##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 WASHINGTON, D.C. 20549
 FORM 10-Q
 þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended December 31, 2005
 OR
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from  to      Commission File No. 0-27338
 ATARI, INC.
  DELAWARE
    
    13-3689915(State or Other Jurisdiction of
Incorporation or Organization)
    
    (I.R.S. Employer
Identification No.)
 417 FIFTH AVENUE, NEW YORK, NY 10016
 (212) 726-6500
  o þ
  o þ o
  o þ




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##### 



ATARI, INC. AND SUBSIDIARIES
DECEMBER 31, 2005 QUARTERLY REPORT ON FORM 10-Q
TABLE OF CONTENTS
 PagePART I  FINANCIAL INFORMATIONItem 1.
    

Financial
Statements (unaudited):Condensed Consolidated Balance Sheets
as of March 31, 2005 and December 31, 2005
    
    
    3Condensed Consolidated
Statements of Operations and Comprehensive Income (Loss) for the
Three Months and Nine Months Ended December 31, 2004 and 2005
    
    
    4Condensed Consolidated
Statements of Cash Flows for the Nine Months Ended December 31,
2004 (as restated-see Note 13) and 2005
    
    
    5Condensed Consolidated Statement of
Stockholders Equity for the Nine Months Ended December 31, 2005
    
    
    7Notes to the Condensed Consolidated Financial Statements
    
    
    8Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    24Item 3.
    
    Quantitative and Qualitative Disclosures about Market Risk
    
    
    36Item 4.
    
    Controls and Procedures
    
    
    36PART II  OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    
    37Item 6.
    
    Exhibits
    
    
    39Signature
    
    
    
    
    40EX-10.1: AMENDMENT NO.1 TO EMPLOYMENT AGREEMENTEX-10.2: CONSULTING AGREEMENTEX-10.3: FORM OF 2005 STOCK INCENTIVE PLAN OPTION AWARD AGREEMENTEX-10.4: FORM OF 2005 STOCK INCENTIVE PLAN RESTRICTED STOCK AWARD AGREEMENTEX-31.1: CERTIFICATIONEX-32.1: CERTIFICATION




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##### Table of Contents



PART I. FINANCIAL INFORMATION
 
 Item 1. Financial Statements
 ATARI, INC. AND SUBSIDIARIES
 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 (in thousands)
 (unaudited)
 March 31,
    
    
    December 31,2005
    
    
    2005ASSETSCurrent assets:Cash
    
    $
    10,433
    
    
    $
    3,454Receivables, net of reserves of $24,285 and $24,441, at March 31, 2005
and December 31, 2005, respectively
    
    
    42,179
    
    
    
    31,702Inventories, net
    
    
    25,209
    
    
    
    28,898Due from related parties (Note 7)
    
    
    248
    
    
    
    11,209Prepaid expenses and other current assets
    
    
    22,529
    
    
    
    11,026Assets of discontinued operations (Note 10)
    
    
    3,555
    
    
    
    220Total current assets
    
    
    104,153
    
    
    
    86,509Property and equipment, net
    
    
    8,289
    
    
    
    6,603Goodwill
    
    
    70,224
    
    
    
    66,398Other assets
    
    
    7,373
    
    
    
    5,721Total assets
    
    $
    190,039
    
    
    $
    165,231LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    27,756
    
    
    $
    27,974Accrued liabilities
    
    
    18,999
    
    
    
    23,345Royalties payable
    
    
    13,641
    
    
    
    15,689Revolving credit facility
    
    
    
    
    
    
    4,399Due to related parties (Note 7)
    
    
    5,421
    
    
    
    13,330Liabilities of discontinued operations (Note 10)
    
    
    2,685
    
    
    
    406Total current liabilities
    
    
    68,502
    
    
    
    85,143Long-term liabilities
    
    
    870
    
    
    
    625Total liabilities
    
    
    69,372
    
    
    
    85,768Commitments and contingencies  See Note 8Stockholders equity:Preferred stock, $0.01 par value, 5,000 shares authorized, none issued or
outstanding
    
    
    
    
    
    
    Common stock, $0.01 par value, 300,000 shares authorized, 121,296 and 134,749
shares issued and outstanding at March 31, 2005 and December 31, 2005,
respectively
    
    
    1,213
    
    
    
    1,347Additional paid-in capital
    
    
    736,790
    
    
    
    758,156Accumulated deficit
    
    
    (619,744
    )
    
    
    (682,533
    )Accumulated other comprehensive income
    
    
    2,408
    
    
    
    2,493Total stockholders equity
    
    
    120,667
    
    
    
    79,463Total liabilities and stockholders equity
    
    $
    190,039
    
    
    $
    165,231
  Page 3




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##### Table of Contents



ATARI, INC. AND SUBSIDIARIES
 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)
 (in thousands, except per share data)
 (unaudited)
 Three Months
    
    
    Nine MonthsEnded
    
    
    EndedDecember 31,
    
    
    December 31,2004
    
    
    2005
    
    
    2004
    
    
    2005Net revenues
    
    $
    156,364
    
    
    $
    100,784
    
    
    $
    332,472
    
    
    $
    163,385Costs and expenses:Cost of goods sold
    
    
    89,518
    
    
    
    60,669
    
    
    
    181,596
    
    
    
    104,114Research and product development
    
    
    15,397
    
    
    
    12,965
    
    
    
    46,109
    
    
    
    46,807Selling and distribution expenses
    
    
    19,177
    
    
    
    19,629
    
    
    
    50,929
    
    
    
    34,486General and administrative expenses
    
    
    9,765
    
    
    
    8,689
    
    
    
    26,989
    
    
    
    24,852Restructuring expenses
    
    
    
    
    
    
    1,144
    
    
    
    
    
    
    
    4,845Depreciation and amortization
    
    
    2,973
    
    
    
    2,076
    
    
    
    8,194
    
    
    
    6,665Total costs and expenses
    
    
    136,830
    
    
    
    105,172
    
    
    
    313,817
    
    
    
    221,769Operating income (loss)
    
    
    19,534
    
    
    
    (4,388
    )
    
    
    18,655
    
    
    
    (58,384
    )Interest income (expense), net
    
    
    94
    
    
    
    (244
    )
    
    
    (608
    )
    
    
    (589
    )Other (expense) income
    
    
    (11
    )
    
    
    19
    
    
    
    23
    
    
    
    (217
    )Income (loss) before provision for (benefit
from) income taxes
    
    
    19,617
    
    
    
    (4,613
    )
    
    
    18,070
    
    
    
    (59,190
    )Provision for (benefit from) income taxes
    
    
    376
    
    
    
    (122
    )
    
    
    758
    
    
    
    (405
    )Income (loss) from continuing operations
    
    
    19,241
    
    
    
    (4,491
    )
    
    
    17,312
    
    
    
    (58,785
    )Income (loss) from discontinued operations
of Humongous Entertainment (Note 10),
net of tax
    
    
    365
    
    
    
    (270
    )
    
    
    (2,541
    )
    
    
    (4,004
    )Net income (loss)
    
    $
    19,606
    
    
    $
    (4,761
    )
    
    $
    14,771
    
    
    $
    (62,789
    )Basic and diluted net income (loss) per share:Income (loss) from continuing operations
    
    $
    0.16
    
    
    $
    (0.03
    )
    
    $
    0.14
    
    
    $
    (0.46
    )Income (loss) from discontinued
operations, net of tax
    
    
    0.00
    
    
    
    (0.01
    )
    
    
    (0.02
    )
    
    
    (0.04
    )Net income (loss)
    
    $
    0.16
    
    
    $
    (0.04
    )
    
    $
    0.12
    
    
    $
    (0.50
    )Basic weighted average shares outstanding
    
    
    121,283
    
    
    
    134,749
    
    
    
    121,269
    
    
    
    126,626Diluted weighted average shares outstanding
    
    
    121,376
    
    
    
    134,749
    
    
    
    121,412
    
    
    
    126,626Net income (loss)
    
    $
    19,606
    
    
    $
    (4,761
    )
    
    $
    14,771
    
    
    $
    (62,789
    )Other comprehensive (loss) income:Foreign currency translation adjustments
    
    
    (100
    )
    
    
    66
    
    
    
    (106
    )
    
    
    85Recognition of cumulative translation
adjustment from liquidation of a foreign
subsidiary
    
    
    
    
    
    
    
    
    
    
    (859
    )
    
    
    Comprehensive income (loss)
    
    $
    19,506
    
    
    $
    (4,695
    )
    
    $
    13,806
    
    
    $
    (62,704
    )
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ATARI, INC. AND SUBSIDIARIES
 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 (in thousands)
 (unaudited)
 Nine MonthsEndedDecember 31,2004
    
    
    2005(as restated  see
Note 13)CASH FLOWS FROM OPERATING ACTIVITIES:Net income (loss)
    
    $
    14,771
    
    
    $
    (62,789
    )Adjustments to reconcile net income (loss) to net cash provided by (used
in)
operating activities:Loss from discontinued operations of Humongous Entertainment, net of
tax
    
    
    2,541
    
    
    
    4,004Non-cash restructuring charges
    
    
    139
    
    
    
    701Loss on sale of IESA shares
    
    
    
    
    
    
    239Depreciation and amortization
    
    
    8,194
    
    
    
    6,665Recognition of deferred income
    
    
    (2,087
    )
    
    
    (57
    )Recognition of cumulative translation adjustment from liquidation of a
foreign subsidiary
    
    
    (859
    )
    
    
    Amortization of deferred financing fees
    
    
    616
    
    
    
    375Other miscellaneous adjustments to net income (loss)
    
    
    221
    
    
    
    74Changes in operating assets and liabilities:Receivables, net
    
    
    (41,070
    )
    
    
    10,487Inventories, net
    
    
    (1,782
    )
    
    
    (3,454
    )Due from related parties
    
    
    (13,045
    )
    
    
    (10,637
    )Due to related parties
    
    
    19,532
    
    
    
    15,718Prepaid expenses and other current assets
    
    
    (2,124
    )
    
    
    8,667Accounts payable
    
    
    5,506
    
    
    
    275Accrued liabilities
    
    
    16,560
    
    
    
    1,762Royalties payable
    
    
    5,407
    
    
    
    3,773Deferred income and other long-term liabilities
    
    
    (136
    )
    
    
    229Other assets
    
    
    (4,986
    )
    
    
    1,098Net cash provided by (used in) continuing operations
    
    
    7,398
    
    
    
    (22,870
    )Net cash used in discontinued operations
    
    
    (762
    )
    
    
    (3,668
    )Net cash provided by (used in) operating activities
    
    
    6,636
    
    
    
    (26,538
    )CASH FLOWS FROM INVESTING ACTIVITIES:Proceeds from sale of IESA shares
    
    
    
    
    
    
    10,051Purchases of property and equipment
    
    
    (1,534
    )
    
    
    (2,093
    )Proceeds from sale of property and equipment
    
    
    21
    
    
    
    20Net cash (used in) provided by continuing operations
    
    
    (1,513
    )
    
    
    7,978Net cash (used in) discontinued operations
    
    
    (90
    )
    
    
    (5
    )Net cash (used in) provided by investing activities
    
    
    (1,603
    )
    
    
    7,973CASH FLOWS FROM FINANCING ACTIVITIES:Borrowings under HSBC Business Credit (USA) Inc. revolving
credit facility
    
    
    
    
    
    
    4,399Proceeds from issuance of common stock
    
    
    
    
    
    
    7,267Proceeds from exercise of stock options
    
    
    88
    
    
    
    115Payments under capitalized lease obligation
    
    
    (73
    )
    
    
    (129
    )Net cash provided by financing activities
    
    
    15
    
    
    
    11,652Effect of exchange rates on cash
    
    
    43
    
    
    
    (66
    )Net increase (decrease) in cash
    
    
    5,091
    
    
    
    (6,979
    )Cash  beginning of fiscal period
    
    
    9,607
    
    
    
    10,433Cash  end of fiscal period
    
    $
    14,698
    
    
    $
    3,454
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Nine MonthsEndedDecember 31,2004
    
    
    2005SUPPLEMENTAL CASH FLOW INFORMATIONCash paid for interest
    
    
    379
    
    
    
    247Income tax refunds
    
    
    731
    
    
    
    1,403SUPPLEMENTAL DISCLOSURE OF NON-CASH
OPERATING ACTIVITIES:Receipt of IESA stock for prepayment of Humongous, Inc. inventory
and other costs
    
    
    
    
    
    
    1,972Issuance of 1,557,668 shares of common stock in lieu of partial royalty
payment
    
    
    
    
    
    
    2,113Offset of
certain related party trade payables against short-term notes
receivable from related parties
    
    
    1,317
    
    
    
    Offset and
assignment of short-term notes receivable from related parties into a
secured promissory note
    
    
    7,254
    
    
    
    Issuance of a
secured promissory note in exchange for certain short-term notes
receivable and certain related party trade receivables
    
    
    (23,059
    )
    
    
    Offset of
certain related party trade payables against a secured promissory note
    
    
    2,229
    
    
    
    SUPPLEMENTAL DISCLOSURE OF NON-CASH
INVESTING ACTIVITIES:Sale of Humongous Entertainment in exchange for shares of IESA stock
    
    
    
    
    
    
    8,318Capital lease obligation for computer equipment
    
    
    391
    
    
    
    107SUPPLEMENTAL DISCLOSURE OF NON-CASH
FINANCING ACTIVITIES:Issuance of 6,145,051 shares of common stock in lieu of payment of net
related
party payables
    
    
    
    
    
    
    7,988
  Page 6




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ATARI, INC. AND SUBSIDIARIES
 
 CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS EQUITY
 (in thousands)
 (unaudited)
 AccumulatedCommon
    
    
    
    
    
    
    Additional
    
    
    
    
    
    
    OtherStock
    
    
    Common
    
    
    Paid-In
    
    
    Accumulated
    
    
    ComprehensiveShares
    
    
    Stock
    
    
    Capital
    
    
    Deficit
    
    
    Income
    
    
    TotalBalance, March 31, 2005
    
    
    121,296
    
    
    $
    1,213
    
    
    $
    736,790
    
    
    $
    (619,744
    )
    
    $
    2,408
    
    
    $
    120,667Net (loss)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (62,789
    )
    
    
    
    
    
    
    (62,789
    )Foreign currency translation adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    85
    
    
    
    85Exercise of stock options
    
    
    47
    
    
    
    
    
    
    
    116
    
    
    
    
    
    
    
    
    
    
    
    116Modification of stock options
    
    
    
    
    
    
    
    
    
    
    404
    
    
    
    
    
    
    
    
    
    
    
    404Issuance of common stock in lieu of partial royalty
payment
    
    
    1,558
    
    
    
    16
    
    
    
    2,096
    
    
    
    
    
    
    
    
    
    
    
    2,112Sale of Humongous Entertainment
    
    
    
    
    
    
    
    
    
    
    3,613
    
    
    
    
    
    
    
    
    
    
    
    3,613Issuance of common stock in lieu of payment of
net related party payables (Note 7)
    
    
    6,145
    
    
    
    61
    
    
    
    7,927
    
    
    
    
    
    
    
    
    
    
    
    7,988Issuance of common stock
    
    
    5,703
    
    
    
    57
    
    
    
    7,210
    
    
    
    
    
    
    
    
    
    
    
    7,267Balance, December 31, 2005
    
    
    134,749
    
    
    $
    1,347
    
    
    $
    758,156
    
    
    $
    (682,533
    )
    
    $
    2,493
    
    
    $
    79,463
  Page 7




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ATARI, INC. AND SUBSIDIARIES
 
 NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 (unaudited)
 NOTE 1  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND OTHER MATTERS
 Nature of Business
   Going Concern
    Goodwill and Other Intangible Assets
    Basis of Presentation
  Page 8




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Principles of Consolidation
  Use of Estimates
  Reclassifications
  Revenue Recognition
   Concentration of Credit Risk
   Research and Product Development Costs
   Licenses
  Fair Values of Financial Instruments
  Long-Lived Assets
  Income Taxes
  Page 9




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Recent Accounting Pronouncements
      Page 10




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NOTE 2  EQUITY
 Sale of common stock to third party investors
  Sale of Humongous Entertainment
  Issuance of common stock as settlement of certain net related party balances
  NOTE 3  STOCK BASED COMPENSATION
   Three Months
    
    
    Nine MonthsEnded
    
    
    EndedDecember 31,
    
    
    December 31,2004
    
    
    2005
    
    
    2004
    
    
    2005Income (loss) from continuing operations:As reported
    
    $
    19,241
    
    
    $
    (4,491
    )
    
    $
    17,312
    
    
    $
    (58,785
    )Add:
Stock-based employee compensation expense, included in reported
income (loss) from continuing operations, net of related tax
effects
    
    
    139
    
    
    
    
    
    
    
    139
    
    
    
    404Less: Fair value of stock-based employee
compensation expense, net of related tax
effects
    
    
    (1,479
    )
    
    
    (400
    )
    
    
    (3,892
    )
    
    
    (1,588
    )Pro forma income (loss)
from
continuing operations
    
    $
    17,901
    
    
    $
    (4,891
    )
    
    $
    13,559
    
    
    $
    (59,969
    )
 Page 11




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Three Months
    
    
    Nine MonthsEnded
    
    
    EndedDecember 31,
    
    
    December 31,2004
    
    
    2005
    
    
    2004
    
    
    2005Income (loss) from continuing operations per
share:Basic and diluted  as reported
    
    $
    0.16
    
    
    $
    (0.03
    )
    
    $
    0.14
    
    
    $
    (0.46
    )Basic and diluted  pro forma
    
    $
    0.15
    
    
    $
    (0.04
    )
    
    $
    0.11
    
    
    $
    (0.47
    )Net income (loss):As reported
    
    $
    19,606
    
    
    $
    (4,761
    )
    
    $
    14,771
    
    
    $
    (62,789
    )Add:
Stock-based employee compensation expense, included in reported net
income (loss), net of related tax
effects
    
    
    139
    
    
    
    
    
    
    
    139
    
    
    
    404Less: Fair value of stock-based employee
compensation expense, net of related tax effects
    
    
    (1,479
    )
    
    
    (400
    )
    
    
    (3,892
    )
    
    
    (1,588
    )Pro forma net income (loss)
    
    $
    18,266
    
    
    $
    (5,161
    )
    
    $
    11,018
    
    
    $
    (63,973
    )Net income (loss) per share:Basic and diluted  as reported
    
    $
    0.16
    
    
    $
    (0.04
    )
    
    $
    0.12
    
    
    $
    (0.50
    )Basic and diluted  pro forma
    
    $
    0.15
    
    
    $
    (0.04
    )
    
    $
    0.09
    
    
    $
    (0.51
    )




Three Months
    
    Nine MonthsEnded
    
    EndedDecember 31,
    
    December 31,2004
    
    2005
    
    2004
    
    2005Dividend yield
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %Anticipated volatility
    
    
    255
    %
    
    
    244
    %
    
    
    255
    %
    
    
    244
    %Expected lives
    
    4 years
    
    
    2 years
    
    
    4 years
    
    
    2 years




NOTE 4  NET INCOME (LOSS) PER SHARE




Three Months
    
    
    Nine MonthsEnded
    
    
    EndedDecember 31,
    
    
    December 31,2004
    
    
    2005
    
    
    2004
    
    
    2005Basic and diluted earnings per share calculation:Income (loss) from continuing operations
    
    $
    19,241
    
    
    $
    (4,491
    )
    
    $
    17,312
    
    
    $
    (58,785
    )Income (loss) from discontinued operations of
Humongous Entertainment, net of tax
    
    
    365
    
    
    
    (270
    )
    
    
    (2,541
    )
    
    
    (4,004
    )Net income (loss)
    
    $
    19,606
    
    
    $
    (4,761
    )
    
    $
    14,771
    
    
    $
    (62,789
    )Basic weighted average shares outstanding
    
    
    121,283
    
    
    
    134,749
    
    
    
    121,269
    
    
    
    126,626Dilutive potential common shares:Employee stock options and warrants
    
    
    93
    
    
    
    
    
    
    
    143
    
    
    
    Diluted weighted average shares outstanding
    
    
    121,376
    
    
    
    134,749
    
    
    
    121,412
    
    
    
    126,626


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Three Months
    
    
    Nine MonthsEnded
    
    
    EndedDecember 31,
    
    
    December 31,2004
    
    
    2005
    
    
    2004
    
    
    2005Basic and diluted income (loss) from continuing
operations per share
    
    $
    0.16
    
    
    $
    (0.03
    )
    
    $
    0.14
    
    
    $
    (0.46
    )Basic and diluted income (loss) from discontinued
operations of Humongous Entertainment per share
    
    
    0.00
    
    
    
    (0.01
    )
    
    
    (0.02
    )
    
    
    (0.04
    )Basic and diluted net income (loss) per share
    
    $
    0.16
    
    
    $
    (0.04
    )
    
    $
    0.12
    
    
    $
    (0.50
    )
  NOTE 5  BALANCE SHEET DETAILS
 Inventories
  March 31,
    
    
    December 31,2005
    
    
    2005Finished goods, net
    
    $
    21,726
    
    
    $
    25,533Return inventory, net
    
    
    3,379
    
    
    
    3,114Raw materials, net
    
    
    104
    
    
    
    251$
    25,209
    
    
    $
    28,898
 Prepaid Expenses and Other Current Assets
  March 31,
    
    
    December 31,2005
    
    
    2005Licenses short-term
    
    $
    6,795
    
    
    $
    4,979Prepaid insurance
    
    
    1,130
    
    
    
    1,316Royalties receivable
    
    
    6,551
    
    
    
    1,101Atari name license
    
    
    3,350
    
    
    
    860Income taxes receivable
    
    
    1,533
    
    
    
    80Other prepaid expenses and current assets
    
    
    3,170
    
    
    
    2,690$
    22,529
    
    
    $
    11,026
 Accrued Liabilities
  March 31,
    
    
    December 31,2005
    
    
    2005Accrued advertising
    
    $
    1,810
    
    
    $
    7,560Accrued distribution services
    
    
    3,332
    
    
    
    4,320Accrued salary and related costs
    
    
    3,344
    
    
    
    2,668Accrued professional fees and other services
    
    
    1,418
    
    
    
    2,010Accrued third-party development expenses
    
    
    2,551
    
    
    
    1,908Restructuring reserve
    
    
    1,885
    
    
    
    960Accrued freight and handling fees
    
    
    1,141
    
    
    
    852Income taxes payable
    
    
    500
    
    
    
    85Other
    
    
    3,018
    
    
    
    2,982$
    18,999
    
    
    $
    23,345
 Page 13




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##### Table of Contents



NOTE 6  INCOME TAXES
   NOTE 7  RELATED PARTY TRANSACTIONS
 Relationship with IESA
    Summary of Related Party Transactions
  Page 14




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##### Table of Contents



Three Months
    
    
    Nine MonthsEnded
    
    
    EndedDecember 31,
    
    
    December 31,Income (expense)
    
    2004
    
    
    2005
    
    
    2004
    
    
    2005Net revenues
    
    $
    156,364
    
    
    $
    100,784
    
    
    $
    332,472
    
    
    $
    163,385Related party activity:Royalty income (1)
    
    
    722
    
    
    
    8,965
    
    
    
    17,015
    
    
    
    12,636License income
    
    
    173
    
    
    
    98
    
    
    
    173
    
    
    
    282Sale of goods
    
    
    533
    
    
    
    531
    
    
    
    1,567
    
    
    
    793Quality and assurance testing and other services
    
    
    731
    
    
    
    260
    
    
    
    1,971
    
    
    
    947Total related party net revenues
    
    
    2,159
    
    
    
    9,854
    
    
    
    20,726
    
    
    
    14,658Cost of goods sold
    
    
    (89,518
    )
    
    
    (60,669
    )
    
    
    (181,596
    )
    
    
    (104,114
    )Related party activity:Distribution fee for Humongous, Inc.
products (Note 10)
    
    
    
    
    
    
    (3,830
    )
    
    
    
    
    
    
    (5,057
    )Royalty expense (2)
    
    
    (18,488
    )
    
    
    (4,611
    )
    
    
    (28,803
    )
    
    
    (6,784
    )Total related party cost of goods sold
    
    
    (18,488
    )
    
    
    (8,441
    )
    
    
    (28,803
    )
    
    
    (11,841
    )Research and product development
    
    
    (15,397
    )
    
    
    (12,965
    )
    
    
    (46,109
    )
    
    
    (46,807
    )Related party activity:Development expenses (3)
    
    
    (3,651
    )
    
    
    (4,368
    )
    
    
    (9,365
    )
    
    
    (12,650
    )Other miscellaneous development expenses
    
    
    (34
    )
    
    
    (12
    )
    
    
    (61
    )
    
    
    (83
    )Total related party research and product
development
    
    
    (3,685
    )
    
    
    (4,380
    )
    
    
    (9,426
    )
    
    
    (12,733
    )Selling and distribution expenses
    
    
    (19,177
    )
    
    
    (19,629
    )
    
    
    (50,929
    )
    
    
    (34,486
    )Related party activity:Miscellaneous purchase of services
    
    
    (17
    )
    
    
    
    
    
    
    (45
    )
    
    
    (8
    )Total related party selling and distribution
expenses
    
    
    (17
    )
    
    
    
    
    
    
    (45
    )
    
    
    (8
    )General and administrative expenses
    
    
    (9,765
    )
    
    
    (8,689
    )
    
    
    (26,989
    )
    
    
    (24,852
    )Related party activity:Management fee revenue
    
    
    750
    
    
    
    480
    
    
    
    2,250
    
    
    
    1,693Management fee expense
    
    
    (750
    )
    
    
    (750
    )
    
    
    (2,250
    )
    
    
    (2,250
    )Office rental and other services
    
    
    (97
    )
    
    
    65
    
    
    
    (270
    )
    
    
    34Total related party general and administrative
expenses
    
    
    (97
    )
    
    
    (205
    )
    
    
    (270
    )
    
    
    (523
    )Interest income (expense), net
    
    
    94
    
    
    
    (244
    )
    
    
    (608
    )
    
    
    (589
    )Related party activity:Interest income
    
    
    368
    
    
    
    
    
    
    
    595
    
    
    
    Total related party interest expense, net
    
    
    368
    
    
    
    
    
    
    
    595
    
    
    
    Income (loss) from discontinued operations, net of tax
    
    
    365
    
    
    
    (270
    )
    
    
    (2,541
    )
    
    
    (4,004
    )Related party activity:Royalty income from discontinued operations
    
    
    49
    
    
    
    
    
    
    
    84
    
    
    
    10Total related party income from discontinued
operations
    
    
    49
    
    
    
    
    
    
    
    84
    
    
    
    10
 
 (1)
    
    We have entered into a distribution agreement with IESA and Atari Europe which
provides for IESAs and Atari Europes distribution of our products across Europe, Asia, and
certain other regions pursuant to which IESA, Atari Europe, or any of their subsidiaries, as
applicable, will pay us 30.0% of the gross margin on such products or 130.0% of the royalty rate
due to the developer, whichever is greater. We recognize this amount as royalty income as part
of net revenues, net of returns.(2)
    
    We have also entered into a distribution agreement with IESA and Atari Europe, which
provides for our distribution of IESAs (or any of its subsidiaries) products in the United
States, Canada and Mexico, pursuant to which we will pay IESA either 30.0% of the gross margin
on such products or 130.0% of the royalty rate due to the Page 15




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##### Table of Contents



developer, whichever is greater. We recognize this amount as royalty expense as part of cost of
goods sold, net of returns.(3)
    
    We engage certain related party development studios to provide services such as product
development, design, and testing.  March 31,
    
    
    December 31,2005
    
    
    2005Due from/(Due to)IESA (1)
    
    $
    
    
    
    $
    (2,165
    )Atari Europe (2)
    
    
    (1,431
    )
    
    
    10,456Atari UK (3)
    
    
    (1,696
    )
    
    
    Eden Studios (4)
    
    
    
    
    
    
    (1,510
    )Paradigm (4)
    
    
    (154
    )
    
    
    (718
    )Atari Melbourne House (4)
    
    
    
    
    
    
    (2,082
    )Humongous, Inc. (5)
    
    
    
    
    
    
    (3,216
    )Atari Interactive (6)
    
    
    (2,106
    )
    
    
    (3,628
    )Other miscellaneous net receivables
    
    
    214
    
    
    
    742Net due to related parties
    
    $
    (5,173
    )
    
    $
    (2,121
    )
  March 31,
    
    
    December 31,2005
    
    
    2005Due from related parties
    
    $
    248
    
    
    $
    11,209Due to related parties
    
    
    (5,421
    )
    
    
    (13,330
    )Net due to related parties
    
    $
    (5,173
    )
    
    $
    (2,121
    )
 
 (1)
    
    Balances comprised primarily from the management fees charged to us by IESA and other
recharges of cost incurred on our behalf.(2)
    
    Balances comprised of royalty income or expense from our distribution agreements with
IESA and Atari Europe relating to properties owned or licensed by Atari Europe.(3)
    
    Balance at March 31, 2005 represents a loan owed by our dormant UK subsidiary to
another IESA subsidiary. This note was settled through the issuance of stock in September
2005 (see below).(4)
    
    Represents net payables related to related party development activities.(5)
    
    Represents distribution fees owed to Humongous, Inc., a related party. As of
March 31, 2005, Humongous existed as a development studio within Atari, Inc. (see Note 9).(6)
    
    Comprised primarily of payables related to royalty expense from our distribution
agreement with IESA relating to properties owned or licensed by Atari Interactive, offset
by receivables related to management fee revenue earned from Atari Interactive. Issuance of Common Stock to Related Parties
  
    
    Related Party Payables
  Page 16




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##### Table of Contents




    
    Settlement of Indebtedness
  Related Party Transactions with Employees or Former Employees
 Driver:
Parallel Lines
 NOTE 8  COMMITMENTS AND CONTINGENCIES
 Litigation
   Atari, Inc., Atari Interactive, Inc., and Hasbro, Inc. v. Games, Inc., Roger W. Ach, II, and
Chicago West Pullman LLC
   Page 17




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##### Table of Contents



American Video Graphics, L.P., v. Electronic Arts, Inc. et al.
   iEntertainment
Network, Inc. v. Epic Games, Inc., Atari, Inc., Valve Corporation, Sierra
Entertainment, Inc., Sony Corporation of Japan, Sony Corporation of America, Sony Computer
Entertainment America, Inc. and Sony Online Entertainment, Inc.
  Mr. M.L. Edmondson v. Reflections Interactive Limited
  Bouchat
v. Champion Products, et al. (Accolade)
  Page 18




---



##### Table of Contents



Indigo Moon Productions, LLC v. Hasbro, Inc., et al.
  Rafael Curulla v. SAS Atari Europe
and Atari, Inc.
  NOTE 9  DEBT
 Credit Facilities
 HSBC Loan and Security Agreement
   NOTE 10  DISCONTINUED OPERATIONS
  Page 19




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##### Table of Contents



Sale of Humongous
      Balance Sheets
  March 31, 2005
    
    
    December 31, 2005Assets:Cash
    
    $
    6
    
    
    $
    3Inventory, net
    
    
    1,104
    
    
    
    Prepaid expenses and other
current assets
    
    
    259
    
    
    
    1Property and equipment, net
    
    
    452
    
    
    
    168Other non-current assets
    
    
    1,734
    
    
    
    48Total assets
    
    $
    3,555
    
    
    $
    220Liabilities:Accounts payable
    
    $
    31
    
    
    $
    Accrued liabilities
    
    
    2,078
    
    
    
    71Restructuring reserve
    
    
    
    
    
    
    273Royalty payable
    
    
    386
    
    
    
    Other non-current liabilities
    
    
    190
    
    
    
    62Total liabilities
    
    $
    2,685
    
    
    $
    406
 Restructuring
  Page 20




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##### Table of Contents



Results of Operations
  Three Months
    
    Nine MonthsEnded
    
    EndedDecember 31,
    
    December 31,2004
    
    2005
    
    2004
    
    2005Net revenues
    
    $
    5,395
    
    
    $
    
    
    
    $
    10,974
    
    
    $
    580Income (loss) from discontinued operations,
net of tax
    
    $
    365
    
    
    $
    (270
    )
    
    $
    (2,541
    )
    
    $
    (4,004
    )
  Results of Continuing Involvement with Humongous, Inc.
  Three Months
    
    Nine MonthsEnded
    
    EndedDecember 31,
    
    December 31,2004
    
    2005
    
    2004
    
    2005Net revenues
    
    $
    
    

    
    $
    
    4,511

    
    $
    
    

    
    $
    
    6,229Cost of
goods sold
    
    
    
    

    
    
    
    (3,646
    )

    
    
    

    
    
    
    (4,838
    )Total
    
    $
    
    

    
    $
    
    865

    
    $
    
    

    
    $
    
    1,391
 NOTE 11  RESTRUCTURING
  Three Months
    
    
    Nine MonthsEnded
    
    
    EndedDecember 31, 2005
    
    
    December 31, 2005Severance and retention expenses
    
    $
    111
    
    
    $
    1,728Lease related costs
    
    
    272
    
    
    
    1,044Relocation
    
    
    254
    
    
    
    418Modification of stock options
    
    
    
    
    
    
    404Consultants
    
    
    358
    
    
    
    358
 Page 21




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##### Table of Contents



Three Months
    
    
    Nine MonthsEnded
    
    
    EndedDecember 31, 2005
    
    
    December 31, 2005Fixed asset write offs
    
    
    
    
    
    
    297Miscellaneous costs
    
    
    149
    
    
    
    596Total
    
    $
    1,144
    
    
    $
    4,845
   Balance at
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Balance atMarch 31, 2004
    
    
    Accrued Amounts
    
    
    Reclasses
    
    

Cash
payments, net
    
    
    March 31, 2005Severance and retention
    
    $
    
    
    
    $
    4,219
    
    
    $
    
    
    
    $
    (2,414
    )
    
    $
    1,805Severance and retention  long term
    
    
    
    
    
    
    52
    
    
    
    
    
    
    
    
    
    
    
    52Miscellaneous costs
    
    
    
    
    
    
    117
    
    
    
    
    
    
    
    (37
    )
    
    
    80Total
    
    $
    
    
    
    $
    4,388
    
    
    $
    
    
    
    $
    (2,451
    )
    
    $
    1,937Balance at
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Balance atMarch 31, 2005
    
    
    Accrued Amounts
    
    
    Reclasses
    
    
    Cash payments, net
    
    
    December 31, 2005Severance and retention
    
    $
    1,805
    
    
    $
    1,728
    
    
    $
    52
    
    
    $
    (3,060
    )
    
    $
    525Severance and retention  long term
    
    
    52
    
    
    
    
    
    
    
    (52
    )
    
    
    
    
    
    
    Lease related costs
    
    
    
    
    
    
    1,044
    
    
    
    
    
    
    
    (681
    )
    
    
    363Relocation
    
    
    
    
    
    
    418
    
    
    
    
    
    
    
    (418
    )
    
    
    Consultants
    
    
    
    
    
    
    358
    
    
    
    
    
    
    
    (358
    )
    
    
    Miscellaneous costs
    
    
    80
    
    
    
    596
    
    
    
    
    
    
    
    (604
    )
    
    
    72Total
    
    $
    1,937
    
    
    $
    4,144
    
    
    $
    
    
    
    $
    (5,121
    )
    
    $
    960
  NOTE 12  OPERATIONS BY REPORTABLE SEGMENTS
     Page 22




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##### Table of Contents



Publishing
    
    Distribution
    
    Corporate
    
    TotalThree months ended December 31, 2004:Net revenues
    
    $
    137,859
    
    
    $
    18,505
    
    
    $
    
    
    
    $
    156,364Operating income (loss)
    
    
    26,618
    
    
    
    2,579
    
    
    
    (9,663
    )
    
    
    19,534Depreciation and amortization
    
    
    (624
    )
    
    
    
    
    
    
    (2,349
    )
    
    
    (2,973
    )Interest income, net
    
    
    
    
    
    
    
    
    
    
    94
    
    
    
    94Three months ended December 31, 2005:Net revenues
    
    $
    82,426
    
    
    $
    18,358
    
    
    $
    
    
    
    $
    100,784Operating income (loss) (1)
    
    
    4,195
    
    
    
    2,052
    
    
    
    (9,491
    )
    
    
    (3,244
    )Depreciation and amortization
    
    
    (403
    )
    
    
    
    
    
    
    (1,673
    )
    
    
    (2,076
    )Interest expense, net
    
    
    
    
    
    
    
    
    
    
    (244
    )
    
    
    (244
    )Nine months ended December 31, 2004:Net revenues
    
    $
    289,979
    
    
    $
    42,493
    
    
    $
    
    
    
    $
    332,472Operating income (loss)
    
    
    38,242
    
    
    
    6,496
    
    
    
    (26,083
    )
    
    
    18,655Depreciation and amortization
    
    
    (2,317
    )
    
    
    
    
    
    
    (5,877
    )
    
    
    (8,194
    )Interest expense, net
    
    
    
    
    
    
    
    
    
    
    (608
    )
    
    
    (608
    )Nine months ended December 31, 2005:Net revenues
    
    $
    117,797
    
    
    $
    45,588
    
    
    $
    
    
    
    $
    163,385Operating (loss) income (1)
    
    
    (30,731
    )
    
    
    4,604
    
    
    
    (27,412
    )
    
    
    (53,539
    )Depreciation and amortization
    
    
    (1,551
    )
    
    
    
    
    
    
    (5,114
    )
    
    
    (6,665
    )Interest expense, net
    
    
    
    
    
    
    
    
    
    
    (589
    )
    
    
    (589
    )
 
 (1)
    
    Operating income (loss) for the Corporate segment for the three months and nine months
ended December 31, 2005, excludes restructuring charges of $1.1 million and $4.8 million,
respectively. Including restructuring charges, total operating loss for the three months
and nine months ended December 31, 2005 is $4.4 million and $58.4 million, respectively. NOTE 13  RESTATEMENT OF CASH FLOWS
   Nine Months Ended December 31, 2004
    
    As Previously Reported
    
    
    Adjustment
    
    
    As RestatedCash Flows From Operating Activities:Due from related parties
    
    $
    3,181
    
    
    $
    (16,226
    )
    
    $
    (13,045
    )Due to related parties
    
    
    15,565
    
    
    
    3,967
    
    
    
    19,532Net cash provided by continuing operations
    
    
    19,657
    
    
    
    (12,259
    )
    
    
    7,398Net cash (used in) discontinued operations
    
    
    (762
    )
    
    
    
    
    
    
    (762
    )Net cash provided by operating activities
    
    $
    18,895
    
    
    $
    (12,259
    )
    
    $
    6,636Cash Flows From Investing Activities:Repayment of
short-term notes receivable from related party
    
    $
    1,317
    
    
    $
    (1,317
    )
    
    $
    Transfer and assignment of
short-term notes receivable from related
party
    
    
    7,254
    
    
    
    (7,254
    )
    
    
    Issuance of secured promissory note
    
    
    (23,059
    )
    
    
    23,059
    
    
    
    Repayment of secured promissory note, net
    
    
    2,229
    
    
    
    (2,229
    )
    
    
    Net cash
(used in) continuing operations
    
    
    (13,772
    )
    
    
    12,259
    
    
    
    (1,513
    )Net cash (used in) discontinued operations
    
    
    (90
    )
    
    
    
    
    
    
    (90
    )Net cash (used in) investing activities
    
    $
    (13,862
    )
    
    $
    12,259
    
    
    $
    (1,603
    )SUPPLEMENTAL DISCLOSURE OF NON-CASH
    
    
    
    
    
    
    




    

    As RestatedOPERATING ACTIVITIES:Offset of certain related party trade
payables against short-term notes receivable from related parties
    
    
    
    
    
    
    
    
    
    
    1,317Offset and assignment of
short-term notes receivable from related parties into a secured promissory note
    
    
    
    
    
    
    
    
    
    
    7,254Issuance of a secured promissory note in
exchange for certain short-term notes receivable and certain related party trade receivables
    
    
    
    
    
    
    
    
    
    
    (23,059
    )Offset of certain related party trade
payables against a secured promissory note
    
    
    
    
    
    
    
    
    
    
    2,229
 Page 23




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##### Table of Contents



Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
 This document includes statements that may constitute forward-looking statements made pursuant
to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. We caution
readers regarding certain forward-looking statements in this document, press releases, securities
filings, and all other documents and communications. All statements, other than statements of
historical fact, including statements regarding industry prospects and future results of operations
or financial position, made in this Quarterly Report on Form 10-Q are forward looking. The words
believe, expect, anticipate, intend and similar expressions generally identify
forward-looking statements. While we believe in the veracity of all statements made herein,
forward-looking statements are necessarily based upon a number of estimates and assumptions that,
while considered reasonable by us, are inherently subject to significant business, economic and
competitive uncertainties and contingencies and known and unknown risks. As a result of such
risks, our actual results could differ materially from those expressed in any forward-looking
statements made by, or on behalf of, us. Some of the factors which could cause our results to
differ materially include the following: the loss of key customers, such as Wal-Mart, Best Buy,
Target, GameStop and Electronics Boutique; delays in product development and related product
release schedules; inability to secure capital; loss of our credit facility; adapting to the
rapidly changing industry technology, including new console technology; maintaining relationships
with leading independent video game software developers; maintaining or acquiring licenses to
intellectual property; fluctuations in the Companys quarterly net revenues and results of
operations based on the seasonality of our industry; and the termination or modification of our
agreements with hardware manufacturers. Please see the Risk Factors in our Annual Report on Form
10-K for the year ended March 31, 2005, which we expect to amend
for the effects of the restatement discussed in Note 13 to the
condensed consolidated financial statements included in Item 1, or in our other filings with the Securities and Exchange
Commission for a description of some, but not all, risks, uncertainties and contingencies. Except
as otherwise required by the applicable securities laws, we disclaim any intention or obligation
publicly to update or revise any forward-looking statements, whether as a result of new
information, future events or otherwise.
 Overview
 Restatement of Cash Flows
   Year Ended March 31, 2004
    
    As Previously Reported
    
    
    Adjustment
    
    
    As RestatedCash Flows From Operating Activities:Due from related parties
    
    $
    (793
    )
    
    $
    (8,571
    )
    
    $
    (9,364
    )Net cash provided by continuing operations
    
    
    13,667
    
    
    
    (8,571
    )
    
    
    5,096Net cash (used in) discontinued operations
    
    
    (1,799
    )
    
    
    
    
    
    
    (1,799
    )Net cash provided by operating activities
    
    $
    11,868
    
    
    $
    (8,571
    )
    
    $
    3,297Cash Flows From Investing Activities:Issuance of related party notes receivable
    
    $
    (8,571
    )
    
    $
    8,571
    
    
$
    Net cash (used in) continuing operations
    
    
    (27,977
    )
    
    
    8,571
    
    
    
    (19,406
    )Net cash (used in) discontinued operations
    
    
    (90
    )
    
    
    
    
    
    
    (90
    )Net cash (used in) investing activities
    
    $
    (28,067
    )
    
    $
    8,571
    
    
    $
    (19,496
    )SUPPLEMENTAL DISCLOSURE OFNON-CASH OPERATING ACTIVITIES:Issuance of related party notes receivable
    
    
    
    
    
    
    
    
    
    
    (8,571
    )
 Six Months Ended September 30, 2004
    
    As Previously Reported
    
    
    Adjustment
    
    
    As RestatedCash Flows From Operating Activities:Due to related parties
    
    $
    (1,016
    )
    
    $
    1,317
    
    
    $
    301Net cash (used in) continuing operations
    
    
    (6,734
    )
    
    
    1,317
    
    
    
    (5,417
    )Net cash (used in) discontinued operations
    
    
    (2,039
    )
    
    
    
    
    
    
    (2,039
    )Net cash (used in) operating activities
    
    $
    (8,773
    )
    
    $
    1,317
    
    
    $
    (7,456
    )Cash Flows From Investing Activities:Repayment of
short-term notes receivable to related parties
    
    $
    1,317
    
    
    $
    (1,317
    )
    
$
    Net cash provided by (used in) continuing operations
    
    
    119
    
    
    
    (1,317
    )
    
    
    (1,198
    )Net cash (used in) discontinued operations
    
    
    (14
    )
    
    
    
    
    
    
    (14
    )Net cash provided by (used in) investing activities
    
    $
    105
    
    
    $
    (1,317
    )
    
    $
    (1,212
    )SUPPLEMENTAL DISCLOSURE OF NON-CASHOPERATING ACTIVITIES:
    
    
    
    
    
    
    
    As RestatedOffset of
certain related party trade payables against short-term notes receivable from related parties
    
    
    
    
    
    
    
    
    
    
    1,317
 Year Ended March 31, 2005
    
    As Previously Reported
    
    
    Adjustment
    
    
    As RestatedCash Flows From Operating Activities:Due from related parties
    
    $
    3,934
    
    
    $
    (16,226
    )
    
    $
    (12,292
    )Due to related parties
    
    
    (1,333
    )
    
    
    24,797
    
    
    
    23,464Net cash (used in) provided by continuing operations
    
    
    (2,280
    )
    
    
    8,571
    
    
    
    6,291Net cash (used in) discontinued operations
    
    
    (3,364
    )
    
    
    
    
    
    
    (3,364
    )Net cash (used in) provided by operating activities
    
    $
    (5,644
    )
    
    $
    8,571
    
    
    $
    2,927Cash Flows From Investing Activities:Repayment of related party notes receivable
    
    $
    1,317
    
    
    $
    (1,317
    )
    
$
    Transfer and
assignment of related party notes receivable
    
    
    7,254
    
    
    
    (7,254
    )
    
    
    Issuance of secured promissory note
    
    
    (23,059
    )
    
    
    23,059
    
    
    
    Repayment of secured promissory note, net
    
    
    23,059
    
    
    
    (23,059
    )
    
    
    Net cash provided by (used in) continuing operations
    
    
    6,549
    
    
    
    (8,571
    )
    
    
    (2,022
    )Net cash (used in) discontinued operations
    
    
    (90
    )
    
    
    
    
    
    
    (90
    )Net cash provided by (used in) investing activities
    
    $
    6,459
    
    
    $
    (8,571
    )
    
    $
    (2,112
    )SUPPLEMENTAL DISCLOSURE OFNON-CASH OPERATING ACTIVITIES:
    
    
    
    
    
    
    
    As RestatedTransfer of certain related party trade payables against
short-term notes receivable from related parties
    
    
    
    
    
    
    
    
    
    
    1,317Transfer and assignment of short-term notes receivable from
related parties into a secured promissory note
    
    
    
    
    
    
    
    
    
    
    7,254Issuance of a secured promissory note in exchange for certain
short-term notes receivable and certain related party trade receivables
    
    
    
    
    
    
    
    
    
    
    (23,059
    )Transfer of certain related party trade payables against a secured promissory note
    
    
    
    
    
    
    
    
    
    
    23,059
   Going Concern
    Goodwill and Other Intangible Assets
   Business and Operating Segments
  Page 24




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Industry
    Critical accounting policies
   Revenue
recognition, sales returns, price protection, other customer related allowances and allowance for doubtful accounts
   Page 25




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Inventories
  Research and Product Development Costs
   Licenses
  Income Taxes
   Page 26




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Related Party Transactions
  Results of operations
 Three
months ended December 31, 2005 versus the three months ended December 31, 2004
 Condensed Consolidated Statement of Operations (dollars in thousands):
 Three
    
    
    
    
    
    
    ThreeMonths
    
    
    % of
    
    
    Months
    
    
    % ofEnded
    
    
    Net
    
    
    Ended
    
    
    NetDecember 31,
    
    
    Revenues
    
    
    December 31,
    
    
    Revenues
    
    
    (Unfavorable)/2004
    
    
    2004
    
    
    2005
    
    
    2005
    
    
    FavorableNet revenues
    
    $
    156,364
    
    
    
    100.0
    %
    
    $
    100,784
    
    
    
    100.0
    %
    
    $
    (55,580
    )Costs and expenses:Cost of goods sold
    
    
    89,518
    
    
    
    57.3
    %
    
    
    60,669
    
    
    
    60.2
    %
    
    
    28,849Research and product development
    
    
    15,397
    
    
    
    9.8
    %
    
    
    12,965
    
    
    
    12.9
    %
    
    
    2,432Selling and distribution expenses
    
    
    19,177
    
    
    
    12.3
    %
    
    
    19,629
    
    
    
    19.5
    %
    
    
    (452
    )General and administrative expenses
    
    
    9,765
    
    
    
    6.2
    %
    
    
    8,689
    
    
    
    8.6
    %
    
    
    1,076Restructuring expenses
    
    
    
    
    
    
    0.0
    %
    
    
    1,144
    
    
    
    1.1
    %
    
    
    (1,144
    )Depreciation and amortization
    
    
    2,973
    
    
    
    1.9
    %
    
    
    2,076
    
    
    
    2.1
    %
    
    
    897Total costs and expenses
    
    
    136,830
    
    
    
    87.5
    %
    
    
    105,172
    
    
    
    104.4
    %
    
    
    31,658Operating income (loss)
    
    
    19,534
    
    
    
    12.5
    %
    
    
    (4,388
    )
    
    
    (4.4
    )%
    
    
    (23,922
    )Interest income (expense), net
    
    
    94
    
    
    
    0.0
    %
    
    
    (244
    )
    
    
    (0.2
    )%
    
    
    (338
    )Other (expense) income
    
    
    (11
    )
    
    
    0.0
    %
    
    
    19
    
    
    
    0.0
    %
    
    
    30Income (loss) before provision for
(benefit from)
income taxes
    
    
    19,617
    
    
    
    12.5
    %
    
    
    (4,613
    )
    
    
    (4.6
    )%
    
    
    (24,230
    )Provision for (benefit from) income taxes
    
    
    376
    
    
    
    0.2
    %
    
    
    (122
    )
    
    
    (0.1
    )%
    
    
    498Income (loss) from continuing operations
    
    
    19,241
    
    
    
    12.3
    %
    
    
    (4,491
    )
    
    
    (4.5
    )%
    
    
    (23,732
    )Income (loss) from discontinued operations of
Humongous Entertainment, net of tax
    
    
    365
    
    
    
    0.2
    %
    
    
    (270
    )
    
    
    (0.2
    )%
    
    
    (635
    )Net income (loss)
    
    $
    19,606
    
    
    
    12.5
    %
    
    $
    (4,761
    )
    
    
    (4.7
    )%
    
    $
    (24,367
    )
 Net Revenues
 Net Revenues by Segment (in thousands):
 Three MonthsEndedDecember 31,2004
    
    
    2005
    
    
    (Unfavorable)Publishing
    
    $
    137,859
    
    
    $
    82,426
    
    
    $
    (55,433
    )Distribution
    
    
    18,505
    
    
    
    18,358
    
    
    
    (147
    )Total
    
    $
    156,364
    
    
    $
    100,784
    
    
    $
    (55,580
    )
 Page 27




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##### Table of Contents



Publishing Sales Platform Mix
 Three MonthsEndedDecember 31,2004
    
    2005PlayStation 2
    
    
    39.3
    %
    
    
    49.5
    %PC
    
    
    29.4
    %
    
    
    20.6
    %Xbox
    
    
    4.8
    %
    
    
    10.9
    %Plug and Play
    
    
    9.9
    %
    
    
    9.0
    %Game Boy Advance
    
    
    11.9
    %
    
    
    6.0
    %Nintendo DS
    
    
    0.0
    %
    
    
    3.5
    %Game Cube
    
    
    3.9
    %
    
    
    0.5
    %PlayStation
    
    
    0.8
    %
    
    
    0.0
    %Total
    
    
    100.0
    %
    
    
    100.0
    %
  
    
    Net product sales of new releases during the current quarter were approximately $51.1
million. This includes Dragon Ball Z: Budokai Tenkaichi(Playstation 2), Matrix: Path of
Neo(Playstation 2, Xbox, and PC), Roller Coaster Tycoon 3: Gold(PC), and Dragon Ball Z:
Super Sonic Warriors 2(Nintendo DS).Net product sales of new releases in the prior years comparable quarter were approximately
$94.5 million and included Dragonball Z: Budokai 3(PlayStation 2), Roller Coaster Tycoon 3
(PC), Godzilla: Save the Earth(PlayStation 2 and Xbox), Atari Anthology(PlayStation 2 and
Xbox), Sid Meiers Pirates!(PC), and Atari Flashback(plug and play).
    
    Back catalogue reorder sales decreased by approximately 41.9% from the prior year. Net
product sales of $6.1 million of Atari Flashback 2 (plug and play), released in the prior
quarter, contributed to the current period total. The prior comparable periods sales
included strong reorders of DRIV3R,released in the first quarter of fiscal 2005.
    
    Publishing net revenue during the current quarter includes $9.0 million of international
royalties earned on IESAs international sales of our titles, primarily for sales of
Matrix: Path of Neo, shipped in October 2005. The three months ended December 31, 2004
includes international royalties of $0.7 million, earned on various catalog titles.
    
    The overall average unit sales price (ASP) of the publishing business has increased from
$20.18 in the prior comparable quarter to $23.61 in the current period. The increase ASP
is due to the shift in the mix towards a greater percent of console product which carries a
greater average sales price. This is offset by a decrease in the ASP for the plug and play
product from $29.87 in the prior period to $21.29 in the current period.
  Cost of Goods Sold
  
    
    higher mix of international royalty income in the current period, with a lower
associated expense,
    
    a greater mix of higher cost console product sales in the publishing business,
    
    increased license amortization due to sales of Dragon Ball
Ztitles, and
    
    higher distribution net revenues (on which we incur higher costs) as a percentage of
total net revenues, which increased from 11.8% for the three months ended December 31,
2004 to 18.2% for the three months ended December 31, 2005, offset by
    
    higher average sales price for the current period as compared to the prior period (see
above).
 Page 28




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##### Table of Contents



Research and Product Development Expenses
  
    
    decreased spending for projects in development with external developers due to timing of
milestone completions, offfset by
    
    increased spending for certain projects currently in
development at our related party development studios.
  Selling and Distribution Expenses
  
    
    increased spend on advertising ($14.7 million in the current period as compared to $12.1
million in the prior period) driven by a television media campaign for Matrix: Path of Neo,
offset by
    
    savings in salaries and related overhead costs due to reduced headcount resulting from
managements restructuring plan, and
    
    lower variable distribution costs, including freight, shipping and handling, on lower
sales.
 General and Administrative Expenses
  
    
    a reduction in salary, rent, and other overhead costs due to reduced headcount and the
closure of the Beverly and Santa Monica offices (expenses included in restructuring expense
in the current period),
    
    reduced bad debt expense due to lower sales, offset by
    
    an increase of $0.5 million in professional and consulting fees, primarily due to outsourced legal services.
 Restructuring Expenses
  Page 29




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##### Table of Contents



Depreciation and Amortization
  Interest Income (Expense), net
  Provision for (Benefit from) Income Taxes
  Income (Loss) from Discontinued Operations of Humongous Entertainment, net of tax
  Nine months ended December 31, 2005 versus the nine months ended December 31, 2004
 Condensed
Consolidated Statement of Operations (dollars in thousands):
 Nine
    
    
    
    
    
    
    NineMonths
    
    
    % of
    
    
    Months
    
    
    % ofEnded
    
    
    Net
    
    
    Ended
    
    
    NetDecember 31,
    
    
    Revenues
    
    
    December 31,
    
    
    Revenues
    
    
    (Unfavorable)/2004
    
    
    2004
    
    
    2005
    
    
    2005
    
    
    FavorableNet revenues
    
    $
    332,472
    
    
    
    100.0
    %
    
    $
    163,385
    
    
    
    100.0
    %
    
    $
    (169,087
    )Costs and expenses:Cost of
goods sold
    
    
    181,596
    
    
    
    54.6
    %
    
    
    104,114
    
    
    
    63.7
    %
    
    
    77,482Research and product development
    
    
    46,109
    
    
    
    13.9
    %
    
    
    46,807
    
    
    
    28.7
    %
    
    
    (698
    )Selling and distribution expenses
    
    
    50,929
    
    
    
    15.3
    %
    
    
    34,486
    
    
    
    21.1
    %
    
    
    16,443General and administrative expenses
    
    
    26,989
    
    
    
    8.1
    %
    
    
    24,852
    
    
    
    15.1
    %
    
    
    2,137Restructuring expenses
    
    
    
    
    
    
    0.0
    %
    
    
    4,845
    
    
    
    3.0
    %
    
    
    (4,845
    )Depreciation and amortization
    
    
    8,194
    
    
    
    2.5
    %
    
    
    6,665
    
    
    
    4.1
    %
    
    
    1,529Total costs and expenses
    
    
    313,817
    
    
    
    94.4
    %
    
    
    221,769
    
    
    
    135.7
    %
    
    
    92,048Operating income (loss)
    
    
    18,655
    
    
    
    5.6
    %
    
    
    (58,384
    )
    
    
    (35.7
    )%
    
    
    (77,038
    )Interest expense, net
    
    
    (608
    )
    
    
    (0.2
    )%
    
    
    (589
    )
    
    
    (0.4
    )%
    
    
    18Other income (expense)
    
    
    23
    
    
    
    0.0
    %
    
    
    (217
    )
    
    
    (0.1
    )%
    
    
    (240
    )Income (loss) before provision for
(benefit from)
income taxes
    
    
    18,070
    
    
    
    5.4
    %
    
    
    (59,190
    )
    
    
    (36.2
    )%
    
    
    (77,260
    )Provision for (benefit from) income taxes
    
    
    758
    
    
    
    0.2
    %
    
    
    (405
    )
    
    
    (0.2
    )%
    
    
    1,163Income (loss) from continuing operations
    
    
    17,312
    
    
    
    5.2
    %
    
    
    (58,785
    )
    
    
    (36.0
    )%
    
    
    (76,097
    )(Loss) from discontinued operations of
Humongous
Entertainment, net of tax
    
    
    (2,541
    )
    
    
    (0.8
    )%
    
    
    (4,004
    )
    
    
    (2.4
    )%
    
    
    (1,463
    )Net income (loss)
    
    $
    14,771
    
    
    
    4.4
    %
    
    $
    (62,789
    )
    
    
    (38.4
    )%
    
    $
    (77,560
    )
 Page 30




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##### Table of Contents



Net Revenues
 Net Revenues by Segment (in thousands):
 Nine MonthsEndedDecember 31,
    
    
(Unfavorable)/2004
    
    
    2005
    
    

    FavorablePublishing
    
    $
    289,979
    
    
    $
    117,797
    
    
    $
    (172,182
    )Distribution
    
    
    42,493
    
    
    
    45,588
    
    
    
    3,095Total
    
    $
    332,472
    
    
    $
    163,385
    
    
    $
    (169,087
    )
 Publishing Sales Platform Mix
 Nine MonthsEndedDecember 31,2004
    
    2005PC
    
    
    24.3
    %
    
    
    28.9
    %Plug and play
    
    
    4.9
    %
    
    
    11.1
    %PlayStation 2
    
    
    41.5
    %
    
    
    38.2
    %Game Boy Advance
    
    
    12.9
    %
    
    
    7.7
    %Xbox
    
    
    11.9
    %
    
    
    9.6
    %Game Cube
    
    
    3.3
    %
    
    
    1.9
    %Nintendo DS
    
    
    0.0
    %
    
    
    2.5
    %PlayStation
    
    
    1.2
    %
    
    
    0.1
    %Total
    
    
    100.0
    %
    
    
    100.0
    %
 DRIV3R
 
    
    Net product sales for all new releases during the current period were $73.0 million and
include Dragon Ball Z: Budokai Tenkaichi(Playstation 2), Matrix: Path of Neo(Playstation
2 and Xbox), Atari Flashback 2(Plug and Play), Indigo Prophecy(PC, PlayStation 2, and
Xbox), and Dragon Ball Z: Transformations(Game Boy Advance).Prior period publishing net product sales for new releases were $197.0 million led by DRIV3R
which contributed approximately $38.6 million of publishing net product sales. Other new
releases in the prior year included Dragonball Z: Budokai 3(PlayStation 2), Roller Coaster
Tycoon 3(PC), Transformers(PlayStation 2), Duel Masters: Sempai Legends(PlayStation 2 and
Game Boy Advance), Dragonball Z: Buus Fury(Game Boy Advance), Dragon Ball Z: Super Sonic
Warriors(Game Boy Advance), Atari Anthology(PlayStation 2 and Xbox), and Atari Flashback,
a plug and play classic game console.
    
    Back catalogue reorder sales decreased by approximately 47.8% from the prior year. The
prior comparable periods sales included strong reorders of Unreal Tournament 2004, Dragon
Ball Z: Budokai 2, and Enter the Matrix.
    
    Publishing net revenues during the current period include $12.6 million of international
royalties earned on IESAs international sales of our titles, primarily for sales of
Matrix: Path of Neo, which shipped in October 2005, and Indigo Prophecy, released in
September 2005. Publishing net revenues during the nine months ended December 31, 2004
included international royalties of $16.9 million, which
included $14.9 million from
international sales of DRIV3R.
    
    Publishing net revenues also decreased from the prior period due to lower license income
as well as the recognition in the prior period of deferred revenue of approximately $4.0
million related to the release of DRIV3Ron Xbox paid by Microsoft. No such revenues were
recorded in the current period.
 Page 31




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##### Table of Contents




    
    The overall ASP of the publishing business has remained consistent with the prior period
at approximately $20.00. Trends include a mix shift toward lower priced PC product and
plug and play console, offset by an increase in price for PlayStation 2 and Xbox product.
  Cost of Goods Sold
  
    
    lower international royalty, license, and other income in the current period, which
have a higher associated royalty expense as a percentage of income than in the prior
period,
    
    increased license amortization due to sales of Dragon Ball Ztitles, and
    
    higher distribution net revenues (on which we incur higher costs) as a percentage of
total net revenues, which increased from 12.8% to 27.9% for the three months ended
December 31, 2004 and 2005, respectively, offset by
    
    higher mix of international royalty income in the current period, with a lower
associated expense.
 Research and Product Development Expenses
  
    
    increased spending for certain projects currently in
development at our related party development studios, offset by
    
    decreased spending for current titles in development with external developers due to
fewer titles in development and timing of milestone completions.
  Selling and Distribution Expenses
  
    
    a significant savings in the current period on advertising ($20.9 million in the current
period as compared to $30.5 million in the prior period) due to fewer new titles released,
    
    savings in salaries and related overhead costs due to reduced headcount resulting from
managements restructuring plan, and
    
    lower variable distribution costs, including freight, shipping and handling, on lower
sales.
 General and Administrative Expenses
  
    
    a reduction in salary, rent, and other overhead costs due to reduced headcount and the
closure of the Beverly and Santa Monica offices,
    
    decreased bad debt expense on lower sales, offset by
 Page 32




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
    
    an increase of $1.6 million in professional fees, including $0.2 million for a
settlement with AVG as well as a general increase in legal expense due to outsourcing, and
    
    the recognition of a $0.9 million translation gain from the liquidation of the dormant
Australian subsidiary in the first quarter of the prior year.
 Restructuring Expenses
  Depreciation and Amortization
  Interest Expense, net
  Other Income (Expense)
  Provision for (Benefit from) Income Taxes
  (Loss) from Discontinued Operations of Humongous Entertainment, net of tax
  Liquidity and Capital Resources
 Overview
  Page 33




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Cash Flows
 (in thousands)
 March 31,
    
    December 31,2005
    
    2005Cash
    
    $
    10,433
    
    
    $
    3,454Working capital
    
    $
    35,651
    
    
    $
    1,366Nine Months EndedDecember 31,2004
    
    2005Cash provided by (used in) operating
activities
    
    $
    6,636
    
    
    $
    (26,538
    )Cash (used in) provided by investing activities
    
    
    (1,603
    )
    
    
    7,973Cash provided by financing activities
    
    
    15
    
    
    
    11,652Effect of exchange rates on cash
    
    
    43
    
    
    
    (66
    )Net increase (decrease) in cash
    
    $
    5,091
    
    
    $
    (6,979
    )
 Dragon Ball Z
      Page 34




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Credit Facilities
 HSBC Loan and Security Agreement
    Contractual Obligations
  Contractual Obligations
Payments Due by Period
 Within 1 Year
    
    
    1-3 Years
    
    
    4-5 Years
    
    
    After 5 Years
    
    
    TotalRoyalty and license advances (1)
    
    $
    2,264
    
    
    $
    175
    
    
    $
    
    
    
    $
    
    
    
    $
    2,439Milestone payments (2)
    
    
    10,107
    
    
    
    15,771
    
    
    
    
    
    
    
    
    
    
    
    25,878Operating lease obligations (3)
    
    
    4,618
    
    
    
    3,223
    
    
    
    1,167
    
    
    
    
    
    
    
    9,008Capital lease obligations (4)
    
    
    212
    
    
    
    126
    
    
    
    
    
    
    
    
    
    
    
    338Total
    
    $
    17,201
    
    
    $
    19,295
    
    
    $
    1,167
    
    
    $
    
    
    
    $
    37,663
 
 (1)
    
    We have committed to pay advance payments under certain royalty and license
agreements. These payments are tied to significant obligations of performance and we
accrue for these commitments once those performance obligations are met. Page 35




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(2)
    
    Milestone payments represent royalty advances to developers for products that are
currently in development. Although milestone payments are not guaranteed, we expect to
make these payments if all deliverables and milestones are met timely and accurately.(3)
    
    We account for our leases as operating leases, with expiration dates ranging from
fiscal 2006 through fiscal 2012. These are future minimum annual rental payments
required under the leases, including a related party sub-lease with Atari Interactive.(4)
    
    We entered into several capital leases for computer equipment beginning in the
third quarter of fiscal 2005. Per FASB Statement No. 13, Accounting for Leases, we
account for capital leases by recording them at the present value of the total future
lease payments. They are amortized using the straight-line method over the minimum lease
term. Recent Accounting Pronouncements
       
 Item 3. Quantitative and Qualitative Disclosures about Market Risk
  Foreign Currency Exchange Rates
  
 Item 4. Controls and Procedures
 Evaluation of Disclosure Controls and Procedures
 Changes in Internal Control Over Financial Reporting
  Page 36




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##### Table of Contents



PART II. OTHER INFORMATION
 
 Item 1. Legal Proceedings
 Litigation
   Atari, Inc., Atari Interactive, Inc., and Hasbro, Inc. v. Games, Inc., Roger W. Ach, II, and
Chicago West Pullman LLC
       American Video Graphics, L.P., v. Electronic Arts, Inc. et al.
  Page 37




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##### Table of Contents



iEntertainment
Network, Inc. v. Epic Games, Inc., Atari, Inc., Valve Corporation, Sierra
Entertainment, Inc., Sony Corporation of Japan, Sony Corporation of America, Sony Computer
Entertainment America, Inc. and Sony Online Entertainment, Inc.
  Mr. M.L. Edmondson v. Reflections Interactive Limited
  Bouchat
v. Champion Products, et al. (Accolade)
  Indigo Moon Productions, LLC v. Hasbro, Inc., et al.
  Rafael Curulla v. SAS Atari Europe
and Atari, Inc.
  Page 38




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##### Table of Contents



Item 6. Exhibits
 (a)
    
    
    Exhibits10.1*
    
    
    Amendment No. 1 to Employment Agreement, dated as of November 23, 2005, between the Company and Bruno Bonnell.10.2*
    
    
    Consulting Agreement, dated November 22, 2005, between the Company and Ann E. Kronen.10.3*
    
    
    Form of 2005 Stock Incentive Plan Option Award Agreement.10.4*
    
    
    Form of 2005 Stock Incentive Plan Restricted Stock Award Agreement.31.1
    
    
    Chief Executive Officer and Acting
Chief Financial Officer Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    
    Chief Executive Officer and Acting
Chief Financial Officer Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 *
    
    Exhibit indicated with an * symbol is a management or compensatory plan arrangement. Page 39




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##### Table of Contents



SIGNATURE
  ATARI, INC.By:
    
    /s/  Bruno BonnellBruno BonnellChief Executive Officer,
Chief Creative Officer, Acting Chief Financial Officer, and Chairman(Principal Executive Officer and Duly Authorized Officer)
  Page 40




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INDEX TO EXHIBITS
 Exhibit No.
    
    Description10.1*
    
    Amendment No. 1 to Employment Agreement, dated as of November 23, 2005, between the Company and
Bruno Bonnell.10.2*
    
    Consulting Agreement, dated November 22, 2005, between the Company and Ann E. Kronen.10.3*
    
    Form of 2005 Stock Incentive Plan Option Award Agreement.10.4*
    
    Form of 2005 Stock Incentive Plan Restricted Stock Award Agreement.31.1
    
    Chief Executive Officer and Acting
Chief Financial Officer Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Chief Executive Officer and Acting
Chief Financial Officer Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 *
    
    Exhibit indicated with an * symbol is a management or compensatory plan arrangement.