restructuring Charges
Restructuring and other charges in 2014 and 2013 consist of costs associated with the ongoing reorganization of our business operations and our ongoing expense alignment efforts. The expense amounts in both years relate primarily to severance costs due to workforce reductions.
In the latter half of 2012, we announced the elimination of approximately 160 positions worldwide, which was concluded as of the second quarter of 2013. During 2013 and 2014, we have incurred restructuring charges consisting of costs associated with the reorganization of our business operations and our ongoing expense alignment efforts. These costs are reflected in the table below.
Restructuring charges by type of cost (in thousands):
 
Employee Separation Costs
Asset Related and Other Costs
Total
Costs incurred and charged to expense for the nine months ended September 30, 2014
$
3,805

—

$
3,805

Costs incurred and charged to expense for the nine months ended September 30, 2013
$
2,891

1,184

$
4,075


Changes to the accrued restructuring cost liability (in thousands):

11


 
Employee Separation Costs
Accrued liability as of December 31, 2013
$
756

Costs incurred and charged to expense for the nine months ended September 30, 2014
3,805

Cash payments
(3,626
)
Accrued liability at September 30, 2014 (included in Accrued and other current liabilities)
$
935


Note 12. Lease Exit and Related Charges
As a result of the reduction in use of RealNetworks' office space, losses have been recognized representing rent and contractual operating expenses over the remaining life of the leases.
Changes to accrued lease exit and related charges (in thousands):
 
Accrued loss as of December 31, 2013
$
254

Additions and adjustments to the lease exit charges accrual, including sublease income estimate revision
480

Less amounts paid, net of sublease amounts
(611
)
Accrued loss as of September 30, 2014 (included in Accrued and other current liabilities)
$
123

Note 13.
Shareholders’ Equity
Accumulated Other Comprehensive Income (Loss)

Changes in components of accumulated other comprehensive income (in thousands):

 
 
 
Quarters Ended
September 30,
 
Nine Months Ended
September 30,
 
 
 
2014
 
2013
 
2014
 
2013
Investments
 
 
 
 
 
 
 
 
 
Accumulated other comprehensive income (loss), beginning of period
 
$
2,784

 
$
27,700

 
$
6,397

 
26,685

 
Unrealized gains (losses), net of tax effects of $0, $587, $0 and $(129)
 
(323
)
 
(1,043
)
 
(1,565
)
 
(28
)
 
Reclassification adjustments for losses (gains) included in other income (expense), net of tax effects of $0, $0, $(4) and $0
 
—

 
—

 
(2,371
)
 
—

 
Net current period other comprehensive income
 
(323
)
 
(1,043
)
 
(3,936
)
 
(28
)
 
Accumulated other comprehensive income (loss) balance, end of period
 
$
2,461

 
$
26,657

 
$
2,461

 
$
26,657

Foreign currency translation
 
 
 
 
 
 
 
 
 
Accumulated other comprehensive income (loss), beginning of period
 
$
(53,901
)
 
$
(54,851
)
 
$
(54,092
)
 
$
(53,225
)
 
Translation adjustments
 
(2,338
)
 
1,235

 
(2,099
)
 
(356
)
 
Reclassification adjustments for losses (gains) included in other income (expense)
 
—

 
—

 
(48
)
 
(35
)
 
Net current period other comprehensive income
 
(2,338
)
 
1,235

 
(2,147
)
 
(391
)
 
Accumulated other comprehensive income (loss) balance, end of period
 
$
(56,239
)
 
$
(53,616
)
 
$
(56,239
)
 
$
(53,616
)
Total accumulated other comprehensive income (loss), end of period
 
$
(53,778
)
 
$
(26,959
)
 
$
(53,778
)
 
$
(26,959
)

Note 14. Income Taxes

12


As of September 30, 2014, there have been no material changes to RealNetworks’ uncertain tax positions disclosures as provided in Note 14 of the 2013 10-K. We currently anticipate the expiration of the statute of limitations within the next twelve months that may decrease the Company's total unrecognized tax benefit by an amount up to $0.9 million of which $0.4 million could potentially impact tax expense.
We file numerous consolidated and separate income tax returns in the U.S including federal, state and local, as well as foreign jurisdictions. With few exceptions, we are no longer subject to U.S federal income tax examinations for tax years before 2008 or state, local, or foreign income tax examinations for years before 1993. We are currently under audit by various states and foreign jurisdictions for certain tax years subsequent to 1993. We are currently under United States federal audit for the consolidated group (RealNetworks, Inc. and Subsidiaries) for the year ended December 31, 2012.
Note 15. Earnings (Loss) Per Share
Basic net income (loss) per share (EPS) is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted EPS is computed by dividing net income (loss) by the weighted average number of common and dilutive potential common shares outstanding during the period. Basic and diluted EPS (in thousands, except per share amounts):
 
 
Quarters Ended
September 30,
 
Nine Months Ended
September 30,
 
2014
 
2013
 
2014
 
2013
Net income (loss)
$
(22,178
)
 
$
(31,375
)
 
$
(50,977
)
 
$
(61,520
)
Weighted average common shares outstanding used to compute basic EPS
36,003

 
35,670

 
35,912

 
35,490

Dilutive effect of stock based awards
—

 
—

 
—

 
—

Weighted average common shares outstanding used to compute diluted EPS
36,003

 
35,670


35,912


35,490

Basic EPS
$
(0.62
)
 
$
(0.88
)
 
$
(1.42
)
 
$
(1.73
)
Diluted EPS
$
(0.62
)
 
$
(0.88
)
 
$
(1.42
)
 
$
(1.73
)
During the quarter and nine months ended September 30, 2014, 6.3 million and 6.2 million shares of common stock, respectively, of potentially issuable shares from stock awards were excluded from the calculation of diluted EPS because of their antidilutive effect.
During the quarter and nine months ended September 30, 2013, 4.6 million and 4.4 million shares of common stock, respectively, of potentially issuable shares from stock awards were excluded from the calculation of diluted EPS because of their antidilutive effect.
Note 16. Commitments and Contingencies
We may become subject to legal proceedings, governmental investigations and claims in the ordinary course of business, including employment claims, contract-related claims, and claims of alleged infringement of third-party patents, trademarks and other intellectual property rights. Such claims, even if not meritorious, could force us to expend significant financial and managerial resources. In addition, given the broad distribution of some of our consumer products, any individual claim related to those products could give rise to liabilities that may be material to us. In the event of a determination adverse to us, we may incur substantial monetary liability, and/or be required to change our business practices. Either of these could have a material adverse effect on our consolidated financial statements.  
Note 17. Guarantees
In the ordinary course of business, RealNetworks is subject to potential obligations for standard warranty and indemnification provisions that are contained within many of our customer license and service agreements. Our warranty provisions are consistent with those prevalent in our industry, and we do not have a history of incurring losses on warranties; therefore, we do not maintain accruals for warranty-related obligations. With regard to indemnification provisions, nearly all of our carrier contracts obligate us to indemnify our carrier customers for certain liabilities that may be incurred by them. We have received in the past, and may receive in the future, claims for indemnification from carrier customers.
In relation to the patents and other technology assets we sold to Intel in the second quarter of 2012, we have specific obligations to indemnify Intel for breaches of the representations and warranties that we made and covenants that we agreed to

13


in the asset purchase agreement for certain potential future intellectual property infringement claims brought by third parties against Intel. The amount of any potential liabilities related to our indemnification obligations to Intel will not be determined until a claim has been made, but we are obligated to indemnify Intel up to the amount of the gross purchase price that we received in the sale.  
Note 18. Segment Information
We have three reportable segments: (1) RealPlayer Group, which includes sales of our RealPlayer media player software and related products, such as the distribution of third party software products, advertising on RealPlayer websites, and sales of RealPlayer Plus software licenses to consumers, sales of intellectual property licenses, and consumer subscriptions such as SuperPass and our RealPlayer Cloud service; (2) Mobile Entertainment, which includes our SaaS services, our LISTEN product, and sales of technology licenses of our software products such as Helix; and (3) Games, which includes all our games-related businesses, including sales of games licenses, online games subscription services, advertising on games sites and social network sites, microtransactions from online and social games, and sales of mobile games.
We allocate certain corporate expenses which are directly attributable to supporting the business to our reportable segments. These corporate expenses include but are not limited to a portion of finance, legal, human resources and headquarters facilities. Remaining expenses, which are not directly attributable to supporting the business, are reported as corporate items. All restructuring, lease exit and related charges, and loss on litigation settlements are included in the corporate segment.
RealNetworks reports three reportable segments based on factors such as how we manage our operations and how our Chief Operating Decision Maker reviews results. Our Chief Operating Decision Maker is considered to be the CEO Staff (CEOS), which includes the Chief Executive Officer, Chief Financial Officer, our Presidents, and General Counsel. The CEOS reviews financial information presented on both a consolidated basis and on a business segment basis. The accounting policies used to derive segment results are the same as those described in Note 1, Description of Business and Summary of Significant Accounting Policies, in the 10-K.
Segment results for the quarters and nine months ended September 30, 2014 and 2013 (in thousands):
RealPlayer Group
 
 
Quarters Ended
September 30,
 
Nine Months Ended
September 30,
 
2014
 
2013
 
2014
 
2013
Revenue
$
6,565

 
$
17,641

 
$
30,336

 
$
58,407

Cost of revenue
3,566

 
3,264

 
10,704

 
12,984

Gross profit
2,999

 
14,377

 
19,632

 
45,423

Operating expenses
12,392

 
14,449

 
42,668

 
44,656

Operating income (loss)
$
(9,393
)
 
$
(72
)
 
$
(23,036
)
 
$
767



Mobile Entertainment
 
 
Quarters Ended
September 30,
 
Nine Months Ended
September 30,
 
2014
 
2013
 
2014
 
2013
Revenue
$
19,190

 
$
19,948

 
$
62,285

 
$
59,035

Cost of revenue
12,626

 
11,972

 
38,874

 
33,974

Gross profit
6,564

 
7,976

 
23,411

 
25,061

Operating expenses
7,086

 
9,453

 
26,126

 
26,976

Operating income (loss)
$
(522
)
 
$
(1,477
)
 
$
(2,715
)
 
$
(1,915
)


Games
 

14


 
Quarters Ended
September 30,
 
Nine Months Ended
September 30,
 
2014
 
2013
 
2014
 
2013
Revenue
$
8,402

 
$
11,369

 
$
28,085

 
$
38,159

Cost of revenue
2,573

 
3,216

 
8,419

 
10,397

Gross profit
5,829

 
8,153

 
19,666

 
27,762

Operating expenses
8,658

 
11,513

 
27,193

 
35,120

Operating income (loss)
$
(2,829
)
 
$
(3,360
)
 
$
(7,527
)
 
$
(7,358
)


Corporate
 
 
Quarters Ended
September 30,
 
Nine Months Ended
September 30,
 
2014
 
2013
 
2014
 
2013
Cost of revenue
$
163

 
$
538

 
$
503

 
$
1,660

Extinguishment of liability
—

 
—

 
(10,580
)
 
—

Operating expenses
7,856

 
22,990

 
25,270

 
46,201

Operating income (loss)
$
(8,019
)
 
$
(23,528
)
 
$
(15,193
)
 
$
(47,861
)
Our customers consist primarily of consumers and corporations located in the U.S., Europe, Republic of Korea and various foreign countries (Rest of the world). Revenue by geographic region (in thousands):
 
 
Quarters Ended
September 30,
 
Nine Months Ended
September 30,
 
2014
 
2013
 
2014
 
2013
United States
$
12,280

 
$
21,039

 
$
47,800

 
$
70,525

Europe
5,749

 
8,750

 
21,129

 
29,278

Republic of Korea
9,728

 
11,839

 
31,114

 
32,062

Rest of the world
6,400

 
7,330

 
20,663

 
23,736

Total net revenue
$
34,157

 
$
48,958

 
$
120,706

 
$
155,601

Long-lived assets (consists of equipment, software, leasehold improvements, other intangible assets, and goodwill) by geographic region (in thousands):
 
 
September 30,
2014
 
December 31,
2013
United States
$
35,375

 
$
40,347

Europe
7,352

 
8,280

Republic of Korea
655

 
936

Rest of the world
3,641

 
4,078

Total long-lived assets
$
47,023

 
$
53,641


Note 19. Related Party Transactions
Transactions with Rhapsody. See Note 5, Rhapsody Joint Venture, for details on the 2010 restructuring transaction involving Rhapsody. Subsequent to the restructuring transaction, we were obligated to provide Rhapsody with certain support services. These support services, which included information technology and limited operational support provided directly to Rhapsody, were completed in 2013. RealNetworks has no further obligations or liabilities pursuant to the support services agreement.

15



Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
This Quarterly Report on Form 10-Q and the documents incorporated herein by reference contain forward-looking statements that have been made pursuant to the provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on current expectations, estimates, and projections about RealNetworks’ industry, products, management’s beliefs, and certain assumptions made by management. Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” and similar expressions are intended to identify forward-looking statements. All statements contained in this report that do not relate to matters of historical fact should be considered forward-looking statements. Forward-looking statements include statements with respect to:
•
the expected benefits and other consequences of our growth plans, strategic initiatives, and restructurings;
•
our expected introduction, and related monetization, of new and enhanced products, services and technologies across our businesses;
•
future revenues, operating expenses, income and other taxes, tax benefits, net income (loss) per diluted share available to common shareholders, acquisition costs and related amortization, and other measures of results of operations;
•
the effects of our past acquisitions and expectations for future acquisitions and divestitures;
•
plans, strategies and expected opportunities for future growth, increased profitability and innovation;
•
the expected financial position, performance, growth and profitability of, and investment in, our businesses and the availability of resources;
•
the effects of legislation, regulations, administrative proceedings, court rulings, settlement negotiations and other factors that may impact our businesses;
•
the continuation and expected nature of certain customer relationships;
•
impacts of competition and certain customer relationships on the future financial performance and growth of our businesses;
•
our involvement in potential claims, legal proceedings and government investigations, and the potential outcomes and effects of such potential claims, legal proceedings and governmental investigations on our business, prospects, financial condition or results of operations;
•
the effects of U.S. and foreign income and other taxes on our business, prospects, financial condition or results of operations; and
•
the effect of economic and market conditions on our business, prospects, financial condition or results of operations.
These statements are not guarantees of future performance and actual actions or results may differ materially. These statements are subject to certain risks, uncertainties and assumptions that are difficult to predict, including those noted in the documents incorporated herein by reference. Particular attention should also be paid to the cautionary language in Item 1A of Part II entitled “Risk Factors.” RealNetworks undertakes no obligation to update publicly any forward-looking statements as a result of new information, future events or otherwise, unless required by law. Readers should, however, carefully review the risk factors included in other reports or documents filed by RealNetworks from time to time with the Securities and Exchange Commission, particularly the Quarterly Reports on Form 10-Q and any Current Reports on Form 8-K.
Overview
RealNetworks creates innovative products and services that make it easy to connect with and enjoy digital media. We invented the streaming media category in 1995 and continue to connect consumers with their digital media both directly and through partners, aiming to support every network, device, media type and social network.
We manage our business and report revenue and operating income (loss) in three segments: (1) RealPlayer Group, (2) Mobile Entertainment, and (3) Games. Within our RealPlayer Group, revenue is derived from the sale of our RealPlayer media player software and related products, such as the distribution of third party software products, advertising on RealPlayer websites, and sales of RealPlayer Plus software licenses to consumers, sales of intellectual property licenses, and consumer subscriptions such as SuperPass and our RealPlayer Cloud service. Our Mobile Entertainment business generates revenue from the sale of its SaaS services, which include ringback tones, music on demand, intercarrier messaging, and our LISTEN product, and sales of technology licenses of our software products such as Helix. Our Games business, through its Slingo, GameHouse and Zylom brands, derives revenue from sales of games licenses, online games subscription services, advertising on games sites and social networks, microtransactions within online and social games, and sales of mobile games.
We allocate certain corporate expenses which are directly attributable to supporting our businesses, including but not limited to a portion of finance, legal, human resources and headquarters facilities, to our reportable segments. The allocation of these costs to our business units ensures accountability for financial and operational performance within each of our reportable segments. Our most significant expenses relate to cost of revenue, compensating employees, and selling and marketing our products and services.

16


For the quarter and nine months ended September 30, 2014, our consolidated revenue declined by $14.8 million and $34.9 million, respectively, compared to the same periods in 2013. The decline in revenue for the quarter in our RealPlayer Group was $11.1 million, $3.0 million in Games and $0.8 million in Mobile Entertainment. For the year to date period, the decline was primarily due to a decline of $28.1 million in our RealPlayer Group and a decline of $10.1 million in Games. For the year to date period, revenue increased by $3.3 million in Mobile Entertainment.
Revenue from our legacy products continues to decline as a result of certain changes in our businesses and market-driven factors. In our RealPlayer Group segment, revenue suffered from pricing pressure and lower distribution in our intellectual property licensing business as well as lower rates, distribution and installations from transitioning to a new partner in our third party software distribution business. Moreover, as we focus more of our distribution and marketing efforts on our new RealPlayer Cloud service, sales of RealPlayer Plus licenses are declining, resulting in reduced revenue. The business also continues to be negatively impacted by a decline in subscribers, attributable solely to our SuperPass product. These changes have also negatively impacted gross margins in the RealPlayer Group, as described in more detail in Segment Operating Results below. In our Games segment, our business continues to be challenged in line with overall trends in the online games market, including the shift from downloadable PC games to social networks and mobile devices. In our Mobile Entertainment segment, the revenue increase in the year-to-date period was related primarily to our music on demand services in Korea and our acquisition of Muzicall in the third quarter of 2013, which increased our direct-to-consumer ringback tones revenue. Partially offsetting these increases was a loss in revenue due to termination of carrier contracts.
Over the past several quarters we have developed a growth plan, implemented strategic initiatives, and executed certain restructuring efforts, all in an effort to grow our businesses, move towards profitability, and streamline our operations. In line with our growth plan, we continue to invest in each of our three business units. During the first half of 2014, we released RealPlayer Cloud worldwide. This global roll out allows us to reach our base of millions of active RealPlayer users around the world. In our Mobile Entertainment business we continue our efforts to roll out our new LISTEN product. LISTEN leverages our pioneering leadership in ringback tones, and our large, global installed base of over 18 million active ringback tone subscribers with more than 20 carriers worldwide, to create a hybrid distribution model that combines partnership with carriers with direct-to-consumer marketing. In our Games business, we launched Slingo Adventure worldwide on Facebook in mid-September and plan to launch the product on mobile platforms worldwide during the fourth quarter of 2014. We expect to continue to invest heavily in our growth initiatives, including further development and marketing efforts around our products. These investments have negatively impacted our recent operating results, which may continue until the expected revenue growth materializes.
During the quarter ended March 31, 2014 certain accrued royalty liabilities of $10.6 million associated with our historical music business, which had originally been recorded based on statutory rates, were extinguished.
Condensed consolidated results of operations were as follows (dollars in thousands):
 
 
Quarters ended September 30, 2014
 
Nine months ended September 30, 2014
 
2014
 
2013
 
$ Change
 
% Change
 
2014
 
2013
 
$ Change
 
% Change
Total revenue
$
34,157

 
$
48,958

 
$
(14,801
)
 
(30
)%
 
$
120,706

 
$
155,601

 
$
(34,895
)
 
(22
)%
Cost of revenue
18,928

 
18,990

 
(62
)
 
—
 %
 
58,500

 
59,015

 
(515
)
 
(1
)%
Extinguishment of liability
—

 
—

 
—

 
—
 %
 
(10,580
)
 
—

 
(10,580
)
 
(100
)%
Gross profit
15,229

 
29,968

 
(14,739
)
 
(49
)%
 
72,786

 
96,586

 
(23,800
)
 
(25
)%
Gross margin
45
%
 
61
%
 
 
 
 
 
60
%
 
62
%
 
 
 
 
Operating expenses
35,992

 
58,405

 
(22,413
)
 
(38
)%
 
121,257

 
152,953

 
(31,696
)
 
(21
)%
Operating income (loss)
$
(20,763
)
 
$
(28,437
)
 
$
7,674

 
27
 %
 
$
(48,471
)
 
$
(56,367
)
 
$
7,896

 
(14
)%
In the third quarter of 2014, our total consolidated revenue declined by $14.8 million, compared with the year-earlier period. The reduction in revenue resulted from a decline of $11.1 million in our RealPlayer Group segment, $3.0 million in our Games segment, and $0.8 million in Mobile Entertainment, due to the factors described above. Gross margin decreased to 45% from 61% during the quarter ended September 30, 2014, primarily related to our RealPlayer segment, as described in more detail in Segment Operating Results below. Operating expenses decreased by $22.4 million in the quarter ended September 30, 2014, compared with the prior year, primarily due to a litigation settlement of $11.5 million in the prior year, reduced marketing costs in 2014 of $4.6 million in line with the decrease in our third party distribution revenue and reductions in personnel and related costs of $2.4 million.

17


For the nine months ended September 30, 2014, our consolidated revenue declined by $34.9 million, compared with the year-earlier period. The reduction in revenue primarily resulted from a decline of $28.1 million in our RealPlayer Group and a decline of $10.1 million in our Games segment, due to the factors described above, partially offset by an increase in Mobile Entertainment revenue of $3.3 million primarily due to an increase in music on demand services in Korea. Gross margin decreased to 60% from 62% for the year-earlier period primarily due to a decline in higher margin revenue. Operating expenses decreased by $31.7 million in the nine months ended September 30, 2014, compared with the prior year, primarily due to a litigation settlement of $11.5 million in the prior year and reduced marketing costs in 2014 of $6.5 million and reductions in personnel and related costs of $7.4 million.

Segment Operating Results
RealPlayer Group
RealPlayer Group segment results of operations were as follows (dollars in thousands):
 
 
Quarters ended September 30, 2014
 
Nine months ended September 30, 2014
 
2014
 
2013
 
$ Change
 
% Change
 
2014
 
2013
 
$ Change
 
% Change
Revenue
$
6,565

 
$
17,641

 
$
(11,076
)
 
(63
)%
 
$
30,336

 
$
58,407

 
$
(28,071
)
 
(48
)%
Cost of revenue
3,566

 
3,264

 
302

 
9
 %
 
10,704

 
12,984

 
(2,280
)
 
(18
)%
Gross profit
2,999

 
14,377

 
(11,378
)
 
(79
)%
 
19,632

 
45,423

 
(25,791
)
 
(57
)%
Gross margin
46
%
 
81
%
 
 
 
 
 
65
%
 
78
%
 
 
 
 
Operating expenses
12,392

 
14,449

 
(2,057
)
 
(14
)%
 
42,668

 
44,656

 
(1,988
)
 
(4
)%
Operating income (loss)
$
(9,393
)
 
$
(72
)
 
$
(9,321
)
 
—
 %
 
$
(23,036
)
 
$
767

 
$
(23,803
)
 
—
 %

Total RealPlayer Group revenue decreased by $11.1 million in the quarter ended September 30, 2014, compared with the year-earlier period. This decrease was primarily a result of our transition to a new third party distribution partner, which resulted in lower rates, decreased distribution and decreased installations compared to our previous partner resulting in a decrease of $5.4 million in our third party distribution revenue. In addition, lower distribution of intellectual property licenses decreased revenue by $2.0 million. Further contributing to the decline was a decrease in RealPlayer Plus license revenue of $1.8 million due to our focus on increasing RealPlayer Cloud subscriptions.

Total RealPlayer Group revenue decreased by $28.1 million in the nine months ended September 30, 2014, compared with the year-earlier period. This decrease was primarily a result of reduced rates that caused a decrease in our third party distribution revenue by $11.2 million and lower subscriptions revenue of $4.7 million due to fewer subscribers, attributable solely to our SuperPass product. Further contributing to the decline was a decrease in RealPlayer license revenue of $5.3 million due to our focus on increasing RealPlayer Cloud subscriptions and a decrease of $4.7 million in distribution of intellectual property licenses.
Cost of revenue decreased by $2.3 million during the nine months ended September 30, 2014, compared with the year-earlier period. Costs related to our RealPlayer Plus licensing business decreased by $1.2 million due to lower license royalties. Costs related to our subscription business declined $1.0 million in connection with lower subscription revenue.
Gross margin during the quarter ended September 30, 2014 declined primarily as a result of our transition to a new third party distribution partner at significantly lower rates compared to our previous partner. Although gross margins will be lower on the revenue derived under our new third party distribution arrangement, we expect that our marketing costs related to this business will decline as well.
Operating expenses decreased by $2.1 million and $2.0 million, respectively, in the quarter and nine months ended September 30, 2014, compared with the year-earlier period primarily due to decreased marketing spend related to our third party distribution arrangements.
Mobile Entertainment
Mobile Entertainment segment results of operations were as follows (dollars in thousands): 

18


 
Quarters ended September 30, 2014
 
Nine months ended September 30, 2014
 
2014
 
2013
 
$ Change
 
% Change
 
2014
 
2013
 
$ Change
 
% Change
Revenue
$
19,190

 
$
19,948

 
$
(758
)
 
(4
)%
 
$
62,285

 
$
59,035

 
$
3,250

 
6
 %
Cost of revenue
12,626

 
11,972

 
654

 
5
 %
 
38,874

 
33,974

 
4,900

 
14
 %
Gross profit
6,564

 
7,976

 
(1,412
)
 
(18
)%
 
23,411

 
25,061

 
(1,650
)
 
(7
)%
Gross margin
34
%
 
40
%
 
 
 
 
 
38
%
 
42
%
 
 
 
 
Operating expenses
7,086

 
9,453

 
(2,367
)
 
(25
)%
 
26,126

 
26,976

 
(850
)
 
(3
)%
Operating income (loss)
$
(522
)
 
$
(1,477
)
 
$
955

 
65
 %
 
$
(2,715
)
 
$
(1,915
)
 
$
(800
)
 
(42
)%
Total Mobile Entertainment revenue decreased by $0.8 million in the quarter ended September 30, 2014, compared with the year-earlier period. A decrease of $2.2 million was primarily due to discounts in our ringback tones business, the termination of our carrier application services in Asia and a decrease in our direct to consumer business that was part of our Muzicall acquisition in 2013. Partially offsetting this decrease was an increase in music on demand revenue of $1.4 million in our Korea business.
Total Mobile Entertainment revenue increased by $3.3 million in the nine months ended September 30, 2014, compared with the year-earlier period. The increase was primarily due to an increase of $6.7 million in music on demand revenue in Korea and an increase of $1.7 million in our direct to consumer ringback tones business due to our Muzicall acquisition. Partially offsetting this increase was a decrease of $2.7 million due to termination of carrier contracts, in addition to slower growth in our ringback tones business of $0.7 million and $1.5 million related to the termination of our video on demand service in 2013.
Cost of revenue increased by $0.7 million and $4.9 million in the quarter and nine months ended September 30, 2014, respectively, compared with the year-earlier periods, primarily due to an increase in label royalties related to our music on demand services.     This is partially offset by a decrease of $0.5 million and $1.6 million in the quarter and nine months ended September 30, 2014, respectively, from our integrated music project.
Gross margin declined for the quarter and nine months ended September 30, 2014, due to a decline in higher margin revenues.
Operating expenses decreased by $2.4 million for the quarter ended September 30, 2014, compared with the year-earlier period, primarily due to savings of $1.1 million in marketing related expenses and a decrease of $0.8 million due to reductions in personnel and related costs.
Games
Games segment results of operations were as follows (dollars in thousands):
 
 
Quarters ended September 30, 2014
 
Nine months ended September 30, 2014
 
2014
 
2013
 
$ Change
 
% Change
 
2014
 
2013
 
$ Change
 
% Change
Revenue
$
8,402

 
$
11,369

 
$
(2,967
)
 
(26
)%
 
$
28,085

 
$
38,159

 
$
(10,074
)
 
(26
)%
Cost of revenue
2,573

 
3,216

 
(643
)
 
(20
)%
 
8,419

 
10,397

 
(1,978
)
 
(19
)%
Gross profit
5,829

 
8,153

 
(2,324
)
 
(29
)%
 
19,666

 
27,762

 
(8,096
)
 
(29
)%
Gross margin
69
%
 
72
%
 
 
 
 
 
70
%
 
73
%
 
 
 
 
Operating expenses
8,658

 
11,513

 
(2,855
)
 
(25
)%
 
27,193

 
35,120

 
(7,927
)
 
(23
)%
Operating income (loss)
$
(2,829
)
 
$
(3,360
)
 
$
531

 
16
 %
 
$
(7,527
)
 
$
(7,358
)
 
$
(169
)
 
(2
)%
Total Games revenue decreased by $3.0 million in the quarter ended September 30, 2014, compared with the year-earlier period. Lower revenue from our subscription products, licensing and advertising due to continued declines in our storefront and subscription businesses contributed $1.4 million, $0.4 million and $0.8 million, respectively, to the overall decrease.
Total Games revenue decreased by $10.1 million in the nine months ended September 30, 2014, compared with the year-earlier period. Lower revenue from our subscription products, licensing and advertising due to continued declines in our storefront and subscription businesses contributed $4.0 million, $2.5 million and $2.7 million, respectively, to the overall decrease.
Cost of revenue decreased by $0.6 million and $2.0 million in the quarter and nine months ended September 30, 2014, respectively, compared with the year-earlier period. The decreases were due to the decrease in partner royalties expense, which

19


has a direct correlation with the decrease in Games revenue. The decrease in cost of revenue was also due to a decline in our advertising business. Gross margin declined during the quarter and nine months ended September 30, 2014 to 69% from 72% and to 70% from 73%, respectively, due primarily to a higher proportion of lower margin revenue in the current year.
Operating expenses declined by $2.9 million in the quarter ended September 30, 2014, compared with the year-earlier period. The decrease was due to reductions in personnel and related costs of $1.1 million and reduced marketing spend of $1.4 million.
Operating expenses declined by $7.9 million in the nine months ended September 30, 2014, compared with the year-earlier period. The decrease was due to reductions in personnel and related costs of $2.4 million and reduced marketing spend of $3.7 million.
Corporate
We allocate certain corporate expenses which are directly attributable to supporting the business to our reportable segments. These allocated corporate expenses include but are not limited to a portion of finance, legal, human resources and headquarters facilities. Remaining expenses, which are not directly attributable to supporting the business, are reported as corporate items. All restructuring, and lease exit and related charges, are included in the corporate segment.

Corporate segment results of operations were as follows (dollars in thousands):
 
 
Quarters ended September 30, 2014
 
Nine months ended September 30, 2014
 
2014
 
2013
 
$ Change
 
% Change
 
2014
 
2013
 
$ Change
 
% Change
Cost of revenue
$
163

 
$
538

 
$
(375
)
 
(70
)%
 
$
503

 
$
1,660

 
$
(1,157
)
 
(70
)%
Extinguishment of liability
—

 
—

 
—

 
—
 %
 
(10,580
)
 
—

 
(10,580
)
 
(100
)%
Operating expenses
7,856

 
22,990

 
(15,134
)
 
(66
)%
 
25,270

 
46,201

 
(20,931
)
 
(45
)%
Operating income (loss)
$
(8,019
)
 
$
(23,528
)
 
$
15,509

 
66
 %
 
$
(15,193
)
 
$
(47,861
)
 
$
32,668

 
68
 %
During the quarter ended March 31, 2014 certain accrued royalty liabilities of $10.6 million associated with our historical music business, which had originally been recorded based on statutory rates, were extinguished.
Operating expenses decreased by $15.1 million in the quarter ended September 30, 2014 compared with the year-earlier period. The decrease was primarily due to a litigation settlement of $11.5 million in the prior year and $2.1 million in savings from the relocation of our Seattle headquarters.
Operating expenses decreased by $20.9 million in the nine months ended September 30, 2014, compared with the year-earlier period. The decrease was primarily due to a litigation settlement of $11.5 million in the prior year and $2.4 million of reduced expense for lease exit charges. An additional savings of $4.0 million resulted from the relocation of our Seattle headquarters.
Consolidated Operating Expenses
Our operating expenses consist primarily of salaries and related personnel costs including stock based compensation, consulting fees associated with product development, sales commissions, amortization of certain intangible assets capitalized in our acquisitions, professional service fees, advertising costs, and restructuring charges. Operating expenses were as follows (dollars in thousands):
 
 
Quarters ended September 30, 2014
 
Nine months ended September 30, 2014
 
2014
 
2013
 
$ Change
 
% Change
 
2014
 
2013
 
$ Change
 
% Change
Research and development
$
12,784

 
$
15,707

 
$
(2,923
)
 
(19
)%
 
$
40,110

 
$
45,951

 
$
(5,841
)
 
(13
)%
Sales and marketing
13,283

 
19,427

 
(6,144
)
 
(32
)%
 
51,022

 
59,830

 
(8,808
)
 
(15
)%
General and administrative
7,723

 
9,869

 
(2,146
)
 
(22
)%
 
25,617

 
28,506

 
(2,889
)
 
(10
)%
Restructuring and other charges
2,048

 
1,877

 
171

 
9
 %
 
3,805

 
4,075

 
(270
)
 
(7
)%
Lease exit and related charges
154

 
—

 
154

 
—

 
703

 
3,066

 
(2,363
)
 
(77
)%
Loss on litigation settlements
—

 
11,525

 
(11,525
)
 
100
 %
 
—

 
11,525

 
(11,525
)
 
100
 %
Total consolidated operating expenses
$
35,992

 
$
58,405

 
$
(22,413
)
 
(38
)%
 
$
121,257

 
$
152,953

 
$
(31,696
)
 
(21
)%

20


Research and development expenses decreased by $2.9 million and $5.8 million, respectively, in the quarter and nine months ended September 30, 2014, compared with the year-earlier period. The decrease was primarily due to savings resulting from the relocation of our Seattle headquarters of $1.5 million and $3.8 million, respectively.
Sales and marketing expenses decreased by $6.1 million in the quarter ended September 30, 2014, compared with the year-earlier period. The decrease was primarily due to reduced marketing spend of $4.6 million and $0.9 million in reduced personnel and related costs.
Sales and marketing expenses decreased by $8.8 million in the nine months ended September 30, 2014, compared with the year-earlier period. The decrease was primarily due to reduced marketing spend of $6.5 million and $1.5 million from the relocation of our Seattle headquarters.
General and administrative expenses decreased by $2.1 million in the quarter ended September 30, 2014, compared with the year-earlier period. The decrease was primarily due to higher legal fees related to litigation in the prior year and tax refunds.
General and administrative expenses decreased by $2.9 million in the nine months ended September 30, 2014, compared with the year-earlier period. The decrease was primarily due to $1.8 million in higher legal fees related to ligation in the prior year.
Restructuring and other charges and Lease exit and related charges consist of costs associated with the ongoing reorganization of our business operations and our ongoing expense alignment efforts. The restructuring expense amounts in both years primarily related to severance costs due to workforce reductions. For additional details on these charges see Note 11, Restructuring Charges and Note 12, Lease Exit and Related Charges.
Other Income (Expenses)
Other income (expenses), net was as follows (dollars in thousands):
 
 
Quarters ended September 30, 2014
 
Nine months ended September 30, 2014
 
2014
 
2013
 
$ Change
 
% Change
 
2014
 
2013
 
$ Change
 
% Change
Interest income, net
$
80

 
$
166

 
$
(86
)
 
(52
)%
 
$
396

 
$