10-Q 1 q310q2016.htm 10-Q Q3 2016 Document



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
(Mark One)
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 30, 2016
OR
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from              to             
Commission file number 0-23137
 
 RealNetworks, Inc.
 
 
(Exact name of registrant as specified in its charter)
 
Washington
 
91-1628146
(State of incorporation)
 
(I.R.S. Employer
Identification Number)
 
 
 
 
 
1501 First Avenue South, Suite 600
Seattle, Washington
 
98134
(Address of principal executive offices)
 
(Zip Code)
 
(206) 674-2700
 
 
(Registrant’s telephone number, including area code)
 
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ý    No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ý    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
 
¨
  
Accelerated filer
ý
 
 
 
 
Non-accelerated filer
 
¨  (Do not check if a smaller reporting company)
  
Smaller reporting company
¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No   ý
The number of shares of the registrant’s Common Stock outstanding as of October 31, 2016 was 36,971,291.




TABLE OF CONTENTS
 

2



PART I. FINANCIAL INFORMATION
Item 1.
Financial Statements
REALNETWORKS, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share data)
 
September 30,
2016
 
December 31,
2015
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
38,284

 
$
47,315

Short-term investments
42,465

 
51,814

Trade accounts receivable, net of allowances
25,287

 
22,511

Deferred costs, current portion
852

 
460

Prepaid expenses and other current assets
5,166

 
7,140

Total current assets
112,054

 
129,240

Equipment, software, and leasehold improvements, at cost:
 
 
 
Equipment and software
57,014

 
66,702

Leasehold improvements
3,204

 
3,122

Total equipment, software, and leasehold improvements, at cost
60,218

 
69,824

Less accumulated depreciation and amortization
54,339

 
61,024

Net equipment, software, and leasehold improvements
5,879

 
8,800

Restricted cash equivalents and investments
2,700

 
2,890

Available for sale securities
2,041

 
1,721

Other assets
1,908

 
2,307

Deferred costs, non-current portion
1,236

 
212

Deferred tax assets, net
1,015

 
957

Other intangible assets, net
1,224

 
2,136

Goodwill
12,974

 
13,080

Total assets
$
141,031

 
$
161,343

 
 
 
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
18,379

 
$
17,050

Accrued and other current liabilities
16,547

 
17,320

Deferred revenue, current portion
3,883

 
3,497

Total current liabilities
38,809

 
37,867

Deferred revenue, non-current portion
343

 
105

Deferred rent
504

 
620

Deferred tax liabilities, net
100

 
88

Other long-term liabilities
1,935

 
1,980

Total liabilities
41,691

 
40,660

Commitments and contingencies

 

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

 

Undesignated series: authorized 59,800 shares

 

Common stock, $0.001 par value authorized 250,000 shares; issued and outstanding 36,829 shares in 2016 and 36,298 shares in 2015
37

 
36

Additional paid-in capital
631,824

 
627,316

Accumulated other comprehensive loss
(58,758
)
 
(59,480
)
Retained deficit
(473,763
)
 
(447,189
)
Total shareholders’ equity
99,340

 
120,683

Total liabilities and shareholders’ equity
$
141,031

 
$
161,343

See accompanying notes to unaudited condensed consolidated financial statements.

3



REALNETWORKS, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE INCOME (LOSS)
(In thousands, except per share data)
 
Quarters Ended
September 30,
 
Nine Months Ended
September 30,
 
2016
 
2015
 
2016
 
2015
Net revenue (A)
$
31,051

 
$
30,823

 
$
89,015

 
$
95,374

Cost of revenue (B)
16,740

 
18,090

 
47,610

 
54,469

Gross profit
14,311

 
12,733

 
41,405

 
40,905

Operating expenses:
 
 
 
 
 
 
 
Research and development
6,699

 
10,501

 
23,185

 
34,681

Sales and marketing
7,183

 
11,938

 
24,157

 
38,822

General and administrative
7,086

 
7,021

 
21,380

 
21,312

Restructuring and other charges
499

 
3,114

 
1,297

 
5,563

Lease exit and related charges
1,233

 
2,121

 
2,191

 
2,208

Total operating expenses
22,700

 
34,695

 
72,210

 
102,586

Operating income (loss)
(8,389
)
 
(21,962
)
 
(30,805
)
 
(61,681
)
Other income (expenses):
 
 
 
 
 
 
 
Interest income, net
119

 
147

 
316

 
597

Gain (loss) on investments, net
6,021

 
(615
)
 
5,978

 
(222
)
Equity in net loss of Rhapsody investment
(233
)
 
(735
)
 
(629
)
 
(13,831
)
Other income (expense), net
(243
)
 
297

 
(515
)
 
628

Total other income (expenses), net
5,664

 
(906
)
 
5,150

 
(12,828
)
Income (loss) before income taxes
(2,725
)
 
(22,868
)
 
(25,655
)
 
(74,509
)
Income tax expense (benefit)
331

 
(1,684
)
 
919

 
(1,075
)
Net income (loss)
$
(3,056
)
 
$
(21,184
)
 
$
(26,574
)
 
$
(73,434
)
 
 
 
 
 
 
 
 
Basic net income (loss) per share
$
(0.08
)
 
$
(0.59
)
 
$
(0.72
)
 
$
(2.03
)
Diluted net income (loss) per share
$
(0.08
)
 
$
(0.59
)
 
$
(0.72
)
 
$
(2.03
)
Shares used to compute basic net income (loss) per share
36,805

 
36,191

 
36,693

 
36,134

Shares used to compute diluted net income (loss) per share
36,805

 
36,191

 
36,693

 
36,134

 
 
 
 
 
 
 
 
Comprehensive income (loss):
 
 
 
 
 
 
 
Unrealized investment holding gains (losses), net of reclassification adjustments
$
72

 
$
(596
)
 
$
239

 
$
(881
)
Foreign currency translation adjustments, net of reclassification adjustments
428

 
(1,144
)
 
483

 
(3,141
)
Total other comprehensive income (loss)
500

 
(1,740
)
 
722

 
(4,022
)
Net income (loss)
(3,056
)
 
(21,184
)
 
(26,574
)
 
(73,434
)
Comprehensive income (loss)
$
(2,556
)
 
$
(22,924
)
 
$
(25,852
)
 
$
(77,456
)
 
 
 
 
 
 
 
 
(A) Components of net revenue:
 
 
 
 
 
 
 
License fees
$
7,850

 
$
7,049

 
$
20,305

 
$
21,259

Service revenue
23,201

 
23,774

 
68,710

 
74,115

 
$
31,051

 
$
30,823

 
$
89,015

 
$
95,374

(B) Components of cost of revenue:
 
 
 
 
 
 
 
License fees
$
1,755

 
$
1,877

 
$
4,458

 
$
5,048

Service revenue
14,985

 
16,213

 
43,152

 
49,421

 
$
16,740

 
$
18,090

 
$
47,610

 
$
54,469

See accompanying notes to unaudited condensed consolidated financial statements.

4



REALNETWORKS, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
 
Nine Months Ended
September 30,
 
2016
 
2015
Cash flows from operating activities:
 
 
 
Net income (loss)
$
(26,574
)
 
$
(73,434
)
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
 
 
 
Depreciation and amortization
5,897

 
7,952

Stock-based compensation
4,557

 
3,761

Equity in net loss of Rhapsody
629

 
13,831

Deferred income taxes, net
(198
)
 
(1,531
)
Loss (gain) on investments, net
(5,978
)
 
222

Realized translation loss (gain)
272

 
(264
)
Fair value of warrants granted in 2015, net of subsequent mark to market adjustments in 2016 and 2015
112

 
(1,078
)
Trade accounts receivable
(1,744
)
 
(6,279
)
Prepaid expenses and other assets
1,155

 
3,851

Accounts payable
450

 
(1,628
)
Accrued and other liabilities
(872
)
 
(1,372
)
Net cash provided by (used in) operating activities
(22,294
)
 
(55,969
)
Cash flows from investing activities:
 
 
 
Purchases of equipment, software, and leasehold improvements
(2,009
)
 
(1,110
)
Proceeds from sale of equity and other investments
2,110

 
459

Purchases of short-term investments
(59,124
)
 
(52,475
)
Proceeds from sales and maturities of short-term investments
68,473

 
60,516

Decrease (increase) in restricted cash equivalents and investments, net
190

 

Acquisitions
(150
)
 
(161
)
Advance to Rhapsody

 
(5,000
)
Repayment from Rhapsody

 
5,000

Proceeds from the sale of Slingo and social casino business
4,000

 
10,000

Net cash provided by (used in) investing activities
13,490

 
17,229

Cash flows from financing activities:
 
 
 
Proceeds from issuance of common stock (stock options and stock purchase plan)
166

 
297

Tax payments from shares withheld upon vesting of restricted stock
(843
)
 
(69
)
Net cash provided by (used in) financing activities
(677
)
 
228

Effect of exchange rate changes on cash and cash equivalents
450

 
(2,910
)
Net increase (decrease) in cash and cash equivalents
(9,031
)
 
(41,422
)
Cash and cash equivalents, beginning of period
47,315

 
103,253

Cash and cash equivalents, end of period
$
38,284

 
$
61,831

 
 
 
 
Supplemental disclosure of cash flow information:
 
 
 
Cash received from income tax refunds
$
531

 
$
1,035

Cash paid for income taxes
$
1,876

 
$
1,136

Non-cash investing activities:
 
 
 
Increase (decrease) in accrued purchases of equipment, software, and leasehold improvements
$
(6
)
 
$
(124
)
Acquisition of intangible assets
$

 
$
312

See accompanying notes to unaudited condensed consolidated financial statements.


5



REALNETWORKS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Quarters and Nine Months Ended September 30, 2016 and 2015
Note 1
Description of Business and Summary of Significant Accounting Policies
Description of Business. RealNetworks, Inc. and subsidiaries is a global provider of network-delivered digital media applications and services that make it easy to manage, play and share digital media. The Company also develops and markets software products and services that enable the creation, distribution and consumption of digital media, including audio and video.
Inherent in our business are various risks and uncertainties, including a limited history of certain of our product and service offerings. RealNetworks' success will depend on the acceptance of our technology, products and services and the ability to generate related revenue.
In this Quarterly Report on Form 10-Q (10-Q or Report), RealNetworks, Inc. and Subsidiaries is referred to as “RealNetworks”, the “Company”, “we”, “us”, or “our”. "RealPlayer®" and other trademarks of ours appearing in this report are our property.
Basis of Presentation. The unaudited condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. Intercompany balances and transactions have been eliminated in consolidation.
The unaudited condensed consolidated financial statements reflect all adjustments, consisting only of normal, recurring adjustments that, in the opinion of management, are necessary for a fair presentation of the results of operations for the periods presented. Operating results for the quarter and nine months ended September 30, 2016 are not necessarily indicative of the results that may be expected for any subsequent period or for the year ending December 31, 2016. Certain information and disclosures normally included in financial statements prepared in conformity with accounting principles generally accepted in the United States of America (GAAP) have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission (SEC).
These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2015 (the 10-K).
Use of Estimates. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Reportable Segments. In the first quarter of 2016, we reorganized the management of our businesses and as a result, we
changed our reportable segments. See Note 18, Segment Information, for details. The historical financial information presented has been recast to reflect the new segments and the new corporate expense presentation.

Note 2
Recent Accounting Pronouncements
In August 2014, the Financial Accounting Standards Board (FASB) issued a new standard, "Disclosure of Uncertainties About an Entity's Ability to Continue as a Going Concern". This standard provides guidance around management's responsibility to evaluate whether there is substantial doubt about an entity's ability to continue as a going concern and to provide related footnote disclosures in certain circumstances. The new guidance is effective for the first annual period ending after December 15, 2016 and interim periods thereafter. We are currently evaluating the impact, if any, the adoption of this standard will have on our consolidated financial statements.
In May 2014, the FASB issued new revenue recognition guidance. The guidance will require an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The new guidance will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. The new guidance is effective for us on January 1, 2018; with early adoption permitted beginning January 1, 2017. The guidance permits the use of either the retrospective or cumulative effect transition method. We are evaluating the effect that the guidance will have on our consolidated financial statements and related disclosures. We have not yet selected a transition method nor determined the effect of the standard on our ongoing financial reporting.

6



    
In February 2016, the FASB issued new guidance related to the accounting for leases by lessees. A major change in the new guidance is that lessees will be required to present right-of-use assets and lease liabilities on the balance sheet. The new guidance will be effective for us on January 1, 2019. We will be evaluating the effect that the guidance will have on our consolidated financial statements and related disclosures.
In March 2016, the FASB issued new guidance that is intended to simplify several aspects of the accounting for stock-based compensation, including the treatment of forfeitures, income taxes and statutory tax withholding requirements. The new guidance will be effective for us on January 1, 2017; with early adoption permitted beginning January 1, 2016. We will be evaluating the effect that the guidance will have on our consolidated financial statements and related disclosures.
There have been no other recent accounting pronouncements or changes in accounting pronouncements to be implemented that are of significance or potential significance to RealNetworks.

Note 3
Acquisitions & Disposals

2015 Sale of Slingo and social casino business. On July 24, 2015, we entered into an agreement to sell the Slingo and social casino portion of our games business, including substantially all of the related assets and liabilities, as well as the stock of Backstage Technologies Incorporated, to Gaming Realms plc. Of the total transaction price of $18.0 million, $10.0 million was paid in cash at closing on August 10, 2015 and $4.0 million was paid in cash on August 10, 2016. The remaining $4.0 million will be payable either all in cash or a mix of cash and Gaming Realms plc stock, at our election, on August 10, 2017. We recognized the gain related to the 2016 payment in Gain (loss) on investments, net on the statement of operations. Based on several factors, including the timing of the receipt of the remaining $4.0 million consideration, we deferred the remaining gain of $4.0 million and will recognize that gain upon realization.

Note 4
Stock-Based Compensation
Total stock-based compensation expense recognized in our unaudited condensed consolidated statements of operations and comprehensive income (loss) includes amounts related to stock options, restricted stock, and employee stock purchase plans and was as follows (in thousands):
 
 
Quarters Ended
September 30,
 
Nine Months Ended
September 30,
 
2016
 
2015
 
2016
 
2015
Total stock-based compensation expense
$
778

 
$
1,178

 
$
4,557

 
$
3,761

The fair value of options granted determined using the Black-Scholes model used the following weighted-average assumptions:
 
 
Quarters Ended
September 30,
 
Nine Months Ended
September 30,
 
2016
 
2015
 
2016
 
2015
Expected dividend yield
0
%
 
0
%
 
0
%
 
0
%
Risk-free interest rate
1.00
%
 
1.27
%
 
1.25
%
 
1.26
%
Expected life (years)
3.8

 
3.8

 
4.6

 
4.3

Volatility
32
%
 
35
%
 
35
%
 
37
%

The total stock-based compensation amounts for 2016 and 2015 disclosed above are recorded in their respective line items within operating expenses in the unaudited condensed consolidated statements of operations and comprehensive income (loss). Included in the expense for the nine months ended September 30, 2016 was stock compensation expense recorded in the first quarter of 2016 related to our 2015 incentive bonuses paid in fully vested restricted stock units which were authorized and granted in the first quarter of 2016.


7



As of September 30, 2016, $4.6 million of total unrecognized compensation cost, net of estimated forfeitures, related to stock awards. The unrecognized compensation cost is expected to be recognized over a weighted-average period of approximately 2 years.

Stock Option Exchange

As previously disclosed in our SEC filings, on September 19, 2016 our shareholders approved amendments to our stock plans to allow for an option exchange program. The program, which launched on November 3, 2016, offers eligible employees and certain other service providers an opportunity to exchange certain outstanding options, with a per share exercise price in excess of $4.33, for new awards.  We currently expect to incur additional stock based compensation due to this exchange beginning in the fourth quarter of fiscal year 2016, which will be determined based upon participation in the program.


Note 5
Rhapsody Joint Venture
As of September 30, 2016 we owned approximately 42% of the issued and outstanding stock of Rhapsody and account for our investment using the equity method of accounting.
Rhapsody was initially formed in 2007 as a joint venture between RealNetworks and MTV Networks, a division of Viacom International Inc. (MTVN), to own and operate a business-to-consumer digital audio music service known as Rhapsody.
Following certain restructuring transactions effective March 31, 2010, we began accounting for our investment in Rhapsody using the equity method of accounting. As part of the 2010 restructuring transactions, RealNetworks contributed $18.0 million in cash, the Rhapsody brand and certain other assets, including content licenses, in exchange for shares of convertible preferred stock of Rhapsody, carrying a $10.0 million preference upon certain liquidation events.
We recorded our share of losses of Rhapsody of $0.2 million and $0.6 million for the quarter and nine months ended September 30, 2016 and $0.7 million and $13.8 million for the quarter and nine months ended September 30, 2015. Because of the $10.0 million liquidation preference on the preferred stock we hold in Rhapsody, under the equity method of accounting we did not record any share of Rhapsody losses that would reduce our carrying value of Rhapsody, which is impacted by Rhapsody equity transactions, below $10.0 million, until Rhapsody's book value was reduced below $10.0 million. This occurred in the first quarter of 2015. As of September 30, 2016, the carrying value of our Rhapsody equity investment is zero, as we do not record any share of Rhapsody losses that would reduce our carrying value of Rhapsody below zero unless we commit to provide financial support for Rhapsody.
Summarized financial information for Rhapsody, which represents 100% of their financial information, is as follows (in thousands): 
 
Quarters Ended
September 30,
 
Nine Months Ended
September 30,
 
2016
 
2015
 
2016
 
2015
Net revenue
$
54,306

 
$
52,769

 
$
160,269

 
$
149,156

Gross profit
15,195

 
9,552

 
29,288

 
25,395

Net income (loss)
1,632

 
(6,335
)
 
(11,421
)
 
(27,320
)




8



Note 6
Fair Value Measurements
Items Measured at Fair Value on a Recurring Basis
The following table presents information about our financial assets that have been measured at fair value on a recurring basis as of September 30, 2016 and December 31, 2015, and indicates the fair value hierarchy of the valuation inputs utilized to determine such fair value (in thousands).

 
Fair Value Measurements as of
 
Amortized Cost as of
 
September 30, 2016
 
September 30, 2016
 
Level 1
 
Level 2
 
Level 3
 
Total
 
 
Cash and cash equivalents:
 
 
 
 
 
 
 
 
 
Cash
$
27,401

 
$

 
$

 
$
27,401

 
$
27,401

Money market funds
49

 

 

 
49

 
49

Corporate notes and bonds

 
10,834

 

 
10,834

 
10,834

Total cash and cash equivalents
27,450

 
10,834

 

 
38,284

 
38,284

Short-term investments:
 
 
 
 
 
 
 
 
 
Corporate notes and bonds

 
42,465

 

 
42,465

 
42,460

Total short-term investments

 
42,465

 

 
42,465

 
42,460

Restricted cash equivalents and investments

 
2,700

 

 
2,700

 
2,700

Equity investment in publicly traded securities
2,041

 

 

 
2,041

 
362

Warrant issued by Rhapsody (included in Other assets)

 

 
941

 
941

 

Total
$
29,491

 
$
55,999

 
$
941

 
$
86,431

 
$
83,806



 
Fair Value Measurements as of
 
Amortized Cost as of
 
December 31, 2015
 
December 31, 2015
 
Level 1
 
Level 2
 
Level 3
 
Total
 
 
Cash and cash equivalents:
 
 
 
 
 
 
 
 
 
Cash
$
23,152

 
$

 
$

 
$
23,152

 
$
23,152

Money market funds
5,061

 

 

 
5,061

 
5,061

Corporate notes and bonds

 
19,102

 

 
19,102

 
19,102

Total cash and cash equivalents
28,213

 
19,102

 

 
47,315

 
47,315

Short-term investments:
 
 
 
 
 
 
 
 
 
Corporate notes and bonds

 
51,814

 

 
51,814

 
51,862

Total short-term investments

 
51,814

 

 
51,814

 
51,862

Restricted cash equivalents and investments

 
2,890

 

 
2,890

 
2,890

Equity investment in publicly traded securities
1,721

 

 

 
1,721

 
362

Warrant issued by Rhapsody (included in Other assets)

 

 
1,053

 
1,053

 

Total
$
29,934

 
$
73,806

 
$
1,053

 
$
104,793

 
$
102,429


Restricted cash equivalents and investments as of September 30, 2016 and December 31, 2015 relate to cash pledged as collateral against letters of credit in connection with lease agreements.
Realized gains or losses on sales of short-term investment securities for the quarters and nine months ended September 30, 2016 and 2015 were not significant. Gross unrealized gains and gross unrealized losses on short-term investment securities as of September 30, 2016 and December 31, 2015 were also not significant.

9



Investments with remaining contractual maturities of five years or less are classified as short-term because the investments are marketable and highly liquid, and we have the ability to utilize them for current operations. Contractual maturities of short-term investments as of September 30, 2016 (in thousands):
 
 
Estimated
Fair Value
Within one year
$
39,565

Between one year and five years
2,900

Total short-term investments
$
42,465

Our equity investment in a publicly traded company as of September 30, 2016 and December 31, 2015 consisted of J-Stream Inc., a Japanese media services company. This equity investment is accounted for as available for sale. During the nine months ended September 30, 2015, we sold a portion of J-Stream shares we held, resulting in cash proceeds of $0.5 million and a pre-tax gain of $0.4 million.
In October 2016, we completed the sale of the remaining investment in J-Stream, Inc, resulting in cash proceeds of $3.3 million and a realized pre-tax gain of $3.0 million. The impact of this transaction will be reflected in our fourth quarter financial statements.
In February 2015, Rhapsody issued warrants to purchase Rhapsody common shares to each of RealNetworks and Rhapsody's one other 43% stockholder. The warrants were issued as compensation for past services provided by RealNetworks and the other 43% stockholder, and both warrants covered the same number of underlying shares. The exercise price of the warrants was equal to the fair value of the underlying shares on the issuance date, and we used the Black-Scholes option-pricing model to calculate the fair value of the warrant, using an expected term of 5 years and expected volatility of 55%. On the date of issuance, we recognized and recorded the $1.2 million fair value of the warrant issued to RealNetworks within other assets in the unaudited condensed consolidated balance sheets, and as an expense reduction within General and administrative expense in the unaudited condensed consolidated statements of operations. The warrants are free-standing derivatives and as such their fair value is determined each quarter using updated inputs in the Black-Scholes option-pricing model. During the nine months ended September 30, 2016, the decrease in the fair value of the warrants was insignificant.
Items Measured at Fair Value on a Non-recurring Basis
Certain of our assets and liabilities are measured at estimated fair value on a non-recurring basis, using Level 3 inputs. These instruments are subject to fair value adjustments only in certain circumstances (for example, when there is evidence of impairment). During the nine months ended September 30, 2016 and 2015, we did not record any impairments on those assets required to be measured at fair value on a non-recurring basis.

See Note 12, Lease Exit and Related Charges, for a discussion of the losses related to reductions in the use of RealNetworks' office space, which were recorded at the estimated fair value of remaining lease obligations, less expected sub-lease income.


10



Note 7
Allowance for Doubtful Accounts Receivable and Sales Returns
Activity in the allowance for doubtful accounts receivable and sales returns (in thousands):
 
 
Allowance For
 
Doubtful
Accounts
Receivable
 
Sales
Returns
Balances, December 31, 2015
$
765

 
$
158

Addition (reduction) to allowance
52

 
15

Amounts written off
(6
)
 
(3
)
Foreign currency translation
29

 

Balances, September 30, 2016
$
840

 
$
170

One customer accounted for 57% and one other customer accounted for 14% of trade accounts receivable as of September 30, 2016. At December 31, 2015, one customer accounted for 52% and one other customer accounted for 12% of trade accounts receivable.
One customer accounted for 32% or $9.9 million of consolidated revenue during the quarter ended September 30, 2016 and 31% or $27.9 million during the nine months ended September 30, 2016, which is reflected in our Mobile Services segment.
One customer accounted for 28% of consolidated revenue or $8.7 million during the quarter ended September 30, 2015 and for 25% of consolidated revenue or $24.2 million during the nine months ended September 30, 2015, which is reflected in our Mobile Services segment.

Note 8
Other Intangible Assets
Other intangible assets (in thousands):
 
 
 
 
September 30, 2016
 
December 31, 2015
 
 
 
Gross
Amount
 
Accumulated
Amortization
 
Net
 
Gross
Amount
 
Accumulated
Amortization
 
Net
Amortizing intangible assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
Customer relationships
 
$
31,476

 
$
30,851

 
$
625

 
$
30,182

 
$
29,236

 
$
946

 
Developed technology
 
24,725

 
24,253

 
472

 
24,047

 
23,244

 
803

 
Patents, trademarks and tradenames
 
3,801

 
3,674

 
127

 
3,717

 
3,398

 
319

 
Service contracts
 
5,447

 
5,447

 

 
5,269

 
5,201

 
68

 
Total
 
$
65,449

 
$
64,225

 
$
1,224

 
$
63,215

 
$
61,079

 
$
2,136



An asset purchase relating to our Games business was completed in the second quarter of 2016 and resulted in an intangible asset of $0.2 million.

In the third quarter of 2016 we recognized a gain of $2.0 million, net of transaction costs, to Gain (loss) on investments, net, as the result of a sale of a domain name to a third party.

No impairments of other intangible assets were recognized in either of the nine months ended September 30, 2016 or 2015.

11



Note 9
Goodwill
Changes in goodwill (in thousands):
 
Balance, December 31, 2015
$
13,080

Effects of foreign currency translation
(106
)
Balance, September 30, 2016
$
12,974



Goodwill by segment (in thousands):
 
 
September 30,
2016
Consumer Media
$
580

Mobile Services
2,096

Games
10,298

Total goodwill
$
12,974



No impairment of goodwill was recognized in either of the nine months ended September 30, 2016 or in 2015.

Note 10
Accrued and Other Current Liabilities
Accrued and other current liabilities (in thousands):
 
 
September 30, 2016
 
December 31, 2015
Royalties and other fulfillment costs
$
2,515

 
$
3,094

Employee compensation, commissions and benefits
5,381

 
5,958

Sales, VAT and other taxes payable
3,281

 
2,976

Other
5,370

 
5,292

Total accrued and other current liabilities
$
16,547

 
$
17,320


Note 11
Restructuring Charges
Restructuring and other charges in 2016 and 2015 consist of costs associated with the ongoing reorganization of our business operations and our ongoing expense re-alignment efforts. The expense amounts in both years relate primarily to severance costs due to workforce reductions.
Restructuring charges are as follows (in thousands):
 
Employee Separation Costs
Costs incurred and charged to expense for the nine months ended September 30, 2016
$
1,297

Costs incurred and charged to expense for the nine months ended September 30, 2015
$
5,563



12



Changes to the accrued restructuring liability (which is included in Accrued and other current liabilities) for 2016 (in thousands) are as follows:
 
Employee Separation Costs
Accrued liability at December 31, 2015
$
1,404

Costs incurred and charged to expense for the nine months ended September 30, 2016
1,297

Cash payments
(2,279
)
Accrued liability at September 30, 2016
$
422


Note 12
Lease Exit and Related Charges
As a result of the reduction in use of RealNetworks' office space, lease exit and related charges have been recognized representing rent and contractual operating expenses over the remaining life of the leases, including estimates of sublease income expected to be received. In the quarter ended September 30, 2016, we recorded additional losses relating to a further reduction of office space at our corporate headquarters in Seattle, Washington. We continue to regularly evaluate the market for office space. If the market for such space changes further in future periods, we may have to revise our estimates which may result in future adjustments to expense for excess office facilities.
Changes to accrued lease exit and related charges (which is included in Accrued and other current liabilities) for 2016 (in thousands) are as follows:
 
Accrued loss at December 31, 2015
$
2,595

Additions and adjustments to the lease loss accrual, including estimated sublease income
2,287

Less amounts paid, net of sublease amounts
(1,257
)
Accrued loss at September 30, 2016
3,625

Less current portion (included in Accrued and other current liabilities)
(1,824
)
Accrued loss, non-current portion (included in Other long term liabilities)
$
1,801



13



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

Changes in components of accumulated other comprehensive income (loss) (in thousands):
 
 
 
Quarters Ended
September 30,
 
Nine Months Ended
September 30,
 
 
 
2016
 
2015
 
2016
 
2015
Investments
 
 
 
 
 
 
 
 
 
Accumulated other comprehensive income (loss), beginning of period
 
$
1,464

 
$
1,967

 
$
1,297

 
$
2,252

 
Unrealized gains (losses), net of tax effects of $42, $(56), $141 and $0
 
72

 
(596
)
 
239

 
(488
)
 
Reclassification adjustments for losses (gains) included in other income (expense), net of tax effects of $0, $0, $0 and $(1)
 

 

 

 
(393
)
 
Net current period other comprehensive income (loss)
 
72

 
(596
)
 
239

 
(881
)
 
Accumulated other comprehensive income (loss) balance, end of period
 
$
1,536

 
$
1,371

 
$
1,536

 
$
1,371

Foreign currency translation
 
 
 
 
 
 
 
 
 
Accumulated other comprehensive income (loss), beginning of period
 
$
(60,722
)
 
$
(59,501
)
 
$
(60,777
)
 
$
(57,504
)
 
Translation adjustments
 
156

 
(880
)
 
211

 
(2,877
)
 
Reclassification adjustments for losses (gains) included in other income (expense)
 
272

 
(264
)
 
272

 
(264
)
 
Net current period other comprehensive income (loss)
 
428

 
(1,144
)
 
483

 
(3,141
)
 
Accumulated other comprehensive income (loss) balance, end of period
 
$
(60,294
)
 
$
(60,645
)
 
$
(60,294
)
 
$
(60,645
)
Total accumulated other comprehensive income (loss), end of period
 
$
(58,758
)
 
$
(59,274
)
 
$
(58,758
)
 
$
(59,274
)

Note 14
Income Taxes
As of September 30, 2016, there have been no material changes to RealNetworks’ uncertain tax positions disclosures as provided in Note 14 of the 2015 10-K. We do not anticipate that the total amount of unrecognized tax benefits will significantly change within the next twelve months.
We file numerous consolidated and separate income tax returns in the U.S. including federal, state and local, as well as foreign jurisdictions. With few exceptions, we are no longer subject to U.S. federal income tax examinations for tax years before 2013 or state, local, or foreign income tax examinations for years before 1993. We are currently under audit by various states and foreign jurisdictions for certain tax years subsequent to 1993.


14



Note 15
Earnings (Loss) Per Share
Basic net income (loss) per share (EPS) is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted EPS is computed by dividing net income (loss) by the weighted average number of common and dilutive potential common shares outstanding during the period. Basic and diluted EPS (in thousands, except per share amounts):
 
 
Quarters Ended
September 30,
 
Nine Months Ended
September 30,
 
2016
 
2015
 
2016
 
2015
Net income (loss)
$
(3,056
)
 
$
(21,184
)
 
$
(26,574
)
 
$
(73,434
)
Weighted average common shares outstanding used to compute basic EPS
36,805

 
36,191

 
36,693

 
36,134

Dilutive effect of stock based awards

 

 

 

Weighted average common shares outstanding used to compute diluted EPS
36,805

 
36,191


36,693


36,134

 
 
 
 
 
 
 
 
Basic EPS
$
(0.08
)
 
$
(0.59
)
 
$
(0.72
)
 
$
(2.03
)
Diluted EPS
$
(0.08
)
 
$
(0.59
)
 
$
(0.72
)
 
$
(2.03
)
During the quarter and nine months ended September 30, 2016, 4.6 million and 4.8 million shares of common stock, respectively, of potentially issuable shares from stock awards were excluded from the calculation of diluted EPS because of their antidilutive effect.
During the quarter and nine months ended September 30, 2015, 5.7 million and 6.0 million shares of common stock, respectively, of potentially issuable shares from stock awards were excluded from the calculation of diluted EPS because of their antidilutive effect.

Note 16
Commitments and Contingencies
We could in the future become subject to legal proceedings, governmental investigations and claims in the ordinary course of business, including employment claims, contract-related claims, and claims of alleged infringement of third-party patents, trademarks and other intellectual property rights. Such claims, even if not meritorious, could force us to expend significant financial and managerial resources. In addition, given the broad distribution of some of our consumer products, any individual claim related to those products could give rise to liabilities that may be material to us. In the event of a determination adverse to us, we may incur substantial monetary liability, and/or be required to change our business practices. Either of these could have a material adverse effect on our consolidated financial statements.  

Note 17
Guarantees
In the ordinary course of business, RealNetworks is subject to potential obligations for standard warranty and indemnification provisions that are contained within many of our customer license and service agreements. Our warranty provisions are consistent with those prevalent in our industry, and we do not have a history of incurring losses on warranties; therefore, we do not maintain accruals for warranty-related obligations. With regard to indemnification provisions, nearly all of our carrier contracts obligate us to indemnify our carrier customers for certain liabilities that may be incurred by them. We have received in the past, and may receive in the future, claims for indemnification from some of our carrier customers.
In relation to certain patents and other technology assets we sold to Intel in the second quarter of 2012, we have specific obligations to indemnify Intel for breaches of the representations and warranties that we made and covenants that we agreed to in the asset purchase agreement for certain potential future intellectual property infringement claims brought by third parties against Intel. The amount of any potential liabilities related to our indemnification obligations to Intel will not be determined

15



until a claim has been made, but we are obligated to indemnify Intel up to the amount of the gross purchase price that we received in the sale.  

Note 18
Segment Information
In the first quarter of 2016, we reorganized the management of our businesses and as a result, we now report three segments: (1) Consumer Media, which includes our PC-based RealPlayer products, including RealPlayer Plus and related products and intellectual property licensing; (2) Mobile Services, which includes our SaaS services, our LISTEN® product, and our mobile RealTimes® product that is primarily sold through mobile carriers; and (3) Games, which includes all our games-related businesses, including sales of games licenses, online games subscription services, advertising on games sites and social network sites, microtransactions from online and social games, and sales of mobile games.
We allocate certain corporate expenses which are directly attributable to supporting our businesses, including but not limited to a portion of finance, legal, human resources and headquarters facilities, to our reportable segments. Remaining expenses, which are not directly attributable to supporting the business, are reported as corporate items. Also reported in our corporate segment are restructuring charges, lease exit and related charges, as well as stock compensation charges. Concurrent with the first quarter of 2016 segment change described above, we also changed our corporate expense allocation methodology to increase accountability, resulting in an increase in costs allocated to the Consumer Media and Mobile Services businesses.
RealNetworks reports three reportable segments based on factors such as how we manage our operations and how our Chief Operating Decision Maker (CODM) reviews results. The CODM reviews financial information presented on both a consolidated basis and on a business segment basis. The accounting policies used to derive segment results are the same as those described in Note 1, Description of Business and Summary of Significant Accounting Policies, in the 10-K.
The historical financial information presented has been recast to reflect the new segments and the new corporate expense presentation. Segment results for the quarters and nine months ended September 30, 2016 and 2015 (in thousands):
Consumer Media
 
 
Quarters Ended
September 30,
 
Nine Months Ended
September 30,
 
2016
 
2015
 
2016
 
2015
Revenue
$
6,482

 
$
6,495

 
$
18,608

 
$
21,765

Cost of revenue
1,507

 
3,142

 
5,485

 
10,173

Gross profit
4,975

 
3,353

 
13,123

 
11,592

Operating expenses
4,271

 
6,421

 
13,940

 
19,882

Operating income (loss)
$
704

 
$
(3,068
)
 
$
(817
)
 
$
(8,290
)


Mobile Services
 
 
Quarters Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2016
 
2015
 
2016
 
2015
Revenue
 
$
17,683

 
$
16,484

 
$
51,445

 
$
49,566

Cost of revenue
 
13,026

 
12,512

 
36,347

 
36,802

Gross profit
 
4,657

 
3,972

 
15,098

 
12,764

Operating expenses
 
8,075

 
11,093

 
26,653

 
35,153

Operating income (loss)
 
$
(3,418
)
 
$
(7,121
)
 
$
(11,555
)
 
$
(22,389
)



16



Games

 
Quarters Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2016
 
2015
 
2016
 
2015
Revenue
 
$
6,886

 
$
7,844

 
$
18,962

 
$
24,043

Cost of revenue
 
2,203

 
2,513

 
5,865

 
7,593

Gross profit
 
4,683

 
5,331

 
13,097

 
16,450

Operating expenses
 
4,649

 
6,431

 
14,669

 
23,833

Operating income (loss)
 
$
34

 
$
(1,100
)
 
$
(1,572
)
 
$
(7,383
)


Corporate
 
 
Quarters Ended
September 30,
Nine Months Ended
September 30,
 
 
2016
 
2015
 
2016
 
2015
Cost of revenue
 
$
4

 
$
(77
)
 
$
(87
)
 
$
(99
)
Operating expenses
 
5,705

 
10,750

 
16,948

 
23,718

Operating income (loss)
 
$
(5,709
)
 
$
(10,673
)
 
$
(16,861
)
 
$
(23,619
)

Our customers consist primarily of consumers and corporations located in the U.S., Europe, Republic of Korea and various foreign countries (Rest of the World). Revenue by geographic region (in thousands):
 
 
Quarters Ended
September 30,
 
Nine Months Ended
September 30,
 
2016
 
2015
 
2016
 
2015
United States
$
10,642

 
$
11,460

 
$
31,379

 
$
36,112

Europe
3,288

 
3,670

 
10,002

 
11,561

Republic of Korea
10,582

 
9,569

 
30,227

 
28,268

Rest of the World
6,539

 
6,124

 
17,407

 
19,433

Total net revenue
$
31,051

 
$
30,823

 
$
89,015

 
$
95,374


Long-lived assets (which consist of equipment, software, leasehold improvements, other intangible assets, and goodwill) by geographic region (in thousands) are as follows:
 
 
September 30,
2016
 
December 31,
2015
United States
$
13,626

 
$
16,821

Europe
4,194

 
4,898

Republic of Korea
211

 
282

Rest of the World
2,046

 
2,015

Total long-lived assets
$
20,077

 
$
24,016



17



Note 19
Related Party Transactions
 See Note 5, Rhapsody Joint Venture, and Note 6, Fair Value Measurements, for details on transactions involving Rhapsody.



    

18



Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
This Quarterly Report on Form 10-Q and the documents incorporated herein by reference contain forward-looking statements that have been made pursuant to the provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on current expectations, estimates, and projections about RealNetworks’ industry, products, management’s beliefs, and certain assumptions made by management. Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” and similar expressions are intended to identify forward-looking statements. All statements contained in this report that do not relate to matters of historical fact should be considered forward-looking statements. Forward-looking statements include statements with respect to:

the expected benefits and other consequences of our growth plans, strategic initiatives, and restructurings;
our expected introduction, distribution and monetization, of new and enhanced products, services and technologies across our businesses;
future revenues, operating expenses, income and other taxes, tax benefits, net income (loss) per diluted share available to common shareholders, acquisition costs and related amortization, and other measures of results of operations;
the effects of our past acquisitions and expectations for future acquisitions and divestitures;
plans, strategies and expected opportunities for future growth, increased profitability and innovation;
the expected financial position, performance, growth and profitability of, and investment in, our businesses and the availability of resources;
the effects of legislation, regulations, administrative proceedings, court rulings, settlement negotiations and other factors that may impact our businesses;
the continuation and expected nature of certain customer relationships;
impacts of competition and certain customer relationships on the future financial performance and growth of our businesses;
our involvement in potential claims, legal proceedings and government investigations, and the potential outcomes and effects of such potential claims, legal proceedings and governmental investigations on our business, prospects, financial condition or results of operations;
the effects of U.S. and foreign income and other taxes on our business, prospects, financial condition or results of operations; and
the effect of economic and market conditions on our business, prospects, financial condition or results of operations.
These statements are not guarantees of future performance and actual actions or results may differ materially. These statements are subject to certain risks, uncertainties and assumptions that are difficult to predict, including those noted in the documents incorporated herein by reference. Particular attention should also be paid to the cautionary language in Item 1A of Part II entitled “Risk Factors.” RealNetworks undertakes no obligation to update publicly any forward-looking statements as a result of new information, future events or otherwise, unless required by law. Readers should, however, carefully review the risk factors included in other reports or documents filed by RealNetworks from time to time with the Securities and Exchange Commission, particularly the Quarterly Reports on Form 10-Q and any Current Reports on Form 8-K.
Overview
RealNetworks creates innovative applications and services that make it easy to connect with and enjoy digital media. Following a reorganization that took effect in the first quarter of 2016, we manage our business and report revenue and operating income (loss) in three segments: (1) Consumer Media, (2) Mobile Services, and (3) Games. See Note 18 Segment Information, to the unaudited condensed consolidated financial statements included in Item 1 of Part I of this Form 10-Q.
Within our Consumer Media segment, revenue is derived from the sales of our PC-based RealPlayer® products, including RealPlayer Plus and related products, and from the licensing of our intellectual property, primarily our codec technology, including our recently introduced RealMedia High Definition, or RMHD, technology. Distribution of these products and services are delivered directly to consumers and through partners, such as OEMs and mobile device manufacturers.
Our Mobile Services business generates revenue primarily from the sale of our SaaS services, which include ringback tones, music on demand, intercarrier messaging and our LISTEN platform, which we recently launched with a new carrier partner in Brazil. This business also includes revenue related to mobile RealTimes®, our recently introduced photo and video sharing application that is primarily sold through mobile carriers and related partners.
Our Games business, through the GameHouse and Zylom brands, derives revenue from sales of games licenses, online games subscription services, sales of mobile games and advertising on games sites and social networks.

19



We allocate certain corporate expenses which are directly attributable to supporting our businesses, including but not limited to a portion of finance, legal, human resources and headquarters facilities, to our reportable segments. Remaining expenses, which are not directly attributable to supporting the business, are reported as corporate items. These corporate items include restructuring charges, lease exit and related charges, as well as stock compensation expense. Concurrent with the first quarter 2016 segment change described above, we also changed our expense allocation methodology to increase accountability, resulting in an increase in corporate costs allocated to the Consumer Media and Mobile Services businesses. The historical financial information presented below has been recast to reflect the new corporate expense allocation.

As of September 30, 2016, we had $80.7 million in unrestricted cash, cash equivalents and short-term investments, compared to $99.1 million as of December 31, 2015. The 2016 decrease of cash, cash equivalents, and short-term investments was due primarily to cash used in operating activities during the nine months of $22.3 million.

Condensed consolidated results of operations were as follows (dollars in thousands):
 
 
Quarters ended September 30,
 
Nine months ended September 30,
 
2016
 
2015
 
$ Change
 
% Change
 
2016
 
2015
 
$ Change
 
% Change
Total revenue
$
31,051

 
$
30,823

 
$
228

 
1
 %
 
$
89,015

 
$
95,374

 
$
(6,359
)
 
(7
)%
Cost of revenue
16,740

 
18,090

 
(1,350
)
 
(7
)%
 
47,610

 
54,469

 
(6,859
)
 
(13
)%
Gross profit
14,311

 
12,733

 
1,578

 
12
 %
 
41,405

 
40,905

 
500

 
1
 %
Gross margin
46
%
 
41
%
 
 
 
 
 
47
%
 
43
%
 
 
 
 
Operating expenses
22,700

 
34,695

 
(11,995
)
 
(35
)%
 
72,210

 
102,586

 
(30,376
)
 
(30
)%
Operating income (loss)
$
(8,389
)
 
$
(21,962
)
 
$
13,573

 
62
 %
 
$
(30,805
)
 
$
(61,681
)
 
$
30,876

 
50
 %
In the third quarter of 2016, our total consolidated revenue was flat as compared with the year-earlier period. Stable revenue resulted from an increase of $1.2 million in Mobile Services due to increased, low-margin music on demand revenue in Korea, offset in part by a decrease of $1.0 million in Games, due primarily to the sale of the Slingo and social casino games business in the third quarter of 2015. Although revenue was flat compared with the prior-year period, gross margin increased from 41% to 46% during the quarter ended September 30, 2016 driven mainly from an increase in gross margins due to efficiencies in our Consumer Media segment.
Cost of revenues decreased by $1.4 million for the three months ended September 30, 2016, due primarily from savings of $1.1 million from lower bandwidth costs in our Consumer Media business, as well as savings of $0.4 million realized following the sale of the Slingo and the social casino games business.
Operating expenses decreased by $12.0 million in the quarter ended September 30, 2016 compared with the prior year due, in part, to savings of $1.9 million realized from the sale of the Slingo and the social casino games business. Other factors contributing to the decrease in operating expenses were significant reductions in salaries and related personnel costs, professional service fees, marketing expenses and restructuring costs totaling $10.1 million, as described more fully below.
For the nine months ended September 30, 2016, our total consolidated revenue declined by $6.4 million, compared with the year-earlier period. Revenue decreased by $3.2 million in our Consumer Media business due to lower intellectual property licensing and subscriptions revenue. Additionally, Games revenue decreased by $5.1 million, primarily due to the $4.9 million decrease from the sale of the Slingo and social casino games business in the third quarter of 2015. The revenue from our continuing games business did not significantly fluctuate from the prior year. Revenues increased in our Mobile Services segment by $1.9 million, mainly due to increases in our low-margin music on demand businesses in Korea and the signing of new distribution agreements for our RealTimes mobile services which were partially offset by decreases in our ringback tones products. Overall gross margin increased to 47% from 43% for the year-earlier period driven by increased margin in our Consumer Media and Mobile Services segments as described in Segment Operating Results below.
Cost of revenues decreased by $6.9 million for the nine months ended September 30, 2016, due to lower bandwidth costs and lower licensing royalties in Consumer Media of $4.7 million, as well as savings of $2.0 million realized following the sale of the Slingo and the social casino games business.
Operating expenses decreased by $30.4 million in the nine months ended September 30, 2016, compared with the prior year due to our cost reduction efforts and to savings of $11.1 million realized from the sale of the Slingo and social casino games business. Other factors contributing to this decrease were reductions in personnel and related costs of $6.2 million, marketing expenses of $6.4 million and professional services costs of $2.1 million. These reductions were offset in part by the benefit recognized in the first quarter of 2015 relating to warrants received from Rhapsody, and higher stock compensation

20



expense in 2016 resulting from the first quarter 2016 authorization and grant of fully vested equity awards as payment for 2015 incentive bonuses.
Segment Operating Results
Consumer Media
Consumer Media segment results of operations were as follows (dollars in thousands):
 
 
 
Quarters ended September 30,
 
Nine months ended September 30,
 
 
2016
 
2015
 
$ Change
 
% Change
 
2016
 
2015
 
$ Change
 
% Change
Revenue
 
$
6,482

 
$
6,495

 
$
(13
)
 
 %
 
$
18,608

 
$
21,765

 
$
(3,157
)
 
(15
)%
Cost of revenue
 
1,507

 
3,142

 
(1,635
)
 
(52
)%
 
5,485

 
10,173

 
(4,688
)
 
(46
)%
Gross profit
 
4,975

 
3,353

 
1,622

 
48
 %
 
13,123

 
11,592

 
1,531

 
13
 %
Gross margin
 
77
%
 
52
%
 
 
 
 
 
71
%
 
53
%
 
 
 
 
Operating expenses
 
4,271

 
6,421

 
(2,150
)
 
(33
)%
 
13,940

 
19,882

 
(5,942
)
 
(30
)%
Operating income (loss)
 
$
704

 
$
(3,068
)
 
$
3,772

 
123
 %
 
$
(817
)
 
$
(8,290
)
 
$
7,473

 
90
 %

Total Consumer Media revenue for the quarter ended September 30, 2016 was flat as compared to the same quarter of fiscal 2015. Total Consumer Media revenue for the nine months ended September 30, 2016 declined $3.2 million when compared with the year-earlier period. Intellectual property licensing revenue declined by $2.2 million for the nine month period due primarily to the timing of contracts and contract renewals, of which $1.7 million occurred in the first quarter. Continuing declines in our subscription products of $1.1 million also contributed to the decline in Consumer Media revenue.
Cost of revenue decreased by $1.6 million during the quarter ended September 30, 2016, compared with the year-earlier period resulting in an increase in gross margin of 25 percentage points. The decrease in cost of revenue was primarily due to lower bandwidth costs of $1.1 million directly resulting from our ongoing efforts to optimize functionality and increase efficiencies.
Cost of revenue decreased by $4.7 million during the nine months ended September 30, 2016, compared with the year-earlier period resulting in an increase in gross margin of 18 percentage points. The decrease in cost of revenue was driven mainly by lower bandwidth costs of $2.8 million, as well as lower licensing royalties and support service costs.
Operating expenses decreased by $2.2 million in the quarter ended September 30, 2016, compared with the year-earlier period. The decrease was primarily due to reductions in salaries and related personnel costs of $0.9 million, marketing costs of $0.8 million, and professional services costs of $0.3 million.
Operating expenses decreased by $5.9 million in the nine months ended September 30, 2016, compared with the year-earlier period. The decrease was primarily due to reductions in salaries and related personnel costs of $3.8 million, marketing costs of $1.8 million, and professional services costs of $1.1 million. These declines were offset, in part, by an acceleration of depreciation expense in the first quarter related to the obsolescence of e-commerce assets as we moved the platform to a third party cloud service.

Mobile Services
Mobile Services segment results of operations were as follows (dollars in thousands): 
 
Quarters ended September 30,
 
Nine months ended September 30,
 
2016
 
2015
 
$ Change
 
% Change
 
2016
 
2015
 
$ Change
 
% Change
Revenue
$
17,683

 
$
16,484

 
$
1,199

 
7
 %
 
$
51,445

 
$
49,566

 
$
1,879

 
4
 %
Cost of revenue
13,026

 
12,512

 
514

 
4
 %
 
36,347

 
36,802

 
(455
)
 
(1
)%
Gross profit
4,657

 
3,972

 
685

 
17
 %
 
15,098

 
12,764

 
2,334

 
18
 %
Gross margin
26
%
 
24
%
 
 
 
 
 
29
%
 
26
%
 
 
 
 
Operating expenses
8,075

 
11,093

 
(3,018
)
 
(27
)%
 
26,653

 
35,153

 
(8,500
)
 
(24
)%
Operating income (loss)
$
(3,418
)
 
$
(7,121
)
 
$
3,703

 
52
 %
 
$
(11,555
)
 
$
(22,389
)
 
$
10,834

 
48
 %

21



Total Mobile Services revenue increased by $1.2 million in the quarter ended September 30, 2016 compared with the prior-year period. This increase was driven by increases of $1.2 million in our low-margin music on demand business in Korea, as well as an increase of $0.4 million from sales of system integration services. These increases were offset in part by a decline of $0.7 million from our ringback tones services.
Total Mobile Services revenue increased by $1.9 million in the nine months ended September 30, 2016, compared with the prior-year period. This increase was driven by increases of $3.7 million in our low-margin music on demand business in Korea, as well as an increase of $1.5 million from system implementations for our carrier partners. These increases were offset in part by decreases in revenue from our ringback tones business of $2.1 million and $0.7 million from our Helix product, which we no longer sell.
Cost of revenue increased by $0.5 million in the quarter ended September 30, 2016 compared with the prior-year period. Higher costs of $1.1 million due to higher sales from our music on demand business were offset by savings from our other SaaS service offerings.
Cost of revenue decreased by $0.5 million in the nine months ended September 30, 2016 compared with the prior-year period, primarily from savings related to our SaaS service offerings, such as professional services, ringback tones and from our RealTimes mobile services. These declines were offset in part by an increase in music on demand service costs directly related to the higher revenue during the nine months ended September 30, 2016.
Operating expenses decreased by $3.0 million and $8.5 million for the quarter and nine months ended September 30, 2016 compared with the year-earlier periods. These decreases were primarily due to reductions in salaries and related personnel costs of $1.5 million and $4.3 million, as well as lower marketing expense of $1.3 million and $3.8 million for the quarter and nine months ended September 30, 2016, respectively.
Games
Games segment results of operations were as follows (dollars in thousands):
 
 
Quarters ended September 30,
 
Nine months ended September 30,
 
 
2016
 
2015
 
$ Change
 
% Change
 
2016
 
2015
 
$ Change
 
% Change
Revenue
 
$
6,886

 
$
7,844

 
$
(958
)
 
(12
)%
 
$
18,962

 
$
24,043

 
$
(5,081
)
 
(21
)%
Cost of revenue
 
2,203

 
2,513

 
(310
)
 
(12
)%
 
5,865

 
7,593

 
(1,728
)
 
(23
)%
Gross profit
 
4,683

 
5,331

 
(648
)
 
(12
)%
 
13,097

 
16,450

 
(3,353
)
 
(20
)%
Gross margin
 
68
%
 
68
%
 
 
 
 
 
69
%
 
68
%
 
 
 
 
Operating expenses
 
4,649

 
6,431

 
(1,782
)
 
(28
)%
 
14,669

 
23,833

 
(9,164
)
 
(38
)%
Operating income (loss)
 
$
34

 
$
(1,100
)
 
$
1,134

 
103
 %
 
$
(1,572
)
 
$
(7,383
)
 
$
5,811

 
79
 %
Total Games revenue decreased by $1.0 million in the quarter ended September 30, 2016, compared with the year-earlier period primarily due to the sale of our Slingo and social casino games business in the third quarter of 2015. Revenue from this business was $1.0 million in the third quarter of 2015. The revenue from our continuing casual games business was flat as compared to the prior-year period, as a $0.5 million increase to our mobile games revenue was offset by a decrease in our other games revenue.
Total Games revenue decreased by $5.1 million in the nine months ended September 30, 2016, compared with the prior-year period primarily due to the sale of our Slingo and social casino games business in the third quarter of 2015. Revenue from this business was $4.9 million in the first nine months of 2015. The revenue from our casual games business did not significantly fluctuate. Our mobile games revenue increased by $2.0 million which was offset by a decrease in our other games revenue.
Cost of revenue decreased by $0.3 million and $1.7 million in the quarter and nine months ended September 30, 2016 compared with the prior-year periods. Decreases of $0.4 million and $2.0 million were primarily due to savings realized following the sale of the Slingo and social casino games business offset, in part, by an increase in app store fees related to our mobile revenue growth in the casual games business.
Operating expenses declined by $1.8 million and $9.2 million in the quarter and nine months ended September 30, 2016, compared with the prior-year period. The decreases in expense were due to savings of $1.9 million and $11.1 million in the quarter and nine month periods from the 2015 sale of our Slingo and social casino games business. These decreases were

22



partially offset by increases in research and development salaries and related personnel costs from our continuing casual games business.
Corporate

Corporate segment results of operations were as follows (dollars in thousands):
 
 
Quarters ended September 30,
 
Nine months ended September 30,
 
 
2016
 
2015
 
$ Change
 
% Change
 
2016
 
2015
 
$ Change
 
% Change
Cost of revenue
 
$
4

 
$
(77
)
 
$
81

 
105
 %
 
$
(87
)
 
$
(99
)
 
$
12

 
12
 %
Operating expenses
 
5,705

 
10,750

 
(5,045
)
 
(47
)%
 
16,948

 
23,718

 
(6,770
)
 
(29
)%
Operating income (loss)
 
$
(5,709
)
 
$
(10,673
)
 
$
4,964

 
47
 %
 
$
(16,861
)
 
$
(23,619
)
 
$
6,758

 
29
 %
Operating expenses decreased by $5.0 million in the quarter ended September 30, 2016 compared with the year-earlier period. The decrease was primarily due to $3.5 million lower restructuring charges in 2016 compared to 2015 and reductions in salary, benefit and professional service expenses of $0.6 million as well as lower expenses for facilities and support services as a result of our reduction of office space at our corporate headquarters and ongoing cost reduction efforts.
Operating expenses decreased by $6.8 million in the nine months ended September 30, 2016 compared with the year-earlier period. The decrease from the prior-year period was due to a decrease of $4.3 million relating to restructuring charges, as well as a reduction of $1.6 million in salary, benefit and professional service expenses and lower expenses for facilities and support services as a result of our reduction of office space at our corporate headquarters and ongoing cost reduction efforts. These decreases were offset in part by the benefit of $1.2 million relating to the warrants received from Rhapsody in the first quarter of 2015 and an increase in stock compensation expense of $0.8 million in 2016 due in part to the authorization and granting of fully vested equity awards for our 2015 incentive bonuses in the first quarter of 2016.

Consolidated Operating Expenses
Our operating expenses consist primarily of salaries and related personnel costs including stock based compensation, consulting fees associated with product development, sales commissions, amortization of certain intangible assets capitalized in our acquisitions, professional service fees, advertising costs, restructuring charges and lease exit costs. Operating expenses were as follows (dollars in thousands):
 
 
Quarters ended September 30,
 
Nine months ended September 30,
 
2016
 
2015
 
$ Change
 
% Change
 
2016
 
2015
 
$ Change
 
% Change
Research and development
$
6,699

 
$
10,501

 
$
(3,802
)
 
(36
)%
 
$
23,185

 
$
34,681

 
$
(11,496
)
 
(33
)%
Sales and marketing
7,183

 
11,938

 
(4,755
)
 
(40
)%
 
24,157

 
38,822

 
(14,665
)
 
(38
)%
General and administrative
7,086

 
7,021

 
65

 
1
 %
 
21,380

 
21,312

 
68

 
 %
Restructuring and other charges
499

 
3,114

 
(2,615
)
 
(84
)%
 
1,297

 
5,563

 
(4,266
)
 
(77
)%
Lease exit and related charges
1,233

 
2,121

 
(888
)
 
(42
)%
 
2,191

 
2,208

 
(17
)
 
(1
)%
Total consolidated operating expenses
$
22,700

 
$
34,695

 
$
(11,995
)
 
(35
)%
 
$
72,210

 
$
102,586

 
$
(30,376
)
 
(30
)%
Research and development expenses decreased by $3.8 million in the quarter ended September 30, 2016, compared with the year-earlier period. The decrease was primarily due to $1.5 million from an overall reduction in salaries and benefits costs and professional service fees, a $0.8 million reduction from the sale of our Slingo and social casino games business, and lower expenses for facilities and support services as a result of our reduction of office space at our corporate headquarters and ongoing cost reduction efforts.
Research and development expenses decreased by $11.5 million in the nine months ended September 30, 2016 compared with the year-earlier period. The decrease was primarily due to a $5.0 million reduction from the sale of our Slingo and social casino games business and $4.3 million from a reduction in salaries and benefits costs and professional service fees.

23



Sales and marketing expenses decreased by $4.8 million in the quarter ended September 30, 2016 compared with the year-earlier period. The decrease was due to a $2.5 million reduction in marketing expense, a $0.9 million reduction from the sale of our Slingo and social casino games business, as well as an overall decrease of $0.7 million in salaries, benefits, and professional service fees.
Sales and marketing expenses decreased by $14.7 million in the nine months ended September 30, 2016 compared with the year-earlier period. The decrease was primarily due to a $4.9 million reduction from the sale of our Slingo and social casino games business, $2.3 million of decreases in salaries and benefits costs and professional service fees and a decrease in marketing expenses of $6.2 million. These decreases were offset in part by an increase in stock compensation expenses for the fully vested equity awards authorized and granted for our 2015 incentive bonuses in the first quarter of 2016.
General and administrative expenses were flat for the quarter ended September 30, 2016, compared with the year-earlier period, primarily due to the sale of our Slingo and social casino games business in 2015 and an overall decrease in salaries, benefits and professional fees, offset by accelerated depreciation expense in the quarter, due in part to a reduction in space at our corporate headquarters.
General and administrative expenses were also flat for the nine months ended September 30, 2016 compared with the year-earlier period. In the current year, we recognized savings from the sale of our Slingo and social casino games business, as well as savings due to decreased salaries, benefits and professional services fees. These decreased costs were offset by the benefit recognized in 2015 relating to warrants received from Rhapsody and accelerated depreciation expense in 2016 due in part to a reduction in space at our corporate headquarters.
Restructuring and other charges and Lease exit and related charges consist of costs associated with the ongoing reorganization of our business operations and expense re-alignment efforts. Restructuring expense primarily relates to severance costs due to workforce reductions. For additional details on these charges see Note 11, Restructuring Charges and Note 12, Lease Exit and Related Charges, to the unaudited condensed consolidated financial statements included in Item 1 of Part I of this 10-Q.
Other Income (Expenses)
Other income (expenses), net was as follows (dollars in thousands):
 
 
Quarters ended September 30,
 
Nine months ended September 30,
 
2016
 
2015
 
$ Change
 
% Change
 
2016
 
2015
 
$ Change
 
% Change
Interest income, net
$
119

 
$
147

 
$
(28
)
 
(19
)%
 
$
316

 
$
597

 
$