10-Q 1 a12-3641_110q.htm 10-Q

Table of Contents

 

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 


 

x

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

 

For the Quarterly Period Ended December 23, 2011

 

OR

 

o

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: 001-34818

 

RealD Inc.

(Exact name of registrant as specified in its charter)

 


 

 

 

Delaware

 

77-0620426

(State or other jurisdiction of
incorporation or organization)

 

(I.R.S. Employer
Identification No.)

 

100 N. Crescent Drive, Suite 200
Beverly Hills, CA

 

90210

(Address of principal executive offices)

 

(Zip Code)

 

 

 

(310) 385-4000

(Registrant’s telephone number, including area code)

 


 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such  filing requirements for the past 90 days.   Yes  x    No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 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 
x   No  o

 

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.

 

Large accelerated filer

 

o

 

Accelerated filer

 

o

Non-accelerated filer

 

x  (Do not check if a smaller reporting company)

 

Smaller reporting company

 

o

 

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

 

On January 27, 2012, the registrant had 54,468,754 shares of common stock, par value $0.0001 per share, outstanding.

 

 



Table of Contents

 

RealD Inc.

QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED
December 23, 2011

 

 

TABLE OF CONTENTS

 

PART I – FINANCIAL INFORMATION

 

 

 

 

 

 

 

Page
Number

 

 

 

 

ITEM 1.

Financial statements

 

3

 

 

 

 

 

Condensed consolidated balance sheets as of December 23, 2011 (unaudited) and March 25, 2011

 

3

 

 

 

 

 

Condensed consolidated statements of operations (unaudited) for the three and nine months ended December 23, 2011 and December 24, 2010

 

4

 

 

 

 

 

Condensed consolidated statements of cash flows (unaudited) for the nine months ended December 23, 2011 and December 24, 2010

 

5

 

 

 

 

 

Notes to condensed consolidated financial statements (unaudited)

 

6

 

 

 

 

ITEM 2.

Management’s discussion and analysis of financial condition and results of operations

 

14

 

 

 

 

ITEM 3.

Quantitative and qualitative disclosures about market risk

 

29

 

 

 

 

ITEM 4.

Controls and procedures

 

31

 

 

 

 

PART II – OTHER INFORMATION

 

 

 

 

ITEM 1.

Legal proceedings

 

31

 

 

 

 

ITEM 1A.

Risk factors

 

31

 

 

 

 

ITEM 2.

Unregistered sales of equity securities and use of proceeds

 

42

 

 

 

 

ITEM 3.

Defaults upon senior securities

 

42

 

 

 

 

ITEM 5.

Other information

 

42

 

 

 

 

ITEM 6.

Exhibits

 

42

 

2



Table of Contents

 

PART I – FINANCIAL INFORMATION

 

ITEM 1. – FINANCIAL STATEMENTS

 

RealD Inc.

Condensed consolidated balance sheets

(in thousands, except per share data)

 

 

 

December 23,

 

March 25,

 

 

 

2011

 

2011

 

 

 

(unaudited)

 

 

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

  $

29,180 

 

  $

16,936

 

Accounts receivable, net

 

44,015

 

50,676

 

Inventories

 

46,020 

 

54,971

 

Deferred costs – eyewear

 

573 

 

49

 

Deferred income taxes

 

– 

 

1,029

 

Income taxes receivable

 

– 

 

139

 

Prepaid expenses and other current assets

 

2,040 

 

1,734

 

Total current assets

 

121,828

 

125,534

 

Property and equipment, net

 

10,970 

 

7,889

 

Cinema systems, net

 

142,954 

 

122,226

 

Digital projectors, net-held for sale

 

4,360 

 

10,475

 

Goodwill

 

10,657 

 

10,657

 

Other intangibles, net

 

1,788 

 

1,918

 

Deferred income taxes

 

817 

 

 

Other assets

 

4,906 

 

1,448

 

Total assets

 

  $

298,280

 

  $

280,147

 

 

 

 

 

 

 

Liabilities and equity

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

  $

26,584

 

  $

58,713

 

Accrued expenses and other liabilities

 

27,457 

 

40,118

 

Deferred revenue

 

7,820 

 

14,176

 

Income taxes payable

 

3,885 

 

 

Deferred income taxes

 

700 

 

 

Current portion of long-term debt

 

– 

 

2,291

 

Total current liabilities

 

66,446

 

115,298

Credit facility agreement

 

25,000

 

Deferred revenue, net of current portion

 

14,193

 

14,106

Other long-term liabilities, customer deposits and virtual print fee liability

 

3,679

 

4,533

Long-term debt, net of current portion

 

– 

 

19

Deferred income taxes

 

– 

 

1,091

Commitments and contingencies

 

 

 

 

 

Equity

 

 

 

 

 

Common stock, $0.0001 par value, 200,000 shares authorized; 54,468 and 53,570 shares issued and outstanding at December 23, 2011 and March 25, 2011, respectively

 

305,424

 

292,904

Accumulated deficit

 

(118,247)

 

(149,580)

Total RealD Inc. stockholders’ equity

 

187,177

 

143,324

 

Noncontrolling interest

 

1,785 

 

1,776

 

Total equity

 

188,962

 

145,100

 

Total liabilities and equity

 

  $

298,280

 

  $

280,147

 

 

 

 

 

 

 

 

 

 

See accompanying notes to condensed consolidated financial statement

 

3



Table of Contents

 

RealD Inc.

Condensed consolidated statements of operations (unaudited)

(in thousands, except per share data)

 

 

 

Three months ended

 

Nine months ended

 

 

December 23,

 

December 24,

 

December 23,

 

December 24,

 

 

2011

 

2010

 

2011

 

2010

 

 

 

 

 

 

 

 

 

Revenue:

 

 

 

 

 

 

 

 

License

 

  $

28,454

 

  $

18,838  

 

  $

116,146

 

  $

68,390

Product and other

 

20,572  

 

38,942  

 

80,435  

 

119,232

Total revenue

 

49,026

 

57,780  

 

196,581

 

187,622

Cost of revenue:

 

 

 

 

 

 

 

 

License

 

9,202  

 

5,301  

 

30,321  

 

11,660

Product and other

 

15,870  

 

46,341  

 

64,465  

 

138,099

Total cost of revenue

 

25,072  

 

51,642  

 

94,786  

 

149,759

Gross profit

 

23,954

 

6,138  

 

101,795

 

37,863

Operating expenses:

 

 

 

 

 

 

 

 

Research and development

 

4,336  

 

4,347  

 

12,736  

 

10,751

Selling and marketing

 

6,564  

 

5,813  

 

20,259  

 

15,251

General and administrative

 

11,513  

 

10,596  

 

29,735  

 

25,195

Total operating expenses

 

22,413  

 

20,756  

 

62,730  

 

51,197

Operating income (loss)

 

1,541

 

(14,618) 

 

39,065

 

(13,334)

Interest expense

 

(227) 

 

(71) 

 

(710) 

 

(873)

Other income (loss)

 

(792) 

 

(431) 

 

157  

 

6,376

Income (loss) before income taxes

 

522

 

(15,120) 

 

38,512

 

(7,831)

Income tax expense (benefit)

 

(2,241)

 

1,648  

 

7,170

 

3,299

Net income (loss)

 

2,763

 

(16,768) 

 

31,342

 

(11,130)

Net (income) loss attributable to noncontrolling interest

 

70  

 

181  

 

(9) 

 

(692)

Accretion of preferred stock

 

-      

 

-      

 

-      

 

(4,934)

Net income (loss) attributable to RealD Inc. common stockholders

 

  $

2,833

 

  $

(16,587) 

 

  $

31,333

 

  $

(16,756)

 

 

 

 

 

 

 

 

 

Earnings (loss) per common share:

 

 

 

 

 

 

 

 

Basic

 

  $

0.05  

 

  $

(0.34) 

 

  $

0.58

 

  $

(0.43)

Diluted

 

  $

0.05  

 

  $

(0.34) 

 

  $

0.55

 

  $

(0.43)

 

 

 

 

 

 

 

 

 

Shares used in computing earnings (loss) per common share:

 

 

 

 

 

 

 

 

Basic

 

54,524  

 

48,760  

 

54,274  

 

38,689

Diluted

 

56,385  

 

48,760  

 

56,985  

 

38,689

 

 

 

 

 

 

 

 

 

 

See accompanying notes to condensed consolidated financial statements

 

4



Table of Contents

 

RealD Inc.

Condensed consolidated statements of cash flows (unaudited)

(in thousands)

 

 

 

Nine Months Ended

 

 

 

December 23,

 

December 24,

 

 

 

2011

 

2010

 

Cash flows from operating activities

 

 

 

 

 

Net income (loss)

 

  $

31,342

 

 

  $

(11,130

)

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

 

 

 

 

 

Depreciation and amortization

 

20,558 

 

10,428

 

Deferred income tax

 

(179)

 

 

Non-cash interest expense

 

133 

 

132

 

Non-cash stock compensation

 

11,718 

 

5,988

 

Motion picture exhibitor option reduction in revenue

 

– 

 

34,008

 

Gain on sale of digital projectors

 

(1,156)

 

(6,720

)

(Gain) loss on disposal of assets

 

434 

 

 

Impairment of long-lived assets

 

9,024 

 

814

 

Changes in operating assets and liabilities:

 

 

 

 

 

Accounts receivable

 

6,661

 

(8,074

)

Inventories

 

8,951

 

(36,537

)

Prepaid expenses and other current assets

 

(306)

 

(3,785

)

Deferred costs - eyewear

 

(524)

 

271

 

Other assets

 

(3,458)

 

2,382

 

Accounts payable

 

(32,904)

 

19,625

 

Accrued expenses and other liabilities

 

(12,794)

 

14,139

 

Other long-term liabilities, customer deposits and virtual print fee liability

 

1,700 

 

1,791

 

Income taxes receivable/payable

 

4,024 

 

166

 

Deferred revenue

 

(6,269)

 

(1,886

)

Net cash provided by operating activities

 

36,955 

 

21,612

 

 

 

 

 

 

 

Cash flows from investing activities

 

 

 

 

 

Purchases of marketable securities

 

– 

 

(6,849

)

Proceeds from sale of marketable securities

 

– 

 

6,849

 

Purchases of property and equipment

 

(5,545)

 

(3,623

)

Purchases of cinema systems and related components

 

(46,656)

 

(63,983

)

Purchases of digital projectors

 

– 

 

(418

)

Proceeds from sale of digital projectors

 

3,999 

 

15,612

 

Net cash used in investing activities

 

(48,202)

 

(52,412

)

 

 

 

 

 

 

Cash flows from financing activities

 

 

 

 

 

Proceeds from common stock issuance, net of issuance costs

 

– 

 

81,940

 

Noncontrolling interest distribution

 

– 

 

(888

)

Repayments of long-term debt

 

(2,311)

 

(9,089

)

Proceeds from credit facility - revolving credit facility

 

30,000 

 

5,000

 

Repayments on credit facility - revolving credit facility

 

(5,000)

 

(15,150

)

Repayments on credit facility - term loan

 

– 

 

(10,000

)

Proceeds from exercise of stock options

 

528 

 

951

 

Proceeds from exercise of warrants

 

271 

 

363

 

Proceeds from exercise of motion picture exhibitor options

 

 

11

 

Net cash provided by financing activities

 

23,491 

 

53,138

 

Net increase in cash and cash equivalents

 

12,244 

 

22,338

 

Cash and cash equivalents, beginning of year

 

16,936 

 

13,134

 

Cash and cash equivalents, end of year

 

  $

29,180 

 

  $

35,472

 

 

 

 

 

 

 

Supplemental disclosures of cash flow information

 

 

 

 

 

Accretion of Series C preferred stock

 

  $

-     

 

  $

4,934

 

 

See accompanying notes to condensed consolidated financial statements

 

5



Table of Contents

 

RealD Inc.

Notes to condensed consolidated financial statements (unaudited)

 

1. Business and basis of presentation

 

RealD Inc., including its subsidiaries (“RealD”), is a global licensor of stereoscopic 3D technologies.

 

The accompanying condensed consolidated financial statements are unaudited. These unaudited interim condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) and applicable rules and regulations of the Securities and Exchange Commission (“SEC”) regarding interim financial reporting and include all adjustments (consisting of only normal recurring adjustments, unless otherwise indicated), necessary for a fair presentation of our condensed consolidated financial statements. Interim results are not necessarily indicative of results for any subsequent quarter, the full fiscal year or any future periods. Certain information and note disclosures normally included in the financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. Accordingly, these interim condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto contained in our Annual Report on Form 10-K for the year ended March 25, 2011.

 

The condensed consolidated financial statements include the accounts of RealD, its wholly owned subsidiaries and its majority owned subsidiaries. We do not have any interests in variable interest entities. For consolidated subsidiaries that are not wholly owned but are majority owned, the subsidiaries’ assets, liabilities, and operating results are included in their entirety in the accompanying condensed consolidated financial statements. The noncontrolling interests in those assets, liabilities, and operations are reflected as non-controlling interest in the condensed consolidated balance sheets under equity and condensed consolidated statements of operations.

 

On April 8, 2010, we reincorporated in Delaware. Each class of our capital stock has a par value of $0.0001 per share.

 

On March 6, 2007, Digital Link II, LLC (“Digital Link II”) was formed between Ballantyne of Omaha, Inc. and RealD with member interests of 44.4% and 55.6%, respectively. Digital Link II was formed to fund the deployment of digital projector systems and servers to third-party exhibitors.

 

All significant intercompany balances and transactions have been eliminated in consolidation.

 

We have evaluated the impact of subsequent events up to the filing date of these interim condensed consolidated financial statements.

 

2. Summary of significant accounting policies

 

Accounting period

Our fiscal year consists of four 13-week periods for a total of 52 weeks. The fiscal year for 2012 will end on March 23, 2012.

 

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 and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expense during the reporting period. Actual results could differ from those estimates.

 

Net income (loss) per share of common stock

Basic income (loss) per share of common stock is computed by dividing the net income (loss) attributable to RealD Inc. common stockholders for the period by the weighted average number of shares of common stock outstanding during the period. Because the holders of our convertible preferred stock were entitled to participate in dividends and earnings of our company, we applied the two-class method in calculating our earnings per share for periods when we generated net income prior to the conversion of the preferred shares into common shares on July 21, 2010. The two-class method requires net income to be allocated between the common and preferred stockholders based on their respective rights to receive dividends, whether or not declared. No such dividends were paid. Because the convertible preferred stock was not contractually obligated to share in our losses, no such allocation is made for periods when we had net losses.  Due to the conversion of the preferred shares into common shares on July 21, 2010, the two-class method of calculating earnings per share was not applied subsequent to that date.

 

6



Table of Contents

 

The calculation of the basic and diluted income (loss) per share of common stock for the three and nine months ended December 23, 2011 and December 24, 2010 was as follows:

 

 

 

Three months ended

 

Nine months ended

 

 

December 23,

 

December 24,

 

December 23,

 

December 24,

(in thousands, except per share data)

 

2011

 

2010

 

2011

 

2010

Numerator:

 

 

 

 

 

 

 

 

Net income (loss)

 

$

2,763

 

$

(16,768)

 

$

31,342

 

$

(11,130)

Net (income) loss attributable to noncontrolling interest

 

70

 

181

 

(9

)

(692)

Accretion of preferred stock

 

-   

 

-   

 

-   

 

(4,934)

Net income (loss) attributable to RealD Inc. common stockholders

 

$

2,833

 

$

(16,587)

 

$

31,333

 

$

(16,756)

 

 

 

 

 

 

 

 

 

Denominator:

 

 

 

 

 

 

 

 

Weighted-average common shares outstanding (basic)

 

54,524

 

48,760

 

54,274

 

38,689

Effect of dilutive securities

 

1,861

 

 

2,711

 

Weighted-average common shares outstanding (diluted)

 

56,385

 

48,760

 

56,985

 

38,689

 

 

 

 

 

 

 

 

 

Earnings (loss) per common share:

 

 

 

 

 

 

 

 

Basic

 

$

0.05

 

$

(0.34)

 

$

0.58

 

$

(0.43)

Diluted

 

$

0.05

 

$

(0.34)

 

$

0.55

 

$

(0.43)

 

The weighted-average number of anti-dilutive shares excluded from the calculation of diluted income (loss) per common share for the three and nine months ended December 23, 2011 and December 24, 2010 was as follows:

 

 

 

Three months ended 

 

Nine months ended

 

 

December 23,

 

December 24,

 

December 23,

 

December 24,

(in thousands)

 

2011

 

2010

 

2011

 

2010

Options and warrants to purchase common stock

 

5,318

 

11,113

 

3,358

 

9,796

Conversion of convertible preferred stock

 

-   

 

-   

 

-   

 

6,907

Total

 

5,318

 

11,113

 

3,358

 

16,703

 

In the above anti-dilution table, the columns for the three and nine months ended December 24, 2010 exclude 1,222,781 motion picture exhibitor options that vested upon the achievement of screen installation targets because the targets were not met as of December 24, 2010.

 

Derivative instruments

Our assets and liabilities associated with derivative instruments are recorded at fair value in other current assets or other current liabilities, respectively, in the condensed consolidated balance sheets. Changes in fair value are reported as a component of other income or loss on our condensed consolidated statements of operations. For all periods presented, none of our derivative instruments were designated as hedging instruments. We do not use foreign currency option or foreign exchange forward contracts for speculative or trading purposes.

 

We purchase foreign currency forward contracts, generally with maturities of six months or less, to reduce the volatility of cash flows primarily related to forecasted payments and expenses denominated in certain foreign currencies. As of December 23, 2011, we had outstanding forward contracts based in Canadian dollar, British pound sterling and Euro with notional amounts totaling an aggregate of $1.6 million. As of December 23, 2011, the carrying amount of our foreign currency forward contracts was $0.1 million and was classified as Level 2 fair value instruments, which was determined based on observable inputs that were corroborated by market data.  As of March 25, 2011, the carrying amount of our foreign currency forward contracts was not significant and was classified as Level 2 fair value instruments, which was determined based on observable inputs that were corroborated by market data. For the three months ended December 23, 2011, the net loss related to the change in fair value of our foreign currency forward contracts was $0.1 million. For the three months ended December 24, 2010, the net gain related to the change in fair value of our foreign currency forward contracts was $0.1 million. For the nine months ended December 23, 2011 and December 24, 2010, the net gain (loss) related to the change in fair value of our foreign currency forward contracts was not significant.

 

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Table of Contents

 

Accounts receivable

Accounts receivable consist of trade receivables, VAT receivable and other receivables. We extend credit to our customers, who are primarily in the movie production and exhibition businesses. We provide for the estimated accounts receivable that will not be collected. These estimates are based on an analysis of historical bad debts, customer concentrations, customer creditworthiness, current economic trends and changes in the customers’ payment terms and their economic condition. Collection of accounts receivable may be affected by changes in economic or other industry conditions and may, accordingly, impact our overall credit risk. The allowance for doubtful accounts and customer credits totaled $4.0 million and $6.8 million as of December 23, 2011 and March 25, 2011, respectively.

 

Inventories and deferred costs-eyewear

Inventories and deferred costs eyewear represent eyewear and are substantially all finished goods. Inventories and deferred costs eyewear are valued at the lower of cost (first-in, first-out method) or market value. At each balance sheet date, we evaluate ending inventories and deferred costs-eyewear for net realizable value. We also evaluate inventories for excess quantities and obsolescence. These evaluations include analyses of expected future average selling prices, projections of future demand and technology changes. In order to state inventories at the lower of cost or market, we maintain reserves against such inventories. If our analyses indicate that market is lower than cost, a write-down of inventories is recorded in cost of revenue in the period the loss is identified. As of December 23, 2011 and March 25, 2011, the inventory reserve as a result of our net realizable value analyses was $3.0 million and $3.2 million, respectively.

 

Domestically, we provide our RealD eyewear free of charge to motion picture exhibitors and then receive a fee from the motion picture studios for the usage of that RealD eyewear by the motion picture exhibitors’ consumers.

 

We believe that it is not operationally practical to perform physical counts or request the motion picture exhibitor to perform physical counts and confirm quantities held to ensure that losses due to damage, destruction and shrinkage are specifically recognized in the period incurred due to the number of domestic RealD-enabled screens and related usage of RealD eyewear. We believe that the cost to monitor shrinkage or usage significantly outweighs the financial reporting benefits of using a specific identification methodology of expensing. We believe that utilizing a composite method of expensing RealD eyewear inventory costs provides a rational and reasonable approach to ensuring that shrinkage is provided for in the period incurred and that inventory costs are expensed in the periods that reasonably reflect the periods in which the related revenue is recognized. In doing so, we believe the following methodology reasonably and generally reflects periodic income or loss under these facts and circumstances:

 

·                  For an estimated period of time following shipment to domestic motion picture exhibitors, no expense is recognized between the time of shipment and until the delivery is made as the inventory unit is in transit and unused.

·                  The inventory unit cost is expensed on a straight-line basis over an estimated usage period beginning when we believe usage of the inventory unit has started. In estimating the expensing start date and related expense period, we consider various factors including, but not limited to, those relating to a 3D motion picture’s opening release date, a 3D motion picture’s expected release period, the number of currently playing 3D motion pictures, the motion picture exhibitor’s buying and stocking patterns and practices and the quantities shipped per inventory unit.

 

We believe that the expensing methodology described above rationally and reasonably approximates the period the related usage occurs resulting in our RealD eyewear product revenue. The expensing start date following the date of shipment is meant to approximate the date at which usage begins. Additionally, as the expense recognition period has been and is expected to continue to be short, we believe it adequately recognizes inventory impairments due to loss and damage on a timely basis. We further believe that exposures due to loss or damage, if any, are considered normal shrinkage and a necessary and expected cost to generate the revenue per 3D motion picture earned through RealD eyewear usage. We continue to monitor the reasonableness of this methodology to ensure that it approximates the period over which the related RealD eyewear product revenue is earned and realizable. RealD eyewear inventory costs for products shipped that have not yet been expensed are reported as deferred costs-eyewear.

 

Impairment of long-lived assets

We review long-lived assets, such as property and equipment, cinema systems, digital projectors and intangibles, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Factors or circumstances that could indicate the occurrence of such events include current period operating or cash flow losses combined with a history of operating or cash flow losses, a projection or forecast that demonstrates continuing operating or cash flow losses, or incurring costs in excess of amounts originally expected to acquire or construct an asset. If the asset is not recoverable, an impairment loss is recognized as the amount by which the carrying amount of the asset exceeds its fair value.

 

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During the three months ended September 23, 2011, we determined that certain of our cinema systems were not recoverable and that the carrying value of the assets exceeded fair value, primarily due to the number of certain of our cinema system assets on hand, including related outstanding purchase commitments and the continuing shift in the mix in the deployment of cinema systems based on the type of digital projectors installed and theater configuration.  The fair value was primarily determined by evaluating the discounted future cash flows expected to be generated from the cinema systems. The impairment charged during the three months ended September 23, 2011 to cost of revenue for certain of the cinema systems totaled $6.8 million.

 

For the three months ended December 23, 2011 and December 24, 2010, impairment charges for all impaired RealD Cinema Systems charged to cost of revenue totaled $1.2 million and $0.5 million, respectively. For the nine months ended December 23, 2011 and December 24, 2010, impairment charges for all impaired RealD Cinema Systems charged to cost of revenue totaled $9.0 million and $0.8 million, respectively.

 

Revenue recognition and revenue reductions

We derive substantially all of our revenue from the license of our RealD Cinema Systems and the product sale of our RealD eyewear. We evaluate revenue recognition for transactions using the criteria set forth by the SEC in Staff Accounting Bulletin No. 104, Revenue Recognition (SAB 104) and Accounting Standards Codification Topic 605, Revenue Recognition (ASC 605). The revenue recognition guidance states that revenue is recognized when all of the following criteria are met: persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the seller’s price to the buyer is fixed or determinable and collectability is reasonably assured.

 

License revenue

License revenue is accounted for as an operating lease. License revenue is primarily derived under per-admission, periodic fixed fee, or per-motion picture basis with motion picture exhibitors. Amounts received up front, less estimated allowances, are deferred and recognized over the lease term using the straight-line method. Additional lease payments that are contingent upon future events outside our control, including those related to admission and usage, are recognized as revenues when the contingency is resolved and we have no more obligations to our customers specific to the contingent payment received. Certain of our license revenue from leasing our RealD Cinema Systems is earned upon admission by the motion picture exhibitor’s consumers. Our licensees, however, do not report and pay for such license revenue until after the admission has occurred, which may be received subsequent to our fiscal period end. We estimate and record licensing revenue related to motion picture exhibitor consumer admissions in the quarter in which the admission occurs, but only when reasonable estimates of such amounts can be made. We determine that there is persuasive evidence of an arrangement upon the execution of a license agreement or upon the receipt of a licensee’s admissions report. Revenue is deemed fixed or determinable upon receipt of a licensee’s admissions report. We determine collectability based on an evaluation of the licensee’s recent payment history.

 

Product revenue

We recognize product revenue, net of allowances, when title and risk of loss have passed and when there is persuasive evidence of an arrangement, the payment is fixed or determinable, and collectability of payment is reasonably assured. In the United States and Canada, certain of our product revenue from the sale of our RealD eyewear is earned upon admission and usage by the motion picture exhibitor’s consumers. Our customers, however, do not report admission or usage information until after the admission and usage has occurred, and such information may be received subsequent to our fiscal period end. We estimate and record such product revenue in the quarter in which the admission and usage occurs, but only when reasonable estimates of such amounts can be made.

 

Revenue reductions

We record revenue net of motion picture exhibitor stock options and revenue allowances. In connection with certain exhibitor licensing agreements, we issued the motion picture exhibitors a 10-year option to purchase shares of our common stock at approximately $0.00667 per share. The stock options were fully vested by March 25, 2011 upon the achievement of screen installation targets. Prior to being fully vested, the motion picture exhibitor stock options were valued at the underlying stock price at each reporting period until the targets were met. Amounts recognized were based on the number of RealD-enabled screens as a percentage of total screen installation targets. The stock options do not have net cash settlement features. Amounts recorded as a revenue reduction totaled $22.0 million and $34.0 million for the three months and nine months ended December 24, 2010, respectively. As the motion picture exhibitor stock options had fully vested as of March 25, 2011, all of the associated reduction of revenue had been recognized through that date.

 

Shipping and handling costs

Amounts billed to customers for shipping and handling costs are included in revenue. Shipping and handling costs that we incur consist primarily of packaging and transportation charges and are recorded in cost of revenue. Shipping and handling costs recognized in cost of revenue were $1.6 million and $2.2 million for the three months ended December 23, 2011 and December 24, 2010, respectively. Shipping and handling costs recognized in cost of revenue were $5.6 million and $8.7 million for the nine months ended December 23, 2011 and December 24, 2010, respectively.

 

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Recent accounting pronouncements

In September 2011, the FASB issued ASU 2011-08, Intangibles (Topic 350)— Goodwill and Other (ASU 2011-08) which allows companies to waive comparing the fair value of a reporting unit to its carrying amount in assessing the recoverability of goodwill if, based on qualitative factors, it is not more likely than not that the fair value of a reporting unit is less than its carrying amount.   ASU 2011-08 will be effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011.  We are currently evaluating the impact the adoption of the new guidance will have on the consolidated financial statements.

 

3. Property and equipment, RealD Cinema Systems and digital projectors

 

Property and equipment, RealD Cinema Systems and digital projectors consist of the following:

 

 

 

December 23,

March 25,

(in thousands)

 

2011

2011

RealD Cinema Systems

 

$

179,900

 

$

142,602

 

Digital projectors - held for sale

 

6,193

 

13,333

 

Leasehold improvements

 

999

 

1,163

 

Machinery and equipment

 

6,695

 

6,430

 

Furniture and fixtures

 

12

 

15

 

Computer equipment and software

 

2,537

 

2,089

 

Construction in process

 

4,360

 

820

 

Total

 

$

200,696

 

$

166,452

 

Less accumulated depreciation

 

(42,412

)

(25,862

)

Property and equipment, RealD Cinema Systems and digital projectors, net

 

 

$

158,284

 

$

140,590

 

 

Depreciation expense amounted to $7.4 million and $4.4 million for the three months ended December 23, 2011 and December 24, 2010, respectively. Depreciation expense amounted to $20.4 million and $10.4 million for the nine months ended December 23, 2011 and December 24, 2010, respectively.

 

We receive virtual print fees (“VPFs”) from third-party motion picture studios. VPFs represent amounts from third-party motion picture studios that are paid to us when a motion picture is played on one of our digital projectors. VPFs are deferred and deducted from the selling price of the digital projector. VPFs are recorded as a liability on the accompanying condensed consolidated balance sheets and totaled $1.0 million and $1.5 million as of December 23, 2011 and March 25, 2011, respectively.

 

There were no sales of digital projectors during the three months ended December 23, 2011. During the three months ended December 24, 2010, we received $0.3 million in cash from motion picture exhibitor customers for the sale of digital projectors and the resulting gain was not significant. During the nine months ended December 23, 2011, we received $4.0 million in cash from motion picture exhibitor customers for the sale of digital projectors, resulting in a gain of $1.2 million in other income (loss). During the nine months ended December 24, 2010, we received $15.6 million in cash from motion picture exhibitor customers for the sale of digital projectors, resulting in a gain of $6.7 million in other income (loss). With the proceeds, we repaid an aggregate of $5.3 million of notes payable to the equipment providers.

 

During the three months ended September 23, 2011, we determined that certain of our cinema systems were not recoverable and that the carrying value of the assets exceeded fair value, primarily due to the number of certain of our cinema system assets on hand, including related outstanding purchase commitments and the continuing shift in the mix in the deployment of cinema systems based on the type of digital projectors installed and theater configuration.  The fair value was primarily determined by evaluating the discounted future cash flows expected to be generated from the cinema systems. The impairment charged during the three months ended September 23, 2011 to cost of revenue for certain of the cinema systems totaled $6.8 million.

 

4. Borrowings

 

Credit Agreement

We have entered into a credit and security agreement with City National Bank, a national banking association, or City National, which was dated as of June 24, 2010 and amended on April 5, 2011 (as amended, the “Credit Agreement”), to provide that the aggregate principal amount outstanding at any one time under our revolving credit loans may be (i) up to $50 million through December 31, 2011 and (ii) up to $25.0 million thereafter and which will mature on June 30, 2012.  On December 6, 2011, we further amended the Credit Agreement to provide that the aggregate principal amount outstanding at any one time under our revolving credit loans shall

 

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remain $50 million after December 31, 2011 and to extend the maturity date of the revolving credit loans under the Credit Agreement to December 31, 2013. The Credit Agreement and the revolving credit facility provided thereunder became effective on July 21, 2010. Our obligations under the Credit Agreement are secured by a first priority security interest in substantially all of our tangible and intangible assets in favor of City National and are guaranteed by our subsidiaries, ColorLink, Inc., or ColorLink  and Stereographics Corporation , or Stereographics. The revolving credit facility provides for, at our option, Revolving London Interbank Offered Rate (“LIBOR”) loans, which bear interest at the greater of three and one half percent (3.50%) or the LIBOR plus two and one-half percent (2.50%) or Revolving Prime loans which bear interest at the greater of three and one half percent (3.50%) or the fluctuating Prime Rate per annum.

 

Under the Credit Agreement, our business will be subject to certain limitations, including limitations on our ability to incur additional debt, make certain investments or acquisitions, enter into certain merger and consolidation transactions, and sell our assets other than in the ordinary course of business. We will also be required to maintain compliance with certain financial covenants, including a minimum fixed charge coverage ratio and a maximum leverage ratio. As of December 23, 2011, we were in compliance with all financial covenants in the Credit Agreement. If we fail to comply with any of the covenants or if any other event of default, as defined in the Credit Agreement, should occur, the bank could elect to prevent us from borrowing and declare the indebtedness to be immediately due and payable.

 

As of December 23, 2011, there was $25.0 million in borrowings outstanding under the Credit Agreement. As of December 23, 2011, borrowings outstanding under the Credit Agreement bear interest at 3.50%. As of March 25, 2011, there were no borrowings outstanding under the Credit Agreement. Interest expense related to our borrowings under our credit facility agreement was $0.2 million and $0.6 million for the three and nine months ended December 23, 2011, respectively. Interest expense related to our borrowings under our credit and security agreement was not significant for the three months ended December 24, 2010. Interest expense related to our borrowings under our credit facility agreement and credit and security agreement was $0.6 million for the nine months ended December 24, 2010.

 

Notes Payable

As of December 23, 2011, we had no notes payable outstanding. As of March 25, 2011, we had $2.3 million aggregate principal amount of notes payable outstanding. Interest expense is based on annual interest rates ranging from 7.0% to 8.4%. Interest expense related to notes payable was $0.1 million for the three months ended December 24, 2010. Interest expense related to notes payable was $0.1 million and $0.3 million for the nine months ended December 23, 2011 and December 24, 2010, respectively.

 

5. Commitments and contingencies

 

Indemnities and commitments

During the ordinary course of business, we make certain indemnities and commitments under which we may be required to make payments in relation to certain transactions. These indemnities include indemnities of certain customers and licensees of our technologies, and indemnities to our directors and officers to the maximum extent permitted under the laws of the State of Delaware. The duration of these indemnities and commitments varies, and in certain cases, is indefinite. The majority of these indemnities and commitments do not provide for any limitation of the maximum potential future payments we could be obligated to make. We have not recorded any liability for these indemnities and commitments in the accompanying condensed consolidated balance sheets. We do, however, accrue for losses for any known contingent liability, including those that may arise from indemnification provisions, when future payment is reasonably probable and estimable.

 

We have entered into contracts with certain of our vendors. Future obligations under such contracts totaled $1.3 million at December 23, 2011 and include revolving 90-day supply commitments. Many of the contracts contain cancellation penalty provisions requiring payment of up to 20.0% of the unused contract.

 

6. Mandatorily redeemable convertible preferred stock and equity

 

Mandatorily redeemable convertible preferred stock

We accreted the carrying value of the Series C mandatorily redeemable convertible preferred stock up to liquidation value through July 21, 2010, the date at which such preferred shares were converted into common shares. Accretion was provided using the effective interest-rate method. For the nine months ended December 24, 2010, we recorded accretion of $4.9 million.

 

Motion picture exhibitor stock options

In connection with certain motion picture exhibitor licensing agreements, we issued to motion picture exhibitors a 10-year option to purchase 3,668,340 shares of our common stock at $0.00667 per share. These stock options to our motion picture exhibitor licensees

 

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vested upon the achievement of screen installation targets and were valued at the underlying stock price at each reporting period until the targets were met.

 

Amounts recorded as a revenue reduction totaled $22.0 million and $34.0 million for the three and nine months ended December 24, 2010, respectively. As the motion picture exhibitor stock options had fully vested as of March 25, 2011, all of the associated reduction of revenue had been recognized through that date.  Additionally, 407,593 exhibitor stock options were exercised by certain of our motion picture exhibitors during the nine months ended December 23, 2011. As of June 24, 2011 all motion picture exhibitor stock options have been exercised.

 

Warrants

As of December 23, 2011, there were no warrants outstanding to purchase shares of common stock.  For the nine months ended December 23, 2011 and December 24, 2010, 326,700 and 435,600, warrants were exercised, respectively.

 

7. Share-based compensation

 

We account for stock options granted to employees and directors by recording compensation expense based on estimated fair values. We estimate the fair value of share-based payment awards on the date of grant. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in our consolidated statements of operations. Share-based awards are attributed to expense using the straight-line method over the vesting period. We determine the value of each option award that contains a market condition using a lattice-based option valuation model, while all other option awards are valued using the Black-Scholes valuation model as permitted under ASC 718, Compensation — Stock Compensation. The assumptions used in calculating the fair value of share-based payment awards represent our best estimates. Our estimates of the fair values of stock options granted and the resulting amounts of share-based compensation recognized may be impacted by certain variables including stock price volatility, employee stock option exercise behaviors, additional stock option grants, estimates of forfeitures, and the related income tax impact.

 

Stock options

Stock options granted generally vest over a four-year period, with 25% of the shares vesting after one year and monthly vesting thereafter.  The options generally expire ten years from the date of grant. For the nine months ended December 23, 2011, we granted 1.9 million stock options at a weighted average grant date fair value of $11.52 per share.  For the three months ended December 23, 2011 and December 24, 2010, share-based compensation expense related to stock options was $3.1 million and $2.2 million, respectively. For the nine months ended December 23, 2011 and December 24, 2010, share-based compensation expense related to stock options was $9.1 million and $4.7 million, respectively.

 

Performance stock options

Certain of our management-level employees receive performance stock options, which gives the recipient the right to receive common stock that is contingent upon achievement of specified pre-established performance goals over the performance period, which is generally three years. The performance goals for the performance stock options are based on the measurement of our total shareholder return, on a percentile basis, compared to a comparable group of companies. Depending on the outcome of the performance goals, the recipient may ultimately earn performance stock options equal to or less than the number of performance stock options granted.  For the three months ended December 23, 2011 and December 24, 2010, share-based compensation expense related to performance stock options was $0.5 million and $0.5 million, respectively. For the nine months ended December 23, 2011 and December 24, 2010, share-based compensation expense related to performance stock options was $1.3 million and $0.9 million, respectively.

 

Restricted stock units

Restricted stock units vest over one to four years. For the nine months ended December 23, 2011, we granted 0.2 million restricted stock units at a weighted average grant date fair value of $20.53 per restricted stock unit. For the three months ended December 23, 2011 and December 24, 2010, share-based compensation expense related to restricted stock units was $0.5 million and $0.2 million, respectively. For the nine months ended December 23, 2011 and December 24, 2010, share-based compensation expense related to restricted stock units was $1.3 million and $0.4 million, respectively.

 

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Share-based compensation expense for all share-based arrangements for the three and nine months ended December 23, 2011 and December 24, 2010 was as follows:

 

 

 

 

Three months ended 

 

Nine months ended 

(in thousands)

 

 

December 23,
2011

 

December 24,
2010

 

December 23,
2011

 

December 24, 
2010 

Share-based compensation

 

 

 

 

 

 

 

 

 

 

Cost of revenue

 

 

$

119

 

$

50

 

$

317

 

$

93

 

Research and development

 

 

524

 

434

 

2,095

 

1,016

 

Selling and marketing

 

 

1,305

 

898

 

3,529

 

2,053

 

General and administrative

 

 

2,138

 

1,598

 

5,777

 

2,826

 

Total

 

 

$

4,086

 

$

2,980

 

$

11,718

 

$

5,988

 

 

Included in research and development for the nine months ended December 23, 2011 is $0.6 million of additional share-based compensation expense recognized in connection with a modification of stock options and performance stock options pursuant to a separation agreement for one of our officers.

 

8. Income taxes

 

Our income tax expense (benefit) for the three months ended December 23, 2011 and December 24, 2010 was a benefit of $2.2 million and an expense of $1.6 million, respectively. Our income tax expense for the nine months ended December 23, 2011 and December 24, 2010 was $7.2 million and $3.3 million, respectively. We have net operating losses that may potentially be offset against earnings. We file federal income tax returns and income tax returns in various state and foreign jurisdictions. Due to the net operating loss carryforwards, our United States federal and state returns are open to examination by the Internal Revenue Service and state jurisdictions for all years since inception.

 

As of December 23, 2011, we have determined based on the weight of the available evidence, both positive and negative, to provide for a valuation allowance against substantially all of the net deferred tax assets. The current deferred tax assets not reserved for by the valuation allowance are those in foreign jurisdictions or amounts that may be carried back in future years. If there is a change in circumstances that causes a change in judgment about the realizability of the deferred tax assets, we will adjust all or a portion of the applicable valuation allowance in the period when such change occurs.

 

9. Equity

 

A summary of the changes in total equity for the nine months ended December 23, 2011 was as follows:

 

 

 

RealD Inc.

 

 

 

 

 

 

 

 

stockholders'

 

Noncontrolling

 

 

Total

 

(in thousands)

 

equity

 

interest

 

 

equity

 

 

 

 

 

 

 

 

 

 

Balance, March 25, 2011

 

$

143,324

 

$

1,776

 

 

$

145,100

 

Share-based compensation

 

11,718

 

-

 

 

11,718

 

Exercise of stock options

 

528

 

-

 

 

528

 

Exercise of motion picture exhibitor options

 

3

 

-

 

 

3

 

Exercise of warrants

 

271

 

-

 

 

271

 

Comprehensive income:

 

 

 

 

 

 

 

 

Net income (loss)

 

31,333

 

9

 

 

$

31,342

 

Total comprehensive income

 

 

 

 

 

 

31,342

 

Balance, December 23, 2011

 

$

187,177

 

$

1,785

 

 

$

188,962

 

 

 

 

 

 

 

 

 

 

 

10. Related-party transactions

 

On May 19, 2011, we entered into a separation agreement and general release of claims with Joshua Greer, a current director and who previously served as our president. Pursuant to the terms of the separation agreement, Mr. Greer will receive the following benefits: (i) cash severance of $450,000 paid in ten equal installments, with the first such installment paid on October 15, 2011; (ii) reimbursement from us for insurance coverage under COBRA for 18 months following July 15, 2011 or such earlier time as Mr. Greer becomes eligible for insurance through another employer; (iii) a pro-rated cash performance bonus for fiscal year 2012 (to be paid no later than June 15, 2012), in an amount equal to 30% of 80% of Mr. Greer’s salary, computed assuming that Mr. Greer had remained as our

 

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president through the end of fiscal year 2012; and (iv) acceleration of a time-based vesting stock option for 105,000 shares granted to Mr. Greer on July 15, 2010 as of July 15, 2011, which will remain exercisable for 6 months following the end of the term of the consulting agreement that we entered into with Mr. Greer on the same date.  A second stock option for 105,000 shares granted to Mr. Greer on July 15, 2010 was entirely forfeited and cancelled without consideration.  We entered into a consulting agreement with Mr. Greer pursuant to which Mr. Greer will be paid $275,000 per year commencing as of July 16, 2011.  The consulting agreement with Mr. Greer expires on July 16, 2012 (unless earlier terminated).

 

For the three and nine months ended December 23, 2011 we paid $0.1 million pursuant to the separation agreement and $0.1 million pursuant to the consulting agreement.

 

11. Subsequent event

 

In January 2012, the Members of Digital Link II, a majority owned subsidiary of RealD approved the distribution of $3.4 million to the operating members based on the membership interest of 55.6%, or $1.9 million for RealD and 44.4%, or $1.5 million for our noncontrolling interest partner.

 

ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Cautionary note on forward-looking statements

 

The following discussion and analysis should be read in conjunction with our interim condensed consolidated financial statements and the related notes that appear elsewhere in this Form 10-Q. These discussions contain forward-looking statements reflecting our current expectations that involve risks and uncertainties. In some cases, you can identify forward-looking statements by terminology such as “intends,” “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” “continue” or the negative of these terms or other comparable terminology, but the absence of these words does not necessarily mean that a statement is not forward-looking. Forward-looking statements include, but are not limited to: statements regarding the extent and timing of future licensing, products and services revenue levels and mix, expenses, margins, net income (loss) per diluted share, income taxes, tax benefits, acquisition costs and related amortization, and other measures of results of operations; our expectations regarding demand and acceptance for our technologies; 3D motion picture releases and conversions scheduled for fiscal 2012 ending March 23, 2012 as well their commercial success and consumer preferences; our relationships with consumer electronics panel manufacturers and our ability to generate substantial revenue from the licensing of our 3D technologies for use in the 3D consumer electronics market; our ability to increase the number of RealD-enabled screens in domestic and international markets and market share; our ability to supply our solutions to our customers on a timely basis; RealD relationships with exhibitor and studio partners and the business model for 3D eyewear in North America; the progress, timing and amount of expenses associated with our research and development activities; market and industry growth opportunities and trends in the markets in which we operate, including in 3D content; our plans, strategies and expected opportunities; the deployment of and demand for our products and products incorporating our technologies; and competitive pressures in domestic and international cinema markets impacting licensing and product revenues. Actual results may differ materially from those discussed in these forward-looking statements due to a number of factors, including the risks set forth in the section entitled “Risk Factors” in Part II, Item 1A of this Quarterly Report on Form 10-Q and elsewhere in this filing. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of these forward-looking statements. We are under no duty to update any of the forward-looking statements after the date of this Quarterly Report on Form 10-Q to conform our prior statements to actual results.

 

Overview

 

We are a leading global licensor of 3D technologies. Our extensive intellectual property portfolio is used in applications that enable a premium 3D viewing experience in the theater, the home and elsewhere. We license our RealD Cinema Systems to motion picture exhibitors that show 3D motion pictures and alternative 3D content. We also provide our RealD Display, active and passive eyewear, and RealD Format to consumer electronics manufacturers and content providers and distributors to enable the delivery and viewing of 3D content on high definition televisions, laptops and other displays. Our cutting-edge 3D technologies have been used for applications such as piloting the Mars Rover.

 

For financial reporting purposes, we currently have one reportable segment. We have three operating segments: cinema, consumer electronics and professional within which we market our various applications. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision-making group, in deciding how to allocate resources and in assessing performance. Our chief operating decision maker is our Chief Executive Officer. We aggregate our three operating segments into one reportable segment based on qualitative factors, including similar economic characteristics and the nature of the products and services. Our product portfolio is used in applications that enable a premium 3D viewing experience across these segments. We currently generate substantially all of our revenue from the license of our RealD Cinema Systems and the use and sale of our eyewear.

 

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Key business metrics

 

Our management regularly reviews a number of business metrics, including the following key metrics to evaluate our business, monitor the performance of our business model, identify trends affecting our business, determine the allocation of resources, make decisions regarding corporate strategies and evaluate forward-looking projections. The measures that we believe are the primary indicators of our quarterly and annual performance are as follows:

 

·                  Number of screens. Domestic screens are motion picture theater screens in the United States or Canada enabled with our RealD Cinema Systems. International screens are motion picture theater screens outside the United States and Canada enabled with our RealD Cinema Systems.

·                  Number of locations. Domestic locations are motion picture exhibition complexes in the United States or Canada with one or more screens enabled with our RealD Cinema Systems. International locations are motion picture exhibition complexes outside the United States and Canada with one or more screens enabled with our RealD Cinema Systems.

·                  Number of 3D motion pictures. Total 3D motion pictures are the number of 3D motion pictures that are exhibited for more than three showings per day and for a period in excess of one week and for which we receive a license fee from the motion picture exhibitor during the relevant period.

·                  Adjusted EBITDA. We use Adjusted EBITDA as a supplemental measure of our performance. We define Adjusted EBITDA as net income (loss), plus net interest expense, income and other taxes, depreciation and amortization, share-based compensation expense and exhibitor option expense, as further adjusted to eliminate the impact of certain other items that we do not consider indicative of our core operating performance. We consider our core operating performance to be that which can be affected by our managers in any particular period through their management of the resources that affect our underlying revenue and profit generating operations for that period. However, Adjusted EBITDA is not a recognized measurement under U.S. GAAP and should not be considered in isolation or as a substitute for performance measures calculated in accordance with U.S. GAAP. For a reconciliation of Adjusted EBITDA to U.S. GAAP net income (loss) and for futher discussion regarding Adjusted EBITDA, see ‘‘—Non-U.S. GAAP discussion.’’

 

The following table sets forth additional performance highlights of key business metrics for the periods presented (approximate numbers):

 

 

 

Nine months ended 

 

 

December 23,

 

December 24, 

(approximate numbers)

 

2011

 

2010 

Number of RealD enabled screens (at period end)

 

 

 

 

 

 

Total domestic RealD enabled screens

 

11,500

 

 

6,900

 

Total international RealD enabled screens

 

8,200

 

 

4,400

 

Total RealD enabled screens

 

19,700

 

 

11,300

 

Number of locations with RealD enabled screens (at period end)

 

 

 

 

 

 

Total domestic locations with RealD enabled screens

 

2,500

 

 

2,300

 

Total international locations with RealD enabled screens

 

2,400

 

 

1,900

 

Total locations with RealD enabled screens

 

4,900

 

 

4,200

 

Number of 3D motion pictures (released during period)

 

28

 

 

20

 

 

Performance highlights for Adjusted EBITDA, another key business metric and a Non-U.S. GAAP financial measure, are presented below under the caption “Non-U.S. GAAP discussion.”  If we are successful in expanding our business with consumer electronics manufacturers and content producers and distributors to incorporate our RealD Display and RealD Format technologies into their products and platforms, our key business metrics in future periods may include the number of units of 3D-enabled plasma and LCD televisions, interactive gaming consoles and laptop computers shipped in that period. To date, we have not generated significant revenue in our consumer electronics business.

 

Opportunities, trends and factors affecting comparability

 

We have rapidly evolved and expanded our business since we acquired ColorLink in March 2007. This expansion has included hiring most of our senior management team, acquiring and growing our research and development facilities in Boulder, Colorado, and building infrastructure to support our business. These investments in and changes to our business have allowed us to significantly increase our revenue and key business metrics. We expect to continue to invest for the foreseeable future in expanding our business as we increase our direct sales and marketing presence in the United States, Europe, Asia and other geographic regions, enhance and expand our technology and product offerings and pursue strategic acquisitions.

 

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Table of Contents

 

Cinema

The shift in the motion picture industry from analog to digital over the past decade has created an opportunity for new and transformative 3D technologies. As of December 23, 2011, there were approximately 19,700 RealD-enabled screens worldwide as compared to approximately 11,300 RealD-enabled screens worldwide as of December 24, 2010, an increase of 8,400 RealD-enabled screens or 74%.  Based on the slate announcements by motion picture studios, we anticipate that approximately 36 3D motion pictures will be released worldwide in our fiscal year 2012, including sequels to successful major motion picture franchises, such as Harry Potter, Transformers, Pirates of the Caribbean, Kung Fu Panda, Cars, Underworld, Journey to the Center of the Earth and Ghost Rider.

 

Consumer electronics

We have recently made available our RealD Display, active and passive eyewear, and RealD Format technologies to consumer electronics manufacturers and content distributors to enable 3D in high definition televisions, laptops and other displays in the home and elsewhere. We believe that the recent success of major 3D motion pictures, including Pirates of the Caribbean, Thor, Rio, Kung Fu Panda and the Smurfs is leading to the creation and distribution of 3D content for consumer electronics. The development of these technologies represents a significant opportunity for new revenue. After having jointly announced with Samsung a license agreement in May 2011 which we had expected to lead to the incorporation of RealD’s 3D display technology into LCD panels manufactured by Samsung beginning in early 2012, Samsung’s initiative to manufacture panels under the license agreement with RealD is not currently being pursued.

 

Motion picture exhibitor stock options

We incurred variability in our license revenue and operating results in connection with stock options issued to some of our motion picture exhibitor licensees that vested upon the achievement of screen installation targets. For further discussion regarding exhibitor stock options, see “Critical accounting policies and estimates.”

 

Results of operations

 

The following table sets forth our condensed consolidated statements of operations and other data for each of the periods indicated:

 

 

 

Three months ended

 

 

 

 

Nine months ended

 

 

 

December 23,

 

December 24,

 

 

 

 

December 23,

 

December 24,

 

(in thousands)

 

2011

 

2010

 

 

 

 

2011

 

2010

 

Consolidated statements of operations data:

 

 

 

 

 

 

 

 

 

 

 

 

Gross revenue

 

$

49,026 

 

$

79,740 

 

 

 

 

$

196,581 

 

$

221,630 

 

Motion picture exhibitor options

 

-

 

(21,960)

 

 

 

 

-

 

(34,008)

 

Net revenue

 

49,026

 

57,780

 

 

 

 

196,581

 

187,622

 

Cost of revenue

 

25,072

 

51,642

 

 

 

 

94,786

 

149,759

 

Gross profit

 

23,954

 

6,138

 

 

 

 

101,795

 

37,863

 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

 

 

Research and development

 

4,336

 

4,347

 

 

 

 

12,736

 

10,751

 

Selling and marketing

 

6,564

 

5,813

 

 

 

 

20,259

 

15,251

 

General and administrative

 

11,513

 

10,596

 

 

 

 

29,735

 

25,195

 

Total operating expenses

 

22,413

 

20,756

 

 

 

 

62,730

 

51,197

 

Operating income

 

1,541

 

(14,618)

 

 

 

 

39,065

 

(13,334)

 

Interest expense

 

(227)

 

(71)

 

 

 

 

(710)

 

(873)

 

Other income

 

(792)

 

(431)

 

 

 

 

157

 

6,376

 

Income (loss) before income taxes

 

522

 

(15,120)

 

 

 

 

38,512

 

(7,831)

 

Income tax expense

 

(2,241)

 

1,648

 

 

 

 

7,170

 

3,299

 

Net income (loss)

 

2,763

 

(16,768)

 

 

 

 

31,342

 

(11,130)

 

Net (income) loss attributable to noncontrolling interest

 

70

 

181

 

 

 

 

(9)

 

(692)

 

Accretion of preferred stock

 

-

 

-

 

 

 

 

-

 

(4,934)

 

Net income (loss) attributable to RealD Inc.

 

 

 

 

 

 

 

 

 

 

 

 

common stockholders

 

$

2,833

 

$

(16,587)

 

 

 

 

$

31,333

 

$

(16,756)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other data:

 

 

 

 

 

 

 

 

 

 

 

 

Adjusted EBITDA (1)

 

$

16,165

 

$

16,908

 

 

 

 

$

86,574

 

$

44,361

 

 

(1)    Adjusted EBITDA is not a recognized measurement under U.S. GAAP.  For a definition of Adjusted EBITDA and reconciliation to net income (loss), the comparable U.S. GAAP item, see “—Non-U.S. GAAP discussion.” In the period to period comparative discussion below, we describe our net revenue, license revenue (composed principally of revenue from our RealD Cinema Systems), and product and other revenue (principally composed of our RealD eyewear and, to a much lesser extent, professional product revenue).

 

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Table of Contents

 

Three months ended December 23, 2011 compared to three months ended December 24, 2010

 

Revenue

 

 

Three months ended 

 

 

 

 

 

 

December 23,

 

December 24, 

 

 

 

Amount

 

 

Percentage

(in thousands)

 

2011

 

2010 

 

 

 

change

 

 

change

Revenue:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross license

 

$

28,454

 

 

$

40,798

 

 

 

 

$

(12,344

)

 

(30%)

 

Motion picture exhibitor options

 

-    

 

 

(21,960

)

 

 

 

21,960

 

 

(100%)

 

Net license

 

28,454

 

 

18,838

 

 

 

 

9,616

 

 

51%

 

Product and other

 

20,572

 

 

38,942

 

 

 

 

(18,370

)

 

(47%)

 

Total net revenue

 

$

49,026

 

 

$

57,780

 

 

 

 

$

(8,754

)

 

(15%)

 

 

The decrease in net revenue recorded during the three months ended December 23, 2011 compared to the three months ended December 24, 2010 was primarily due to a decrease in net license revenues resulting from the decrease in the box office of 3D motion pictures on RealD-enabled screens. The decrease in product and other revenue was also primarily due to the resulting decrease in the box office of 3D motion pictures on RealD-enabled screens. Our international markets comprised approximately 55% of total gross revenue for the three months ended December 23, 2011 as compared to 58% for the three months ended December 24, 2010.  The decrease in net revenues attributable to international markets was driven by decreases in purchases of RealD eyewear by international motion picture exhibitor customers.

 

For the three months ended December 23, 2011, there were eight motion pictures that contributed greater than $1.0 million of admission-based fees to net license revenue. Net license revenue for the three months ended December 23, 2011 includes admission-based fees related to the following motion pictures: Puss in Boots ($3.2 million), The Lion King 3D ($3.0 million), Immortals ($2.3 million), The Adventures of Tintin ($2.3 million), The Three Musketeers ($1.2 million), Dolphin Tale ($1.2 million), The Smurfs ($1.1 million) and Arthur Christmas ($1.0 million).

 

For the three months ended December 24, 2010, there were 12 motion pictures that contributed greater than $1.0 million of admission-based fees to net license revenue. The top ten motion pictures that contributed greater than $1.0 million of admission-based fees to net license revenue for the three months ended December 24, 2010 included the following: Jackass 3D ($3.7 million), Megamind ($3.2 million), Tangled ($3.0 million), Despicable Me ($2.8 million), Toy Story 3 ($2.2 million), Saw VII ($2.1 million), Resident Evil: Afterlife ($1.9 million), The Chronicles of Narnia ($1.9 million), Legends of the Guardians ($1.6 million), and Tron: Legacy ($1.4 million).

 

Net license revenues comprised 58% and 33% of total revenues for each of the three months ended December 23, 2011 and December 24, 2010, respectively. International license revenues comprised 60% of gross license revenues in the three months ended December 23, 2011 as compared to 58% for the three months ended December 24, 2010.

 

The decrease in our net product and other revenue in the three months ended December 23, 2011 as compared to the three months ended December 24, 2010, was primarily a result of a decrease in the volume of RealD eyewear used in our domestic markets and eyewear sold in our international markets. The decrease in RealD eyewear volume internationally compared to the prior period resulted from a growing trend among consumers to reuse RealD eyewear for multiple viewings, as well as exhibitor buying patterns relative to the film slate. International product revenues comprised 47% of total product revenues in the three months ended December 23, 2011 as compared to 57% for the three months ended December 24, 2010. International product and other revenues were 56% and 94% of international license revenue for the three months ended December 23, 2011 and December 24, 2010, respectively.

 

We expect our future revenue, particularly in our license business, will be driven by the number of RealD-enabled screens and motion pictures released in 3D, the box office performance of those motion pictures as well as the relative performance of those motion pictures displayed in 2D vs. 3D.

 

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Table of Contents

 

Cost of Revenue

 

 

 

 

 

 

 

 

 

 

 

 

Three months ended 

 

 

 

 

 

 

 

 

December 23,

 

December 24, 

 

Amount

 

 

Percentage

(in thousands)

 

2011

 

2010 

 

change

 

 

change

Revenue

 

$

49,026

 

 

$

57,780

 

 

$

(8,754

)

 

(15%)

 

Cost of revenue:

 

 

 

 

 

 

 

 

 

 

 

 

License

 

9,202

 

 

5,301

 

 

3,901

 

 

74%

 

Product and other

 

15,870

 

 

46,341

 

 

(30,471

)

 

(66%)

 

Total cost of revenue

 

$

25,072

 

 

$

51,642

 

 

$

(26,570

)

 

(51%)

 

Gross profit

 

$

23,954

 

 

$

6,138

 

 

$

17,816

 

 

290%

 

Gross margin

 

49%

11%

 

 

 

 

 

 

 

For the three months ended December 23, 2011, our cost of revenue decreased primarily due to the decrease of RealD eyewear sales and the increased usage of recycled eyewear, which generates higher gross margin. Cost of revenue decreased, as a percentage of revenue, to 51% for the three months ended December 23, 2011, as compared to 89% for the three months ended December 24, 2010.

 

There was no motion picture exhibitor option expense in the three months ended December 23, 2011.

 

License cost of revenue increased $3.9 million quarter-over-quarter primarily as a result of a $0.7 million increase in impairment expense and a $2.9 million increase in depreciation expense resulting from an increase in RealD-enabled screens. Included in license cost of sales for the three months ended December 23, 2011 and December 24, 2010 is depreciation expense of $6.6 million and $4.1 million, respectively. Depreciation expense as a percentage of gross license revenue increased to 23% for the three months ended December 23, 2011 from 10% for the three months ended December 24, 2010.

 

We had product and other gross profit of $4.7 million for the three months ended December 23, 2011, primarily due to RealD eyewear. The decrease in our cost of product and other revenue is primarily a result of the decrease in the volume of RealD eyewear, the increased usage of recycled eyewear and a decrease in freight related expenses. Product and other gross margin increased to 23% for the three months ended December 23, 2011 as compared to negative 19% for the three months ended December 24, 2010. Freight related expense decreased by an aggregate of $3.1 million as a result of the decreased volume of RealD eyewear. Expedited freight charges were insignificant in the three months ended December 23, 2011 and December 24, 2010.

 

Our cost of revenue as a percentage of net revenue, as well as our gross profit and gross margin, will be affected in the future by the relative mix of net license and net product revenue, the mix of domestic and international product revenues, the relative mix of products and any new revenue sources, impairment charges and the percentage of usage of recycled eyewear. Impairment charges in future periods may increase as a result of system upgrades and replacements as well as changes in product offerings and new technology. As the number of RealD-enabled screens and the number of 3D motion pictures and attendance increase, our total cost of revenue may continue to increase.

 

Operating expenses

 

 

Three months ended 

 

 

 

 

 

 

December 23,

 

December 24, 

 

Amount

 

Percentage

(in thousands)

 

2011

 

2010 

 

change

 

change

Research and development

 

$

4,336

 

 

$

4,347

 

 

$

(11)

 

(0%)

Selling and marketing

 

6,564

 

 

5,813

 

 

751 

 

13%

General and administrative

 

11,513

 

 

10,596

 

 

917 

 

9%

Total operating expenses

 

$

22,413

 

 

$

20,756

 

 

$

1,657 

 

8%

 

Research and development. Our research and development expenses decreased slightly primarily due to an increase of $0.2 million in consultant fees offset by decreases in personnel costs of $0.2 million. We expect to increase our research and development expenses to support our anticipated growth in consumer electronics projects and initiatives, primarily for additional personnel, consultants and prototype and materials costs, as well as for continued investment in our cinema business.

 

Selling and marketing.  Our selling and marketing expenses increased primarily due to the incurrence of additional advertising and marketing initiatives of $0.3 million, $0.2 million increase in occupancy costs, a $0.2 million increase in salaries and benefits as the number of selling and marketing personnel increased to 30 at December 23, 2011 from 23 at December 24, 2010 and a $0.4 million increase in share-based compensation expense. These increases were partially offset by decreases in professional fees and outside

 

18



Table of Contents

 

services of $0.4 million. We expect to incur additional selling and marketing expenses as we increase our international marketing efforts, particularly in Asia and Latin America, build our consumer electronics business worldwide and market future 3D films.

 

General and administrative.  Our general and administrative expenses increased primarily due to a $1.0 million increase in personnel costs. The increase in personnel costs includes an increase of $0.5 million in share-based compensation expense and an increase in salaries and benefits of $0.5 million as we increased the number of general and administrative employees to 41 at December 23, 2011 from 24 at December 24, 2010 to support our overall growth, including the requirements of being a public company. Professional fees increased $0.2 million, occupancy costs increased $0.3 million and travel costs increased $0.2 million to support the growth in our operations.  These increases were partially offset by decreases in bad debt expense of $0.5 million and decreases in public company related expenses of $0.6 million which includes listing, registration and issuance costs, as well as investor relations and compliance fees.

 

Sales and use tax expense increased $0.3 million to $1.6 million for the three months ended December 23, 2011.  Property tax expense was $0.4 million for the three months ended December 23, 2011 and December 24, 2010. We expect to continue to incur additional general and administrative expenses to comply with SEC reporting requirements, stock exchange listing standards and the provisions of the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

 

Other

Interest expense.  Interest expense for the three months ended December 23, 2011 and December 24, 2010 was $0.2 million and $0.1 million, respectively.

 

Income tax.  Our income tax expense (benefit) for the three months ended December 23, 2011 was a benefit of $2.2 million compared to an expense of $1.6 million for the three months ended December 24, 2010, primarily due the differences in the effective tax rate estimate used. For the three months ended December 23, 2011 the effective tax rate at the end of the interim period was calculated using an estimate of the annual effective tax rate expected to be applicable for the full fiscal year.  For the three months ended December 24, 2010, we used the actual effective year-to-date tax rate to calculate the interim effective tax rate, as a reliable estimate of the annual effective tax rate could not be made. We have net operating losses that may potentially offset taxable income in the future. We expect to incur an increasing amount of income tax expenses that relate primarily to federal and state income tax and international operations. We file federal income tax returns and income tax returns in various state and foreign jurisdictions. Due to the net operating loss carryforwards, our United States federal and state returns are open to examination by the Internal Revenue Service and state jurisdictions for all years since inception.

 

Nine months ended December 23, 2011 compared to nine months ended December 24, 2010

 

Revenue

 

 

Nine months ended 

 

 

 

 

 

 

December 23,

 

December 24, 

 

 

 

Amount

 

 

Percentage

(in thousands)

 

2011

 

2010 

 

 

 

change

 

 

change

Revenue:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross license

 

$

116,146

 

 

$

102,398

 

 

 

 

$

13,748

 

 

13%

 

Motion picture exhibitor options

 

-    

 

 

(34,008

)

 

 

 

34,008

 

 

(100%)

 

Net license

 

116,146

 

 

68,390

 

 

 

 

47,756

 

 

70%

 

Product and other

 

80,435

 

 

119,232

 

 

 

 

(38,797

)

 

(33%)

 

Total net revenue

 

$

196,581

 

 

$

187,622

 

 

 

 

$

8,959

 

 

5%

 

 

The increase in net revenue recorded during the nine months ended December 23, 2011 compared to the nine months ended December 24, 2010 was primarily due to the an increase in net license revenues resulting from an increase in the number of RealD-enabled screens, an increase in the number of 3D motion pictures released and the resulting increase in the box office of 3D motion pictures on RealD-enabled screens partially offset by a decrease in product and other revenue. Our international markets comprised approximately 52% of total gross revenue for the nine months ended December 23, 2011 as compared to 55% for the nine months ended December 24, 2010.

 

For the nine months ended December 23, 2011, there were 18 motion pictures that contributed greater than $1.0 million of admission-based fees to net license revenue. The top ten motion pictures that contributed greater than $1.0 million of admission-based fees to net license revenue for the nine months ended December 23, 2011 included the following: Transformers: Dark of the Moon ($11.2 million), Harry Potter and the Deathly Hallows Part 2 ($10.8 million), Pirates of the Caribbean: On Stranger Tides ($9.2 million), Kung Fu Panda 2 ($5.8 million), Thor ($5.8 million), Rio ($5.3 million), The Smurfs ($5.3 million), Cars 2 ($4.8 million), The Lion King 3D ($4.3 million) and Captain America: The First Avenger ($3.6 million).

 

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Table of Contents

 

For the nine months ended December 24, 2010, there were 19 motion pictures which contributed greater than $1.0 million of admission-based fees to net license revenue. The top ten motion pictures that contributed greater than $1.0 million of admission-based fees to net license revenue for the nine months ended December 24, 2010 included the following: Toy Story 3 ($14.3 million), Shrek Forever After ($9.0 million), Despicable Me ($6.5 million), How to Train Your Dragon ($6.1 million), Alice in Wonderland ($5.4 million), Clash of the Titans ($4.7 million), The Last Airbender ($3.8 million), Avatar ($3.7 million), Jackass 3D ($3.7 million) and Resident Evil: Afterlife ($3.3 million).

 

Our net license revenue increased during the period as a result of the increased number of RealD-enabled screens and the box office generated by those 3D motion picture releases. In addition, all reduction of revenue related to motion picture exhibitor stock options had been recognized as of March 25, 2011.

 

Net license revenues comprised 59% and 36% of total revenues for each of the nine months ended December 23, 2011 and December 24, 2010, respectively. International license revenues comprised 58% of gross license revenues in the nine months ended December 23, 2011 as compared to 50% for the nine months ended December 24, 2010.

 

The decrease in our net product and other revenue in the nine months ended December 23, 2011 as compared to the nine months ended December 24, 2010, was primarily a result of a decrease in the volume of RealD eyewear used in our domestic markets and eyewear sold to our international markets. The decrease in RealD eyewear volume internationally compared to the prior period resulted from a growing trend among consumers to reuse RealD eyewear for multiple viewings, as well as the inventory build by non-U.S. motion picture exhibitors in prior periods. International product revenues comprised 43% of total product revenues in the nine months ended December 23, 2011 as compared to 58% for the nine months ended December 24, 2010. International product and other revenues were 51% and 136% of international license revenue for the nine months ended December 23, 2011 and December 24, 2010, respectively.

 

Cost of Revenue

 

 

 

 

 

 

 

 

Nine months ended 

 

 

 

 

 

 

December 23, 

 

December 24, 

 

Amount

 

 

Percentage

(in thousands)

 

2011 

 

2010 

 

change

 

 

change

Revenue

 

$

196,581

 

 

$

187,622

 

 

$

8,959

 

 

5%

 

Cost of Revenue:

 

 

 

 

 

 

 

 

 

 

 

 

License

 

30,321

 

 

11,660

 

 

18,661

 

 

160%

 

Product and other

 

64,465

 

 

138,099

 

 

(73,634

)

 

(53%)

 

Total cost of revenue

 

$

94,786

 

 

$

149,759

 

 

$

(54,973

)

 

(37%)

 

Gross profit

 

$

101,795

 

 

$

37,863

 

 

$

63,932

 

 

169%

 

Gross margin

 

52%

 

20%

 

 

 

 

 

 

 

For the nine months ended December 23, 2011, our cost of revenue decreased primarily due to the decrease of RealD eyewear sales and the increased usage of recycled eyewear. Cost of revenue decreased, as a percentage of revenue, to 48% for the nine months ended December 23, 2011, as compared to 80% for the nine months ended December 24, 2010. Contributing to the improvement in gross margin was an increase in license revenue, a decrease in RealD eyewear sales and the increased usage of recycled eyewear, which generates higher gross margin. The percentage of usage of recycled eyewear may decrease in future periods resulting in lower gross profit and gross margin.

 

There was no motion picture exhibitor option expense in the nine months ended December 23, 2011.

 

License cost of revenue increased $18.7 million primarily as a result of an $8.2 million increase in impairment expense and a $10.1 million increase in depreciation expense resulting from an increase in RealD-enabled screens. Included in license cost of sales for the nine months ended December 23, 2011 and December 24, 2010 is depreciation expense of $18.4 million and $9.7 million, respectively. Depreciation expense as a percentage of gross license revenue increased to 16% for the nine months ended December 23, 2011 from 10% for the nine months ended December 24, 2010.

 

During the three months ended September 23, 2011, we determined that certain of our cinema systems were not recoverable and that the carrying value of the assets exceeded fair value, primarily due to the number of certain of our cinema system assets on hand, including related outstanding purchase commitments and the continuing shift in the mix in the deployment of cinema systems based on the type of digital projectors installed and theater configuration.  The fair value was primarily determined by evaluating the discounted future cash flows expected to be generated from the cinema systems. The impairment charged during the three months ended September 23, 2011 to cost of revenue for certain of the cinema systems totaled $6.8 million.

 

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Table of Contents

 

We had product and other gross profit of $16.0 million for the nine months ended December 23, 2011, primarily due to RealD eyewear. The decrease in our cost of product and other revenue is primarily a result of the decrease in the volume of RealD eyewear, the increased usage of recycled eyewear and a decrease in freight related expenses. Product and other gross margin increased to 20% for the nine months ended December 23, 2011 as compared to negative 16% for the nine months ended December 24, 2010. Freight related expense decreased by an aggregate of $9.4 million as a result of the decreased volume of RealD eyewear as well as a reduction in expedited freight charges. Expedited freight charges were $0.2 million and $4.0 million in the nine months ended December 23, 2011 and December 24, 2010, respectively.

 

Our cost of revenue as a percentage of net revenue, as well as our gross profit and gross margin, will be affected in the future by the relative mix of net license and net product revenue, the mix of domestic and international product revenues the relative mix of products and any new revenue sources, impairment charges, and the percentage of usage of recycled eyewear. Impairment charges in future periods may increase as a result of system upgrades and replacements as well as changes in product offerings and new technology. As the number of RealD-enabled screens and the number of 3D motion pictures and attendance increase, our total cost of revenue may continue to increase.

 

Operating expenses

 

 

 

 

 

 

 

 

Nine months ended  

 

 

 

 

 

 

December 23,

 

December 24, 

 

Amount

 

 

Percentage

(in thousands)

 

2011  

 

2010  

 

change

 

 

change

Research and development

 

$

12,736

 

 

$

10,751

 

 

$

1,985

 

 

18%

 

Selling and marketing

 

20,259

 

 

15,251

 

 

5,008

 

 

33%

 

General and administrative

 

29,735

 

 

25,195

 

 

4,540

 

 

18%

 

Total operating expenses

 

$

62,730

 

 

$

51,197

 

 

$

11,533

 

 

23%

 

 

Research and development.  Our research and development expenses increased primarily due to a $0.2 million increase in spending on personnel costs, which includes a $0.5 million increase in severance costs pursuant to a separation agreement for one of our officers, a $0.3 million increase in consultant fees, a $0.7 million increase in depreciation, and a $1.1 million increase in share-based compensation expense, partially offset by a decrease of $0.1 million in travel and entertainment expenses and a decrease of $0.2 million in occupancy costs. The number of research and development personnel increased to 35 at December 23, 2011 from 33 at December 24, 2010. We expect to increase our research and development expenses to support our anticipated growth in consumer electronics projects and initiatives, primarily for additional personnel, consultants and prototype and materials costs, as well as for continued investment in our cinema business.

 

Selling and marketing.  Our selling and marketing expenses increased primarily due to the incurrence of additional advertising and marketing initiatives of $2.6 million in the nine months ended December 24, 2011, an increase of $0.7 million in personnel expenses, $0.4 million of selling and marketing costs related to the feature film, Carmen in 3D which we co-produced with London’s Royal Opera House, an increase of $0.4 million in occupancy expenses and an increase of $1.5 million in share-based compensation expense, partially offset by decreases in professional fees and outside services of $0.6 million. The change in personnel costs includes an increase of $0.9 million in salaries and benefits as we increased the number of selling and marketing personnel to 30 at December 23, 2011 from 23 at December 24, 2010, partially offset by decreases in contractual and discretionary bonuses of $0.2 million. We expect to incur additional selling and marketing expenses as we increase our international marketing efforts, particularly in Asia and Latin America, build our consumer electronics business worldwide and market future 3D films.

 

General and administrative.  Our general and administrative expenses increased primarily due to a $1.6 million increase in personnel costs. The increase in personnel costs includes an increase in salaries and benefits of $1.7 million as we increased the number of general and administrative employees to 41 at December 23, 2011 from 24 at December 24, 2010 to support our overall growth, including the requirements of being a public company, partially offset by decreases in contractual and discretionary bonuses of $0.1 million.  Additionally, there were increases of $3.0 million in share-based compensation expense, $2.2 million in professional and consulting fees, $0.4 million in depreciation expense, and $0.9 million in occupancy costs to support the growth in our operations.  These increases were partially offset by decreases of $3.0 million in bad debt expense and $0.5 million in public company related expenses, which includes listing, registration and issuance costs, as well as investor relations and compliance fees. Sales and use tax expense was $5.1 million and $5.4 million for the nine months ended December 23, 2011 and December 24, 2010, respectively. The decrease of $0.3 million of sales and use tax was primarily due to the decrease in the volume of RealD eyewear used in our domestic markets. Property tax was $1.1 million and $0.8 million for the nine months ended December 23, 2011 and December 24, 2010, respectively. The increase of $0.3 million of property tax was primarily attributable to the increased installed base of RealD Cinema Systems. We expect to continue to incur additional general and administrative expenses to comply with SEC reporting requirements,

 

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stock exchange listing standards and the provisions of the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

 

Other

Interest expense.  Interest expense for the nine months ended December 23, 2011 and December 24, 2010 was $0.7 million and $0.9 million, respectively. The decrease was primarily due to interest rates related to the borrowings under our Credit Agreement and reduction in the outstanding amounts of our notes payable.

 

Other income (loss).  Other income (loss) for the nine months ended December 23, 2011 and December 24, 2010 was $0.2 million and $6.4 million. Other income (loss) decreased primarily due to a $6.7 million gain from the sale of digital projectors during the nine months ended December 24, 2010.

 

Income tax.  Our income tax expense for the nine months ended December 23, 2011 was $7.2 million compared to $3.3 million for the nine months ended December 24, 2010, primarily due to the differences in the effective tax rate estimate used. For the nine months ended December 23, 2011 the effective tax rate at the end of the interim period was calculated using an estimate of the annual effective tax rate expected to be applicable for the full fiscal year. For the nine months ended December 24, 2010, we used the actual effective year-to-date tax rate to calculate the interim effective tax rate, as a reliable estimate of the annual effective tax rate could not be made. We have net operating losses that may potentially offset taxable income in the future. We expect to incur an increasing amount of income tax expenses that relate primarily to federal and state income tax and international operations. We file federal income tax returns and income tax returns in various state and foreign jurisdictions. Due to the net operating loss carryforwards, our United States federal and state returns are open to examination by the Internal Revenue Service and state jurisdictions for all years since inception.

 

Seasonality and Quarterly Performance

 

Although not apparent in our results of operations due to our rapid growth rate, our operations are generally subject to seasonal trends based on the number of 3D motion pictures released and the box office of those 3D motion pictures.  As is the case with other participants in the motion picture exhibition industry, we expect that our fiscal quarters ending September and December generally will tend to show stronger box office performance and higher revenues due to the summer and holiday moviegoing seasons, when many of the largest grossing films in any given year are typically released. The quarters ending March and June traditionally do not benefit from the same box office performance due to the number and nature of the motion pictures released in those seasonal periods.  We expect to experience seasonal fluctuations in results of operations as a result of these trends.  Our quarterly financial results have fluctuated in the past and may continue to fluctuate in the future based on a number of other factors in addition to these seasonal trends, many of which are beyond our control. Factors that may cause our operating results to vary or fluctuate include those discussed in Part II, Item 1.A below under the caption “Risk factors.”

 

Liquidity and capital resources

 

Since our inception and through December 23, 2011, we have financed our operations through the proceeds we received in connection with our IPO, the sale of redeemable convertible preferred stock, borrowings under our previous credit facility agreement and our current Credit Agreement with City National and through the net cash provided by operating activities. Our cash flow from operating activities has historically been significantly impacted by the contractual payment terms and patterns related to the license of our RealD Cinema Systems and use and sale of our RealD eyewear, as well as significant investments in research, development, selling and marketing activities and corporate infrastructure. Prior to fiscal 2010, many of our licensing and product sale contracts included terms that required upfront payments.

 

Cash provided by operating activities is expected to be a primary recurring source of funds in future periods and will be driven by our expected revenue generated from the 3D motion pictures exhibited on our RealD Cinema Systems and RealD-enabled screens, partially offset by increased working capital requirements associated with installing new RealD Cinema Systems as well as for building inventory, logistics and recycling costs for our RealD eyewear. Depending on our operating performance in any given period and the installation rate of additional RealD Cinema Systems, including system upgrades and replacements, changes in product offerings and new technology, we expect to supplement our liquidity needs primarily with borrowings under our Credit Agreement.

 

On December 6, 2011, we entered into a second amendment to the Credit Agreement to provide that the aggregate principal amount outstanding at any one time under our revolving credit loans shall remain $50 million after December 31, 2011 and to extend the maturity date of the revolving credit loans under the Credit Agreement to December 31, 2013. As of December 23, 2011, our primary sources of liquidity were our cash and cash equivalents of $29.2 million and our Credit Agreement providing for a revolving credit facility of up to $50.0 million through December 31, 2013, $25.0 million of which was available for borrowing.

 

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Our cash equivalents primarily consist of money market funds and other marketable securities that mature within three months from the date of purchase. The carrying amount of cash equivalents reasonably approximates fair value due to the short maturities of these instruments. The primary objective of our investment activities is preservation of capital, fulfillment of liquidity needs and fiduciary control of cash and investments. We also seek to maximize income from our investments without assuming significant risk. We do not enter into investments for trading or speculative purposes.

 

We believe that our cash, cash equivalents, potential cash flows from operations, and our availability under our Credit Agreement will be sufficient to satisfy our currently anticipated cash requirements through at least the next 12 months.

 

The following table sets forth our major sources and (uses) of cash for each period as set forth below.

 

 

 

Nine months ended 

 

 

December 23,  

 

December 24,   

(in thousands)

 

2011  

 

2010  

Operating activities

 

$

36,955

 

 

$

21,612

 

Investing activities

 

(48,202

)

 

(52,412

)

Financing activities

 

$

23,491

 

 

$

53,138

 

 

Cash flow from operating activities

Net cash inflows from operating activities during the nine months ended December 23, 2011 primarily resulted from net income, increased collections of accounts receivable, decreased inventories, partially offset by decreases in accounts payable and accrued expenses. Decreases in accounts payable and accrued expenses were related to timing of payments due to increased cash flow from operations.

 

Net cash inflows from operating activities during the nine months ended December 24, 2010 primarily resulted from improved operating performance as RealD Cinema System installations and admissions increased. Net cash inflows from operating activities also benefited from increases in accounts payable and accrued expenses, partially offset by an increase in glasses inventories. Increases in accounts payable and accrued expenses were due to increased business activities at quarter end, resulting in significant amounts due to vendors and employees.

 

Cash flow from investing activities and capital resources

For both the nine months ended December 23, 2011 and December 24, 2010, cash outflow for investing activities was primarily related to the establishment of our initial infrastructure and for the purchase of component parts for our RealD Cinema Systems, digital projectors, and other property, equipment and leasehold improvements. In the nine months ended December 23, 2011 and December 24, 2010, we received proceeds of $4.0 million and $15.6 million, respectively, as a result of the sale of digital projectors to certain of our motion picture exhibitors. Capital expenditures were $52.2 million for the nine months ended December 23, 2011 and $68.0 million for the nine months ended December 24, 2010. We expect our capital expenditures of cinema systems and related components to be approximately $50.0 million to $60.0 million for the fiscal year ending March 23, 2012. In the future, we will continue to invest in our business to grow sales and develop new products and support the related increasing employee headcount.

 

Cash flow from financing activities

Net cash inflows from financing activities for the nine months ended December 23, 2011 primarily resulted from proceeds from the Credit Agreement of $30.0 million partially offset by $5.0 million of repayments on the Credit Agreement.

 

Net cash inflows from financing activities for the nine months ended December 24, 2010 primarily resulted from the proceeds from the completion of the initial public offering of our common stock in which we sold and issued 6 million shares of common stock at an issue price of $16.00 per share. A total of approximately $96.0 million in gross proceeds were raised from the initial public offering, or $81.9 million in net proceeds after deducting underwriting discounts and commissions of approximately $6.7 million and other offering costs of approximately $7.4 million. We used the net proceeds from the initial public offering to repay $25.1 million of amounts outstanding under the credit facility agreement.  In the nine months ended December 24, 2010, repayments of long-term debt of $9.1 million and a noncontrolling interest distribution of $0.9 million offset proceeds from our revolving credit facility of $5.0 million.

 

As of December 23, 2011, we had no notes payable outstanding. As of March 25, 2011 we had $2.3 million aggregate principal amount of notes payable outstanding. Interest expense was based on annual interest rates ranging from 7.0% to 8.4%. The notes were secured by the underlying equipment.

 

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We have entered into the Credit Agreement with City National, which was dated as of June 24, 2010 and amended on April 5, 2011, to provide that the aggregate principal amount outstanding at any one time under our revolving credit loans may be (i) up to $50.0 million through December 31, 2011 and (ii) up to $25.0 million thereafter and which will mature on June 30, 2012. On December 6, 2011, we further amended the Credit Agreement to provide that the aggregate principal amount outstanding at any one time under our revolving credit loans shall remain up to $50 million and to extend the maturity date of the revolving credit loans under the Credit Agreement to December 31, 2013. The Credit Agreement and the revolving credit facility provided thereunder became effective on July 21, 2010. Our obligations under the Credit Agreement are secured by a first priority security interest in substantially all of our tangible and intangible assets in favor of City National and are guaranteed by our subsidiaries, ColorLink and Stereographics.

 

Under the Credit Agreement, our business is subject to certain limitations, including limitations on our ability to incur additional debt, make certain investments or acquisitions, enter into certain merger and consolidation transactions, and sell our assets other than in the ordinary course of business. We will also be required to maintain compliance with certain financial covenants, including a minimum fixed charge coverage ratio and a maximum leverage ratio. As of December 23, 2011, we were in compliance with all financial covenants in our Credit Agreement. If we fail to comply with any of the covenants or if any other event of default, as defined in the Credit Agreement, should occur, the bank could elect to prevent us from borrowing and declare the indebtedness to be immediately due and payable. As of December 23, 2011, there was $25.0 million outstanding under the Credit Agreement and there was $25.0 million available to borrow under the Credit Agreement. In the future, we may continue to utilize commercial financing, lines of credit and term loans for general corporate purposes, including investing in technology.

 

For the nine months ended December 23, 2011 and December 24, 2010, proceeds from employee stock option exercises were $0.5 million and $1.0 million, respectively.  For the nine months ended December 23, 2011 and December 24, 2010 proceeds from the exercise of warrants in our common stock were $0.3 million and $0.4 million. From time to time, we expect to receive cash from the exercise of employee stock options and warrants in our common stock. Proceeds from the exercise of employee stock options and warrants outstanding will vary from period to period based upon, among other factors, fluctuations in the market value of our common stock relative to the exercise price of such stock options and warrants.

 

Off-balance sheet arrangements

 

We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities that would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such, we are not exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in those types of relationships. We enter into guarantees in the ordinary course of business related to the guarantee of our own performance and the performance of our subsidiaries.

 

Non-U.S. GAAP discussion

 

In addition to our U.S. GAAP results, we present Adjusted EBITDA as a supplemental measure of our performance. However, Adjusted EBITDA is not a recognized measurement under U.S. GAAP. We define Adjusted EBITDA as net income (loss), plus net interest expense, income and other taxes, depreciation and amortization, share-based compensation expense and exhibitor option expense, as further adjusted to eliminate the impact of certain items that we do not consider indicative of our core operating performance. Management considers our core operating performance to be that which can be affected by our managers in any particular period through their management of the resources that affect our underlying revenue and profit generating operations that period. Non-U.S. GAAP adjustments to our results prepared in accordance with U.S. GAAP are itemized below. You are encouraged to evaluate these adjustments and the reasons we consider them appropriate for supplemental analysis. In evaluating Adjusted EBITDA, you should be aware that in the future we may incur expenses that are the same as or similar to some of the adjustments in this presentation. Our presentation of Adjusted EBITDA should not be construed as an inference that our future results will be unaffected by unusual or non-recurring items.

 

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Set forth below is a reconciliation of Adjusted EBITDA to net income for the three and nine months ended December 23, 2011 and December 24, 2010:

 

 

 

Three months ended  

 

 

Nine months ended 

 

 

December 23, 

 

December 24,  

 

 

December 23, 

 

December 24, 

(in thousands)

 

2011 

 

2010 

 

 

2011 

 

2010 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

2,763

 

 

$

(16,768)

 

 

 

$

31,342

 

 

$

(11,130)

 

Add (deduct):

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest expense

 

227

 

 

71

 

 

 

710

 

 

873

 

Income tax expense (benefit)

 

(2,241)

 

 

1,648

 

 

 

7,170

 

 

3,299

 

Depreciation and amortization

 

7,406

 

 

4,384

 

 

 

20,558

 

 

10,428

 

Other (income) loss (1)

 

792

 

 

431

 

 

 

(157)

 

 

(6,376)

 

Share-based compensation expense (2)

 

4,086

 

 

2,980

 

 

 

11,718

 

 

5,988

 

Exhibitor option expense (3)

 

-

 

 

21,960

 

 

 

-

 

 

34,008

 

Impairment of assets and intangibles (4)

 

1,196

 

 

519

 

 

 

9,024

 

 

814

 

Sales and use tax (5)

 

1,569

 

 

1,291

 

 

 

5,076

 

 

5,443

 

Property tax (6)

 

367

 

 

392

 

 

 

1,133

 

 

839

 

Management fee (7)

 

-

 

 

-

 

 

 

-

 

 

175

 

Adjusted EBITDA

 

$

16,165

 

 

$

16,908

 

 

 

$

86,574

 

 

$

44,361

 

 

(1)   Includes amortization of debt issue costs and unrealized foreign currency exchange gains and losses and gain on sale of digital projectors.

(2)   Represents share-based compensation expense of nonstatutory and incentive stock options and restricted stock units to employees, officers and directors.

(3)   Represents stock options granted to some of our motion picture exhibitor licensees. The amounts are recorded as contra revenue in the condensed consolidated financial statements.

(4)   Represents impairment of long-lived assets, such as fixed assets, theatrical equipment and identifiable intangibles.

(5)   Represents taxes incurred by us for cinema license and product revenue.

(6)   Represents property taxes on RealD Cinema Systems and digital projectors.

(7)   Represents payment of management fees to our Series C mandatorily redeemable convertible preferred stockholder (included in general and administrative expense), which were terminated upon the completion of our IPO.

 

We present Adjusted EBITDA because we believe it assists investors and analysts in comparing our performance across reporting periods on a consistent basis by excluding items that we do not believe are indicative of our core operating performance. In addition, we use Adjusted EBITDA in developing our internal budgets, forecasts and strategic plan, in analyzing the effectiveness of our business strategies in evaluating potential acquisitions; in making compensation decisions, in communications with our board of directors concerning our financial performance and because our credit facility agreement uses Adjusted EBITDA to measure our compliance with certain covenants. Adjusted EBITDA has limitations as an analytical tool which includes, among others, the following:

 

·                  Adjusted EBITDA does not reflect our cash expenditures, or future requirements, for capital expenditures or contractual commitments;

·                  Adjusted EBITDA does not reflect changes in, or cash requirements for, our working capital needs;

·                  Adjusted EBITDA does not reflect the significant interest expense, or the cash requirements necessary to service interest or principal payments, on our debts;

·                  although depreciation and amortization are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future, and Adjusted EBITDA does not reflect any cash requirements for such replacements;

·                  non-cash compensation is and will remain a key element of our overall long-term incentive compensation package, although we exclude it as an expense when evaluating our ongoing operating performance for a particular period;

·                  Adjusted EBITDA does not reflect the impact of certain cash charges resulting from matters we consider not to be indicative of our ongoing operations; and

·                  other companies in our industry may calculate Adjusted EBITDA differently than we do, limiting its usefulness as a comparative measure.

 

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Because of these limitations, Adjusted EBITDA should not be considered in isolation or as a substitute for performance measures calculated in accordance with U.S. GAAP. We compensate for these limitations by relying primarily on our U.S. GAAP results and using Adjusted EBITDA only as a supplement. Our consolidated financial statements and the notes to those statements included elsewhere are prepared in accordance with U.S. GAAP. See also “Part II, Item 7: Management’s discussion and analysis of financial condition and results of operations—Non-U.S. GAAP discussion” and “—Seasonality.”

 

Critical accounting policies and estimates

 

This discussion is based upon our condensed consolidated financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of our 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, estimates and judgments are evaluated, including those related to revenue recognition, revenue deductions, product returns, fair value of our common stock, share-based compensation, inventories, definite lived asset impairments, goodwill impairment and income taxes. These estimates and judgments are based on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, which form the basis for our judgments about the carrying values of assets and liabilities not readily apparent from other sources. By their nature, estimates are subject to an inherent degree of uncertainty. Actual results may differ from these estimates.

 

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

 

Revenue recognition and revenue reductions

 

We derive substantially all of our revenue from the license of our RealD Cinema Systems and the product sale of our RealD eyewear. We evaluate revenue recognition for transactions using the criteria set forth by the SEC in Staff Accounting Bulletin No. 104, Revenue Recognition (SAB 104) and Accounting Standards Codification Topic 605, Revenue Recognition (ASC 605). The revenue recognition guidance states that revenue is recognized when all of the following criteria are met: persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the seller’s price to the buyer is fixed or determinable and collectability is reasonably assured.

 

License revenue.  License revenue is accounted for as an operating lease. License revenue is primarily derived under per-admission, periodic fixed fee, or per-motion picture basis with motion picture exhibitors. Amounts received up front, less estimated allowances, are deferred and recognized over the lease term using the straight-line method. Additional lease payments that are contingent upon future events outside our control, including those related to admission and usage, are recognized as revenues when the contingency is resolved and we have no more obligations to our customers specific to the contingent payment received. Certain of our license revenue from leasing our RealD Cinema Systems is earned upon admission by the motion picture exhibitor’s consumers. Our licensees, however, do not report and pay for such license revenue until after the admission has occurred, which may be received subsequent to our fiscal period end. We estimate and record licensing revenue related to motion picture exhibitor consumer admissions in the quarter in which the admission occurs, but only when reasonable estimates of such amounts can be made. We determine that there is persuasive evidence of an arrangement upon the execution of a license agreement or upon the receipt of a licensee’s admissions report. Revenue is deemed fixed or determinable upon receipt of a licensee’s admissions report. We determine collectability based on an evaluation of the licensee’s recent payment history.

 

Product revenue.  We recognize product revenue, net of allowances, when title and risk of loss have passed and when there is persuasive evidence of an arrangement, the payment is fixed or determinable, and collectability of payment is reasonably assured. In the United States and Canada, certain of our product revenue from the sale of our RealD eyewear is earned upon admission and usage by the motion picture exhibitor’s consumers. Our customers, however, do not report admission or usage information until after the admission and usage has occurred, and such information may be received subsequent to our fiscal period end. We estimate and record such product revenue in the quarter in which the admission and usage occurs, but only when reasonable estimates of such amounts can be made.

 

Revenue reductions.  We record revenue net of motion picture exhibitor stock options and revenue allowances. In connection with certain exhibitor licensing agreements, we issued the motion picture exhibitors a 10-year option to purchase shares of our common stock at approximately $0.00667 per share. The stock options vested upon the achievement of screen installation targets. Motion picture exhibitor stock options were valued at the underlying stock price at each reporting period until the targets were met. Amounts recognized were based on the number of RealD-enabled screens as a percentage of total screen installation targets. The stock options do not have net cash settlement features. Amounts recorded as a revenue reduction totaled $22.0 million and $34.0 million for the

 

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three months and nine months ended December 24, 2010, respectively. As of March 25, 2011, all 3,668,340 motion picture exhibitor stock options had vested and all associated reduction of revenue had been recognized.

 

Share-based compensation

 

We account for stock options granted to employees and directors by recording compensation expense based on estimated fair values. We estimate the fair value of share-based payment awards on the date of grant. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in our consolidated statements of operations. Share-based awards are attributed to expense using the straight-line method over the vesting period.  We determine the value of each option award that contains a market condition using a lattice-based option valuation model, while all other option awards are valued using the Black-Scholes valuation model as permitted under ASC 718, Compensation — Stock Compensation. The assumptions used in calculating the fair value of share-based payment awards represent our best estimates. Our estimates of the fair values of stock options granted and the resulting amounts of share-based compensation recognized may be impacted by certain variables including stock price volatility, employee stock option exercise behaviors, additional stock option grants, estimates of forfeitures, and the related income tax impact.

 

Stock options

Stock options granted generally vest over a four-year period, with 25% of the shares vesting after one year and monthly vesting thereafter.  The options generally expire ten years from the date of grant. For the nine months ended December 23, 2011, we granted 1.9 million stock options at a weighted average grant date fair value of $11.52 per share.  For the three months ended December 23, 2011 and December 24, 2010, share-based compensation expense related to stock options was $3.1 million and $2.2 million, respectively. For the nine months ended December 23, 2011 and December 24, 2010, share-based compensation expense related to stock options was $9.1 million and $4.7 million, respectively.

 

For purposes of determining the expected term and in the absence of historical data relating to stock option exercises, we apply a simplified approach: the expected term of awards granted is presumed to be the mid-point between the vesting date and the end of the contractual term. We use the average volatility of similar, publicly traded companies as an estimate for expected volatility. The risk-free interest rate for periods within the expected or contractual life of the option, as applicable, is based on the United States Treasury yield curve in effect during the period the options were granted. Our expected dividend yield is zero.

 

Performance stock options

Certain of our management-level employees receive performance stock options, which gives the recipient the right to receive common stock that is contingent upon achievement of specified pre-established performance goals over the performance period, which is generally three years. The performance goals for the performance stock options are based on the measurement of our total shareholder return, on a percentile basis, compared to a comparable group of companies. Depending on the outcome of the performance goals, the recipient may ultimately earn performance stock options equal to or less than the number of performance stock options granted. For the three months ended December 23, 2011 and December 24, 2010, share-based compensation expense related to performance stock options was $0.5 million and $0.5 million, respectively. For the nine months ended December 23, 2011 and December 24, 2010, share-based compensation expense related to performance stock options was $1.3 million and $0.9 million, respectively.

 

The lattice-based option valuation model uses terms based on the length of the performance period and compound annual growth rate goals for total stockholder return based on the provisions of the award. For purposes of determining the expected term and in the absence of historical data relating to stock option exercises, we apply a simplified approach: the expected term of awards granted is presumed to be the mid-point between the vesting date and the end of the contractual term. We use the average volatility of a peer group of companies as an estimate for expected volatility. The risk-free interest rate for periods within the expected or contractual life of the option, as applicable, is based on the United States Treasury yield curve in effect during the period the options were granted.

 

Restricted stock units

Restricted stock units vest over one to four years. For the nine months ended December 23, 2011, we granted 0.2 million restricted stock units at a weighted average grant date fair value of $20.53 per restricted stock unit. For the three months ended December 23, 2011 and December 24, 2010, share-based compensation expense related to restricted stock units was $0.5 million and $0.2 million, respectively. For the nine months ended December 23, 2011 and December 24, 2010, share-based compensation expense related to restricted stock units was $1.3 million and $0.4 million, respectively.

 

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Share-based compensation expense for the three and nine months ended December 23, 2011 and December 24, 2010 was as follows:

 

 

 

 

Three months ended

 

Nine months ended

 

(in thousands)

 

 

December 23,
2011

 

December 24,
2010

 

December 23,
2011

 

December 24,
2010

 

Share-based compensation

 

 

 

 

 

 

 

 

 

 

Cost of revenue

 

 

$

119

 

$

50

 

$

317

 

$

93

 

Research and development

 

 

524

 

434

 

2,095

 

1,016

 

Selling and marketing

 

 

1,305

 

898

 

3,529

 

2,053

 

General and administrative

 

 

2,138

 

1,598

 

5,777

 

2,826

 

Total

 

 

$

4,086

 

$

2,980

 

$

11,718

 

$

5,988

 

 

Included in research and development for the nine months ended December 23, 2011 is $0.6 million of additional share-based compensation expense recognized in connection with a modification of stock options and performance stock options pursuant to a separation agreement for one of our officers.

 

Inventories

 

Domestically, we provide our RealD eyewear free of charge to motion picture exhibitors and then receive a fee from the motion picture studios for the usage of that RealD eyewear by the motion picture exhibitors’ consumers.

 

For RealD eyewear located at a motion picture exhibitor, we believe that it is not operationally practical to perform physical counts or request the motion picture exhibitor to perform physical counts and confirm quantities held to ensure that losses due to damage, destruction, and shrinkage are specifically recognized in the period incurred due to the number of domestic RealD-enabled screens and related usage of RealD. We believe that the cost to monitor shrinkage or usage significantly outweighs the financial reporting benefits of using a specific identification methodology of expensing. We believe that utilizing a composite method of expensing RealD eyewear inventory costs provides a rational and reasonable approach to ensuring that shrinkage is provided for in the period incurred and that inventory costs are expensed in the periods that reasonably reflect the periods in which the related revenue is recognized. In doing so, we believe the following methodology reasonably and generally reflects periodic income or loss under these facts and circumstances:

 

·                  For an estimated period of time following shipment to domestic motion picture exhibitors, no expense is recognized between the time of shipment and until the delivery is made as the inventory unit is in transit and unused.

·                  The inventory unit cost is expensed on a straight-line basis over an estimated usage period beginning when we believe usage of the inventory unit has started. In estimating the expensing start date and related expense period, we consider various factors including, but not limited to, those relating to a 3D motion picture’s opening release date, a 3D motion picture’s expected release period, the number of currently playing 3D motion pictures, the motion picture exhibitor’s buying and stocking patterns and practices and the quantities shipped per inventory unit.

 

We believe that the expensing methodology described above rationally and reasonably approximates the period the related usage occurs resulting in our RealD eyewear product revenue. The expensing start date following the date of shipment is meant to approximate the date at which usage begins. Additionally, as the expense recognition period has been and is expected to continue to be short, we believe it adequately recognizes inventory impairments due to loss and damage on a timely basis. We further believe that exposures due to loss or damage, if any, are considered normal shrinkage and a necessary and expected cost to generate the revenue per 3D motion picture earned through RealD eyewear usage. We continue to monitor the reasonableness of this methodology to ensure that it approximates the period over which the related RealD eyewear product revenue is earned and realizable. RealD eyewear inventory costs for products shipped that have not yet been expensed are reported as deferred costs-eyewear.

 

Impairment of long-lived assets

 

We review long-lived assets, such as property and equipment, cinema systems, digital projectors and intangibles, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Factors or circumstances that could indicate the occurrence of such events include current period operating or cash flow losses combined with a history of operating or cash flow losses, a projection or forecast that demonstrates continuing operating or cash flow losses, or incurring costs in excess of amounts originally expected to acquire or construct an asset. If the asset is not recoverable, an impairment loss is recognized as the amount by which the carrying amount of the asset exceeds its fair value.

 

During the three months ended September 23, 2011, we determined that certain of our cinema systems were not recoverable and that the carrying value of the assets exceeded fair value, primarily due to the number of certain of our cinema system assets on hand, including

 

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related outstanding purchase commitments and the continuing shift in the mix in the deployment of cinema systems based on the type of digital projectors installed and theater configuration.  The fair value was primarily determined by evaluating the discounted future cash flows expected to be generated from the cinema systems. The impairment charged during the three months ended September 23, 2011 to cost of revenue for certain of the cinema systems totaled $6.8 million.

 

For the three months ended December 23, 2011 and December 24, 2010, impairment charges for all impaired RealD Cinema Systems charged to cost of revenue totaled $1.2 million and $0.5 million, respectively. For the nine months ended December 23, 2011 and December 24, 2010, impairment charges for all impaired RealD Cinema Systems charged to cost of revenue totaled $9.0 million and $0.8 million, respectively.

 

Deferred tax asset valuation and tax exposures

 

As of December 23, 2011, we have determined based on the weight of the available evidence, both positive and negative, to provide for a valuation allowance against substantially all of the net deferred tax assets. The current deferred tax assets not reserved for by the valuation allowance are those in foreign jurisdictions or amounts that may be carried back in future years. If there is a change in circumstances that causes a change in judgment about the realizability of the deferred tax assets, we will adjust all or a portion of the applicable valuation allowance in the period when such change occurs.

 

We are subject to ongoing tax exposures, examinations and assessments in various jurisdictions. Accordingly, we may incur additional tax expense based upon the outcomes of such matters. In addition, when applicable, we adjust tax expense to reflect our ongoing assessments of such matters which require judgment and can materially increase or decrease its effective rate as well as impact operating results.

 

Significant judgment is required in determining the provision for income taxes, deferred tax assets and liabilities, the valuation allowance against our deferred tax assets and uncertainty in income tax positions. Our financial position and results of operations may be materially impacted if actual results significantly differ from these estimates or the estimates are adjusted in future periods.

 

Contingencies and assessments

 

We are subject to various loss contingencies and assessments arising in the course of our business, some of which relate to litigation, claims, property taxes and sales and use or goods and services tax assessments. We consider the likelihood of the loss or the incurrence of a liability, as well as our ability to reasonably estimate the amount of loss in determining loss, contingencies and assessments. An estimated loss contingency or assessment is accrued when it is probable that a liability has been incurred and the amount of loss can be reasonably estimated. We regularly evaluate current information available to us to determine whether such accruals should be adjusted. Based on the information presently available, including discussion with counsel and other consultants, management believes that resolution of these matters will not have a material adverse effect on our business, consolidated results of operations, financial condition or cash flows.

 

Recent accounting pronouncements

 

In September 2011, the FASB issued ASU 2011-08, Intangibles (Topic 350)— Goodwill and Other (ASU 2011-08) which allows companies to waive comparing the fair value of a reporting unit to its carrying amount in assessing the recoverability of goodwill if, based on qualitative factors, it is not more likely than not that the fair value of a reporting unit is less than its carrying amount.   ASU 2011-08 will be effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011.  We are currently evaluating the impact the adoption of new guidance will have on the consolidated financial statements.

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

We have operations outside the United States. We are exposed to market risks in the ordinary course of our business. These risks primarily include interest rate, foreign exchange and inflation risks as well as changes in the general economic conditions in the countries where we conduct business. To reduce certain of these risks, we monitor the financial condition of our large customers and limit credit exposure by collecting in advance and setting credit limits, as we deem appropriate. In addition, our investment strategy currently has been to invest in financial instruments that are highly liquid, readily convertible into cash and which mature within three months from the date of purchase. We also enter into foreign exchange derivative hedging transactions as part of our risk management program. For accounting purposes, we do not designate any of our derivative instruments as hedges and we do not use derivatives for speculating trading purposes and are not a party to leveraged derivatives.

 

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Interest rate risk

 

We are exposed to market risk related to changes in interest rates.

 

Our investments are considered cash equivalents and primarily consist of money market funds. At December 23, 2011, we had cash and cash equivalents of $29.2 million. The carrying amount of cash equivalents reasonably approximates fair value due to the short maturities of these instruments. The primary objective of our investment activities is preservation of capital, fulfillment of liquidity needs and fiduciary control of cash and investments. We also seek to maximize income from our investments without assuming significant risk. We do not enter into investments for trading or speculative purposes. Our investments are exposed to market risk due to a fluctuation in interest rates, which may affect our interest income and the fair market value of our investments. Due to the short-term nature of our investment portfolio, however, we do not believe an immediate 10% increase or decrease in interest rates would have a material effect on the fair market value of our portfolio, and therefore, we do not expect our operating results or cash flows to be materially affected by a sudden change in market interest rates.

 

We do not believe our cash equivalents have significant risk of default or illiquidity. While we believe our cash equivalents do not contain excessive risk, we cannot provide absolute assurance that in the future our investments will not be subject to adverse changes in market value. In addition, we maintain significant amounts of cash and cash equivalents at one or more financial institutions that are in excess of federally insured limits. We cannot be assured that we will not experience losses on these deposits.

 

The revolving credit facility provides for, at our option, Revolving London Interbank Offered Rate (“LIBOR”) loans, Revolving Prime loans which bear interest at the greater of three and one half percent (3.50%) or the fluctuating Prime Rate per annum. Changes in interest rates do not affect operating results or cash flows on our fixed rate borrowings but would impact our variable rate borrowings. At December 23, 2011, we had $25.0 million borrowings outstanding under the Credit Agreement.  As of December 23, 2011, borrowings outstanding under the Credit Agreement bear interest at 3.50%.

 

Foreign currency risk

 

We have foreign currency risks related to our revenue and operating expenses denominated in currencies other than the United States dollar. Our historical revenue has generally been denominated in United States dollars, and a significant portion of our current revenue continues to be denominated in United States dollars; however, we expect an increasing portion of our future revenue to be denominated in currencies other than the United States dollar, primarily the Euro, British pound sterling, Canadian dollar, Japanese yen, Chinese Yuan and Hong Kong dollar. Our operating expenses are generally denominated in the currencies of the countries in which our operations are located, primarily the United States and United Kingdom. Increases and decreases in our international revenue from movements in foreign exchange rates are partially offset by the corresponding increases or decreases in our international operating expenses. To further reduce our net exposure to foreign exchange rate fluctuations on our results of operations, we have entered into foreign currency forward contracts.

 

As of December 23, 2011, we had outstanding forward contracts based in Canadian dollar, British pound sterling and Euro with notional amounts totaling an aggregate of $1.6 million. We do not designate any of our forward contracts as hedges for accounting purposes. For the three months ended December 23, 2011, the net loss related to the change in fair value of our foreign currency forward contracts was $0.1 million. For the three months ended December 24, 2010, the net gain related to the change in fair value of our foreign currency forward contracts was $0.1 million. For the nine months ended December 23, 2011 and December 24, 2010, the net gain (loss) related to the change in fair value of our foreign currency forward contracts was not significant. With regard to these contracts, a hypothetical 10.0% adverse movement in foreign exchange rates compared with the U.S. dollar relative to exchange rates on December 23, 2011 would result in a $0.2 million reduction in fair value of these forward contracts and a corresponding foreign currency loss of approximately $0.1 million. This analysis does not consider the impact that hypothetical changes in foreign currency exchange rates would have on anticipated transactions and assets and liabilities that these foreign currency sensitive instruments were designed to offset.

 

As our international operations grow, our risks associated with fluctuation in currency rates will become greater, and we will continue to reassess our approach to managing this risk. In addition, currency fluctuations or a weakening United States dollar can increase the costs of our international expansion. As our international operations grow, we expect to conduct more of our business in currencies other than the U.S. dollar, thereby increasing risks associated with fluctuation in currency rates. Currency fluctuations or a weakening United States dollar can increase the costs of our international expansion.   As our exposure to currency risks grows, we will continue to reassess our risk management.

 

Inflation risk

 

We do not believe that inflation has had a material effect on our business, financial condition or results of operations. If our costs were to become subject to significant inflationary pressures, we may not be able to fully offset such higher costs through price increases. Our inability or failure to do so could harm our business, financial condition and results of operations.

 

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Counterparty risk

 

Our financial statements, including derivatives, are subject to counterparty credit risk, which we consider as part of the overall fair value measurement. We attempt to mitigate this risk through credit monitoring procedures.

 

ITEM 4.  CONTROLS AND PROCEDURES

 

Evaluation of Disclosure Controls and Procedures

 

We maintain “disclosure controls and procedures,” as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”), that are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.

 

Subject to the limitations noted above, our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the fiscal period covered by this Quarterly Report on Form 10-Q. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of such date, our disclosure controls and procedures were effective to meet the objective for which they were designed and operate at the reasonable assurance level.

 

Changes in Internal Control over Financial Reporting

 

There were no changes in our internal control over financial reporting during the fiscal quarter ended December 23, 2011, 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

 

We are involved in various legal proceedings from time to time arising from the normal course of business activities, including claims of alleged infringement of intellectual property rights, commercial, employment and other matters. Our management believes that losses in excess of the amounts accrued arising from such lawsuits are remote, but that litigation is necessarily uncertain and there is the potential for a material adverse effect on our financial statements if one or more matters are resolved in a particular period in an amount in excess of that anticipated by management.

 

ITEM 1A. RISK FACTORS

 

The following risk factors and other information included in this Quarterly Report on Form 10-Q should be carefully considered. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we presently deem less significant may also impair our business operations. If any of the following risks actually occur, our business, operating results and financial condition could be materially adversely affected.

 

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Risks relating to our business

 

If motion pictures that can be viewed with RealD Cinema Systems are not made or are not commercially successful, our revenue will decline.

 

Almost all of our revenue is currently dependent upon both the number of 3D motion pictures released and the commercial success of those 3D motion pictures. Although we have produced alternative content in 3D, such as the production of Carmen in 3D with London’s Royal Opera House, we are not actively developing 3D motion pictures or our own 3D content, other than the current production of Madame Butterfly, and therefore, we rely on motion picture studios producing and releasing 3D motion pictures compatible with our RealD Cinema Systems. There is no guarantee an increasing number of 3D motion pictures will be released or that motion picture studios will continue to produce 3D motion pictures at all. Motion picture studios may refrain from producing and releasing 3D motion pictures for any number of reasons, including their lack of commercial success, consumer preferences, the lower-cost to produce 2D motion pictures or the availability of other entertainment options. The commercial success of a 3D motion picture depends on a number of factors that are outside of our control, including whether it achieves critical acclaim, timing of the release, cost, marketing efforts and promotional support for the release. In the past, consumer interest in 3D motion pictures was episodic and motion picture studios tended to use 3D motion pictures as a gimmick rather than as an artistic tool to enhance the viewing experience. If consumers’ recent renewed interest in the 3D viewing experience fails to grow or it declines for any reason, box office performance may suffer and motion picture studios may reduce the number of 3D motion pictures they produce. Poor box office performance of 3D motion pictures, disruption or reduction in 3D motion picture production or conversion of two-dimensional motion pictures into 3D motion pictures, changes in release schedules, cancellations of motion picture releases in 3D versions, a reduction in marketing efforts for 3D motion pictures by motion picture studios or a lack of consumer demand for 3D motion pictures could result in lower 3D motion picture attendance, which would substantially reduce our revenue. For example, that fact that Warner Brothers was unable to convert Harry Potter and the Deathly Hallows Part 1 from 2D into 3D in time for a 2010 release in 3D negatively impacted 3D motion picture attendance and, we believe, the box office for that motion picture and our revenue in the period in which that motion picture was released.

 

If motion picture exhibitors do not continue to use our RealD Cinema Systems or experience financial difficulties, our growth and results of operations could be adversely affected.

 

Our primary licensees in the motion picture industry are motion picture exhibitors. Our license agreements with motion picture exhibitors do not obligate these licensees to deploy a specific number of our RealD Cinema Systems. We cannot predict whether any of our existing motion picture exhibitor licensees will continue to perform under their license agreements with us, whether they will renew their license agreements with us at the end of their term or whether we may now or in the future be in breach of those agreements. If motion picture exhibitors reduce or eliminate the number of 3D motion pictures that are exhibited in theaters, then motion picture studios may not produce and release 3D motion pictures and our revenue could be materially and adversely affected.

 

In addition, license revenue from American Multi-Cinema, Inc., or AMC, Cinemark USA, Inc., or Cinemark, and Regal Cinemas, Inc., or Regal, together comprised approximately 23% of our gross license revenue in the nine months ended December 23, 2011, 23% in the year ended March 25, 2011, 30% in the year ended March 26, 2010 and 37% in the year ended March 27, 2009.

 

Any inability or failure by our motion picture exhibitors to pay us amounts due in a timely fashion or at all could substantially reduce our cash flow and could materially and adversely impact our financial condition and results of operations.

 

A deterioration in our relationships with the major motion picture studios could adversely affect our business.

 

The six major motion picture studios accounted for approximately 82% of domestic box office revenue and 9 of the top 10 grossing 3D motion pictures in calendar year 2010. Such 3D motion pictures are also released internationally. In addition, for our domestic operations, these major motion picture studios pay us a per use fee for our RealD eyewear. To the extent that our relationship with any of these major motion picture studios deteriorates or any of these studios stop making motion pictures that can be viewed at RealD-enabled theater screens, refuse to co-brand with us or stop using or paying for the use of our RealD eyewear in domestic markets, our costs could increase and our revenue could decline, which would adversely affect our business and results of operations. We understand that at least one motion picture studio is demanding a change to the 3D eyewear business model in North America to resemble the international model, and that May 2012 may be the timeline for the proposed change.  While we support multiple business models for our RealD eyewear around the world, the uncertainty and any potential dispute with a motion picture studio over the domestic eyewear business model could adversely affect our results of operations, financial condition, business and prospects.

 

If motion picture exhibitors do not continue converting analog theaters to digital or the pace of conversions slows, our future prospects could be limited and our business could be adversely affected.

 

Our RealD Cinema Systems only work in theaters equipped with digital cinema projection systems, which enable 3D motion pictures to be delivered, stored and projected electronically, and our systems are not compatible with analog motion picture projectors. Motion picture exhibitors have been converting projectors to digital cinema over the last several years, giving us the opportunity to deploy our RealD Cinema Systems. After motion picture exhibitors convert their projectors to digital cinema, they must install a silver screen and our RealD Cinema System in order to display motion pictures in RealD 3D. The conversion by motion picture exhibitors of their projectors and screens from analog to digital cinema requires significant expense. In 2010, motion picture exhibitors installed approximately 20,000 digital cinema projectors, an approximately 123% growth from 2009, and in 2009, motion picture exhibitors installed approximately 7,500 digital cinema projectors, an approximately 86% growth rate from 2008. Although DCIP completed its financing in March 2010 that is providing funding for the digital conversion of approximately 14,000 additional domestic theater

 

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screens operated by our licensees AMC, Cinemark and Regal, we cannot predict the pace or success of this conversion, or that we will have adequate supply of the components comprising our RealD Cinema Systems in any given period to satisfy motion picture exhibitor demand. As of December 31, 2010, approximately 39% of domestic theater screens had converted to digital and a much smaller percentage of international theater screens had been converted. If the market for digital cinema develops more slowly than expected, or if the motion picture exhibitors we have agreements with, including AMC, Cinemark and Regal, delay or abandon the conversion of their theaters, our ability to grow our revenue and our business could be adversely affected.

 

If the deployment of our RealD Cinema Systems is delayed or not realized, our future prospects could be limited and our business could be adversely affected.

 

We have license agreements with motion picture exhibitors that give us the right, subject to certain exceptions, to deploy our RealD Cinema Systems if a location under contract is already equipped with our systems and they choose to install additional 3D digital projector systems. As of December 23, 2011, we were working with our motion picture exhibitor licensees to deploy our RealD Cinema Systems on up to approximately 2,900 additional screens under our existing agreements with them. On January 26, 2011, the Company entered into an amendment to its license agreement with Regal to, among other things, provide for revised terms in respect of payment, royalties and duration of the agreement, as well as to expand the number of RealD-enabled screens across the Regal theater circuit by up to 1,500 additional screens. On July 21, 2011, we entered into an amendment to our license agreement with Cinemark to, among other things, provide for revised terms in respect of payment, royalties and duration of the agreement, as well as to expand the number of RealD-enabled screens across the Cinemark theater circuit by up to 1,500 additional screens. On July 28, 2011, we entered into an amendment to our license agreement with AMC to, among other things, expand the number of RealD-enabled screens across the AMC theater circuit in the United States and Canada by up to 1,000 additional screens, as well as to revise the term. However, our license agreements do not obligate our licensees to deploy a specific number of our RealD Cinema Systems. Numerous factors beyond our control could influence when and whether our RealD Cinema Systems will be deployed, including motion picture exhibitors’ ability to fund capital expenditures, or their decision to delay or abandon the conversion of their theaters to digital projection or reduce the number of 3D motion pictures exhibited in their theaters, and our ability to secure adequate supplies of components comprising our RealD Cinema System in any given period. If motion picture exhibitors delay, postpone or decide not to deploy RealD Cinema Systems at the number of screens they have announced, or we are unable to deploy our RealD Cinema Systems in a timely manner, our future prospects could be limited and our business could be adversely affected.

 

We have a history of net losses and may continue to suffer losses in the future.

 

We have incurred net losses in each of our last six full fiscal years, and incurred a net loss of approximately $12.3 million for the year ended March 25, 2011. If we cannot become profitable, our financial condition will deteriorate, and we may be unable to achieve our business objectives

 

Any inability to protect our intellectual property rights could reduce the value of our 3D technologies and brand, which could adversely affect our financial condition, results of operations and business.

 

Our business is dependent upon our patents, trademarks, trade secrets, copyrights and other intellectual property rights. Effective intellectual property rights protection, however, may not be available under the laws of every country in which we and our licensees operate, such as China. The efforts we have taken to protect our proprietary rights may not be sufficient or effective. Any significant impairment of our intellectual property rights could harm our business or our ability to compete. In addition, protecting our intellectual property rights is costly and time consuming. It may not be practicable or cost effective for us to fully protect our intellectual property rights in some countries or jurisdictions. If we are unable to successfully identify and stop unauthorized use of our intellectual property, we could lose potential revenue and experience increased operational and enforcement costs, which could adversely affect our financial condition, results of operations and business.

 

It is possible that some of our 3D technologies may not be protectable by patents. In addition, given the costs of obtaining patent protection, we may choose not to protect particular innovations that later turn out to be important. Even where we do have patent protection, the scope of such protection may be insufficient to prevent third parties from designing around our particular patent claims or otherwise avoiding infringement. Furthermore, there is always the possibility that an issued patent may later be found to be invalid or unenforceable, or a competitor may attempt to engineer around our issued patent. Additionally, patents only offer a limited term of protection. Moreover, the intellectual property we maintain as trade secrets could be compromised by third parties, or intentionally or accidentally by our employees, which would cause us to lose the competitive advantage resulting from them.

 

Our RealD Cinema Systems and other technologies are generally designed for use with third-party technologies and hardware, and if we are unable to maintain the ability of our RealD Cinema Systems and other technologies to work with these third-party technologies and hardware, our business and operating results could be adversely affected.

 

Our RealD Cinema Systems and other technologies are generally designed for use with third-party technologies and hardware, such as Christie projectors, Doremi servers, Harkness Hall screens and Sony Electronics 4K SXRD® digital cinema projectors. Third-party technologies and hardware may be modified, re-engineered or removed altogether from the marketplace. In addition, third-party technologies used to interact with our RealD Cinema Systems, RealD Format and other 3D technologies can change without prior

 

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notice to us, which could result in increased costs or our inability to provide our 3D technologies to our licensees. If we are unable to maintain the ability of our RealD Cinema Systems, RealD Format and other 3D technologies to work with these third-party technologies and hardware, our business and operating results could be adversely affected.