| MAD CATZ INTERACTIVE INC Item 1A Risk Factors You should consider each of the following factors, as well as the other information in this Annual Report, and in our other filings with the SEC, before deciding whether to invest in or continue to hold our common stock |
| The risks and uncertainties described below are not the only ones we face |
| Additional risks and uncertainties not presently known to us or that we currently consider immaterial may also impair our business operations |
| If any of the following risks actually occur, our business and financial results could be harmed |
| In that case, the trading price of our common shares could decline |
| You should also refer to the other information set forth in this Annual Report, including our financial statements and the related notes |
| Risks Concerning Our Customers and Products A significant portion of our revenue is derived from a few large customers |
| The vast majority of our sales are generated from a small number of customers |
| Our top three customers accounted for approximately 52prca and 47prca of our gross sales in fiscal 2006 and 2005, respectively and our top two customers accounted for approximately 39prca in fiscal 2004 |
| In fiscal 2006, our three largest customers were Wal-Mart, GameStop, and Target |
| Our top ten customers accounted for approximately 75prca of gross sales in fiscal 2006, 78prca in fiscal 2005 and 79prca in fiscal 2004 |
| We do not have long-term agreements with these or other significant customers and our agreements with these customers do not require them to purchase any specific number or amount of our products |
| As a result, agreements with respect to pricing, shelf space, cooperative advertising or special promotions, among other things, are subject to periodic negotiation with each customer |
| No assurance can be given that these or other customers will continue to do business with us or that they will maintain their historical levels of business |
| The loss of any of our significant customers could have a material adverse effect on our business, results of operations, financial condition and liquidity |
| In addition, the uncertainty of product orders can make it difficult to forecast our sales and allocate our resources in a manner consistent with actual sales, and our expense levels are based in part on our expectations of future sales |
| If our expectations regarding future sales are inaccurate, we may be unable to reduce costs in a timely manner to adjust for sales shortfalls |
| This could cause a significant decline in our sales and profitability |
| Video game accessories are widely available from manufacturers and other suppliers around the world |
| Each of our largest customers has substantially greater resources than we do, and has the ability to directly import or private-label video game accessories from manufacturers and other suppliers, including from some of our own subcontract manufacturers and suppliers |
| Our customers may believe that higher profit margins can be achieved if they implement a direct import or private-label program, reducing sales of our products |
| As a consequence, our sales and profitability could decline significantly |
| A significant portion of our revenue is derived from a few core product categories |
| We are dependent on a small number of core product categories to generate a significant proportion of our revenues |
| No assurance can be given that these or other products will continue to have consumer acceptance or that they will maintain their historical levels of sales |
| The loss of one or more of these products could have a material adverse effect on our business, results of operations, financial condition and liquidity |
| We must constantly change our product mix to respond to changes in the market |
| If we fail to introduce new products, our sales and profitability could be harmed |
| We generate our revenues from a number of continuously updated and enhanced “active products |
| ” We define active products as products that have maintained a minimum level of average gross sales per quarter |
| Each product may be configured and sold in a number of different stock keeping units |
| Each year we introduce new products and discontinue a similar number of products to maintain an optimal number of active products that we believe best supports our customers and the market |
| If we do not introduce new products in a timely and efficient manner and in accordance with our operating plans, our results of operations, financial condition and liquidity could be negatively and materially affected |
| Our financial results are dependent on timely introduction of new products, and any failure to introduce new products to the marketplace may have a material adverse effect on our business, results of operations, financial condition and liquidity |
| Our product mix constantly changes |
| There are numerous steps required to develop a product from conception to commercial introduction and to ensure timely shipment to retail customers, including designing, sourcing and testing the electronic components, receiving approval of hardware and other third party licensors, factory availability and manufacturing and designing the graphics and packaging |
| Any difficulties or delays in the product development process will likely result in delays in the contemplated product introduction schedule |
| It is common in new product introductions or product updates to encounter technical and other difficulties affecting manufacturing efficiency and, at times, the ability to manufacture the product at all |
| Although these difficulties can be corrected or improved over time with continued manufacturing experience and engineering efforts, if one or more aspects necessary for the introduction of products are not completed as scheduled, or if technical difficulties take longer than anticipated to overcome, the product introductions will be delayed, or in some cases may be terminated |
| No assurances can be given that products will be introduced in a timely fashion, and if new products are delayed, our sales and revenue growth may be limited or impaired |
| The typical life cycle of successful video game accessories and titles is similar to the life cycle of video game consoles, which historically has ranged from two to ten years |
| Factors such as competition for access to retail shelf space, consumer preferences and seasonality could result in the shortening of the life cycle for older products and increase the importance of our ability to release new products on a timely basis |
| We must introduce new products in order to generate new revenues and/or to replace declining revenues from older products |
| The complexity of new video game systems has resulted in higher development expenses, longer development cycles, and the need to carefully monitor and plan the product development process |
| 10 ______________________________________________________________________ [32]Table of Contents Some of our products have been only recently introduced and although they may experience strong initial market acceptance, no assurance can be given that any initial acceptance will result in future sales |
| We cannot predict the length of the life cycle for any particular product |
| In order to control costs, and take advantage of the limited shelf space provided to us, we must periodically discontinue some of our product offerings |
| Our long-term operating results will therefore depend largely upon our continued ability to conceive, develop and introduce new appealing products at competitive prices |
| We depend upon third parties to develop products and software |
| Our business is dependent upon the continued development of new and enhanced video game platforms by first party manufacturers, such as Sony, Microsoft and Nintendo, and video games by software publishers, such as Electronic Arts, Activision, THQ and Take-Two Interactive Software |
| Our business could suffer if any of these parties fail to develop new or enhanced video game platforms or popular game and entertainment titles for current or future generation platforms |
| If a platform is withdrawn from the market or fails to sell, we may be forced to liquidate our inventories or accept returns resulting in significant losses |
| During 2005, Microsoft introduced the Xbox 360 and Sony and Nintendo announced plans to introduce new versions of their respective PlayStation and GameCube platforms |
| As a result of limited availability of Microsoft’s Xbox 360 in the fall of 2005, the demand for accessories was also restricted |
| There is no guarantee that the new platforms from Sony and Nintendo will create a demand for related accessories |
| New video game platforms and development for multiple consoles create additional technical and business model uncertainties that could impact our business |
| Our revenues are derived primarily from the sale of video game accessories for use with proprietary video game platforms, such as the Sony PlayStation, PlayStation 2 and PSP; the Microsoft Xbox and Xbox 360; the Nintendo GameCube, Game Boy Advance, Game Boy Advance SP, DS; N64 and Micro and the Nokia N-Gage QD The success of our products is significantly affected by commercial acceptance of new video game platforms and the life cycle of older platforms |
| In addition, we anticipate that the research and development expenses incurred to develop compatible accessories for new and updated video game platforms may impact our profitability |
| If first party manufacturers choose to design video game systems that do not operate with third party accessories and are successful in implementing technological barriers that prevent us from developing, manufacturing, marketing and distributing products for these new video game platforms, our ability to continue our current business would be severely limited and our business, financial condition, results of operations and liquidity would be harmed |
| Changes to current video game platforms or introductions of new video game platforms may result in our products becoming inoperable on some video game platforms, which would reduce sales of our products and adversely affect our business, results of operations, financial condition and liquidity |
| A significant proportion of our revenues are derived from products that are reverse engineered |
| First party manufacturers continually update their video game platforms to correct problems in the operating systems and reduce costs |
| These manufacturers also expend significant resources to create next generation video game platforms |
| During the development of such product updates and new video game platforms, manufacturers may implement changes to the design of the new video game platforms that render our products inoperable |
| If our products become inoperable on one or more video game platforms, our sales may be significantly reduced |
| Moreover, we may have excess inventories of products that do not operate properly with new gaming platforms, which would limit our growth and harm our business, results of operations, financial condition and liquidity |
| 11 ______________________________________________________________________ [33]Table of Contents We are subject to various environmental laws and regulations that could impose substantial costs upon us and may adversely affect our business, operating results and financial condition |
| Our operations and some of our products are regulated under various federal, state, local and international environmental laws, including those governing the discharge of pollutants into the air and water, the management, disposal and labeling of, and exposure to, hazardous substances and wastes and the cleanup of contaminated sites |
| We could incur costs, fines and civil or criminal sanctions, third-party property damage or personal injury claims, or could be required to incur substantial investigation or remediation costs, if we were to violate or become liable under environmental laws |
| Liability under environmental laws can be joint and several and without regard to comparative fault |
| The ultimate costs under environmental laws and the timing of these costs are difficult to predict |
| We also expect that our manufacturing operations will be affected by other new environmental laws and regulations on an ongoing basis |
| Although we cannot predict the ultimate impact of any such new laws and regulations, they will likely result in additional costs or decreased revenue, and could require that we re-design or change how we manufacture our products, any of which could have a material adverse effect on our business |
| For example, the European Union Directive 2002/96/EC on waste electrical and electronic equipment, known as the WEEE Directive, requires producers of certain electrical and electronic equipment, including RFID readers, to be financially responsible for specified collection, recycling, treatment and disposal of past and present covered products placed on the market in the European Union |
| The European Union Directive 2002/95/EC on the restriction of the use of hazardous substances in electrical and electronic equipment, known as the RoHS Directive, restricts the use of certain hazardous substances, including lead, in covered products that are put on the market by July 1, 2006 |
| Although individual European member states are required to enact legislation to implement these two Directives, not all countries have done so |
| Pursuant to WEEE legislation to be enacted by individual countries, we may be required to register as a WEEE producer in some European Union countries |
| With respect to the RoHS Directive, we continue to work with our suppliers to design and manufacture products for sale in the European Union that comply with the RoHS Directive |
| Failure to comply with existing laws or future laws could have a material adverse affect on our business, results of operations, financial condition and liquidity |
| In addition, compliance with these and other environmental laws and regulations may be costly, thereby increasing the cost of manufacturing and significantly reducing our margins and profitability |
| To the extent that our competitors choose not to abide by these environmental laws and regulations, we will be at a cost disadvantage, thereby hindering our ability to effectively compete in the market place |
| Errors or defects contained in our products, failure to comply with applicable safety standards or a product recall could result in delayed shipments or rejection of our products, damage to our reputation and expose us to regulatory or other legal action |
| Any defects or errors in the operation of our products may result in delays in their introduction |
| In addition, errors or defects may be uncovered after commercial shipments have begun, which could result in the rejection of our products by our customers, damage to our reputation, lost sales, diverted development resources and increased customer service and support costs and warranty claims, any of which could harm our business |
| There is a risk that these claims or liabilities may exceed, or fall outside the scope of, our insurance coverage |
| We may also be unable to obtain adequate liability insurance in the future |
| Because we are a small company, a product recall would be particularly harmful to us because we have limited financial and administrative resources to effectively manage a product recall and it would detract management’s attention from implementing our core business strategies |
| A significant product defect or product recall could materially and adversely affect our brand image, causing a decline in our sales, and could reduce or deplete our financial resources |
| 12 ______________________________________________________________________ [34]Table of Contents If we do not correctly anticipate demand for particular products, we could incur additional costs or experience manufacturing delays, which would reduce our gross margins or cause us to lose sales |
| Demand for our products depends on many factors such as consumer preferences and the introduction or adoption of video game platforms and related content, and can be difficult to forecast |
| We expect that it will become more difficult to forecast demand for specific products as we introduce and support additional products, enter additional markets and as competition in our markets intensifies |
| If we misjudge the demand for our products, we could face the following problems in our operations, each of which could harm our operating results: • If our forecasts of demand are too high, we may accumulate excess inventories of products, which could lead to markdown allowances or write-offs affecting some or all of such excess inventories |
| We may also have to adjust the prices of our existing products to reduce such excess inventories |
| • If demand for specific products increases beyond what we forecast, our suppliers and third party manufacturers may not be able to increase production rapidly enough to meet the demand |
| Our failure to meet market demand would lead to missed opportunities to increase our base of users, damage our relationships with retailers and harm our business |
| • Rapid increases in production levels to meet unanticipated demand could result in increased manufacturing errors, as well as higher component, manufacturing and shipping costs, including increased air-freight, all of which could reduce our profit margins and harm our relationships with retailers and consumers |
| Our pricing and product return policies and other promotional activities may negatively impact our sales and profitability and harm our business, results of operations, financial condition and liquidity |
| Many of our products are value-priced or feature-enhanced versions of products offered by first party manufacturers |
| Sales of products that compete with a similar first party product generally comprise nearly half of our gross sales |
| In the event a first party manufacturer or other competitor reduces its prices, we could be forced to respond by lowering our prices to remain competitive |
| If we are forced to lower prices, we may be required to “price protect” the products that remain unsold in our customers’ inventories at the time of the price reduction |
| Price protection results in us issuing a credit to our customers in the amount of the price reduction for each unsold unit in the customer’s inventory |
| Our price protection policies, which are customary in the video game industry, can have a major impact on our sales and profitability if we are forced to reduce the price of products for which a large inventory exists |
| It is also likely that we will experience additional price competition, which may lead to price protection, as we continue to introduce new and enhanced products |
| Although we established allowances for anticipated product returns and believe our existing policies have resulted in allowances that are adequate, there can be no assurance that such product return obligations will not exceed our allowances in the future, which would have a material adverse effect on our future operating results and financial condition |
| Some of our license agreements with video game console developers have expired or may expire within the next fiscal year, which could limit our product offerings and significantly reduce our revenues |
| Historically, a majority of our revenues have come from the sale of video game accessories for use with video game consoles sold by first party manufacturers |
| Some of these products have been produced under license agreements with these first party manufacturers |
| Some of these licenses are necessary in order for us to actually produce and sell the products (“license dependent products”), while other licenses have some perceived or actual marketing or sales benefit, but do not dictate whether we can produce the product (“marketing licenses”) |
| Some of these license agreements have expired and others may expire, which could limit our product offerings and significantly reduce our revenues |
| 13 ______________________________________________________________________ [35]Table of Contents On May 12, 2005, we entered into a license agreement with Microsoft Corporation under which we were granted the right to manufacture, market and sell certain peripheral products for the upcoming Xbox 360 video game console (“Xbox 360 Agreement”) |
| The products produced pursuant to the Xbox 360 Agreement are license dependent products |
| The Xbox 360 Agreement has a term of two years |
| Should the Xbox 360 Agreement expire, be terminated for cause or fail to be renewed, our product offerings may be limited thereby significantly reducing our revenues |
| We have a peripheral and compatibility license from Microsoft covering products relating to Microsoft’s Xbox video game console |
| This license expires on February 28, 2007 |
| Unless either Microsoft or our Company provides notice of its desire to terminate the license at least 90 days prior to that date, the agreement will automatically renew for an additional one-year period |
| While we do not intend to terminate the agreement and we have not received any indication from Microsoft that it desires to terminate the agreement, no assurance can be given that the agreement will not expire in accordance with its terms |
| We are uncertain whether we will be able to renew or replace the Microsoft license |
| Nonetheless, this license only relates to the use of Microsoft’s logo on our Company’s products, so even without the license, we would be able to continue producing and selling similar products which do not contain the logo |
| There can be no assurance, however, that sales of unlicensed products will be equivalent to sales of the licensed products |
| Any decline in the sale of such products could significantly reduce our revenues and have a material adverse effect on our financial condition and results of operations |
| Our success depends on the continued viability and financial stability of our retailers and distributors |
| We sell our products through a network of domestic and international retailers, as well as some distributors, and our success depends on the continued viability and financial stability of these customers |
| The retail industry has historically been characterized by rapid change, including periods of widespread financial difficulties and consolidations, and the emergence of alternative distribution channels |
| The loss of one or more of our major retailers or distributors could significantly harm our business, financial condition and operating results |
| As of March 31, 2006, our two largest accounts receivable balances accounted for 57prca of total accounts receivable |
| We generally do not require any collateral from our customers to secure payment of these accounts receivable |
| However, we do seek to control credit risk through ongoing credit evaluations of our customers’ financial condition and by purchasing credit insurance on European retail accounts receivable balances |
| If any of our major customers were to default in the payment of their obligations to us, our business, financial condition, operating results and cash flows could be adversely affected |
| Risks Concerning Our Suppliers The manufacture and supply of our products is dependent upon a limited number of third parties, and our success is dependent upon the ability of these parties to manufacture and supply us with sufficient quantities of our products and on the continued viability and financial stability of these third party suppliers |
| We rely on a limited number of manufacturers and suppliers for our products |
| There can be no assurance that these manufacturers and suppliers will be able to manufacture or supply us with sufficient quantities of products to ensure consumer availability |
| In addition, these parties may not be able to obtain the raw materials or to obtain the energy or oil supply required to manufacture sufficient quantities of our products |
| Moreover, there can be no assurance that such manufacturers and suppliers will not refuse to supply us with products, and independently market their own competing products in the future, or will not otherwise discontinue their relationships with or support of our Company |
| Our failure to maintain our existing manufacturing and supplier relationships, or to establish new relationships in the future, could have a material adverse effect on our business, results of operations, financial condition and liquidity |
| If our suppliers are unable or unwilling for any reason to supply us with a sufficient quantity of our products, our business, revenues, results of operations, financial condition and liquidity would be materially adversely affected |
| We obtain our GameShark products from third 14 ______________________________________________________________________ [36]Table of Contents party suppliers, for which an alternative source may not be available |
| If any of our key suppliers became financially unstable, our access to these products might be jeopardized, thereby adversely affecting our business, cash flow, financial condition and operational results |
| Production levels that do not match demand for our products could result in lost sales or a reduction in our gross margins |
| The video game accessories industry is characterized by rapid technological change, frequent new product introductions, short-term customer commitments and rapid changes in demand |
| We determine production levels based on forecasts of the demand for our products |
| Actual demand for our products is difficult to forecast |
| If the actual demand for our products does not match the manufacture of our products, a number of problems could occur, including the loss of potential sales if production cannot be increased to match demand, and additional expenditures necessary to accelerate the production of some products, resulting in lower gross margins |
| Additionally, if customers find alternative sources of supply to meet their needs, our revenues, results of operations and financial condition could be adversely affected |
| Any disruption of shipping and product delivery operations globally could harm our business |
| We rely on contract ocean carriers to ship virtually all of our products from Hong Kong to our primary distribution centers in California and the United Kingdom |
| Retailers and distributors that take delivery of our products in Hong Kong rely on a variety of carriers to ship those products to their distribution centers and retail outlets |
| We also rely on a number of sources of ground transportation to deliver our products from our primary distribution centers to our retail customers’ and distributors’ distribution centers and retail outlets |
| Any disruption or delay in the importation of our products, in the operation of our distribution centers or in the delivery of our products from our primary distribution centers to our retail customers’ and distributors’ distribution centers and retail outlets for any reason, including labor strikes or other labor disputes, terrorism, international incidents or lack of available shipping containers or vehicles, could significantly harm our business and reputation |
| Risks of Doing Business Internationally Any loss of China’s Normal Trade Relations “NTR” with the United States, or any changes in tariffs or trade policies, could increase our manufacturing expenses and make it more difficult for us to manufacture our products in China, if at all |
| The majority of our products are manufactured in China and exported from Hong Kong and China to the United States and worldwide |
| Our products sold in the United States are currently not subject to United States import duties |
| However, as a result of opposition to policies of the Chinese government and China’s growing trade surpluses with the United States, there has been, and in the future may be, opposition to the extension of NTR status for China |
| The loss of NTR status for China, changes in current tariff structures or adoption in the United States of other trade policies adverse to China could increase our manufacturing expenses and make it more difficult for us to manufacture our products in China, if at all |
| Our manufacturing relationships in China may be adversely affected by changes in the political, economic and legal environment in China |
| We maintain offices in Hong Kong and in China |
| The success of our operations in Hong Kong and China is highly dependent on the Chinese government’s continued support of economic reform programs that encourage private investment, and particularly foreign private investment |
| A change in these policies by the Chinese government could adversely affect us by, among other things, imposing confiscatory taxation, restricting currency conversion, imports and sources of supplies, prohibiting us from manufacturing our products in China or restricting our ability to ship products from China into Hong Kong or to ship finished products out of Hong Kong or otherwise shutting down our offices in Hong Kong and China |
| Although the Chinese government has 15 ______________________________________________________________________ [37]Table of Contents chosen economic reform policies to date, no assurance can be given that it will continue to pursue such policies or that such policies will not be significantly altered, especially in the event of a change in leadership or other social or political disruption |
| Our sources of manufacturing and distribution capabilities could be adversely affected by ongoing tensions between the Chinese and Taiwanese governments |
| If Taiwan does not adopt a plan for unifying with China, the Chinese government has threatened military action against Taiwan |
| As of yet, Taiwan has not indicated that it intends to propose or adopt a reunification plan |
| If an invasion were to occur, the supply of components from Taiwanese suppliers that are used in our products could be interrupted, potentially limiting the production of our products |
| Invasion could also lead to sanctions or military action by the United States and/or European countries, which could materially affect our sales to those countries |
| China does not have a comprehensive system of laws |
| Enforcement of existing laws may be sporadic and implementation and interpretation thereof inconsistent |
| The Chinese judiciary is relatively inexperienced in enforcing the laws that exist, leading to a higher than usual degree of uncertainty as to the outcome of any litigation |
| Even where adequate laws exist in China, it may be impossible to obtain swift and equitable enforcement of such laws, or to obtain enforcement of a judgment by a court in a different jurisdiction |
| The Chinese tax system is subject to substantial uncertainties and has been subject to recently enacted changes, the interpretation and enforcement of which are also uncertain |
| There can be no assurance that changes in Chinese tax laws or their interpretation or their application will not subject us to substantial Chinese taxes in the future |
| There are numerous risks associated with our international operations, any number of which could harm our business |
| We have offices and sales throughout the world |
| Our registered office and a sales office are in Canada |
| Our operational headquarters is in San Diego, California |
| We also have offices in the United Kingdom, China and Hong Kong |
| Approximately 81prca of our gross sales in fiscal year 2006 were generated in North America, and a substantial majority of our products are manufactured by third parties in Hong Kong and China |
| The geographical distances between our operations create a number of logistical and communications challenges |
| These challenges include managing operations across multiple time zones, directing the manufacture and delivery of products across long distances, coordinating procurement of components and raw materials and their delivery to multiple locations, and coordinating the activities and decisions of the management team, which is based in a number of different countries |
| In addition, there are other risks inherent in international operations, which could result in disruption or termination of supply of our products available for sale |
| These risks include: • unexpected changes in regulatory requirements, taxes, trade laws and tariffs; • political instability and the potential reversal of current favorable policies encouraging foreign investment or foreign trade by host countries; • differences in labor laws, labor unrest and difficulties in staffing and managing international operations; • longer payment cycles; • fluctuations in currency exchange rates; • potential adverse tax consequences; • limitations on imports or exports of components or assembled products, or other travel restrictions; • differing intellectual property rights and protections; • delays from doing business with customs brokers and governmental agencies; and • higher costs of operations |
| These factors could materially and adversely affect our business, operating results, and financial condition |
| 16 ______________________________________________________________________ [38]Table of Contents Intellectual Property Risks We may be faced with legal challenges related to our products, including that our products infringe third parties’ intellectual property rights of others |
| These challenges could cause us to incur significant litigation or licensing expenses or could prohibit us from producing or marketing some or all of our products entirely |
| Although we do not believe that our products infringe the proprietary rights of any third parties, there can be no assurance that infringement or other legal claims will not be asserted against us or that any such claims will not materially adversely affect our business, financial condition, or results of operations |
| Regardless of their validity or success, such claims may result in costly litigation, divert management’s time and attention, cause product shipment delays or require us to enter into royalty or licensing agreements, which may not be available on terms acceptable to us, or at all |
| If licensing arrangements are required but unavailable, we may be prohibited from marketing and distributing these products |
| In addition, we could also incur substantial costs to redesign our products to comply with legal orders or contractual arrangements |
| Any of these costs or outcomes could adversely affect our business, results of operations, financial condition and liquidity |
| For information regarding lawsuits filed against the Company claiming that our products infringe third party intellectual |