10-Q 1 iwerks10q.txt IWERKS 10Q 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 March 31, 2001 or [ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. Commission file number 0-22558 IWERKS ENTERTAINMENT, INC. (Exact name of registrant as specified in its charter) Delaware 95-4439361 ------------------------------- ---------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 4520 West Valerio Street, Burbank, California 91505-1046 ------------------------------------------------------------------------------- (Address of principal executive offices) (Zip Code) (818) 841-7766 ------------------------------------------------------------------------------- (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 __. The number of shares outstanding of the Registrant's Common Stock, $0.001 par value, at April 30, 2001 was 3,540,911 shares. IWERKS ENTERTAINMENT, INC. INDEX Page PART I. FINANCIAL INFORMATION Number Item 1. Financial Statements Condensed Consolidated Balance Sheets as of March 31, 2001 and June 30, 2000 3 Condensed Consolidated Statements of Operations for the Three and Nine Months ended March 31, 2001 and 2000 5 Condensed Consolidated Statements of Cash Flows for the Nine Months ended March 31, 2001 and 2000 6 Notes to the Condensed Consolidated Financial Statements 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 9 PART II. OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K 22 Signatures 23 Page 2

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See accompanying notes. Page 6 IWERKS ENTERTAINMENT, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE 1. INTRODUCTION The accompanying condensed consolidated financial statements of Iwerks Entertainment, Inc. (the "Company") have been prepared without audit pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC"). Certain information and footnote disclosures normally included in the financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations, although the Company believes that the disclosures made are adequate to make the information presented not misleading. In the opinion of management, all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the consolidated financial position of the Company as of March 31, 2001 and the results of its operations for the three and nine months ended March 31, 2001 and 2000 and the cash flows for the nine months ended March 31, 2001 and 2000 have been included. The results of operations for interim periods are not necessarily indicative of the results which may be realized for the full year. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company's latest Annual Report on Form 10-K as filed with the SEC. Certain reclassifications were made to the financial statements for the nine months ended March 31, 2000 in order to conform to the nine months ended March 31, 2001 presentation. NOTE 2. RESTRICTED CASH Included in the March 31, 2000 cash and cash equivalents balance is $1,046,000 of cash received from one customer, which was restricted as to its use. This restriction remained in effect until the second quarter of fiscal 2001, when the Company reached a certain milestone related to completion of the project. At that time, the cash became available for Company use. There is no such restriction in the March 31, 2001 cash and cash equivalents balance of $2,363,000. NOTE 3. ASSETS HELD FOR SALE On September 30, 1999 the Company decided to sell the assets relating to the Touring Division. These assets are described as the portable ride simulation theatres and are reflected at management's estimate of their fair value less cost to sell. Management discontinued depreciating these assets and will continue to periodically assess the net fair value of these assets. The Company has sold four units since June 30, 2000 with aggregate net proceeds of $874,000. NOTE 4. ISSUANCE OF WARRANTS On September 8, 1999 the Company appointed two outside members to its Board of Directors. The two new members purchased warrants to purchase an aggregate of 442,857 shares of Iwerks common stock. The warrants were issued in four tranches of equal amounts ranging in a per share exercise price of $5.01 to $10.50. Certain restrictions apply to the exercise of these warrants, which have a term of five years. These two board members resigned on January 18, 2000. The warrants remain outstanding with the same terms described above. NOTE 5. DEPRECIATION AND AMORTIZATION Depreciation expense and amortization expense of property and equipment, goodwill and other is computed using the straight-line method over the estimated useful lives of the assets. Film costs are amortized using the individual film forecast method. Page 7

Depreciation and amortization included in cost of sales was $491,000 and $626,000 for the quarters ended March 31, 2001 and 2000, respectively, and $1,004,000 and $1,352,000 for the nine months ended March 31, 2001 and 2000, respectively. NOTE 6 NOTES PAYABLE On October 19, 2000, the Company issued a five-year, 8% convertible debenture in the amount of $300,000. Interest is paid semi-annually and the debenture is convertible into shares of common stock at $2.00 per share. NOTE 7. NET LOSS PER COMMON SHARE For the three and nine months ended March 31, 2001 and 2000, the basic and diluted per share data is based on the weighted average number of common shares outstanding during the period. Common equivalent shares, consisting of outstanding stock options and warrants, are not included in the diluted loss per share calculation since they are antidilutive. On January 13, 2000, the Company's stockholders approved an amendment to the Company's certificate of incorporation to effect a one for three and one-half reverse stock split. The reverse stock split was effective January 18, 2000. All references to per share amounts and shares outstanding included herein have been retroactively restated to reflect the stock split. NOTE 8. INCOME TAXES At June 30, 2000, the Company had available federal and state tax net operating loss carryforwards of approximately $36,200,000 and $13,100,000, respectively. The federal and state net operating loss carryforwards expire, in varying amounts, through 2019. As a result of these net operating loss carryforwards and current period losses, the Company's effective tax rate was negligible and consequently no income tax provision or benefit was recorded in the periods presented. Under Section 382 of the Internal Revenue Code, the utilization of the net operating loss carryforwards may be limited based on changes in the percentage of ownership of the Company. NOTE 9. LITIGATION The proceedings to which the Company is a defendant consist of routine litigation in the ordinary course of business. In the opinion of management, and, based in part upon the advice of outside counsel, resolution of these matters will not have a material adverse impact on the Company's consolidated financial position or results of operations. NOTE 10. LETTER OF INTENT WITH SIMEX, INC. On March 5, 2001, the Company announced the signing of a non-binding letter of intent for a strategic $2.2 million acquisition of the Company by SimEx Inc., a Canadian company. The letter of intent provides that SimEx will acquire the Company in exchange for $0.63 per share of common stock currently issued and outstanding. The Company's Board of Directors has approved this transaction and final completion is subject to due diligence, financing, the execution of binding transaction documents, shareholder approval and other customary closing conditions. The Company currently anticipates completing the transaction in the first quarter of fiscal 2002. Page 8 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS SPECIAL NOTE REGARDING FORWARD-LOOKING INFORMATION This Report contains statements that constitute "forward-looking statements" within the meaning of Section 21E of the Exchange Act and Section 27A of the Securities Act. The words "expect", "estimate", "anticipate", "predict", "believe" and similar expressions and variations thereof are intended to identify forward-looking statements. Such statements appear in a number of places in this filing and include statements regarding the intent, belief or current expectations of the Company, its directors or officers with respect to, among other things (a) trends affecting the financial condition or results of operations of the Company and (b) the business and growth strategies of the Company. The stockholders of the Company are cautioned not to put undue reliance on such forward-looking statements. Such forward-looking statements are not guarantees of future performance and involve risks and uncertainties, and actual results may differ materially from those projected in this Report, for the reasons, among others, discussed in the Sections - "Management's Discussion and Analysis of Financial Condition and Results of Operations", and "Future Operating Results". The Company undertakes no obligation to publicly revise these forward-looking statements to reflect events or circumstances that arise after the date hereof. Readers should review carefully the risk factors described in other documents the Company files from time to time with the Securities and Exchange Commission, including the Annual Report on form 10-K filed by the Company on September 29, 2000, the Quarterly Reports on Form 10-Q filed by the Company on February 14, 2001 and November 14, 2000, and any Current Reports on Form 8-K filed by the Company. RESULTS OF OPERATIONS HARDWARE SALES AND SERVICE Revenues on sales of theatre systems are recognized on the percentage-of-completion method over the life of the contract. The gross margin for each contract varies based upon pricing strategies, competitive conditions and product mix. FILM LICENSING AND PRINTS Revenues and related expenses from film licensing are recognized at the beginning of the license period at which time the customer is billed the license fee and the film is delivered to the customer. CAMERAS AND OTHER PRODUCTION SERVICES The Company contracts with third parties to lease its 15/70 and 8/70 large format cameras and related equipment, (including a 3D rig, lenses and accessories). Rental periods range from several days to several months. The Company has developed and manufactured one 15/70 large format camera and is in the process of completing two additional 15/70 cameras. The Company also provides technical and post-production services to third party producers for a fee and maintains a 15/70 and 8/70 projection room at its Burbank facilities for rent to large format filmmakers for use in the post-production process. The Company has also begun a film conversion business in fiscal 2001. The Company's internal executive production capability develops and oversees the production of films for the Company's film productions as well as for third party custom film projects. Page 9 OWNED AND OPERATED Revenues from owned and operated (O&O) consist of portable ride simulation theatre revenues (touring) derived primarily from corporate sponsorship or ticket sales at state fairs, air shows, and similar events, as well as revenues derived from fixed site joint venture revenues which includes the Company's contractual share of the sites' revenues or profits as applicable. The Company has made the determination to shut down the touring division and sell the related assets in an effort to concentrate on its core business. THREE MONTHS ENDED MARCH 31, 2001 COMPARED TO THREE MONTHS ENDED MARCH 31, 2000 For the three months ended March 31, 2001 the Company recorded revenues of $5,922,000 compared to $5,913,000 for the same period last year. For the three months ended March 31, 2001, the Company recorded a net loss of $355,000 or ($0.10) per share compared to a net loss of $14,017,000 or ($4.06) per share for the same period last year. REVENUES Revenue for the three months ended March 31, 2001 increased $9,000 or 0.01% from the three months ended March 31, 2000. The following table presents summary information regarding revenues (amounts in thousands):

Hardware Sales and Service for the three months ended March 31, 2001 decreased by approximately $1.5 million or 44% compared to the same period last year. During the third quarter of fiscal 2001, hardware sales recognized in the Asia-Pacific region decreased by approximately $593,000, hardware sales recognized in Europe and the Middle East decreased by approximately $506,000 and hardware sales recognized in North America decreased by approximately $159,000. Revenue generated from Customer Service decreased by $210,000 during the third quarter of fiscal 2001 compared to the third quarter of fiscal 2000. Generally, hardware sales are subject to quarterly fluctuations as they are dependent on customer installation dates. Film Licensing and Prints revenues for the quarter ended March 31, 2001 increased by approximately $1.7 million or 122% compared to the same period last year. This increase primarily is due to several large multi-year film licenses signed in the current quarter and several film license agreements signed with new customers. Cameras and Other Production Services revenue for the three months ended March 31, 2001 decreased by approximately $127,000 compared to the same period last year. The decrease primarily is due to a reduction in production revenues ($316,000) due to timing of completion of one large project in fiscal 2000 compared to a smaller project in fiscal 2001. The decrease was partially offset by an increase ($189,000) in facility camera rentals. The increase was the result of revenue from film conversions, which is a new line of business for the Company. Page 10 Owned and Operated revenue for the three months ended March 31, 2001 decreased by approximately $80,000 as compared to the same period last year. This was primarily due to reduced revenues from joint ventures as a result of a reclassification of revenues for one joint venture ($132,000) to film licensing revenue in fiscal 2001 rather than as owned and operated revenue. COST OF SALES Cost of sales primarily includes costs of theatre systems sold, expenses associated with operating portable ride simulation theatres, and costs associated with film production and licensing fees. The cost of theatre systems includes the cost of components, customization, engineering, project management, assembly, system integration and installation. Also included in cost of sales are royalties payable to a former joint venture partner and estimated warranty expenses. The costs associated with film license fees primarily reflect amortization of film production costs over the lives of certain films and royalties paid to third parties. The cost of sales associated with operating portable ride simulation theatres includes costs for personnel, event fees, fuel, insurance and maintenance. Cost of sales as a percentage of sales was 72% for the three months ended March 31, 2001 as compared to 93% for the three months ended March 31, 2000. The decrease resulted primarily from reduced film amortization costs as a result of film write-downs made during fiscal 2000. Additionally, reduced warranty claims resulted in lower customer service cost of sales for the quarter ended March 31, 2001. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES Selling, general and administrative expenses include, among other things, personnel costs, trade shows and other promotional expenses, sales commissions, travel expenses, public relations costs, outside consulting and professional fees, depreciation on fixed assets, amortization of goodwill, departmental administrative costs and research and development costs. Selling, general and administrative expenses were approximately $2.0 million and $2.7 million, for the quarters ended March 31, 2001 and 2000, respectively. This decrease primarily is attributable to senior management cost containment efforts including marketing, travel and entertainment expense and office lease and reduced depreciation and amortization, and research and development expenses. IMPAIRMENT OF GOODWILL In the quarter ended March 31, 2000, the Company recorded a one-time non-cash write-down to goodwill associated with the acquisition of Omni Film International. There was no similar write-down in the current quarter. INTEREST INCOME & EXPENSE Interest income for the quarters ended March 31, 2001 and 2000 was approximately $0 and $4,000, respectively. The decrease resulted primarily from a reduction in the invested cash balances during the three months ended March 31, 2001. Interest expense for the quarters ended March 31, 2001 and 2000 was approximately $14,000 and $67,000, respectively. The decrease was primarily due to reduced notes payable and capital lease obligation balances in the current quarter as compared to the quarter ended March 31, 2000. NET LOSS The Company recorded a net loss of approximately $355,000 in the quarter ended March 31, 2001, compared to a net loss of approximately $14 million in the quarter ended March 31, 2000 due to the reasons mentioned above. Page 11 NINE MONTHS ENDED MARCH 31, 2001 COMPARED TO NINE MONTHS ENDED MARCH 31, 2000 For the nine months ended March 31, 2001 the Company recorded revenues of approximately $17.6 million compared to approximately $22.7 million for the same period last year. For the nine months ended March 31, 2001, the Company recorded a net loss of approximately $1.8 million or $0.51 per share compared to a net loss of approximately $17.5 million or $5.00 per share for the same period last year. REVENUES Revenue for the nine months ended March 31, 2001 decreased by $5,067,000 or 22% from the nine months ended March 31, 2000. The following table presents summary information regarding revenues (amounts in thousands):

Hardware Sales and Service for the nine months ended March 31, 2001 decreased by approximately $4.8 million or 35% compared to the same period last year. During the nine months ended March 31, 2001, hardware sales recognized in the Asia-Pacific region decreased by approximately $2.7 million, hardware sales recognized in South America decreased by $1.0 million, hardware sales recognized in Europe and the Middle East decreased by approximately $1.2 million and hardware sales recognized in the North American region increased by approximately $712,000. In addition, revenue generated from Customer Service decreased by $471,000 in the nine months ended March 31, 2001 compared to the nine months ended March 31, 2000. Film Licensing and Prints revenues for the nine months ended March 31, 2001 increased by approximately $1.1 million or 28% compared to the same period last year. The increase primarily is due to several large multi-year film licenses signed in the nine months ended March 31, 2001 and several film license agreements signed with new customers. Cameras and Other Production Services revenue for the nine months ended March 31, 2001 increased by approximately $138,000 due to higher Facility and Camera rental revenue. The increase was the result of revenue from film conversions, which is a new line of business. Owned and Operated revenue for the nine months ended March 31, 2001 decreased by approximately $1.6 million as compared to the same period last year, primarily due to declining sales in the touring division. Revenues generated from the touring division were approximately $124,000 during the nine months ended March 31, 2001 compared to $1.2 million during the nine months ended March 31, 2000 due to the Company's decision to shut down the touring division during fiscal 2000. Revenues from joint venture venues decreased by approximately $473,000 as a result of a reclassification of revenues for one joint venture to film licensing revenue in fiscal 2001 rather than as owned and operated revenue. COST OF SALES Cost of sales as a percentage of sales was 76% for the nine months ended March 31, 2001 as compared to 87% for the nine months ended March 31, 2000. The decrease resulted primarily from shutting down the touring division operations. For the nine months ended March 31, 2001 the touring division had a negative gross margin. Page 12 SELLING, GENERAL AND ADMINISTRATIVE EXPENSES Selling, general and administrative expenses decreased to approximately $5.9 million for the nine months ended March 31, 2001 compared to approximately $8.7 million for the nine months ended March 31, 2000, respectively. This decrease was related to senior management cost containment efforts including marketing, travel and entertainment expense and office expense and reduced depreciation and amortization, commission and research and development expense. IMPAIRMENT OF GOODWILL In the nine months ended March 31, 2000, the Company recorded a one-time non-cash write-down to goodwill associated with the acquisition of Omni Film International. There was no similar write-down in the current fiscal year. INTEREST INCOME & EXPENSE Interest income for the nine months ended March 31, 2001 and 2000 was approximately $90,000 and $153,000, respectively. The decrease resulted primarily from a reduction in the invested cash balances during the nine months ended March 31, 2001. Interest expense for the nine months ended March 31, 2001 and 2000 was approximately $124,000 and $219,000, respectively. The decrease was primarily due to reduced notes payable and capital lease obligation balances in the nine months ended March 31, 2001 as compared to the nine months ended March 31, 2000. NET LOSS The Company recorded a net loss of approximately $1.8 million in the nine months ended March 31, 2001, compared to a net loss of approximately $17.5 million in the nine months ended March 31, 2000 due to the reasons mentioned above. FUTURE OPERATING RESULTS The market for the Company's products is intensely competitive and is undergoing significant changes, primarily due to technological developments as well as changing consumer tastes. Numerous companies are developing and are expected to develop new entertainment products or concepts for the out-of-home entertainment industry. There is competition for financial, creative and technological resources in the industry and there can be no assurance that existing products will continue to compete effectively or that products under development will ever be competitive. The Company and its principal competitor in the giant screen market, Imax Corporation ("Imax"), are aggressively competing, particularly in the United States market, for new 15 perforation, 70 millimeter format (15/70) theatre installations. The Company primarily competes in this market based upon the price and terms of its projection technology. Imax, the dominant competitor in the market, competes primarily on the basis of its brand identity and its larger base of installed theatres. These factors, and Imax's access to greater financial and other resources, are expected to continue to place the Company at a competitive disadvantage in this market and could have a negative impact on the Company's gross margins in this market. However, the Company believes there is potential and is pursuing the 8 perforation, 70 millimeter (8/70) format theatre market in addition to its 15/70 sales efforts. Imax does not offer an 8/70 product. Page 13 In addition to competition in the giant screen market, the Company faces competition in the simulation industry from a number of other competitors. The Company competes in this market based upon the breadth of its product offerings and the size and quality of its film library. Few of its competitors in this market have sufficient financial resources to effectively compete with the Company based on these criteria. The Company's competitive position in this market segment could be materially affected if any of its existing competitors or a new entrant were to assemble the financial, technical and creative resources required to effectively compete with the Company's range of product offerings and film library. The Company recognizes these competitive issues and is in the process of creating new products, such as a 3D/4D FXTM specialty attraction system which includes multiple sensory effects and the development of a new generation of smaller ride simulation configurations that can accommodate the potential opportunity in the mass retail environment and movie theatres. The Company already has made three sales of its new 3D/4D FXTM theatre system. All three of the sales were in China, the first of which opened in February 2000. The other two theater systems are scheduled to open in the fourth quarter of fiscal 2001. The Company has experienced quarterly fluctuations in operating results and anticipates that these fluctuations will continue in future periods. Operating results and cash flow can fluctuate substantially from quarter to quarter and periodically as a result of the timing of theatre system deliveries, contract signing, the mix of theatre systems shipped, the completion of custom film contracts, the existence of world expos, the amount of revenues from film licensing agreements, the timing of sales of ride simulation attractions, the timing of delivery and installation of such sales (pursuant to percentage of completion accounting) and any delays therein caused by permitting or construction delays at the customer's site, the size, type and configuration of the attractions sold, the timing of film rental payments from existing attractions and the performance of those attractions that pay film rental based on a percentage of box office receipts and the timing of sales and marketing efforts and related expenditures. In particular, fluctuations in theatre system sales and deliveries from quarter to quarter can materially affect quarterly and periodic operating results, and theatre system contract signing can materially affect quarterly or periodic cash flow. Accordingly, the Company's revenues and earnings in any particular period may not be indicative of the results for any future period. The seasonal fluctuations in earnings also may cause volatility in the stock price of the Company. While a significant portion of the Company's expense levels are relatively fixed, the timing of increases in expense levels is based in large part on the Company's forecasts of future sales. The Company may also choose to reduce prices or increase spending in response to market conditions, which may have a material adverse effect on the Company's results of operations. If net sales are below expectations in any given period, the adverse impact on results of operations may be magnified by Iwerks inability to adjust spending quickly enough to compensate for the sales shortfall. Additionally, the Company plans to continue to evaluate and, when appropriate, make acquisitions of complementary technologies, products or businesses. The Company will continue to evaluate the changing value of its assets, and when necessary, make adjustments to these assets. While the Company cannot predict what effect these various factors may have on its financial results, the aggregate effect of these and other factors could result in significant volatility in the Company's future performance and stock price. LIQUIDITY AND CAPITAL RESOURCES Net cash used in operating activities for the nine months ended March 31, 2001 was approximately $250,000. This was primarily attributable to the net loss of approximately $1.8 million and negative changes in operating assets and liabilities of approximately $694,000 offset by non-cash charges of approximately $2.2 million for depreciation and amortization. Investing activities for the nine months ended March 31, 2001 consisted of purchases of property and equipment that was offset by the proceeds from the sale of four portable simulation units. Cash used in financing activities consisted primarily of principal payments on notes payable and capital leases that were partially offset by proceeds from the issuance of debt. Page 14 At March 31, 2001, the Company had cash and cash equivalents of approximately $2.4 million. The Company's cash and short-term investment balances have declined since June 30, 2000 and the Company expects to experience further declining balances during the remainder of fiscal 2001. Because of the reductions in the Company's cash balances over the last twenty-one months the Company may not be able to continue operations at its current levels. The Company is dependent upon current cash collections to meet its operating needs and pay its current liabilities. The Company has experienced significant difficulty in accurately projecting its cash balances historically. The Company's cash flow is dependent on the timing of delivery of hardware systems, collections and the signing of new contracts, all of which are difficult to predict with accuracy. Further complicating its ability to project cash balances is that the timing of progress payments of the hardware projects are dependent upon achieving certain performance milestones under its hardware sales agreements. On October 19, 2000, the Company announced the signing of a strategic $4 million investment transaction with the S. Kumars Group, an Indian company. As part of the investment transaction, on October 19, 2000, the Company issued to S. Kumars Group a $300,000 convertible subordinated debenture. On January 19, 2001, the Company announced that other than the convertible debenture, the investment transaction was terminated and the Company does not expect to receive any additional funds in connection with that financing. On March 5, 2001, the Company announced the signing of a non-binding letter of intent for a strategic $2.2 million acquisition of the Company by SimEx Inc., a Canadian company ("SimEx"). The letter of intent provides that SimEx will acquire the Company in exchange for $0.63 per share of common stock currently issued and outstanding. The Company's Board of Directors has approved this transaction and final completion is subject to due diligence, financing, execution of binding transaction documents, shareholder approval and other customary closing conditions. The Company currently anticipates completing the transaction in the first quarter of fiscal 2002. In the event the transaction does not close, the Company will need to aggressively seek additional debt or equity financing and other strategic alternatives. However, recent operating losses, the Company's declining cash balances, the Company's historical stock performance, the delisting of the Company's common shares from The Nasdaq Stock Market, the recent decline in revenue, and a general decrease in investor interest in the Company's industry, may make it difficult for the Company to attract equity investments or debt financing or strategic partners on terms that are deemed to be favorable to the Company. If the Company's financial condition continues to worsen and it is unable to attract alternative equity or debt financing or other strategic transactions, the Company could be forced to consider steps that would protect its assets against its creditors. The Company's independent auditors' report contains an emphasis paragraph indicating there is substantial doubt about the Company's ability to continue as a going concern. The Company is in the process of selling its portable ride simulation theaters, which when sold, will generate cash. The Company is considering a number of other options to improve its financial condition. The Company sold four portable ride simulation units during the first nine months of the fiscal year. There can be no assurance that any additional ride simulation theaters will be sold. In order to preserve cash, the Company has been required to reduce expenditures for capital projects (including new films), research and development, and in its corporate infrastructure, any of which may have a material adverse affect on the Company's future operations. Further reductions in its cash balances could require the Company to make more significant cuts in its operations, which would have a material adverse impact on its future operations. There can be no assurance that the Company can achieve these reductions over a short enough period of time in order to allow it to continue as a going concern. Page 15 RISK FACTORS THERE IS DOUBT ABOUT OUR ABILITY TO CONTINUE AS A GOING CONCERN. We have experienced significant operating losses in the current and prior years. Our cash and short-term investment balances continue to decline since June 30, 2000 and we expect to experience further declining balances. We have been unable to pay all of our trade creditors and certain other obligations in accordance with their terms and some of our creditors have refused to provide further products or services except on a C.O.D. basis. We intend to improve liquidity by the continued monitoring and reduction of manufacturing, facility and administrative costs including reduction of personnel and the sale of our portable ride simulation units. We expect that our cash on hand and short-term investments, together with cash generated by operations, cannot sufficiently fund future operating losses and capital requirements. We have attempted to raise additional capital through debt or equity financings and to date have had nominal success. If we are unable to obtain financing on terms acceptable to us, or at all, or if the transaction with SimEx does not close on a timely basis, we will not be able to accomplish any or all of our initiatives and could be forced to consider steps that would protect our assets against our creditors. WE HAVE A HISTORY OF LOSSES AND THERE CAN BE NO ASSURANCE THAT WE WILL BE ABLE TO ACHIEVE PROFITABLE OPERATIONS IN FISCAL 2001. We have not been profitable in five of the last six years and have an aggregate net loss for the last six years of $59.2 million. During the nine months ended March 31, 2001, we incurred a net loss of $1.8 million and for the fiscal year ended June 30, 2000, we incurred a net loss of $22.5 million. Because substantial portions of our expenses are fixed and our gross margin is relatively low, achieving profitability depends upon our ability to generate and sustain substantially higher revenues. Although we have implemented plans to increase revenues and operating margin, we cannot assure you that we will be able to do so and consequently we expect to experience additional losses in fiscal 2001. OUR COMMON SHARES HAVE BEEN DELISTED FROM THE NASDAQ STOCK MARKET. On November 1, 2000, we were notified by The Nasdaq Stock Market that we did not meet the continued listing requirements of The Nasdaq Small Capital Market and our common shares were delisted on the close of business on November 1, 2000. Our common stock currently is trading on the Over the Counter Bulletin Board. It may be more difficult to raise additional debt or equity financing while trading on the Over the Counter Bulletin Board. If we are unable to raise additional financing, we will not be able to accomplish our business objectives and may consider steps to protect our assets against creditors. WE DEPEND ON SINGLE OR LIMITED SUPPLIERS FOR CERTAIN OF OUR COMPONENTS AND IF THESE SUPPLIERS ARE UNABLE TO PROVIDE THESE COMPONENTS, WE MAY EXPERIENCE DELAYS IN PRODUCT SHIPMENT AND ADDITIONAL COSTS. We currently use only one or a limited number of suppliers for certain of the components that we use in our theater systems. If our suppliers are unable to deliver these components to us we may be unable to locate an alternate source of these components, which would result in a material adverse effect on our revenues, results of operations, liquidity and financial position. Our reliance on a limited number of vendors involves many risks including: o Shortages of certain key components; o Delays in product shipment; o Product performance shortfalls; o Additional costs associated with the purchase of the components from alternative suppliers; and Page 16 o Reduced control over delivery schedules, manufacturing capabilities, quality and costs; If any of our suppliers suffer business disruptions, financial difficulties, or if there is any significant change in condition of our relationship with the supplier, our costs of goods sold may increase or we may be unable to obtain these key components for our products. In either event, our revenues, results of operations, liquidity and financial condition would be adversely affected. While we believe that we can obtain most of the components necessary for our products from other manufacturers, any unanticipated change in the source of our supplies, or unanticipated supply limitations, could adversely affect our ability to meet our product orders. IT IS POSSIBLE THAT OUR CURRENT FILM SOFTWARE MAY NOT SUSTAIN ITS POPULARITY AND OUR NEW FILM SOFTWARE MAY NOT BECOME POPULAR. A substantial portion of our revenue is dependent upon the production and distribution of entertainment film software for exhibition on our theatre systems. Each production is an individual artistic work. We try to develop and produce film software that will achieve high market acceptance. However, market acceptance depends upon many factors beyond our control, including: o audience reaction; o competitive programming; o other forms of entertainment; and o perceived quality of programming. We cannot assure you that our film software will obtain market acceptance. If our film software becomes less popular, we will most likely derive less revenue from the license of our film library and from new hardware sales. OUR COMPETITIVE POSITION IS DEPENDENT ON CONTINUING TO INVEST IN NEW FILM PRODUCTIONS. IF WE ARE UNABLE TO DO SO, IT COULD HAVE A NEGATIVE IMPACT ON OUR REVENUES. We believe that our extensive library of popular films is a competitive advantage and that we must continue to add to this library if we are to be successful. Film production is expensive. We typically spend $100,000 to $2,000,000 to produce a film. Although we try to reduce the financial impact of a new film by entering into licensing, participation or other financing arrangements with third parties, prior to release we typically do not recoup our costs until 2 to 3 years later. Even if we are able to reduce the costs of production, we cannot assure you that the films we produce and acquire will be popular. In addition, because our cash balances have continued to decline, we have had to decrease substantially the level of our investment in film software and this may have an adverse impact on our revenues in future periods. OUR PRINCIPAL COMPETITORS DEVOTE GREATER FINANCIAL, PERSONNEL AND MARKETING RESOURCES TO THE DEVELOPMENT AND EXPANSION OF COMPETITIVE PRODUCTS. We face significant competition in each of the markets in which we operate. Our principal direct competition for customers comes from manufacturers of competing movie-based attractions, and in the case of amusement and theme parks, manufacturers of traditional amusement park attractions. In addition, there is also competition from systems integrators and some amusement and theme parks developing and constructing their own attractions. We have significantly fewer financial, technical, manufacturing, marketing and other resources than certain of our competitors and these limited resources may harm our business in many ways. Our competitors may leverage their greater resources to: o develop, manufacture and market products that are less expensive or technologically superior to our products; Page 17 o reach a wider array of potential customers through increased marketing and sales activities; o attend more trade shows and spend more on advertising and marketing; o operate at lower margins for longer periods; o respond more quickly to new or changing technologies, customer requirements and standards; or o reduce prices in order to preserve or gain market share. In addition, the out-of-home entertainment industry in general is undergoing significant changes, primarily due to technological developments as well as changing consumer tastes. Many companies are developing and are expected to develop new entertainment products or concepts in response to these developments that may be directly competitive with our products. We believe these competitive pressures are likely to continue. We cannot guarantee that our resources will be sufficient to address this competition or that we will manage costs and adopt strategies capable of effectively utilizing our resources. If we are unable to respond to competitive pressures successfully, our prices and profit margins may fall and our market share may decrease. OUR FUTURE SUCCESS WILL DEPEND IN PART UPON OUR ABILITY TO ANTICIPATE CHANGES IN TECHNOLOGY AND DEVELOP NEW AND ENHANCED PRODUCTS ON A TIMELY AND COST-EFFECTIVE BASIS. We operate in a technology-driven segment of the entertainment industry. Consequently, it is important for us to develop new and enhanced products in response to technological changes. Risks inherent in the development and introduction of new products include: o difficulty in forecasting customer demand accurately; o our inability to expand capacity fast enough to meet customer demand; o the possibility that new products may cannibalize current products; o delays or interruptions in the manufacture and installation of new products; o competitors' responses to our introduction of new products; o the desire by customers to evaluate new products for longer periods of time before making a purchase decision; and o the possibility the market may reject certain new technology and products. If we are unable, for technological or other reasons, to develop products in a timely manner or the products or product enhancements that we develop do not achieve market acceptance, our revenues may decline and our financial condition would be adversely affected. A SIGNIFICANT PORTION OF OUR SALES AND CUSTOMERS ARE LOCATED OUTSIDE THE UNITED STATES. CURRENCY FLUCTUATIONS AND THE INCREASED COSTS ASSOCIATED WITH INTERNATIONAL SALES COULD MAKE OUR PRODUCTS UNAFFORDABLE IN FOREIGN MARKETS, WHICH COULD REDUCE OUR PROFITABILITY. Sales to customers outside the United States accounted for approximately 46%, 56%, 70% and 56% of our revenues in fiscal 1998, 1999, 2000, and the nine months ended March 31, 2001, respectively. We believe that international sales will continue to represent a significant portion of our total sales. Our foreign sales subject us to a number of risks including: Page 18 o although we denominate our international sales in U.S. dollars, currency fluctuations could make our products unaffordable to foreign purchasers or more expensive compared to those of foreign manufacturers; o greater difficulty of administering business overseas may increase the costs of foreign sales and support; o foreign governments may impose tariffs, quotas and taxes on our products; o longer payment cycles typically associated with international sales and potential difficulties in collecting accounts receivable may reduce the profitability of foreign sales; o political and economic instability may reduce demand for our products or our ability to market our products; o restrictions on the export or import of technology may reduce or eliminate our ability to sell in certain markets; and o although we have met certain international manufacturing standards, our lack of ISO 9000 certification, a widely accepted method of establishing and certifying the technical characteristics and quality of our products, may hinder our foreign sales. These risks may increase our costs of doing business internationally and reduce our sales or profitability. WE ARE DEPENDENT ON THE STRENGTH OF THE NATIONAL AND INTERNATIONAL ECONOMIES. RECESSIONARY OR DEFLATIONARY CONDITIONS IN ANY OF OUR PRINCIPAL MARKETS COULD REDUCE OUR SALES AND PROFITABILITY. Our revenues and profitability are dependent on the strength of the national and international economies. In a recessionary or deflationary environment, sales of our products may be adversely affected. Theme parks and other out-of-home entertainment venues may also experience a downturn in sales which could reduce the funds available for capital improvements and film licensing, resulting in price and other concessions and discounts by us in order to maintain sales activity. OUR QUARTERLY REVENUES AND OPERATING RESULTS ARE DIFFICULT TO FORECAST. IF REVENUES AND OPERATING RESULTS FLUCTUATE UNEXPECTEDLY FROM QUARTER TO QUARTER, OUR STOCK PRICE MAY FLUCTUATE. Our quarterly revenues and operating results are difficult to forecast. As a result, we believe that the period-to-period comparisons for operating results are not necessarily reliable indicators of our future performance. A variety of factors may affect our operating results, including factors that are outside our control. These factors include the following: o the size and timing of customer orders; o the timing, introduction or enhancement of products by us or our competitors; o the timing and level of our operating expenses. Any unanticipated change in operating results may cause our stock price to fluctuate since such changes reflect new information for investors and analysts. New information causes investors and analysts to revalue our stock and this in the aggregate could cause our stock price to fluctuate. Page 19 OUR CUSTOMERS HAVE THE RIGHT TO TERMINATE THEIR CONTRACTS WITH US IN CERTAIN CIRCUMSTANCES, WHICH CAN HAVE AN ADVERSE EFFECT ON OUR CASH FLOW. Our hardware sales contracts typically provide that the customer may terminate our contract prior to delivery. However, a customer canceling its contract is obligated to pay to us a cancellation fee equal to the costs committed or incurred plus 20%. Customers typically pay a deposit upon execution of a contract. If a customer cancels a contract and the amount of the deposit exceeds the cancellation fee, we are contractually obligated to refund the excess to the customer. In the event of a large refund, we could experience a negative impact on cash flow. IF WE ARE SUED ON A PRODUCT LIABILITY CLAIM, OUR INSURANCE POLICIES MAY NOT BE SUFFICIENT. Although we maintain general liability insurance and product liability insurance, our insurance may not cover all potential types of product liability claims to which manufacturers are exposed or may not be adequate to indemnify us for all liability that may be imposed. Any imposition of liability that is not covered by insurance or is in excess of our insurance coverage could harm our business. IF WE ARE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS ADEQUATELY, THE ADVANTAGES OF OUR RESEARCH, MANUFACTURING AND DISTRIBUTION SYSTEMS MAY BE REDUCED AS COMPETITORS ADOPT SOME OR ALL OF THESE TECHNIQUES. Since our business depends in part on intellectual property rights, our ability to compete effectively depends in part on our ability to develop and maintain proprietary aspects of our technology in creative works. We currently hold several patents on the design elements of our products and also rely on a combination of trademark, trade secret, copyright and other intellectual property laws to protect our proprietary rights. Such rights, however, may not preclude competitors from developing products that are essentially equivalent or superior to ours. In addition, many aspects of our product are not subject to intellectual property protection and therefore may be reproduced by our competitors. INTELLECTUAL PROPERTY INFRINGEMENT CLAIMS AGAINST US COULD BE TIME CONSUMING AND EXPENSIVE TO DEFEND AND MAY HARM OUR BUSINESS. In recent years there has been significant litigation in the United States involving patents and other intellectual property rights. While we currently are not engaged in any material intellectual property litigation or proceedings, we may become involved in the future. An adverse outcome of litigation could force us to do one or more of the following: o stop selling, incorporating or using our products for services that use the challenged intellectual property; o subject us to significant liabilities to third parties; o obtain from the owners of the infringed intellectual property right a license to sell or use the relevant technology, which license may not be available on reasonable terms or at all; or o redesign those products and services that use such technology, which redesign may be either economically or technologically infeasible. Whether or not an intellectual property litigation claim is valid, the cost of responding to it, in terms of legal fees and expenses and the diversion of management resources, could harm our business. Page 20 THE ABILITY OF OUR BOARD OF DIRECTORS TO ISSUE PREFERRED STOCK AND OUR STOCKHOLDER RIGHTS PLAN MAY MAKE TAKEOVER ATTEMPTS DIFFICULT OR IMPOSSIBLE. Our Board of Directors has the authority, without any action of the shareholders, to issue up to one million shares of Preferred Stock and to fix the rights and preferences of those shares. In addition, we have in place a Stockholder Rights Plan. The ability of our Board to issue Preferred Stock and the existence of the Stockholder Rights Plan may have the effect of delaying, deferring or preventing a change of control, may discourage bids for our common stock at a premium over its market price and may adversely affect the market price, and the voting and rights of the holders of our Common Stock. Page 21 PART II - OTHER INFORMATION ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K a. EXHIBITS: None. b. REPORTS ON FORM 8-K FILED DURING THE QUARTER ENDED MARCH 31, 2001 A Form 8-K was filed on March 7, 2001, Item 5, regarding a press release dated March 5, 2001. Page 22 SIGNATURES Pursuant to the requirements of Sections 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has caused this report to be signed on its behalf by the undersigned thereunto duly authorized, in the city of Burbank, State of California on the 14th day of May, 2001. IWERKS ENTERTAINMENT, INC. (Registrant) By: /S/ JEFFREY M. DAHL -------------------- Senior Vice President Chief Financial Officer (Principal Finance Officer) By: /S/ DEBRA L. WISE ------------------- Vice President / Controller (Principal Accounting Officer) DATE: MAY 14, 2001 Page 23

IWERKS ENTERTAINMENT INC 10-Q