Quarterly Report





UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
(Mark One)
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 30, 2017
OR
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from              to             
Commission file number 0-23137
 
  RealNetworks, Inc.
 
 
(Exact name of registrant as specified in its charter)
 
Washington
 
91-1628146
(State of incorporation)
 
(I.R.S. Employer
Identification Number)
1501 First Avenue South, Suite 600
Seattle, Washington
 
98134
(Address of principal executive offices)
 
(Zip Code)
 
(206) 674-2700
 
 
(Registrant’s telephone number, including area code)
 
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes   ý     No   ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes   ý     No   ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and "emerging growth company" in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
 
¨
  
Accelerated filer
ý
Non-accelerated filer
 
¨   (Do not check if a smaller reporting company)
  
Smaller reporting company
¨
 
 
 
 
Emerging growth company
¨
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes   ¨     No    ý
The number of shares of the registrant’s Common Stock outstanding as of October 26, 2017 was 37,302,869 .




TABLE OF CONTENTS
 
 
Page
 
 

2



PART I. FINANCIAL INFORMATION
Item 1.
Financial Statements
REALNETWORKS, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share data)
 
September 30,
2017
 
December 31,
2016
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
45,597

 
$
33,721

Short-term investments
13,482

 
43,331

Trade accounts receivable, net of allowances
26,651

 
22,162

Deferred costs, current portion
508

 
760

Prepaid expenses and other current assets
4,558

 
4,910

Total current assets
90,796

 
104,884

Equipment, software, and leasehold improvements, at cost:
 
 
 
Equipment and software
45,557

 
46,231

Leasehold improvements
3,464

 
3,317

Total equipment, software, and leasehold improvements, at cost
49,021

 
49,548

Less accumulated depreciation and amortization
44,962

 
44,294

Net equipment, software, and leasehold improvements
4,059

 
5,254

Restricted cash equivalents and investments
2,400

 
2,700

Other assets
2,177

 
1,742

Deferred costs, non-current portion
1,010

 
1,246

Deferred tax assets, net
871

 
816

Other intangible assets, net
429

 
938

Goodwill
13,042

 
12,857

Total assets
$
114,784

 
$
130,437

 
 
 
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
18,560

 
$
18,225

Accrued and other current liabilities
12,933

 
15,425

Commitment to Rhapsody

 
1,500

Deferred revenue, current portion
3,008

 
3,430

Total current liabilities
34,501

 
38,580

Deferred revenue, non-current portion
553

 
240

Deferred rent
798

 
748

Deferred tax liabilities, net
98

 
87

Other long-term liabilities
1,651

 
2,201

Total liabilities
37,601

 
41,856

Commitments and contingencies

 

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

 

Undesignated series: authorized 59,800 shares

 

Common stock, $0.001 par value authorized 250,000 shares; issued and outstanding 37,289 shares in 2017 and 37,501 shares in 2016
37

 
37

Additional paid-in capital
637,862

 
633,928

Accumulated other comprehensive loss
(59,833
)
 
(61,645
)
Retained deficit
(500,883
)
 
(483,739
)
Total shareholders’ equity
77,183

 
88,581

Total liabilities and shareholders’ equity
$
114,784

 
$
130,437

See accompanying notes to unaudited condensed consolidated financial statements.

3



REALNETWORKS, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE INCOME (LOSS)
(In thousands, except per share data)
 
Quarter Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
2016
 
2017
 
2016
Net revenue (A)
$
30,002

 
$
31,051

 
$
93,689

 
$
89,015

Cost of revenue (B)
16,534

 
16,740

 
51,117

 
47,610

Gross profit
13,468

 
14,311

 
42,572

 
41,405

Operating expenses:
 
 
 
 
 
 
 
Research and development
7,152

 
6,699

 
22,085

 
23,185

Sales and marketing
4,883

 
7,183

 
17,534

 
24,157

General and administrative
5,081

 
7,086

 
15,638

 
21,380

Restructuring and other charges
557

 
499

 
2,271

 
1,297

Lease exit and related charges

 
1,233

 

 
2,191

Total operating expenses
17,673

 
22,700

 
57,528

 
72,210

Operating income (loss)
(4,205
)
 
(8,389
)
 
(14,956
)
 
(30,805
)
Other income (expenses):
 
 
 
 
 
 
 
Interest income, net
116

 
119

 
353

 
316

Gain (loss) on investments, net

 
6,021

 

 
5,978

Equity in net loss of Rhapsody investment

 
(233
)
 
(1,097
)
 
(629
)
Other income (expense), net
(50
)
 
(243
)
 
(288
)
 
(515
)
Total other income (expenses), net
66

 
5,664

 
(1,032
)
 
5,150

Income (loss) before income taxes
(4,139
)
 
(2,725
)
 
(15,988
)
 
(25,655
)
Income tax expense (benefit)
195

 
331

 
1,156

 
919

Net income (loss)
$
(4,334
)
 
$
(3,056
)
 
$
(17,144
)
 
$
(26,574
)
 
 
 
 
 
 
 
 
Basic net income (loss) per share
$
(0.12
)
 
$
(0.08
)
 
$
(0.46
)
 
$
(0.72
)
Diluted net income (loss) per share
$
(0.12
)
 
$
(0.08
)
 
$
(0.46
)
 
$
(0.72
)
Shares used to compute basic net income (loss) per share
37,200

 
36,805

 
37,112

 
36,693

Shares used to compute diluted net income (loss) per share
37,200

 
36,805

 
37,112

 
36,693

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

 
$
72

 
$
10

 
$
239

Foreign currency translation adjustments, net of reclassification adjustments
562

 
428

 
1,802

 
483

Total other comprehensive income (loss)
562

 
500

 
1,812

 
722

Net income (loss)
(4,334
)
 
(3,056
)
 
(17,144
)
 
(26,574
)
Comprehensive income (loss)
$
(3,772
)
 
$
(2,556
)
 
$
(15,332
)
 
$
(25,852
)
 
 
 
 
 
 
 
 
(A) Components of net revenue:
 
 
 
 
 
 
 
License fees
$
6,319

 
$
7,850

 
$
21,996

 
$
20,305

Service revenue
23,683

 
23,201

 
71,693

 
68,710

 
$
30,002

 
$
31,051

 
$
93,689

 
$
89,015

(B) Components of cost of revenue:
 
 
 
 
 
 
 
License fees
$
1,655

 
$
1,755

 
$
5,381

 
$
4,458

Service revenue
14,879

 
14,985

 
45,736

 
43,152

 
$
16,534

 
$
16,740

 
$
51,117

 
$
47,610

See accompanying notes to unaudited condensed consolidated financial statements.

4



REALNETWORKS, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
 
Nine Months Ended
September 30,
 
2017
 
2016
Cash flows from operating activities:
 
 
 
Net income (loss)
$
(17,144
)
 
$
(26,574
)
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
 
 
 
Depreciation and amortization
2,402

 
5,897

Stock-based compensation
3,045

 
4,557

Equity in net loss of Rhapsody
1,097

 
629

Deferred income taxes, net
(55
)
 
(198
)
Loss (gain) on investments, net

 
(5,978
)
Realized translation loss (gain)

 
272

Fair value of warrants granted in 2015 and 2017, net of subsequent mark to market adjustments in 2017 and 2016
(367
)
 
112

Net change in certain operating assets and liabilities:
 
 
 
Trade accounts receivable
(3,516
)
 
(1,744
)
Prepaid expenses and other assets
1,072

 
1,155

Accounts payable
(447
)
 
450

Accrued and other liabilities
(3,630
)
 
(872
)
Net cash provided by (used in) operating activities
(17,543
)
 
(22,294
)
Cash flows from investing activities:
 
 
 
Purchases of equipment, software, and leasehold improvements
(541
)
 
(2,009
)
Proceeds from sale of equity and other investments

 
2,110

Purchases of short-term investments
(13,905
)
 
(59,124
)
Proceeds from sales and maturities of short-term investments
43,754

 
68,473

Decrease (increase) in restricted cash equivalents and investments, net
300

 
190

Acquisitions

 
(150
)
Advance to Rhapsody
(1,500
)
 

Proceeds from the sale of Slingo and social casino business

 
4,000

Net cash provided by (used in) investing activities
28,108

 
13,490

Cash flows from financing activities:
 
 
 
Proceeds from issuance of common stock (stock options and stock purchase plan)
130

 
166

Tax payments from shares withheld upon vesting of restricted stock
(338
)
 
(843
)
Net cash provided by (used in) financing activities
(208
)
 
(677
)
Effect of exchange rate changes on cash and cash equivalents
1,519

 
450

Net increase (decrease) in cash and cash equivalents
11,876

 
(9,031
)
Cash and cash equivalents, beginning of period
33,721

 
47,315

Cash and cash equivalents, end of period
$
45,597

 
$
38,284

 
 
 
 
Supplemental disclosure of cash flow information:
 
 
 
Cash received from income tax refunds
$
419

 
$
531

Cash paid for income taxes
$
1,124

 
$
1,876

Non-cash investing activities:
 
 
 
Increase (decrease) in accrued purchases of equipment, software, and leasehold improvements
$
42

 
$
(6
)
See accompanying notes to unaudited condensed consolidated financial statements.


5



REALNETWORKS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Quarters and Nine Months Ended September 30, 2017 and 2016
Note 1
Description of Business and Summary of Significant Accounting Policies
Description of Business. RealNetworks, Inc. and subsidiaries is a global provider of network-delivered digital media applications and services that make it easy to manage, play and share digital media. The Company also develops and markets software products and services that enable the creation, distribution and consumption of digital media, including audio and video.
Inherent in our business are various risks and uncertainties, including a limited history of certain of our product and service offerings. RealNetworks' success will depend on the acceptance of our technology, products and services and the ability to generate related revenue.
In this Quarterly Report on Form 10-Q (10-Q or Report), RealNetworks, Inc. and Subsidiaries is referred to as “RealNetworks”, the “Company”, “we”, “us”, or “our”. "RealPlayer ® " and other trademarks of ours appearing in this report are our property.
Basis of Presentation. The unaudited condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. Intercompany balances and transactions have been eliminated in consolidation.
The unaudited condensed consolidated financial statements reflect all adjustments, consisting only of normal, recurring adjustments that, in the opinion of management, are necessary for a fair presentation of the results of operations for the periods presented. Operating results for the quarter and nine months ended September 30, 2017 are not necessarily indicative of the results that may be expected for any subsequent period or for the year ending December 31, 2017 . Certain information and disclosures normally included in financial statements prepared in conformity with accounting principles generally accepted in the United States of America (GAAP) have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission (SEC).
These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2016 (the 10-K).
Use of Estimates.  The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Note 2
Recent Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board (FASB) issued new revenue recognition guidance, which was subsequently updated and amended in 2015 and 2016. The guidance requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The new guidance will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective.
The guidance permits two methods of adoption: the full retrospective method where the standard would be applied to each prior reporting period presented and the cumulative effect of applying the standard would be recognized at the earliest period shown, or the modified retrospective method, where the cumulative effect of applying the standard would be recognized at the date of initial application. We will adopt the requirements of the new standard effective January 1, 2018, and will use the modified retrospective transition method with the cumulative effect to the opening balance of retained earnings recognized as of the date of initial adoption.
Our evaluation of the new standard has made significant progress, and we continue to monitor any authoritative and interpretive guidance issued by standard-setting bodies for impacts on our evaluations. Under the new standard, we currently expect the greatest impact in certain areas where we will be required to estimate usage which drives the underlying revenue. Under the current guidance, we do not recognize revenues until we achieve fixed and determinable status, which would typically be at a later date. We also expect an impact related to the licensing of our RealTimes and RealPlayer products. As we transition to the new revenue standard, we will recognize the revenue predominantly at the time of delivery rather than over the contract period. Revenue recognition for all other product lines is not expected to be significantly impacted.

6



As a result of the new standard, based on currently executed contracts, we may be required to record a cumulative adjustment increasing our Retained Earnings on January 1, 2018. We expect that the new standard will not have a cash impact and will not affect the economics of the underlying customer contracts. We expect that our disclosures in our notes to the Consolidated Financial Statements related to revenue recognition will be significantly expanded under the new standard, specifically around the quantitative and qualitative information about our underlying performance obligations. Our assessment of impacts resulting from the new standard is substantially complete and we are in the process of finalizing our conclusions and evaluating the quantitative impact of these conclusions in both recognition and presentation in the related disclosures. We believe we are continuing to follow an appropriate timeline for proper recognition, presentation and disclosure upon adoption, including the related impacts to our internal controls.
In February 2016, the FASB issued new guidance related to the accounting for leases by lessees. A major change in the new guidance is that lessees will be required to present right-of-use assets and lease liabilities on the balance sheet. The new guidance will be effective for us on January 1, 2019. We will be evaluating the effect that the guidance will have on our consolidated financial statements and related disclosures.
In November 2016, the FASB issued guidance on the classification and presentation of changes in restricted cash on the statement of cash flows. This guidance is effective for interim and annual reporting for us on January 1, 2018. We do not expect the adoption of this guidance to have a material impact on our statement of cash flows.
In January 2017, the FASB issued new guidance simplifying the test for goodwill impairment. The new guidance eliminates Step 2 from the goodwill impairment test, instead requiring an entity to recognize a goodwill impairment charge for the amount by which the reporting unit's carrying amount exceeds the reporting unit's fair value. This guidance is effective for interim and annual goodwill impairment tests beginning on December 15, 2019, with early adoption permitted. We will be evaluating the impact of the guidance, but do not currently expect the adoption to have a material impact on our consolidated financial statements and related disclosures.
There have been no other recent accounting pronouncements or changes in accounting pronouncements to be implemented that are of significance or potential significance to RealNetworks.
Note 3
Stock-Based Compensation
Total stock-based compensation expense recognized in our unaudited condensed consolidated statements of operations and comprehensive income (loss) includes amounts related to stock options, restricted stock, and employee stock purchase plans and was as follows (in thousands):
 
 
Quarter Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
2016
 
2017
 
2016
Total stock-based compensation expense
$
748

 
$
778

 
$
3,045

 
$
4,557

The fair value of options granted determined using the Black-Scholes model used the following weighted-average assumptions:
 
 
Quarter Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
2016
 
2017
 
2016
Expected dividend yield
0
%
 
0
%
 
0
%
 
0
%
Risk-free interest rate
1.61
%
 
1.00
%
 
1.71
%
 
1.25
%
Expected life (years)
3.7

 
3.8

 
4.2

 
4.6

Volatility
34
%
 
32
%
 
35
%
 
35
%

The total stock-based compensation amounts for 2017 and 2016 disclosed above are recorded in their respective line items within operating expenses in the unaudited condensed consolidated statements of operations and comprehensive income (loss). Included in the expense for the nine months ended September 30, 2017 and 2016 was stock compensation expense recorded in the first quarter of 2017 and 2016 related to our 2016 and 2015 incentive bonuses paid in fully vested restricted stock units, which were authorized and granted in the first quarter of 2017 and 2016, respectively.


7



As of September 30, 2017 , $3.9 million of total unrecognized compensation cost, net of estimated forfeitures, related to stock awards. The unrecognized compensation cost is expected to be recognized over a weighted-average period of approximately 2 years.

Note 4
Rhapsody Joint Venture
As of September 30, 2017 we owned approximately 42% of the issued and outstanding stock of Rhapsody and account for our investment using the equity method of accounting.
Rhapsody was initially formed in 2007 as a joint venture between RealNetworks and MTV Networks, a division of Viacom International Inc. (MTVN), to own and operate a business-to-consumer digital audio music service known as Rhapsody.
Following certain restructuring transactions effective March 31, 2010, we began accounting for our investment in Rhapsody using the equity method of accounting. As part of the 2010 restructuring transactions, RealNetworks contributed $18.0 million in cash, the Rhapsody brand and certain other assets, including content licenses, in exchange for shares of convertible preferred stock of Rhapsody, carrying a $10.0 million preference upon certain liquidation events.
We recorded our share of losses of Rhapsody of $0.0 million and $1.1 million for the quarter and nine months ended September 30, 2017 ; and $0.2 million and $0.6 million for the quarter and nine months ended September 30, 2016. Because of the $10.0 million liquidation preference on the preferred stock we hold in Rhapsody, under the equity method of accounting we did not record any share of Rhapsody losses that would reduce our carrying value of Rhapsody, which is impacted by Rhapsody equity transactions, below $10.0 million , until Rhapsody's book value was reduced below $10.0 million . This occurred in the first quarter of 2015. As of September 30, 2017 , the carrying value of our Rhapsody equity investment was zero , as we do not have further commitment to provide future support to Rhapsody. Unless we commit to provide future financial support to Rhapsody, we do not record our share of Rhapsody losses that would reduce our carrying value of Rhapsody below zero, and instead we track those suspended losses separately.
In December 2016, RealNetworks entered into an agreement to loan up to $5 million to Rhapsody for general operating purposes, as did the other large owner of Rhapsody, Columbus Nova. In 2016, $3.5 million of the loan was made by each lender. In January 2017, the remaining $1.5 million commitment was funded by each lender. The loan is subordinate to all existing loans, and bears an interest a rate of 10% per annum, which accretes into the outstanding principal balance and will be due at the December 7, 2017 maturity date. Under the terms of the loan agreement between RealNetworks and Rhapsody, a default by Rhapsody under its agreements with other third party lenders that would entitle such parties to accelerate repayments with an aggregate value in excess of $1 million , would constitute a cross default of the RealNetworks and Columbus Nova loans. In that case, RealNetworks and Columbus Nova could elect to declare all outstanding obligations owed to us by Rhapsody to become immediately due and payable.
We recognized previously suspended losses up to the amount of the commitment at the time of signing the agreement in the fourth quarter of 2016, and, consequently, we do not have a receivable recorded related to this loan. As of the date of this report, we have no further commitments for additional fundings to Rhapsody.
In late March 2017, we were notified that Rhapsody would likely be in default of existing agreements with its third party lenders, which was confirmed in April 2017. We believe this default constitutes a cross default under the loan agreements between Rhapsody and RealNetworks and Rhapsody and Columbus Nova. The default with the third party lenders relates to Rhapsody missing a quarterly revenue target that included assumptions regarding the launch of a new product which Rhapsody subsequently determined not to launch, thus contributing to a revenue shortfall. In June 2017, Rhapsody obtained forbearance agreements from the third party lenders, pursuant to which (in general terms) the lenders agreed to forbear from exercising any remedies they have against Rhapsody relating to defaults existing at June 30, 2017.
In October 2017, Rhapsody entered into a financing agreement with a new third party, under which Rhapsody's wholly owned subsidiary will factor certain receivable in return for cash advances. Rhapsody applied the initial cash proceeds from this arrangement to pay in full and terminate all outstanding term loans with third party lenders and a portion of the amounts outstanding under a revolving credit facility.
The forbearance agreement entered into in June 2017 (as discussed above) has been further extended with the remaining third party lender through November 30, 2017, or until a new default event, whichever may occur first. As of the date of our filing, to our knowledge, Rhapsody has not incurred any such default events; and RealNetworks and Columbus Nova have not elected to declare all amounts outstanding under our loan agreements to be immediately due and payable.

8



Summarized financial information for Rhapsody, which represents 100% of their financial information, is as follows (in thousands):  
 
Quarter Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
2016
 
2017
 
2016
Net revenue
$
42,816

 
$
54,306

 
$
134,414

 
$
160,269

Gross profit
7,245

 
15,195

 
19,927

 
29,288

Net income (loss)
(627
)
 
1,632

 
(13,960
)
 
(11,421
)
Note 5
Fair Value Measurements
Items Measured at Fair Value on a Recurring Basis
The following table presents information about our financial assets that have been measured at fair value on a recurring basis as of September 30, 2017 and December 31, 2016 , and indicates the fair value hierarchy of the valuation inputs utilized to determine such fair value (in thousands).

 
Fair Value Measurements as of
 
Amortized Cost as of
 
September 30, 2017
 
September 30, 2017
 
Level 1
 
Level 2
 
Level 3
 
Total
 
 
Cash and cash equivalents:
 
 
 
 
 
 
 
 
 
Cash
$
27,254

 
$

 
$

 
$
27,254

 
$
27,254

Money market funds
16,843

 

 

 
16,843

 
16,843

Corporate notes and bonds

 
1,500

 

 
1,500

 
1,500

Total cash and cash equivalents
44,097

 
1,500

 

 
45,597

 
45,597

Short-term investments:
 
 
 
 
 
 
 
 
 
Corporate notes and bonds

 
13,482

 

 
13,482

 
13,478

Total short-term investments

 
13,482

 

 
13,482

 
13,478

Restricted cash equivalents and investments

 
2,400

 

 
2,400

 
2,400

Warrants issued by Rhapsody (included in Other assets)

 

 
1,140

 
1,140

 

Total
$
44,097

 
$
17,382

 
$
1,140

 
$
62,619

 
$
61,475



 
Fair Value Measurements as of
 
Amortized Cost as of
 
December 31, 2016
 
December 31, 2016
 
Level 1
 
Level 2
 
Level 3
 
Total
 
 
Cash and cash equivalents:
 
 
 
 
 
 
 
 
 
Cash
$
32,585

 
$

 
$

 
$
32,585

 
$
32,585

Money market funds
136

 

 

 
136

 
136

Corporate notes and bonds

 
1,000

 

 
1,000

 
1,000

Total cash and cash equivalents
32,721

 
1,000

 

 
33,721

 
33,721

Short-term investments:
 
 
 
 
 
 
 
 
 
Corporate notes and bonds

 
43,331

 

 
43,331

 
43,343

Total short-term investments

 
43,331

 

 
43,331

 
43,343

Restricted cash equivalents and investments

 
2,700

 

 
2,700

 
2,700

Warrant issued by Rhapsody (included in Other assets)

 

 
773

 
773

 

Total
$
32,721

 
$
47,031

 
$
773

 
$
80,525

 
$
79,764

Restricted cash equivalents and investments as of September 30, 2017 and December 31, 2016 relate to cash pledged as collateral against letters of credit in connection with lease agreements.

9



Realized gains or losses on sales of short-term investment securities for the quarters and nine months ended September 30, 2017 and 2016 were not significant. Gross unrealized gains and gross unrealized losses on short-term investment securities as of September 30, 2017 and December 31, 2016 were also not significant.
Investments with remaining contractual maturities of five years or less are classified as short-term because the investments are marketable and highly liquid, and we have the ability to utilize them for current operations. Contractual maturities of short-term investments as of September 30, 2017 (in thousands):
 
 
Estimated
Fair Value
Within one year
$
11,969

Between one year and five years
1,513

Total short-term investments
$
13,482

In February 2015, Rhapsody issued warrants to purchase Rhapsody common shares to each of RealNetworks and Rhapsody's one other large stockholder, Columbus Nova. The warrants were issued as compensation for past services provided by RealNetworks and Columbus Nova, and both warrants covered the same number of underlying shares. The exercise price of the warrants was equal to the fair value of the underlying shares on the issuance date, and we used the Black-Scholes option-pricing model to calculate the fair value of the warrant, using an expected term of 5 years and expected volatility of 55% . On the date of issuance, we recognized and recorded the $1.2 million fair value of the warrant issued to RealNetworks within Other assets in the unaudited condensed consolidated balance sheets, and as an expense reduction within General and administrative expense in the unaudited condensed consolidated statements of operations. The warrants are free-standing derivatives and as such their fair value is determined each quarter using updated inputs in the Black-Scholes option-pricing model. During the nine months ended September 30, 2017 , the decrease in the fair value of the warrants was $0.1 million .
In February 2017, Rhapsody issued additional warrants to purchase Rhapsody common shares to both RealNetworks and Columbus Nova. Consistent with the warrants issued in 2015, the 2017 warrants were issued as compensation for past services provided by RealNetworks and Columbus Nova, and both warrants covered the same number of underlying shares. The exercise price of the warrants exceeded the fair value of the underlying shares on the issuance date, and we used the Black-Scholes option-pricing model to calculate the fair value of the warrant, using an expected term of 5 years and expected volatility of 55% , resulting in a recognized fair value of $0.5 million in Other assets in the unaudited condensed consolidated balance sheets, and as an expense reduction within general and administrative expense in the unaudited condensed consolidated statements of operations. During the nine months ended September 30, 2017 , the decrease in the fair value of the warrants was insignificant.
Items Measured at Fair Value on a Non-recurring Basis
Certain of our assets and liabilities are measured at estimated fair value on a non-recurring basis, using Level 3 inputs. These instruments are subject to fair value adjustments only in certain circumstances (for example, when there is evidence of impairment). During the nine months ended September 30, 2017 and 2016 , we did not record any impairments on those assets required to be measured at fair value on a non-recurring basis.

See Note 11 , Lease Exit and Related Charges , for a discussion of the losses related to reductions in the use of RealNetworks' office space, which were recorded at the estimated fair value of remaining lease obligations, less expected sub-lease income.

10



Note 6
Allowance for Doubtful Accounts Receivable and Sales Returns
Activity in the allowance for doubtful accounts receivable and sales returns (in thousands):
 
 
Allowance For
 
Doubtful
Accounts
Receivable
 
Sales
Returns
Balances, December 31, 2016
$
633

 
$
169

Addition (reduction) to allowance
(19
)
 
13

Amounts written off

 
(11
)
Foreign currency translation
73

 
(1
)
Balances, September 30, 2017
$
687

 
$
170

Our low-margin music on demand customer, LOEN Entertainment, Co, Ltd. (LOEN), accounted for 63% of trade accounts receivable as of September 30, 2017 . At December 31, 2016 , the same customer accounted for 64% of trade accounts receivable.
LOEN accounted for 38% or $11.4 million of consolidated revenue during the quarter ended September 30, 2017 , and 36% or $33.8 million during the nine months ended September 30, 2017 , which is reflected in our Mobile Services segment.
LOEN accounted for 32% of consolidated revenue or $9.9 million during the quarter ended September 30, 2016 and 31% or $27.9 million during the nine months ended September 30, 2016 , which is reflected in our Mobile Services segment.
Note 7
Other Intangible Assets
Other intangible assets (in thousands):
 
 
 
 
September 30, 2017
 
December 31, 2016
 
 
 
Gross
Amount
 
Accumulated
Amortization
 
Net
 
Gross
Amount
 
Accumulated
Amortization
 
Net
Amortizing intangible assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
Customer relationships
 
$
30,810

 
$
30,452

 
$
358

 
$
29,308

 
$
28,781

 
$
527

 
Developed technology
 
24,440

 
24,422

 
18

 
23,574

 
23,263

 
311

 
Patents, trademarks and tradenames
 
3,758

 
3,705

 
53

 
3,530

 
3,430

 
100

 
Service contracts
 
5,413

 
5,413

 

 
5,205

 
5,205

 

 
Total
 
$
64,421

 
$
63,992

 
$
429

 
$
61,617

 
$
60,679

 
$
938


No impairments of other intangible assets were recognized in either of the nine months ended September 30, 2017 or 2016 .
Note 8
Goodwill
Changes in goodwill (in thousands):
 
Balance, December 31, 2016
$
12,857

Effects of foreign currency translation
185

Balance, September 30, 2017
$
13,042



Goodwill by segment (in thousands):

11



 
 
September 30,
2017
Consumer Media
$
580

Mobile Services
2,164

Games
10,298

Total goodwill
$
13,042


No impairment of goodwill was recognized in either of the nine months ended September 30, 2017 or in 2016 .
Note 9
Accrued and Other Current Liabilities
Accrued and other current liabilities (in thousands):
 
 
September 30, 2017
 
December 31, 2016
Royalties and other fulfillment costs
$
2,951

 
$
2,629

Employee compensation, commissions and benefits
3,690

 
5,136

Sales, VAT and other taxes payable
2,944

 
3,258

Other
3,348

 
4,402

Total accrued and other current liabilities
$
12,933

 
$
15,425

Note 10
Restructuring Charges
Restructuring and other charges in 2017 and 2016 consist of costs associated with the ongoing reorganization of our business operations and our ongoing expense re-alignment efforts. The expense amounts in both years relate primarily to severance costs due to workforce reductions.
Restructuring charges are as follows (in thousands):
 
Employee Separation Costs
Costs incurred and charged to expense for the nine months ended September 30, 2017
$
2,271

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

Changes to the accrued restructuring liability (which is included in Accrued and other current liabilities) for 2017 (in thousands) are as follows:
 
Employee Separation Costs
Accrued liability at December 31, 2016
$
209

Costs incurred and charged to expense for the nine months ended September 30, 2017
2,271

Cash payments
(2,024
)
Accrued liability at September 30, 2017
$
456


12



Note 11
Lease Exit and Related Charges
As a result of the reduction in use of RealNetworks' office space, lease exit and related charges have been recognized representing rent and contractual operating expenses over the remaining life of the leases, including estimates of sublease income expected to be received. We continue to regularly evaluate the market for office space. If the market for such space changes further in future periods, we may have to revise our estimates which may result in future adjustments to expense for excess office facilities.
Changes to accrued lease exit and related charges (which is included in Accrued and other current liabilities) for 2017 (in thousands) are as follows:
 
Accrued loss at December 31, 2016
$
3,186

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

Less amounts paid, net of sublease amounts
(1,275
)
Accrued loss at September 30, 2017
1,911

Less current portion (included in Accrued and other current liabilities)
(313
)
Accrued loss, non-current portion (included in Other long term liabilities)
$
1,598


Note 12
Shareholders’ Equity
Accumulated Other Comprehensive Income (Loss)

Changes in components of accumulated other comprehensive income (loss) (in thousands):
 
 
 
Quarter Ended
September 30,
 
Nine Months Ended
September 30,
 
 
 
2017
 
2016
 
2017
 
2016
Investments
 
 
 
 
 
 
 
 
 
Accumulated other comprehensive income (loss), beginning of period
 
$
4

 
$
1,464

 
$
(6
)
 
$
1,297

 
Unrealized gains (losses), net of tax effects of $0, $42, $5 and $141
 

 
72

 
10

 
239

 
Net current period other comprehensive income (loss)
 


72

 
10

 
239

 
Accumulated other comprehensive income (loss) balance, end of period
 
$
4


$
1,536

 
$
4

 
$
1,536

Foreign currency translation
 
 
 
 
 
 
 
 
 
Accumulated other comprehensive income (loss), beginning of period
 
$
(60,399
)
 
$
(60,722
)
 
$
(61,639
)
 
$
(60,777
)
 
Translation adjustments
 
562

 
156

 
1,802

 
211

 
Reclassification adjustments for losses (gains) included in other income (expense)
 

 
272

 

 
272

 
Net current period other comprehensive income (loss)
 
562


428

 
1,802

 
483

 
Accumulated other comprehensive income (loss) balance, end of period
 
$
(59,837
)

$
(60,294
)
 
$
(59,837
)
 
$
(60,294
)
Total accumulated other comprehensive income (loss), end of period
 
$
(59,833
)

$
(58,758
)
 
$
(59,833
)
 
$
(58,758
)

Note 13
Income Taxes
As of September 30, 2017 , there have been no material changes to RealNetworks’ uncertain tax positions disclosures as provided in Note 14 of the 2016 10-K. We do not anticipate that the total amount of unrecognized tax benefits will significantly change within the next twelve months.
We file numerous consolidated and separate income tax returns in the U.S. including federal, state and local, as well as foreign jurisdictions. With few exceptions, we are no longer subject to U.S. federal income tax examinations for tax years before 2013 or state, local, or foreign income tax examinations for years before 1993. We are currently under audit by various states and foreign jurisdictions for certain tax years subsequent to 1993.

13



Note 14
Earnings (Loss) Per Share
Basic net income (loss) per share (EPS) is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted EPS is computed by dividing net income (loss) by the weighted average number of common and dilutive potential common shares outstanding during the period. Basic and diluted EPS (in thousands, except per share amounts):
 
 
Quarter Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
2016
 
2017
 
2016
Net income (loss)
$
(4,334
)
 
$
(3,056
)
 
$
(17,144
)
 
$
(26,574
)
Weighted average common shares outstanding used to compute basic EPS
37,200

 
36,805

 
37,112

 
36,693

Dilutive effect of stock based awards

 

 

 

Weighted average common shares outstanding used to compute diluted EPS
37,200

 
36,805


37,112


36,693

 
 
 
 
 
 
 
 
Basic EPS
$
(0.12
)
 
$
(0.08
)
 
$
(0.46
)
 
$
(0.72
)
Diluted EPS
$
(0.12
)
 
$
(0.08
)
 
$
(0.46
)
 
$
(0.72
)
During the quarter and nine months ended September 30, 2017 , 5.3 million and 5.2 million shares of common stock, respectively, of potentially issuable shares from stock awards were excluded from the calculation of diluted EPS because of their antidilutive effect.
During the quarter and nine months ended September 30, 2016 , 4.6 million and 4.8 million shares of common stock, respectively, of potentially issuable shares from stock awards were excluded from the calculation of diluted EPS because of their antidilutive effect.
Note 15
Commitments and Contingencies
From time to time we are and may be subject to legal proceedings, governmental investigations and claims in the ordinary course of business, including employment claims, contract-related claims, and claims of alleged infringement of third-party patents, trademarks and other intellectual property rights. Although we believe that resolving such claims, individually or in aggregate, will not have a material adverse impact on our business or financial condition, these matters are subject to inherent uncertainties. Such claims, even if not meritorious, could force us to expend significant financial and managerial resources. In addition, given the broad distribution of some of our consumer products, any individual claim related to those products could give rise to liabilities that may be material to us. In the event of a determination adverse to us, we may incur substantial monetary liability, and/or be required to change our business practices. Either of these could have a material adverse effect on our consolidated financial statements.  
Note 16
Guarantees
In the ordinary course of business, RealNetworks is subject to potential obligations for standard warranty and indemnification provisions that are contained within many of our customer license and service agreements. Our warranty provisions are consistent with those prevalent in our industry, and we do not have a history of incurring losses on warranties; therefore, we do not maintain accruals for warranty-related obligations. With regard to indemnification provisions, nearly all of our carrier contracts obligate us to indemnify our carrier customers for certain liabilities that may be incurred by them. We have received in the past, and may receive in the future, claims for indemnification from some of our carrier customers.
In relation to certain patents and other technology assets we sold to Intel in the second quarter of 2012, we have specific obligations to indemnify Intel for breaches of the representations and warranties that we made and covenants that we agreed to in the asset purchase agreement for certain potential future intellectual property infringement claims brought by third parties against Intel. The amount of any potential liabilities related to our indemnification obligations to Intel will not be determined until a claim has been made, but we are obligated to indemnify Intel up to the amount of the gross purchase price that we received in the sale.  

14



Note 17
Segment Information
We manage our business and report revenue and operating income (loss) in three segments: (1) Consumer Media, which includes our PC-based RealPlayer products, including RealPlayer Plus and related products and intellectual property licensing; (2) Mobile Services, which includes our SaaS services of our low-margin music on demand product, ringback tones, intercarrier messaging services, and our RealTimes ® product; and (3) Games, which includes all our games-related businesses, including sales of mobile games, sales of games licenses, online games subscription services, advertising on games sites and social network sites, and microtransactions from online games.
We allocate certain corporate expenses which are directly attributable to supporting our businesses, including but not limited to a portion of finance, legal, human resources and headquarters facilities, to our reportable segments. Remaining expenses, which are not directly attributable to supporting the business, are reported as corporate items. Also reported in our corporate segment are restructuring charges, lease exit and related charges, as well as stock compensation charges.
RealNetworks reports three reportable segments based on factors such as how we manage our operations and how our Chief Operating Decision Maker (CODM) reviews results. The CODM reviews financial information presented on both a consolidated basis and on a business segment basis. The accounting policies used to derive segment results are the same as those described in Note 1, Description of Business and Summary of Significant Accounting Policies, in the 10-K.
Segment results for the quarters and nine months ended September 30, 2017 and 2016 (in thousands):
Consumer Media
 
 
Quarter Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
2016
 
2017
 
2016
Revenue
$
4,197

 
$
6,482

 
$
16,817

 
$
18,608

Cost of revenue
981

 
1,507

 
3,545

 
5,485

Gross profit
3,216

 
4,975

 
13,272

 
13,123

Operating expenses
3,217

 
4,271

 
10,957

 
13,940

Operating income (loss)
$
(1
)
 
$
704

 
$
2,315

 
$
(817
)

Mobile Services
 
Quarter Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
2016
 
2017
 
2016
Revenue
$
19,123

 
$
17,683

 
$
57,434

 
$
51,445

Cost of revenue
13,325

 
13,026

 
40,668

 
36,347

Gross profit
5,798

 
4,657

 
16,766

 
15,098

Operating expenses
6,437

 
8,075

 
21,261

 
26,653

Operating income (loss)
$
(639
)
 
$
(3,418
)
 
$
(4,495
)
 
$
(11,555
)


Games

 
Quarter Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
2016
 
2017
 
2016
Revenue
$
6,682

 
$
6,886

 
$
19,439

 
$
18,962

Cost of revenue
2,226

 
2,203

 
6,842

 
5,865

Gross profit
4,456

 
4,683

 
12,597

 
13,097

Operating expenses
5,071

 
4,649

 
15,108

 
14,669

Operating income (loss)
$
(615
)
 
$
34

 
$
(2,511
)
 
$
(1,572
)


15




Corporate
 
 
Quarter Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
2016
 
2017
 
2016
Cost of revenue
$
2

 
$
4

 
$
62

 
$
(87
)
Operating expenses
2,948

 
5,705

 
10,202

 
16,948

Operating income (loss)
$
(2,950
)
 
$
(5,709
)
 
$
(10,264
)
 
$
(16,861
)

Our customers consist primarily of consumers and corporations located in the U.S., Europe, Republic of Korea and various foreign countries (Rest of the World). Revenue by geographic region (in thousands):
 
 
Quarter Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
2016
 
2017
 
2016
United States
$
10,084

 
$
10,642

 
$
30,713

 
$
31,379

Europe
3,337

 
3,288

 
9,736

 
10,002

Republic of Korea
12,054

 
10,582

 
37,026

 
30,227

Rest of the World
4,527

 
6,539

 
16,214

 
17,407

Total net revenue
$
30,002

 
$
31,051

 
$
93,689

 
$
89,015

Long-lived assets (which consist of equipment, software, leasehold improvements, other intangible assets, and goodwill) by geographic region (in thousands) are as follows:
 
 
September 30,
2017
 
December 31,
2016
United States
$
12,274

 
$
13,052

Europe
3,555

 
3,920

Republic of Korea
105

 
168

Rest of the World
1,596

 
1,909

Total long-lived assets
$
17,530

 
$
19,049


Note 18
Related Party Transactions
 See Note 4 , Rhapsody Joint Venture , and Note 5 , Fair Value Measurements , for details on transactions involving Rhapsody.



    

16



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

the expected benefits and other consequences of our growth plans, strategic initiatives, and restructurings;
our expected introduction, distribution and monetization, of new and enhanced products, services and technologies across our businesses;
future revenues, gross profits, operating expenses, income and other taxes, tax benefits, net income (loss) per diluted share available to common shareholders, acquisition costs and related amortization, and other measures of results of operations;
the effects of our past acquisitions and expectations for future acquisitions and divestitures;
plans, strategies and expected opportunities for future growth, increased profitability and innovation;
the expected financial position, performance, growth and profitability of, and investment in, our businesses and the availability of resources;
the effects of legislation, regulations, administrative proceedings, court rulings, settlement negotiations and other factors that may impact our businesses;
the continuation and expected nature of certain customer relationships;
impacts of competition and certain customer relationships on the future financial performance and growth of our businesses;
our involvement in potential claims, legal proceedings and government investigations, and the potential outcomes and effects of such potential claims, legal proceedings and governmental investigations on our business, prospects, financial condition or results of operations;
the effects of U.S. and foreign income and other taxes on our business, prospects, financial condition or results of operations; and
the effect of economic and market conditions on our business, prospects, financial condition or results of operations.
These statements are not guarantees of future performance and actual actions or results may differ materially. These statements are subject to certain risks, uncertainties and assumptions that are difficult to predict, including those noted in the documents incorporated herein by reference. Particular attention should also be paid to the cautionary language in Item 1A of Part I in our 2016 10-K entitled “Risk Factors.” RealNetworks undertakes no obligation to update publicly any forward-looking statements as a result of new information, future events or otherwise, unless required by law. Readers should, however, carefully review the risk factors included in other reports or documents filed by RealNetworks from time to time with the Securities and Exchange Commission, particularly the Quarterly Reports on Form 10-Q and any Current Reports on Form 8-K.
Overview
RealNetworks creates innovative applications and services that make it easy to connect with and enjoy digital media. We manage our business and report revenue and operating income (loss) in three segments: (1) Consumer Media, (2) Mobile Services, and (3) Games. See Note 17 Segment Information , to the unaudited condensed consolidated financial statements included in Item 1 of Part I of this Form 10-Q.
Within our Consumer Media segment, revenue is derived from the sales of our PC-based RealPlayer ® products, including RealPlayer Plus and related products, and from the licensing of our intellectual property, primarily our codec technology, including our recently introduced RealMedia High Definition, or RMHD, technology. These products and services are delivered directly to consumers and through partners, such as OEMs and mobile device manufacturers.
Our Mobile Services business generates revenue primarily from the sale of SaaS services, which include ringback tones, RealTimes ®, intercarrier messaging, and our low-margin music on demand service. We generate a significant portion of our revenue from sales within our Mobile Services business to a few mobile telecommunications carriers and our low-margin music on demand customer in Korea. The loss of these contracts or the termination or non-renewal or renegotiation of contract terms that are less favorable to us could result in the loss of future revenues and could result in the loss of anticipated profits. Our contract with our music on demand customer in Korea, LOEN, is set to expire at the end of fiscal year 2017, and we do not

17



anticipate renewal. As discussed in Note 6 Allowance for Doubtful Accounts Receivable and Sales Returns , our low-margin music on demand business generated revenue of $11.4 million and $33.8 million for the three and nine months ended September 30, 2017, respectively. While non-renewal would result in a material decline in our consolidated revenue in periods after 2017, we would not expect the impact to consolidated Gross profit to be significant as the profitability of this contract has declined over time, currently generating less than three percent of our consolidated Gross profit; or $0.3 million and $0.9 million for the three and nine months ended September 30, 2017, respectively.
Our Games business, through the GameHouse and Zylom brands, derives revenue from sales of mobile games, games licenses, online games subscription services, and advertising on games sites.
We allocate certain corporate expenses which are directly attributable to supporting our businesses, including but not limited to a portion of finance, legal, human resources and headquarters facilities, to our reportable segments. Remaining expenses, which are not directly attributable to supporting the business, are reported as corporate items. These corporate items include restructuring charges, lease exit and related charges, as well as stock compensation expense.

As of September 30, 2017 , we had $59.1 million in unrestricted cash, cash equivalents and short-term investments, compared to $77.1 million as of December 31, 2016 . The 2017 decrease of cash, cash equivalents, and short-term investments was due to cash used in operating activities during the first nine months of $17.5 million .

Condensed consolidated results of operations were as follows (dollars in thousands):
 
 
Quarters ended September 30,
 
Nine months ended September 30,
 
2017
 
2016
 
$ Change
 
% Change
 
2017
 
2016
 
$ Change
 
% Change
Total revenue
$
30,002

 
$
31,051

 
$
(1,049
)
 
(3
)%
 
$
93,689

 
$
89,015

 
$
4,674

 
5
 %
Cost of revenue
16,534

 
16,740

 
(206
)
 
(1
)%
 
51,117

 
47,610

 
3,507

 
7
 %
Gross profit
13,468

 
14,311

 
(843
)
 
(6
)%
 
42,572

 
41,405

 
1,167

 
3
 %
Gross margin
45
%
 
46
%
 
 
 
 
 
45
%
 
47
%
 
 
 
 
Operating expenses
17,673

 
22,700

 
(5,027
)
 
(22
)%
 
57,528

 
72,210

 
(14,682
)
 
(20
)%
Operating income (loss)
$
(4,205
)
 
$
(8,389
)
 
$
4,184

 
50
 %
 
$
(14,956
)
 
$
(30,805
)
 
$
15,849

 
51
 %
In the third quarter of 2017 , our total consolidated revenue decreased $1.0 million as compared with the year-earlier period. Of this decrease, $2.3 million is attributed to our Consumer Media segment, due primarily to timing of shipments by our intellectual property customers. The decrease was offset in part by a $1.4 million increase in our Mobile Services segment due primarily to increased low-margin music on demand revenue in Korea.
Cost of revenues decreased by $0.2 million for the quarter ended September 30, 2017 , due in part to savings of $0.5 million in our Consumer Media segment. These savings were offset in part by higher costs of $0.3 million in our Mobile Services segment.
Operating expenses decreased by $5.0 million in the quarter ended September 30, 2017 compared with the prior year primarily due to savings realized from reductions in salaries, benefits and professional service fees, and marketing expenses totaling $2.1 million, as described more fully below, lower facilities and support services costs of $1.6 million, as well as a decrease of $1.2 million relating to decreased lease exit and related charges as compared to the prior-year period.
For the nine months ended September 30, 2017 , our total consolidated revenue increased by $4.7 million , compared with the year-earlier period. Revenues increased in our Mobile Services segment by $6.0 million due primarily to increased low-margin music on demand revenue in Korea and revenue increased $0.5 million in our Games segment. These increases were offset in part by a decrease of $1.8 million in our Consumer Media segment.
Cost of revenues increased by $3.5 million in the nine months ended September 30, 2017 compared with the prior year period, resulting in a two percentage point decrease in gross margin, due to higher costs of $4.3 million in our Mobile Services segment, as well as a $1.0 million increase in our Games segment. These increases were offset by savings of $1.9 million in our Consumer Media segment.
Operating expenses decreased $14.7 million in the nine months ended September 30, 2017 as compared with the prior year due to savings realized from reductions in salaries, benefits and professional service fees, and marketing expenses totaling $12.2 million, as described more fully below. Further contributing to decreased expense as compared to the prior-year period was the impact of reduced lease exit costs of $2.2 million, as well as the benefit recorded following the receipt of warrants in the first quarter

18



of 2017 from Rhapsody of $0.5 million and the release of previously accrued taxes of $0.4 million in the first quarter of 2017. These decreases were offset by an increase of $1.0 million relating to increased restructuring costs due to increased severance charges as compared to the prior-year period.

Segment Operating Results
Consumer Media
Consumer Media segment results of operations were as follows (dollars in thousands):
 
 
 
Quarters ended September 30,
 
Nine months ended September 30,
 
 
2017
 
2016
 
$ Change
 
% Change
 
2017
 
2016
 
$ Change
 
% Change
Revenue
 
$
4,197

 
$
6,482

 
$
(2,285
)
 
(35
)%
 
$
16,817

 
$
18,608

 
$
(1,791
)
 
(10
)%
Cost of revenue
 
981

 
1,507

 
(526
)
 
(35
)%
 
3,545

 
5,485

 
(1,940
)
 
(35
)%
Gross profit
 
3,216

 
4,975

 
(1,759
)
 
(35
)%
 
13,272

 
13,123

 
149

 
1
 %
Gross margin
 
77
%
 
77
%
 
 
 
 
 
79
%
 
71
%
 
 
 
 
Operating expenses
 
3,217

 
4,271

 
(1,054
)
 
(25
)%
 
10,957

 
13,940

 
(2,983
)
 
(21
)%
Operating income (loss)
 
$
(1
)
 
$
704

 
$
(705
)
 
(100
)%
 
$
2,315

 
$
(817
)
 
$
3,132

 
383
 %

Total Consumer Media revenue for the quarter ended September 30, 2017 decreased $2.3 million as compared to the same quarter in 2016. Intellectual property licensing revenue decreased by $1.7 million for the quarter due primarily to timing of shipment by our customers. Continuing declines in our subscription products of $0.5 million further contributed to the overall decrease as compared to the prior year period.
Cost of revenue decreased by $0.5 million during the quarter ended September 30, 2017 , compared with the year-earlier period. The decrease in cost of revenue was primarily due to lower bandwidth costs of $0.2 million directly resulting from our ongoing efforts to optimize functionality and increase efficiencies.
Operating expenses decreased by $1.1 million in the quarter ended September 30, 2017 , compared with the year-earlier period, primarily due to lower expenses for facilities and support services of $0.5 million as a result of our ongoing cost reduction efforts, as well as a decrease in salaries, benefits and professional services fees of $0.6 million.
Total Consumer Media revenue for the nine months ended September 30, 2017 decreased $1.8 million as compared to the same period in 2016, primarily due to continuing declines in our subscription products of $1.2 million and a decrease of $0.2 million in related advertising revenue.
Cost of revenue decreased by $1.9 million during the nine months ended September 30, 2017 , compared with the year-earlier period resulting in an increase in gross margin of 8 percentage points. The decrease in cost of revenue was primarily due to lower bandwidth and other support costs of $1.5 million directly resulting from our ongoing efforts to optimize functionality and increase efficiencies.
Operating expenses decreased by $3.0 million in the nine months ended September 30, 2017 , compared with the year-earlier period, due to lower expenses for facilities and support services of $1.8 million as a result of our ongoing cost reduction efforts, the acceleration of depreciation expense of $0.7 million taken in the first quarter of 2016 related to the obsolescence of e-commerce assets, and lower marketing expense of $0.3 million in 2017 compared to 2016.

19



Mobile Services
Mobile Services segment results of operations were as follows (dollars in thousands):  
 
Quarter Ended September 30,
 
Nine months ended September 30,
 
 
2017
 
2016
 
$ Change
 
% Change
 
2017
 
2016
 
$ Change
 
% Change
Revenue
 
$
19,123

 
$
17,683

 
$
1,440

 
8
 %
 
$
57,434

 
$
51,445

 
$
5,989

 
12
 %
Cost of revenue
 
13,325

 
13,026

 
299

 
2
 %
 
40,668

 
36,347

 
4,321

 
12
 %
Gross profit
 
5,798

 
4,657

 
1,141

 
25
 %
 
16,766

 
15,098

 
1,668

 
11
 %
Gross margin
 
30
%
 
26
%
 
 
 
 
 
29
%
 
29
%
 
 
 
 
Operating expenses
 
6,437

 
8,075

 
(1,638
)
 
(20
)%
 
21,261

 
26,653

 
(5,392
)
 
(20
)%
Operating income (loss)
 
$
(639
)
 
$
(3,418
)
 
$
2,779

 
81
 %
 
$
(4,495
)
 
$
(11,555
)
 
$
7,060

 
61
 %
Total Mobile Services revenue increased by $1.4 million in the quarter ended September 30, 2017 compared with the prior-year period which was due to an increase of $1.5 million in our low-margin music on demand contract in Korea.
Cost of revenue increased by $0.3 million in the quarter ended September 30, 2017 compared with the prior-year period, due primarily to an increase of $1.7 million in our low-margin music on demand business related to higher sales, offset in part by reductions in salaries and benefits of $0.5 million, facilities and support services costs of $0.3 million and third-party customer service of $0.3 million.
Operating expenses decreased by $1.6 million for the quarter ended September 30, 2017 compared with the year-earlier period primarily due to reductions in salaries, benefits and professional services fees of $0.9 million and a reduction in our facilities and support services costs of $0.5 million as a result of our ongoing cost reduction efforts.
Total Mobile Services revenue increased by $6.0 million in the nine months ended September 30, 2017 compared with the prior-year period. This increase was driven by an increase of $5.9 million in our low-margin music on demand contract in Korea and an increase of $0.6 million in our ringback tones business. These increases were offset by a decrease of $0.5 million in our intercarrier messaging service.
Cost of revenue increased by $4.3 million in the nine months ended September 30, 2017 compared with the prior-year period, due to an increase of $6.3 million in our low-margin music on demand business related to higher sales. The increased cost was offset by reduced spending on third-party customer service of $0.8 million, reduced facilities spend of $0.7 million and lower bandwidth costs of $0.6 million.
Operating expenses decreased by $5.4 million for the nine months ended September 30, 2017 compared with the year-earlier period primarily due to reductions in salaries, benefits and professional services fees of $3.4 million, as well as reduced facilities and support services costs of $1.3 million as a result of our ongoing cost reduction efforts and reduced marketing spend of $0.4 million.
Games
Games segment results of operations were as follows (dollars in thousands):
 
 
Quarter Ended September 30,
 
Nine months ended September 30,
 
 
2017
 
2016
 
$ Change
 
% Change
 
2017
 
2016
 
$ Change
 
% Change
Revenue
 
$
6,682

 
$
6,886

 
$
(204
)
 
(3
)%
 
$
19,439

 
$
18,962

 
$
477

 
3
 %
Cost of revenue
 
2,226

 
2,203

 
23

 
1
 %
 
6,842

 
5,865

 
977

 
17
 %
Gross profit
 
4,456

 
4,683

 
(227
)
 
(5
)%
 
12,597

 
13,097

 
(500
)
 
(4
)%
Gross margin
 
67
%
 
68
%
 
 
 
 
 
65
%
 
69
%
 
 
 
 
Operating expenses
 
5,071

 
4,649

 
422

 
9
 %
 
15,108

 
14,669

 
439

 
3
 %
Operating income (loss)
 
$
(615
)
 
$
34

 
$
(649
)
 
NM

 
$
(2,511
)
 
$
(1,572
)
 
$
(939
)
 
(60
)%
Total Games revenue declined slightly for the quarter ended September 30, 2017 , compared with the year-earlier period due to a $0.5 million decrease in our other games revenue offset by a $0.3 million increase in our mobile games revenue.
Cost of revenue was flat for the quarter ended September 30, 2017 when compared with the prior-year period due to increases in app store fees related to our mobile revenue growth, offset by decreased bandwidth and advertising costs.

20



Operating expenses increased by $0.4 million in the quarter ended September 30, 2017 , compared with the prior-year period primarily as a result of increased salaries and benefits costs due to our continued investment in growing our mobile games offerings.
Total Games revenue increased by $0.5 million in the nine months ended September 30, 2017 , compared with the year-earlier period as a $2.0 million increase in our mobile games revenue was offset by a decrease of $1.5 million in our other games revenue.
Cost of revenue increased by $1.0 million in the nine months ended September 30, 2017 compared with the prior-year period due to increases in app store fees related to our mobile revenue growth, as well as increased royalty fees paid to developers.
Operating expenses increased by $0.4 million in the nine months ended September 30, 2017 , compared with the prior-year period, due to increased salaries and benefit costs due to our continued investment in growing our mobile games offerings, offset in part by lower marketing costs.
Corporate

Corporate segment results of operations were as follows (dollars in thousands):
 
 
 
Quarter Ended September 30,
Nine months ended September 30,
 
 
2017
 
2016
 
$ Change
 
% Change
 
2017
 
2016
 
$ Change
 
% Change
Cost of revenue
 
2

 
$
4

 
$
(2
)
 
50
 %
 
$
62

 
$
(87
)
 
$
149

 
171
 %
Operating expenses
 
2,948

 
5,705

 
(2,757
)
 
(48
)%
 
10,202

 
16,948

 
(6,746
)
 
(40
)%
Operating income (loss)
 
$
(2,950
)
 
$
(5,709
)
 
$
2,759

 
48
 %
 
$
(10,264
)
 
$
(16,861
)
 
$
6,597

 
39
 %
Operating expenses decreased by $2.8 million in the quarter ended September 30, 2017 compared with the year-earlier period. The decrease was primarily due to a reduction of $1.2 million in our restructuring costs due to lower lease exit and related charges compared to the prior-year period, a $0.9 million reduction in salary, benefit and professional service expenses, and a $0.7 million reduction in facilities and support services.
Operating expenses decreased by $6.7 million in the nine months ended September 30, 2017 compared with the year-earlier period. The decrease was primarily due to a $4.5 million reduction in salary, benefit and professional service expenses, a reduction of $2.2 million due to lower lease exit and related charges, and a benefit of $0.5 million relating to the warrant received from Rhapsody in the first quarter of 2017, which is discussed further in Note 5 Fair Value Measurements . These decreases were offset by an increase of $1.0 million relating to increased restructuring costs due to increased severance charges as compared to the prior-year period.
Consolidated Operating Expenses
Our operating expenses consist primarily of salaries and related personnel costs including stock based compensation, consulting fees associated with product development, sales commissions, amortization of certain intangible assets capitalized in our acquisitions, professional service fees, advertising costs, restructuring charges and lease exit costs. Operating expenses were as follows (dollars in thousands):
 
 
Quarter Ended September 30,
 
Nine months ended September 30,
 
2017
 
2016
 
$ Change
 
% Change
 
2017
 
2016
 
$ Change
 
% Change
Research and development
$
7,152

 
$
6,699

 
$
453

 
7
 %
 
$
22,085

 
$
23,185

 
$