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REALNETWORKS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) This Quarterly Report on Form 10-Q and the documents incorporated herein by reference contain forward-looking statements that have been made pursuant to the provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on current expectations, estimates, and projections about RealNetworks' industry, products, management's beliefs, and certain assumptions made by management. Words such as "anticipates," "expects," "intends," "plans," "believes," "seeks," "estimates," and similar expressions are intended to identify forward-looking statements. All statements contained in this report that do not relate to matters of historical fact should be considered forward-looking statements. Forward-looking statements include statements with respect to: • the expected benefits and other consequences of our growth plans, strategic initiatives, and restructurings; • our expected introduction, and related monetization, of new and enhanced products, services and technologies across our businesses; • future revenues, operating expenses, income and other taxes, tax benefits, net income (loss) per diluted share available to common shareholders, acquisition costs and related amortization, and other measures of results of operations; • the effects of our past acquisitions and expectations for future acquisitions and divestitures; • plans, strategies and expected opportunities for future growth, increased profitability and innovation; • the expected financial position, performance, growth and profitability of, and investment in, our businesses and the availability of resources; • the effects of legislation, regulations, administrative proceedings, court rulings, settlement negotiations and other factors that may impact our businesses; • the continuation and expected nature of certain customer relationships; • impacts of competition and certain customer relationships on the future financial performance and growth of our businesses; • our involvement in potential claims, legal proceedings and government investigations, and the potential outcomes and effects of such potential claims, legal proceedings and governmental investigations on our business, prospects, financial condition or results of operations; • the effects of U.S. and foreign income and other taxes on our business, prospects, financial condition or results of operations; and • the effect of economic and market conditions on our business, prospects, financial condition or results of operations. These statements are not guarantees of future performance and actual actions or results may differ materially. These statements are subject to certain risks, uncertainties and assumptions that are difficult to predict, including those noted in the documents incorporated herein by reference. Particular attention should also be paid to the cautionary language in Item 1A of Part II entitled "Risk Factors." RealNetworks undertakes no obligation to update publicly any forward-looking statements as a result of new information, future events or otherwise, unless required by law. Readers should, however, carefully review the risk factors included in other reports or documents filed by RealNetworks from time to time with the Securities and Exchange Commission, particularly the Quarterly Reports on Form 10-Q and any Current Reports on Form 8-K. Overview RealNetworks creates innovative products and services that make it easy to connect with and enjoy digital media. We invented the streaming media category in 1995 and continue to connect consumers with their digital media both directly and through partners, aiming to support every network, device, media type and social network. We manage our business and report revenue and operating income (loss) in three segments: (1) RealPlayer Group, (2) Mobile Entertainment, and (3) Games. Within our RealPlayer Group, revenue is derived from the sale of our RealPlayer media player software and related products, such as the distribution of third party software products, advertising on RealPlayer websites, and sales of RealPlayer Plus software licenses to consumers, sales of intellectual property licenses, and consumer subscriptions such as SuperPass and our RealPlayer Cloud service. Our Mobile Entertainment business generates revenue from the sale of its SaaS services, which include ringback tones, music on demand, intercarrier messaging, and our LISTEN product, and sales of technology licenses of our software products such as Helix. Our Games business, through its Slingo, GameHouse and Zylom brands, derives revenue from sales of games licenses, online games subscription services, advertising on games sites and social networks, microtransactions within online and social games, and sales of mobile games. We allocate certain corporate expenses which are directly attributable to supporting our businesses, including but not limited to a portion of finance, legal, human resources and headquarters facilities, to our reportable segments. The allocation of these costs to our business units ensures accountability for financial and operational performance within each of our reportable segments. Our most significant expenses relate to cost of revenue, compensating employees, and selling and marketing our products and services. 16 -------------------------------------------------------------------------------- For the quarter and nine months ended September 30, 2014, our consolidated revenue declined by $14.8 million and $34.9 million, respectively, compared to the same periods in 2013. The decline in revenue for the quarter in our RealPlayer Group was $11.1 million, $3.0 million in Games and $0.8 million in Mobile Entertainment. For the year to date period, the decline was primarily due to a decline of $28.1 million in our RealPlayer Group and a decline of $10.1 million in Games. For the year to date period, revenue increased by $3.3 million in Mobile Entertainment. Revenue from our legacy products continues to decline as a result of certain changes in our businesses and market-driven factors. In our RealPlayer Group segment, revenue suffered from pricing pressure and lower distribution in our intellectual property licensing business as well as lower rates, distribution and installations from transitioning to a new partner in our third party software distribution business. Moreover, as we focus more of our distribution and marketing efforts on our new RealPlayer Cloud service, sales of RealPlayer Plus licenses are declining, resulting in reduced revenue. The business also continues to be negatively impacted by a decline in subscribers, attributable solely to our SuperPass product. These changes have also negatively impacted gross margins in the RealPlayer Group, as described in more detail in Segment Operating Results below. In our Games segment, our business continues to be challenged in line with overall trends in the online games market, including the shift from downloadable PC games to social networks and mobile devices. In our Mobile Entertainment segment, the revenue increase in the year-to-date period was related primarily to our music on demand services in Korea and our acquisition of Muzicall in the third quarter of 2013, which increased our direct-to-consumer ringback tones revenue. Partially offsetting these increases was a loss in revenue due to termination of carrier contracts. Over the past several quarters we have developed a growth plan, implemented strategic initiatives, and executed certain restructuring efforts, all in an effort to grow our businesses, move towards profitability, and streamline our operations. In line with our growth plan, we continue to invest in each of our three business units. During the first half of 2014, we released RealPlayer Cloud worldwide. This global roll out allows us to reach our base of millions of active RealPlayer users around the world. In our Mobile Entertainment business we continue our efforts to roll out our new LISTEN product. LISTEN leverages our pioneering leadership in ringback tones, and our large, global installed base of over 18 million active ringback tone subscribers with more than 20 carriers worldwide, to create a hybrid distribution model that combines partnership with carriers with direct-to-consumer marketing. In our Games business, we launched Slingo Adventure worldwide on Facebook in mid-September and plan to launch the product on mobile platforms worldwide during the fourth quarter of 2014. We expect to continue to invest heavily in our growth initiatives, including further development and marketing efforts around our products. These investments have negatively impacted our recent operating results, which may continue until the expected revenue growth materializes. During the quarter ended March 31, 2014 certain accrued royalty liabilities of $10.6 million associated with our historical music business, which had originally been recorded based on statutory rates, were extinguished. Condensed consolidated results of operations were as follows (dollars in thousands): Quarters ended September 30, 2014 Nine months ended September 30, 2014 2014 2013 $ Change % Change 2014 2013 $ Change % Change Total revenue $ 34,157 $ 48,958 $ (14,801 ) (30 )% $ 120,706 $ 155,601 $ (34,895 ) (22 )% Cost of revenue 18,928 18,990 (62 ) - % 58,500 59,015 (515 ) (1 )% Extinguishment of liability - - - - % (10,580 ) - (10,580 ) (100 )% Gross profit 15,229 29,968 (14,739 ) (49 )% 72,786 96,586 (23,800 ) (25 )% Gross margin 45 % 61 % 60 % 62 % Operating expenses 35,992 58,405 (22,413 ) (38 )% 121,257 152,953 (31,696 ) (21 )% Operating income (loss) $ (20,763 ) $ (28,437 ) $ 7,674 27 % $ (48,471 ) $ (56,367 ) $ 7,896 (14 )% In the third quarter of 2014, our total consolidated revenue declined by $14.8 million, compared with the year-earlier period. The reduction in revenue resulted from a decline of $11.1 million in our RealPlayer Group segment, $3.0 million in our Games segment, and $0.8 million in Mobile Entertainment, due to the factors described above. Gross margin decreased to 45% from 61% during the quarter ended September 30, 2014, primarily related to our RealPlayer segment, as described in more detail in Segment Operating Results below. Operating expenses decreased by $22.4 million in the quarter ended September 30, 2014, compared with the prior year, primarily due to a litigation settlement of $11.5 million in the prior year, reduced marketing costs in 2014 of $4.6 million in line with the decrease in our third party distribution revenue and reductions in personnel and related costs of $2.4 million. 17 -------------------------------------------------------------------------------- For the nine months ended September 30, 2014, our consolidated revenue declined by $34.9 million, compared with the year-earlier period. The reduction in revenue primarily resulted from a decline of $28.1 million in our RealPlayer Group and a decline of $10.1 million in our Games segment, due to the factors described above, partially offset by an increase in Mobile Entertainment revenue of $3.3 million primarily due to an increase in music on demand services in Korea. Gross margin decreased to 60% from 62% for the year-earlier period primarily due to a decline in higher margin revenue. Operating expenses decreased by $31.7 million in the nine months ended September 30, 2014, compared with the prior year, primarily due to a litigation settlement of $11.5 million in the prior year and reduced marketing costs in 2014 of $6.5 million and reductions in personnel and related costs of $7.4 million. Segment Operating Results RealPlayer Group RealPlayer Group segment results of operations were as follows (dollars in thousands): Quarters ended September 30, 2014 Nine months ended September 30, 2014 2014 2013 $ Change % Change 2014 2013 $ Change % Change Revenue $ 6,565 $ 17,641 $ (11,076 ) (63 )% $ 30,336 $ 58,407 $ (28,071 ) (48 )% Cost of revenue 3,566 3,264 302 9 % 10,704 12,984 (2,280 ) (18 )% Gross profit 2,999 14,377 (11,378 ) (79 )% 19,632 45,423 (25,791 ) (57 )% Gross margin 46 % 81 % 65 % 78 % Operating expenses 12,392 14,449 (2,057 ) (14 )% 42,668 44,656 (1,988 ) (4 )% Operating income (loss) $ (9,393 ) $ (72 ) $ (9,321 ) - % $ (23,036 ) $ 767 $ (23,803 ) - % Total RealPlayer Group revenue decreased by $11.1 million in the quarter ended September 30, 2014, compared with the year-earlier period. This decrease was primarily a result of our transition to a new third party distribution partner, which resulted in lower rates, decreased distribution and decreased installations compared to our previous partner resulting in a decrease of $5.4 million in our third party distribution revenue. In addition, lower distribution of intellectual property licenses decreased revenue by $2.0 million. Further contributing to the decline was a decrease in RealPlayer Plus license revenue of $1.8 million due to our focus on increasing RealPlayer Cloud subscriptions. Total RealPlayer Group revenue decreased by $28.1 million in the nine months ended September 30, 2014, compared with the year-earlier period. This decrease was primarily a result of reduced rates that caused a decrease in our third party distribution revenue by $11.2 million and lower subscriptions revenue of $4.7 million due to fewer subscribers, attributable solely to our SuperPass product. Further contributing to the decline was a decrease in RealPlayer license revenue of $5.3 million due to our focus on increasing RealPlayer Cloud subscriptions and a decrease of $4.7 million in distribution of intellectual property licenses. Cost of revenue decreased by $2.3 million during the nine months ended September 30, 2014, compared with the year-earlier period. Costs related to our RealPlayer Plus licensing business decreased by $1.2 million due to lower license royalties. Costs related to our subscription business declined $1.0 million in connection with lower subscription revenue. Gross margin during the quarter ended September 30, 2014 declined primarily as a result of our transition to a new third party distribution partner at significantly lower rates compared to our previous partner. Although gross margins will be lower on the revenue derived under our new third party distribution arrangement, we expect that our marketing costs related to this business will decline as well. Operating expenses decreased by $2.1 million and $2.0 million, respectively, in the quarter and nine months ended September 30, 2014, compared with the year-earlier period primarily due to decreased marketing spend related to our third party distribution arrangements. Mobile Entertainment Mobile Entertainment segment results of operations were as follows (dollars in thousands): 18 -------------------------------------------------------------------------------- Quarters ended September 30, 2014 Nine months ended September 30, 2014 2014 2013 $ Change % Change 2014 2013 $ Change % Change Revenue $ 19,190 $ 19,948 $ (758 ) (4 )% $ 62,285 $ 59,035 $ 3,250 6 % Cost of revenue 12,626 11,972 654 5 % 38,874 33,974 4,900 14 % Gross profit 6,564 7,976 (1,412 ) (18 )% 23,411 25,061 (1,650 ) (7 )% Gross margin 34 % 40 % 38 % 42 % Operating expenses 7,086 9,453 (2,367 ) (25 )% 26,126 26,976 (850 ) (3 )% Operating income (loss) $ (522 ) $ (1,477 ) $ 955 65 % $ (2,715 ) $ (1,915 ) $ (800 ) (42 )% Total Mobile Entertainment revenue decreased by $0.8 million in the quarter ended September 30, 2014, compared with the year-earlier period. A decrease of $2.2 million was primarily due to discounts in our ringback tones business, the termination of our carrier application services in Asia and a decrease in our direct to consumer business that was part of our Muzicall acquisition in 2013. Partially offsetting this decrease was an increase in music on demand revenue of $1.4 million in our Korea business. Total Mobile Entertainment revenue increased by $3.3 million in the nine months ended September 30, 2014, compared with the year-earlier period. The increase was primarily due to an increase of $6.7 million in music on demand revenue in Korea and an increase of $1.7 million in our direct to consumer ringback tones business due to our Muzicall acquisition. Partially offsetting this increase was a decrease of $2.7 million due to termination of carrier contracts, in addition to slower growth in our ringback tones business of $0.7 million and $1.5 million related to the termination of our video on demand service in 2013. Cost of revenue increased by $0.7 million and $4.9 million in the quarter and nine months ended September 30, 2014, respectively, compared with the year-earlier periods, primarily due to an increase in label royalties related to our music on demand services. This is partially offset by a decrease of $0.5 million and $1.6 million in the quarter and nine months ended September 30, 2014, respectively, from our integrated music project. Gross margin declined for the quarter and nine months ended September 30, 2014, due to a decline in higher margin revenues. Operating expenses decreased by $2.4 million for the quarter ended September 30, 2014, compared with the year-earlier period, primarily due to savings of $1.1 million in marketing related expenses and a decrease of $0.8 million due to reductions in personnel and related costs. Games Games segment results of operations were as follows (dollars in thousands): Quarters ended September 30, 2014 Nine months ended September 30, 2014 2014 2013 $ Change % Change 2014 2013 $ Change % Change Revenue $ 8,402 $ 11,369 $ (2,967 ) (26 )% $ 28,085 $ 38,159 $ (10,074 ) (26 )% Cost of revenue 2,573 3,216 (643 ) (20 )% 8,419 10,397 (1,978 ) (19 )% Gross profit 5,829 8,153 (2,324 ) (29 )% 19,666 27,762 (8,096 ) (29 )% Gross margin 69 % 72 % 70 % 73 % Operating expenses 8,658 11,513 (2,855 ) (25 )% 27,193 35,120 (7,927 ) (23 )% Operating income (loss) $ (2,829 ) $ (3,360 ) $ 531 16 % $ (7,527 ) $ (7,358 ) $ (169 ) (2 )% Total Games revenue decreased by $3.0 million in the quarter ended September 30, 2014, compared with the year-earlier period. Lower revenue from our subscription products, licensing and advertising due to continued declines in our storefront and subscription businesses contributed $1.4 million, $0.4 million and $0.8 million, respectively, to the overall decrease. Total Games revenue decreased by $10.1 million in the nine months ended September 30, 2014, compared with the year-earlier period. Lower revenue from our subscription products, licensing and advertising due to continued declines in our storefront and subscription businesses contributed $4.0 million, $2.5 million and $2.7 million, respectively, to the overall decrease. Cost of revenue decreased by $0.6 million and $2.0 million in the quarter and nine months ended September 30, 2014, respectively, compared with the year-earlier period. The decreases were due to the decrease in partner royalties expense, which 19 -------------------------------------------------------------------------------- has a direct correlation with the decrease in Games revenue. The decrease in cost of revenue was also due to a decline in our advertising business. Gross margin declined during the quarter and nine months ended September 30, 2014 to 69% from 72% and to 70% from 73%, respectively, due primarily to a higher proportion of lower margin revenue in the current year. Operating expenses declined by $2.9 million in the quarter ended September 30, 2014, compared with the year-earlier period. The decrease was due to reductions in personnel and related costs of $1.1 million and reduced marketing spend of $1.4 million. Operating expenses declined by $7.9 million in the nine months ended September 30, 2014, compared with the year-earlier period. The decrease was due to reductions in personnel and related costs of $2.4 million and reduced marketing spend of $3.7 million. Corporate We allocate certain corporate expenses which are directly attributable to supporting the business to our reportable segments. These allocated corporate expenses include but are not limited to a portion of finance, legal, human resources and headquarters facilities. Remaining expenses, which are not directly attributable to supporting the business, are reported as corporate items. All restructuring, and lease exit and related charges, are included in the corporate segment. Corporate segment results of operations were as follows (dollars in thousands): Quarters ended September 30, 2014 Nine months ended September 30, 2014 2014 2013 $ Change % Change 2014 2013 $ Change % Change Cost of revenue $ 163 $ 538 $ (375 ) (70 )% $ 503 $ 1,660 $ (1,157 ) (70 )% Extinguishment of liability - - - - % (10,580 ) - (10,580 ) (100 )%Operating expenses 7,856 22,990 (15,134 ) (66 )% 25,270 46,201 (20,931 ) (45 )% Operating income (loss) $ (8,019 ) $ (23,528 ) $ 15,509 66 % $ (15,193 ) $ (47,861 ) $ 32,668 68 % During the quarter ended March 31, 2014 certain accrued royalty liabilities of $10.6 million associated with our historical music business, which had originally been recorded based on statutory rates, were extinguished. Operating expenses decreased by $15.1 million in the quarter ended September 30, 2014 compared with the year-earlier period. The decrease was primarily due to a litigation settlement of $11.5 million in the prior year and $2.1 million in savings from the relocation of our Seattle headquarters. Operating expenses decreased by $20.9 million in the nine months ended September 30, 2014, compared with the year-earlier period. The decrease was primarily due to a litigation settlement of $11.5 million in the prior year and $2.4 million of reduced expense for lease exit charges. An additional savings of $4.0 million resulted from the relocation of our Seattle headquarters. Consolidated Operating Expenses Our operating expenses consist primarily of salaries and related personnel costs including stock based compensation, consulting fees associated with product development, sales commissions, amortization of certain intangible assets capitalized in our acquisitions, professional service fees, advertising costs, and restructuring charges. Operating expenses were as follows (dollars in thousands): Quarters ended September 30, 2014 Nine months ended September 30, 2014 2014 2013 $ Change % Change 2014 2013 $ Change % Change Research and development $ 12,784 $ 15,707 $ (2,923 ) (19 )% $ 40,110 $ 45,951 $ (5,841 ) (13 )% Sales and marketing 13,283 19,427 (6,144 ) (32 )% 51,022 59,830 (8,808 ) (15 )% General and administrative 7,723 9,869 (2,146 ) (22 )% 25,617 28,506 (2,889 ) (10 )% Restructuring and other charges 2,048 1,877 171 9 % 3,805 4,075 (270 ) (7 )% Lease exit and related charges 154 - 154 - 703 3,066 (2,363 ) (77 )% Loss on litigation settlements - 11,525 (11,525 ) 100 % - 11,525 (11,525 ) 100 % Total consolidated operating expenses $ 35,992 $ 58,405 $ (22,413 ) (38 )% $ 121,257 $ 152,953 $ (31,696 ) (21 )% 20-------------------------------------------------------------------------------- Research and development expenses decreased by $2.9 million and $5.8 million, respectively, in the quarter and nine months ended September 30, 2014, compared with the year-earlier period. The decrease was primarily due to savings resulting from the relocation of our Seattle headquarters of $1.5 million and $3.8 million, respectively. Sales and marketing expenses decreased by $6.1 million in the quarter ended September 30, 2014, compared with the year-earlier period. The decrease was primarily due to reduced marketing spend of $4.6 million and $0.9 million in reduced personnel and related costs. Sales and marketing expenses decreased by $8.8 million in the nine months ended September 30, 2014, compared with the year-earlier period. The decrease was primarily due to reduced marketing spend of $6.5 million and $1.5 million from the relocation of our Seattle headquarters. General and administrative expenses decreased by $2.1 million in the quarter ended September 30, 2014, compared with the year-earlier period. The decrease was primarily due to higher legal fees related to litigation in the prior year and tax refunds. General and administrative expenses decreased by $2.9 million in the nine months ended September 30, 2014, compared with the year-earlier period. The decrease was primarily due to $1.8 million in higher legal fees related to ligation in the prior year. Restructuring and other charges and Lease exit and related charges consist of costs associated with the ongoing reorganization of our business operations and our ongoing expense alignment efforts. The restructuring expense amounts in both years primarily related to severance costs due to workforce reductions. For additional details on these charges see Note 11, Restructuring Charges and Note 12, Lease Exit and Related Charges. Other Income (Expenses) Other income (expenses), net was as follows (dollars in thousands): Quarters ended September 30, 2014 Nine months ended September 30, 2014 2014 2013 $ Change % Change 2014 2013 $ Change % Change Interest income, net $ 80 $ 166 $ (86 ) (52 )% $ 396 $ 992 $ (596 ) (60 )% Gain (loss) on sale of available for sale securities, net - - - - 2,371 - 2,371 100 % Equity in net loss of Rhapsody (1,530 ) (2,629 ) 1,099 42 % (4,170 ) (6,209 ) 2,039 33 % Other income (expense), net 325 (118 ) 443 375 % 153 (146 ) 299 205 % Total other income (expense), net $ (1,125 ) $ (2,581 ) $ 1,456 56 % $ (1,250 ) $ (5,363 ) $ 4,113 77 % As described further in Note 5, Rhapsody Joint Venture, we account for our investment in Rhapsody under the equity method of accounting. The net carrying value of our investment in Rhapsody is not necessarily indicative of the underlying fair value of our investment. The increase in Other income (expense), net, of $4.1 million for the nine months ended September 30, 2014 was primarily due to the $2.4 million gain on sale of a portion of our shares held in J-Stream, as discussed further in Note 6, Fair Value Measurements, as well as our lower recorded net loss associated with our investment in Rhapsody. Income Taxes During the quarters ended September 30, 2014 and 2013, we recognized income tax expense of $0.3 million and $0.4 million, respectively, related to U.S. and foreign income taxes. During the nine months ended September 30, 2014 and 2013, we recognized income tax expense of $1.3 million and an income tax benefit of $0.2 million, respectively, related to U.S. and foreign income taxes. The change in income tax expense during the quarter and nine months ended September 30, 2014 was largely the result of an income tax benefit related to the acquisition of Slingo, Inc. recognized in the quarter ending September 30, 2013 and changes in our jurisdictional income. As of September 30, 2014, there have been no material changes to RealNetworks' uncertain tax positions disclosures as provided in Note 14 of the 2013 10-K. We currently anticipate the expiration of the statute of limitations within the next twelve 21 -------------------------------------------------------------------------------- months that may decrease the Company's total unrecognized tax benefit by an amount up to $0.9 million of which $0.4 million could potentially impact tax expense. The majority of our tax expense is due to income in our foreign jurisdictions and we have not benefitted from losses in the U.S. and certain foreign jurisdictions in the third quarter of 2014. We generate income in a number of foreign jurisdictions, some of which have higher or lower tax rates relative to the U.S. federal statutory rate. Our tax expense could fluctuate significantly on a quarterly basis to the extent income is less than anticipated in countries with lower statutory tax rates and more than anticipated in countries with higher statutory tax rates. For the quarters ended September 30, 2014, decreases in tax expense from income generated in foreign jurisdictions with lower tax rates in comparison to the U.S. federal statutory rate was offset by increases in tax expense from income generated in foreign jurisdictions having comparable, or higher tax rates in comparison to the U.S. federal statutory rate. As such, the effect of differences in foreign tax rates on the Company's tax expense for the third quarter of 2014 is minimal. As of September 30, 2014, we have not provided for U.S. federal and state income taxes on certain undistributed earnings of our foreign subsidiaries, since such earnings are considered indefinitely reinvested outside the U.S. or may be remitted tax-free to the U.S. If these amounts were distributed to the U.S., in the future in the form of dividends or otherwise, we could be subject to additional U.S. income and foreign withholding taxes. It is not practicable to determine the foreign withholding and U.S. income tax liability or benefit on such earnings due to the timing of such future distributions, the availability of foreign tax credits, and the complexity of the computation if such earnings were not deemed to be permanently reinvested. If future events, including material changes in estimates of cash, working capital, and long-term investment requirements necessitate that these earnings be distributed, an additional provision for U.S. income and foreign withholding taxes, net of foreign tax credits, may be necessary. We file numerous consolidated and separate income tax returns in the U.S., including federal, state and local returns, as well as in foreign jurisdictions. With few exceptions, we are no longer subject to United States federal income tax examinations for tax years prior to 2008 or state, local or foreign income tax examinations for years prior to 1993. We are currently under audit by various states and foreign jurisdictions for certain tax years subsequent to 1993. We are currently under United States federal audit for the consolidated group (RealNetworks, Inc. and Subsidiaries) for the year ended December 31, 2012. Geographic Revenue Revenue by geographic region was as follows (dollars in thousands): Quarters ended September 30, 2014 Nine months ended September 30, 2014 2014 2013 $ Change % Change 2014 2013 $ Change % Change United States $ 12,280 $ 21,039 $ (8,759 ) (42 )% $ 47,800 $ 70,525 $ (22,725 ) (32 )% Europe 5,749 8,750 (3,001 ) (34 )% 21,129 29,278 (8,149 ) (28 )% Republic of Korea 9,728 11,839 (2,111 ) (18 )% 31,114 32,062 (948 ) (3 )% Rest of world 6,400 7,330 (930 ) (13 )% 20,663 23,736 (3,073 ) (13 )% Total net revenue $ 34,157 $ 48,958 $ (14,801 ) (30 )% $ 120,706 $ 155,601 $ (34,895 ) (22 )% Revenue in the United States declined by $8.8 million in the quarter ended September 30, 2014, compared with the year-earlier period. The decline was due primarily to lower revenue generated from the distribution of third party software products of $4.9 million, lower revenue generated from our games business of $1.3 million, lower revenue from our SuperPass subscription revenue of $1.0 million and a decline in our RealPlayer Plus license revenue of $0.7 million. Revenue in the United States declined by $22.7 million in the nine months ended September 30, 2014, compared with the year-ago period. The decline was due primarily to lower revenue generated from the distribution of third party software products of $10.2 million, a decline in our SuperPass subscription revenue of $4.0 million, a decrease in our games revenue of $3.8 million, a decrease in our RealPlayer Plus license revenue of $2.7 million and a decline in SaaS revenue of $1.5 million. Revenue in Europe declined by $3.0 million in the quarter ended September 30, 2014, compared with the year-earlier period. The decrease was primarily due to lower revenue from our Games business of $1.7 million, lower revenue from RealPlayer Plus licenses of $0.5 million, a decline in third party software distribution revenue of $0.5 million as well a decline in our SaaS revenue of $0.3 million. Revenue in Europe declined by $8.1 million in the nine months ended September 30, 2014, compared with the year-ago period. The decline was due primarily to a decrease in revenue from our Games business of $6.1 million, a decrease in RealPlayer Plus license revenue of $1.5 million, offset in part by an increase in SaaS revenue of $0.7 million. 22 -------------------------------------------------------------------------------- Revenue in Korea decreased $2.1 million in the quarter ended September 30, 2014 , compared with the year-earlier period. The decrease was primarily due to lower intellectual property license revenue of $2.6 million and lower revenue from our SaaS offerings (excluding music on demand) of $0.9 million, including ringback tones revenue partially offset by higher music on demand revenue of $1.5 million. Revenue in Korea decreased $0.9 million in the nine months ended September 30, 2014, compared with the year-ago period. The decrease was mainly due to lower intellectual property license revenue of $5.3 million and lower revenue from our SaaS offerings (excluding music on demand) of $2.6 million, including ringback tones revenue partially offset by higher music on demand revenue of $7.4 million. Revenue in the rest of world decreased by $0.9 million in the quarter ended September 30, 2014, compared with the year-earlier period. The decrease was primarily due to lower revenue from our RealPlayer Plus licenses of $0.6 million, a decrease in our third party distribution revenue of $0.3 million and a decrease in our mobile entertainment revenue of $0.3 million. These decreases were partially offset by an increase in our intellectual property license revenue of $0.5 million. Revenue in the rest of world decreased by $3.1 million in the nine months ended September 30, 2014, compared with the year-ago period. The decrease was due to lower revenue from our RealPlayer Plus licenses of $1.9 million, $1.3 million from SaaS revenue, and $1.0 million from our subscription revenue. These decreases were partially offset by an increase in system integration services in Japan of $1.3 million. New Accounting Pronouncements See Note 2, Recent Accounting Pronouncements. Liquidity and Capital Resources The following summarizes working capital, cash, cash equivalents, short-term investments, and restricted cash (in thousands): September 30, December 31, 2014 2013 Working capital $ 153,685 $ 191,522 Cash, cash equivalents, and short-term investments 178,021 226,155 Restricted cash equivalents and investments 3,000 3,000 The 2014 decrease of cash, cash equivalents, and short-term investments from December 31, 2013 was primarily due to cash used in operating activities of $(45.6) million in the first nine months of 2014. The following summarizes cash flow activity (in thousands): Nine Months Ended September 30, 2014 2013 Cash provided by (used in) operating activities $ (45,642 ) $ (28,303 ) Cash provided by (used in) investing activities 10,472 1,411 Cash provided by (used in) financing activities (458 ) (1,331 ) Cash used in operating activities consisted of net income (loss) adjusted for certain non-cash items such as depreciation and amortization, and the effect of changes in certain operating assets and liabilities. Cash used in operating activities was $17.3 million more in the nine months ended September 30, 2014, as compared to the same period in 2013. This increase was primarily due to the decline in revenue of $34.9 million for the nine months ended September 30, 2014 compared with the prior year period, which was only partially offset by a decline in cash operating expenses. For the nine months ended September 30, 2014, cash provided by investing activities of $10.5 million was primarily due to sales and maturities, net of purchases, of short-term investments of $11.0 million and cash proceeds received from the sale of available for sale securities during the first quarter of $2.8 million, partially offset by purchases of equipment, software and leasehold improvements of $2.1 million. 23 -------------------------------------------------------------------------------- For the nine months ended September 30, 2013, cash provided by investing activities of $1.4 million was primarily due to net cash received of $24.7 million from the sales, maturity and purchases of short-term investments. Partially offsetting these proceeds was a cash outlay of $22.5 million for the acquisitions of businesses, net of cash acquired. Financing activities for the nine months ended September 30, 2014 used cash totaling $0.5 million primarily from the payment of the principal amount of contingent consideration of $0.7 million related to an earlier period business acquisition. Financing activities for the nine months ended September 30, 2013 used cash totaling $1.3 million primarily from certain tax payments from shares withheld upon the vesting of employee restricted stock of $0.9 million as well as the payment of the principal amount of contingent consideration of $0.8 million related to an earlier period business acquisition. We currently have no planned significant capital expenditures for the remainder of 2014 other than those in the ordinary course of business. Our principal future cash commitments include office leases. We believe that our current cash, cash equivalents, and short-term investments will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. In the future, we may seek to raise additional funds through public or private equity financing, or through other sources such as credit facilities. The sale of additional equity securities could result in dilution to our shareholders. In addition, in the future, we may enter into cash or stock acquisition transactions or other strategic transactions that could reduce cash available to fund our operations or result in dilution to shareholders. Our cash equivalents and short-term investments consist of investment grade securities, as specified in our investment policy guidelines. The policy limits the amount of credit exposure to any one non-U.S. Government or non-U.S. Agency issue or issuer to a maximum of 5% of the total portfolio. These securities are subject to interest rate risk and will decrease in value if interest rates increase. Because we have historically had the ability to hold our fixed income investments until maturity, we do not expect our operating results or cash flows to be significantly affected by a sudden change in market interest rates in our securities portfolio. We conduct our operations primarily in five functional currencies: the U.S. dollar, the Korean won, the Japanese yen, the British pound and the euro. We currently do not hedge the majority of our foreign currency exposures and are therefore subject to the risk of exchange rate fluctuations. We invoice our international customers primarily in U.S. dollars, except for certain countries where we invoice our customers primarily in the respective foreign currencies. We are exposed to foreign exchange rate fluctuations as the financial results of foreign subsidiaries are translated into U.S. dollars in consolidation. Our exposure to foreign exchange rate fluctuations also arises from intercompany payables and receivables to and from our foreign subsidiaries. As of September 30, 2014, approximately $24.1 million of the $178.0 million of cash, cash equivalents, and short-term investments was held by our foreign subsidiaries. If these funds are needed for our operations in the U.S., we may be required to accrue and pay U.S. income and foreign withholding taxes to repatriate these funds. However, our intent is to permanently reinvest these funds outside of the U.S. and our current plans do not demonstrate a need to repatriate them to fund our U.S. operations. Additionally, the Company currently has significant net operating losses and other tax attributes that could be used to offset potential U.S. income tax that could result if these amounts were distributed to the U.S. We utilize a variety of tax planning and financing strategies in an effort to ensure that our worldwide cash is available in the locations in which it is needed. We do not expect restrictions or potential taxes on repatriation of amounts held outside of the U.S to have a material effect on our overall liquidity, financial condition or results of operations. As of September 30, 2014, we have not provided for U.S. federal and state income taxes on certain undistributed earnings of our foreign subsidiaries, since such earnings are considered indefinitely reinvested outside the U.S. or may be remitted tax-free to the U.S. If these amounts were distributed to the U.S., in the future in the form of dividends or otherwise, we could be subject to additional U.S. income and foreign withholding taxes. It is not practicable to determine the foreign withholding and U.S. income tax liability or benefit on such earnings due to the timing of such future distributions, the availability of foreign tax credits, other tax attributes, and the complexity of the computation if such earnings were not deemed to be permanently reinvested. If future events, including material changes in estimates of cash, working capital, and long-term investment requirements necessitate that these earnings be repatriated, an additional provision for U.S. income and foreign withholding taxes, net of foreign tax credits, may be necessary. Off-Balance Sheet Arrangements We have operating lease obligations for office facility leases with future cash commitments that are not required to be recorded on our consolidated balance sheet. Accordingly, these operating lease obligations constitute off-balance sheet 24 -------------------------------------------------------------------------------- arrangements. In addition, since we do not maintain accruals associated with certain guarantees, as discussed in Note 17, Guarantees, those guarantee obligations also constitute off-balance sheet arrangements. Critical Accounting Policies and Estimates The preparation of our financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reported period. Our critical accounting policies and estimates are as follows: • Revenue recognition; • Estimating music publishing rights and music royalty accruals; • Estimating recoverability of deferred costs; • Estimating allowances for doubtful accounts and sales returns; • Valuation of equity method investments; • Valuation of definite-lived assets; • Valuation of goodwill and indefinite-lived intangible assets; • Stock-based compensation; and • Accounting for income taxes. Revenue Recognition. We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collection is probable. Physical products are considered delivered to the customer once they have been shipped and title and risk of loss have been transferred. For online sales, the products or services are considered delivered at the time the product or services are made available, digitally, to the end user. We recognize revenue on a gross or net basis. In most arrangements, we contract directly with end user customers, and are the primary obligor. In such arrangements, we recognize revenue on a gross basis. In some cases, we utilize third-party distributors who are the primary obligor to sell products or services directly to end user customers. In such instances, we recognize revenue on a net basis. In our direct to consumer business segments, we derive revenue primarily through (1) subscriptions of SuperPass within our RealPlayer Group segment and subscriptions sold by our Games segment, (2) sales of content downloads, software and licenses offered by our RealPlayer Group, Mobile Entertainment, and Games segments and (3) the sale of advertising and the distribution of third-party products on our websites and in our games. Consumer subscription products are paid in advance, typically for monthly, quarterly or annual duration. Subscription revenue is recognized ratably over the related subscription time period. Revenue from sales of content downloads, software and licenses is recognized at the time the product is made available, digitally, to the end user. Revenue generated from advertising on our websites and from advertising and the distribution of third-party products included in our products is recognized as revenue at the time of delivery. We also generate revenue through business-to-business channels by providing services within our Mobile Entertainment segment enabling mobile carriers to deliver audio and video content to their customers and by selling software licenses and products and related support and other services. Revenue generated from services provided to mobile carriers that enable the delivery of audio and video content to their customers is recognized as the services are provided. Setup fees to build these services are recognized ratably upon launch of the service over the remaining expected term of the service. Non-software revenue arrangements containing multiple elements are divided into separate units of accounting, after being evaluated for specific criteria. If the criteria for separation are met, revenue is allocated to the individual units using the relative price method. If the criteria are not met, the elements are treated as one unit of accounting and revenue recognition is delayed until all elements have been delivered. In the case of revenue arrangements containing software, elements are divided into separate units of accounting only when vendor-specific objective evidence has been established. In cases where vendor-specific objective evidence has not been established, undelivered elements are combined into one unit of accounting and are not recognized in revenue until all elements have been delivered. Estimating Music Publishing Rights and Music Royalty Accruals. We must make estimates of amounts that may be owed related to music royalties for our domestic and international music services, primarily the Rhapsody music service which was separated from our operating results beginning April 1, 2010. Material differences may impact the amount and timing of our expense for any period if management made different judgments or utilized different estimates. Under copyright law, we may be required to pay licensing fees for digital sound recordings and compositions we deliver. Copyright law generally does not specify the rate and terms of the licenses, which are determined by voluntary negotiations among the parties or, for certain compulsory licenses where voluntary negotiations are unsuccessful, by arbitration. There are certain geographies and agencies for which we have not completed negotiations with regard to the royalty rate to be applied to the historic sales of our digital music offerings. Our estimates are based on contracted or statutory rates, when established, or management's best estimates 25 -------------------------------------------------------------------------------- based on facts and circumstances regarding the specific music services and agreements in similar geographies or with similar agencies. While we base our estimates on historical experience and on various other assumptions that management believes to be reasonable under the circumstances, actual results may differ materially from these estimates under different assumptions or conditions. Estimating Recoverability of Deferred Costs. We defer costs on projects for service revenue and system sales. Deferred costs consist primarily of direct and incremental costs to customize and install systems, as defined in individual customer contracts, including costs to acquire hardware and software from third parties and payroll costs for our employees and other third parties. We recognize such costs as a component of cost of revenue, the timing of which is dependent upon the revenue recognition policy by contract. For revenue recognized under the completed contract method, costs are deferred until the products are delivered, or upon completion of services or, where applicable, customer acceptance. For revenue recognized under the percentage of completion method, costs are recognized as products are delivered or services are provided in accordance with the percentage of completion calculation. For revenue recognized ratably over the term of the contract, costs are recognized ratably over the term of the contract, commencing on the date of revenue recognition. At each balance sheet date, we review deferred costs to ensure they are ultimately recoverable. Any anticipated losses on uncompleted contracts are recognized when evidence indicates the estimated total cost of a contract exceeds its estimated total revenue. Assessing the recoverability of deferred project costs is based on significant assumptions and estimates, including future revenue and cost of sales. Significant or sustained decreases in revenue or increases in cost of sales in future periods could result in impairments of deferred project costs. We cannot accurately predict the amount and timing of any such impairments. Should the value of deferred project costs become impaired, we would record the appropriate charge, which could have a material adverse effect on our financial condition or results of operations. Estimating Allowances for Doubtful Accounts and Sales Returns. We make estimates of the uncollectible portion of our accounts receivable. We specifically analyze the age of accounts receivable and historical bad debts, customer credit-worthiness and current economic trends when evaluating the adequacy of the allowance for doubtful accounts. Similarly, we make estimates of potential future product returns related to current period revenue. We analyze historical returns, current economic trends, and changes in customer demand and acceptance of our products when evaluating the adequacy of the sales returns allowance. Significant judgments and estimates are made and used in connection with establishing allowances for doubtful accounts and sales returns. Material differences may result in the amount and timing of our revenue for any period if we were to make different judgments or utilize different estimates or actual future experience was different from the judgments and estimates. Valuation of Equity Method Investments. We use the equity method of accounting for investments in circumstances where we have the ability to exert significant influence, but not control, over an investee or joint venture. We initially record our investment based on a fair value analysis of the investment. We record our percentage interest in the investee's recorded income or loss and changes in the investee's capital under this method, which will increase or decrease the reported value of our investment. We record investee losses up to the aggregate amount of the investment. See Note 5 Rhapsody Joint Venture for a discussion of the $10.0 million preference on the convertible preferred stock we hold in Rhapsody and its impact on our equity method of accounting for this investment, We evaluate impairment of an investment valued under the equity method if events and circumstances warrant. An impairment charge would be recorded if a decline in value of an equity investment below its carrying amount were determined to be other than temporary. In determining if a decline is other than temporary, we consider factors such as the length of time and extent to which the fair value of the investment has been less than the carrying amount of the investee or joint venture, the near-term and longer-term operating and financial prospects of the investee or joint venture and our intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery. Valuation of Definite-Lived Assets. Definite-lived assets consist primarily of property, plant and equipment, as well as amortizable intangible assets acquired in business combinations. Definite-lived assets are depreciated or amortized on a straight line basis over their estimated useful lives. We review definite-lived assets for impairment whenever events or changes in circumstances indicate the carrying amount of such assets may not be recoverable. Recoverability of these assets is measured by comparison of their carrying amount to future undiscounted cash flows the assets are expected to generate. If definite-lived assets are considered to be impaired, the impairment to be recognized equals the amount by which the carrying value of the assets exceeds their fair market value. The impairment analysis of definite-lived assets is based upon estimates and assumptions relating to our future revenue, cash flows, operating expenses, costs of capital and capital purchases. These estimates and assumptions are complex and subject to a significant degree of judgment with respect to certain factors including, but not limited to, the estimation of the related future revenues, the cash flows of our long-term operating plans, valuation multiples, market and interest rate risk, and risk-commensurate discount rates and cost of capital. Significant or sustained declines in future revenue or cash flows, or 26 -------------------------------------------------------------------------------- adverse changes in our business climate, among other factors, and their resulting impact on the estimates and assumptions relating to the value of our definite-lived assets could result in the need to perform an impairment analysis in future periods which could result in a significant impairment. While we believe our estimates and assumptions are reasonable, due to their complexity and subjectivity, these estimates and assumptions could vary from period to period. Changes in these estimates and assumptions could materially affect the estimate of future undiscounted cash flows and related fair market values of these assets and result in significant impairments, which could have a material adverse effect on our financial condition or results of operations. As of September 30, 2014, we had approximately $10 million and $8 million in total carrying value of definite-lived assets related to our Mobile Entertainment and our RealPlayer groups, respectively. In accordance with our policy as described above, we reviewed these assets for impairment as of September 30, 2014. Our estimate of the fair value of these asset groups indicate that the carrying amounts are expected to be recovered and, therefore, no impairment is indicated as of September 30, 2014. However, it is reasonably possible that the estimate of the fair value of either or both of the Mobile Entertainment and RealPlayer groups may change in the near term should we experience adverse changes in our estimates and assumptions, which could result in impairments of those assets. For further discussion, please see the risk factor entitled, "Any impairment to our goodwill, indefinite-lived intangible assets or definite-lived assets could result in a significant charge to our earnings" under Item 1A Risk Factors. Valuation of Goodwill and Indefinite-Lived Intangible Assets. We test goodwill for impairment on an annual basis, in our fourth quarter, or more frequently if circumstances indicate reporting unit carrying values may exceed their fair values. Circumstances that may indicate a reporting unit's carrying value exceeds its fair value include, but are not limited to: poor economic performance relative to historical or projected future operating results; significant negative industry, economic or company specific trends; changes in the manner of our use of the assets or the plans for our business; and loss of key personnel. Due to the ongoing difficult economic environment and the decline in revenues in our businesses, we continue to monitor whether there could be potential impairment of goodwill. When evaluating goodwill for impairment, based upon our annual test or due to changes in circumstances described above, we first perform a qualitative assessment to determine if the fair value of a reporting unit is more likely than not less than the reporting unit's carrying amount including goodwill. If this assessment indicates it is more likely than not, we then compare the carrying value of the reporting unit to the estimated fair value of the reporting unit. If the carrying value of the reporting unit exceeds the estimated fair value, we then calculate the implied estimated fair value of goodwill for the reporting unit and compare it to the carrying amount of goodwill for the reporting unit. If the carrying amount of goodwill exceeds the implied estimated fair value, an impairment charge to current operations is recorded to reduce the carrying value to implied estimated value. Significant judgments and estimates are required in determining the reporting units and assessing the fair value of the reporting units. These estimates and assumptions are complex and subject to a significant degree of judgment with respect to certain factors including, but not limited to, the estimation of the related future revenues, the cash flows of long-term operating plans, valuation multiples, market and interest rate risk, and risk-commensurate discount rates and cost of capital. While we believe our estimates and assumptions are reasonable, due to their complexity and subjectivity, these estimates and assumptions could vary from period to period. Changes in these estimates and assumptions could materially affect the estimated fair market values of the reporting units and result in significant impairments, which could have a material adverse effect on our financial condition or results of operations. We evaluate indefinite-lived intangible assets (primarily tradenames and trademarks) for impairment on an annual basis, in the fourth quarter, or more frequently if an event occurs or changes in circumstances indicate that impairment may exist. When evaluating indefinite-lived intangible assets for impairment, we may first perform a qualitative assessment to determine if the fair value of the intangible assets is more likely than not greater than its carrying amount. If we do not perform a qualitative assessment or if the fair value of the intangible assets is not more likely than not greater than its carrying amount, we calculate the estimated fair value of the intangible assets. If the carrying amount of the intangible assets exceeds the estimated fair value, an impairment charge is recorded to reduce the carrying value to the implied estimated fair value. Significant judgments and estimates are required in assessing the fair value of the indefinite-lived intangible assets. These estimates and assumptions are complex and subject to a significant degree of judgment with respect to certain factors including, but not limited to, the estimation of the related future revenues, the cash flows of long-term operating plans, valuation multiples, market and interest rate risk, and risk-commensurate discount rates and cost of capital. While we believe our estimates and assumptions are reasonable, due to their complexity and subjectivity, these estimates and assumptions could vary from period to period. Changes in these estimates and assumptions could materially affect the estimated fair market values of these assets and result in significant impairments, which could have a material adverse effect on our financial condition or results of operations. 27 -------------------------------------------------------------------------------- Stock-Based Compensation. Stock-based compensation cost is estimated at the grant date based on the award's fair value and is recognized as expense over the requisite service period, which is the vesting period. For stock options, the fair value is calculated by the Black-Scholes option-pricing model or other appropriate valuation models. The valuation models require various highly judgmental assumptions including volatility in our common stock price and expected option life. If any of the assumptions used in the valuation models change significantly, stock-based compensation expense may differ materially in the future from the amounts recorded in our consolidated statement of operations. For all awards, we are required to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting forfeitures and record stock-based compensation expense only for those awards that are expected to vest. Accounting for Income Taxes. We use the asset and liability method of accounting for income taxes. Under this method, income tax expense is recognized for the amount of taxes payable or refundable for the current year. In addition, deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax basis of assets and liabilities and for operating losses and tax credit carryforwards. Deferred tax assets and liabilities and operating loss and tax credit carryforwards are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences and operating loss and tax credit carryforwards are expected to be recovered or settled. We must make assumptions, judgments and estimates to determine current provision for income taxes, deferred tax assets and liabilities and any valuation allowance to be recorded against deferred tax assets. Our judgments, assumptions, and estimates relative to the current provision for income tax take into account current tax laws, our interpretation of current tax laws and possible outcomes of future audits conducted by foreign and domestic tax authorities. Changes in tax law or our interpretation of tax laws and future tax audits could significantly impact the amounts provided for income taxes in our consolidated financial statements. Each reporting period we must periodically assess the likelihood that our deferred tax assets will be recovered from future sources of taxable income, and to the extent that recovery is not more likely than not, a valuation allowance must be established. The establishment of a valuation allowance and increases to such an allowance result in either increases to income tax expense or reduction of income tax benefit in the statement of operations and comprehensive income. In certain instances, changes in the valuation allowance may be allocated directly to the related components of shareholders' equity on the consolidated balance sheet. Factors we consider in making such an assessment include, but are not limited to, past performance and our expectation of future taxable income, macroeconomic conditions and issues facing our industry, existing contracts, our ability to project future results and any appreciation of our investments and other assets. As of September 30, 2014, $24.1 million of the $178.0 million of cash, cash equivalents, and short-term investments was held by our foreign subsidiaries. As of September 30, 2014, we have not provided for U.S. federal and state income taxes on certain undistributed earnings of our foreign subsidiaries, since such earnings are considered indefinitely reinvested outside the U.S. or may be remitted tax-free to the U.S. If these amounts were distributed to the U.S., in the form of dividends or otherwise, RealNetworks could be subject to additional U.S. income and foreign withholding taxes. It is not practicable to determine the foreign withholding and U.S. income tax liability or benefit on such earnings due to the timing of such future distributions, the availability of foreign tax credits, and the complexity of the computation if such earnings were not deemed to be permanently reinvested. If future events, including material changes in estimates of cash, working capital, and long-term investment requirements necessitate that these earnings be distributed, an additional provision for U.S. income and foreign withholding taxes, net of foreign tax credits, may be necessary. Item 3. Quantitative and Qualitative Disclosures About Market Risk The following discussion about our market risk involves forward-looking statements. All statements that do not relate to matters of historical fact should be considered forward-looking statements. Actual results could differ materially from those projected in any forward-looking statements. Interest Rate Risk. Our exposure to interest rate risk from changes in market interest rates relates primarily to our short-term investment portfolio. Our short-term investments consist of investment grade debt securities as specified in our investment policy. Investments in both fixed and floating rate instruments carry a degree of interest rate risk. The fair value of fixed rate securities may be adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Additionally, a declining rate environment creates reinvestment risk because as securities mature the proceeds are reinvested at a lower rate, generating less interest income. See Note 6, Fair Value Measurements for additional information. Due in part to these factors, our future interest income may be adversely impacted due to changes in interest rates. In addition, we may incur losses in principal if we are forced to sell securities that have declined in market value due to changes in interest rates. Because we have historically had the ability to hold our short-term investments until maturity, we would not expect our operating results or cash flows to be significantly impacted by a sudden 28 -------------------------------------------------------------------------------- change in market interest rates. There have been no material changes in our investment methodology regarding our cash equivalents and short-term investments during the quarter ended September 30, 2014. Based on our cash, cash equivalents, short-term investments, and restricted cash equivalents as of September 30, 2014, a hypothetical 10% increase/decrease in interest rates would not increase/decrease our annual interest income or cash flows by more than a nominal amount. Investment Risk. As of September 30, 2014, we had investments in voting capital stock of both publicly traded and privately held technology companies for business and strategic purposes. See Note 1, Description of Business and Summary of Significant Accounting Policies - Valuation of Equity Method Investments, and Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and Estimates (Valuation of equity method investments) in the 10-K for details on our accounting treatment for these investments, including the analysis of other-than-temporary impairments. Foreign Currency Risk. We conduct business internationally in several currencies and thus are exposed to adverse movements in foreign currency exchange rates. Our exposure to foreign exchange rate fluctuations arise in part from: (1) translation of the financial results of foreign subsidiaries into U.S. dollars in consolidation; (2) the remeasurement of non-functional currency assets, liabilities and intercompany balances into U.S. dollars for financial reporting purposes; and (3) non-U.S. dollar denominated sales to foreign customers. We manage a portion of these risks through the use of financial derivatives, but fluctuations could impact our results of operations and financial position. Generally, our practice is to manage foreign currency risk for the majority of material short-term intercompany balances through the use of foreign currency forward contracts. These contracts require us to exchange currencies at rates agreed upon at the contract's inception. Because the impact of movements in currency exchange rates on forward contracts offsets the related impact on the short-term intercompany balances, these financial instruments help alleviate the risk that might otherwise result from certain changes in currency exchange rates. We do not designate our foreign exchange forward contracts related to short-term intercompany accounts as hedges and, accordingly, we adjust these instruments to fair value through results of operations. However, we may periodically hedge a portion of our foreign exchange exposures associated with material firmly committed transactions, long-term investments, highly predictable anticipated exposures and net investments in foreign subsidiaries. Some of our unhedged exposures are recorded in our statement of operations on a mark-to-market basis each quarter, so to the extent we continue to experience adverse economic conditions, we may record losses related to such unhedged exposures in future periods that may have a material adverse effect on our financial condition and results of operations. Our foreign currency risk management program reduces, but does not entirely eliminate, the impact of currency exchange rate movements. We have cash balances denominated in foreign currencies which are subject to foreign currency fluctuation risk. The majority of our foreign currency denominated cash is held in Korean won and euros. A hypothetical 10% increase or decrease in the Korean won and euro relative to the U.S. dollar as of September 30, 2014 would not result in a material impact on our financial position, results of operations or cash flows. Item 4. Controls and Procedures (a) Evaluation of Disclosure Controls and Procedures Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures as of September 30, 2014. The term "disclosure controls and procedures," as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company's management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives, and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based upon that evaluation, our chief executive officer and chief financial officer concluded that, as of September 30, 2014, our disclosure controls and procedures were effective. (b) Changes in Internal Control over Financial Reporting 29 -------------------------------------------------------------------------------- There have been no changes in our internal control over financial reporting (as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the third quarter of 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 30-------------------------------------------------------------------------------- |