Avid Technology, Inc.
AVID TECHNOLOGY INC (Form: 10-Q, Received: 11/09/2006 16:38:12)

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

__________________

 

FORM 10-Q

  (Mark One)

 

 

x

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

 

For the quarterly period ended September 30, 2006

 

 

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: 0-21174

 

__________________

 

Avid Technology, Inc.

( Exact Name of Registrant as Specified in Its Charter)

 

 

 

Delaware

(State or Other Jurisdiction of
Incorporation or Organization)

 

04-2977748

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

 

 

Avid Technology Park, One Park West

Tewksbury, Massachusetts 01876

(Address of Principal Executive Offices, Including Zip Code)

 

(978) 640-6789

(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 is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

 

 

Large Accelerated Filer   x   

Accelerated Filer   o   

Non-accelerated Filer   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

 

The number of shares outstanding of the registrant’s Common Stock as of October 31, 2006 was 40,993,400.

 

 

 

 


AVID TECHNOLOGY, INC.

 

FORM 10-Q

 

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006

 

TABLE OF CONTENTS

 

 

Page

PART I.

FINANCIAL INFORMATION

 

 

 

 

ITEM 1.

Condensed Consolidated Financial Statements :

 

 

Condensed Consolidated Statements of Operations (unaudited) for
the three and nine months ended September 30, 2006 and 2005


1

 

Condensed Consolidated Balance Sheets (unaudited) as of
September 30, 2006 and December 31, 2005


2

 

Condensed Consolidated Statements of Cash Flows (unaudited) for
the nine months ended September 30, 2006 and 2005


3

 

Notes to Condensed Consolidated Financial Statements (unaudited)

4

ITEM 2.

Management’s Discussion and Analysis of Financial Condition and
Results of Operations


21

ITEM 3.

Quantitative and Qualitative Disclosure About Market Risk

37

ITEM 4.

Controls and Procedures

38

 

 

 

PART II.

OTHER INFORMATION

 

 

 

 

ITEM 1.

Legal Proceedings

39

ITEM 1A.

Risk Factors

39

ITEM 2.

Unregistered Sales of Equity Securities and Use of Proceeds

49

ITEM 6.

Exhibits

49

 

 

 

SIGNATURES

50

 

 

 

EXHIBIT INDEX

51

 

 

 

This Form 10-Q includes forward-looking statements, as defined by the Private Securities Litigation Reform Act of 1995, about our performance. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words “believes,” “anticipates,” “plans,” “expects” and similar expressions are intended to identify forward-looking statements. There are a number of factors that could cause actual events or results to differ materially from those indicated by such forward-looking statements, many of which are beyond our control, including the factors set forth under “Part II - Item 1A. Risk Factors.” In addition, the forward-looking statements contained herein represent our estimate only as of the date of this filing and should not be relied upon as representing our estimate as of any subsequent date. While we may elect to update these forward-looking statements at some point in the future, we specifically disclaim any obligation to do so to reflect actual results, changes in assumptions or changes in other factors affecting such forward-looking statements.

 


PART I.     FINANCIAL INFORMATION

 

ITEM 1.   

CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

AVID TECHNOLOGY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data; unaudited)

 

 

 

Three Months Ended

 

 

 

Nine Months Ended

 

 

 

September 30,

 

 

 

September 30,

 

 

 

2006

 

 

 

2005

 

 

 

2006

 

 

 

2005

 

Net revenues:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Product

 

$

203,274

 

 

 

$

183,658

 

 

 

$

595,597

 

 

 

$

472,975

 

Services

 

 

27,959

 

 

 

 

20,762

 

 

 

 

75,932

 

 

 

 

57,497

 

Total net revenues

 

 

231,233

 

 

 

 

204,420

 

 

 

 

671,529

 

 

 

 

530,472

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of revenues:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Product

 

 

99,202

 

 

 

 

82,133

 

 

 

 

284,382

 

 

 

 

204,274

 

Services

 

 

13,968

 

 

 

 

11,587

 

 

 

 

41,095

 

 

 

 

31,684

 

Amortization of intangible assets

 

 

6,208

 

 

 

 

3,854

 

 

 

 

16,304

 

 

 

 

4,417

 

Total cost of revenues

 

 

119,378

 

 

 

 

97,574

 

 

 

 

341,781

 

 

 

 

240,375

 

Gross profit

 

 

111,855

 

 

 

 

106,846

 

 

 

 

329,748

 

 

 

 

290,097

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Research and development

 

 

35,250

 

 

 

 

29,636

 

 

 

 

106,363

 

 

 

 

79,225

 

Marketing and selling

 

 

50,641

 

 

 

 

44,601

 

 

 

 

153,136

 

 

 

 

120,895

 

General and administrative

 

 

16,021

 

 

 

 

12,188

 

 

 

 

47,011

 

 

 

 

32,961

 

Amortization of intangible assets

 

 

3,298

 

 

 

 

2,544

 

 

 

 

10,940

 

 

 

 

5,729

 

Restructuring costs (recoveries)

 

 

(1,620

)

 

 

 

1,997

 

 

 

 

(554

)

 

 

 

1,997

 

In-process research and development

 

 

569

 

 

 

 

32,390

 

 

 

 

879

 

 

 

 

32,390

 

Total operating expenses

 

 

104,159

 

 

 

 

123,356

 

 

 

 

317,775

 

 

 

 

273,197

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating income (loss)

 

 

7,696

 

 

 

 

(16,510

)

 

 

 

11,973

 

 

 

 

16,900

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

 

1,977

 

 

 

 

1,618

 

 

 

 

6,190

 

 

 

 

3,478

 

Interest expense

 

 

(137

)

 

 

 

(66

)

 

 

 

(324

)

 

 

 

(255

)

Other income (expense), net

 

 

(8

)

 

 

 

167

 

 

 

 

(183

)

 

 

 

512

 

Income (loss) before income taxes

 

 

9,528

 

 

 

 

(14,791

)

 

 

 

17,656

 

 

 

 

20,635

 

Provision for income taxes, net

 

 

5,935

 

 

 

 

2,966

 

 

 

 

8,018

 

 

 

 

5,080

 

Net income (loss)

 

$

3,593

 

 

 

$

(17,757

)

 

 

$

9,638

 

 

 

$

15,555

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss) per common share – basic

 

$

0.09

 

 

 

$

(0.46

)

 

 

$

0.23

 

 

 

$

0.43

 

Net income (loss) per common share – diluted

 

$

0.08

 

 

 

$

(0.46

)

 

 

$

0.22

 

 

 

$

0.41

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted-average common shares outstanding – basic

 

 

41,531

 

 

 

 

38,935

 

 

 

 

41,978

 

 

 

 

36,381

 

Weighted-average common shares outstanding – diluted

 

 

42,281

 

 

 

 

38,935

 

 

 

 

42,845

 

 

 

 

38,217

 

 

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

 

1


 

AVID TECHNOLOGY, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, unaudited)

 

 

 

September 30,

 

 

 

December 31,

 

 

 

2006

 

 

 

2005

 

ASSETS

 

 

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

72,747

 

 

 

$

123,073

 

Marketable securities

 

 

86,984

 

 

 

 

115,357

 

Accounts receivable, net of allowances of $22,326 and $22,233 at

 

 

 

 

 

 

 

 

 

September 30, 2006 and December 31, 2005, respectively

 

 

149,073

 

 

 

 

140,669

 

Inventories

 

 

134,390

 

 

 

 

96,845

 

Deferred tax assets, net

 

 

573

 

 

 

 

528

 

Prepaid expenses

 

 

9,926

 

 

 

 

8,548

 

Other current assets

 

 

15,687

 

 

 

 

16,657

 

Total current assets

 

 

469,380

 

 

 

 

501,677

 

 

 

 

 

 

 

 

 

 

 

Property and equipment, net

 

 

39,362

 

 

 

 

38,563

 

Intangible assets, net

 

 

110,451

 

 

 

 

118,676

 

Goodwill

 

 

424,735

 

 

 

 

396,902

 

Other assets

 

 

6,421

 

 

 

 

6,228

 

Total assets

 

$

1,050,349

 

 

 

$

1,062,046

 

 

 

 

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

 

 

 

Accounts payable

 

$

44,759

 

 

 

$

43,227

 

Accrued compensation and benefits

 

 

27,365

 

 

 

 

27,841

 

Accrued expenses and other current liabilities

 

 

48,774

 

 

 

 

55,443

 

Income taxes payable

 

 

20,589

 

 

 

 

13,027

 

Deferred revenues

 

 

67,235

 

 

 

 

62,863

 

Total current liabilities

 

 

208,722

 

 

 

 

202,401

 

 

 

 

 

 

 

 

 

 

 

Long-term liabilities

 

 

20,105

 

 

 

 

20,048

 

Total liabilities

 

 

228,827

 

 

 

 

222,449

 

 

 

 

 

 

 

 

 

 

 

Contingencies (Note 9)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

 

 

 

 

Common stock

 

 

423

 

 

 

 

421

 

Additional paid-in capital

 

 

944,911

 

 

 

 

928,703

 

Accumulated deficit

 

 

(80,282

)

 

 

 

(88,795

)

Treasury stock at cost, net of reissuances

 

 

(47,924

)

 

 

 

 

Deferred compensation

 

 

 

 

 

 

(1,830

)

Accumulated other comprehensive income

 

 

4,394

 

 

 

 

1,098

 

Total stockholders’ equity

 

 

821,522

 

 

 

 

839,597

 

Total liabilities and stockholders’ equity

 

$

1,050,349

 

 

 

$

1,062,046

 

 

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

 

2


AVID TECHNOLOGY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands, unaudited)

 

 

 

Nine Months Ended
September 30,

 

 

 

2006

 

 

 

2005

 

Cash flows from operating activities:

 

 

 

 

 

 

 

 

 

Net income

 

$

9,638

 

 

 

$

15,555

 

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

 

 

 

 

 

 

 

 

 

Depreciation and amortization

 

 

43,527

 

 

 

 

21,971

 

Provision for (recoveries of) doubtful accounts

 

 

(609

)

 

 

 

687

 

In-process research and development

 

 

879

 

 

 

 

32,390

 

Loss (gain) on disposal of fixed assets

 

 

147

 

 

 

 

(55

)

Compensation expense from stock grants and options

 

 

13,256

 

 

 

 

2,042

 

Equity in loss (income) of non-consolidated company

 

 

203

 

 

 

 

(254

)

Changes in deferred tax assets and liabilities, excluding initial effects of acquisitions

 

 

(1,582

)

 

 

 

(363

)

Changes in operating assets and liabilities, excluding initial effects of acquisitions:

 

 

 

 

 

 

 

 

 

Accounts receivable

 

 

(1,083

)

 

 

 

(23,516

)

Inventories

 

 

(34,740

)

 

 

 

(16,744

)

Prepaid expenses and other current assets

 

 

1,098

 

 

 

 

2,348

 

Accounts payable

 

 

(3,357

)

 

 

 

530

 

Income taxes payable

 

 

7,559

 

 

 

 

3,783

 

Accrued expenses, compensation and benefits and other liabilities

 

 

(11,039

)

 

 

 

(9,172

)

Deferred revenues

 

 

(1,230

)

 

 

 

10,103

 

Net cash provided by operating activities

 

 

22,667

 

 

 

 

39,305

 

 

 

 

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

 

 

 

 

Purchases of property and equipment

 

 

(14,711

)

 

 

 

(12,916

)

Payments for other long-term assets

 

 

(886

)

 

 

 

(782

)

Payments for business acquisitions, including transaction costs, net of cash acquired

 

 

(43,351

)

 

 

 

(5,049

)

Cash received in business acquisition, including transaction costs, net of cash paid

 

 

 

 

 

 

24,942

 

Purchases of marketable securities

 

 

(53,198

)

 

 

 

(77,962

)

Proceeds from sales of marketable securities

 

 

82,422

 

 

 

 

48,662

 

Net cash used in investing activities

 

 

(29,724

)

 

 

 

(23,105

)

 

 

 

 

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

 

 

 

 

Payments on capital lease obligations

 

 

(74

)

 

 

 

(64

)

Purchases of common stock for treasury

 

 

(50,043

)

 

 

 

 

Proceeds from issuance of common stock under employee stock plans

 

 

5,736

 

 

 

 

10,995

 

Net cash (used in) provided by financing activities

 

 

(44,381

)

 

 

 

10,931

 

 

 

 

 

 

 

 

 

 

 

Effect of exchange rate changes on cash and cash equivalents

 

 

1,112

 

 

 

 

(1,215

)

Net increase (decrease) in cash and cash equivalents

 

 

(50,326

)

 

 

 

25,916

 

Cash and cash equivalents at beginning of period

 

 

123,073

 

 

 

 

76,558

 

Cash and cash equivalents at end of period

 

$

72,747

 

 

 

$

102,474

 

 

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

 

3

 


PART I.    FINANCIAL INFORMATION

 

ITEM 1D.   

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

AVID TECHNOLOGY, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

1.   

FINANCIAL INFORMATION

 

The accompanying condensed consolidated financial statements include the accounts of Avid Technology, Inc. and its wholly owned subsidiaries (collectively, “Avid” or the “Company”). These financial statements are unaudited. However, in the opinion of management, the condensed consolidated financial statements include all adjustments, consisting of only normal, recurring adjustments, necessary for their fair statement. Interim results are not necessarily indicative of results expected for a full year. The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the instructions for Form 10-Q and therefore do not include all information and footnotes necessary for a complete presentation of operations, financial position and cash flows of the Company in conformity with generally accepted accounting principles. The accompanying condensed consolidated balance sheet as of December 31, 2005 was derived from Avid’s audited consolidated financial statements, but does not include all disclosures required by generally accepted accounting principles. The Company filed audited consolidated financial statements for the year ended December 31, 2005 in its 2005 Annual Report on Form 10-K, which included all information and footnotes necessary for such presentation; the financial statements contained in this Form 10-Q should be read in conjunction with the audited consolidated financial statements in the Form 10-K. Certain amounts in the prior years’ financial statements have been reclassified to conform to the current year presentation. As disclosed in the Company’s 2005 Annual Report on Form 10-K, during 2005, the Company began reclassifying certain European administrative expenses as general and administrative expense rather than as marketing and selling expense. During 2006, the Company began reclassifying the long-term portion of certain liabilities from the captions ‘deferred revenues’ and ‘accrued expenses and other current liabilities’ to ‘long-term liabilities’ in the Condensed Consolidated Balance Sheets. See Note 6 for the amounts included in long-term liabilities for each period presented.

 

The Company’s preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reported periods. The most significant estimates reflected in these financial statements include accounts receivable and sales allowances, purchase accounting, stock-based compensation, inventory valuation and income tax asset valuation allowances. Actual results could differ from those estimates.

 

In connection with preparation of the accompanying condensed consolidated financial statements, the Company concluded that it was appropriate to classify its investments in variable rate demand note securities as marketable securities.  Previously, such investments were classified as cash and cash equivalents.  Accordingly, the Company has revised the classification to exclude from cash and cash equivalents $30.0 million and $10.9 million of variable rate demand note securities at September 30, 2006, and December 31, 2005, respectively, and to include such amounts as marketable securities.  In addition the Company has made corresponding adjustments to the accompanying statement of cash flows to reflect the gross purchases and sales of these securities as investing activities.  As a result, cash used in investing activities increased by $19.1 million and $8.8 million for each of the nine-month periods ended September 30, 2006 and 2005, respectively.  This change in classification does not affect previously reported cash flows from operations or from financing activities.

 

On July 28, 2006, the Company acquired Sibelius Software Limited (“Sibelius”), a UK-based music applications software company and a leading provider of music notation software in the education and professional markets. The acquisition of Sibelius will allow Avid to broaden the Company's Audio segment product offerings and accelerate its expansion into the educational market. The results of operations of Sibelius have been included in the Company’s results of operations since the acquisition date (see Note 3).

 

4

 


 

On April 13, 2006, the Company acquired Sundance Digital, Inc. (“Sundance”), a Texas-based developer of automation and device control software for broadcast video servers, tape transports, graphics systems and other broadcast station equipment. The results of operations of Sundance have been included in the Company’s results of operations since the acquisition date (see Note 3).

 

On January 12, 2006, the Company acquired Medea Corporation (“Medea”), a California-based provider of low cost storage solutions for real-time media applications. The results of operations of Medea have been included in the Company’s results of operations since the acquisition date (see Note 3).

 

2.   

NET INCOME PER COMMON SHARE

 

Basic and diluted net income (loss) per share were as follows (in thousands, except per share data):

 

 

 

Three Months Ended
September 30,

 

 

 

Nine Months Ended
September 30,

 

 

 

2006

 

 

 

2005

 

 

 

2006

 

 

 

2005

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

3,593

 

 

 

$

(17,757

)

 

 

$

9,638

 

 

 

$

15,555

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted-average common shares outstanding - basic

 

 

41,531

 

 

 

 

38,935

 

 

 

 

41,978

 

 

 

 

36,381

 

Weighted-average potential common stock:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Options

 

 

750

 

 

 

 

 

 

 

 

867

 

 

 

 

1,722

 

Warrant

 

 

 

 

 

 

 

 

 

 

 

 

 

 

114

 

Weighted-average common shares outstanding - diluted

 

 

42,281

 

 

 

 

38,935

 

 

 

 

42,845

 

 

 

 

38,217

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss) per common share – basic

 

$

0.09

 

 

 

$

(0.46

)

 

 

$

0.23

 

 

 

$

0.43

 

Net income (loss) per common share – diluted

 

$

0.08

 

 

 

$

(0.46

)

 

 

$

0.22

 

 

 

$

0.41

 

 

For the three- and nine-month periods ended September 30, 2006 and 2005, certain stock options, warrants, and restricted stock and restricted stock units have been excluded from the diluted net income (loss) per share calculation as their effect would be anti-dilutive. For periods that the Company reports a loss, all potential common stock is considered anti-dilutive; for periods when the Company reports net income, potential common shares with combined purchase prices and unamortized compensation cost in excess of the Company’s average common stock fair value for the related period are considered anti-dilutive. Common stock equivalents that were considered anti-dilutive securities and excluded from the diluted net income per share calculations, were as follows, on a weighted-average basis (in thousands):

 

 

Three Months Ended
September 30,

             

Nine Months Ended
September 30,

 

2006

 

2005

 

2006

 

2005

Options

2,618

 

4,230

 

2,554

 

786

Warrant

1,155

 

1,155

 

1,155

 

Unvested restricted stock and restricted stock units

226

 

 

176

 

Total anti-dilutive common stock equivalents

3,999

 

5,385

 

3,885

 

786

 

 

5

 


3.          ACQUISITIONS

 

Sibelius

 

On July 28, 2006, the Company acquired all the outstanding shares of Sibelius Software Limited, a UK-based music applications software company and a leading provider of music notation software in the education and professional markets, for cash, net of cash acquired, of $20.3 million, plus transaction costs of $0.7 million and $0.5 million for the fair value of stock options assumed. The Company performed a preliminary allocation of the purchase price to the net tangible assets and intangible assets of Sibelius based on their fair values as of the consummation of the acquisition. The purchase price was allocated as follows: $1.0 million to net tangible assets acquired, $9.2 million to amortizable identifiable intangible assets, $0.5 million to in-process research and development (“R&D”) and the remaining $10.8 million to goodwill. An additional $3.2 million was recorded as goodwill for deferred tax liabilities related to non-deductible intangible asset amortization. The total goodwill of $14.0 million, which reflects the value of the assembled workforce and the synergies the Company expects to realize by offering its products to Sibelius’ education customer base and by offering Sibelius’ products to its customer base, is reported within the Audio segment and is not deductible for tax purposes.

 

The Company used the income approach to determine the values of the acquired intangible assets. The income approach presumes that the value of an asset can be estimated by the net economic benefit to be received over the life of the asset, generally cash flows discounted to present value. This approach typically uses a projection of revenues and expenses attributed to the intangible asset to calculate a potential income stream which is then discounted using a rate of return that is based on the weighted-average cost of capital factored for the risk, or uncertainty, associated with achieving the projected income stream. Such risks vary from acquisition to acquisition based on the characteristics of the acquired company and the perceived ability to accurately estimate future revenues and expenses. Projections of revenues and expenses and the determination of the appropriate discount rate reflect management's best estimates of these factors at the time of the valuation. The weighted-average discount rate (or rate of return) used to determine the value of Sibelius’ intangible assets was 17% and the effective tax rate used was 40%.

 

The amortizable identifiable intangible assets include developed technology of $6.6 million, customer relationships of $1.8 million and a trade name of $0.8 million. The values of the customer relationships and trade name are both being amortized on a straight-line basis over their estimated useful lives of six years. The value of the developed technology is being amortized over the greater of the amount calculated using the ratio of current quarter revenue to the total of current quarter and anticipated future revenues, or the straight-line method, over the estimated useful life of four years. The weighted-average amortization period for the amortizable identifiable intangible assets is approximately five years. Amortization expense for these intangibles totaled $0.3 million for both the three- and nine-month periods ended September 30, 2006 and accumulated amortization was $0.3 million at September 30, 2006. The allocation of $0.5 million to in-process R&D was expensed during the three months ended September 30, 2006 and represents technology that had not yet reached technological feasibility and had no alternative future use.

 

Sundance

 

On April 13, 2006, Avid acquired all the outstanding shares of Sundance Digital, Inc., a Texas-based developer of automation and device control software for broadcast video servers, tape transports, graphics systems and other broadcast station equipment, for cash, net of cash acquired, of $11.2 million plus transaction costs of $0.2 million. The Company performed a preliminary allocation of the purchase price to the net tangible and intangible assets of Sundance based on their fair values as of the consummation of the acquisition. The purchase price was allocated as follows: ($4.0) million to net liabilities assumed, $5.6 million to amortizable identifiable intangible assets and the remaining $9.8 million to goodwill. During the third quarter of 2006, the Company continued its analysis of the fair values of certain assets and liabilities, primarily related to accounts receivable reserves. Accordingly, the Company recorded an additional liability of $0.6 million and a corresponding increase to goodwill. The total goodwill of $10.4 million, which reflects the value of the assembled workforce and the synergies the Company expects to realize by offering Sundance’s broadcast automation products to its Professional Video segment customers, is reported within the Professional Video segment and is not deductible for tax purposes.

 

6

 


The Company used the cost approach to determine the value of the developed technology and used the income approach to determine the values of the other acquired intangible assets. While the income approach presumes that the value of an asset can be estimated by the net economic benefit to be received over the life of the asset discounted to present value, the cost approach is based on the economic principles of substitution and price equilibrium and requires an estimation of the costs required to reproduce the intangible asset which is reduced for depreciation of the asset. The weighted-average discount rate (or rate of return) used to determine the value of Sundance’s intangible assets was 20% and the effective tax rate used was 35%.

 

The amortizable identifiable intangible assets include developed technology of $3.9 million, customer relationships of $1.0 million, non-compete agreements of $0.4 million and trademarks and trade name of $0.3 million. The values of the customer relationships, non-compete agreements and trademarks and trade name, which were determined using the income approach, are being amortized on a straight-line basis over their estimated useful lives of six years, two years and six years, respectively. The value of the developed technology, which was determined using the cost approach, is being amortized over the greater of the amount calculated using the ratio of current quarter revenue to the total of current quarter and anticipated future revenues, or the straight-line method, over the estimated useful life of three years. The weighted-average amortization period for the amortizable identifiable intangible assets is approximately four years. Amortization expense for these intangibles totaled $0.4 million and $0.8 million, respectively, for the three- and nine-month periods ended September 30, 2006, and accumulated amortization was $0.8 million at September 30, 2006.

 

Medea

 

On January 12, 2006, Avid acquired all the outstanding shares of Medea Corporation, a California-based provider of local storage solutions for real-time media applications, for cash of $8.9 million plus transaction costs of $0.2 million. The Company performed a preliminary allocation of the total purchase price of $9.1 million to the net tangible and intangible assets of Medea based on their fair values as of the consummation of the acquisition. The purchase price was allocated as follows: ($2.1) million to net liabilities assumed, $3.8 million to amortizable identifiable intangible assets, $0.3 million to in-process R&D and the remaining $7.1 million to goodwill. During the second and third quarters of 2006, the Company continued its analysis of the fair values of certain assets and liabilities, primarily related to accruals for employee terminations. Accordingly, the Company recorded additional net liabilities of $0.2 million and a corresponding increase to goodwill. The total goodwill of $7.3 million, which reflects the value of the assembled workforce and the synergies the Company expects to realize by offering Medea’s RAID (Redundant Array of Independent Disks) storage solutions to its Professional Video segment customers, is reported within the Professional Video segment and is not deductible for tax purposes.

 

The Company used the income approach to determine the value of the intangible assets, using a weighted-average discount rate (or rate of return) of 19% and an effective tax rate of 35%. The amortizable identifiable intangible assets include developed technology of $2.7 million, customer relationships of $0.7 million, order backlog of $0.3 million and non-compete agreements of $0.1 million. The customer relationships, order backlog and non-compete agreements are being amortized on a straight-line basis over their estimated useful lives of six years, one-half year and two years, respectively. Developed technology is being amortized over the greater of the amount calculated using the ratio of current quarter revenue to the total of current quarter and anticipated future revenues, or the straight-line method, over the estimated useful life of two and one-half years. The weighted-average amortization period for the amortizable identifiable intangible assets is approximately three years. Amortization expense for these intangibles totaled $0.4 million and $1.3 million, respectively, for the three- and nine-month periods ended September 30, 2006, and accumulated amortization was $1.3 million at September 30, 2006. The allocation of $0.3 million to in-process R&D was expensed during the three months ended March 31, 2006.

 

Pinnacle

 

In August 2005, Avid completed the acquisition of California-based Pinnacle Systems, Inc. (“Pinnacle”), a supplier of digital video products to customers ranging from individuals to broadcasters. Avid paid $72.1 million in cash plus common stock consideration of approximately $362.9 million in exchange for all of the outstanding shares of Pinnacle. Avid also incurred $6.5 million of transaction costs. The Company has included Pinnacle’s broadcast and professional offerings, including the Deko on-air graphics system and the MediaStream playout server, into its

 

7

 


Professional Video segment and has formed a new Consumer Video segment that offers Pinnacle’s consumer products, including Pinnacle Studio and other products.

 

During 2005, the Company allocated the total purchase price of $441.4 million as follows: $91.8 million to net assets acquired, $123.1 million to identifiable intangible assets (including $32.3 million of in-process R&D) and the remaining $226.5 million to goodwill. During the first nine months of 2006, the Company continued its analysis of the fair values of certain assets and liabilities, in particular accruals for employee terminations, facilities closures and contract terminations; inventory reserves and certain other accruals. Accordingly, the Company recorded adjustments to these assets and liabilities, resulting in a $4.7 million increase in the value of the net assets acquired and a corresponding decrease to goodwill. The purchase price allocation was complete as of September 30, 2006.

 

The identifiable intangible assets, with the exception of the in-process R&D, which was expensed at the time of acquisition, are being amortized over their estimated useful lives of six and one-half years for customer relationships, seven years for the trade names and two to three years for the developed technology. The weighted-average amortization period for these intangible assets in total is approximately five years. These intangible assets are being amortized using the straight-line method, with the exception of developed technology. Developed technology is being amortized on a product-by-product basis over the greater of: 1) the amount calculated using the ratio of current quarter revenues to the total of current quarter and anticipated future revenues over the estimated useful lives of two to three years; or 2) the straight-line method over each product’s remaining respective useful life. Amortization expense for these intangibles totaled $6.5 million and $19.1 million, respectively, for the three- and nine-month periods ended September 30, 2006 and $4.5 million for both the three- and nine-month periods ended September 30, 2005. Accumulated amortization was $31.7 million at September 30, 2006.

 

The goodwill of $221.8 million resulting from the purchase price allocation reflects the value of the underlying enterprise, as well as planned synergies that Avid expects to realize, including incremental sales of legacy Avid Professional Video products. $87.5 million of the goodwill has been assigned to the Company’s Professional Video segment and $134.3 million has been assigned to the Consumer Video segment. This goodwill is not deductible for tax purposes and will not be amortized for financial reporting purposes, in accordance with the requirements of Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets.”

 

Wizoo

 

In August 2005, Avid acquired all the outstanding shares of Wizoo Sound Design GmbH (“Wizoo”), a Germany-based provider of virtual instruments for music producers and sound designers. The total purchase price of $5.1 million was allocated as follows: ($0.6 million) to net liabilities assumed, $1.2 million to amortizable identifiable intangible assets, $0.1 million to in-process R&D and the remaining $4.4 million to goodwill. The amortizable identifiable intangible assets, which include developed technology of $0.6 million and license agreements of $0.6 million, are being amortized on a straight-line basis over their estimated useful lives of two to four years and three to four years, respectively. Amortization expense for these intangibles totaled $0.1 million and $0.3 million, respectively, for the three- and nine-month periods ended September 30, 2006 and accumulated amortization was $0.5 million at September 30, 2006. The in-process R&D of $0.1 million was expensed during the quarter ended September 30, 2005. The goodwill of $4.4 million, which reflects the value of the assembled workforce and the synergies the Company hopes to realize by integrating the Wizoo technology with its other products, is reported within the Company’s Audio segment and is not deductible for tax purposes.

 

As part of the purchase agreement, Avid was contingently obligated to make additional payments to the former shareholders of Wizoo of up to €1.0 million ($1.2 million), dependent upon Wizoo achieving certain engineering milestones through January 2008. These payments, if required, would be recorded as additional purchase consideration, allocated to goodwill. As of September 30, 2006, four engineering milestones have been met and $0.8 million has been recorded as additional purchase price.

 

Pro Forma Financial Information for Acquisitions (Unaudited)

 

The results of operations of Sibelius, Sundance, Medea, Pinnacle and Wizoo have been included in the results of operations of the Company since the respective date of each acquisition. The following unaudited pro forma financial information presents the results of operations for the three- and nine-month periods ended September 30, 2005 as if the acquisitions of Pinnacle, Sibelius, Sundance and Medea had occurred at the beginning of 2005. Pro forma results

 

8

 


of operations giving effect to the Wizoo acquisition are not included as they would not differ materially from reported results. The pro forma financial information for the combined entities has been prepared for comparative purposes only and is not indicative of what actual results would have been if the acquisitions had taken place at the beginning of fiscal 2005, or of future results.

 

(in thousands except per share data)

 

Three Months Ended
September 30, 2005

 

 

 

Nine Months Ended
September 30, 2005

 

Net revenues

 

 

$221,419

 

 

 

 

$682,946

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

 

($8,179

)

 

 

 

($37,061

)

 

 

 

 

 

 

 

 

 

 

Net loss per share:

 

 

 

 

 

 

 

 

 

Basic

 

 

($0.20

)

 

 

 

($0.89

)

Diluted

 

 

($0.20

)

 

 

 

($0.89

)

 

Included in the pro forma net income reported above for the nine-month period ended September 30, 2005 is a charge of $32.3 million for in-process R&D related to the Pinnacle acquisition.

 

The following unaudited pro forma financial information presents the results of operations for the three- and nine-month periods ended September 30, 2006 as if the acquisitions of Sibelius and Sundance had occurred at the beginning of 2006. Pro forma results of operations giving effect to the Medea acquisition are not included as they would not differ materially from reported results. The pro forma financial information for the combined entities has been prepared for comparative purposes only and is not indicative of what actual results would have been if the acquisitions had taken place at the beginning of fiscal 2006, or of future results.

 

(in thousands except per share data)

 

Three Months Ended
September 30, 2006

 

 

 

Nine Months Ended
September 30, 2006

 

Net revenues

 

 

$232,175

 

 

 

 

$680,902

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

$3,773

 

 

 

 

$7,415

 

 

 

 

 

 

 

 

 

 

 

Net income per share:

 

 

 

 

 

 

 

 

 

Basic

 

 

$0.09

 

 

 

 

$0.18

 

Diluted

 

 

$0.09

 

 

 

 

$0.17

 

 

Amortizing Identifiable Intangible Assets

 

As a result of the Company’s acquisitions, amortizing identifiable intangible assets consist of the following (in thousands):

 

 

 

September 30, 2006

 

 

 

December 31, 2005

 

 


Gross

 

 

 

Accumulated
Amortization

 

 

 


Net

 

 

 


Gross

 

 

 

Accumulated
Amortization

 

 

Net

Completed technologies
   and patents

 

$

66,299

 

 

 

$

(31,814)

 

 

 

$

34,485

 

 

 

$

52,698

 

 

 

$

(14,606)

 

 

 

$

38,092

Customer relationships

 

 

71,701

 

 

 

 

(13,528)

 

 

 

 

58,173

 

 

 

 

68,200

 

 

 

 

(6,755)

 

 

 

 

61,445

Trade names

 

 

21,315

 

 

 

 

(4,295)

 

 

 

 

17,020

 

 

 

 

20,245

 

 

 

 

(1,993)

 

 

 

 

18,252

Non-compete covenants

 

 

1,704

 

 

 

 

(1,322)

 

 

 

 

382

 

 

 

 

1,200

 

 

 

 

(818)

 

 

 

 

382

License agreements

 

 

560

 

 

 

 

(169)

 

 

 

 

391

 

 

 

 

560

 

 

 

 

(55)

 

 

 

 

505

Order backlog

 

 

340

 

 

 

 

(340)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$

161,919

 

 

 

$

(51,468)

 

 

 

$

110,451

 

 

 

$

142,903

 

 

 

$

(24,227)

 

 

 

$

118,676

 

Amortization expense related to all intangible assets in the aggregate was $9.5 million and $6.4 million, respectively, for the three-month periods ended September 30, 2006 and 2005, and $27.2 million and $10.1 million, respectively, for the nine-month periods ended September 30, 2006 and 2005. The Company expects amortization of these

 

9

 


intangible assets to be approximately $9 million for the remainder of 2006, $31 million in 2007, $19 million in 2008, $15 million in 2009, $12 million in 2010, $10 million in 2011 and $14 million thereafter.

 

4.   

ACCOUNTS RECEIVABLE

 

Accounts receivable, net of allowances, consists of the following (in thousands):

 

 

 

September 30,
2006

 

 

 

December 31,
2005

 

Accounts receivable

 

$

171,399

 

 

 

$

162,902

 

Less:

 

 

 

 

 

 

 

 

 

Allowance for doubtful accounts

 

 

(3,058

)

 

 

 

(4,847

)

Allowance for sales returns and rebates

 

 

(19,268

)

 

 

 

(17,386

)

 

 

$

149,073

 

 

 

$

140,669

 

 

The allowance for doubtful accounts represents a reserve for estimated bad debt losses resulting from the inability of customers to make required payments for products or services. When evaluating the adequacy of this allowance, the Company analyzes accounts receivable balances, historical bad debt experience, customer concentrations, customer credit-worthiness and current economic trends. The allowance for sales returns and rebates, which includes allowances for estimated returns, exchanges and credits for price protection, are provided as a reduction of revenues in the same period that related revenues are recorded, based upon the Company’s historical experience. To date, actual returns and other allowances have not differed materially from management’s estimates.

 

The accounts receivable balances as of September 30, 2006 and December 31, 2005 are net of approximately $29 million and $17 million, respectively, which represent amounts for large solution and certain distributor sales that have been invoiced but for which revenue has not been earned and payment is not due.

 

5.   

INVENTORIES

 

Inventories, net of related reserves, consist of the following (in thousands):

 

 

 

September 30,
2006

 

 

 

December 31,
2005

Raw materials

 

$

44,680

 

 

 

$

26,878

Work in process

 

 

8,708

 

 

 

 

13,040

Finished goods

 

 

81,002

 

 

 

 

56,927

 

 

$

134,390

 

 

 

$

96,845

 

As of September 30, 2006 and December 31, 2005, the finished goods inventory includes inventory at customer locations of $15.1 million and $11.5 million, respectively, associated with product shipped to customers for which revenue has not yet been recognized.

 

6.   

LONG-TERM LIABILITIES

 

Long-term liabilities consist of the following (in thousands):

 

 

 

September 30,
2006

 

 

 

December 31,
2005

Long-term deferred tax liabilities

 

$

10,465

 

 

 

$

9,372

Long-term deferred revenue

 

 

4,052

 

 

 

 

3,171

Long-term deferred rent

 

 

3,501

 

 

 

 

3,644

Long-term accrued restructuring

 

 

2,087

 

 

 

 

3,861

 

 

$

20,105

 

 

 

$

20,048

 

 

10


 

7.   

ACCOUNTING FOR STOCK-BASED COMPENSATION

 

The Company has several stock-based compensation plans under which employees, officers, directors and consultants may be granted stock awards or options to purchase the Company’s common stock, generally at the market price on the date of grant. Certain plans allow for options to be granted at below market price under certain circumstances, although this is typically not the Company’s practice. The options become exercisable over various periods, typically four years for employees and one year for non-employee directors, and have a maximum term of ten years. As of September 30, 2006, 2,571,418 shares of common stock remain available to cover future stock option grants under the Company’s stock-based compensation plans, including 2,189,293 shares that may alternatively be issued as awards of restricted stock, restricted stock units or other forms of stock-based compensation.

 

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”), which is a revision of SFAS No. 123, “Accounting for Stock Based Compensation.” SFAS 123(R) requires employee stock-based compensation awards to be accounted for under the fair value method and eliminates the ability to account for these instruments under the intrinsic value method as prescribed by Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. The Company adopted SFAS 123(R) on January 1, 2006 using the modified prospective application method as permitted under SFAS 123(R). Under this method, the Company is required to record compensation cost, based on the fair value estimated in accordance with SFAS 123(R), for stock-based awards granted after the date of adoption over the requisite service periods for the individual awards, which generally equals the vesting period. The Company is also required to record compensation cost for the unvested portion of previously granted stock-based awards outstanding at the date of adoption over the requisite service periods for the individual awards based on the fair value estimated in accordance with the original provisions of SFAS No. 123 adjusted for forfeitures as required by SFAS 123(R).

 

Prior to the adoption of SFAS 123(R), the Company accounted for stock-based compensation under the recognition and measurement principles of APB Opinion No. 25 and related interpretations. Accordingly, no compensation expense was recorded for options issued to employees and directors in fixed amounts and with fixed exercise prices at least equal to the market price of the Company’s common stock at the date of grant. In connection with the acquisition of M-Audio in August 2004, the Company granted options to certain M-Audio employees at exercise prices that were less than the market price of the Company’s common stock at the date of grant. The Company recorded the difference between the exercise prices and the fair values of the options at the date of completion of the acquisition, determined under the Black-Scholes method, multiplied by the number of shares underlying the options, as deferred compensation. The resulting deferred compensation is being expensed over the vesting period of the options. Additionally, deferred compensation was recorded for restricted stock granted to employees based on the market price of the Company’s common stock at the date of grant, which is being expensed over the period in which the restrictions lapse. In connection with the adoption of SFAS 123(R) on January 1, 2006, the Company reversed the remaining deferred compensation of $1.8 million, with the offset to additional paid-in capital.

 

11

 


The following table illustrates the effect on net income and net income per share as if the Company had applied the fair value recognition provisions of SFAS No. 123 to all stock-based employee awards for the three- and nine-month periods ended September 30, 2005 (in thousands, except per share data):

 

 

 

Three Months
Ended
September 30,
2005

 

 

 

Nine Months
Ended
September 30,
2005

 

Net income (loss) as reported

 

$


(17,757

)

 

 

$

15,555

 

Add:  Stock-based employee compensation expense included in reported net
      income, net of related tax effects

 

 


528

 

 

 

 


2,042

 

Deduct:  Total stock-based employee compensation expense determined under
      the fair value based method for all awards, net of related tax effects

 

 


(6,199


)

 

 

 


(16,923


)

Pro forma net income (loss)

 

$

(23,428

)

 

 

$

674

 

 

 

 

 

 

 

 

 

 

 

Net income per share:

 

 

 

 

 

 

 

 

 

Basic-as reported

 

$

(0.46

)

 

 

$

0.43

 

Basic-pro forma

 

$

(0.60

)

 

 

$

0.02

 

Diluted-as reported

 

$

(0.46

)

 

 

$

0.41

 

Diluted-pro forma

 

$

(0.60

)

 

 

$

0.02

 

 

Beginning with the adoption of SFAS 123(R) in the first quarter of 2006, the Company recorded stock-based compensation expense for the fair value of stock options. Stock-based compensation expense of $4.4 million and $13.3 million, resulting from the adoption of SFAS 123(R), the acquisition of M-Audio and the issuance of restricted stock and restricted stock units, was included in the following captions in the Company’s condensed consolidated statement of operations for the three- and nine-month periods ended September 30, 2006, respectively (in thousands):

 

 

 

Three Months Ended
September 30, 2006

 

 

 

Nine Months Ended
September 30, 2006

Product cost of revenues

 

$

128

 

 

 

$

398

Services cost of revenues

 

 

196

 

 

 

 

623

Research and development expense

 

 

1,280

 

 

 

 

3,887

Marketing and selling expense

 

 

1,232

 

 

 

 

3,765

General and administrative expense

 

 

1,560

 

 

 

 

4,583

 

 

$

4,396

 

 

 

$

13,256

 

The fair values of restricted stock awards, including restricted stock and restricted stock units, are based on the intrinsic values of the awards at the date of grant. As permitted under SFAS No. 123 and SFAS 123(R), the Company uses the Black-Scholes option pricing model to estimate the fair value of stock option grants. The Black-Scholes model relies on a number of key assumptions to calculate estimated fair values. The following table sets forth the weighted-average key assumptions and fair value results for stock options granted during the three- and nine-month periods ended September 30, 2006 and 2005:

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

2006

 

2005

 

2006

 

2005

Expected dividend yield

0.00%

 

0.00%

 

0.00%

 

0.00%

Risk-free interest rate

4.97%

 

4.14%

 

4.89%

 

3.99%

Expected volatility

34.59%

 

51.00%

 

35.54%

 

50.86%

Expected life (in years)

4.29

 

4.24

 

4.43

 

4.13

Weighted-average fair value of options granted

$13.24

 

$17.88

 

$14.61

 

$22.95

 

 

12

 


The dividend yield of zero is based on the fact that the Company has never paid cash dividends and has no present intention to pay cash dividends. Since adoption of SFAS 123(R) on January 1, 2006, the expected stock-price volatility assumption used by the Company has been based on recent (six month trailing) implied volatility calculations. These calculations are performed on exchange-traded options of the Company’s stock, based on the implied volatility of long-term (nine to thirty-nine month term) exchange traded options, which is consistent with the requirements of SFAS 123(R) and Securities and Exchange Commission Staff Accounting Bulletin No. 107. The Company believes that using a forward-looking, market-driven volatility assumption will result in the best estimate of expected volatility. Prior to adoption of SFAS 123(R), the expected volatility was based on historical volatilities of the underlying stock. The risk-free interest rate is the U.S. Treasury security rate with a term equal to the expected life of the option. The expected life is based on company-specific historical experience. With regard to the estimate of the expected life, the Company considers the exercise behavior of past grants and models the pattern of aggregate exercises.

 

Based on the Company’s historical turnover rates, an annualized estimated forfeiture rate of 6.5% has been used in calculating the estimated compensation cost for both the three- and nine-month periods ended September 30, 2006. Additional expense will be recorded if the actual forfeiture rates are lower than estimated and a recovery of prior expense will be recorded if the actual forfeitures are higher than estimated. Prior to the adoption of SFAS 123(R), forfeitures were not estimated at the time of award.

 

Information with respect to options granted under all stock option plans is as follows:

 

 

 

Nine Months Ended September 30, 2006

 

 

 

 

Shares

 

 

Weighted-
Average
Exercise
Price

 

Weighted-
Average
Remaining
Contractual
Term

 

Aggregate
Intrinsic
Value
(in thousands)

 

Options outstanding at December 31, 2005

 

4,220,174

 

 

$36.65

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Granted

 

254,750

 

 

$40.40

 

 

 

 

 

Assumed in Sibelius acquisition

 

34,581

 

 

$8.45

 

 

 

 

 

Exercised

 

(281,654

)

 

$16.44

 

 

 

 

 

Forfeited

 

(142,799

)

 

$40.29

 

 

 

 

 

Canceled

 

(42,215

)

 

$51.01

 

 

 

 

 

Options outstanding at September 30, 2006

 

4,042,837

 

 

$37.77

 

7.19

 

$36,305

 

 

 

 

 

 

 

 

 

 

 

 

Options vested at September 30, 2006 or expected to vest

 

3,920,827

 

 

$37.54

 

7.14

 

$36,030

 

 

 

 

 

 

 

 

 

 

 

 

Options exercisable at September 30, 2006

 

2,510,044

 

 

$34.77

 

6.41

 

$30,954

 

 

Options assumed through the acquisition of Sibelius had exercise prices below the Company's average market price on the date of acquisition. The weighted-average fair value of the assumed options was $27.65 which was determined using the Black-Scholes option pricing model assuming an expected volatility of 34.32%, a risk-free interest rate of 5.01% and an expected life of 2.55 years for the remaining vesting.

 

The aggregate intrinsic value of stock options exercised during the nine months ended September 30, 2006 was approximately $5.8 million. Cash received from the exercise of stock options for the nine months ended September 30, 2006 was $4.6 million. The Company did not realize any actual tax benefit from the tax deductions for stock option exercises during the nine months ended September 30, 2006, due to the full valuation allowance on the Company’s U.S. deferred tax assets.

 

13

 


The following table summarizes the status of the Company’s non-vested restricted stock units as of December 31, 2005 and changes during the nine months ended September 30, 2006:

 

 

 

Non-Vested Restricted Stock Units

 

 

 

 

 

 

Shares

 

 

 

Weighted-
Average
Grant-Date
Fair Value

 

Weighted-
Average
Remaining
Recognition
Period

 

 

Aggregate
Intrinsic
Value
(in thousands)

Non-vested at December 31, 2005

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Granted

 

207,757

 

 

$47.01

 

 

 

 

Vested

 

 

 

 

 

 

 

Forfeited

 

(4,940

)

 

$47.01

 

 

 

 

Non-vested at September 30, 2006

 

202,817

 

 

$47.01

 

3.44

 

$7,385

 

The following table summarizes the status of the Company’s non-vested restricted stock as of December 31, 2005 and changes during the nine months ended September 30, 2006:

 

 

 

Non-Vested Restricted Stock

 

 

 

 

 

 

Shares

 

 

 

Weighted-
Average
Grant-Date
Fair Value

 

Weighted-
Average
Remaining
Recognition
Period

 

 

Aggregate
Intrinsic
Value
(in thousands)

Non-vested at December 31, 2005

 

15,000

 

 

$56.72

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Granted

 

8,618

 

 

$47.01

 

 

 

 

Vested

 

 

 

 

 

 

 

Forfeited

 

 

 

 

 

 

 

Non-vested at September 30, 2006

 

23,618

 

 

$53.18

 

2.60

 

$860

 

As of September 30, 2006, there was $31.6 million of total unrecognized compensation cost, before forfeitures, related to non-vested stock-based compensation awards granted under the Company’s stock-based compensation plans. This cost will be recognized over the next four years. The Company expects this amount to be amortized as follows: $4.6 million during the remainder of 2006, $13.9 million in 2007 and $13.1 million thereafter. The weighted-average recognition period of the total unrecognized compensation cost is 1.34 years.

 

The Company’s Amended and Restated 1996 Employee Stock Purchase Plan authorizes the issuance of a maximum of 1,700,000 shares of common stock in quarterly offerings to employees at a price equal to 95% of the closing price on the applicable offering termination date. As of September 30, 2006, 299,139 shares remain available for issuance under this plan. Based on the plan design, the Company’s Amended and Restated 1996 Employee Stock Purchase Plan is considered noncompensatory under SFAS 123(R). Accordingly, the Company is not required to assign fair value to shares issued from this plan.

 

8.   

STOCK REPURCHASE

 

A stock repurchase program was approved by the Company’s board of directors effective July 21, 2006. Under this program, the Company was authorized to repurchase up to $50 million of the Company’s common stock through transactions on the open market, in block trades or otherwise. The program was completed on August 7, 2006 with 1,432,327 shares of the Company’s common stock repurchased from July 25, 2006 through the completion date. The average price per share, including commissions, paid for the shares of common stock repurchased under this program was $34.94. The stock repurchase program was funded using the Company’s working capital. At September 30, 2006 and December 31, 2005, the outstanding shares of the Company's common stock, net of treasury shares, were 41.0 million and 42.1 million, respectively.

 

14

 


9.   

CONTINGENCIES

 

Avid receives inquiries from time to time with regard to possible patent infringement claims. If any infringement is determined to exist, the Company may seek licenses or settlements. In addition, as a normal incidence of the nature of the Company’s business, various claims, charges and litigation have been asserted or commenced from time to time against the Company arising from or related to contractual or employee relations, intellectual property rights or product performance. Management does not believe these claims will have a material adverse effect on the financial position or results of operations of the Company.

 

In April 2005, Avid was notified by the Korean Federal Trade Commission (“KFTC”) that a former reseller, Neat Information Telecommunication, Inc. (“Neat”), had filed a petition against a subsidiary, Avid Technology Worldwide, Inc., alleging unfair trade practices. On August 11, 2005, the KFTC issued a decision in favor of Avid regarding the complaint filed by Neat. On February 16, 2006, in response to a second petition filed by Neat, the KFTC reaffirmed its earlier decision in favor of Avid and concluded its review of the case. In addition, on October 14, 2005, Neat filed a civil lawsuit in Seoul Central District Court against Avid Technology Worldwide, Inc. alleging tortious conduct and unfair trade practices. On August 11, 2006, Neat filed an identical complaint against Avid Technology, Inc., the parent company of Avid Technology Worldwide, Inc. The cases will proceed in parallel, with judgment expected at the same time. Neat alleged damages of approximately $1.1 million, plus interest and attorneys' fees. The Company has filed answers to the complaints denying Neat’s allegations. Avid believes that Neat's claims are without merit and intends to vigorously defend itself in these actions. Avid cannot predict the outcome of these actions at this time and, accordingly, no costs have been accrued for any possible loss contingency.

 

On or about September 26, 2006, Roman Koller filed a complaint against the Company's subsidiary, Sibelius Software Limited, in the District Court of Munich, Germany. The complaint has not yet been served, nor has the Company received a copy of the complaint. Correspondence with Mr. Koller included allegations that German patent DE4143257C2 was infringed by the "FlexiTime" feature in a particular Sibelius product. The Company cannot predict the outcome of this matter, but believes that its disposition will not have a material adverse effect on its financial position. Because the Company cannot predict the outcome of this action at this time, no costs have been accrued for any possible loss contingency.

 

On August 16, 2006, Trevor Blumenau filed a complaint against the Company in the U.S. District Court, Northern District of Texas, alleging infringement of U.S. Patent 5,664,216, entitled “Iconic Audiovisual Data Editing Environment.” The plaintiff seeks unspecified compensatory damages, attorneys’ fees, costs and interest. Prior to the filing of this complaint, the Company was unaware of Mr. Blumenau’s allegations. The complaint has not yet been served. Because the Company cannot predict the outcome of this action at this time, no costs have been accrued for any possible loss contingency.

 

From time to time, the Company provides indemnification provisions in agreements with customers covering potential claims by third parties of intellectual property infringement. These agreements generally provide that the Company will indemnify customers for losses incurred in connection with an infringement claim brought by a third party with respect to the Company’s products. These indemnification provisions generally offer perpetual coverage for infringement claims based upon the products covered by the agreement. The maximum potential amount of future payments the Company could be required to make under these indemnification provisions is theoretically unlimited; however, to date, the Company has not incurred material costs related to these indemnification provisions. As a result, the Company believes the estimated fair value of these indemnification provisions is minimal.

 

As permitted under Delaware law and pursuant to Avid's Third Amended and Restated Certificate of Incorporation, as amended, the Company is obligated to indemnify its current and former officers and directors for certain events that occur or occurred while the officer or director is or was serving in such capacity. The term of the indemnification period is for each respective officer’s or director’s lifetime. The maximum potential amount of future payments the Company could be required to make under these indemnification obligations is unlimited; however, Avid has mitigated the exposure through the purchase of directors and officers insurance, which is intended to limit the risk and, in most cases, enable the Company to recover all or a portion of any future amounts paid. As a result of this insurance policy coverage, the Company believes the estimated fair value of these indemnification obligations is minimal.

 

15

 


The Company currently has a standby letter of credit at a bank that is used as a security deposit in connection with the Company’s Daly City, California office space lease. In the event of default on this lease, the landlord would be eligible to draw against this letter of credit to a maximum, as of September 30, 2006, of $3.5 million. On September 25, 2006, the Company and the landlord entered into an amendment to the lease for this facility that allowed a reduction of the letter of credit to $0.75 million, provided the Company was not in default of the lease. The Company is currently in the process of changing the amount of the letter of credit to $0.75 million. Once it is changed, the letter of credit will remain in effect at $0.75 million throughout the remaining lease period, which extends to September 2014. As of September 30, 2006, the Company was not in default of this lease.

 

The Company, through a third party, provides lease financing options to its customers, including end-users and, on a limited basis, resellers. During the terms of these leases, which are generally three years, the Company remains liable for any unpaid principal balance upon default by the end-user, but such liability is limited in the aggregate based on a percentage of initial amounts funded or, in certain cases, amounts of unpaid balances. At September 30, 2006 and December 31, 2005, Avid’s maximum recourse exposure totaled approximately $12.4 million and $13.0 million, respectively. The Company records revenue from these transactions upon the shipment of products, provided that all other revenue recognition criteria, including collectibility being reasonably assured, are met. Because the Company has been providing these financing options to its customers for many years, the Company has a substantial history of collecting under these arrangements without providing significant refunds or concessions to the end user, reseller or financing party. To date, the payment default rate has consistently been between 2% and 4% per year of the original funded amount. This low default rate results from the diligence of the third party leasing company in screening applicants and in collecting amounts due, and because Avid actively monitors its exposures under the financing program and participates in the approval process for any lessees outside of agreed-upon credit-worthiness metrics. The Company maintains a reserve for estimated losses under this recourse lease program based on these historical default rates applied to the funded amount outstanding at period end. At both September 30, 2006 and December 31, 2005, the Company’s accrual for estimated losses was $1.8 million.

 

Avid provides warranties on externally sourced and internally developed hardware. For internally developed hardware and in cases where the warranty granted to customers for externally sourced hardware is greater than that provided by the manufacturer, the Company records an accrual for the related liability based on historical trends and actual material and labor costs. The warranty period for all of the Company’s products is generally 90 days to one year, but can extend up to five years depending on the manufacturer’s warranty or local law.

 

The following table sets forth the activity in the product warranty accrual account (in thousands):

 

 

 

Nine Months Ended September 30,

 

 

 

2006

 

 

 

2005

 

Accrual balance at beginning of period

 

$

6,190

 

 

 

$

2,261

 

 

 

 

 

 

 

 

 

 

 

Acquired product warranty

 

 

67

 

 

 

 

3,510

 

Accruals for product warranties

 

 

3,994

 

 

 

 

3,458

 

Cost of warranty claims

 

 

(4,253

)

 

 

 

(2,800

)

Accrual balance at end of period

 

$

5,998

 

 

 

$

6,429

 

 

 

16

 


10.         COMPREHENSIVE INCOME

 

Total comprehensive income net of taxes consists of net income and the net changes in foreign currency translation adjustment and net unrealized gains and losses on available-for-sale securities. The following is a summary of the Company’s comprehensive income (in thousands):

 

 

 

Three Months Ended
September 30,

 

 

 

Nine Months Ended
September 30,

 

 

 

2006

 

 

 

2005

 

 

 

2006

 

 

 

2005

 

Net income (loss)

 

$

3,593

 

 

 

$

(17,757

)

 

 

$

9,638

 

 

 

$

15,555

 

Net changes in:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign currency translation adjustment

 

 

(446

)

 

 

 

575

 

 

 

 

3,300

 

 

 

 

(2,611

)

Unrealized gains (losses) on securities

 

 

98

 

 

 

 

4

 

 

 

 

(4

)

 

 

 

139

 

Total comprehensive income (loss)

 

$

3,245

 

 

 

$

(17,178

)

 

 

$

12,934

 

 

 

$

13,083

 

 

11.   

SEGMENT INFORMATION

 

The Company’s organizational structure is based on strategic business units, each of which offers various products to the principal markets in which the Company’s products are sold. These business units equate to three reportable segments: Professional Video, Audio and Consumer Video. The following is a summary of the Company’s operations by reportable segment (in thousands):

 

 

 

Three Months Ended
September 30,

 

 

 

Nine Months Ended
September 30,

 

 

2006

 

 

 

2005

 

 

 

2006

 

 

 

2005

Professional Video:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

126,579

 

 

 

$

118,924

 

 

 

$

361,642

 

 

 

$

318,393

Operating income

 

 

13,620

 

 

 

 

13,402

 

 

 

 

29,982

 

 

 

 

35,600

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Audio:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

74,189

 

 

 

$

66,986

 

 

 

$

221,199

 

 

 

$

193,569

Operating income

 

 

9,305

 

 

 

 

11,144

 

 

 

 

29,096

 

 

 

 

27,476

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Consumer Video:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

30,465

 

 

 

 

$18,510

 

 

 

$

88,688

 

 

 

 

$18,510

Operating income (loss)

 

 

(2,448

)

 

 

 

187

 

 

 

 

(6,492

)

 

 

 

187

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Combined Segments:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

231,233

 

 

 

$

204,420

 

 

 

$

671,529

 

 

 

$

530,472

Operating income

 

 

20,477

 

 

 

 

24,733

 

 

 

 

52,586

 

 

 

 

63,263

 

 

17

 


Certain expenses are not included in the operating results of the reportable segments because management does not consider them in evaluating operating results of the segments. The following table reconciles operating income (loss) for reportable segments to the total consolidated amounts for the three- and nine-month periods ended September 30, 2006 and 2005 (in thousands):

 

 

 

Three Months Ended
September 30,

 

 

 

Nine Months Ended
September 30,

 

 

 

2006

 

 

 

2005

 

 

 

2006

 

 

 

2005

 

Total operating income for reportable segments

 

$

20,477

 

 

 

$

24,733

 

 

 

$

52,586

 

 

 

$

63,263

 

Unallocated amounts:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Restructuring (costs) recoveries

 

 

1,620

 

 

 

 

(1,997

)

 

 

 

554

 

 

 

 

(1,997

)

In-process research and development

 

 

(569

)

 

 

 

(32,390

)

 

 

 

(879

)

 

 

 

(32,390

)

Stock-based compensation

 

 

(4,326

)

 

 

 

(458

)

 

 

 

(13,044

)

 

 

 

(1,830

)

Amortization of acquisition-related intangible assets

 

 

(9,506

)

 

 

 

(6,398

)

 

 

 

(27,244

)

 

 

 

(10,146

)

Consolidated operating income (loss)

 

$

7,696

 

 

 

$

(16,510

)

 

 

$

11,973

 

 

 

$

16,900

 

 

12.   

RESTRUCTURING COSTS AND ACCRUALS

 

During the three months ended September 30, 2006, the Company reached an agreement with the landlord of its Daly City, California facility and executed an amendment to the existing lease for that office space which extended the lease through September 2014. Based on the new terms of the amended lease and the Company's changing facilities requirements, the Company has determined that it will re-occupy the space in this facility that had previously been vacated under a 2002 restructuring plan. Accordingly, the existing $1.5 million restructuring accrual for that facility was reversed during the three months ended September 30, 2006.

 

In March 2006, the Company implemented a restructuring program within the Consumer Video segment under which 23 employees worldwide, primarily in the marketing and selling function and the research and development function, were notified that their employment would be terminated. The purpose of the program was to maximize the efficiency of the Company’s organizational structure. In connection with this action, the Company recorded a charge of $1.1 million. Payments to these employees were completed during the three months ended September 30, 2006, and approximately $0.1 million remaining in the related restructuring accrual was reversed.

 

In December 2005, the Company implemented a restructuring program under which the employment of 20 employees worldwide was terminated and a portion of a leased facility in Montreal, Canada was vacated. In connection with these actions, the Company recorded charges of $0.8 million for employee terminations and $0.5 million for continuing rent obligations on excess space vacated, net of potential sublease income.

 

Also during 2005, the Company recorded a charge of $1.8 million in connection with a revised estimate of the lease obligation associated with a facility that was vacated as part of a restructuring plan in 1999. The revision was necessary due to one of the subtenants in the facility giving notice of their intention to discontinue their sublease. The lease extends through September 2010.

 

The Company recorded these charges in accordance with the guidance of SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” These restructuring charges and accruals require significant estimates and assumptions, including sub-lease income assumptions. These estimates and assumptions are monitored on at least a quarterly basis for changes in circumstances and any corresponding adjustments to the accrual are recorded in the Company’s statement of operations in the period when such changes are known.

 

In connection with the August 2005 Pinnacle acquisition and the January 2006 Medea acquisition, the Company recorded accruals of $14.4 million for Pinnacle in 2005 and $0.3 million for Medea in 2006 related to severance agreements and lease or other contract terminations in accordance with EITF 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination.” Such amounts recorded in connection with the Pinnacle and Medea acquisitions are reflected in the purchase price allocations for the acquisitions and any adjustments to the accruals are recorded as adjustments to goodwill (see Note 3) and are not recorded in the Company’s statement of operations.

 

18

 


 

The following table sets forth the activity in the restructuring and other costs accruals for the nine months ended September 30, 2006 (in thousands):

 

 

 

Non-Acquisition
Related
Restructuring
Liabilities

 

        

 

Acquisition
Related
Restructuring
Liabilities

 

        

 


 

 

 

Employee
Related

 

 

 

Facilities
Related

 

 

 

Employee
Related

 

 

 

Facilities
Related

 

 

 

Total

 

Accrual balance at December 31, 2005

 

$

129

 

 

 

$

4,467

 

 

 

$

2,976

 

 

 

$

2,785

 

 

 

$

10,357

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

New restructuring activities

 

 

1,134

 

 

 

 

 

 

 

 

257

 

 

 

 

 

 

 

 

1,391

 

Revisions of estimated liabilities

 

 

(183

)

 

 

 

(1,504

)

 

 

 

(1,841

)

 

 

 

(656

)

 

 

 

(4,184

)

Accretion

 

 

 

 

 

 

106

 

 

 

 

 

 

 

 

55

 

 

 

 

161

 

Cash payments for employee-related charges

 

 

(1,149

)

 

 

 

 

 

 

 

(932

)

 

 

 

 

 

 

 

(2,081

)

Cash payments for facilities, net of sublease income

 

 

 

 

 

 

(1,248

)

 

 

 

 

 

 

 

(1,084

)

 

 

 

(2,332

)

Foreign exchange impact on ending balance

 

 

69

 

 

 

 

207

 

 

 

 

132

 

 

 

 

138

 

 

 

 

546

 

Accrual balance at September 30, 2006

 

$

 

 

 

$

2,028

 

 

 

$

592

 

 

 

$

1,238

 

 

 

$

3,858

 

 

The employee-related accruals at September 30, 2006 represent severance and outplacement costs to former employees that will be paid out within the next 12 months.

 

The facilities-related accruals at September 30, 2006 represent estimated losses on subleases of space vacated as part of the Company’s restructuring actions. The leases, and payments against the amounts accrued, extend through 2011 unless the Company is able to negotiate earlier terminations.

 

13.   

RECENT ACCOUNTING PRONOUNCEMENTS

 

In September 2006, the Securities and Exchange Commission staff issued Staff Accounting Bulletin No. 108 (“SAB 108”), “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” which was issued in order to eliminate the diversity of practice surrounding how public companies quantify financial statement misstatements. SAB 108 provides interpretive guidance on the consideration of the effects of prior year misstatements for the purpose of materiality assessment and allows application of its provisions either by (1) restating prior financial statements or (2) recording the cumulative effect of applying the guidance as adjustments to the carrying values of assets and liabilities with an offsetting adjustment recorded to the opening balance of retained earnings. SAB 108 will be effective for fiscal years ending after November 15, 2006, or December 31, 2006 for Avid, with early application encouraged in any report for an interim period of the first fiscal year ending after November 15, 2006. The Company is currently completing its assessment of the impact of the adoption of SAB 108, but does not expect that adoption will result in either a restatement of prior year financial statements or changes in its financial position.

 

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 does not require any new fair value measurements, but its provisions apply to all other accounting pronouncements that require or permit fair value measurement. SFAS No. 157 will be effective for fiscal years beginning after November 15, 2007, or January 1, 2008 for Avid. Adoption of SFAS No. 157 is not expected to have a material impact on the Company’s financial position or results of operations.

 

In June 2006, the FASB issued FASB Interpretation No. (“FIN”) 48, “Accounting for Uncertainty in Income Taxes – An Interpretation of FASB Statement No. 109,” which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 will be effective for fiscal years beginning after December 15, 2006, or January 1, 2007 for Avid. The Company has not yet completed its evaluation of the impact of adoption on the Company’s financial position or results of operations.

 

19

 


 

In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets,” an amendment to FASB Statement No. 140. SFAS No. 156 requires recognition of a servicing asset or servicing liability whenever an entity enters into certain service agreements which result in an obligation to service a financial asset, and requires that servicing assets and servicing liabilities be recognized at fair value, if practicable. SFAS No. 156 will be effective for fiscal years beginning after September 15, 2006, or January 1, 2007 for Avid. Adoption of SFAS No. 156 is not expected to have a material impact on the Company’s financial position or results of operations.

 

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments,” an amendment to FASB Statements No. 133 and 140. SFAS No. 155 permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation. SFAS No. 155 will be effective for fiscal years beginning after September 15, 2006, or January 1, 2007 for Avid. As of September 30, 2006, the Company did not have any hybrid financial instruments subject to the fair value election of SFAS No. 155.

 

In November 2005, the FASB issued FASB Staff Position No. FAS 123(R)-3, “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards.” The Company is considering whether to adopt the alternative transition method provided in the FASB Staff Position (“FSP”) for calculating the tax effects of stock-based compensation pursuant to SFAS 123(R). The alternative transition method includes simplified methods to establish the beginning balance of the additional paid-in capital pool (“APIC Pool”) related to the excess tax benefits available to absorb tax deficiencies recognized subsequent to the adoption of SFAS 123(R). The Company is currently evaluating which transition method it will use for calculating its APIC Pool. An entity may take up to one year from the later of its initial adoption of SFAS 123(R) or the effective date of this FSP to evaluate its available transition alternatives and make its one-time election. Until and unless the Company elects the transition method described in the FSP, the transition method provided in SFAS 123(R) is being followed. The Company expects to complete its evaluation by December 31, 2006.

 

In June 2005, the FASB issued FSP No. FAS 143-1, “Accounting for Electronic Equipment Waste Obligations,” or FSP 143-1, which provides guidance on the accounting for obligations associated with the European Union, or EU, Directive on Waste Electrical and Electronic Equipment, or the WEEE Directive. FSP 143-1 provides guidance on how to account for the effects of the WEEE Directive with respect to historical waste associated with products in the market on or before August 13, 2005. FSP 143-1 is required to be applied to the later of the first reporting period ending after June 8, 2005 or the date of the adoption of the WEEE Directive into law by the applicable EU member country. The Company is in the process of registering with the member countries, as appropriate, and is still awaiting guidance from these countries with respect to the compliance costs and obligations for historical waste. Avid will continue to work with each country to obtain guidance and will accrue for compliance costs when they are probable and reasonably estimable. The accruals for these compliance costs may have a material impact on the Company’s financial position or results of operations when guidance is issued by each member country.

 

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

 

EXECUTIVE OVERVIEW

 

We develop, market, sell and support a wide range of software and hardware products for digital media production, management and distribution. Digital media are video, audio or graphic elements in which an image or sound is recorded and stored in digital values, as opposed to analog, or tape-based, signals. Our diverse range of product and service offerings enables customers to “Make, Manage and Move Media.”

 

Make Media . Our products help every class of user create and use video and audio assets, from the home user to the feature film professional. We are organized into strategic business units, or reportable segments, that reflect the principal markets in which our products are sold: Professional Video, Audio and Consumer Video. Our Professional Video segment offers innovative video and film editing systems, as well as 3D and special-effects software. These products enable professionals, and aspiring professionals, in the post-production and broadcast markets to manipulate moving pictures and sound in fast, easy, creative and cost-effective ways. Our Audio segment offers consumer and professional digital audio software applications and hardware systems for music, film, television, video, broadcast, streaming media and web development. These systems are based upon proprietary audio hardware, software and control surfaces, and allow users to record, edit, mix, process and master audio in an integrated manner. Our Consumer Video segment offers products for home video editing and TV viewing. Our home video editing products allow users to create, edit and share video content more easily and effectively, while our TV viewing products allow consumers to view, record and time shift television programming on their computers.

 

Manage Media . The ability to manage digital media assets effectively is a critical component of success for all content creators. Our technology enables users to simultaneously share and manage media assets throughout a project or organization. As a result, professionals can collaborate in real time on all production elements and streamline the process for cost-effective management and delivery of media. In addition, our tools allow customers to easily repurpose digital assets to take advantage of a variety of market opportunities. For consumer applications, we also offer products that allow users to manage their media projects, such as home movies or recorded music.

 

Move Media . Our products allow our customers to distribute media over multiple platforms - including air, cable or satellite, or on the Internet. In addition, we provide technology for playback directly to air for broadcast television applications. Many of our products also support the broadcast of streaming Internet video. For professionals as well as consumers, our laptop-based editing systems, storage products and DVD authoring tools enable easy portability of media.

 

Our products are used worldwide in production and post-production facilities; film studios; network, affiliate, independent and cable television stations; recording studios; performance venues; advertising agencies; government and educational institutions; corporate communication departments; and by game developers and Internet professionals, as well as by amateurs, aspiring professionals and home hobbyists. Projects produced by customers using our products have been honored with Oscar®, Emmy® and Grammy® awards, in addition to a host of other international awards. We have also received numerous awards for technical innovations, including two Oscar awards, 12 Emmy awards and a Grammy award. Oscar is a registered trademark and service mark of the Academy of Motion Picture Arts and Sciences. Emmy is a registered trademark of ATAS/NATAS. Grammy is a registered trademark of The National Academy of Recording Arts and Sciences, Inc.

 

Our strategy consists of four key elements: deliver best of breed stand-alone products, deliver integrated workflow for customers with multiple systems, support open standards for media and deliver excellent customer service. We continue to focus on enhancing our existing products and broadening our product offerings to satisfy customer demand for new technology across the spectrum of educational to consumer to professional markets. We continue to position ourself and deliver new products and services to benefit from a number of important industry trends, including the move to high-definition, or HD, in television production, the switch to all-digital production in broadcast, the growth of home audio studios, the move to digital audio mixing and the growth of consumer video

 

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editing and consumption. Our products may be developed internally or through acquisitions. As part of this strategy, we made the following acquisitions in 2006.

 

 

On July 28, 2006, we acquired Sibelius Software Limited, a UK-based music applications software company and a leading provider of music notation software in the education and professional markets. Our acquisition of Sibelius will allow us to broaden our Audio product offerings and accelerate our expansion into the educational market.

 

 

On April 13, 2006, we acquired Sundance Digital, Inc., a Texas-based developer of automation and device control software for broadcast video servers, tape transports, graphics systems and other broadcast station equipment. The acquisition of Sundance will allow us to offer more open and streamlined broadcast production workflows across the entire spectrum of media acquisition, production and transmission.

 

 

On January 12, 2006, we acquired Medea Corporation, a California-based provider of local storage solutions for real-time media applications. The acquisition of Medea will allow us to provide high performance, low cost RAID (Redundant Array of Independent Disks) storage solutions to our Professional Video customers.

 

Total net revenues for the first nine months of 2006 were $671.5 million, an increase of $141.1 million, or 27%, compared to the first nine months of last year. Approximately 74% of this increase represents net revenues in 2006 from Pinnacle, which was acquired in the third quarter of 2005.

 

Net income for the first nine months of 2006 was $9.6 million, a decrease of $5.9 million, or 38%, from $15.6 million for the same period in 2005. Net income for the first nine months of 2006 includes $28.1million of acquisition-related amortization of intangible assets and in-process research and development expense compared to $42.5 million for the same period in 2005. Our net income for the first nine months of 2006 also includes $12.3 million of stock-based compensation expense resulting from the adoption of Statement of Financial Accounting Standard No. 123 (revised 2004), “Share-Based Payment,” or SFAS 123(R), on January 1, 2006. Our operating activities continue to generate positive cash flow with cash of $22.7 million provided by operating activities in the first nine months of 2006, compared to $39.3 million for the same period last year.

 

In our Professional Video segment, net revenues increased 14% to $362 million for the nine months ended September 30, 2006 as compared to the same period in 2005, while segment operating income decreased 16% to $30 million. Of the total revenue increase, 77% relates to our August 2005 acquisition of the Pinnacle broadcast video business. Segment operating income excludes stock-based compensation, amortization of intangible assets and in-process research and development expense, as these costs are not considered when evaluating the operating results of our segments. The decrease in operating income reflects lower gross margins, which are primarily from changes in product mix, largely due to the acquisitions of the Pinnacle and Medea businesses, as well as an unfavorable impact from foreign currency fluctuations on revenue.

 

In our Audio segment, net revenues increased 14% to $221 million for the nine months ended September 30, 2006 as compared to the same period in 2005, while segment operating income increased 6% to $29 million. The increase in revenues represents continued strong demand for our products in both the professional and home user markets with increased revenues from the Digidesign mixing consoles (ICON), the new live sound product line (Venue) and the M-Audio product lines.

 

The Consumer Video segment was formed as part of our August 2005 acquisition of Pinnacle, so comparisons of revenues and segment operating results for nine months ended September 30, 2006 to the same period in 2005 are not meaningful. For the nine months ended September 30, 2006, this segment had net revenues of $89 million and an operating loss of $6.5 million. Due to the seasonality of the consumer business, a significant portion of this segment's net revenues are received in the fourth quarter of the calendar year. We have made operational changes in this segment to address recent product reliability issues and ensure that the business runs as efficiently as possible. We have also been focusing on several operating initiatives, including marketing and sales efforts to meet consumer demand, expansion of the channel and new product development efforts. We expect to see improvement for this segment in the fourth quarter as a result of the upcoming holiday buying season and our operating initiatives.

 

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CRITICAL ACCOUNTING POLICIES AND ESTIMATES

 

The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles and our discussion and analysis of our financial condition and results of operations requires us to make judgments, assumptions and estimates that affect the amounts reported in our consolidated financial statements and accompanying notes. Note B of the Notes to Consolidated Financial Statements in our 2005 Annual Report on Form 10-K describes the significant accounting policies and methods used in the preparation of our consolidated financial statements. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances, the results of which form the basis for judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates.

 

We believe that our critical accounting policies are those related to revenue recognition and allowances for product returns and exchanges, allowance for bad debts and reserves for recourse under financing transactions, inventories, business combinations, goodwill and intangible assets, stock-based compensation and income tax assets. We believe these policies are critical because they are important to the portrayal of our financial condition and results of operations, and they require us to make judgments and estimates about matters that are inherently uncertain. Additional information about our critical accounting policies, except stock-based compensation, may be found in our 2005 Annual Report on Form 10-K in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” under the heading “Critical Accounting Policies and Estimates.” The critical accounting policy for stock-based compensation, which follows, was added to our Quarterly Report on Form 10-Q for the quarter ended March 31, 2006, as a result of the adoption of SFAS 123(R) on January 1, 2006.

 

Stock-Based Compensation

 

During the first quarter of 2006, we adopted the provisions of and accounted for stock-based compensation in accordance with Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” which is a revision of SFAS No. 123, “Accounting for Stock Based Compensation.” SFAS 123(R) requires employee stock-based compensation awards to be accounted for under the fair value method and eliminates the ability to account for these instruments under the intrinsic value method as prescribed by Accounting Principles Board, or APB, Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations. We adopted SFAS 123(R) on January 1, 2006 using the modified prospective application method as permitted under SFAS 123(R). Under this method, we are required to record compensation cost, based on the fair value estimated in accordance with SFAS 123(R), for stock-based awards granted after the date of adoption over the requisite service periods for the individual awards, which generally equals the vesting period. We are also required to record compensation cost for the unvested portion of previously granted stock-based awards outstanding at the date of adoption over the requisite service periods for the individual awards based on the fair value estimated in accordance with the original provisions of SFAS No. 123 adjusted for forfeitures as required by SFAS 123(R).

 

Prior to the adoption of SFAS 123(R), we accounted for stock-based compensation under the recognition and measurement principles of APB Opinion No. 25 and related interpretations. Accordingly, no compensation expense was recorded for options issued to employees and non-employee directors in fixed amounts and with fixed exercise prices at least equal to the market price of our common stock at the date of grant. In connection with our acquisition of M-Audio in August 2004, we granted options to certain M-Audio employees at exercise prices that were less than the market price of our common stock at the date of grant. We recorded the difference between the exercise prices and the fair value of the options at the date of completion of the acquisition, determined under the Black-Scholes method, multiplied by the number of shares underlying the options, as deferred compensation. The resulting deferred compensation is being expensed over the vesting period of the options. Additionally, deferred compensation was recorded for restricted stock granted to employees based on the market price of our common stock at the date of grant, which is being expensed over the period in which the restrictions lapse. In connection with the adoption of SFAS 123(R) on January 1, 2006, we reversed the remaining deferred compensation of $1.8 million, with the offset to additional paid-in capital.

 

In anticipation of the adoption of SFAS 123(R), on October 26, 2005, our board of directors approved a partial acceleration of the vesting of all outstanding options to purchase our common stock that were granted on February 17, 2005. Vesting was accelerated for options to purchase 371,587 shares of our common stock with an exercise price of $65.81 per share, including options to purchase 157,624 shares of our common stock held by our executive officers.

 

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The decision to accelerate vesting of these options was made to avoid recognizing compensation cost related to these out-of-the money options in our future statements of operations upon the adoption of SFAS 123(R). It is estimated that the maximum future compensation expense that would have been recorded in our statements of operations had the vesting of these options not been accelerated is approximately $4.4 million.

 

The fair values of restricted stock awards, including restricted stock and restricted stock units, are based on the intrinsic values of the awards at the date of grant. As permitted under SFAS No. 123 and SFAS 123(R), we use the Black-Scholes option pricing model to estimate the fair value of stock option grants. The Black-Scholes model relies on a number of key assumptions to calculate estimated fair values. Our assumed dividend yield of zero is based on the fact that we have never paid cash dividends and have no present intention to pay cash dividends. Since adoption of SFAS 123(R) on January 1, 2006, the expected stock-price volatility assumption used by us has been based on recent (six month trailing) implied volatility calculations. These calculations are performed on exchange traded options of our stock. We believe that using a forward-looking market driven volatility assumption will result in the best estimate of expected volatility. Prior to adoption of SFAS 123(R), the expected volatility was based on the historical volatility of the underlying stock. The assumed risk-free interest rate is the U.S. Treasury security rate with a term equal to the expected life of the option. The assumed expected life is based on company-specific historical experience. With regard to the estimate of the expected life, we consider the exercise behavior of past grants and model the pattern of aggregate exercises. Based on our historical turnover rates, an annualized estimated forfeiture rate of 6.5% has been used in calculating the estimated compensation cost for the three- and nine-month periods ending September 30, 2006. Additional expense will be recorded if the actual forfeiture rates are lower than estimated, and a recovery of prior expense will be recorded if the actual forfeitures are higher than estimated. Prior to the adoption of SFAS 123(R), forfeitures were not estimated at the time of award.

 

If factors change and we employ different assumptions for estimating stock-based compensation expense in future periods, or if we decide to use a different valuation model, the stock-based compensation expense we recognize in future periods may differ significantly from what we have recorded in the current period and could materially affect our operating income, net income and earnings per share. It may also result in a lack of comparability with other companies that use different models, methods and assumptions. The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. These characteristics are not present in our option grants. Existing valuation models, including the Black-Scholes model, may not provide reliable measures of the fair values of our stock-based compensation. Consequently, there is a risk that our estimates of the fair values of our stock-based compensation awards on the grant dates may bear little resemblance to the actual values realized upon the exercise, expiration, early termination or forfeiture of those stock-based payments in the future. Certain stock-based payments, such as employee stock options, may expire with little or no intrinsic value compared to the fair values originally estimated on the grant date and reported in our financial statements. Alternatively, the value realized from these instruments may be significantly higher than the fair values originally estimated on the grant date and reported in our financial statements. The guidance in SFAS 123(R) is relatively new and the application of these principles may be subject to further interpretation and refinement over time. See Note 7 of the Condensed Consolidated Financial Statements in Item 1 for further information regarding our adoption of SFAS 123(R).

 

During the first quarter of 2006, we granted restricted stock units, rather than stock options, as part of our annual stock-based compensation program. During the first three quarters of 2006, we also granted restricted stock and stock options to new hires and for other purposes. In the future, we may grant either stock awards, options, or other equity-based instruments allowed by our stock-based compensation plans, or a combination thereof, as part of our overall compensation strategy.

 

RESULTS OF OPERATIONS

 

Net Revenues

 

We develop, market, sell and support a wide range of software and hardware for digital media production, management and distribution. Our net revenues are derived mainly from the sales of computer-based digital, nonlinear media editing and finishing systems and related peripherals including shared storage systems, licensing of software and sales of related software maintenance contracts.

 

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The following is a summary of our net revenues by segment for the three- and nine-month periods ended September 30, 2006 and 2005, respectively:

 

 

Three Months Ended September 30,

 

(dollars in thousands)

 

2006

Net Revenues

 

% of Consolidated Net Revenues

 

2005

Net Revenues

 

% of Consolidated Net Revenues

 

Change

 

% Change

in Revenues

Professional Video:

 

 

 

 

 

 

 

 

 

 

 

Product revenues

$98,789

 

42.7%

 

$98,307

 

48.1%

 

$482

 

0.5%

Services revenues

27,790

 

12.0%

 

20,617

 

10.1%

 

7,173

 

34.8%

Total

126,579

 

54.7%

 

118,924

 

58.2%

 

7,655

 

6.4%

 

 

 

 

 

 

 

 

 

 

 

 

Audio: