FORM 10-Q

Commission File No. 0-27338

ATARI, INC.

(Exact name of registrant as specified in its charter)


DELAWARE		13-3689915
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)

417 FIFTH AVENUE, NEW YORK, NY 10016
(Address of principal executive offices) (Zip code)

(212) 726-6500
(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 þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o Accelerated filer o Non-accelerated filer x

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

As of November 16, 2007, there were 13,477,920 shares of the registrant’s Common Stock outstanding.

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

ATARI, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

(unaudited)


	March 31,			September 30,
	2007			2007
ASSETS
Current assets:
Cash	$	7,603		$	2,718
Receivables, net of allowances of $14,148 and $490 at March 31, 2007 and September 30, 2007, respectively		6,473			513
Inventories, net (Note 4)		8,843			6,211
Due from related parties (Note 6)		1,799			610
Prepaid expenses and other current assets (Note 4)		10,229			9,470
Assets of discontinued operations (Note 9)		645			395

Total current assets		35,592			19,917
Property and equipment, net of accumulated depreciation of $30,945 and $26,052 at March 31, 2007 and September 30, 2007, respectively		4,217			6,483
Security deposits		1,940			1,924
Other assets		1,070			966

Total assets	$	42,819		$	29,290


LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIENCY)
Current liabilities:
Accounts payable	$	11,013		$	10,606
Accrued liabilities (Note 4)		13,381			13,916
Royalties payable		4,282			6,591
Due to related parties (Note 6)		5,703			4,641

Total current liabilities		34,379			35,754
Due to related parties – long-term (Note 6)		1,912			3,021
Long-term deferred rent and related rental obligations		3,093			6,665
Other long-term liabilities		341			286

Total liabilities		39,725			45,726


Commitments and contingencies (Note 7)

Stockholders’ equity (deficiency):
Preferred stock, $0.01 par value, 5,000,000 shares authorized, none issued or outstanding		—			—
Common stock, $0.10 par value, 30,000,000 shares authorized, 13,477,920 shares issued and outstanding at March 31, 2007 and September 30, 2007		1,348			1,348
Additional paid-in capital		760,527			760,653
Accumulated deficit		(761,299	)		(780,932	)
Accumulated other comprehensive income		2,518			2,495

Total stockholders’ equity (deficiency)		3,094			(16,436	)

Total liabilities and stockholders’ equity (deficiency)	$	42,819		$	29,290

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

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ATARI, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)


	Three Months						Six Months
	Ended						Ended
	September 30,						September 30,
	2006			2007			2006			2007
Net revenues	$	28,588		$	13,309		$	48,062		$	23,729
Costs, expenses, and income:
Cost of goods sold		15,251			6,276			29,178			13,042
Research and product development		7,321			3,557			14,467			7,968
Selling and distribution expenses		9,317			5,209			14,418			8,760
General and administrative expenses		5,680			4,852			11,115			10,552
Restructuring expenses		204			44			334			993
Gain on sale of intellectual property		—			—			(9,000	)		—
Gain on sale of development studio assets		(885	)		—			(885	)		—
Atari trademark license expense		555			555			1,109			1,109
Depreciation and amortization		768			460			1,662			875

Total costs, expenses, and income		38,211			20,953			62,398			43,299

Operating loss		(9,623	)		(7,644	)		(14,336	)		(19,570	)
Interest (expense) income, net		116			(32	)		233			(45	)
Other (expense) income		15			(4	)		34			15

(Loss) before (benefit from) income taxes		(9,492	)		(7,680	)		(14,069	)		(19,600	)
(Benefit from) income taxes		(5,015	)		—			(4,833	)		—

Loss from continuing operations		(4,477	)		(7,680	)		(9,236	)		(19,600	)
(Loss) income from discontinued operations of Reflections Interactive Ltd., net of tax		4,409			(11	)		1,873			(33	)


Net loss	$	(68	)	$	(7,691	)	$	(7,363	)	$	(19,633	)


Basic and diluted net loss income per share:
Loss from continuing operations	$	(0.33	)	$	(0.57	)	$	(0.69	)	$	(1.45	)
(Loss) income from discontinued operations of Reflections Interactive Ltd., net of tax		0.33			0.00			0.14			(0.01	)

Net loss	$	0.00		$	(0.57	)	$	(0.55	)	$	(1.46	)


Basic weighted average shares outstanding		13,477			13,478			13,476			13,478


Diluted weighted average shares outstanding		13,477			13,478			13,476			13,478

See Note 6 for detail of related party amounts included within the line items above.

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

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ATARI, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)


	Six Months
	Ended
	September 30,
	2006			2007
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss	$	(7,363	)	$	(19,633	)
Adjustments to reconcile net loss to net cash used in operating activities:
Loss from discontinued operations of Reflections Interactive Ltd., net of tax		9,599			33
Gain on sale of Reflections Interactive Ltd.		(11,472	)		—
Adjustment for non-cash gain on sale of Reflections Interactive Ltd.		2,400			—
Gain on sale of intellectual property		(9,000	)		—
Gain on sale of development studio assets		(885	)		—
Adjustment for non-cash gain on sale of development studio assets		200			—
Stock-based compensation expense		698			126
Non-cash expense/income on cash collateralized security deposit		—			14
Atari name license expense		1,109			1,109
Depreciation and amortization		1,662			875
Amortization of deferred financing fees		115			104
Accrued interest		—			1
Gain on sale of property and equipment		(74	)		—
Other miscellaneous adjustments to net loss		(38	)		(38	)
Changes in operating assets and liabilities:
Receivables, net		4,826			5,958
Inventories, net		4,024			2,631
Due from related parties		2,112			1,188
Due to related parties		(5,088	)		(1,061	)
Prepaid expenses and other current assets		(634	)		743
Accounts payable		(7,781	)		(415	)
Accrued liabilities		983			549
Royalties payable		(10,030	)		2,309
Long-term liabilities		1,003			781
Other assets		386			15

Net cash used in continuing operating activities		(23,248	)		(4,711	)
Net cash (used in) provided by discontinued operations		(10,907	)		217

Net cash used in operating activities		(34,155	)		(4,494	)

CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from sale of intellectual property		9,000			—
Increase in restricted cash collateralizing letter of credit		(1,764	)		—
Proceeds from sale of development studio assets		1,550			—
Purchases of acquired intangible assets		(350	)		—
Purchases of property and equipment		(455	)		(349	)

Net cash provided by (used in) continuing investing activities		7,981			(349	)
Net cash provided by discontinued operations		21,593			—

Net cash provided by (used in) investing activities		29,574			(349	)

CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from exercise of stock options		8			—
Payments under capitalized lease obligation		(160	)		(51	)

Net cash used in continuing financing activities		(152	)		(51	)

Effect of foreign exchange rates on cash		9			9

Net decrease in cash		(4,724	)		(4,885	)
Cash — beginning of fiscal period		14,948			7,603

Cash — end of fiscal period	$	10,224		$	2,718

Page 5

ATARI, INC. AND SUBSIDIARIES

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND OTHER MATTERS

Nature of Business

We are a publisher of video game software that is distributed throughout the world and a distributor of video game software in North America. We publish, develop (through external resources), and distribute video games for all platforms, including Sony PlayStation 2, PlayStation 3, and PSP; Nintendo Game Boy Advance, GameCube, Wii, and DS; and Microsoft Xbox and Xbox 360, as well as for personal computers, or PCs. The products we publish or distribute extend across every major video game genre, including action, adventure, strategy, role-playing, and racing.

Through our relationship with our majority stockholder, Infogrames Entertainment S.A., a French corporation (“IESA”), listed on Euronext, our products are distributed exclusively by IESA throughout Europe, Asia and certain other regions. Similarly, we exclusively distribute IESA’s products in the United States and Canada. Furthermore, we distribute product in Mexico through various non-exclusive agreements. At September 30, 2007, IESA owns approximately 51% of us through its wholly-owned subsidiary California U.S. Holdings, Inc. (“CUSH”). As a result of this relationship, we have significant related party transactions (Note 6).

Going Concern

Until 2005, we were actively involved in developing video games and in financing development of video games by independent developers, which we would publish and distribute under licenses from the developers. However, beginning in 2005, because of cash constraints, we substantially reduced our involvement in development of video games, and announced plans to divest ourselves of our internal development studios.

During fiscal 2006 and 2007, we sold a number of intellectual properties and development facilities in order to obtain cash to fund our operations. During fiscal 2007, we raised approximately $35.0 million through the sale of the rights to the Driver games and certain other intellectual property, and the sale of our Reflections Interactive Ltd. (“Reflections”) and Shiny Entertainment (“Shiny”) studios. By the end of fiscal 2007, we did not own any development studios.

The reduction in our development and development financing activities has significantly reduced the number of games we publish. During fiscal 2007, our revenues from publishing activities were $104.7 million, compared with $153.6 million during fiscal 2006 and $289.6 million during fiscal 2005. During the six months ended September 30, 2007, our revenues from our publishing business were $21.1 million.

For the year ended March 31, 2007, we had an operating loss of $77.6 million , which included a charge of $54.1 million for the impairment of our goodwill, which is related to our publishing unit. During the six months ended September 30, 2007, we incurred an operating loss of approximately $19.6 million. We have taken significant steps to reduce our costs such as our May 2007 workforce reduction of approximately 20%. Our ability to deliver products on time depends in good part on developers’ ability to meet completion schedules. Further, our expected releases in fiscal 2008 are even fewer than our releases in fiscal 2007. In addition, most of our releases for fiscal 2008 are focused on the holiday season. As a result our cash needs have become more seasonal and we face significant cash requirements to fund our working capital needs during the third quarter of our fiscal year.

As of September 30, 2007, our only borrowing facility is an asset-based secured credit facility that we established in November 2006 with a group of lenders for which Guggenheim Corporate Funding LLC (“Guggenheim”) is the administrative agent. The credit facility consists of a secured, committed, revolving line of credit in an initial amount up to $15.0 million (subject to a borrowing base calculation), which initially included a $10.0 million sublimit for the issuance of letters of credit. On October 1, 2007, the lenders provided a waiver of covenant defaults as of June 30, 2007 and reduced the aggregate borrowing commitment of the revolving line of credit to $3.0 million.

Page 8

On October 5, 2007, CUSH, via a written consent, removed James Ackerly, Ronald C. Bernard, Michael G. Corrigan, Denis Guyennot, and Ann E. Kronen from the Board of Directors of Atari. On October 15, 2007, we announced the appointment of Wendell Adair, Eugene I. Davis, James B. Shein, and Bradley E. Scher as independent directors of our Board. Further, we have also appointed Curtis G. Solsvig III, as our Chief Restructuring Officer and have retained AlixPartners (of which Mr. Solsvig is a Managing Director) to assist us in evaluating and implementing strategic and tactical options through our restructuring process.

On October 18, 2007, we consented to the transfer of the loans outstanding ($3.0 million) under the Guggenheim credit facility to funds affiliated with BlueBay Asset Management plc and to the appointment of BlueBay High Yield Investments (Luxembourg) S.A.R.L. (“BlueBay”), as successor administrative agent. BlueBay Asset Management plc is a significant shareholder of IESA. On October 23, 2007, we entered into a waiver and amendment with BlueBay for, as amended, a $10.0 million Senior Secured Credit Facility (“Senior Credit Facility”). The Senior Credit Facility matures on December 31, 2009, charges an interest rate of the applicable LIBOR rate plus 7% per year, and eliminates certain financial covenants. The maximum borrowings we can make under the Senior Credit Facility will not by themselves provide all the funding we will need for the calendar 2007 holiday season. Management continues to seek additional financing and is pursuing other options to meet the cash requirements for funding the 2007 holiday season and to meet our working capital cash requirements but there is no guarantee that we will be able to do so.

Historically, we have relied on IESA to provide limited financial support to us, through loans or, in recent years, through purchases of assets. However, IESA has its own financial needs, and its ability to fund its subsidiaries’ operations, including ours, is limited. Therefore, there can be no assurance we will ultimately receive any funding from IESA.

The uncertainty caused by these above conditions raises substantial doubt about our ability to continue as a going concern. Our consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

We continue to explore various alternatives to improve our financial position and secure other sources of financing which could include raising equity, forming both operational and financial strategic partnerships, entering into new arrangements to license intellectual property, and selling, licensing or sub-licensing selected owned intellectual property and licensed rights. Further, as we are contemplating various alternatives, we will be utilizing our new Chief Restructuring Officer, AlixPartners, and our special committee of our board of directors, consisting of our newly appointed independent board members, who are authorized to review significant and special transactions. We continue to examine the reduction of working capital requirements to further conserve cash and may need to take additional actions in the near-term, which may include additional personnel reductions and suspension of certain development projects during fiscal 2008.

The above actions may or may not prove to be consistent with our long-term strategic objectives, which have been shifted in the last fiscal year, as we have discontinued our internal development activities and increased our focus on online and casual gaming, among other things. We cannot guarantee the completion of these actions or that such actions will generate sufficient resources to fully address the uncertainties of our financial position.

Basis of Presentation

Our accompanying interim condensed consolidated financial statements are unaudited, but in the opinion of management, reflect all adjustments, consisting of normal recurring accruals, necessary for a fair presentation of the results for the interim periods presented in accordance with the instructions for Form 10-Q. Accordingly, they do not include all information and notes required by accounting principles generally accepted in the United States of America for complete financial statements. These interim condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended March 31, 2007.

Principles of Consolidation

The condensed consolidated financial statements include the accounts of Atari, Inc. and its wholly-owned subsidiaries. All significant intercompany transactions and balances have been eliminated.

Reclassifications

We have made certain reclassifications on our condensed consolidated statements of operations in order to provide better insight into the results of operations and to align our presentation to certain industry competitors.

Page 9

Revenue recognition, sales returns, price protection, other customer related allowances and allowance for doubtful accounts

Revenue is recognized when title and risk of loss transfer to the customer, provided that collection of the resulting receivable is deemed reasonably probable by management.

Sales are recorded net of estimated future returns, price protection and other customer related allowances. We are not contractually obligated to accept returns; however, based on facts and circumstances at the time a customer may request approval for a return, we may permit the return or exchange of products sold to certain customers. In addition, we may provide price protection, co-operative advertising and other allowances to certain customers in accordance with industry practice. These reserves are determined based on historical experience, market acceptance of products produced, retailer inventory levels, budgeted customer allowances, the nature of the title and existing commitments to customers. Although management believes it provides adequate reserves with respect to these items, actual activity could vary from management’s estimates and such variances could have a material impact on reported results.

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make payments when due or within a reasonable period of time thereafter. If the financial condition of our customers were to deteriorate, resulting in an inability to make required payments, additional allowances may be required.

Concentration of Credit Risk

We extend credit to various companies in the retail and mass merchandising industry for the purchase of our merchandise which results in a concentration of credit risk. This concentration of credit risk may be affected by changes in economic or other industry conditions and may, accordingly, impact our overall credit risk. Although we generally do not require collateral, we perform ongoing credit evaluations of our customers and reserves for potential losses are maintained.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures 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 materially differ from those estimates.

Fair Values of Financial Instruments

Financial Accounting Standards Board (“FASB”) Statement No. 107, “Disclosures About Fair Value of Financial Instruments,” requires disclosure of the fair value of financial instruments for which it is practicable to estimate. We believe that the carrying amounts of our financial instruments, including cash, accounts receivable, inventory, prepaid expenses and other current assets, accounts payable, accrued liabilities, royalties payable, assets and liabilities of discontinued operations, and amounts due to and from related parties, reflected in the condensed consolidated financial statements approximate fair value due to the short-term maturity and the denomination in U.S. dollars of these instruments.

Long-Lived Assets

We review long-lived assets, such as property and equipment, for impairment annually or whenever events or changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable. If the estimated fair value of the asset is less than the carrying amount of the asset plus the cost to dispose, an impairment loss is recognized as the amount by which the carrying amount of the asset plus the cost to dispose exceeds its fair value, as defined in FASB Statement No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”

Research and Product Development Expenses

Research and product development expenses related to the design, development and testing of newly developed software products are charged to expense as incurred. Research and product development expenses also include payments for royalty advances (milestone payments) to third party developers for products that are currently in development. Once a product is sold, we may be obligated to make additional payments in the form of backend royalties to developers which are calculated based on contractual terms, typically a percentage of sales. Such payments are expensed and included in cost of goods sold in the period the sales are recorded.

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Rapid technological innovation, shelf-space competition, shorter product life cycles and buyer selectivity have made it difficult to determine the likelihood of individual product acceptance and success. As a result, we follow the policy of expensing milestone payments as incurred, treating such costs as research and product development expenses.

Licenses

Licenses for intellectual property are capitalized as assets upon the execution of the contract when no significant obligation of performance remains with us or the third party. If significant obligations remain, the asset is capitalized when payments are due or when performance is completed as opposed to when the contract is executed. These licenses are amortized at the licensor’s royalty rate over unit sales to cost of goods sold. Management evaluates the carrying value of these capitalized licenses and records an impairment charge in the period management determines that such capitalized amounts are not expected to be realized. Such impairments are charged to cost of goods sold if the product has released or previously sold, and if the product has never released, these impairments are charged to research and product development expenses.

Atari Trademark License

In connection with a recapitalization completed in fiscal 2004, Atari Interactive, Inc. (“Atari Interactive”), a wholly-owned subsidiary of IESA, extended the term of the license under which we use the Atari trademark to ten years expiring on December 31, 2013. We issued 200,000 shares of our common stock to Atari Interactive for the extended license and will pay a royalty equal to 1% of our net revenues during years six through ten of the extended license. We recorded a deferred charge of $8.5 million, representing the fair value of the shares issued, which was expensed monthly until it became fully expensed in the first quarter of fiscal 2007. The monthly expense was based on the total estimated cost to be incurred by us over the ten-year license period ($8.5 million plus estimated royalty of 1% for years six through ten); upon the full expensing of the deferred charge, this expense is being recorded as a deferred liability owed to Atari Interactive, to be paid beginning in year six of the license.

Net Loss Per Share

Basic net loss per share is computed by dividing net loss by the weighted average number of shares of common stock outstanding for the period. Diluted net loss per share reflects the potential dilution that could occur from shares of common stock issuable through stock-based compensation plans, including stock options and warrants, using the treasury stock method. The number of antidilutive shares that was excluded from the diluted earnings per share calculation for the three months ended September 30, 2006 and 2007 was approximately 1.0 million and 0.5 million, respectively, and for the six months ended September 30, 2006 and 2007 was approximately 0.8 million and 0.5 million, respectively.

Recent Accounting Pronouncements

In September 2006, the FASB issued FASB Statement No. 157, “Fair Value Measurements,” which provides a single definition of fair value, together with a framework for measuring it, and requires additional disclosure about the use of fair value to measure assets and liabilities. Furthermore, in February 2007, the FASB issued FASB Statement No. 159, “The Fair Value Option for Financial Assets and Liabilities,” which permits an entity to measure certain financial assets and financial liabilities at fair value, and report unrealized gains and losses in earnings at each subsequent reporting date. Its objective is to improve financial reporting by allowing entities to mitigate volatility in reported earnings caused by the measurement of related assets and liabilities using different attributes without having to apply complex hedge accounting provisions. Statement No. 159 is effective for fiscal years beginning after November 15, 2007, but early application is encouraged. The requirements of Statement No. 157 are adopted concurrently with or prior to the adoption of Statement No. 159. We have not yet evaluated the impact of this implementation on our consolidated financial statements.

See Note 5 regarding the Company’s adoption of FASB Interpretation No. 48 “Accounting for Uncertainty in Income Taxes (an interpretation of FASB Statement No. 109)” which is effective for fiscal years beginning after December 15, 2006.

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NOTE 2 – STOCK-BASED COMPENSATION

Effective April 1, 2006, we adopted FASB Statement No. 123(R), “Share-Based Payment,” which requires the measurement and recognition of compensation expense at fair value for employee stock awards. We adopted FASB Statement No. 123(R) using the modified prospective method in which we are recognizing compensation expense for all awards granted after the required effective date and for the unvested portion of previously granted awards that remain outstanding at the date of adoption.

At September 30, 2007, we had one stock incentive plan, under which we could issue a total of 1,500,000 shares of common stock as stock options or restricted stock, of which 1,262,348 were still available for grant as of September 30, 2007. Upon approval of this plan, our previous stock option plans were terminated, and we were no longer able to issue options under those plans; however, options originally issued under the previous plans continue to be outstanding. All options granted under our current or previous plans have an exercise price equal to or greater than the market value of the underlying common stock on the date of grant; options vest over four years and expire in ten years.

The recognition of stock-based compensation expense increased our net loss by $0.4 million and $(0.1) million for the three months ended September 30, 2006 and 2007, respectively, and increased our basic or diluted loss per share amount by $0.03 and $(0.01) for the three months ended September 30, 2006 and 2007, respectively. For the six months ended September 30, 2006 and 2007, stock-based compensation expenses increased our net loss by $0.7 million and $0.2 million, respectively. Our basic or diluted loss per share increased due to stock-based compensation by $0.03 and $0.01 for the six months ended September 30, 2006 and 2007, respectively.

We have recorded a full valuation allowance against our net deferred tax asset, so the settlement of stock-based compensation awards will not result in tax benefits that could impact our consolidated statement of operations. Because the tax deduction from current period settlement of awards has not reduced taxes payable, the settlement of awards has no effect on our cash flow from operating and financing activities.

The following table summarizes the classification of stock-based compensation expense in our condensed consolidated statements of operations for the three months ended September 30, 2006 and 2007 (in thousands):


	Three Months Ended						Six Months Ended
	September 30,						September 30,
	2006			2007			2006		2007

Research and product development	$	70		$	(70	)	$	109	$	15
Selling and distribution expenses		(11	)		(55	)		29		(26	)
General and administrative expenses		298			46			560		137

The weighted average fair value of options granted during the three months ended September 30, 2006 and 2007 was $4.60 and $2.59, respectively. The weighted average fair value of options granted during the six months ended September 30, 2006 and 2007 was $17.70 and $3.03, respectively. The fair value of our options is estimated using the Black-Scholes option pricing model. This model requires assumptions regarding subjective variables that impact the estimate of fair value. Our policy for attributing the value of graded vest share-based payment is a single option straight-line approach. The following table summarizes the assumptions used to compute the weighted average fair value of option grants:


	Three Months Ended						Six Months Ended
	September 30,						September 30,
	2006			2007			2006			2007

Expected volatility		85	%		68	%		85	%		68	%
Expected dividend yield		0	%		0	%		0	%		0	%
Expected term		4			4			4			4

The weighted average risk-free interest rate (based on the three year and five year US Treasury Bond average) for the three and six months ended September 30, 2006 was 4.60% and for the three months and six months ended September 30, 2007 was 4.38%.

FASB Statement No. 123(R) requires that we recognize stock-based compensation expense for the number of awards that are ultimately expected to vest. As a result, the expense recognized must be reduced for estimated forfeitures prior to vesting, based on a historical annual forfeiture rate, which is approximately 12%. Estimated forfeitures shall be

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assessed at each balance sheet date and may change based on new facts and circumstances. Prior to the adoption of FASB Statement No. 123(R), forfeitures were accounted for as they occurred when included in required pro forma stock compensation disclosures.

The following table summarizes our option activity under our stock-based compensation plan for the six months ended September 30, 2007:


				Weighted
				Average
	Shares			Exercise Price
	(in thousands)
Options outstanding at March 31, 2007		1,112		$	33.45
Granted		40			3.03
Forfeited		(301	)		11.61
Expired		(365	)		56.21

Options outstanding at September 30,2007		486		$	27.43


Options exercisable at September 30,2007		201		$	56.59

As of September 30, 2007, the weighted average remaining contractual term of options outstanding and exercisable was 7.7 years and 5.8 years, respectively, and the aggregate intrinsic value related to options outstanding and exercisable was $0.1 million and $0.0 million, respectively as the majority of our options’ Strikeprice was greater than the fair-market value as of September 30, 2007. As of September 30, 2007, the total future unrecognized compensation cost related to outstanding unvested options is $2.4 million, which will be recognized as compensation expense over the remaining weighted average vesting period of 3.0 years.

NOTE 3 – CONCENTRATION OF CREDIT RISK

As of March 31, 2007, we had two customers whose accounts receivable exceeded 10% of total accounts receivable:


				For the year ended
	March 31,			March 31,
	2007			2007
	% of Accounts Receivable			% of Net Revenues (1)

Customer 1		34	%		19	%
Customer 2		20	%		9	%

		54	%		28	%

As of September 30, 2007, we had four customers whose accounts receivable exceeded 10% of total accounts receivable:


				For the nine months ended
	September 30,			September 30,
	2007			2007
	% of Accounts Receivable			% of Net Revenues (1)

Customer 1		29	%		23	%
Customer 2		19	%		9	%
Customer 3		12	%		6	%
Customer 4		11	%		12	%

		71	%		50	%


(1)		Excluding international royalty, licensing, and other income.

With the exception of the largest customers noted above, accounts receivable balances from all remaining individual customers were less than 10% of our total accounts receivable balance.

Page 13

With lower sales in the first and second quarter of fiscal 2008, combined with the timing of cash receipts and price protection programs, certain customers were in net credit balance positions within our accounts receivable. As a result, $4.1 million (net of $9.5 million of gross receivables) as of September 30, 2007 were reclassified to accrued liabilities.

NOTE 4 – BALANCE SHEET DETAILS

Inventories

Inventories consist of the following (in thousands):


	March 31,		September 30,
	2007		2007
Finished goods, net	$	8,226	$	5,699
Return inventory, net		615		177
Raw materials, net		2		335

	$	8,843	$	6,211

Prepaid Expenses and Other Current Assets

Prepaid expenses and other current assets consist of the following (in thousands):


	March 31,		September 30,
	2007		2007
Licenses short-term	$	7,054	$	6,478
Royalties receivable		495		169
Prepayments to manufacturers and other deposits		127		1,389
Reflections escrow receivable		626		28
Deferred financing fees		209		209
Taxes receivable		90		68
Prepaid insurance		802		319
Other prepaid expenses and current assets		826		810

	$	10,229	$	9,470

Accrued Liabilities

Accrued liabilities consist of the following (in thousands):


	March 31,		September 30,
	2007		2007
Accounts receivable credit balances (Note 3)	$	828	$	4,071
Accrued distribution services		2,061		1,905
Accrued salary and related costs		1,581		817
Accrued professional fees and other services		2,578		1,311
Accrued third party development expenses		2,660		1,630
Restructuring reserve (Note 10)		54		292
Accrued advertising		1,222		736
Taxes payable		299		283
Accrued freight and handling fees		193		92
Deferred income		231		367
Other		1,674		2,412

	$	13,381	$	13,916

NOTE 5 – INCOME TAXES

As of March 31, 2007, we had net operating loss carryforwards of $544.6 million for federal tax purposes. These tax loss carryforwards expire beginning in the years 2012 through 2027, if not utilized. Utilization of the net operating loss

Page 14

carryforwards may be subject to a restrictive annual limitation pursuant to Section 382 of the Internal Revenue Code which may mechanically prevent the Company from utilizing its entire loss carryforward.

In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income prior to the expiration of any net operating loss carryforwards. Due to the uncertainty regarding our ability to realize our net deferred tax assets in the future, we have provided a full valuation allowance against our net deferred tax assets. Management reassesses its position with regard to the valuation allowance on a quarterly basis.

During the three and six months ended September 30, 2007, no net tax provisions were recorded due to the taxable loss recorded for the respective quarters. During the six months ended September 30, 2006, we recorded a non-cash tax benefit of $5.4 million, which offsets a non-cash tax provision of the same amount included in loss from discontinued operations, recorded in accordance with FASB Statement No, 109, “Accounting for Income Taxes,” paragraph 140, which states that all items should be considered for purposes of determining the amount of tax benefit that results from a loss from continuing operations and that should be allocated to continuing operations. The recording of a benefit is appropriate in this instance, under the guidance of Paragraph 140, because such domestic loss offsets the domestic gain generated in discontinued operations. The effect of this transaction on net loss for fiscal 2007 is zero, and it does not result in the receipt or payment of any cash. Further during the same period, we recorded a $0.6 million of deferred tax liability recorded due to a temporary difference that arose from a difference in the book and tax basis of goodwill

In June 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statement in accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (“FAS 109”). This interpretation prescribes a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of uncertain tax positions taken or expected to be taken in an income tax return. FIN 48 also provides guidance on derecognition of tax benefits, classification on the balance sheet, interest and penalties, accounting in interim periods, disclosure and transition.

The Company adopted FIN 48 effective April 1, 2007 and had approximately $0.4 million of unrecognized tax benefits as of the adoption date and as of September 30, 2007. The Company has decided to classify interest and penalties as a component of tax expense.

The Company is subject to taxation in the U.S. and various state jurisdictions. The Company was previously subject to taxation in the United Kingdom. The Company’s federal tax returns for tax year ended September 24, 2003 and March 31, 2004 through March 31, 2007 tax years remain subject to examination. The Company files in numerous state jurisdictions with varying statues of limitations. During fiscal 2007, the Company completed a tax examination in the United Kingdom (“UK”) through the period ended March 31, 2004 and has terminated its UK business activities.

NOTE 6 – RELATED PARTY TRANSACTIONS

Relationship with IESA

As of September 30, 2007, IESA beneficially owned approximately 51% of our common stock. IESA renders management services to us (systems and administrative support) and we render management services and production services to Atari Interactive and other subsidiaries of IESA. Atari Interactive develops video games, and owns the name “Atari” and the Atari logo, which we use under a license. IESA distributes our products in Europe, Asia, and certain other regions, and pays us royalties in this respect. IESA also develops (through its subsidiaries) products which we distribute in the U.S., Canada, and Mexico and for which we pay royalties to IESA. Both IESA and Atari Interactive are material sources of products which we bring to market in the United States, Canada and Mexico. During the six months ended September 30, 2007, international royalties earned from IESA were the source of 3.4% of our net revenues. Additionally, during the six months ended September 30, 2007, IESA and its subsidiaries (primarily Atari Interactive) were the source of approximately 37.2%, respectively, of our net publishing product revenue.

Historically, IESA has incurred significant continuing operating losses and has been highly leveraged. On September 12, 2006, IESA announced a multi-step debt restructuring plan, subject to its shareholders’ approval, which would significantly reduce its debt and provide liquidity to meet its operating needs. On November 15, 2006, IESA shareholders approved the debt restructuring plan, permitting IESA to execute on this plan. As of September 30, 2007, IESA has raised

Page 15

approximately 74 million Euros, of which approximately 45 million Euros has paid down outstanding short-term and long-term debt and has provided approximately 20 million Euros of liquidity for working capital needs. Although IESA has completed its debt restructuring plan, its current ability to fund, among other things, its subsidiaries’ operations remains limited. Our results of operations could be materially impaired if IESA fails to fund Atari Interactive, as any delay or cessation in product development could materially decrease our revenue from the distribution of Atari Interactive and IESA products. If the above contingencies occurred, we probably would be forced to take actions that could result in a significant reduction in the size of our operations and could have a material adverse effect on our revenue and cash flows.

Additionally, although Atari is a separate and independent legal entity and we are not a party to, or a guarantor of, and have no obligations or liability in respect of IESA’s indebtedness (except that we have guaranteed the Beverly, MA lease obligation of Atari Interactive), because IESA owns the majority of our common stock, potential investors and current and potential business/trade partners may view IESA’s financial situation as relevant to an assessment of Atari. Therefore, if IESA is unable to address its financial issues, it may taint our relationship with our suppliers and distributors, damage our business reputation, affect our ability to generate business and enter into agreements on financially favorable terms, and otherwise impair our ability to raise and generate capital.

Summary of Related Party Transactions

The following table provides the details of related party amounts within each line of our condensed consolidated statements of operations (in thousands):


	Three Months						Six Months
	Ended						Ended
	September 30,						September 30,
	2006			2007			2006			2007
Income (expense)


Net revenues	$	28,588		$	13,309		$	48,062		$	23,729

Related party activity:
Royalty income (1)		1,868			351			977			816
License income (1)		485			5,236			1,499			6,407
Sale of goods		188			89			390			233
Production and quality and assurance testing services		1,458			669			2,290			1,435

Total related party net revenues		3,999			6,345			5,156			8,891


Cost of goods sold		(15,251	)		(6,276	)		(29,178	)		(13,042	)

Related party activity:
Distribution fee for Humongous, Inc. product		(2,033	)		(1,287	)		(3,245	)		(1,452	)
Royalty expense (2)		(335	)		(479	)		(1,712	)		(1,345	)

Total related party cost of goods sold		(2,368	)		(1,766	)		(4,957	)		(2,797	)


Research and product development		(7,321	)		(3,557	)		(14,467	)		(7,968	)

Related party activity:
Development expenses (3)		(2,031	)		(216	)		(5,327	)		(216	)
Other miscellaneous development services		4			—			9			—

Total related party research and product development		(2,027	)		(216	)		(5,318	)		(216	)


Selling and distribution expenses		(9,317	)		(5,209	)		(14,418	)		(8,760	)

Related party activity:
Miscellaneous purchase of services		(79	)		—			(79	)		—

Total related party selling and distribution expenses		(79	)		—			(79	)		—


General and administrative expenses		(5,680	)		(4,852	)		(11,115	)		(10,552	)

Related party activity:
Management fee revenue		740			750			1,520			1,500
Management fee expense		(750	)		(750	)		(1,500	)		(1,500	)
Office rental and other services (4)		46			51			92			101

Total related party general and administrative expenses		36			51			112			101


Restructuring expenses		(204	)		(44	)		(334	)		(993	)

Page 16


	Three Months						Six Months
	Ended						Ended
	September 30,						September 30,
	2006			2007			2006			2007
Related party activity:
Related party rent expense (4)		(116	)		—			(233	)		—

Total related party restructuring expenses		(116	)		—			(233	)		—


(Loss) income from discontinued operations of Reflections Interactive Ltd., net of tax		4,409			(11	)		1,873			(33	)

Related party activity:
Royalty income (1)		(314	)		—			(706	)		—

Total related party loss from discontinued operations		(314	)		—			(706	)		—


(1)		We have entered into a distribution agreement with IESA and Atari Europe which provides for IESA’s and Atari Europe’s distribution of our products across Europe, Asia, and certain other regions pursuant to which IESA, Atari Europe, or any of their subsidiaries, as applicable, will pay us 30.0% of the gross margin on such products or 130.0% of the royalty rate due to the developer, whichever is greater. We recognize this amount as royalty income as part of net revenues, net of returns. Additionally, we earn license income from related parties iFone and Glu Mobile (see below).

(2)		We have also entered into a distribution agreement with IESA and Atari Europe, which provides for our distribution of IESA’s (or any of its subsidiaries’) products in the United States, Canada and Mexico, pursuant to which we will pay IESA either 30.0% of the gross margin on such products or 130.0% of the royalty rate due to the developer, whichever is greater. We recognize this amount as royalty expense as part of cost of goods sold, net of returns.

(3)		We engage certain related party development studios to provide services such as product development, design, and testing.

(4)		In July 2002, we negotiated a sale-leaseback transaction between Atari Interactive and an unrelated party. As part of this transaction, we guaranteed the lease obligation of Atari Interactive. The lease provides for minimum monthly rental payments of approximately $0.1 million escalating nominally over the ten year term of the lease. During fiscal 2006, when the Beverly studio (which held the office space for Atari Interactive) was closed, rental payments were recorded to restructuring expense. We also received indemnification from IESA from costs, if any, that may be incurred by us as a result of the full guarantee.

		We received a $1.3 million payment for our efforts in connection with the sale-leaseback transaction. Approximately $0.6 million, an amount equivalent to a third party broker’s commission, was recognized during fiscal 2003 as other income, while the remaining balance of $0.7 million was deferred and is being recognized over the life of the sub-lease. Accordingly, during the six months ended September 30, 2006 and 2007, a nominal amount of income was recognized in each period. As of September 30, 2007, the remaining balance of approximately $0.4 million is deferred and is being recognized over the life of the sub-lease. Although the Beverly studio was closed in fiscal 2006 as part of a restructuring plan (Note 10), the space was not sublet; the lease expired June 30, 2007.

		Additionally, we provide management information systems services to Atari Australia for which we are reimbursed. The charge is calculated as a percentage of our costs, based on usage, which is agreed upon by the parties.

The following amounts are outstanding with respect to the related party activities described above (in thousands):


	March 31,			September 30,
	2007			2007
Due from/(Due to) – current
IESA (1)	$	(1,494	)	$	(749	)
Atari Europe (2)		280			(1,123	)
Eden Studios (3)		(595	)		(140	)
Atari Studio Asia (3)		(401	)		83
Humongous, Inc. (4)		(2,218	)		(2,562	)
Atari Interactive (5)		(992	)		417
Glu Mobile/iFone (6)		1,265			—
Other miscellaneous net receivables		251			43

Net due to related parties – current		(3,904	)		(4,031	)

Due from/(Due to) – long-term
Atari Interactive (see Atari License below)		(1,912	)		(3,021	)


Net due to related parties	$	(5,816	)	$	(7,052	)

Page 17

The current balances reconcile to the balance sheet as follows (in thousands):


	March 31,			September 30,
	2007			2007
Due from related parties	$	1,799		$	610
Due to related parties		(5,703	)		(4,641	)

Net (due to) due from related parties – current	$	(3,904	)	$	(4,031	)


(1)		Balances comprised primarily of the management fees charged to us by IESA and other charges of cost incurred on our behalf.

(2)		Balances comprised of royalty income or expense from our distribution agreements with IESA and Atari Europe relating to properties owned or licensed by Atari Europe.

(3)		Represents net payables for related party development activities. (Note: Atari Melbourne House, a related party development studio, was sold to a third party by IESA in the third quarter of fiscal 2007. Balances due to Atari Melbourne House as of March 31, 2007 were transferred to Atari Studio Asia.)

(4)		Represents primarily distribution fees owed to Humongous, Inc., a related party, related to sale of their product.

(5)		Comprised primarily of royalties owed to Atari Interactive, offset by receivables related to management fee revenue and production and quality and assurance testing services revenue earned from Atari Interactive.

(6)		Balances comprised of license income from our licensing agreements with Glu Mobile, Inc. (merged with Ifone in 2006) relating to properties in which we own or hold rights to publish and/or sub-license.

Atari Name License

In May 2003, we changed our name to Atari, Inc. upon obtaining rights to use the Atari name through a license from IESA, which IESA acquired as a part of the acquisition of Hasbro Interactive Inc. (“Hasbro Interactive”). In connection with a debt recapitalization in September 2003, Atari Interactive extended the term of the license under which we use the Atari name to ten years expiring on December 31, 2013. We issued 200,000 shares of our common stock to Atari Interactive for the extended license and will pay a royalty equal to 1% of our net revenues during years six through ten of the extended license. We recorded a deferred charge of $8.5 million, which was being amortized monthly and which became fully amortized during the first quarter of fiscal 2007. The monthly amortization was based on the total estimated cost to be incurred by us over the ten-year license period. Upon full amortization of the deferred charge, we began recording a long-term liability at $0.2 million per month, to be paid to Atari Interactive beginning in year six of the term of the license. During the quarters ended September 30, 2006 and 2007, we recorded expense of $0.6 million in each period related to the license. For the six months ended September 30, 2006 and 2007, we recorded license expense of $1.1 million in each period and as of September 30, 2007, $3.0 million relating to this obligation is included in long-term liabilities.

Sale of Hasbro Licensing Rights

On July 18, 2007, IESA, agreed to terminate a license under which it and we, and our sublicensees, had developed, published and distributed video games using intellectual property owned by Hasbro, Inc. In connection with that termination, on the same date, we and IESA entered into an agreement whereby IESA agreed to pay us $4.0 million. In addition, pursuant to the agreements between IESA and Hasbro, Hasbro agreed to assume our obligations under any sublicenses that we had the right to assign to it. As of September 30, 2007, we have received full payment of the $4.0 million and have recorded the same amount as other income as part of our publishing net revenues for the six months ended September 30, 2007.

Related Party Transactions with Employees or Former Employees

•

License Revenue from Glu Mobile

We record license income from Glu Mobile, for which a member of our Board of Directors, until October 5, 2007, Denis Guyennot, is the Chief Executive Officer of activities in Europe, the Middle East, and Africa. This results in treatment of Glu Mobile as a related party. During the three months ended September 30, 2006 and 2007, license income recorded from Glu Mobile was $0.5 million and $1.2 million, respectively. During the six months ended September 30, 2006 and 2007, license income recorded from Glu Mobile was $1.5 million and $2.3 million, respectively. As of March 31, 2007, receivables from Glu Mobile were $1.3 million. As of September 30, 2007, we had no receivables from Glu Mobile. Upon the removal of Mr. Guyennot from our Board of Directors on October 5, 2007, Glu Mobile no longer is a related party.

NOTE 7 – COMMITMENTS AND CONTINGENCIES

Contractual Obligations

Page 18

As of September 30, 2007, royalty and license advance obligations, milestone payments and future minimum lease obligations under non-cancelable operating and capital lease obligations were as follows (in thousands):


	Contractual Obligations
	Royalty and
	license		Milestone		Operating lease		Capital lease
Through	advances (1)		payments (2)		obligations (3)		obligations (4)		Total

September 30, 2008	$	5,900	$	1,704	$	2,045	$	33	$	9,682
September 30, 2009		8		—		1,851		—		1,859
September 30, 2010		2		—		1,806		—		1,808
September 30, 2011		—		—		1,720		—		1,720
September 30, 2012		—		—		1,329		—		1,329
Thereafter		—		—		12,301		—		12,301

Total	$	5,910	$	1,704	$	21,052	$	33	$	28,699


(1)		We have committed to pay advance payments under certain royalty and license agreements. The payments of these obligations are dependent on the delivery of the contracted services by the developers.

(2)		Milestone payments represent royalty advances to developers for products that are currently in development. Although milestone payments are not guaranteed, we expect to make these payments if all deliverables and milestones are met timely and accurately.

(3)		We account for our office leases as operating leases, with expiration dates ranging from fiscal 2008 through fiscal 2022. These are future minimum annual rental payments required under the leases, including a related party sublease with Atari Interactive, net of $1.1 million of sublease income to be received in fiscal 2008 and fiscal 2009. Rent expense and sublease income for the three and six months ended September 30, 2006 and 2007 is as follows (in thousands):


	Three months ended						Six months ended
	September 30,						September 30,
	2006			2007			2006			2007
Rent expense	$	880		$	1,421		$	1,630		$	2,528
Sublease income		(62	)		(220	)		(178	)		(501	)

•

Renewal of New York lease

		During June 2006, we entered into a new lease with our current landlord at our New York headquarters for approximately 70,000 square feet of office space for our principal offices. The term of this lease commenced on July 1, 2006 and is to expire on June 30, 2021. Upon entering into the new lease, our prior lease, which was set to expire in December 2006, was terminated. The rent under the new lease for the office space was approximately $2.4 million per year for the first five years, increased to approximately $2.7 million per year for the next five years, and increased to $2.9 million for the last five years of the term. In addition, we must pay for electricity, increases in real estate taxes and increases in porter wage rates over the term. The landlord is providing us with a one year rent credit of $2.4 million and an allowance of $4.5 million to be used for building out and furnishing the premises, of which $1.2 million has been recorded as a deferred credit as of March 31, 2007; the remainder of the deferred credit will be recorded as the improvements are completed, and will be amortized against rent expense over the life of the lease. A nominal amount of amortization was recorded during the year ended March 31, 2007. For the six months ended September 30, 2007, we recorded an additional deferred credit of $3.0 million and amortization against the total deferred credits of approximately $0.1 million. Shortly after signing the new lease, we provided the landlord with a security deposit under the new lease in the form of a letter of credit in the initial amount of $1.7 million, which has been cash collateralized and is included in security deposits on our condensed consolidated balance sheet. On August 14, 2007, we and our new landlord, W2007 Fifth Realty, LLC, amended the lease under which we occupy space in 417 Fifth Avenue, New York City, to reduce the space we occupy by approximately one-half, effective December 31, 2007. As a result, our rent under the amended lease will be reduced from its current approximately $2.4 million per year to approximately $1.2 million per year from January 1, 2008 through June 30, 2011, approximately $1.3 million per year for the five years thereafter, and approximately $1.5 million per year for the last five years of the term.

(4)		We maintain several capital leases for computer equipment. Per FASB Statement No. 13, “Accounting for Leases,” we account for capital leases by recording them at the present value of the total future lease

Page 19

payments. They are amortized using the straight-line method over the minimum lease term. As of March 31, 2007, the net book value of the assets, included within property and equipment on the balance sheet, was $0.1 million, net of accumulated depreciation of $0.5 million. As of September 30, 2007, the net book value of the assets was $0.1 million, net of accumulated depreciation of $0.5 million.

Litigation

As of September 30, 2007, our management believes that the ultimate resolution of any of the matters summarized below and/or any other claims which are not stated herein, if any, will not have a material adverse effect on our liquidity, financial condition or results of operations. With respect to matters in which we are the defendant, we believe that the underlying complaints are without merit and intend to defend ourselves vigorously.

Bouchat v. Champion Products, et al. (Accolade)

This suit involving Accolade, Inc. (a predecessor entity of Atari) was filed in 1999 in the District Court of Maryland. The plaintiff originally sued the NFL claiming copyright infringement of a logo being used by the Baltimore Ravens that plaintiff allegedly designed. The plaintiff then also sued nearly 500 other defendants, licensees of the NFL, on the same basis. The NFL hired White & Case to represent all the defendants. Plaintiff filed an amended complaint in 2002. In 2003, the District Court held that plaintiff was precluded from recovering actual damages, profits or statutory damages against the defendants, including Accolade. Plaintiff has appealed the District Court’s ruling to the Fourth Circuit Court of Appeals. White & Case continues to represent Accolade and the NFL continues to bear the cost of the defense.

Ernst & Young, Inc. v. Atari, Inc.

On July 21, 2006 we were served with a complaint filed by Ernst & Young as Interim Receiver for HIP Interactive, Inc. This suit was filed in New York State Supreme Court, New York County. HIP is a Canadian company that has gone into bankruptcy. HIP contracted with us to have us act as its distributor for various software products in the U.S. HIP is alleging breach of contract claims; to wit, that we failed to pay HIP for product in the amount of $0.7 million. We will investigate filing counter claims against HIP, as HIP owes us, via our Canadian Agent, Hyperactive, for our product distributed in Canada. Our answer and counterclaim were filed in August of 2006 and we initiated discovery against Ernst & Young at the same time. Settlement discussions commenced in September 2006 and are currently on-going.

Research in Motion Limited v. Atari, Inc. and Atari Interactive, Inc.

On October 26, 2006, Research in Motion Limited (“RIM”) filed a claim against us and Atari Interactive in the Ontario Superior Court of Justice. RIM is seeking a declaration that (i) the game BrickBreaker, as well as the copyright, distribution, sale and communication to the public of copies of the game in Canada and the United States, does not infringe any Atari copyright for Breakout or Super Breakout in Canada or the United States, (ii) the audio-visual displays of Breakout do not constitute a work protected by copyright under Canadian law, and (iii) Atari holds no right, title or interest in Breakout under US or Canadian law. RIM is also requesting the costs of the action and such other relief as the court deems. Breakout and Super Breakout are games owned by Atari Interactive. On January 19, 2007, RIM added claims to its case requesting a declaration that (i) its game Meteor Crusher does not infringe Atari copyright for its game Asteroids in Canada, (ii) the audio-visual displays of Asteroids do not constitute a work protected under Canadian law, and (iii) Atari holds no right, title or interest in Asteroids under Canadian law. In August 2007, the Court ruled against Atari’s December 2006 motion to have the RIM claims dismissed on the grounds that there is no statutory relief available to RIM under Canadian law. Atari is in the process of appealing this decision.

NOTE 8 – DEBT

Credit Facilities

Guggenheim Credit Facility

Page 20

capital needs in the ordinary course of business and to finance acquisitions subject to limitations in the Credit Agreement. The credit facility bears interest at our choice of (i) LIBOR plus 5% per year, or (ii) the greater of (a) the prime rate in effect, or (b) the Federal Funds Effective Rate in effect plus 2.25% per year. Additionally, we are required to pay a commitment fee on the undrawn portions of the credit facility at the rate of 0.75% per year and we paid to Guggenheim a closing fee of $0.2 million. Obligations under the credit facility are secured by liens on substantially all of our present and future assets, including accounts receivable, inventory, general intangibles, fixtures, and equipment, but excluding the stock of our subsidiaries and certain assets located outside of the U.S.

As of September 30, 2007, no borrowings were outstanding, and a nominal amount of interest was included in accrued liabilities.

The credit facility includes provisions for a possible term loan facility and an increased revolving credit facility line in the future. The credit facility also contains financial covenants that require us to maintain enumerated EBITDA, liquidity, and net debt minimums, and a capital expenditure maximum. As of June 30, 2007, we were not in compliance with all financial covenants. On October 1, 2007, the lenders provided a waiver of covenant defaults as of June 30, 2007 and reduced the aggregate borrowing commitment of the revolving line of credit to $3.0 million.

On October 18, 2007, we consented to the transfer of the loans outstanding ($3.0 million) under the Guggenheim credit facility to funds affiliated with BlueBay Asset Management plc and to the appointment of BlueBay High Yield Investments (Luxembourg) S.A.R.L. (“BlueBay”), as successor administrative agent. BlueBay Asset Management plc is a significant shareholder of IESA. On October 23, 2007, we entered into a waiver and amendment with BlueBay for, as amended, a $10.0 million Senior Secured Credit Facility (“Senior Credit Facility”). The Senior Credit Facility matures on December 31, 2009, charges an interest rate of the applicable LIBOR rate plus 7% per year, and eliminates certain financial covenants. On November 6, 2007, we entered into a waiver and amendment to the BlueBay Senior Credit Facility for certain financial covenants as of November 1, 2007. The maximum borrowings we can make under the Senior Credit Facility will not by themselves provide all the funding we will need for the calendar 2007 holiday season. Management continues to seek additional financing and is pursuing other options to meet the cash requirements for funding the 2007 holiday season and to meet the working capital cash requirements of the current quarter but there is no guarantee that we will be able to do so.

As of November 15, 2007, we have drawn the full $10.0 million on the senior credit facility.

NOTE 9 – DISCONTINUED OPERATIONS

Sale of Reflections

In the first quarter of fiscal 2007, following the guidance established under FASB Statement No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” management committed to a plan to sell Reflections.

In August 2006, we sold to a third party the Driver intellectual property and certain assets of Reflections for $24.0 million. We maintained sell-off rights for three months for all Driver products, excluding Driver: Parallel Lines, which we maintained until the end of the third quarter of fiscal 2007. The tangible assets included in the sale were property and equipment only. Goodwill allocated to Reflections was $12.3 million. During the second quarter of fiscal 2007, we recorded a gain in the amount of the difference between the proceeds from the sale and the book value of Reflections’ property and equipment and the goodwill allocation. The gain recorded was approximately $11.5 million, and was included in (loss) from discontinued operations of Reflections in the second quarter of fiscal 2007.

Balance Sheets

At March 31, 2007 and September 30, 2007, the assets of Reflections are presented separately on our condensed consolidated balance sheets. The balances at March 31, 2007 represent assets associated with Reflections and the Driver franchise that were not included in the sale. Management’s intent is to divest itself of the remaining assets associated with Reflections’ office lease during fiscal 2008. The components of the assets of discontinued operations are as follows (in thousands):


	March 31, 2007		September 30, 2007
Assets:
Prepaid expenses and other current assets	$	310	$	47
Other non-current assets		335		348

Total assets	$	645	$	395

Page 21

•

Results of Operations

As Reflections represented a component of our business and its results of operations and cash flows can be separated from the rest of our operations, the results for the periods presented are disclosed as discontinued operations on the face of the condensed consolidated statements of operations. Net revenues and (loss) income from discontinued operations, net of tax, for the three months and six months ended September 30, 2006 and 2007, respectively, are as follows (in thousands):


	Three Months						Six Months
	Ended						Ended
	September 30,						September 30,
	2006			2007			2006			2007
Net revenues	$	(105	)	$	—		$	203		$	—
(Loss) from operations of Reflections Interactive Ltd.		(7,063	)		(11	)		(9,599	)		(33	)
Gain on sale of Reflections Interactive Ltd.		11,472			—			11,472			—
(Loss) income from discontinued operations of Reflections Interactive Ltd., net of tax	$	4,409		$	(11	)	$	1,873		$	(33	)

NOTE 10 – RESTRUCTURING

The charge for restructuring is comprised of the following (in thousands):


	Three Months Ended				Six Months Ended
	September 30,				September 30,
	2006		2007		2006		2007
Severance and retention expenses (1)	$	41	$	19	$	41	$	787
Lease related costs (2)		160		25		273		206
Miscellaneous costs		3		—		20		—

Total	$	204	$	44	$	334	$	993


(1)		In the first quarter of fiscal 2008, management announced a plan to reduce our total workforce by 20%, primarily in general and administrative functions.

(2)		As part of a restructuring plan implemented in fiscal 2005, we recorded the present value of all future lease payments, less the present value of expected sublease income to be recorded, primarily for the Beverly and Santa Monica offices, in accordance with FASB Statement No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” Through the remainder of the related leases, FASB Statement No. 146 requires us to record expense to adjust the present value recorded in 2005 to the actual expense and income recorded for the month. For the three months ended June 30, 2006, we recorded $0.1 million for the present value adjustments related to the Beverly and Santa Monica offices. The Santa Monica lease ended during the second quarter of fiscal 2007; therefore the expense of $0.2 million for the six months ended September 30, 2006. relates to the Beverly lease, which ended as of that date.

The following is a reconciliation of our restructuring reserve from March 31, 2007 to September 30, 2007 (in thousands):


	Balance at										Balance at
	March 31, 2007		Accrued Amounts		Reclasses			Cash payments, net			September 30, 2007
Short term
Severance and retention	$	—	$	787	$	—		$	(507	)	$	280
Lease related costs		54		206		3			(251	)		12

Total		54		993		3			(758	)		292

Long term
Lease related costs		3		—		(3	)		—			—

Total		3		—		(3	)		—			—


Total	$	57	$	993	$	—		$	(758	)	$	292

Page 22

NOTE 11 – SALE OF INTELLECTUAL PROPERTY

In the first quarter of fiscal 2007, we entered into a Purchase and Sale Agreement with a third party to sell and assign all rights, title, and interest in the Stuntman franchise, along with a development agreement with the current developer for the creation of this game. The cash proceeds from the sale were $9.0 million, which was recorded as a gain on sale of intellectual property during the three months ended June 30, 2006.

NOTE 12 – OPERATIONS BY REPORTABLE SEGMENTS

We have three reportable segments: publishing, distribution and corporate. Our publishing segment is comprised of business development, strategic alliances, product development, marketing, packaging, and sales of video game software for all platforms. Distribution constitutes the sale of other publishers’ titles to various mass merchants and other retailers. Corporate includes the costs of senior executive management, legal, finance, and administration. The majority of depreciation expense for fixed assets is charged to the corporate segment and a portion is recorded in the publishing segment. This amount consists of depreciation on computers and office furniture in the publishing unit. Historically, we do not separately track or maintain records, other than those for goodwill (all historically attributable to the publishing segment, and fully impaired as of March 31, 2007) and a nominal amount of fixed assets, which identify assets by segment and, accordingly, such information is not available.

The accounting policies of the segments are the same as those described in the summary of significant accounting policies. We evaluate performance based on operating results of these segments. There are no intersegment revenues.

The results of operations for Reflections are not included in our segment reporting below as they are classified as discontinued operations in our condensed consolidated financial statements. Prior to its classification as discontinued operations, the results for Reflections were part of the publishing segment.

Our reportable segments are strategic business units with different associated costs and profit margins. They are managed separately because each business unit requires different planning, and where appropriate, merchandising and marketing strategies.

The following summary represents the consolidated net revenues, operating (loss) income, depreciation and amortization, and interest (expense) income by reportable segment for the three months and six months ended September 30, 2006 and 2007 (in thousands):


	Publishing			Distribution		Corporate			Total
Three months ended September 30, 2006:
Net revenues	$	23,130		$	5,458	$	—		$	28,588
Operating (loss) income (1)		(3,994	)		1,466		(6,891	)		(9,419	)
Depreciation and amortization		(171	)		—		(598	)		(769	)
Interest income, net		—			—		116			116
Six months ended September 30, 2006:
Net revenues	$	32,894		$	15,168	$	—		$	48,062
Operating (loss) income (1)		(3,057	)		2,446		(13,391	)		(14,002	)
Depreciation and amortization		(373	)		—		(1,289	)		(1,662	)
Interest income, net		—			—		233			233
Three months ended September 30, 2007:
Net revenues	$	11,352		$	1,957	$	—		$	13,309
Operating (loss) income (1)		(1,886	)		49		(5,763	)		(7,600	)
Depreciation and amortization		(77	)		—		(383	)		(460	)
Interest expense, net		—			—		(32	)		(32	)
Six months ended September 30, 2007:
Net revenues	$	21,085		$	2,644	$	—		$	23,729
Operating (loss) income (1)		(6,365	)		126		(12,338	)		(18,577	)
Depreciation and amortization		(147	)		—		(728	)		(875	)
Interest expense, net		—			—		(45	)		(45	)

Page 23


(1)		Operating loss for the Corporate segment for the three months ended September 30, 2006 and 2007, excludes restructuring charges of $0.2 million and $0.1 million, respectively, and for the six months ended September 30, 2006 and 2007 excludes $0.3 million and $1.0 million, respectively. Including restructuring charges, total operating loss for the three months ended September 30, 2006 and 2007 is $9.6 million and $7.6 million, respectively, and for the six months ended September 30, 2006 and 2007 is $14.3 million and $19.6 million, respectively.

NOTE 13 – SUBSEQUENT EVENTS

FUNimation License Agreement

We are a party to two license agreements with FUNimation Productions, Ltd. (“FUNimation”) pursuant to which we distribute the Dragonball Z software titles. On October 18, 2007, FUNimation delivered a notice purporting to terminate the license agreements based on alleged breaches of the license agreements. We dispute the validity of the termination notices and have continued to distribute the titles covered by the license agreements. We and FUNimation are currently in discussions regarding a “standstill” agreement that would permit them to discuss and attempt to resolve the issues under the license agreements that resulted in FUNimation delivering the purported termination notice. There is no assurance that the parties will agree on the terms of the standstill or that they will be able to successfully resolve the issues under the license agreements. While we believe we have valid defenses to the purported termination, in the event that FUNimation is successful in terminating the license agreements it could have a material adverse effect on our results of operations and financial position. We have recorded an additional $2.8 million expense related to the FUNimation dispute during the six months ended September 30, 2007. This amount is comprised of an additional royalty expense of $1.2 million and $1.6 million related to minimum advertising commitment shortfalls. As part of this dispute we have reduced our FUNimation prepaid license advance by approximately $0.8 million during six months ended September 30, 2007 and have a liability of approximately $2.5 million as part of royalties payable as of September 30, 2007.

Restructuring and the License of Intellectual Property

Test Drive

On November 8, 2007, we entered into two separate license agreements (a Trademark Agreement and a IP Agreement) with IESA pursuant to which we grant IESA the exclusive right and license, under its trademark and intellectual and property rights, to create, develop, distribute and otherwise exploit licensed products derived from our series of interactive computer and video games known as “Test Drive” and “Test Drive Unlimited” (the “Franchise”) for a term of seven years (collectively, the “TDU Agreements”).

IESA shall pay the Company a non-refundable advance, fully recoupable against royalties to be paid under each of the TDU Agreements, of (i) $4 million under the Trademark Agreement and (ii) $1 million under the IP Agreement, both advances of which shall accrue interest at a yearly rate of 15% throughout the term of the applicable agreement (collectively, the “Advance Royalty”). The Advance Royalty is to be paid by IESA within five business days of the effective dates of the TDU Agreements. Under the Trademark Agreement, the base royalty rate is 7.2% of net revenue actually received by IESA from the sale of licensed products, or, in lieu of the foregoing royalties, 40% of net revenue actually received by IESA from the exploitation of licensed products on the wireless platform. Under the IP Agreement, the base royalty rate is 1.8% of net revenue actually received by IESA from the sale of licensed products, or, in lieu of the foregoing royalties, 10% of net revenue actually received by IESA from the exploitation of licensed products on the wireless platform.

Overhead Reduction

On November 13, 2007, we announced a plan to lower operating expenses by, among other things, reducing headcount. The plan includes (i) a reduction in force to consolidate certain operations, eliminate certain non-critical functions, and refocus certain engineering and support functions, and (ii) transfer of certain product development and business development employees to IESA in connection with the termination of a production services agreement between us and IESA. We expect that, after implementation of the plan, total headcount will be reduced by approximately 30.0%. We expect to incur restructuring charges in the range of $1.0 million to $1.5 million of which the majority relates to severance arrangements. We expect this plan to be completed by the end of March 31, 2008.

These actions are intended to allow the Company to devote more resources to focusing on its distribution business strategy.

Page 24

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

This document includes statements that may constitute forward-looking statements made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. We caution readers regarding certain forward-looking statements in this document, press releases, securities filings, and all other documents and communications. All statements, other than statements of historical fact, including statements regarding industry prospects and expected future results of operations or financial position, made in this Quarterly Report on Form 10-Q are forward looking. The words “believe,” “expect,” “anticipate,” “intend” and similar expressions generally identify forward-looking statements. Forward-looking statements are necessarily based upon a number of estimates and assumptions that, while considered reasonable by us, are inherently subject to significant business, economic and competitive uncertainties and contingencies and known and unknown risks. As a result of such risks, our actual results could differ materially from those expressed in any forward-looking statements made by, or on behalf of, us. Some of the factors which could cause our results to differ materially include the following: the loss of key customers, such as Wal-Mart, Best Buy, Target, and GameStop; delays in product development and related product release schedules; inability to secure capital; loss of our credit facility; inability to adapt to the rapidly changing industry technology, including new console technology; inability to maintain relationships with leading independent video game software developers; inability to maintain or acquire licenses to intellectual property; fluctuations in our quarterly net revenues or results of operations based on the seasonality of our industry; and the termination or modification of our agreements with hardware manufacturers. Please see the “Risk Factors” in our Annual Report on Form 10-K for the year ended March 31, 2007, or in our other filings with the Securities and Exchange Commission (“SEC”) for a description of some, but not all, risks, uncertainties and contingencies. Except as otherwise required by the applicable securities laws, we disclaim any intention or obligation publicly to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Going Concern

For the year ended March 31, 2007, we had an operating loss of $77.6 million, which included a charge of $54.1 million for the impairment of our goodwill, which is related to our publishing unit. During the six months ended September 30, 2007, we incurred an operating loss of approximately $19.6 million. We have taken significant steps to reduce our costs such as our May 2007, workforce reduction of approximately 20%. Our ability to deliver products on time depends in good part on developers’ ability to meet completion schedules. Further, our expected releases in fiscal 2008 are even fewer than our releases in fiscal 2007. In addition, most of our releases for fiscal 2008 are focused on the holiday season. As a result our cash needs have become more seasonal and we face significant cash requirements to fund our working capital needs during the second and third quarter of our fiscal year.

On October 5, 2007, CUSH, via a written consent, removed, James Ackerly, Ronald C. Bernard, Michael G. Corrigan, Denis Guyennot, and Ann E. Kronen from the Board of Directors of Atari. On October 15, 2007, we announced the appointment of Wendell Adair, Eugene I. Davis, James B. Shein, and Bradley E. Scher as independent directors of our Board. Further, we have also appointed Curtis G. Solsvig III, as our Chief Restructuring Officer and have retained

Page 25

AlixPartners (of which Mr. Solsvig is a Managing Director) to assist us in evaluating and implementing strategic and tactical options through our restructuring process.

On October 18, 2007, we consented to the transfer of the loans outstanding ($3.0 million) under the Guggenheim credit facility to funds affiliated with BlueBay Asset Management plc and to the appointment of BlueBay High Yield Investments (Luxembourg) S.A.R.L. (“BlueBay”), as successor administrative agent. BlueBay Asset Management plc is a significant shareholder of IESA. On October 23, 2007, we entered into a waiver and amendment with BlueBay for, as amended, a $10.0 million Senior Secured Credit Facility (“Senior Credit Facility”). The Senior Credit Facility matures on December 31, 2009, charges an interest rate of the applicable LIBOR rate plus 7% per year, and eliminates certain financial covenants. On November 6, 2007, we entered into a waiver and amendment to the BlueBay Senior Credit Facility for certain financial covenants as of November 1, 2007. The maximum borrowings we can make under the Senior Credit Facility will not by themselves provide all the funding we will need for the calendar 2007 holiday season. Management continues to seek additional financing and is pursuing other options to meet the cash requirements for funding the 2007 holiday season and to meet our working capital cash requirements but there is no guarantee that we will be able to do so.

We continue to explore various alternatives to improve our financial position and secure other sources of financing which could include raising equity, forming both operational and financial strategic partnerships, entering into new arrangements to license intellectual property, and selling, licensing or sub-licensing selected owned intellectual property and licensed rights. Further, as we are contemplating various alternatives, we will be utilizing our new Chief Restructuring Officer, AlixPartners, and our special committee of our board of directors, consisting of our newly appointed independent board members who are authorized to review significant and special transactions. We continue to examine the reduction of working capital requirements to further conserve cash and may need to take additional actions in the near-term, which may include additional personnel reductions and suspension of certain development projects during fiscal 2008.

Related party transactions

We are involved in numerous related party transactions with IESA and its subsidiaries. These related party transactions include, but are not limited to, the purchase and sale of product, game development, administrative and support services and distribution agreements. In addition, we use the name “Atari” under a license from Atari Interactive (a wholly-owned subsidiary of IESA) that expires in 2013. See Note 6 to the condensed consolidated financial statements for details.

Business and Operating Segments

We are a global publisher and developer of video game software for gaming enthusiasts and the mass-market audience, and a distributor of video game software in North America. We develop, publish, and distribute (both retail and digital) games for all platforms, including Sony PlayStation 2, PlayStation 3, and PSP; Nintendo Game Boy Advance, GameCube, DS, and Wii; Microsoft Xbox and Xbox 360; and personal computers, referred to as PCs. We also publish and sublicense games for the wireless, internet (casual games, MMOGs), and other evolving platforms, an area to which we expect to devote increasing attention. Our diverse portfolio of products extends across most major video game genres, including action, adventure, strategy, role-playing, and racing. Our products are based on intellectual properties that we have created internally and own or that have been licensed to us by third parties. We leverage external resources in the development of our games, assessing each project independently to determine which development team is best suited to handle the product based on technical expertise and historical development experience, among other factors. During fiscal 2007, we sold our remaining internal development studios; we believe that through the use of independent developers it will be more cost efficient to publish certain of our games. Additionally, through our relationship with IESA, our products are distributed exclusively by IESA throughout Europe, Asia and other regions. Through our distribution agreement with IESA,

Page 26

we have the rights to publish and sublicense in North America certain intellectual properties either owned or licensed by IESA or its subsidiaries, including Atari Interactive. We also manage the development of product at studios owned by IESA that focus solely on game development.

In addition to our publishing and development activities, we also distribute video game software in North America for titles developed by third party publishers with whom we have contracts. As a distributor of video game software throughout the U.S., we maintain distribution operations and systems, reaching well in excess of 30,000 retail outlets nationwide. Consumers have access to interactive software through a variety of outlets, including mass-merchant retailers such as Wal-Mart and Target; major retailers, such as Best Buy and Toys ‘R’ Us; and specialty stores such as GameStop. Our sales to key customers Wal-Mart, GameStop, and Best Buy accounted for approximately 24.6%, 23.0%, and 11.7%, respectively, of net revenues for the six months ended September 30, 2007. No other customers had sales in excess of 10% of net product revenues. Additionally, our games are made available through various internet, online, and wireless networks.

Key Challenges

The video game software industry has experienced an increased rate of change and complexity in the technological innovations of video game hardware and software. In addition to these technological innovations, there has been greater competition for shelf space as well as increased buyer selectivity. There is also increased competition for creative and executive talent. As a result, the video game industry has become increasingly hit-driven, which has led to higher per game production budgets, longer and more complex development processes, and generally shorter product life cycles. The importance of the timely release of hit titles, as well as the increased scope and complexity of the product development process, have increased the need for disciplined product development processes that limit costs and overruns. This, in turn, has increased the importance of leveraging the technologies, characters or storylines of existing hit titles into additional video game software franchises in order to spread development costs among multiple products.

We suffered large operating losses during fiscal 2007 and 2006. To fund these losses, we sold assets, including intellectual property rights related to game franchises that had generated substantial revenues for us and including our development studios. Further significant asset sales may not be practical if we are going to continue to engage in our current activities. However, we have both short and long term need for funds. Our only credit line is an asset based secured credit line that initially was limited to $15.0 million (subject to a borrowing base calculation), and which the lenders will have the right to cancel if, as is likely, we fail to meet financial covenants. On October 1, 2007, the lenders provided a waiver of covenant defaults as of June 30, 2007 and reduced the aggregate borrowing commitment of the revolving line of credit to $3.0 million. On October 18, 2007, we consented to the transfer of the loans outstanding ($3.0 million) under the Guggenheim credit facility to funds affiliated with BlueBay Asset Management plc and to the appointment of BlueBay High Yield Investments (Luxembourg) S.A.R.L. (“BlueBay”), as successor administrative agent. BlueBay Asset Management plc is a significant shareholder of IESA. On October 23, 2007, we entered into a waiver and amendment with BlueBay for, as amended, a $10.0 million Senior Secured Credit Facility (“Senior Credit Facility”). The Senior Credit Facility matures on December 31, 2009, charges an interest rate of the applicable LIBOR rate plus 7% per year, and eliminates certain financial covenants. On November 6, 2007, we entered into a waiver and amendment to the BlueBay Senior Credit Facility for certain financial covenants as of November 1, 2007. The maximum borrowings we can make under the Senior Credit Facility will not by themselves provide all the funding we will need for the calendar 2007 holiday season. Further, the Senior Credit Facility may be terminated if we do not comply with financial and other covenants. Historically, IESA has sometimes provided funds we needed for our operations, but it is not certain that it will be able, or will be willing, to provide the funding we will need for fiscal 2008 or subsequent to that. Management continues to seek additional financing and is pursuing other options to meet the cash requirements for funding the 2007 holiday season and to meet the working capital cash requirements of the current quarter but there is no guarantee that we will be able to do so.

The “Atari” name (which we license) has been an important part of our branding strategy, and we believe it provides us with an important competitive advantage in dealing with video game developers and in distributing products. Further, our management has been working on a strategic plan to replace part of the revenues we lost in recent years by expanding into new emerging aspects of the video game industry, including casual games, on-line sites, and digital downloading. In addition, we are considering licensing the “Atari” name for use in products other than video games. However, our ability to do at least some of those things will require expansion and extension of our rights to use and sublicense others to use the “Atari” name. We have no agreements or understandings that assure us that we will be able to expand the purposes for which we can use the “Atari” name or extend the period during which we will be able to use it.

Page 27

Critical Accounting Policies

Our discussion and analysis of financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to accounts receivable, inventories, intangible assets, investments, income taxes and contingencies. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ materially from these estimates under different assumptions or conditions.

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our condensed consolidated financial statements.

Revenue recognition, sales returns, price protection, other customer related allowances and allowance for doubtful accounts

Revenue is recognized when title and risk of loss transfer to the customer, provided that collection of the resulting receivable is deemed probable by management.

We maintain allowances for doubtful accounts for estimated losses resulting from the failure of our customers to make payments when due or within a reasonable period of time thereafter. If the financial condition of our customers were to deteriorate, resulting in an inability to make required payments, additional allowances may be required.

For the three months ended September 30, 2006 and 2007, we recorded allowances for bad debts, returns, price protection and other customer promotional programs of approximately $4.6 million and $3.4 million, respectively. For the six months ended September 30, 2006 and 2007, we recorded allowances for bad debts, returns, price protection and other customer promotional programs of approximately $8.8 million and $7.4 million, respectively. As of March 31, 2007 and September 30, 2007, the aggregate reserves against accounts receivable for bad debts, returns, price protection and other customer promotional programs were approximately $14.2 million and $0.5 million, respectively. With lower sales in the first two quarters of fiscal 2008, combined with the timing of cash receipts and price protection programs, certain customers were in net credit balance positions within our accounts receivable. As a result, $4.1 million (net of $9.5 million of gross receivables) as of September 30, 2007 were reclassified to accrued liabilities. As our first two quarters of our fiscal years are trending to be periods of few new product releases, we anticipate credit balance positions.

Inventories

We write down our inventories for estimated slow-moving or obsolete inventories equal to the difference between the cost of inventories and estimated market value based upon assumed market conditions. If actual market conditions are less favorable than those assumed by management, additional inventory write-downs may be required. For the three months ended September 30, 2006 and 2007, we recorded obsolescence expense of approximately $0.7 million and $0.1 million, respectively. For the six months ended September 30, 2006 and 2007 we recorded obsolescence expense of approximately $0.8 million and $0.3 million, respectively. As of March 31, 2007 and September 30, 2007, the aggregate reserve against inventories was approximately $1.9 million in each period.

Research and product development costs

Research and product development costs related to the design, development, and testing of newly developed software products, both internal and external, are charged to expense as incurred. Research and product development costs also include royalty payments (milestone payments) to third party developers for products that are currently in development. Once a product is sold, we may be obligated to make additional payments in the form of backend royalties to developers which are calculated based on contractual terms, typically a percentage of sales. Such payments are expensed and included in cost of goods sold in the period the sales are recorded.

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Licenses

Atari Trademark License

In connection with a recapitalization completed in fiscal 2004, Atari Interactive, Inc. (“Atari Interactive”), a wholly-owned subsidiary of IESA, extended the term of the license under which we use the Atari trademark to ten years expiring on December 31, 2013. We issued 200,000 shares of our common stock to Atari Interactive for the extended license and will pay a royalty equal to 1% of our net revenues during years six through ten of the extended license. We recorded a deferred charge of $8.5 million, representing the fair value of the shares issued, which was expensed monthly until it became fully expensed in the first quarter of fiscal 2007 ($8.5 million plus estimated royalty of 1% for years six through ten). The monthly expense was based on the total estimated cost to be incurred by us over the ten-year license period; upon the full expensing of the deferred charge, this expense is being recorded as a deferred liability owed to Atari Interactive, to be paid beginning in year six of the license.

Goodwill

Goodwill is the excess purchase price paid over identified intangible and tangible net assets of acquired companies. Goodwill is not amortized, and is tested for impairment at the reporting unit level annually or when there are any indications of impairment, as required by FASB Statement No. 142, “Goodwill and Other Intangible Assets.” A reporting unit is an operating segment for which discrete financial information is available and is regularly reviewed by management. We only have one reporting unit, our publishing business, to which goodwill is assigned.

A two-step approach is required to test goodwill for impairment for each reporting unit. The first step tests for impairment by applying fair value-based tests (described below) to a reporting unit. The second step, if deemed necessary, measures the impairment by applying fair value-based tests to specific assets and liabilities within the reporting unit. Application of the goodwill impairment tests require judgment, including identification of reporting units, assignment of assets and liabilities to each reporting unit, assignment of goodwill to each reporting unit, and determination of the fair value of each reporting unit. The determination of fair value for each reporting unit could be materially affected by changes in these estimates and assumptions. Such changes could trigger impairment.

During the fourth quarter of fiscal 2007, our market capitalization declined significantly. As this measure is our primary indicator of the fair value of our publishing unit, management considered this decline to be a triggering event, requiring us to perform step two of the impairment test. As of March 31, 2007, we completed the second step and our management, with the concurrence of the Audit Committee of our Board of Directors, concluded that a material impairment charge of $54.1 million should be recognized. This was a non-cash charge and was recorded in the fourth quarter of fiscal 2007.

Page 29

Results of operations

Three months ended September 30, 2006 versus the three months ended September 30, 2007

Condensed Consolidated Statements of Operations (dollars in thousands):


	Three						Three
	Months			% of			Months			% of
	Ended			Net			Ended			Net			(Decrease)/
	September 30,			Revenues			September 30,			Revenues			Increase
	2006						2007						$			%

Net revenues	$	28,588			100.0	%	$	13,309			100.0	%	$	(15,279	)		(53.4	)%
Costs, expenses, and income:
Cost of goods sold		15,251			53.3	%		6,276			47.2	%		(8,975	)		(58.8	)%
Research and product development		7,321			25.6	%		3,557			26.7	%		(3,764	)		(51.4	)%
Selling and distribution expenses		9,317			32.7	%		5,209			39.2	%		(4,108	)		(44.1	)%
General and administrative expenses		5,680			19.9	%		4,852			36.5	%		(828	)		(14.6	)%
Restructuring expenses		204			0.7	%		44			0.3	%		(160	)		(78.4	)%
Gain on sale of development studio assets		(885	)		(3.1	)%		—			0.0	%		885			100.0	%
Atari trademark license expense		555			1.9	%		555			4.2	%		—			0.0	%
Depreciation and amortization		768			2.7	%		460			3.5	%		(308	)		(40.1	)%

Total costs, expenses, and income		38,211			133.7	%		20,953			157.5	%		(17,258	)		(45.2	)%

Operating loss		(9,623	)		(33.7	)%		(7,644	)		(57.5	)%		1,979			20.6	%
Interest (expense) income, net		116			0.4	%		(32	)		(0.2	)%		(148	)		(127.6	)%
Other (expense) income		15			0.1	%		(4	)		0.0	%		(19	)		(126.7	)%

Loss before (benefit from) income taxes		(9,492	)		(33.2	)%		(7,680	)		(57.7	)%		1,812			19.1	%
(Benefit from) income taxes		(5,015	)		(17.5	)%		—			0.0	%		5,015			100.0	%

Loss from continuing operations		(4,477	)		(15.7	)%		(7,680	)		(57.7	)%		(3,203	)		(71.5	)%
(Loss) income from discontinued operations of Reflections Interactive Ltd., net of tax		4,409			15.4	%		(11	)		(0.1	)%		(4,420	)		(100.2	)%

																	0.0	%
Net loss	$	(68	)		(0.3	)%	$	(7,691	)		(57.8	)%	$	(7,623	)		(11210.3	)%

Net Revenues

Net Revenues by Segment (in thousands):


	Three Months
	Ended
	September 30,
	2006		2007		(Decrease)
Publishing	$	23,130	$	11,352	$	(11,778	)
Distribution		5,458		1,957		(3,501	)

Total	$	28,588	$	13,309	$	(15,279	)

Publishing Sales Platform Mix


	Three Months
	Ended
	September 30,
	2006			2007
PlayStation 2		39.4	%		20.6	%
Xbox 360		32.6	%		1.1	%
PC		15.6	%		38.2	%
PSP		6.3	%		33.6	%
Plug and Play		2.5	%		0.0	%
Game Boy Advance		2.0	%		0.4	%
Nintendo DS		1.4	%		0.9	%
Xbox		0.1	%		1.6	%
GameCube		0.1	%		0.0	%
Wii		0.0	%		3.6	%


Total		100.0	%		100.0	%

We anticipate recognizing the majority of our publishing revenues in our third and fourth quarter of fiscal 2008, a similar trend as compared to fiscal 2007. During the first six months of September 2007 we did not have any major new releases. The year over year comparison includes the following trends:

Page 30

	•		Net publishing product sales during the current quarter were driven by reorders of catalogue titles, which made up 75.3% of sales. The 2006 three months ended sales were driven by the new release of Test Drive Unlimited.

	•		International royalty income decreased by $1.5 million as the prior period income contained international sales of Test Drive Unlimited.

	•		The three months ended September 30, 2007 contains a one-time license payment of $4.0 million related to the sale of Hasbro, Inc. publishing and licensing rights which IESA sold back to Hasbro in July 2007. We anticipate the sale of these rights will reduce the amount of immediate license opportunities we have.

	•		The overall average unit sales price (“ASP”) of the publishing business has decreased from $19.59 in the prior comparable quarter to $17.58 in the current period as the current quarter’s sales consisted primarily of back catalogue sales.

Total distribution net revenues for the three months ended September 30, 2007 decreased by 64.1% from the prior comparable period due to the overall decrease in product sales of third party publishers as a result of management’s decision to reduce our third party distribution operations in efforts to move away from lower margin products. Due to our financial constraints related to fully funding our product development program, we will attempt to increase our focus on higher-margin distribution in the future.

Cost of Goods Sold

Cost of goods sold as a percentage of net revenues can vary primarily due to segment mix, platform mix within the publishing business, average unit sales prices, mix of royalty bearing products and the mix of licensed product. These expenses for the three months ended September 30, 2007 decreased by 58.8%. As a percentage of net revenues, cost of goods sold decreased from 53.3% to 47.2% due to the following:

	•		a lower mix of higher cost third-party distributed product sales as a percentage of net revenues (14.7% in fiscal 2008 compared with 19.0% in fiscal 2007), offset by

	•		a lower average sales price on our publishing products in the current period driven by catalogue sales and budget releases versus the inclusion of new release sales for the newest generation of console platforms in prior period, and

	•		an additional $1.2 million royalty reserve related to the FUNimation dispute.

Research and Product Development Expenses

Research and product development expenses consist of development costs relating to the design, development, and testing of new software products whether internally or externally developed, including the payment of royalty advances to third party developers on products that are currently in development and billings from related party developers. We expect to increase the use of external developers as we have sold all of our internal development studios. By leveraging external developers, we anticipate improvements in liquidity as we will no longer carry fixed studio overhead to support our development efforts. However, due to our cash constraints we have not been able to fully fund our development efforts. These expenses for the three months ended September 30, 2007 decreased approximately 51.4%, due primarily to:

	•		decreased spending of $2.0 million at our related party development studios due to the completion of Test Drive Unlimited, which was released in the second quarter of fiscal 2007,

	•		decreased salaries and other overhead of $1.0 million due to the sale of our Shiny studio in the second quarter of fiscal 2007, as well as additional executive and other personnel reductions, and

	•		decreased spending of $0.8 million for projects in development with external developers, as our development efforts have been limited due to cash constraints.

Page 31

Selling and Distribution Expenses

Selling and distribution expenses primarily include shipping, personnel, advertising, promotions and distribution expenses. During the three months ended September 30, 2007, selling and distribution expenses decreased $4.1 million or approximately 44.1%, due to:

	•		decreased spend on advertising of $4.3 million as the prior period contained advertising expense related to release of Test Drive Unlimited, and

	•		savings in salaries and related overhead costs due to reduced headcount resulting from studio closure and personnel reductions offset by

	•		an additional $1.6 million expense related to minimum advertising commitment shortfalls to be paid to FUNimation.

General and Administrative Expenses

General and administrative expenses primarily include personnel expenses, facilities costs, professional expenses and other overhead charges. General and administrative expenses as a percentage of net revenues increased to 36.5% due to the decreased sales volume in the three months ended September 30, 2007. During the three months ended September 30, 2007, general and administrative expenses decreased to $0.8 million. Trends within general and administrative expenses related to the following:

•

a reduction in salaries and other overhead costs of $0.5 million due to studio closures and other personnel reductions.

Restructuring Expenses

In the first quarter of fiscal 2008, management announced a plan to reduce our total workforce by 20%, primarily in general and administrative functions. This plan resulted in restructuring charges of approximately $1.0 million of which $0.1 million has been incurred in the three months ended September 30, 2007. The second quarter of fiscal 2007 contains $0.2 million of additional restructuring expense from the fiscal 2006 restructuring plan.

Gain on Sale of Development Studio Assets

During the three months ended September 30, 2006, we sold certain development studio assets of Shiny to a third party for a gain of $0.9 million. The gain represents the proceeds of $1.8 million (of which $0.2 million was held in escrow for nine months), less the net book value of the development studio assets sold of $0.9 million.

Depreciation and Amortization

Depreciation and amortization for three months ended September 30, 2007 decreased 40.1% due to:

•

savings in depreciation relate to the closure of offices and reduction of staffing and associated overhead

(Benefit from) Income Taxes

During the three months ended September 30, 2006, a $5.0 million benefit from income taxes primarily resulted from a non-cash tax benefit of $5.4 million, which offsets a non-cash tax provision of the same amount included in loss from discontinued operations, recorded in accordance with FASB Statement No, 109, “Accounting for Income Taxes,” paragraph 140, which states that all items should be considered for purposes of determining the amount of tax benefit that results from a loss from continuing operations and that should be allocated to continuing operations. The recording of a benefit is appropriate in this instance, under the guidance of Paragraph 140, because such domestic loss offsets the domestic gain generated in discontinued operations. The effect of this transaction on net loss for fiscal 2007 is zero, and it does not result in the receipt or payment of any cash.

Page 32

Loss from Discontinued Operations of Reflections Interactive Ltd., net of tax

Loss from discontinued operations of Reflections Interactive Ltd. decreased $4.4 million from a gain from discontinued operations of $4.4 million in the second quarter of fiscal 2007 to a nominal amount in the second quarter of fiscal 2008, which relates to remaining lease costs. The fiscal 2007 gain was driven by the gain of sale of Reflections of $11.4 million (sold in August 2006) offset by the operating costs of the Reflections studio of $1.6 million and a tax provision associated with discontinued operations of $5.4 million, recorded in accordance with FASB Statement No. 109, “Accounting for Income Taxes,” paragraph 140, and offset by a tax benefit of an equal amount in continuing operations (see Benefit from Income Taxes above).

Six months ended September 30, 2006 versus the six months ended September 30, 2007

Condensed Consolidated Statements of Operations (dollars in thousands):


	Six						Six
	Months			% of			Months			% of
	Ended			Net			Ended			Net			(Decrease)/
	September 30,			Revenues			September 30,			Revenues			Increase
	2006						2007						$			%

Net revenues	$	48,062			100.0	%	$	23,729			100.0	%	$	(24,333	)		(50.6	)%
Costs, expenses, and income:
Cost of goods sold		29,178			60.7	%		13,042			55.0	%		(16,136	)		(55.3	)%
Research and product development		14,467			30.1	%		7,968			33.6	%		(6,499	)		(44.9	)%
Selling and distribution expenses		14,418			30.0	%		8,760			36.8	%		(5,658	)		(39.2	)%
General and administrative expenses		11,115			23.1	%		10,552			44.5	%		(563	)		(5.1	)%
Restructuring expenses		334			0.7	%		993			4.2	%		659			197.3	%
Gain on sale of intellectual property		(9,000	)		(18.7	)%		—			0.0	%		9,000			100.0	%
Gain on sale of development studio assets		(885	)		(1.8	)%		—			0.0	%		885			100.0	%
Atari trademark license expense		1,109			2.3	%		1,109			4.7	%		—			0.0	%
Depreciation and amortization		1,662			3.5	%		875			3.7	%		(787	)		(47.4	)%

Total costs, expenses, and income		62,398			129.9	%		43,299			(182.5	)%		(19,099	)		(30.6	)%

Operating loss		(14,336	)		(29.9	)%		(19,570	)		(82.5	)%		(5,234	)		(36.5	)%
Interest (expense) income, net		233			0.5	%		(45	)		(0.2	)%		(278	)		(119.3	)%
Other (expense) income		34			0.1	%		15			0.1	%		(19	)		(55.9	)%

Loss before (benefit from) income taxes		(14,069	)		(29.3	)%		(19,600	)		(82.6	)%		(5,531	)		(39.3	)%
(Benefit from) income taxes		(4,833	)		(10.1	)%		—			0.0	%		4,833			(100.0	)%

Loss from continuing operations		(9,236	)		(19.2	)%		(19,600	)		(82.6	)%		(10,364	)		(112.2	)%
(Loss) income from discontinued operations of Reflections Interactive Ltd., net of tax		1,873			3.9	%		(33	)		(0.1	)%		(1,906	)		(101.8	)%


Net loss	$	(7,363	)		(15.3	)%	$	(19,633	)		(82.7	)%	$	(12,270	)		(166.6	)%

Net Revenues

Net Revenues by Segment (in thousands):


	Six Months
	Ended
	September 30,
	2006		2007		(Decrease)
Publishing	$	32,894	$	21,085	$	(11,809	)
Distribution		15,168		2,644		(12,524	)

Total	$	48,062	$	23,729	$	(24,333	)

Publishing Sales Platform Mix


	Six Months
	Ended
	September 30,
	2006			2007
PlayStation 2		32.3	%		16.9	%
PC		24.4	%		37.1	%
Xbox 360		21.2	%		2.4	%
PSP		10.6	%		29.6	%
Game Boy Advance		5.7	%		0.3	%

Page 33


	Six Months
	Ended
	September 30,
	2006			2007
Plug and Play		3.5	%		0.0	%
Nintendo DS		1.5	%		9.9	%
Xbox		0.4	%		0.7	%
GameCube		0.4	%		0.0	%
Wii		0.0	%		3.1	%

Total		100.0	%		100.0	%

	•		Net publishing product sales during the current quarter were driven by reorders of catalogue titles, which made up 70.6% of sales. Sales from new releases in the first six months were driven mainly by Dungeon and Dragons: Tactics (Sony PSP) and Dragon Ball Z: HARUKANARU DENSETSU (Nintendo DS). The six months ended September 30, 2007 sales are comprised of the new release of Test Drive Unlimited and back catalogue sales.

	•		International royalty income decreased by $0.1 million as the prior period income from the international release of Test Drive Unlimited and reductions due to larger than anticipated returns on international sales of Matrix: Path of Neo and Getting Up: Contents Under Pressure, released in the third quarter and fourth quarter, respectively, of fiscal 2006.

	•		The six months ended September 30, 2007 contains a one-time license payment of $4.0 million related to the sale of Hasbro, Inc. publishing and licensing rights which IESA sold back to Hasbro in July 2007. We anticipate the sale of these rights will reduce the amount of immediate license opportunities we have.

	•		The overall average unit sales price (“ASP”) of the publishing business remained consistent from $18.03 in the prior comparable quarter versus $17.91 in the current period.

Total distribution net revenues for the six months ended September 30, 2007 decreased by 82.6% from the prior comparable period due to the overall decrease in product sales of third party publishers as a result of management’s decision to reduce our third party distribution operations in efforts to move away from lower margin products. Due to our financial constraints related to fully funding our product development program, we will attempt to increase our focus on higher-margin distribution in the future.

Cost of Goods Sold

Cost of goods sold for the six months ended September 30, 2007 decreased by 55.3%. As a percentage of net revenues, cost of goods sold decreased from 60.7% to 55.0% due to the following:

	•		a lower mix of higher cost third-party distributed product sales as a percentage of net revenues (11.1% in fiscal 2008 compared with 31.6% in fiscal 2007), offset by

	•		a lower average sales price on our publishing products in the current period driven by catalogue sales and budget releases versus the inclusion of new release sales for the newest generation of console platforms in prior period, and

	•		an additional $1.2 million royalty reserve related to the FUNimation dispute.

Research and Product Development Expenses

We expect to increase the use of external developers as we have sold all of our internal development studios. By leveraging external developers, we anticipate improvements in liquidity as we will no longer carry fixed studio overhead to support our development efforts. These expenses for the six months ended September 30, 2007 decreased approximately 44.9%, due primarily to:

•

decreased spending of $5.2 million at our related party development studios due to the completion of Test Drive Unlimited, which was released in the second quarter of fiscal 2007, and

Page 34

	•		decreased salaries and other overhead of $2.2 million due to the sale of our Shiny studio in the second quarter of fiscal 2007, as well as additional executive and other personnel reductions, offset by

	•		increased spending of $0.9 million for projects in development with external developers, as we increase our focus on external development.

Selling and Distribution Expenses

During the six months ended September 30, 2007, selling and distribution expenses decreased $5.7 million or approximately 39.2%, due to:

	•		decreased spending on advertising of $4.6 million, and

	•		savings in salaries and related overhead costs due to reduced headcount resulting from studio closure and personnel reductions, offset by

	•		an additional $1.6 million expense related to minimum advertising commitment shortfalls to be paid to FUNimation.

General and Administrative Expenses

General and administrative expenses as a percentage of net revenues increased to 44.5% due to the decreased sales volume in the six months ended September 30, 2007. During the six months ended September 30, 2007, general and administrative expenses decreased by $0.6 million. Trends within general and administrative expenses related to the following:

•

a reduction in salaries and other overhead costs of $0.6 million due to studio closures and other personnel reductions.

Restructuring Expenses

In the first quarter of fiscal 2008, management announced a plan to reduce our total workforce by 20%, primarily in general and administrative functions. This restructuring resulted in restructuring charges of approximately $1.0 million. The first two quarters of fiscal 2007 contains $0.3 million of additional restructuring expense from the fiscal 2006 restructuring plan.

Gain on Sale of Intellectual Property

In the fiscal 2007 first quarter, we sold the Stuntman intellectual property to a third party for $9.0 million, which was recorded as a gain. No such gain was recorded in the current period.

Gain on Sale of Development Studio Assets

During the six months ended September 30, 2006, we sold certain development studio assets of Shiny to a third party for a gain of $0.9 million. The gain represents the proceeds of $1.8 million (of which $0.2 million is held in escrow for nine months), less the net book value of the development studio assets sold of $0.9 million.

Depreciation and Amortization

Depreciation and amortization for six months ended September 30, 2007 decreased 47.4% due to:

•

savings in depreciation relate to the closure of offices and reduction of staffing and associated overhead

(Benefit from) Income Taxes

During the six months ended September 30, 2006, a $4.8 million benefit from income taxes primarily results from a non-cash tax benefit of $5.4 million, which offsets a non-cash tax provision of the same amount included in loss from discontinued operations, recorded in accordance with FASB Statement No, 109, “Accounting for Income Taxes,” paragraph 140, which states that all items should be considered for purposes of determining the amount of tax benefit that results from a loss from continuing operations and that should be allocated to continuing operations. The recording of a benefit is

Page 35

appropriate in this instance, under the guidance of Paragraph 140, because such domestic loss offsets the domestic gain generated in discontinued operations. The effect of this transaction on net loss for fiscal 2007 is zero, and it does not result in the receipt or payment of any cash. This non-cash tax benefit is offset by $0.6 million of deferred tax liability recorded due to a temporary difference that arose from a difference in the book and tax basis of goodwill

Loss from Discontinued Operations of Reflections Interactive Ltd., net of tax

Loss from discontinued operations of Reflections Interactive Ltd. decreased $1.9 million from a gain from discontinued operations of $1.9 million in the second quarter of fiscal 2007 to a nominal amount in the second quarter of fiscal 2008, which relates to remaining lease costs. The fiscal 2007 gain was driven by the gain of sale of Reflections of $11.4 million (sold in August 2006) offset by the operating costs of the Reflections studio of $4.2 million and a tax provision associated with discontinued operations of $5.4 million, recorded in accordance with FASB Statement No, 109, “Accounting for Income Taxes,” paragraph 140, and offset by a tax benefit of an equal amount in continuing operations (see Benefit from Income Taxes above).

Liquidity and Capital Resources

Overview

A need for increased investment in development and increased need to spend advertising dollars to support product launches, caused in part by “hit-driven” consumer taste, have created a significant increase in the amount of financing required to sustain operations, while negatively impacting margins. Further, as our business continues to be more seasonal, which creates a need for significant financing to fund the seasonal development and manufacturing activities, in addition to the financing we need throughout the year to fund our working capital requirements. Our only credit line is an asset based secured credit line that is limited to $10.0 million, and which the lenders will have the right to cancel if we fail to meet financial and other covenants. Even if the credit line remains in effect, it will not provide all the funds we will need to pay for inventory that will be needed for the calendar 2007 holiday season. Historically, IESA has sometimes provided funds we needed for our operations, but it is not certain that it will be able, or will be willing to provide the funding we will need for fiscal 2008 or subsequent to that.

Because of our funding difficulties, we have sharply reduced our expenditures for research and product development regarding new games. During the year ended March 31, 2007, our expenditures on research and product development decreased by 42.0%, to $30.1 million, compared with $51.9 million in fiscal 2006. During the six months ended September 30, 2007, expenditures on research and product development was $8.0 million versus $14.5 million in the comparable fiscal 2007 period. This will reduce the flow of new games that will be available to us in fiscal 2008 and 2009, and possibly after that. Our lack of financial resources to fund a full product development program may reinforce our focus on casual gaming, which requires substantially less research and product investment.

During fiscal 2007, we raised approximately $35.0 million through the sale of a certain intellectual property and the divestiture of our internal development studios. In May 2007, we announced a plan to reduce our total workforce by approximately 20% as a cost cutting initiative. To reduce working capital requirements and further conserve cash we will need to take additional actions in the near-term, which may include additional personnel reductions and suspension of additional development projects. However, these steps may not fully resolve the problems with our financial position. Also, lack of funds will make it difficult for us to undertake a strategic plan to generate new sources of revenues and otherwise enable us to attain long-term strategic objectives. We continue to seek additional funding.

Cash Flows

(in thousands)


	March 31,		September 30,
	2007		2007
Cash	$	7,603	$	2,718
Working capital	$	1,213	$	(15,837	)

Page 36


	Six Months Ended
	September 30,
	2006			2007
Cash used in operating activities	$	(34,155	)	$	(4,494	)
Cash provided by (used in) investing activities		29,574			(349	)
Cash used in financing activities		(152	)		(51	)
Effect of exchange rates on cash		9			9


Net decrease in cash	$	(4,724	)	$	(4,885	)

During the six months ended September 30, 2007, our operations used cash of approximately $4.5 million to support our net loss of $19.6 million for the period offset by collections of accounts receivable and the timing of payments made to vendors during the first six months of fiscal 2008. During the six months ended September 30, 2006, our operations used cash of approximately $34.2 million driven by the net loss of $7.3 million for the period, compounded by increased payments of trade payables and royalties payable, offset by a decrease in accounts receivable from lower sales during the current period.

During the six months ended September 30, 2007, cash used in investing activities of $0.3 million was due to purchases of property and equipment. During the six months ended September 30, 2006, investing activities provided cash of $29.6 million due to several sale transactions completed during the period:

	•		proceeds of $21.6 million received in connection with the sale of our Reflections studio,

	•		proceeds of $9.0 million from the sale of the Stuntman intellectual property,

	•		and proceeds of $1.6 million from the sale of our Shiny studio in the current period

The cash proceeds are partially offset by the increase in restricted cash of $1.8 million for the collateralizing of a letter of credit related to our new office lease and the purchase of assets of $0.8 million.

During the six months ended September 30, 2006 and 2007, our financing activities used a nominal amount of cash due to payments to capital lease obligations.

We have a three-year revolving credit facility with Guggenheim to fund our working capital needs. On October 1, 2007, the lenders provided a waiver of covenant defaults as of June 30, 2007 and reduced the aggregate borrowing commitment of the revolving line of credit to $3.0 million.

The maximum borrowings we can make under the Senior Credit Facility will not by themselves provide all the funding we will need for the calendar 2007 holiday season. Further, the Senior Credit Facility may be terminated if we do not comply with financial and other covenants. Management continues to seek additional financing and is pursuing other options to meet the cash requirements for funding the 2007 holiday season and to meet the working capital cash requirements of the current quarter but there is no guarantee that we will be able to do so.

Our outstanding accounts receivable balance varies significantly on a quarterly basis due to the seasonality of our business and the timing of new product releases. There were no significant changes in the credit terms with customers during the three month period.

Due to our reduced product releases, our business has become increasingly seasonal. This increased seasonality has put significant pressure on our liquidity prior to our holiday season as financing requirements to build inventory are high.

Page 37

During fiscal 2007, our third quarter (which includes the holiday season) represented approximately 38.7% of our net revenues for the entire year.

We do not currently have any material commitments with respect to any capital expenditures. However, we do have commitments to pay royalty and license advances, milestone payments, and operating and capital lease obligations.

Our ability to maintain sufficient levels of cash could be affected by various risks and uncertainties including, but not limited to, customer demand and acceptance of our new versions of our titles on existing platforms and our titles on new platforms, our ability to collect our receivables as they become due, risks of product returns, successfully achieving our product release schedules and attaining our forecasted sales goals, seasonality in operating results, fluctuations in market conditions and the other risks described in the “Risk Factors” as noted in our Annual Report on Form 10-K for the year ended March 31, 2007.

We are also party to various litigations arising in the normal course of our business. Management believes that the ultimate resolution of these matters will not have a material adverse effect on our liquidity, financial condition or results of operations.

Selected Balance Sheet Accounts

Receivables, net

Receivables, net, decreased by $6.0 million from $6.5 million at March 31, 2007 to $0.5 million at September 30, 2007. This is due to lower sales occurring during the quarter, versus the sales in the fourth quarter of fiscal 2007. With lower sales in the first six months of fiscal 2008, combined with the timing of cash receipts and price protection programs, certain customers were in net credit balance positions within our accounts receivable. As a result, $4.1 million (net of $9.5 million of gross receivables) during the six months ended September 30, 2007 were reclassified to accrued liabilities.

Due from Related Parties/Due to Related Parties

Due from related parties decreased by $1.2 million and due to related parties decreased by $1.0 million from March 31, 2007 to September 30, 2007 driven by balances between parties settled by netting during the quarter.

Long-term liabilities and Property Plant and Equipment

Long-term liabilities and property plant and equipment increased during the six months ended September 30, 2007 approximately $3.6 million and $2.3 million, respectively, primarily due to the capitalization of assets and deferred effect of landlord contributions related to our corporate headquarters located at 417 5^th Avenue, New York, New York.

Credit Facilities

Guggenheim Credit Facility

On November 3, 2006, we established a secured credit facility with several lenders for which Guggenheim is the administrative agent. The Guggenheim credit facility will terminate and be payable in full on November 3, 2009. The credit facility consists of a secured, committed, revolving line of credit in an amount up to $15.0 million, which includes a $10.0 million sublimit for the issuance of letters of credit. Availability under the credit facility is determined by a formula based on a percentage of our eligible receivables. The proceeds may be used for general corporate purposes and working capital needs in the ordinary course of business and to finance acquisitions subject to limitations in the Credit Agreement. The credit facility bears interest at our choice of (i) LIBOR plus 5% per year, or (ii) the greater of (a) the prime rate in effect, or (b) the Federal Funds Effective Rate in effect plus 2.25% per year. Additionally, we are required to pay a commitment fee on the undrawn portions of the credit facility at the rate of 0.75% per year and we paid to Guggenheim a closing fee of $0.2 million. Obligations under the credit facility are secured by liens on substantially all of our present and future assets, including accounts receivable, inventory, general intangibles, fixtures, and equipment, but excluding the stock of our subsidiaries and certain assets located outside of the U.S.

Page 38

financial covenants. On October 1, 2007, the lenders provided a waiver of covenant defaults as of June 30, 2007 and reduced the aggregate borrowing commitment of the revolving line of credit to $3.0 million.

On October 18, 2007, we consented to the transfer of the loans outstanding ($3.0 million) under the Guggenheim credit facility to funds affiliated with BlueBay Asset Management plc and to the appointment of BlueBay High Yield Investments (Luxembourg) S.A.R.L. (“BlueBay”), as successor administrative agent. BlueBay Asset Management plc is a significant shareholder of IESA. On October 23, 2007, we entered into a waiver and amendment with BlueBay for, as amended, a $10.0 million Senior Secured Credit Facility (“Senior Credit Facility”). The Senior Credit Facility matures on December 31, 2009, charges an interest rate of the applicable LIBOR rate plus 7% per year, and eliminates certain financial covenants. On November 6, 2007, we entered into a waiver and amendment to the BlueBay Senior Credit Facility for certain financial covenants as of November 1, 2007. The maximum borrowings we can make under the Senior Credit Facility will not by themselves provide all the funding we will need for the calendar 2007 holiday season. Management continues to seek additional financing and is pursuing other options to meet the cash requirements for funding the 2007 holiday season and to meet the working capital cash requirements of the current quarter but there is no guarantee that we will be able to do so.

As of November 15, 2007, we have drawn the full $10.0 million on Senior Credit Facility.

Contractual Obligations


	Contractual Obligations
	Royalty and
	license		Milestone		Operating lease		Capital lease
Through	advances (1)		payments (2)		obligations (3)		obligations (4)		Total

September 30, 2008	$	5,900	$	1,704	$	2,045	$	33	$	9,682
September 30, 2009		8		—		1,851		—		1,859
September 30, 2010		2		—		1,806		—		1,808
September 30, 2011		—		—		1,720		—		1,720
September 30, 2012		—		—		1,329		—		1,329
Thereafter		—		—		12,301		—		12,301

Total	$	5,910	$	1,704	$	21,052	$	33	$	28,699


(1)		We have committed to pay advance payments under certain royalty and license agreements. The payments of these obligations are dependent on the delivery of the contracted services by the developers.

(2)		Milestone payments represent royalty advances to developers for products that are currently in development. Although milestone payments are not guaranteed, we expect to make these payments if all deliverables and milestones are met timely and accurately.

(3)		We account for our office leases as operating leases, with expiration dates ranging from fiscal 2008 through fiscal 2022. There are future minimum annual rental payments required under the leases, including a related party sublease with Atari Interactive, net of $1.1 million of sublease income to be received in fiscal 2008 and fiscal 2009. Leasehold improvements made at the beginning of or during a lease are amortized over the shorter of the remaining lease term or the estimated useful lives of the assets.

		During June 2006, we entered into a new lease with our current landlord at our New York headquarters for approximately 70,000 square feet of office space for our principal offices. The term of this lease commenced on July 1, 2006 and is to expire on June 30, 2021. Upon entering into the new lease, our prior lease, which was set to expire in December 2006, was terminated. The rent under the new lease for the office space was approximately $2.4 million per year for the first five years, increased to approximately $2.7 million per year for the next five years, and increased to $2.9 million for the last five years of the term. In addition, we must pay for electricity, increases in real estate taxes and increases in porter wage rates over the term. The landlord is providing us with a one year rent credit of $2.4 million and an allowance of $4.5 million to be used for building out and furnishing the premises, of which $1.2 million has been recorded as a deferred credit as of March 31, 2007; the remainder of the deferred credit will be recorded as the improvements are completed, and will be amortized against rent expense over the life of the lease. A nominal amount of amortization was recorded during the year ended March 31, 2007. For the six months ended September 30, 2007, we recorded an additional deferred credit of $3.0 million and amortization against the total deferred credits of approximately $0.1 million. Shortly after signing the new

Page 39


		lease, we provided the landlord with a security deposit under the new lease in the form of a letter of credit in the initial amount of $1.7 million, which has been cash collateralized and is included in security deposits on our condensed consolidated balance sheet at September 30, 2007. On August 14, 2007, we and our new landlord, W2007 Fifth Realty, LLC, amended the lease under which we occupy space in 417 Fifth Avenue, New York City, to reduce the space we occupy by approximately one-half, effective December 31, 2007. As a result, our rent under the amended lease will be reduced from its current approximately $2.4 million per year to approximately $1.2 million per year from January 1, 2008 through June 30, 2011, approximately $1.3 million per year for the five years thereafter, and approximately $1.5 million per year for the last five years of the term.

(4)		We maintain several capital leases for computer equipment. Per FASB Statement No. 13, “Accounting for Leases,” we account for capital leases by recording them at the present value of the total future lease payments. They are amortized using the straight-line method over the minimum lease term. As of March 31, 2007, the net book value of the assets, included within property and equipment on the balance sheet, was $0.1 million, net of accumulated depreciation of $0.5 million. As of September 30, 2007, the net book value of the assets was $0.1 million, net of accumulated depreciation of $0.5 million.

Effect of Relationship with IESA on Liquidity

Historically, we have relied on IESA to provide limited financial support to us; however, IESA has its own financial needs and, as it assesses its business operations/plan, its ability and willingness to fund its subsidiaries’ operations, including ours, is uncertain. See Note 6 for a discussion of our relationship with IESA.

Recent Accounting Pronouncements

See Note 1 to the condensed consolidated financial statements.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Our carrying values of cash, trade accounts receivable, inventories, prepaid expenses and other current assets, accounts payable, accrued liabilities, royalties payable, assets of discontinued operations, and amounts due to and from related parties are a reasonable approximation of their fair value.

Foreign Currency Exchange Rates

We earn royalties on sales of our product sold internationally. These revenues, which are based on various foreign currencies and are billed and paid in U.S. dollars, represented a $0.8 million of our revenues for the six months ended September 30, 2007. We also purchase certain of our inventories from foreign developers and pay royalties primarily denominated in euros to IESA from the sale of IESA products in North America. While we do not hedge against foreign exchange rate fluctuations, our business in this regard is subject to certain risks, including, but not limited to, differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions and foreign exchange rate volatility. Our future results could be materially and adversely impacted by changes in these or other factors. As of September 30, 2007, we did not have any net revenues from our foreign subsidiaries; these subsidiaries represent $0.8 million, or 2.5%, of our total assets, of which $0.6 million is associated with our previously wholly-owned Reflections studio and is included in assets of discontinued operations on our condensed consolidated balance sheet. We also recorded a nominal amount of operating expenses attributed to foreign operations of Reflections, included in loss from discontinued operations on our condensed consolidated statement of operations. Currently, substantially all of our business is conducted in the United States where revenues and expenses are transacted in U.S. dollars. As a result, the majority of our results of operations are not subject to foreign exchange rate fluctuations.

Item 4T. Controls and Procedures

Evaluation of disclosure controls and procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to management, as appropriate, to allow timely decisions regarding required disclosure. Management, with participation of our Chief Executive Officer and Acting Chief Financial Officer, has conducted an evaluation of the effectiveness of the Company’s disclosure controls and procedures (as defined in the Securities Exchange Act of 1934 Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this quarterly report on Form 10-Q.

As previously disclosed in our Annual Report on Form 10-K for the fiscal year ended March 31, 2007, we determined that, as of March 31, 2007, there were three material weaknesses affecting our internal control over financial reporting and, as a result of those weaknesses, our disclosure controls and procedures were not effective. As described below,

Page 40

we plan to begin the remediation of those material weaknesses during the fourth quarter of fiscal 2008. Therefore, as the three material weaknesses at March 31, 2007 have not been remediated, the Company’s management, including our Chief Executive Officer and Acting Chief Financial Officer, has concluded that, as of September 30, 2007, the Company’s disclosure controls and procedures were not effective.

Management’s Remediation Initiatives

As previously reported in our Annual Report on Form 10-K for the fiscal year ended March 31, 2007, management determined that, as of March 31, 2007, there were material weaknesses in our internal control over financial reporting relating to (i) ineffective controls relating to the financial closing and reporting process that failed to detect certain accounting errors, (ii) communication controls between us and our majority shareholder, IESA, which lead to the failure to detect certain required accounting entries and (iii) control failures over income tax accounts and related disclosures. Management will leverage internal resources and seek assistance from outside consultants to help design and implement necessary controls. Management is currently determining what level of support will be needed. Management believes our remediation efforts will be completed prior to the end of the fourth quarter of our fiscal year 2008.

Changes in Internal Control over Financial Reporting

There have been no changes in our internal control over financial reporting that occurred during the quarter ended September 30, 2007 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

Litigation

Bouchat v. Champion Products, et al. (Accolade)

Ernst & Young, Inc. v. Atari, Inc.

Research in Motion Limited v. Atari, Inc. and Atari Interactive, Inc.

Page 41

under US or Canadian law. RIM is also requesting the costs of the action and such other relief as the court deems. Breakout and Super Breakout are games owned by Atari Interactive. On January 19, 2007, RIM added claims to its case requesting a declaration that (i) its game Meteor Crusher does not infringe Atari copyright for its game Asteroids in Canada, (ii) the audio-visual displays of Asteroids do not constitute a work protected under Canadian law, and (iii) Atari holds no right, title or interest in Asteroids under Canadian law. In August 2007, the Court ruled against Atari’s December 2006 motion to have the RIM claims dismissed on the grounds that there is no statutory relief available to RIM under Canadian law. Atari is in the process of appealing this decision.

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

The Annual Meeting of Stockholders was held on November 6, 2007. Of the 13,477,920 shares of common stock outstanding and entitled to vote at the Annual Meeting, 10,979,482 shares were present in person or by proxy, each entitled to one vote on each matter to come before the meeting. The matters acted upon at our 2007 Annual Meeting of Stockholders, and the voting tabulation for each such matter are as follows:

Proposal 1. To elect three Class II directors to hold office until the 2009 Annual Meeting of Stockholders.


CLASS III	For		Withheld
Evence-Charles Coppee		10,228,120		751,362
Jean-Michel Perbet		10,186,036		793,446


*		With respect to the election of directors, there were no abstentions or broker non-votes because, pursuant to the terms of the Notice of Annual Meeting and Proxy Statement, proxies received were voted, unless authority was withheld, in favor of the election of the nominees named.

As set forth above, at the Annual Meeting, Evence-Charles Coppee and Jean-Michel Perbet were elected as Class III directors. The five remaining members of our Board of Directors, who are in Classes I and III with terms that do not expire until the 2008 Annual Meeting of Stockholders and 2009 Annual Meeting of Stockholders, respectively, are Wendell H. Adair Jr. (Class II), Eugene I. Davis (Class II), Bradley E. Scher (Class II), Thomas Schmider (Class I) and James B. Shein (Class I).

Page 42


	Page
PART I — FINANCIAL INFORMATION

Item 1. Financial Statements (unaudited):
Condensed Consolidated Balance Sheets as of March 31, 2007 and September 30, 2007		3
Condensed Consolidated Statements of Operations for the Three Months and Six Months Ended September 30, 2006 and 2007		4
Condensed Consolidated Statements of Cash Flows for the Six Months Ended September 30, 2006 and 2007		5
Condensed Consolidated Statement of Stockholders’ Equity and Comprehensive Loss for the Six Months Ended September 30, 2007		7
Notes to the Condensed Consolidated Financial Statements		8
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		25
Item 3. Quantitative and Qualitative Disclosures about Market Risk		43
Item 4T. Controls and Procedures		44

PART II — OTHER INFORMATION

Item 1. Legal Proceedings		45
Item 4. Submission of Matters to a Vote of Security Holders		46
Item 5. Other Information		47
Item 6. Exhibits		48
Signature		49
EX-31.1: CERTIFICATION
EX-31.2: CERTIFICATION
EX-32.1: CERTIFICATION
EX-32.2: CERTIFICATION


										Accumulated
	Common				Additional					Other
	Stock		Common		Paid-In		Accumulated			Comprehensive
	Shares		Stock		Capital		Deficit			Income			Total
Balance, March 31, 2007		13,478	$	1,348	$	760,527	$	(761,299	)	$	2,518		$	3,094
Comprehensive loss:
Net loss		—		—		—		(19,633	)		—			(19,633	)
Foreign currency translation adjustment		—		—		—		—			(23	)		(23	)

Total comprehensive loss														(19,656	)
Stock-based compensation expense		—		—		126		—			—			126


Balance, September 30, 2007		13,478	$	1,348	$	760,653	$	(780,932	)	$	2,495		$	(16,436	)


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


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



31.1		Chief Executive Officer Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Acting Chief Financial Officer Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Chief Executive Officer Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Acting Chief Financial Officer Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.



		ATARI, INC.

		By:		/s/ Curtis G. Solsvig

				Name: Curtis G. Solsvig III
				Title: Chief Restructuring Officer (duly authorized officer)
				Date: November 19, 2007

		By:		/s/ Arturo Rodriquez

				Name: Arturo Rodriguez
				Title: Acting Chief Financial Officer (principal financial officer)
				Date: November 19, 2007


Exhibit No.		Description

31.1		Chief Executive Officer Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Acting Chief Financial Officer Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Chief Executive Officer Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Acting Chief Financial Officer Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.