10-Q 1 d10q.txt FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 FORM 10-Q (Mark One) [X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended September 30, 2001. or [_] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from ____________ to ____________. Commission File No. 333-64483 DIVA Systems Corporation (Exact name of Registrant as specified in its charter) Delaware 94-3226532 (State or other jurisdiction of (IRS Employer Incorporation or organization) Identification Number) 800 Saginaw Drive Redwood City, CA 94063 (Address of principal executive offices) (650) 779-3000 (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 of Registrant's classes of Common Stock at October 31, 2001 was: Title of each class ------------------- Common Stock, $.001 par value 18,247,372 Class C Common Stock, $.001 par value 857,370 DIVA SYSTEMS CORPORATION Quarterly Report on Form 10-Q Table of Contents Quarter Ended September 30, 2001 PART I - FINANCIAL INFORMATION Item 1. Consolidated Financial Statements (Unaudited) Condensed Consolidated Balance Sheet at September 30, 2001 and June 30, 2001 1 Condensed Consolidated Statement of Operations for the three months ended September 30, 2001 and 2000 2 Condensed Consolidated Statement of Cash Flows for the three months ended September 30, 2001 and 2000 3 Notes to Condensed Consolidated Financial Statements 4 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 5 Item 3. Quantitative and Qualitative Disclosures About Market Risk 12 PART II - OTHER INFORMATION Item 2. Changes in Securities and Use of Proceeds 26 Item 6. Exhibits and Reports on Form 8-K 26 Signatures 27

PART I ITEM 1. FINANCIAL STATEMENTS DIVA SYSTEMS CORPORATION AND SUBSIDIARIES Condensed Consolidated Balance Sheets (in thousands, except per share data) (unaudited)

~~March~~September 3130, June 30, Assets 2001 ~~2000~~2001 ------------------ ----------------- ~~Assets~~ Current assets: Cash and cash equivalents $ 4619,~~315~~739 $ 6619,~~253~~146 Short-term investments 116,~~123~~373 2614,~~429~~169 Accounts receivable 69,~~149~~969 ~~264~~15,090 Inventory 1712,~~284~~230 315,~~143~~947 Prepaid expenses and other current assets ~~759 3~~1,~~520~~085 775 ------------------ ----------------- Total current assets 8149,~~630~~396 9965,~~609~~127 Property and equipment, net 1211,~~087~~477 12,~~648~~433 Debt issuance costs, net 54,~~140~~152 64,~~500~~652 Deposits and other assets ~~591~~600 ~~596~~597 ~~Intangible assets, net~~ -- ~~134~~ ---------------- ----------------- Total assets $ 9965,~~448~~625 $ ~~119~~82,~~487~~809 ================== ================= Liabilities, Redeemable Warrants and Stockholders' Deficit Current liabilities: Accounts payable $ 10,~~570~~584 $ 514,~~121~~440 Other current liabilities 13,~~973~~713 45,~~441~~127 Deferred revenue 43,~~377~~294 12,~~015~~126 Current portion of capital lease obligation ~~722~~754 ~~676~~738 ------------------ ----------------- Total current liabilities 1718,~~642~~345 1122,~~253~~431 Notes payable ~~344~~367,~~229~~069 ~~312~~355,~~815~~517 Redeemable put warrants 5,993 7,326 ~~11,989~~ Long - term portion of lease payable ~~482~~97 ~~1,029~~292 Deferred rent ~~868~~904 ~~780~~892 ------------------ ----------------- Total liabilities ~~370~~392,~~547~~408 ~~337~~386,~~866~~458 ------------------ ----------------- Redeemable warrants 54,~~110~~621 75,~~007~~364 ~~Commitments and contingencies~~ ------------------ ----------------- Commitments and contingencies Stockholders' deficit: Preferred stock, $0.001 par value; 80,000,000 shares authorized; 25,120,~~502~~851 and 2425,~~495~~120,~~463~~851 shares issued and outstanding as of ~~March~~September 3130, 2001, and June 30, ~~2000~~2001, respectively. Common stock, $0.001 par value; 165,000,000 shares authorized; 25 2425 19,~~059~~088,~~029~~041 and 1819,~~615~~086,~~618~~839 shares issued and outstanding as of ~~March~~September 3130, 2001, and June 30, ~~2000~~2001, respectively. 19 19 Additional paid-in capital ~~147~~148,~~617~~274 ~~138~~147,~~211~~682 Deferred compensation (42,~~448~~783) (53,~~954~~592) Accumulated deficit (~~419~~476,~~422~~939) (~~357~~453,~~686~~147) ------------------ ----------------- Total stockholders' deficit (~~276~~331,~~209~~404) (~~225~~309,~~386~~013) ------------------ ----------------- Total liabilities, redeemable warrants and stockholders' deficit $ 9965,~~448~~625 $ ~~119~~82,~~487~~809 ================== ================ ~~See accompanying notes to interim condensed consolidated financial statements.~~=

See accompanying notes to interim condensed consolidated financial statements. DIVA SYSTEMS CORPORATION AND SUBSIDIARIES Condensed Consolidated Statements of Operations (in thousands, except per share data) (unaudited)

Three Months Ended ~~Nine~~September ~~Months Ended March 31~~30, ~~March 31,~~ 2001 2000 ~~2001 2000~~ ----------------- --------------- Revenues: Product $ 4,481 $ 35 License 2,781 36 Service 1,169 314 ----------------- --------------- ~~Revenues:~~Total ~~Product~~revenues ~~$ 4~~8,~~502~~431 $385 ~~436~~Cost $of ~~4,555~~revenues: $Cost ~~1,380~~of ~~License~~product 1revenue 7,~~869~~270 16185 ~~1,950~~Cost 16of ~~Service~~service ~~583~~revenue ~~132~~1,418 1,~~927~~048 ~~303~~ ----------------- --------------- Total cost of revenues 8,688 1,233 ----------------- --------------- ~~Total~~Negative ~~revenues~~gross ~~6,954~~margin ~~584~~257 ~~8,432~~848 ~~1,699~~----------------- --------------- Operating expenses: ~~Cost of revenue 6,699 2,555 7,437 3,658 Programming 1,427 983 3,352 3,248~~ Operations ~~1,309~~704 1,~~738~~815 ~~4,897 4,738~~ Engineering and development 93,~~253~~427 78,~~494~~011 ~~24,943 19,697~~ Sales and marketing 1,~~902~~333 1,~~645~~472 ~~5,167 4,938~~ General and administrative 45,~~777~~650 5,~~756~~505 ~~16,368 14,514~~ Depreciation and amortization 1,~~445~~334 21,~~095~~522 ~~4,478 5,370~~ Warrant expense ~~323~~(benefit) -154 ~~389~~(181) - Amortization of stock compensation ~~801~~501 1,~~255~~128 ~~3,021 1,640~~ ------------ -----~~-------~~ ------------ ---~~--------~~ Total operating expenses 2713,~~936~~103 2319,~~521~~272 ~~70,052 57,803~~ ------------ -----~~-------~~ ------------ ---~~--------~~ Operating loss 2013,~~982~~360 2220,~~937~~120 ~~61,620 56,104~~ ------------ -----~~-------~~ ------------ ---~~--------~~ Other (income) expense: Interest income (~~997~~309) (~~1,449~~711) ~~(3,074) (4,548)~~ Gain on sale of investments - - (2412,~~421~~896) - Interest expense 1110,~~286~~741 95,~~903~~294 ~~27,611 28,720~~ ------------ -----~~-------~~ ------------ ---~~--------~~ Total other (income)/expense, net 10,~~289~~432 (8,~~454~~313) ~~116 24,172~~ ------------ -----~~-------~~ ------------ ---~~--------~~ Net loss 3123,~~271~~792 3111,~~391~~807 ~~61,736~~Decrement ~~80,276 Accretion~~ of redeemable warrants ~~254~~(743) ~~4,175~~ (12,~~896~~404) ~~4,478~~ ------------ -----~~-------~~ ------------ ---~~--------~~ Net loss attributable to common stockholders $ 3123,~~525~~049 $ 359,~~566~~403 ~~$ 59,840 $ 84,754~~ ============ =====~~=======~~ ============ ===~~========~~ Basic and diluted net loss per share: $ 1.6721 $ 1.9550 ~~$ 3.18 $ 4.76~~ ============ =====~~=======~~ ============ ===~~========~~ Shares used in per share computation 1819,~~859~~088 18,~~241~~670 ~~18,826 17,812~~ ============ =====~~=======~~ ============ ===~~======== See accompanying notes to interim condensed consolidated financial statements.~~

See accompanying notes to interim condensed consolidated financial statements. 2 DIVA SYSTEMS CORPORATION AND SUBSIDIARIES Condensed Consolidated Statement of Cash Flows (in thousands) (unaudited)

~~Nine~~Three Months Ended ~~March~~September 3130, 2001 2000 ------------~~----~~ ------------- Cash flows from operating activities: Net loss $ (6123,~~736~~792) $ (8011,~~276~~807) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization 41,~~478~~334 51,~~370~~522 ~~(Gain) loss on sale of property and equipment (40) 82~~ Inventory ~~write~~reserves ~~down~~-- ~~3,812~~931 ~~2,477~~ Amortization of debt issuance costs and accretion of discount on notes payable 2810,~~111~~719 285,~~622~~857 Amortization of deferred stock compensation ~~3,021~~501 1,~~640~~128 Warrant expense ~~389~~(benefit) -154 ~~Gain on sale of investments~~ (~~24,421~~181) - Changes in operating assets and liabilities: Accounts receivable (5,~~885)~~121 (111,~~053~~699) Inventory ~~(17~~3,~~953)~~717 (~~498~~4,903) Other assets ~~2,761~~(310) ~~1,244~~558 Accounts payable 5(3,~~449~~856) ~~669~~1,046 Other current liabilities (21,~~468~~414) (1,~~835~~187) Deferred revenue ~~3,362~~ 1,~~013~~168 (32) Deferred rent 8812 -30 --------~~-------~~ --------~~-----~~ Net cash used for operating activities (616,~~032~~646) (3818,~~875~~737) --------~~-------~~ --------~~-----~~ Cash flows from investing activities: Purchases of property and equipment (~~3,864~~381) (~~4,985~~911) Proceeds from sale of ~~investments 24,421 - Proceeds from the sale of assets 125 40 Proceeds from sale of~~ short-term investments 207,~~230~~796 ~~11,768~~ Purchases of short-term investments -- (43,~~924~~931) - -------~~--------~~ --------~~-----~~ Net cash provided by (used in) investing activities 357,~~988~~415 6(4,~~823~~842) --------~~-------~~ --------~~-----~~ Cash flows from financing activities: Issuance of preferred stock, net -- 5,000 ~~7,001~~ Exercise of stock options ~~607~~3 ~~1,203~~150 Payments on capital lease (~~501~~179) (~~255~~165) ~~Payments on note payable~~ - ~~(37)~~ -------~~--------~~ --------~~-----~~ Net cash provided by (used in) financing activities ~~5,106~~(176) 74,~~912~~985 --------~~-------~~ --------~~-----~~ Net increase (decrease) in cash and cash equivalents ~~(19,938)~~593 (2418,~~140~~594) Cash and cash equivalents at beginning of period 19,146 66,253 ~~89,239~~-------- -------- Cash and cash equivalents at end of period $ 4619,~~315~~739 $ 6547,~~099~~659 ========~~=======~~ ========~~=====~~ Supplemental disclosures of cash flow information: Noncash investing and financing activities: ~~Reclassification~~Revaluation of ~~equipment~~put towarrants ~~inventory~~associated with the 1996 notes $ -(1,333) $ ~~556~~(4,663) ========~~=======~~ ========~~=====~~ ~~Equipment~~Decrement ~~acquired~~of ~~under~~redeemable ~~capital~~warrants ~~lease obligations~~ $ -(743) $ (2,~~120~~404) ========~~=======~~ ========~~=====~~ ~~(Decrement)/Accretion~~Deferred ofcompensation ~~redeemable~~expense ~~warrants~~associated with stock options $ (~~1,896~~308) $ 41,~~478~~665 ========~~=======~~ ========~~===== See accompanying notes to interim condensed consolidated financial statements.~~

See accompanying notes to interim condensed consolidated financial statements. 3 DIVA SYSTEMS CORPORATION AND SUBSIDIARIES NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) Note 1--The Company And Basis Of Presentation DIVA Systems Corporation (the "Company") is a leading provider of digital video-on-demand products and services. The Company's principal operations consist of selling, licensing, manufacturing and providing operational support for its video-on-demand products and services. The interim unaudited financial statements as of September 30, 2001, and for the three months ended September 30, 2001 and 2000 have been prepared on substantially the same basis as the Company's audited financial statements for the year ended June 30, 2001 and include all adjustments, consisting only of normal recurring adjustments that, in the opinion of management, are necessary for a fair presentation of the financial information set forth herein. The results of operations for current interim periods are not necessarily indicative of results to be expected for the current year or any other period. These interim unaudited financial statements should be read in conjunction with the Company's annual financial statements, included in the Company's Form 10-K for the year ended June 30, 2001 (Fiscal 2001). Note 2--Basic and Diluted Net Loss Per Share Basic and diluted net loss per share is computed using net loss adjusted for the accretion of the redeemable warrants and the weighted-average number of outstanding shares of common stock. Potentially dilutive securities, including options, warrants, restricted common stock, and preferred stock (amounting to 42,056,510 and 44,775,430 shares of common stock at September 30, 2001 and 2000, respectively) have been excluded from the computation of diluted net loss per share because the effect of this inclusion would be antidilutive. Information pertaining to potentially dilutive securities is included in Notes 5, 6 and 7 of notes to consolidated financial statements included in the Company's Fiscal 2001 Form 10-K. Note 3--Revenue Recognition Policy The Company's contracts are generally multiple-element arrangements with a network operator involving a combination of video-on-demand hardware products, licenses for system software and navigator applications and selected content and operational services. The Company recognizes revenue in accordance with the American Institute of Certified Public Accountants Statement of Position 97-2 (SOP 97-2), "Software Revenue Recognition," and Statement of Position 98-9 (SOP 98-9), "Software Revenue Recognition, with Respect to Certain Transactions." SOP 97-2 generally requires revenue earned on software arrangements involving multiple elements to be allocated to each element based on the relative fair values of the elements. The fair value of an element must be based on vendor specific objective evidence, which is generally determined by the price charged when the element is sold separately. SOP 98-9 requires recognition of revenue using the residual method in a multiple element arrangement when fair value does not exist for one or more of the delivered elements in the arrangement. 4 Under the residual method, revenue for the undelivered elements is deferred and subsequently recognized in accordance with SOP 97-2. The Company adopted Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" (SAB 101), amended by SAB 101A and 101B as of April 1, 2001, which provides guidance on the recognition, presentation and disclosure of revenue in financial statements filed with the Securities and Exchange Commission. SAB 101 outlines the basic criteria that must be met to recognize revenues and provides guidance for disclosure related to revenue recognition policies. The adoption of SAB 101 did not have a material impact on the Company's consolidated financial position or its results of operations. Prior to January 2001, all hardware and software elements were deliverable over the term of the contract and evidence of the fair value of the individual elements in our agreements did not exist. As a result, upon the delivery of the Company's video-on-demand hardware products, revenue was recognized to the extent of the cost of these hardware products. Any remaining product revenue was amortized on a straight-line basis over the remaining term of the agreement. The Company recognized license revenues over the term of the agreement based on the number of subscribers. All of the Company's installations since January 2001 have been made under agreements whereby all hardware and software elements are delivered upon completion of installation and the training of cable network personnel. Accordingly, the Company has recognized product revenue and licensing revenue upon completion of the equipment installation at a customer's site, which includes completion of technical training, according to the residual method. Consequently, the fair value of the maintenance element, determined by the maintenance renewal fee, is deferred and amortized over the maintenance period, which is generally one year. The Company provides services on a fee-for-service basis, whereby service revenue is recognized when the services are performed. If the services are provided on a revenue sharing basis, service revenue is recognized based on program purchases by subscribers. The Company provides limited warranty rights to its customers. Estimated warranty obligations are provided by charges to operations in the period in which the related revenue is recognized. To date, the estimated warranty obligations have not been considered significant. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion of our financial condition and results of operations should be read in conjunction with the Consolidated Financial Statements and the related notes included elsewhere in this Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from the results discussed in the forward-looking statements. Factors that might cause such a difference includes, but are not limited to, those discussed below. The forward-looking statements contained herein are made as of the date hereof, and we assume no obligation to update such forward-looking statements or to update the reason actual results may differ materially from those anticipated in such forward-looking statements. Forward-looking statements are statements identified with an asterisk (*). All forward-looking statements attributable to us or persons 5 acting on our behalf are expressly qualified in their entirety by the cautionary statements set forth above and in "--Factors Affecting Operating Results." Overview We are a leading provider of interactive, on-demand television products and services. Our video-on-demand service operates on industry-standard digital set-top boxes and operating systems, providing a flexible and cost-effective interactive television solution for cable and other broadband network operators, which we refer to as network operators. We have commercially deployed our video-on-demand service with several network operators in North America. In addition to our video-on-demand products and services we developed and beta tested an interactive program guide as a stand-alone product. To date, we have neither commercially deployed nor are we actively marketing our interactive program guide technology. On June 30, 2001 we ceased further development activities related to our interactive program guide technology and reduced our development workforce accordingly. Since our inception, we have devoted substantially all of our resources to developing our video-on-demand and other interactive products and services, establishing industry relationships, carrying out marketing activities, negotiating deployment agreements and establishing the operations necessary to support the commercial deployment of our video-on-demand products and services. Through September 30, 2001, we have generated some revenues and incurred significant losses and substantial negative cash flow, primarily due to engineering and development expenditures and other costs required to develop our video-on-demand products and services. Since our inception through September 30, 2001, we have an accumulated deficit of $476.9 million and have not achieved profitability on a quarterly or annual basis. We expect to continue to incur substantial net losses and negative cash flow for at least the next few years, requiring us to raise additional capital. In addition, we have limited cash reserves and uncertainty exists concerning our ability to raise additional capital and continue as a going concern.* Our historical revenues and expenditures are not necessarily indicative of, and should not be relied upon as an indicator of, revenues that may be attained or expenditures that may be incurred by us in future periods.* Revenues Revenue is comprised of three components: product revenue resulting from the sale of our video-on-demand hardware platform; licensing revenue resulting from the licensing of our system software and navigator applications; and service revenue resulting from programming services and operational support services. Our contracts are generally multiple-element arrangements with a network operator involving a combination of video-on-demand hardware products, licenses for system software and navigator applications, and selected content and operational services. As a result, we recognize revenue in accordance with the American Institute of Certified Public Accountants Statement of Position 97-2 (SOP 97-2), "Software Revenue Recognition," and Statement of Position 98-9 (SOP 98-9), "Software Revenue Recognition, with Respect to Certain Arrangements." SOP 97-2 generally requires revenue earned on software arrangements involving multiple elements to be allocated to each element based on 6 the relative fair values of the elements. The fair value of an element must be based on vendor specific objective evidence, which generally is determined by the price charged when the element is sold separately. SOP 98-9 requires recognition of revenue using the residual method in a multiple element arrangement when fair value does not exist for one or more of the delivered elements in the arrangement. Under the residual method, the total fair value of the undelivered elements is deferred and subsequently recognized in accordance with SOP 97-2. Prior to January 2001, all hardware and software elements were deliverable over the term of the contract and evidence of the fair value of the individual elements in our agreements did not exist. As a result, upon the delivery of our video-on-demand hardware products, revenue was recognized to the extent of the cost of these hardware products and any remaining product revenue was amortized on a straight-line basis over the remaining term of the agreement. We recognized license revenues over the term of the agreement based on the number of subscribers. All of our installations since January 1, 2001 have been made under agreements whereby all hardware and software elements are delivered upon completion of installation and the training of network operator personnel. Accordingly, for the three months ended September 30, 2001, we recognized product revenue and licensing revenue upon completion of the equipment installation at a customer's site, which includes technical training, according to the residual method. Consequently, the fair value of the maintenance element, determined by the maintenance renewal fee, is deferred and amortized over the maintenance period, which is generally one year. We provide services on a fee-for-service basis, whereby service revenue is recognized when the services are performed. If the services are provided on a revenue sharing basis, service revenue is recognized based on program purchases by subscribers. Cost of Revenues Cost of Product Revenues. Cost of revenue consists of contract manufacturing costs, component and material costs, warranty costs, and other direct product expenditures associated specifically with the sale of our video-on-demand hardware and software products. Included in cost of product revenues are allocations of certain manufacturing overhead expenses. We expect our cost of revenue to increase in the future due to increased sales volume of our video-on-demand hardware and software products.* Cost of Service Revenues. Cost of service revenue consists of license fees paid to content providers, costs related to the acquisition and production of digitally encoded programming content, duplication and distribution expenses and other expenditures associated specifically with content management. Operating Expenses Operations. Operations expense includes the cost of field operations, both for initial launches and for ongoing support of our installed video-on-demand systems. These costs include personnel and other costs for technical support, customer service training, installation, launch support, and maintenance costs. In addition, operations expense includes personnel and other costs which support our ongoing manufacturing relationships for our video-on-demand hardware products with third-party manufacturers. 7 Engineering and Development. Engineering and development expense consists of salaries, consulting fees, prototype hardware and other costs to support product development. Our engineering and development efforts involve ongoing system software development, hardware development, system integration and new technology. To date, the most substantial portion of our operating expenses has been engineering and development expense. We expect to continue to incur significant engineering and development expenditures as we continue to enhance our video-on-demand products and services.* We believe these expenditures are necessary to remain competitive, to assure that our products and services comply with industry standards and to offer new products and services to our customers. Sales and Marketing. To date, our sales and marketing expense has consisted of the costs of marketing our video-on-demand products and services to network operators and their customers. It also includes costs related to business development and marketing personnel, travel expenses, trade shows, consulting fees and promotional costs. We expect that direct marketing costs will not represent a significant component of total sales and marketing expense, as most network operators will take responsibility for marketing video-on-demand services to their subscribers.* To the extent we provide these services, they will likely be performed under individual service agreements with the network operators and, accordingly, the related expenses will fluctuate with revenues. Our future sales and marketing costs will consist primarily of market development and product management expenses.* General and Administrative. General and administrative expense consists primarily of salaries and related expenses of management and administrative personnel, professional fees and general corporate and administrative expenses. In addition, general and administrative expense includes costs associated with the development, support and growth of our management information system infrastructure. Depreciation and Amortization. Depreciation and amortization expense includes depreciation of property and equipment, including our video-on-demand hardware. Generally, depreciation is calculated using the straight-line method over the estimated useful lives of the assets, which range from three to five years. Historically, depreciation expense has been a significant component of our operating expenses. This resulted from the significant investment in capital equipment necessary to deploy our end-to-end video-on-demand service. We expect depreciation expense to decrease as a component of operating expense in the future as network operators purchase the various video-on-demand hardware components directly from us.* Warrant Expense. Warrant expense represents the cost of the warrants issued to customers and to strategic business partners based on their estimated fair value, as determined using the Black-Scholes option pricing model, at the earlier of the grant date or the date it becomes probable that the warrants will be earned. Amortization of Deferred Stock Compensation. Deferred stock compensation represents the difference between the estimated fair value of our common stock for accounting purposes and the option exercise price of such options at the grant date. 8 Other Income and Expense. Other income and expense primarily consists of interest income and interest expense. Interest income consists of earnings on cash, cash equivalents and short-term investments. Gain on sale of investments consists of proceeds from the sale of an investment in common stock held by us. Interest expense consists primarily of accreted interest on our outstanding debt and revaluation of redeemable put warrants. Results of Operations Revenue Total revenue for the three months ended September 30, 2001 was $8.4 million compared to $385,000 for the three months ended September 30, 2000. The increase in total revenue is the result of an increase in the number of system deployments and an increase in the number of subscribers. During the three months ended September 30, 2001 we deployed our video-on-demand products, software and services in eleven sites representing approximately $10.4 million in product shipments and services. A portion of this is deferred and unbilled and not recognized as revenue for the three months ended September 30, 2001. There were no deployments in the September 30, 2000 quarter. Product revenue. Product revenue was $4.5 million and $35,000 for the three months ended September 30, 2001 and 2000, respectively. License revenue. License revenue was $2.8 million and $36,000 for the three months ended September 30, 2001 and 2000, respectively. License revenue is the fee for our system manager software and navigator application. Service revenue. Service revenue was $1.2 million and $314,000 for the three months ended September 30, 2001 and 2000, respectively. Cost of Revenues Cost of Product Revenue. Cost of product revenue was $7.3 million and $185,000 for the three months ended September 30, 2001 and 2000, respectively. The increase in cost of product revenue was the result of an increase in sales of our video-on-demand products. Included in cost of product revenue for the three months ended September 30, 2001 was an allocation of $794,000 related to indirect costs from operations overhead. Cost of Service Revenues. Cost of service revenues was $1.4 million and $1.0 million for the three months ended September 30, 2001 and 2000, respectively. The increase in cost of service revenues was primarily attributable to an increase in the number of commercial sites deployed with our video-on-video products and services and a corresponding increase in the number of subscribers, and costs associated with the acquisition of new titles in our content library. Operating Expenses Operations. Operations expense was $704,000 and $1.8 million for the three months ended September 30, 2001 and 2000, respectively. The decrease in operations expense was due primarily to the 9 allocation of $794,000 in overhead costs related to the manufacturing of our video-on-demand hardware products to cost of product revenues, a decrease in travel to customer sites and a reduction in personnel related to our manufacturing operations. Engineering and Development. Engineering and development expense was $3.4 million and $8.0 million for the three months ended September 30, 2001 and 2000, respectively. The decrease in engineering and development expense was primarily attributable to a decrease in development personnel, outside consultants and other engineering expenses in connection with the development of certain hardware products and our interactive program guide. In addition, engineering and development expenses for the three months ended September 30, 2000 included $1.1 million in development related expenses pursuant to a development contract with a third party. There was no similar expense for the three months ended September 30, 2001. Sales and Marketing. Sales and marketing expense was $1.3 million and $1.5 million for the three months ended September 30, 2001 and 2000, respectively. The decrease in sales and marketing expense was primarily due to a decrease in marketing and promotional activities in the United Kingdom. General and Administrative. General and administrative expense was $5.6 million and $5.5 million for the three months ended September 30, 2001 and 2000, respectively. The increase in general and administrative expense was primarily due to $810,000 in legal expenses related to our debt restructuring activities, which was offset by a decrease in other general legal expenses and overall decreases in other general and administrative activities. Depreciation and Amortization. Depreciation and amortization expense was $1.3 million and $1.5 million for the three months ended September 30, 2001 and 2000, respectively. Warrant Expense (Benefit). Warrant expense (benefit) was $154,000 and ($181,000) for the three months ended September 30, 2001 and 2000, respectively. Warrant expense (benefit) relates to the costs associated with warrants issued to customers and strategic business partners. Charges in the three months ended September 30, 2001 and 2000, and in future periods, depends in part on the achievement of specified performance milestones by our customers and strategic business partners. Amortization of Deferred Stock Compensation. Amortization of deferred stock compensation expense was $501,000 and $1.1 million for the three months ended September 30, 2001 and 2000, respectively. Deferred stock compensation expense was related to stock options granted to employees and consultants. Other Income and Expenses Interest income was $309,000 and $711,000 for the three months ended September 30, 2001 and 2000, respectively. The decrease in interest income was the result of a decrease in cash and cash equivalent balances, which are invested in short-term, interest bearing accounts and a decrease in short-term investments. Gain on sale of investments was $12.9 million for the three months ended September 30, 10 2000, and was attributable to the sale of common stock of PMC-Sierra, Inc. that we previously acquired. There was no similar transaction during the three months ended September 30, 2001. Interest expense was $10.7 million and $5.3 million for the three months ended September 30, 2001 and 2000, respectively. Included in interest expense for the three months ended September 30, 2001 and 2000 was a credit of $1.3 million and $4.7 million, respectively, for valuation of the put warrants associated with the 1996 notes. Provision for Income Taxes We have not provided for or paid federal income taxes due to our net losses. As of June 30, 2001, we had net operating loss carryforwards of approximately $267.5 million to offset future income subject to federal income taxes and $115.2 million available to offset future California taxable income. As of June 30, 2001, we also had net operating loss carryforwards in various other states. The extent to which such loss carryforwards can be used to offset future taxable income may be limited because of ownership changes pursuant to Section 382 of the Internal Revenue Code of 1986, as amended. Liquidity and Capital Resources From our inception through September 30, 2001, we have financed our operations primarily through the gross proceeds of private placements totaling approximately $108.3 million of equity and $250.0 million of high yield debt securities, net of repayments. As of September 30, 2001, we had cash and cash equivalents and short-term investments totaling $26.1 million. On February 19, 1998, we received $250.0 million in gross proceeds from an offering of 463,000 units consisting of senior discount notes with an aggregate principal amount at maturity of $463.0 million and warrants to purchase an aggregate of 2,778,000 shares of common stock. The notes are senior unsecured indebtedness, and rank pari passu with our unsubordinated unsecured indebtedness. The notes are senior to subordinated indebtedness, but effectively will be subordinated to any future secured indebtedness at least to the extent of the collateral of such indebtedness. The indenture governing our senior discount notes imposes operating and financial restrictions on us and our subsidiaries. These restrictions in certain cases significantly limit or prohibit our ability directly and through our subsidiaries to incur additional indebtedness, create liens upon assets, apply the proceeds from the disposal of assets, make investments, make dividend payments and other distributions on capital stock and redeem capital stock. These covenants have limited our ability to perform certain activities in the past and may limit our ability to finance our operations or engage in other business activities that may be in our best interest in the future. The senior discount notes were sold at a significant discount, and must be repaid at maturity on March 1, 2008. Commencing September 1, 2003, we will be required to make semi-annual interest payments of $29.2 million. There are no principal payments due on the senior discount notes prior to maturity on March 1, 2008. We have had a number of discussions with a committee of holders of our senior discount notes, which represents over 50% of the outstanding senior discount notes, and their financial and legal advisors. To date these discussions have focused on a restructuring of our senior 11 discount notes and our future funding requirements. We have also approached several other potential strategic and financial partners about raising additional capital to fund our operations. There can be no assurance that such discussions will result in a restructure of our outstanding indebtedness or any additional funding commitment. We expect to require significant working capital and incur significant operating expenses in the future.* Working capital requirements include inventory expenditures for our video-on-demand products and general capital expenditures associated with our anticipated growth. Our working capital needs will, in part, be determined by the rate at which network operators purchase and introduce our video-on demand products and services. In addition to working capital, we intend to make significant expenditures for continued development and enhancement of our video-on-demand technology, development of new services and other expenses associated with the delivery of our video-on-demand products and services.* Our actual cash requirements may vary from expectations and will depend on numerous factors and conditions, many of which are outside of our control. We believe our cash, cash equivalents and short-term investments will be sufficient to fund our operations through March 31, 2002.* Thereafter, we will need to raise additional funds through debt or equity financing, selling assets, or entering into strategic relationships, and there can be no assurance that we will be able to perform any of the foregoing on favorable terms, or at all.* We may also need to raise additional funds in order to respond to unforeseen technological or marketing hurdles or to take advantage of unanticipated opportunities. Although we are currently pursuing initiatives to raise additional funds, we have no present commitments or arrangements assuring us of any additional capital and there can be no assurance that we will be able to obtain additional capital on acceptable terms, or at all. Failure to successfully address our ongoing liquidity requirements will have a material adverse effect upon our business. In the event that we are unable to obtain additional capital, we will be required to take actions that will harm our business and our ability to achieve sufficient cash flow to service our indebtedness, including, potentially, ceasing certain or all of our operations. To the extent we raise additional cash by issuing equity securities, our existing stockholders will be diluted. Item 3. Quantitative and Qualitative Disclosures about Market Risk Market Risk Disclosures The following discussion about our market risk disclosures contains forward-looking statements. Forward-looking statements are subject to risks and uncertainties. Actual results could differ materially from those discussed in the forward-looking statements. We are exposed to market risk related to changes in interest rates, foreign currency exchange rates and derivatives. Interest Rate Sensitivity We maintain a short-term investment portfolio consisting mainly of income securities with an average maturity of less than one year. These available-for-sale securities are subject to interest rate risk and will fall in value if market interest rates increase. We have the ability to hold our fixed income investments until maturity and therefore, we would not expect our operating results or cash flows to be affected to any significant degree by the effect of a sudden change in market interest rates on our securities portfolio.* 12 Our short-term investments have generally been available-for-sale. Gross unrealized gains and losses were not significant as of September 30, 2001. The following table presents the principal amounts and related weighted-average yields for our fixed rate investment portfolio (in thousands, except average yields) at September 30, 2001. Carrying Average Amount Yield ---------- --------- U.S. government obligations $ 5,677 3.23% Commercial paper 9,220 3.02% Certificates of deposits 2,188 2.94% Money market instruments 2,654 3.08% Auction rate preferred stock certificates 6,373 4.69% ---------- Total $26,112 ========== Included in cash and cash equivalents $19,739 Included in short-term investments 6,373 ---------- Total $26,112 ========== Foreign Currency Risks We believe that our exposure to currency exchange fluctuation risk is insignificant because our transactions with international vendors are generally denominated in U.S. dollars, which is considered to be the functional currency for our company and subsidiaries. The currency exchange impact on intercompany transactions for the three months ended September 30, 2001 was $14,000. Factors Affecting Operating Results Our ability to continue as a "going concern" is uncertain Our consolidated financial statements have been prepared on the assumption that we will continue as a going concern, which contemplates the realization of assets and liquidation of liabilities in the normal course of business. The independent accountants' report on our financial statements as of and for the fiscal year ended June 30, 2001, included in our Form 10-K, includes an explanatory paragraph which states that since inception we have incurred net operating losses and negative cash flows, and working capital and stockholders' deficits, that raise substantial doubt about our ability to continue as a 13 going concern. Investors in our securities should review carefully the report of the independent accountants in our Form 10-K for Fiscal 2001. We expect our losses and negative cash flow to continue, which will require us to obtain additional capital. It is uncertain whether we will be able to such obtain additional capital on acceptable terms, or at all. Further, if future financing requirements are satisfied through the issuance of equity or debt securities, investors may experience significant dilution in terms of their percentage interest in DIVA. Commencing on September 1, 2003, we will be required to make cash interest payments on our outstanding senior notes. In addition, we believe our cash, cash equivalents and short-term investments will only be sufficient to satisfy our cash requirements through March 31, 2002.* In the event that we are unable to successfully commercially deploy our video-on-demand products and services and implement our business strategy, obtain additional capital or generate sufficient operating cash flows to fund our working capital needs and make interest payments on our outstanding debt, we may be unable to continue as a going concern. If we do not obtain additional funds in the near future, we will be required to take actions that will harm our business, including potentially ceasing certain or all of our operations. We will require additional funds in order to continue the development, sale, licensing and provisioning of our video-on-demand products and services and, commencing on September 1, 2003, to make cash interest payments on our indebtedness. We have made and expect to continue to make significant investments in working capital in order to fund development activities, sell our video-on-demand products and services and fund operations. We expect to continue to incur significant operating losses and expect that our operating cash flow will be negative for at least into calendar 2003. We believe our cash, cash equivalents and short-term investments will be sufficient to fund our operations through March 31, 2002.* Thereafter, we will need to raise additional funds through debt or equity financing, selling assets, or entering into strategic relationships, and there can be no assurance that we will be able to perform any of the foregoing on favorable terms, or at all.* We may also need to raise additional funds in order to respond to unforeseen technological or marketing challenges or to take advantage of unanticipated opportunities. In addition to our recent discussions with a committee of holders of our senior discount notes, we have also approached several potential strategic and financial partners about raising additional capital to fund our operations. We currently have no commitments or arrangements assuring us of any additional funds and there can be no assurance that we will be able to obtain additional capital on acceptable terms, or at all.* Failure to successfully address our ongoing liquidity requirements will have a material adverse effect upon our business. In the event that we are unable to obtain additional capital, we will be required to take actions that will harm our business and our ability to achieve sufficient cash flow to service our indebtedness, including, potentially, ceasing certain or all of our operations. To the extent we raise additional cash by issuing equity securities, our existing stockholders will be diluted. We will require a significant amount of cash to service our indebtedness, and our ability to generate cash depends on many factors beyond our control We expect to continue to generate substantial net losses and negative cash flow for the next few years. We may be unable to achieve a level of cash flow from operations sufficient to permit us to pay the principal and interest on our current indebtedness and any additional indebtedness we may incur. The senior discount notes were sold at a significant discount and must be repaid at maturity on March 1, 2008. Commencing September 1, 2003, we will be required to make semi-annual interest payments of $29.2 million. Our ability to make scheduled debt service payments will depend upon our ability to 14 achieve significant and sustained growth in our cash generated from operations and to complete necessary additional financing. If we are unable to generate sufficient cash from operations to service our indebtedness, we will be required to restructure or refinance such indebtedness or raise additional capital through additional debt or equity financing, selling assets, or entering into strategic relationships. There can be no assurance that we will be able to perform any of the foregoing on favorable terms, or at all. In the event that we are unable to restructure or refinance our indebtedness or obtain additional capital, we will be required to take actions that will harm our business, including, potentially, ceasing certain or all of our operations. We have had a number of discussions with a committee of holders of our senior discount notes, which represents over 50% of our outstanding senior discount notes, and their financial and legal advisors. To date, these discussions have focused on a restructuring of our senior discount notes and our future funding requirements. There can be no assurance that such discussions will result in a restructuring of our outstanding indebtedness or any additional funding commitment. We have also approached several other potential strategic and financial partners about raising capital to fund our operations. There can be no assurance that these potential investors will provide any additional funding. We may not be able to effect any new financing strategy or funding commitments on satisfactory terms, if at all. If we fail to satisfy our obligations with respect to our indebtedness, this could result in a default under the indenture governing our senior discount notes. In the event of a default, the holders of indebtedness would have enforcement rights, including the right to accelerate the debt and the right to commence an involuntary bankruptcy proceeding against us. Absent successful commercial deployments of our interactive products and services, ongoing technical development and enhancement of our solution and significant growth of our cash flow or other successful attempts to raise cash such as the sale of assets or equity or debt financing, we would not be able to service our indebtedness. Our leverage is substantial and will increase, making it more difficult to respond to changing business conditions We are highly leveraged. As of September 30, 2001 we had senior discount notes payable of approximately $367.1 million. The senior discount notes accrete at the rate of 12 5/8% per annum, compounded semi-annually. The senior discount notes were sold at a significant discount and must be repaid at maturity on March 1, 2008 at the aggregate par value of $463.0 million. The degree to which we are leveraged could have important consequences to us and our investors, including, but not limited to, the following: . our ability to obtain additional financing in the future for working capital, operating expenses in connection with system deployments, development and enhancement of our video-on-demand products and services, capital expenditures, acquisitions and other general corporate purposes may be materially limited or impaired; . our cash flow, if any, will not be available for our business because a substantial portion of our cash flow must be dedicated to the payment of principal and interest on our indebtedness; . the terms of future permitted indebtedness may limit our ability to redeem our outstanding senior discount notes in the event of a change of control; and . our high degree of leverage may make us more vulnerable to economic downturns, may limit our ability to withstand competitive pressures and may reduce our flexibility in responding to changing business and economic conditions. 15 Our indebtedness contains restrictive covenants that could significantly limit our ability to engage in business activities that may be in our best interest The indenture governing our senior discount notes imposes operating and financial restrictions on our subsidiaries and us. These restrictions in specified cases significantly limit or prohibit our ability to: . incur additional indebtedness; . create liens upon assets; . apply the proceeds from the disposal of assets; . make investments; . make dividend payments and other distributions on capital stock; and . redeem capital stock. These covenants have limited our ability to perform certain activities in the past and may limit our ability to finance our operations or engage in other business activities that may be in our best interest in the future. We are an early stage company with limited revenues and a history of losses, we expect to continue to incur substantial losses and negative cash flow and we may never achieve or sustain profitability We are an early stage company with limited commercial operating history. We have generated revenues of $29.2 million and have incurred net losses of $476.9 million from our inception through September 30, 2001. We expect to continue to incur substantial losses and experience substantial negative cash flow for at least the next few years as we continue to develop our operations capability and sell and license our video-on-demand products and services. We do not expect to generate substantial revenues unless and until our video-on-demand products and services are deployed at a significant number of additional cable systems and a significant number of viewers access our video-on-demand and other interactive services enabled by our technology. If we do not achieve and sustain profitability in the future, we may be unable to continue our operations. Our prospects should be considered in light of the risks, expenses and difficulties frequently encountered by companies in their early stage of development, particularly companies in new and rapidly evolving markets. Our future success depends on a number of factors, including the following: . the extent to which cable operators deploy digital set-top boxes; . our ability to enter into agreements for the sale and license of our video-on-demand products and services; . the extent to which consumers accept and use interactive, on-demand television enabled by our video-on-demand products and services; . our ability to continue integrating our software and hardware with other digital applications and services selected by network operators in the United States and internationally, including set-top boxes, application managers and set-top box operating systems, cable system components and electronic program guides; 16 . the extent to which third-party cable equipment suppliers integrate their headend products with our equipment and reduce the cost and physical space requirements for their equipment; . our ability to further reduce the physical space requirements for our video server and other headend equipment; . our ability to continue technical development of our video server, our access equipment, our service software and our other video-on-demand system components in order to reduce their manufacturing cost and enhance their functionality; . our ability to operate existing contracted video-on-demand deployments with acceptable system performance and viewer acceptance; and . our ability to outsource, on favorable economic terms, certain hardware and service components to third parties, some of whom may be competitors, so that we can continue to provide our video-on-demand solution. Because we have a limited operating history, we have limited historical financial data on which to base planned operating expenses, and investors may find it difficult to evaluate our business and future prospects Our limited operating history makes it very difficult to evaluate our business and future prospects. As a result of our limited operating history, it is difficult for us to accurately forecast our revenues, and we have limited meaningful historical financial data on which to base planned operating expenses. We are unable to accurately forecast our revenues because: . we participate in an emerging market; . several of our current video-on-demand deployment agreements with network operators are for selected systems, and we are unable to predict whether they will be expanded to cover additional systems; . changes in network operators' financial condition or priorities may result in delayed or slowed deployments under existing or future agreements; . we cannot predict the rate at which cable subscribers will accept and utilize video-on-demand; . we expect to sign new sales, service and licensing agreements on an irregular basis, if at all, and there may be long periods of time during which we do not enter into new agreements or expanded arrangements; and . we have a lengthy sales cycle, which makes it difficult to forecast the quarter during which a sale will occur. We expect our financial results to fluctuate significantly because we depend on a small number of relatively large orders and other factors Our quarterly operating results will fluctuate significantly in the future as a result of a variety of factors, either alone or in combination. In the short term, we expect our quarterly revenues to be significantly dependent on a small number of relatively large orders for our products and services. As a result, our quarterly operating results may fluctuate significantly if we are unable to complete one or more substantial sales in any given quarter. Factors that will affect our quarterly results, many of which are outside our control, include: . the timing of deployments by network operators of our video-on-demand products and services; 17 . competitive pressure, which may cause us to change our pricing structures; and . demand for and viewer acceptance of video-on-demand and other interactive services. A significant portion of our operating expenses are relatively fixed and necessary to develop our business. These expenses are largely independent of the revenue generated in any given quarter from sales of products and services to network operators. To the extent that increased expenses are not subsequently followed by increased revenues, our operating results will suffer. If revenue falls below expectations in any quarter, the adverse impact of the revenue shortfall on operating results in that quarter may be increased by our inability to adjust fixed spending to compensate for the shortfall. Due to these and other factors, we believe that period-to-period comparisons of our operating results may not be meaningful or indicative of future performance. You should not rely on our results for any one quarter as an indication of our future performance. It is likely that in some future quarters or years our operating results will fall below the expectations of securities analysts or investors. If we do not achieve broad deployment of our video-on-demand products and services, our business will not grow Our future success depends in large part on our ability to sell our digital video-on-demand products and services to a broad base of cable systems, on terms that will generate a profit. We believe that most network operators will deploy interactive platforms purchased from more than one supplier. Accordingly, we believe that network operators will initially commit a limited number of their cable systems to two or more competitors in order to evaluate their interactive products and services. We believe that network operators will not commit to broad deployments of our video-on-demand solution until they have completed evaluation of our products and services as well as those of competitors. Our ability to achieve broad network operator deployments will depend on our success in demonstrating that: . our interactive products and services are reliable and scalable and integrate with products and services provided by other industry suppliers chosen by the network operator; . video-on-demand is a compelling consumer product and viewers will purchase video-on-demand content at prices and in quantities that will justify the network operator's investment in our video-on-demand products and services rather than alternative entertainment services such as pay-per-view and near-video-on-demand; . our video-on-demand products are compatible with industry standards as they evolve; and . our technology enables the network operator to add new revenue-generating services. If we are unable to persuade network operators to purchase our products or services and deploy video-on-demand and other interactive services broadly in their cable systems, the growth of our business will suffer. If the existing commercial deployments of our video-on-demand service with network operators are not expanded, our results of operations and our reputation will suffer Our existing deployments with Charter and AT&T currently serve a small percentage of each company's basic subscriber base. These network operators may not continue these deployments beyond the terms of our existing agreements, and they may choose not to broadly deploy our video-on-demand 18 solution in existing or additional cable systems. In the past, we had limited scope video-on-demand trials with other network operators that did not result in broad deployments. If we are unable to add a substantial number of cable systems to the existing contracts with the network operators currently deploying our products and services, and if video-on-demand is not broadly deployed in each cable system under contract, our results of operations will suffer. In addition, our reputation and our ability to enter into agreements with other network operators could be impaired. Our products and services will not achieve widespread adoption unless network operators deploy digital set-top boxes and roll out and market video-on-demand service to subscribers, all of which are beyond our control Our ability to achieve widespread adoption of our video-on-demand products and services depends on a number of other factors, many of which are beyond our control, including: . the rate at which network operators upgrade deploy digital set-top boxes; . the ability of network operators to provide timely and effective marketing campaigns coordinated with the launch of video-on-demand; . the ability of network operators to maintain their cable infrastructure and headends in accordance with system specifications provided by us; . the success of network operators in marketing video-on-demand service; . the prices that network operators set for video-on-demand movies and other content and for installation or activation of video-on-demand service; . the speed at which network operators can complete the installations required to initiate service for new subscribers; . the quality of customer and technical support provided by us, network operators, and by other third parties whose products are integrated with ours; and . the availability and quality of content delivered to subscribers through a video-on-demand service. We expect rapid technological developments to occur in our industry and, accordingly, must continue to enhance our current products as well as develop new technologies, or competitors could render our products and services obsolete We expect rapid technological developments to occur in the market for interactive home video entertainment products and services. As a result, we have modified and expect to continue to modify our engineering and development plans. These modifications have resulted in delays and increased costs. Furthermore, we expect that we will be required to continue to enhance our current interactive products and services and develop and introduce increased functionality and performance to keep pace with technological developments and consumer preferences. In addition, we may not be successful in developing and marketing product and service enhancements or new services that respond to technological and market changes, and we may experience difficulties that could delay or prevent the successful development, introduction and marketing of such new product and service enhancements. Our failure to successfully develop these products could harm our business. We have encountered delays in product development, service integration and field tests, and other difficulties affecting both software and hardware components of our system and our ability to operate successfully over hybrid fiber-coaxial plant. In addition, many of our competitors have substantially greater resources than us to devote to further technological and new product development. Technological and market changes or other 19 significant developments by our competitors may render our video-on-demand products and services obsolete. Our lengthy sales cycle may cause fluctuations in our operating results We believe that the purchase of our video-on-demand products and services involves a significant commitment of capital and other resources by a network operator. In many cases, the decision to purchase our products and services requires network operators to change their established business practices and conduct their business in new ways. As a result, we need to educate network operators on the use and benefits of our products and services, which can require significant time and resources without necessarily resulting in revenues. In addition, network operators generally must consider a wide range of other issues before committing to purchase and incorporate our technology into their offerings and obtain approval at a number of levels of management. Our sales cycle has ranged from six months to a number of years. Our lengthy sales cycle limits our ability to forecast the timing and amount of specific sales. The market for our video-on-demand products and services is intensely competitive, and our current and potential competitors have significantly greater resources than we do. Consequently, we may not be able to compete effectively, which would harm our operating results Competition in both the video-on-demand market and the broader market for in-home video entertainment is intense and subject to rapid technological change. We expect competition in the market for video-on-demand products and services to intensify in the future. We categorize our video-on-demand competitors as follows: . server manufacturers, such as Concurrent, nCUBE and SeaChange; . software providers, such as Prasara and Scientific-Atlanta; and . system integrators, such as Time Warner and Scientific-Atlanta. We provide products and services that compete in all three categories. Although none of our video-on-demand competitors offer products and services in all of these categories, some of them may form alliances in order to develop an integrated end-to-end video-on-demand system that may be more attractive to network operators and their subscribers than ours. Some of our video-on-demand competitors have long-standing business relationships with network operators and may be able to use those relationships to gain a competitive advantage over us. In addition, we may pursue strategic partnerships in order to decrease our operating and capital expenditures on a going forward basis, which may include outsourcing certain of the elements necessary to deploy our video-on-demand solution to third parties, including our competitors. To the extent that any outsourced element fails to perform to specification or is subject to manufacturing or other delays, the performance, reliability and market acceptance of our video-on-demand solution may be impaired. These factors may adversely affect our ability to compete effectively, even against the competitors to which elements of our video-on-demand solution may be outsourced. In addition to video-on-demand competitors, we compete in the market for in-home video entertainment. We believe our competitors fall into three groups: 20 . companies that provide in-home video entertainment over cable networks, including providers of pay-per-view and near-video-on-demand; . companies that deliver in-home video entertainment over networks, such as regular telephone lines, digital subscriber lines, or DSL, satellite or the Internet, and some providers of video streaming technology; and . companies that enable the viewer to store and access content on an "on-demand" basis, including providers of personal video recorders, such as TiVo, UtlimateTV and Replay TV, and companies that rent and sell videotapes. Many of our competitors and potential competitors have longer operating histories, greater name recognition and significantly greater financial, technical, marketing and distribution resources than we have. As a result, they may be able to respond to new or emerging technologies and changes in customer requirements faster than we do. They may also be able to devote greater resources to the development, promotion and sale of their products and services and may do so in a more effective manner. We may be unable to compete successfully against current or future competitors, and competitive pressures that we face may harm our business. If we fail to manage our growth effectively, our ability to implement our business strategies may be limited In order to execute our business strategy, we must meet aggressive engineering, integration, product delivery and installation targets. The growth in our business has placed and is expected to continue to place significant demands on our management, operating, development, third party manufacturing, assembly, test and financial and accounting resources. Our ability to manage growth effectively will require continued implementation of and improvements to our operating, manufacturing, development and financial and accounting systems and will require us to expand and continue to train and manage our employee base. These demands likely will require the addition of new management personnel and the development of additional expertise by existing management personnel. Our systems, procedures or controls or financial resources may be inadequate to support our operations, and our management may be unable to keep pace with this growth. If we are unable to manage our growth effectively, our business ability to successfully implement our business strategies will suffer. If we are unable to adequately protect or enforce our intellectual property rights, we could suffer competitively, incur costly litigation expenses or lose valuable assets Our future success depends, in part, on our ability to protect our intellectual property and maintain the proprietary nature of our technology through a combination of patents, licenses and other intellectual property arrangements. We have been awarded patents and have filed applications and intend to file additional applications for patents covering various aspects of our video-on-demand products and services. Any patents issued may be challenged, invalidated or circumvented, and the rights granted under any patents might not provide proprietary protection to us. We may not be successful in maintaining these proprietary rights, and our competitors may independently develop or patent technologies that are substantially equivalent or superior to our technologies. To the extent we integrate our products with those of third parties, including competitors, we may be required to disclose or license intellectual property to those companies, and these companies could appropriate our technology or otherwise improperly exploit the information gained through this integration. If we 21 believe third parties are infringing our intellectual property, we may be forced to expend significant resources enforcing our rights or suffer competitive injury. If third parties claim that we infringe their intellectual property, our ability to use some technologies and products could be limited, and we may incur significant costs to resolve these claims From time to time, we have received notices from third parties claiming infringement of intellectual property rights. Although we do not believe that we infringe any third party's intellectual property rights, we could encounter similar claims or litigation in the future. Because patent applications in the United States are not publicly disclosed until the patent has been issued, applications may have been filed that, if issued as patents, would relate to our products. In addition, we have not completed a comprehensive patent search relating to the technology used in our video-on-demand products and services. Parties making claims of infringement may be able to obtain injunctive or other equitable relief that could effectively block our ability to provide our products and services in the United States and internationally and could result in an award of substantial damages. In the event of a successful claim of infringement, our customers and we may be required to obtain one or more licenses from third parties, which may not be available at a reasonable cost or at all. The defense of any lawsuit could result in time consuming and expensive litigation regardless of the merits of such claims, and damages, license fees, royalty payments and restrictions on our ability to provide our video-on-demand products or services, any of which could harm our business. We rely on several sole or limited source suppliers and manufacturers, and our production will be seriously harmed if these suppliers and manufacturers are not able to meet our demand and alternative sources are not available We subcontract manufacturing of our hardware to a single contract manufacturer. We do not have a contract with this manufacturer and operate on a purchase order basis. Because of the complexity of our hardware components, manufacturing and quality control are time-consuming processes. Our contract manufacturer may be unable to meet our requirements in a timely and satisfactory manner, and we may be unable to find or maintain a suitable relationship with alternate qualified manufacturers. Our reliance on a third-party manufacturer involves a number of additional risks, including the absence of guaranteed capacity and reduced control over delivery schedules, quality assurance, production yields and costs. In the event we are unable to obtain such manufacturing on commercially reasonable terms, our production would be seriously harmed. Various subassemblies and components used in our video server and access equipment are procured from single sources and others are procured only from a limited number of sources. Consequently, we may be adversely affected by worldwide shortages of components, significant price increases, reduced control over delivery schedules, and manufacturing capability, quality and cost. Although we believe alternative suppliers of products, services, subassemblies and components are available, the lack of alternative sources could harm our ability to deploy our video-on-demand systems. Manufacturing lead times can be as long as nine months for some critical components. Therefore, we may require significant working capital to pay for such components well in advance of both hardware 22 orders and revenues. Moreover, a prolonged inability to obtain components could harm our business and could result in damage to network operator relationships. Various software elements used in our products are licensed from single providers. Consequently, we may be adversely affected by significant price increases, claims that such licensed software infringes the intellectual property of other third parties, or failure of licensors to update their products or offer updated products at a reasonable cost. Although we believe alternative suppliers of software products are available, the lack of alternative sources could harm our ability to sell, maintain or update our interactive products and services. If we are unable to acquire programming content on reasonable terms, our ability to derive revenues from video-on-demand deployments will be limited In those network operator deployments where we provide programming content, our success will depend, in part, on our ability to obtain access to sufficient movies (including new releases and library titles), special interest videos and other programming content on commercially acceptable terms. Although we have entered into arrangements with major movie studios and other content providers, we may not be able to continue to obtain the content. In addition, for content we do procure, we may not be able to make the content available to video-on-demand customers during the segment of time available to other video-on-demand providers and to programmers such as pay-per-view providers. Studios may require us to make prepayments prior to the time that customers pay for viewing a title or require us to enter into long-term contracts with significant minimum payments. Further, studios may increase the license fees currently charged to us. If we are unable to obtain timely access to content on commercially acceptable terms, our ability to obtain revenue from deployments where we provide content will be limited. Further, to the extent that major movie studios pursue announced efforts to restrict or eliminate content made available for video-on-demand delivery, video-on-demand as a product may not be broadly deployed, and all providers of video-on-demand products and services, including us, may not be able to sell interactive products and services to network operators. If availability of compelling video-on-demand content, including first run movies, is restricted or eliminated, the ability for us to obtain revenue from sales of interactive products and services may be significantly limited. Competition for qualified personnel is intense in technology industries such as ours, and we may not be able to maintain or expand our business if we are unable to hire and retain sufficient technical, sales, marketing and managerial personnel Competition for qualified personnel in technology industries is intense, particularly in Silicon Valley. We may not be able to attract and retain qualified personnel in the future. If we are unable to hire and retain sufficient technical, sales and marketing and managerial personnel, our business will suffer. Our future success depends in part on the continued service of our key engineering, sales, marketing, manufacturing, finance and executive personnel. If we fail to retain and hire a sufficient number and type of personnel, we will not be able to maintain and expand our business. 23 We intend to expand our video-on-demand products and services internationally and these efforts may not be successful in generating revenues sufficient to offset the associated expense International deployments may require adaptation of our products to perform on technical platforms that may differ depending on the country in which our interactive products and services are deployed. We expect to expend significant financial, operational and managerial resources to do so. If our revenues from international operations do not meet our expectations, our operating results will be adversely affected. We face risks inherent in conducting business internationally, including: . unexpected changes in regulatory requirements and tariffs that may be imposed on our services; . difficulties and costs of staffing and managing international operations; . differing technology standards and difficulties in obtaining export and import licenses; . longer payment cycles, difficulties in collecting accounts receivable and longer collection periods; . political and economic instability; . fluctuations in currency exchange rates; . imposition of currency exchange controls; . potentially adverse tax consequences; and . reduced protection for intellectual property rights in some countries. Any of these factors could adversely affect our international operations and, consequently, our business and operating results. Specifically, our failure to manage our international growth successfully could result in higher operating costs than anticipated, or could delay or preclude our ability to generate revenues in key international markets. Network operators are subject to government regulations that could require us to change our products and services In the United States, the Federal Communications Commission, or FCC, has broad jurisdiction over network operators. The FCC does not regulate us, but requirements imposed on network operators could force us to undertake development that would consume significant resources and require changes to our products and services. If we do not change our products so that they comply with FCC rules, or if our products are not integrated with ones that comply with FCC requirements, our products and services will not be broadly deployed, and our business will suffer. In addition, video-on-demand services in Canada and in the United Kingdom and other European Union members are licensed in a variety of ways. We are seeking to determine how best to offer our video-on-demand products and services in Canada, the United Kingdom and other European Union countries. We may not be able to obtain distribution rights to movie titles in non-U.S. jurisdictions under regulatory and financial arrangements acceptable to us. Insiders have significant influence over our efforts Our major stockholders and directors, together with entities affiliated with them, own approximately 74% of our outstanding Common Stock (assuming conversion of all outstanding Preferred Stock into Common Stock) at September 30, 2001. Accordingly, these stockholders have 24 significant influence over our affairs. This concentration of ownership could have the effect of delaying or preventing a change in control of DIVA. 25 PART II OTHER INFORMATION Item 1, Item 3, Item 4 and Item 5 are not applicable with respect to the current reporting period. Item 2. Changes in Securities and Use of Proceeds During the three months ended September 30, 2001, we issued and sold an aggregate of 1,202 shares of Common Stock to our employees for an aggregate purchase price of $3,000 pursuant to exercises of options under our 1995 and 1998 Stock Plans. Item 6. Exhibits and Reports on Form 8-K: a. Exhibits. None. b. Reports on Form 8-K. No reports on Form 8-K were filed with the Securities and Exchange Commission during the quarter ended September 30, 2001. 26 SIGNATURES Pursuant to the requirements of the Securities and Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. DIVA SYSTEMS CORPORATION By: /s/ WILLIAM M. SCHARNINGHAUSEN ------------------------------------- William M. Scharninghausen Senior Vice President, Finance and Administration, and Chief Financial Officer Dated: November 14, 2001 27

Carrying Average Amount Yield -------- -------- U.S. government obligations $25,731 5.32% Commercial paper 23,180 5.25% Certificates of deposits 2,152 4.57% Money market instruments 775 5.60% Auction rate preferred stock certificates 5,600 5.24% ------- ---- Total $57,438 ======= Included in cash and cash equivalents 46,315 Included in short-term investments 11,123 ------- Total $57,438 =======

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