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 September 30, 2006

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

REALNETWORKS, INC.

Washington		91-1628146
(State of incorporation)		(I.R.S. Employer Identification Number)
2601 Elliott Avenue, Suite 1000		98121
Seattle, Washington		(Zip Code)
(Address of principal executive offices)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See the definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer þ      Accelerated filer o      Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2). Yes o No þ

The number of shares of the registrant’s Common Stock outstanding as of October 31, 2006 was 161,595,952.

 

 

TABLE OF CONTENTS

RealNetworks, Inc.

FORM 10-Q

FOR THE QUARTER ENDED SEPTEMBER 30, 2006

TABLE OF CONTENTS

		Page
Part I. Financial Information			3
Item 1. Financial Statements			3
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			19
Item 3. Quantitative and Qualitative Disclosures About Market Risk			32
Item 4. Controls and Procedures			33
Part II. Other Information			33
Item 1. Legal Proceedings			33
Item 1A. Risk Factors			34
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			47
Item 3. Default Upon Senior Securities			47
Item 4. Submission of Matters to a Vote of Security Holders			47
Item 5. Other Information			47
Item 6. Exhibits			48
Signatures			49
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

REALNETWORKS, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share data)

		September 30,				December 31,
		2006				2005
ASSETS
Current assets:
Cash and cash equivalents		$	693,057			$	651,971
Short-term investments			151,745				129,356
Trade accounts receivable, net of allowances for doubtful accounts and sales returns			24,481				16,721
Deferred tax assets, net, current portion			7,046				54,204
Prepaid expenses and other current assets			11,488				11,933
Total current assets			887,817				864,185
Equipment, software and leasehold improvements, at cost:
Equipment and software			65,551				56,402
Leasehold improvements			29,139				27,964
Total equipment, software and leasehold improvements			94,690				84,366
Less accumulated depreciation and amortization			60,235				51,228
Net equipment, software and leasehold improvements			34,455				33,138
Restricted cash equivalents			17,300				17,300
Equity investments			26,269				46,163
Other assets			4,177				2,397
Deferred tax assets, net, non-current portion			15,967				19,147
Goodwill			132,789				123,330
Other intangible assets, net			7,386				7,337
Total assets		$	1,126,160			$	1,112,997
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	14,905			$	11,397
Accrued and other liabilities			72,105				112,340
Deferred revenue, current portion			25,469				25,021
Accrued loss on excess office facilities, current portion			4,053				4,623
Total current liabilities			116,532				153,381
Deferred revenue, non-current portion			340				276
Accrued loss on excess office facilities, non-current portion			11,323				13,393
Deferred rent			4,472				4,018
Convertible debt			100,000				100,000
Other long-term liabilities			1,679				196
Total liabilities			234,346				271,264
Shareholders’ equity:
Preferred stock, $0.001 par value, no shares issued and outstanding
Series A: authorized 200 shares			—				—
Undesignated series: authorized 59,800 shares			—				—
Common stock, $0.001 par value Authorized 1,000,000 shares; issued and outstanding 161,108 shares in 2006 and 166,037 shares in 2005			161				166
Additional paid-in capital			760,347				805,067
Deferred stock compensation			—				(19	)
Accumulated other comprehensive income			15,597				26,724
Retained earnings			115,709				9,795
Total shareholders’ equity			891,814				841,733
Total liabilities and shareholders’ equity		$	1,126,160			$	1,112,997

See accompanying notes to unaudited condensed consolidated financial statements

REALNETWORKS, INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF
OPERATIONS AND COMPREHENSIVE INCOME
(In thousands, except per share data)

		Quarters ended								Nine Months ended
		September 30,								September 30,
		2006				2005				2006				2005
Net revenue (A)		$	93,676			$	82,233			$	269,687			$	241,491
Cost of revenue (B)			28,389				24,695				81,788				74,273
Gross profit			65,287				57,538				187,899				167,218
Operating expenses:
Research and development			18,344				16,354				55,127				45,381
Sales and marketing			37,560				30,745				111,604				93,809
General and administrative			14,043				7,037				41,586				21,120
Loss on excess office facilities			—				—				738				—
Subtotal operating expenses			69,947				54,136				209,055				160,310
Antitrust litigation expenses (benefit), net			(61,861	)			3,531				(159,554	)			11,925
Total operating expenses, net			8,086				57,667				49,501				172,235
Operating income (loss)			57,201				(129	)			138,398				(5,017	)
Other income (expense), net:
Interest income, net			10,618				2,904				27,978				7,499
Equity in net loss of MusicNet			—				—				—				(1,068	)
Gain on sale of equity investments			—				11,740				2,286				19,330
Other, net			242				124				432				(276	)
Other income, net			10,860				14,768				30,696				25,485
Net income before income taxes			68,061				14,639				169,094				20,468
Income tax provision			(25,908	)			(3,457	)			(63,180	)			(3,763	)
Net income		$	42,153			$	11,182			$	105,914			$	16,705
Basic net income per share		$	0.26			$	0.07			$	0.66			$	0.10
Diluted net income per share		$	0.24			$	0.06			$	0.59			$	0.09
Shares used to compute basic net income per share			160,578				170,797				160,466				170,761
Shares used to compute diluted net income per share			178,913				184,180				178,551				184,276
Comprehensive income:
Net income		$	42,153			$	11,182			$	105,914			$	16,705
Unrealized holding gains (losses) on investments, net of tax			28				16,321				(12,887	)			21,831
Adjustments for gains reclassified to net income			—				(4,052	)			—				(4,052	)
Foreign currency translation gains (losses)			388				(109	)			1,760				(1,400	)
Comprehensive income		$	42,569			$	23,342			$	94,787			$	33,084

(A) Components of net revenue:
License fees		$	22,528			$	19,596			$	68,014			$	60,605
Service revenue			71,148				62,637				201,673				180,886
		$	93,676			$	82,233			$	269,687			$	241,491
(B) Components of cost of revenue:
License fees		$	9,675			$	8,666			$	28,865			$	24,888
Service revenue			18,714				16,029				52,923				49,385
		$	28,389			$	24,695			$	81,788			$	74,273

See accompanying notes to unaudited condensed consolidated financial statements

REALNETWORKS, INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

		Nine Months Ended
		September 30,
		2006				2005
Cash flows from operating activities:
Net income		$	105,914			$	16,705
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization			12,480				11,869
Stock-based compensation			12,332				109
Equity in net losses of MusicNet			—				1,068
Changes in accrued loss on excess office facilities and content agreement			(2,640	)			(6,230	)
Loss on disposal of equipment			76				250
Gain on sale of equity investments			(2,286	)			(19,330	)
Deferred income taxes			56,508				3,324
Other			73				48
Net change in certain operating assets and liabilities, net of balances acquired			(48,496	)			6,127
Net cash provided by operating activities			133,961				13,940
Cash flows from investing activities:
Purchases of equipment and leasehold improvements			(9,316	)			(10,728	)
Purchases of intangible assets			—				(1,000	)
Purchases of short-term investments			(177,868	)			(121,540	)
Proceeds from sales and maturities of short-term investments			156,006				127,790
Decrease in restricted cash equivalents			—				2,095
Proceeds from sale of equity investments			2,286				19,530
Purchases of cost based investments			(834	)			(647	)
Payment of acquisition costs, net of cash acquired			(7,086	)			(14,705	)
Net cash provided by (used in) investing activities			(36,812	)			795
Cash flows from financing activities:
Net proceeds from sale of common stock under employee stock purchase plan and exercise of stock options			41,976				4,926
Repayment of long-term note payable			—				(648	)
Repurchase of common stock			(98,869	)			(29,275	)
Net cash used in financing activities			(56,893	)			(24,997	)
Effect of exchange rate changes on cash and cash equivalents			830				(492	)
Net increase (decrease) in cash and cash equivalents			41,086				(10,754	)
Cash and cash equivalents at beginning of period			651,971				219,426
Cash and cash equivalents at end of period		$	693,057			$	208,672
Supplemental disclosure of non-cash investing and financing activities:
Cash paid for income taxes		$	14,181			$	—
Non-cash consideration in business combinations:
Accrued acquisition payments		$	2,079			$	—
Accrued acquisition costs		$	—			$	1
Long-term notes payable acquired in business combination		$	—			$	863

See accompanying notes to unaudited condensed consolidated financial statements

REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

(a) Description of Business

     RealNetworks, Inc. and subsidiaries (RealNetworks or Company) is a leading creator of digital media services and software, such as Rhapsody, RealArcade and RealPlayer. Consumers use the Company’s services and software to find, play, purchase and manage free and premium digital content, including music, games and video. Broadcasters, network operators, media companies and enterprises use the Company’s products and services to create, secure and deliver digital media to PCs, mobile phones and other consumer electronics devices.

     Inherent in the Company’s business are various risks and uncertainties, including the limited history of certain of its product and service offerings and its limited history of offering premium subscription services on the Internet. The Company’s success will depend on, among other things, the acceptance of the Company’s technology, products and services and the ability to generate related revenue.

(b) Basis of Presentation

     The accompanying unaudited condensed consolidated financial statements include the accounts of the Company, its wholly-owned subsidiaries, and an entity in which the Company has a variable interest (see item (d) below for a further discussion of the variable interest entity). All significant intercompany balances and transactions have been eliminated in consolidation.

     These financial statements reflect all adjustments, consisting only of normal, recurring adjustments that, in the opinion of the Company’s management, are necessary for a fair presentation of the results of operations for the periods presented. Operating results for the quarter and nine months ended September 30, 2006 are not necessarily indicative of the results that may be expected for any subsequent quarter or for the year ending December 31, 2006. Certain information and disclosures normally included in financial statements prepared in conformity with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission (SEC).

     These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

(c) Cash, Cash Equivalents and Short-Term Investments

     Cash, cash equivalents and short-term investments are comprised of the following (in thousands):

		September 30, 2006				December 31, 2005
Cash and cash equivalents		$	693,057			$	651,971
Short-term investments			151,745				129,356
Total cash, cash equivalents and short-term investments		$	844,802			$	781,327
Restricted cash equivalents		$	17,300			$	17,300

     Restricted cash equivalents at September 30, 2006 represent (a) cash equivalents pledged as collateral against a $10.0 million letter of credit in connection with a lease agreement for the Company’s corporate headquarters, and (b) cash equivalents pledged as collateral against a $7.3 million letter of credit with a bank which represents collateral on the lease of a building located near the Company’s corporate headquarters.

     The majority of short-term investments mature within twelve months from the date of purchase. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations.

     The Company has classified as available-for-sale all marketable debt and equity securities for which there is a determinable fair market value and on which the Company has no restrictions to sell within the next 12 months. Available-for-sale securities are carried at fair value, with unrealized gains and losses reported as a component of shareholders’ equity, net of applicable income taxes. Realized gains and losses and declines in value judged to be other-than-temporary on available-for-sale securities are included in other

income (expense), net. The cost basis for determining realized gains and losses on available-for-sale securities is determined using the specific identification method.

(d) Equity Investments

     The Company has certain equity investments that are accounted for under the cost method of accounting. The cost method is used to account for equity investments in companies in which the Company holds less than a 20 percent voting interest, does not exercise significant influence and for which the related securities do not have a quoted market price.

     The Company has certain equity investments in which the Company holds less than a 20 percent voting interest in companies that are publicly traded. The investments are accounted for at market value. Changes in the market value of the investments are recognized as unrealized gains (losses), net of tax and are recorded in the accompanying unaudited condensed consolidated balance sheets as a component of Accumulated Other Comprehensive Income.

     The Company’s equity investment in MusicNet, Inc. (MusicNet) was accounted for under the equity method of accounting. Under the equity method of accounting, the Company’s share of the investee’s earnings or loss was included in the Company’s consolidated operating results. In certain cases where the Company had loaned the investee funds, the Company may have recorded more than its relative equity share of the investee’s losses. During the quarter ended June 30, 2005, the Company disposed of all of its preferred shares and convertible notes in MusicNet to a private equity firm, Baker Capital, in connection with the sale of all of the capital stock of MusicNet. There was no investment in MusicNet during 2006.

     During the quarter ended March 31, 2006, the Company established Beijing RealNetworks Technology Co., Ltd, a Wholly Owned Foreign Entity (WOFE) which operates an Internet retail website in the People’s Republic of China (PRC) in cooperation with a PRC affiliate. The results of operations of the WOFE have been included in the Company’s consolidated results since the establishment date of the WOFE. The PRC regulates the WOFE’s business through regulations and license requirements restricting: (i) the scope of foreign investment in the Internet, retail and delivery sectors; (ii) Internet content; and (iii) the sale of certain media products. In order to meet the PRC local ownership and regulatory licensing requirements, the WOFE’s business is operated through a PRC affiliate which is owned by nominee shareholders who are PRC nationals and are RealNetworks employees. The WOFE does not own any capital stock of the PRC affiliate, but is the primary beneficiary of future losses or profits through contractual rights. As a result, the Company consolidates the results of the PRC affiliate in accordance with Financial Accounting Standards Board Interpretation No. 46R, “Consolidation of Variable Interest Entities” (FIN 46R). The net assets and operating results for the PRC affiliate were not significant during the quarter and nine months ended September 30, 2006.

(e) Other Assets

     Other assets primarily consist of offering costs and other long-term deposits. The Company incurred the offering costs as a result of its convertible debt offering in 2003. These costs are deferred and are being amortized using the straight-line method, which approximates the effective interest method, over a 5-year period.

(f) Goodwill and Other Intangible Assets, net

     Goodwill represents the excess of the purchase price over the fair value of identifiable tangible and intangible assets acquired and liabilities assumed in business combinations accounted for under the purchase method. Goodwill and intangible assets not subject to amortization are tested annually for impairment, and are tested for impairment more frequently if events and circumstances indicate that the asset might be impaired. Other intangible assets, net primarily consist of trade names, technology and patents that were acquired through certain of the Company’s acquisitions, as well as other purchased technology. The intangible assets are amortized using the straight-line method over their estimated period of benefit, ranging from one to five years. The Company evaluates the recoverability of intangible assets periodically and takes into account events or circumstances that warrant revised estimates of useful lives or that may indicate that impairment exists. All of the Company’s intangible assets are subject to amortization. No impairments of intangible assets have been identified during any of the periods presented.

(g) Revenue Recognition

     The Company recognizes revenue in accordance with the following authoritative literature: SEC Staff Accounting Bulletin No. 104, “Revenue Recognition in Financial Statements” (SAB 104); Emerging Issues Task Force (EITF) 00-21 “Revenue Arrangements with Multiple Deliverables” (EITF 00-21); Statement of Position (SOP) 97-2, “Software Revenue Recognition” (SOP 97-2); SOP 98-9 “Software Revenue Recognition with Respect to Certain Arrangements” (SOP 98-9); SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts” (SOP 81-1); and EITF 99-19 “Reporting Revenue Gross as a Principal versus Net as an Agent” (EITF 99-19). In general, the Company recognizes revenue when there is persuasive evidence of an arrangement, the fee is fixed or determinable, the product or services have been delivered and collectibility of the resulting receivable is reasonably assured.

     Consumer subscription products are paid in advance, typically for monthly, quarterly or annual periods. Subscription revenue is recognized ratably over the related subscription period. Revenue from sales of downloaded individual tracks, albums and games are recognized at the time the music or game is made available, digitally, to the end user.

     The Company has arrangements whereby customers pay one price for multiple products and services. In some cases, these arrangements involve a combination of products and services. For arrangements with multiple deliverables, revenue is recognized upon the delivery of the separate units in accordance with EITF 00-21. In the event that there is no objective and reliable evidence of fair value of the delivered items, the revenue recognized upon delivery is the total arrangement consideration less the fair value of the undelivered items. The Company applies significant judgment in establishing the fair value of multiple elements within revenue arrangements.

     The Company recognizes revenue on a gross or net basis, in accordance with EITF 99-19. In most arrangements, the Company contracts directly with its end user customers, is the primary obligor and carries all collectibility risk. Revenue in these arrangements is recorded on a gross basis. In some cases, the Company utilizes third party distributors to sell products or services directly to end user customers and carries no collectibility risk. In those instances, in accordance with EITF 99-19, the Company reports the revenue on a net basis.

     The Company recognizes revenue in connection with its software products pursuant to the requirements of SOP 97-2, as amended by SOP 98-9. If the Company provides consulting services that are considered essential to the functionality of the software products, both the software product revenue and services revenue are recognized under contract accounting in accordance with the provisions of SOP 81-1. Revenue from these arrangements is recognized under the percentage of completion method based on the ratio of direct labor hours incurred to total projected labor hours. Revenue from software license agreements with original equipment manufacturers (OEM) is recognized when the OEM delivers its product incorporating the Company’s software to the end user.

     Revenue generated from advertising appearing on the Company’s websites and from advertising included in its products is recognized as revenue as the delivery of the advertising occurs.

(h) Net Income Per Share

     Basic net income per share is computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted net income per share is computed by dividing net income by the weighted average number of common and dilutive potential common shares outstanding during the period.

     The share count used to compute basic and diluted net income per share is calculated as follows (in thousands):

		Quarters								Nine Months
		Ended September 30,								Ended September 30,
		2006				2005				2006				2005
Weighted average common shares outstanding			160,578				170,797				160,466				170,761
Shares used to compute basic net income per share			160,578				170,797				160,466				170,761
Dilutive potential common shares
Stock options			7,585				2,633				7,335				2,765
Convertible debt			10,750				10,750				10,750				10,750
Shares used to compute diluted net income per share			178,913				184,180				178,551				184,276

     Approximately 9.2 million and 7.6 million shares of common stock potentially issuable from stock options for the quarter and nine months ended September 30, 2006, respectively, and 24.1 million shares of common stock for both the quarter and nine months ended September 30, 2005, respectively, are excluded from the calculation of diluted net income per share because the exercise price per share was greater than the average per share market price of the common stock for the respective period.

(i) Derivative Financial Instruments

     During the quarter ended September 30, 2006, the Company entered into foreign currency forward contracts to manage the foreign currency risk of certain intercompany balances denominated in a foreign currency. Although these instruments are effective as a hedge from an economic perspective, they do not meet the criteria for hedge accounting under Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (SFAS 133), as amended.

     At September 30, 2006, the following foreign currency contracts were outstanding and recorded at fair value (in thousands):

Contract Amount

Contract Amount

(Local Currency)

(US Dollars)

Fair Value

Japanese Yen (“YEN”) (contracts to pay YEN/receive US$)

(YEN) 151,300

$

1,293

$

3

     At December 31, 2005, the following foreign currency contracts were outstanding and recorded at fair value (in thousands):

		Contract Amount				Contract Amount
		(Local Currency)				(US Dollars)				Fair Value
British Pounds (“GBP”) (contracts to receive GBP/pay US$)		(GBP) 1,000				$	1,736			$	(15	)
Euro (“EUR”) (contracts to pay EUR/receive US$)		(EUR) 1,260				$	1,514			$	23
Japanese Yen (“YEN”) (contracts to receive YEN/pay US$)		(YEN) 30,000				$	251			$	4

     No derivative instruments designated as hedges for accounting purposes were outstanding at September 30, 2006 or December 31, 2005.

(j) Accumulated Other Comprehensive Income

     The Company’s accumulated other comprehensive income at September 30, 2006 and December 31, 2005 consisted of net unrealized gains on investments and the net amount of foreign currency translation adjustments. The tax effect of the foreign currency translation adjustments and unrealized gains and losses on investments has been taken into account if applicable. The components of accumulated other comprehensive income are as follows (in thousands):

		September 30,				December 31,
		2006				2005
Unrealized gains on investments, net of taxes of $6,278 in 2006 and $13,592 in 2005		$	15,829			$	28,717
Foreign currency translation adjustments			(232	)			(1,993	)
Total accumulated other comprehensive income		$	15,597			$	26,724

(k) Stock-Based Compensation

     On January 1, 2006, the Company adopted the provisions of, and began accounting for stock-based compensation in accordance with, the Financial Accounting Standards Board’s (FASB) Statement of Financial Accounting Standards No. 123 — revised 2004, “Share Based Payment” (SFAS 123R), which replaced SFAS No. 123, “Accounting for Stock-Based Compensation” (SFAS 123) and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25). Under the fair value provisions of this statement, stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the requisite service period, which is the vesting period. The Company uses the Black-Scholes option-pricing model to determine the fair-value of stock-based awards under SFAS 123R, consistent with that used for pro forma disclosures under SFAS 123. The Company utilized the modified prospective transition method, which requires that stock-based compensation expense be recorded for all new and unvested stock options and employee stock purchase plan shares that are ultimately expected to vest as the requisite service is rendered beginning on January 1, 2006, the first day of the Company’s 2006 fiscal year. Stock-based compensation expense for awards granted prior to January 1, 2006 is based on the grant date fair-value as determined under the pro forma provisions of SFAS 123.

     The expected term of the options represents the estimated period of time until exercise and is based on historical experience of similar awards, including the contractual terms, vesting schedules and expectations of future employee behavior. For the quarter and

nine months ended September 30, 2006, expected stock price volatility is based on a combination of historical volatility of the Company’s stock for the related expected term and the implied volatility of its traded options. Prior to the adoption of SFAS 123R, expected stock price volatility was estimated using only historical volatility. The risk-free interest rate is based on the implied yield available on U.S. Treasury zero-coupon issues with a term equivalent to the expected term of the stock options or four years. The Company has not paid dividends in the past.

     In accordance with SFAS 123R the Company presents excess tax benefits from the exercise of stock-based compensation awards as a financing activity in the Condensed Consolidated Statement of Cash Flows for quarters in which a tax benefit is recorded. No such benefit was recorded for the quarter or nine months ended September 30, 2006 and as a result there were no differences in net cash provided by (used in) operating and financing activities due to the implementation of SFAS 123R.

     The Company recognizes compensation cost related to stock options granted prior to the adoption of SFAS 123R on an accelerated basis over the applicable vesting period using the methodology described in Financial Accounting Standards Board (FASB) Interpretation No. 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans” (FIN 28). The Company recognizes compensation cost related to options granted subsequent to the adoption of SFAS 123R on a straight-line basis over the applicable vesting period. At September 30, 2006, the Company had options outstanding under six stock-based compensation plans. The Company issues new shares of its common stock to satisfy stock option exercises.

     During the quarter and nine months ended September 30, 2006, the Company recognized approximately $5.0 million and $12.3 million, respectively, related to stock-based compensation. The amounts are classified in the Company’s unaudited condensed consolidated statements of operations as follows (in thousands):

		Quarter Ended				Nine Months Ended
		September 30, 2006				September 30, 2006
Cost of revenue		$	57			$	148
Research and development			1,878				4,565
Sales and marketing			1,920				4,713
General and administrative			1,166				2,906
Total stock-based compensation		$	5,021			$	12,332

     No stock-based compensation was capitalized as part of the cost of an asset as of September 30, 2006. As of September 30, 2006, $20.8 million of total unrecognized compensation cost, net of estimated forfeitures, related to stock options is expected to be recognized over a weighted-average period of approximately two years.

     Prior to the adoption of SFAS 123R, the Company measured compensation expense for its employee stock-based compensation plans using the intrinsic value method prescribed by APB 25. The Company applied the disclosure provisions of SFAS 123 as amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure” as if the fair-value-based method had been applied in measuring compensation expense. Under APB 25, when the exercise price of the Company’s employee stock options was equal to the market price of the underlying stock on the date of the grant, no compensation expense was recognized.

     The following table presents the impact of the Company’s adoption of SFAS 123R on selected line items from the unaudited condensed consolidated statement of operations for the quarter and nine months ended September 30, 2006 (in thousands, except per share amounts):

		Quarter Ended September 30, 2006								Nine Months Ended September 30, 2006
		As Reported				If Reported				As Reported				If Reported
		Following				Following				Following				Following
		SFAS 123(R)				APB 25				SFAS 123(R)				APB 25
Operating income		$	57,201			$	62,222			$	138,398			$	150,730
Income before income taxes			68,061				73,082				169,094				181,426
Net income		$	42,153			$	45,263			$	105,914			$	113,713
Basic net income per share		$	0.26			$	0.28			$	0.66			$	0.71
Diluted net income per share		$	0.24			$	0.25			$	0.59			$	0.64

     The following table illustrates the effect on net income and net income per share if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation during the quarter and nine months ended September 30, 2005 (in thousands, except per share data):

		Quarter Ended				Nine Months Ended
		September 30, 2005				September 30, 2005
Net income as reported		$	11,182			$	16,705
Plus: stock-based employee compensation expense included in reported net income, net of related tax effects			25				109
Less: stock-based employee compensation expense determined under fair value based methods for all awards, net of related tax effects			(3,720	)			(10,134	)
Pro forma net income		$	7,487			$	6,680
Net income per share:
Basic — as reported		$	0.07			$	0.10
Diluted — as reported		$	0.06			$	0.09
Basic — pro forma		$	0.04			$	0.04
Diluted — pro forma		$	0.04			$	0.04

For further information related to the Company’s equity compensation plans, refer to NOTE 10 — EQUITY COMPENSATION PLANS.

(l) Reclassifications

     Certain reclassifications have been made to the September 30, 2005 unaudited condensed consolidated financial statements, and footnotes thereto, to conform to the September 30, 2006 presentation.

(m) Recently Issued Accounting Pronouncements

     In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—An Interpretation of FASB Statement No. 109” (FIN 48), which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 will be effective beginning the first fiscal quarter in 2007. The Company has not yet evaluated the impact of implementation of FIN 48 on its condensed consolidated financial statements.

NOTE 2 — SEGMENT INFORMATION

     The Company operates in two business segments for which the Company receives revenue from its customers: Consumer Products and Services and Technology Products and Solutions. The Company’s Chief Operating Decision Maker is considered to be the Company’s CEO Staff (CEOS), which is comprised of the Company’s Chief Executive Officer, Chief Financial Officer, Executive Vice President and Senior Vice Presidents. The CEOS reviews financial information presented on both a consolidated basis and on a business segment basis, accompanied by disaggregated information about products and services and geographical regions for purposes of making decisions and assessing financial performance. The CEOS reviews discrete financial information regarding profitability of the Company’s Consumer Products and Services segment and Technology Products and Solutions segment and, therefore, the Company reports these as operating segments as defined by Statement of Financial Accounting Standards No. 131, “Disclosure About Segments of an Enterprise and Related Information” (SFAS 131).

     The Company’s customers consist primarily of business customers and individual consumers located in the United States and various foreign countries. Revenue by geographic region is as follows (in thousands):

		Quarters Ended								Nine Months Ended
		September 30,								September 30,
		2006				2005				2006				2005
United States		$	69,433			$	63,478			$	201,675			$	184,678
Europe			15,895				10,937				45,725				33,547
Rest of the world			8,348				7,818				22,287				23,266
Total net revenue		$	93,676			$	82,233			$	269,687			$	241,491

     The Company’s segment revenue is defined as follows:

•

Consumer Products and Services primarily includes revenue from: digital media subscription services such as Rhapsody, RadioPass, GamePass and SuperPass; sales and distribution of third party software and services; sales of digital content such as music and game downloads; sales of premium versions of our RealPlayer and related products; and advertising. These products and services are sold and provided primarily through the Internet and the Company charges customers’ credit cards at the time of sale. Billing periods for subscription services typically occur monthly, quarterly or annually, depending on the service purchased.

•

Technology Products and Solutions primarily includes revenue from: sales of media delivery system software, including Helix system software and related authoring and publishing tools, both directly to customers and indirectly through OEM channels; support and maintenance services that we sell to customers who purchase our software products; broadcast hosting services; and consulting services we offer to our customers. These products and services are primarily sold to corporate, educational and governmental customers.

     Net revenue by segment is as follows (in thousands):

		Quarters								Nine Months
		Ended September 30,								Ended September 30,
		2006				2005				2006				2005
Consumer Products and Services		$	82,497			$	71,750			$	234,750			$	206,549
Technology Products and Solutions			11,179				10,483				34,937				34,942
Total net revenue		$	93,676			$	82,233			$	269,687			$	241,491

     Consumer Products and Services revenue is comprised of the following (in thousands):

		Quarters								Nine Months
		Ended September 30,								Ended September 30,
		2006				2005				2006				2005
Music		$	30,375			$	26,193			$	89,411			$	74,009
Media Software and Services			29,586				30,858				82,990				92,004
Games			22,536				14,699				62,349				40,536
Total Consumer Products and Services revenue		$	82,497			$	71,750			$	234,750			$	206,549

     Long-lived assets, net by geographic region are as follows (in thousands):

		September 30,				December 31,
		2006				2005
United States		$	147,820			$	149,247
Europe			26,134				14,256
Rest of world			676				302
Total long-lived assets, net		$	174,630			$	163,805

     Goodwill is assigned to the Company’s segments as follows (in thousands):

		September 30,				December 31,
		2006				2005
Consumer Products and Services		$	126,799			$	117,340
Technology Products and Solutions			5,990				5,990
Total goodwill		$	132,789			$	123,330

     Reconciliation of segment operating income (loss) to net income (loss) before income taxes is as follows (in thousands):

		Consumer Products				Technology Products				Reconciling
For the Quarter Ended September 30, 2006		and Services				and Solutions				Amounts				Consolidated
Net revenue		$	82,497			$	11,179			$	—			$	93,676
Cost of revenue			26,302				2,087				—				28,389
Gross profit			56,195				9,092				—				65,287
Antitrust litigation expense (benefit)			—				—				(61,861	)			(61,861	)
Other operating expenses			56,881				13,066				—				69,947
Operating income (loss)			(686	)			(3,974	)			61,861				57,201
Total non-operating income, net			—				—				10,860				10,860
Net income (loss) before income taxes		$	(686	)		$	(3,974	)		$	72,721			$	68,061

		Consumer Products				Technology Products				Reconciling
For the Nine Months Ended September 30, 2006		and Services				and Solutions				Amounts				Consolidated
Net revenue		$	234,750			$	34,937			$	—			$	269,687
Cost of revenue			75,468				6,320				—				81,788
Gross profit			159,282				28,617				—				187,899
Antitrust litigation expense (benefit)			—				—				(159,554	)			(159,554	)
Loss on excess office facilities			—				—				738				738
Other operating expenses			167,223				41,094				—				208,317
Operating income (loss)			(7,941	)			(12,477	)			158,816				138,398
Total non-operating income, net			—				—				30,696				30,696
Net income (loss) before income taxes		$	(7,941	)		$	(12,477	)		$	189,512			$	169,094

		Consumer Products				Technology Products				Reconciling
For the Quarter Ended September 30, 2005		and Services				and Solutions				Amounts				Consolidated
Net revenue		$	71,750			$	10,483			$	—			$	82,233
Cost of revenue			22,770				1,925				—				24,695
Gross profit			48,980				8,558				—				57,538
Antitrust litigation expense (benefit)			—				—				3,531				3,531
Other operating expenses			43,016				11,120				—				54,136
Operating income (loss)			5,964				(2,562	)			(3,531	)			(129	)
Total non-operating income, net			—				—				14,768				14,768
Net income (loss) before income taxes		$	5,964			$	(2,562	)		$	11,237			$	14,639

		Consumer Products				Technology Products				Reconciling
For the Nine Months Ended September 30, 2005		and Services				and Solutions				Amounts				Consolidated
Net revenue		$	206,549			$	34,942			$	—			$	241,491
Cost of revenue			68,133				6,140				—				74,273
Gross profit			138,416				28,802				—				167,218
Antitrust litigation expense (benefit)			—				—				11,925				11,925
Other operating expenses			125,049				35,261				—				160,310
Operating income (loss)			13,367				(6,459	)			(11,925	)			(5,017	)
Total non-operating income, net			—				—				25,485				25,485
Net income (loss) before income taxes		$	13,367			$	(6,459	)		$	13,560			$	20,468

     Operating expenses of both Consumer Products and Services and Technology Products and Solutions include costs directly attributable to those segments and an allocation of general and administrative expenses and other corporate overhead costs. General and administrative and other corporate overhead costs are allocated to the segments and are generally based on the relative headcount of each segment. The accounting policies used to derive segment results are generally the same as those described in Note 1.

NOTE 3 — ACQUISITION

     On January 31, 2006, the Company acquired all of the outstanding securities of Zylom Media Group BV (Zylom) in exchange for approximately $7.9 million in cash payments. Included in the purchase price are $0.3 million in estimated acquisition-related expenditures consisting primarily of professional fees. The Company is also obligated to pay an additional $2.0 million, through individual payments of approximately $1.0 million on the first and second anniversaries of the acquisition date. In addition, the Company may be obligated to pay up to $10.9 million over a three-year period, dependent on whether certain performance criteria are achieved. Such amounts are not included in the initial aggregate purchase price and, to the extent earned, will be recorded as goodwill

when it is probable that the individual payments will be made.

     Zylom is located in Eindhoven, the Netherlands and is a distributor, developer and publisher of PC-based games in Europe. The Company believes that combining Zylom’s assets and distribution network with the Company’s downloadable, PC-based games assets and distribution platform will enhance the Company’s presence in the European games market. The results of Zylom’s operations are included in the Company’s condensed consolidated financial statements starting from the date of acquisition.

     A summary of the purchase price for the acquisition is as follows (in thousands):

Cash paid at acquisition		$	7,922
Additional future payments related to initial purchase price			2,000
Estimated direct acquisition costs			293
Total		$	10,215

     The aggregate purchase consideration has been allocated to the assets and liabilities acquired, including identifiable intangible assets, based on their respective estimated fair values as summarized below. The respective estimated fair values were determined by a third party appraisal at the acquisition date and resulted in excess purchase consideration over the net tangible and identifiable intangible assets acquired of $8.2 million. Goodwill in the amount of $8.2 million is not deductible for tax purposes. Pro forma results are not presented, because they are not material to the Company’s overall financial statements.

     A summary of the allocation of the purchase price is as follows (in thousands):

Current assets		$	1,830
Property and equipment			166
Technology/Games			570
Tradenames/Trademarks			560
Distributor/Customer Relationships			1,290
Non-compete agreements			180
Goodwill			8,168
Current liabilities			(1,781	)
Net deferred tax liabilities			(768	)
Net assets acquired		$	10,215

     Technology/Games and Tradenames/Trademarks have weighted average estimated useful lives of three years. Distributor and customer relationships have weighted average estimated useful lives of approximately five years. Non-compete agreements have a weighted average estimated useful life of four years.

NOTE 4 — GOODWILL

     Goodwill is the excess of the purchase price (including liabilities assumed and direct acquisition related costs) over the fair value of the tangible and identifiable intangible assets acquired through acquisitions of businesses.

     Goodwill changed during 2006 as follows (in thousands):

Goodwill at December 31, 2005		$	123,330
Acquisition of Zylom			8,168
Effects of foreign currency translation			1,291
Goodwill at September 30, 2006		$	132,789

NOTE 5 — EQUITY INVESTMENTS

     The Company has made minority equity investments for business and strategic purposes through the purchase of voting capital stock of certain companies. The Company’s investments in publicly traded companies are accounted for as available-for-sale, carried at current market value and are classified as long-term. The Company periodically evaluates whether declines in fair value, if any, of its investments are other-than-temporary. This evaluation consists of a review of qualitative and quantitative factors. For investments with publicly quoted market prices, these factors include the time period and extent of which the quoted market price is less than its accounting basis. The Company also considers other factors to determine whether declines in fair value are other-than-temporary, such as the investee’s financial condition, results of operations and operating trends. The evaluation also considers publicly available

information regarding the investee companies. For investments in private companies with no quoted market price, the Company considers similar qualitative and quantitative factors and also considers the implied value from any recent rounds of financing completed by the investee. Based upon an evaluation of the facts and circumstances at September 30, 2006, the Company determined that there were no other-than-temporary declines in fair value for the quarter and nine months then ended.

     As of September 30, 2006, the Company owned marketable equity securities of J-Stream, a Japanese media services company, representing approximately 10.6% of the investee’s outstanding shares, accounted for as available-for-sale securities. The market value of these shares has increased from the Company’s original cost of approximately $0.9 million, resulting in a carrying value of $22.7 million and $43.4 million at September 30, 2006 and December 31, 2005, respectively. The increase over the Company’s cost basis, net of tax effects, was $15.5 million and $28.9 million at September 30, 2006 and December 31, 2005, respectively, and is reflected as a component of accumulated other comprehensive income. The market for this company’s shares is relatively limited and the share price is volatile. Accordingly, there can be no assurance that a gain of this magnitude, or any gain, can be realized through the disposition of these shares.

NOTE 6 — INVESTMENT IN MUSICNET

     The Company’s investment in MusicNet, a joint venture with several media companies to create a platform for online music subscription services, was accounted for under the equity method of accounting. During the quarter ended June 30, 2005, the Company disposed of all of its preferred shares and convertible notes in MusicNet to a private equity firm, Baker Capital, in connection with the sale of all of the capital stock of MusicNet. The Company received approximately $7.2 million of cash proceeds in connection with the closing of the transaction and received an additional $0.4 million in connection with the expiration of an escrow arrangement in August 2005. During the quarter ended June 30, 2006, the Company received an additional $2.3 million in cash due to the expiration of an indemnity escrow arrangement which expired on the one-year anniversary of the transaction date.

     The Company recorded in its statement of operations its equity share of MusicNet’s net loss through the date of disposition, which was not significant during the quarter ended September 30, 2005 and was $1.1 million for the nine months ended September 30, 2005. No amounts were recorded during 2006. For purposes of calculating the Company’s equity in net loss of MusicNet, the convertible notes were treated on an “as if” converted basis due to the nature and terms of the convertible notes. As a result, the losses recorded by the Company represented approximately 36.1% of MusicNet’s net losses through the date of disposition in 2005.

NOTE 7 — LOSS ON EXCESS OFFICE FACILITIES

     In October 2000, the Company entered into a 10-year lease agreement for additional office space located near its corporate headquarters in Seattle, Washington. Due to a subsequent decline in the market for office space in Seattle and the Company’s re-assessment of its facilities requirements, the Company has accrued for estimated future losses on excess office facilities. The loss estimate currently includes $11.8 million of sublease income, which is committed under current sublease contracts. During the quarter ended March 31, 2006, the Company increased its loss estimate by $0.7 million due to building operating expenses that are not expected to be recovered under the terms of the existing sublease agreements. Although the Company believes its estimates are reasonable, additional losses may result if actual experience differs from projections.

     A summary of activity for the accrued loss on excess office facilities is as follows (in thousands):

Accrued loss at December 31, 2005		$	18,016
Less amounts paid, net of sublease income			(3,378	)
Revisions to estimates in accrued loss on excess office facilities in 2006			738
Accrued loss at September 30, 2006		$	15,376

NOTE 8 — CONVERTIBLE DEBT

     During 2003, the Company issued $100 million aggregate principal amount of zero coupon convertible subordinated notes due July 1, 2010, pursuant to Rule 144A under the Securities Act of 1933, as amended. The notes are subordinated to any Company senior debt, and are also effectively subordinated in right of payment to all indebtedness and other liabilities of its subsidiaries. The notes are convertible into shares of the Company’s common stock based on an initial effective conversion price of approximately $9.30 per share if (1) the closing sale price of the Company’s common stock exceeds $10.23, subject to certain restrictions, (2) the notes are called for redemption, (3) the Company makes a significant distribution to its shareholders or becomes a party to a transaction that would result in a change in control, or (4) the trading price of the notes falls below 95% of the value of common stock that the notes are convertible into, subject to certain restrictions; one of which allows the Company, at its discretion, to issue cash or common stock

or a combination thereof upon conversion. On or after July 1, 2008, the Company has the option to redeem all or a portion of the notes that have not been previously purchased, repurchased or converted, in exchange for cash at 100% of the principal amount of the notes. The purchasers may require the Company to purchase all or a portion of the notes in cash on July 1, 2008 at 100% of the principal amount of the notes. As a result of this issuance, the Company received proceeds of $97.0 million, net of offering costs. The offering costs are included in other assets and are being amortized over a five-year period. Interest expense from the amortization of offering costs in the amount of $0.2 million and $0.5 million is recorded in interest income, net for the quarter and nine months ended September 30, 2006 and 2005, respectively. The net proceeds of the issuance are to be used for general corporate purposes, acquisitions, other strategic transactions including joint ventures, and other working capital requirements.

NOTE 9 — REPURCHASE OF COMMON STOCK

     In November 2005, the Company announced a share repurchase program to repurchase up to an aggregate of $100.0 million of the Company’s outstanding common stock. During the quarter ended March 31, 2006, the Company repurchased approximately 9.5 million shares for an aggregate value of approximately $77.0 million at an average cost of $8.09 per share. From the inception of the November 2005 repurchase program through March 31, 2006, the Company repurchased 12.4 million shares under the November 2005 program for an aggregate value of $100.4 million (inclusive of transaction costs) at an average price of $8.11 per share. At March 31, 2006, no amounts authorized were outstanding under the November 2005 repurchase program.

     In April 2006, the Company announced a new share repurchase program, in which the Company’s Board of Directors authorized the repurchase of up to an aggregate of $100.0 million of the Company’s outstanding common stock. During the quarter ended September 30, 2006, the Company repurchased approximately 0.2 million shares for an aggregate value of approximately $1.9 million at an average cost of $9.51 per share. Since the inception of the April 2006 repurchase program, the Company has repurchased approximately 2.3 million shares for an aggregate value of approximately $21.9 million at an average cost of $9.44 per share. At September 30, 2006, the remaining amount authorized under the April 2006 repurchase program was approximately $78.1 million.

NOTE 10 — EQUITY COMPENSATION PLANS

     The Company has options outstanding under six equity compensation plans (Plans) to compensate its employees and directors for past and future services. Of the Plans, the RealNetworks Inc. 2005 Stock Incentive Plan (2005 Plan) and the RealNetworks Inc. Director Compensation Stock Plan (Director Plan) remain active and are available for future grants. The Company has reserved 23.6 million shares under the 2005 Plan, which includes a total of 5.1 million shares cancelled from prior Plans and transferred to the 2005 Plan, and 0.4 million shares under the Director Plan. As of September 30, 2006, 8.8 million shares were available for grant under the 2005 Plan and 0.3 million shares were available for grant under the Director Plan. Generally, options vest based on continuous employment, over a four- or five-year period. The options expire in either seven, ten or twenty years from the date of grant and are exercisable at the fair market value of the common stock at the grant date. Shares that lapse due to forfeiture or expiration are available for re-issuance.

     A summary of stock option related activity is as follows:

		Shares				Options Outstanding								Weighted
		Available				Number				Weighted				Average Fair
		for Grant				of Shares				Average				Value-
		in (000’s)				in (000’s)				Exercise Price				Grants
Balance at December 31, 2005			14,473				35,622			$	6.95
Options granted at common stock price			(8,629	)			8,629				9.52			$	4.30
Options exercised			—				(6,773	)			6.04
Options canceled			3,003				(3,003	)			6.41
Balance at September 30, 2006			8,847				34,475			$	7.82

     The weighted average fair value of options granted during the nine months ended September 30, 2005 was $2.41. Pursuant to the provisions of the 2005 Stock Incentive Plan, Shares Available for Grant as of December 31, 2005 were adjusted to reflect an additional 3.1 million available shares which were cancelled from previously expired Plans during 2005.

     The fair value of options granted was determined using the Black-Scholes model. The following assumptions were used to perform the calculations:

		Quarters Ended								Nine Months Ended
		September 30,								September 30,
		2006				2005				2006				2005
Expected dividend yield			0	%			0	%			0	%			0	%
Risk-free interest rate			4.68-5.06	%			3.17	%			4.35-5.07	%			2.83–3.17	%
Expected life (years)			4.3				4.4				4.3				4.4
Volatility			49	%			56	%			48-49	%			48-56	%

     The following table summarizes information about stock options outstanding at September 30, 2006:

		Options Outstanding
						Weighted								Options Exercisable
						Average				Weighted								Weighted
		Number				Remaining				Average				Number of				Average
		of Shares				Contractual				Exercise				Shares				Exercise
Exercise Prices		(in 000’s)				Life (Years)				Price				(in 000’s)				Price
$0.02 — $5.01			5,779				10.06			$	4.19				2,493			$	3.42
$5.03 — $5.89			5,713				14.56				5.52				1,463				5.58
$5.90 — $6.74			4,631				16.37				6.17				2,287				6.11
$6.75 — $7.22			4,718				15.37				7.15				4,063				7.19
$7.24 — $8.58			4,579				7.88				7.97				1,120				7.89
$8.69 — $10.06			6,064				7.65				9.85				869				9.55
$10.06 — $46.00			2,981				10.71				18.41				1,861				23.24
$46.19 — $46.19			10				12.95				46.19				10				46.19
			34,475				11.72			$	7.82				14,166			$	8.52

     At September 30, 2005, there were approximately 18.1 million exercisable options outstanding with a weighted average exercise price of $8.10.

     The aggregate intrinsic value of options outstanding and options exercisable at September 30, 2006 was $120.1 million and $53.5 million, respectively. The aggregate intrinsic value represents the difference between the Company’s closing stock price on the last day of trading during the quarter, which was $10.61 per share as of September 30, 2006, and the exercise price multiplied by the number of applicable options. The total intrinsic value of options exercised during the nine months ended September 30, 2006 and 2005 was $31.0 million and $4.4 million, respectively.

NOTE 11 — GUARANTEES

     In the ordinary course of business, the Company is not subject to potential obligations under guarantees that fall within the scope of FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees and Indebtedness of Others (“FIN 45”) an interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB interpretation No. 34, except for standard indemnification and warranty provisions that are contained within many of the Company’s customer license and service agreements, and give rise only to the disclosure requirements prescribed by FIN 45.

     Indemnification and warranty provisions contained within the Company’s customer license and service agreements are generally consistent with those prevalent in the Company’s industry. The duration of the Company’s product warranties generally does not exceed 90 days following delivery of the Company’s products. The Company has not incurred significant obligations under customer indemnification or warranty provisions historically and does not expect to incur significant obligations in the future. Accordingly, the Company does not maintain accruals for potential customer indemnification or warranty-related obligations.

NOTE 12 — LITIGATION

     In August 2005, a lawsuit was filed against the Company in the U.S. District Court for the District of Maryland by Ho Keung Tse, an individual residing in Hong Kong. The suit alleges that certain of the Company’s products and services infringe the plaintiff’s patent relating to “the distribution of digital files, including sound tracks, music, video and executable software in a manner which restricts unauthorized use.” The plaintiff seeks to enjoin the Company from the allegedly infringing activity and to recover treble damages for the alleged infringement. In October 2005, the Company’s co-defendant moved to transfer the lawsuit from the District of Maryland to the Northern District of California. The Company disputes the plaintiff’s allegations in the action and intends to vigorously defend itself.

     In June 2003, a lawsuit was filed against the Company and Listen.com, Inc. (Listen) in federal district court for the Northern District of Illinois by Friskit, Inc. (Friskit), alleging that certain features of the Company’s and Listen’s products and services willfully infringe certain patents relating to allowing users “to search for streaming media files, to create custom playlists, and to listen to the streaming media file sequentially and continuously.” Friskit seeks to enjoin the Company from the alleged infringing activity and to recover treble damages from the alleged infringement. The Company has filed its answer and a counterclaim against Friskit challenging the validity of the patents at issue. The trial court has also granted the Company’s motion to transfer the action to the Northern District of California. The Company disputes Friskit’s allegations in this action and intends to vigorously defend itself.

     From time to time the Company is, and expects to continue to be, subject to legal proceedings and claims in the ordinary course of its business, including employment claims, contract-related claims and claims of alleged infringement of third-party patents, trademarks and other intellectual property rights. These claims, including those described above, even if not meritorious, could force the Company to spend significant financial and managerial resources. The Company is not aware of any legal proceedings or claims that the Company believes will have, individually or taken together, a material adverse effect on the Company’s business, prospects, financial condition or results of operations. However, the Company may incur substantial expenses in defending against third party claims and certain pending claims are moving closer to trial. The Company expects that its potential costs of defending these claims may increase as the disputes move into the trial phase of the proceedings. In the event of a determination adverse to the Company, the Company may incur substantial monetary liability, and/or be required to change its business practices. Either of these could have a material adverse effect on the Company’s financial position and results of operations.

NOTE 13 — SUBSEQUENT EVENT

     On September 12, 2006, the Company entered into a definitive agreement to acquire all of the issued and outstanding common shares and American Depository Shares (ADSs) of WiderThan Co., Ltd. (WiderThan), through a cash tender offer for approximately $350.0 million. The tender offer was made pursuant to the Offer to Purchase and Letter of Transmittal, each filed with the Securities and Exchange Commission on September 29, 2006, as amended and supplemented. WiderThan, based in Seoul, South Korea, is a provider of integrated mobile music and entertainment solutions, including ringback tones and music-on-demand services. On October 31, 2006, the Company successfully completed the tender offer pursuant to which the Company acquired 2,840,329 common shares and 15,905,999 ADSs, together representing approximately 95% of WiderThan’s outstanding common shares, including common shares underlying ADSs, for an aggregate value of $319.6 million.

     The Company announced a subsequent offering period of ten business days, expiring on November 10, 2006, unless otherwise extended. During the subsequent offering period, holders of WiderThan common shares and ADSs that were not previously tendered in the offer may tender their common shares and ADSs on the same terms that applied prior to the initial expiration of the tender offer.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

     The discussion in this report contains forward-looking statements that involve risks and uncertainties. RealNetworks’ actual results could differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section titled “Risk Factors” included elsewhere in this Report. You should also carefully review the risk factors set forth in other reports or documents that RealNetworks files from time to time with the Securities and Exchange Commission, particularly RealNetworks’ Annual Reports on Form 10-K, other Quarterly Reports on Form 10-Q and any Current Reports on Form 8-K. You should also read the following discussion and analysis in conjunction with our unaudited condensed consolidated financial statements and related notes included in this report.

Overview

     RealNetworks, Inc. is a leading creator of digital media services and software, such as Rhapsody, RealArcade and RealPlayer. Consumers use our services and software to find, play, purchase and manage free and premium digital content, including music, games and video. Broadcasters, network operators, media companies and enterprises use our products and services to create, secure and deliver digital media to PCs, mobile phones and other consumer electronics devices.

     Over the last several years, we have focused on the development of our consumer businesses through both internal initiatives and strategic acquisitions of businesses and technologies. These efforts have resulted in increases in the number of subscribers to our music and games subscription offerings and increased sales of our digital music and games content. This shift in focus and the increases in subscribers and sales of digital media content have resulted in a significantly higher percentage of our total revenue arising from our consumer businesses. Our Consumer Products and Services segment accounted for approximately 88% and 87% of our total revenue for the quarter and nine months ended September 30, 2006, respectively. In addition, we have increased our focus on “free-to-consumer” products and services, such as Rhapsody 25, our Rhapsody.com website and our RealArcade game service, which generate advertising revenue and are designed to increase the exposure of our paid digital music and games products and services to consumers. Our Technology Products and Solutions revenue in dollar terms has remained relatively consistent over the last several years; however, it has decreased as a percentage of total revenue.

     In the quarter ended September 30, 2006, we recorded the highest total quarterly revenue in our history due to the significant growth in our Consumer Products and Services segment. This growth, as compared to the same quarter in 2005, was driven primarily by increased revenue from our Games and Music businesses, including increased sales resulting from our acquisition of Zylom in January 2006. Media Software and Services revenue declined for the quarter and nine months ended September 30, 2006 from the same periods ended September 30, 2005, primarily due to a decline in subscribers to our SuperPass subscription service and a decline in our stand-alone subscription products. Although total revenue for the quarter and nine months ended September 30, 2006 grew approximately 14% and 12% over the respective periods in 2005, our quarterly sequential revenue growth rate has fluctuated in recent periods.

     In October 2005, we entered into an agreement to settle all of our antitrust disputes worldwide with Microsoft. Upon settlement of the legal disputes, we also entered into two commercial agreements with Microsoft that provide for collaboration in digital music and casual games. The remaining contractual payments to be made subsequent to the quarter ended September 30, 2006 by Microsoft to us over the remaining term of the commercial agreements, or through 2007, are approximately $122.3 million in cash and services in support of our music and games businesses. Microsoft can earn credits at pre-determined market rates for music subscribers and users delivered to us through its MSN network during the contract period which will be netted against the quarterly contractual payments in the music agreement. Pursuant to these commercial agreements we received a payment of approximately $62.3 million during the quarter ended September 30, 2006 and received a total of approximately $160.7 million during the nine months ended September 30, 2006.

     On September 12, 2006, we entered into a definitive agreement to acquire WiderThan Co., Ltd. (WiderThan), through a cash tender offer for approximately $350.0 million. WiderThan is a provider of integrated mobile music and entertainment solutions, including ringback tones and music-on-demand services. On October 31, 2006, we successfully completed the tender offer pursuant to which we acquired approximately 95% of WiderThan’s outstanding common shares and American Depository shares. We believe the acquisition of WiderThan will enhance our mobile entertainment products and services, and increase our revenue in our Technology Products and Solutions segment as well as increase our revenue arising from our international operations. We will include WiderThan’s results of operations from the date of the acquisition in our consolidated financial statements for the quarter ending December 31, 2006.

     We manage our business, and correspondingly report revenue, based on our two operating segments: Consumer Products and Services and Technology Products and Solutions.

	•		Consumer Products and Services primarily includes revenue from: digital media subscription services such as Rhapsody, RadioPass, GamePass and SuperPass; sales and distribution of third party software and services; sales of digital content such as music and game downloads; sales of premium versions of our RealPlayer and related products; and advertising.
	•		Technology Products and Solutions includes revenue from: sales of our media delivery system software, including Helix system software and related authoring and publishing tools, both directly to customers and indirectly through original equipment manufacturer (OEM) channels; support and maintenance services that we sell to customers who purchase our software products; broadcast hosting services; and consulting services we offer to our customers.

Critical Accounting Policies and Estimates

     The preparation of our financial statements requires us to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Our critical accounting policies and estimates are as follows:

	•		Revenue recognition;
	•		Estimating music publishing rights and music royalty accruals;
	•		Stock-based compensation;
	•		Estimating sales returns and the allowance for doubtful accounts;
	•		Estimating losses on excess office facilities;
	•		Determining whether declines in the fair value of investments are other-than-temporary and estimating fair market value of investments in privately held companies;
	•		Valuation of goodwill;
	•		Accounting for income taxes; and
	•		Determining the loss on a purchase commitment.

     Revenue Recognition. As described below, significant management judgments and estimates must be made and used in connection with the revenue recognized in any accounting period. Material differences may result in the amount and timing of our revenue for any period if our management made different judgments or utilized different estimates.

     We recognize revenue in accordance with the following authoritative literature: Staff Accounting Bulletin No. 104, “Revenue Recognition in Financial Statements” (SAB 104); Emerging Issues Task Force (EITF) 00-21 “Revenue Arrangements with Multiple Deliverables” (EITF 00-21); Statement of Position (SOP) 97-2, “Software Revenue Recognition” (SOP 97-2); SOP 98-9 “Software Revenue Recognition with Respect to Certain Arrangements” (SOP 98-9); SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts” (SOP 81-1); and EITF 99-19 “Reporting Revenue Gross as a Principal versus Net as an Agent” (EITF 99-19). In general, we recognize revenue when there is persuasive evidence of an arrangement, the fee is fixed or determinable, the products or services have been delivered and collectibility of the resulting receivable is reasonably assured.

     Consumer subscription products are paid in advance, typically for monthly, quarterly or annual periods. Subscription revenue is recognized ratably over the related subscription period. Revenue from sales of downloaded individual tracks, albums and individual games are recognized at the time the music or game is made available, digitally, to the end user.

     We have arrangements whereby customers pay one price for multiple products and services. In some cases, these arrangements involve a combination of products and services. For arrangements with multiple deliverables, revenue is recognized upon the delivery of the separate units in accordance with EITF 00-21. In the event that there is no objective and reliable evidence of fair value of the delivered items, the revenue recognized upon delivery is the total arrangement consideration less the fair value of the undelivered

items. Management applies significant judgment in establishing the fair value of multiple elements within revenue arrangements.

     We recognize revenue on a gross or net basis, in accordance with EITF 99-19. In most arrangements, we contract directly with our end user customers, are the primary obligor and carry all collectibility risk. Revenue in these arrangements is recorded on a gross basis. In some cases, we utilize third party distributors to sell products or services directly to end user customers and carry no collectibility risk. In those instances, in accordance with EITF 99-19, we report the revenue on a net basis.

     We recognize revenue in connection with our software products pursuant to the requirements of SOP 97-2, as amended by SOP 98-9. If we provide consulting services that are considered essential to the functionality of the software products, both the software product revenue and services revenue are recognized under contract accounting in accordance with the provisions of SOP 81-1. Revenue from these arrangements is recognized under the percentage of completion method based on the ratio of direct labor hours incurred to total projected labor hours. Revenue from software license agreements with original equipment manufacturers (OEM) is recognized when the OEM delivers its product incorporating our software to the end user.

     Revenue generated from advertising appearing on our websites and from advertising included in our products is recognized as revenue as the delivery of the advertising occurs.

     Music Publishing Rights and Music Royalty Accruals. We must make estimates of amounts owed related to our music publishing rights and music royalties owed for our domestic and international music services. Material differences may result in the amount and timing of our expense for any period if our management made different judgments or utilized different estimates. Under copyright law, we may be required to pay licensing fees for digital sound recordings and compositions we deliver. Copyright law generally does not specify the rate and terms of the licenses, which are determined by voluntary negotiations among the parties or, for certain compulsory licenses where voluntary negotiations are unsuccessful, by arbitration. There are certain geographies and agencies for which we have not yet completed negotiations with regard to the royalty rate to be applied to the current or historic sales of our digital music offerings. Our estimates are based on contracted or statutory rates, when established, or management’s best estimates based on facts and circumstances regarding the specific music services and agreements in similar geographies or with similar agencies. While our management bases its estimates on historical experience and on various other assumptions that management believes to be reasonable under the circumstances, actual results may differ materially from these estimates under different assumptions or conditions.

     Stock-Based Compensation. We account for stock-based compensation in accordance with Statement of Financial Accounting Standards, “Share-Based Payment” (SFAS 123R). Under the provisions of SFAS 123R, which we adopted as of January 1, 2006, stock-based compensation cost is estimated at the grant date based on the award’s fair-value as calculated by the Black-Scholes option-pricing model and is recognized as expense over the requisite service period, which is the vesting period. The Black-Scholes model requires various highly judgmental assumptions including volatility and expected option life. If any of the assumptions used in the Black-Scholes model change significantly, stock-based compensation expense may differ materially in the future from the amounts recorded in our condensed consolidated statement of operations. We are required to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting option forfeitures and record stock-based compensation expense only for those awards that are expected to vest. Prior to the adoption of SFAS 123R, we measured compensation expense for our employee stock-based compensation plans using the intrinsic value method prescribed by APB Opinion No. 25 (APB 25). Under APB 25, when the exercise price of the Company’s employee stock options was equal to the market price of the underlying stock on the date of the grant, no compensation expense was recognized.

     Sales Returns and the Allowance for Doubtful Accounts. We must make estimates of potential future product returns related to current period revenue. We analyze historical returns, current economic trends, and changes in customer demand and acceptance of our products when evaluating the adequacy of the sales returns and other allowances. Similarly, we must make estimates of the uncollectibility of our accounts receivable. We specifically analyze the age of accounts receivable and analyze historical bad debts, customer credit-worthiness and current economic trends when evaluating the adequacy of the allowance for doubtful accounts. Significant judgments and estimates must be made and used in connection with establishing allowances for sales returns and the allowance for doubtful accounts in any accounting period. Material differences may result in the amount and timing of our revenue for any period if we were to make different judgments or utilize different estimates.

     Accrued Loss On Excess Office Facilities. We made significant estimates in determining the appropriate amount of accrued loss on excess office facilities. If we made different estimates, our loss on excess office facilities could be significantly different from that recorded, which could have a material impact on our operating results. We have revised our original estimate four times in the last four years, increasing the accrual for loss on excess office facilities each time. The first two revisions were the result of changes in the market for commercial real estate where we operate. The third revision, which took place in 2003, resulted from adding an additional

tenant at a sublease rate lower than the rate used in previous estimates. The fourth revision, which took place during the quarter ended March 31, 2006, resulted from incremental increases in the building operating expenses which were greater than the amounts previously estimated as not recoverable. The significant factors we considered in making our estimates are discussed in the section entitled “Loss on Excess Office Facilities.”

     Impairment of Investments. As part of the process of preparing our consolidated financial statements we periodically evaluate whether any declines in the fair value of our investments are other-than-temporary. Significant judgments and estimates must be made to assess whether an other-than-temporary decline in fair value of investments has occurred and to estimate the fair value of investments in privately held companies. See “Other Income (Expense), Net” in the following pages for a discussion of the factors we considered in evaluating whether declines in fair value of our investments were other-than-temporary and the factors we considered in estimating the fair value of investments in private companies.

     Valuation of Goodwill. We assess the impairment of goodwill on an annual basis or whenever events or changes in circumstances indicate that the fair value of the reporting unit to which goodwill relates is less than the carrying value. Factors we consider important which could trigger an impairment review include the following:

	•		poor economic performance relative to historical or projected future operating results;
	•		significant negative industry, economic or company specific trends;
	•		changes in the manner of our use of the assets or the plans for our business; and
	•		loss of key personnel.

     If we were to determine that the fair value of a reporting unit was less than its carrying value, including goodwill, based upon the annual test or the existence of one or more of the above indicators of impairment, we would measure impairment based on a comparison of the implied fair value of reporting unit goodwill with the carrying amount of goodwill. The implied fair value of goodwill is determined by allocating the fair value of a reporting unit to its assets (recognized and unrecognized) and liabilities in a manner similar to a purchase price allocation. The residual fair value after this allocation is the implied fair value of reporting unit goodwill. To the extent the carrying amount of reporting unit goodwill is greater than the implied fair value of reporting unit goodwill, we would record an impairment charge for the difference. Judgment is required in determining what our reporting units are for the purpose of assessing fair value compared to carrying value. There were no impairments related to goodwill for any of the periods presented.

     Accounting for Income Taxes. We use the asset and liability method of accounting for income taxes. Under this method, income tax expense is recognized for the amount of taxes payable or refundable for the current year. In addition, deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit carryforwards. Deferred tax assets and liabilities and operating loss and tax credit carryforwards are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences and operating loss and tax credit carryforwards are expected to be recovered or settled. Management must make assumptions, judgments and estimates to determine our current provision for income taxes, our deferred tax assets and liabilities and any valuation allowance to be recorded against a deferred tax asset. Our judgments, assumptions and estimates relative to the current provision for income tax take into account current tax laws, our interpretation of current tax laws and possible outcomes of future audits conducted by foreign and domestic tax authorities. Changes in tax law or our interpretation of tax laws and future tax audits could significantly impact the amounts provided for income taxes in our consolidated financial statements.

     We must periodically assess the likelihood that our deferred tax assets will be recovered from future taxable income, and to the extent that recovery is not likely, a valuation allowance must be established. The establishment of a valuation allowance and increases to such an allowance result in either increases to income tax expense or reduction of income tax benefits in the statement of operations. Factors we consider in making such an assessment include, but are not limited to: past performance and our expectation of future taxable income, macro-economic conditions and issues facing our industry, existing contracts, our ability to project future results and any appreciation of our investments and other assets.

     In 2005, we reduced our valuation allowance by $220 million, as we determined at year-end that it is more likely than not that the results of our future operations, as a result of the settlement with Microsoft, will generate sufficient taxable income to realize certain of our deferred tax assets. As of September 30, 2006, we have a valuation allowance of $36.6 million relating primarily to net operating losses that are restricted under Internal Revenue Code Section 382 and losses not yet realized for tax purposes on certain equity investments.

     Determining the loss on a purchase commitment. We may from time-to-time enter into purchase commitments that commit us to the purchase of certain products and services. We periodically evaluate, based on market conditions, product plans and other factors, the future benefit of these purchase commitments. If it is determined that the purchase commitments do not have a future benefit, then a reserve is established for the amount of the commitment in excess of the estimated future benefit. Significant judgments and estimates must be made to determine such reserves.

Revenue by Segment

     We operate our business in two segments: Consumer Products and Services and Technology Products and Solutions. Revenue by segment is as follows:

		Quarters Ended September 30,												Nine Months Ended September 30,
		2006				2005				Change				2006				2005				Change
		(Dollars in thousands)
Consumer Products and Services		$	82,497			$	71,750				15	%		$	234,750			$	206,549				14	%
Technology Products and Solutions			11,179				10,483				7				34,937				34,942				(0	)
Total net revenue		$	93,676			$	82,233				14	%		$	269,687			$	241,491				12	%

		Quarters Ended September 30,								Nine Months Ended September 30,
		2006				2005				2006				2005
		(As a percentage of total net revenue)
Consumer Products and Services			88	%			87	%			87	%			86	%
Technology Products and Solutions			12				13				13				14
Total net revenue			100	%			100	%			100	%			100	%

     Consumer Products and Services. Consumer Products and Services primarily includes revenue from: digital media subscription services such as Rhapsody, RadioPass, GamePass and SuperPass and stand-alone subscriptions; sales and distribution of third party software and services; sales of digital content such as music and game downloads; sales of premium versions of our RealPlayer and related products; and advertising. These products and services are sold and provided primarily through the Internet and we charge customers’ credit cards at the time of sale. Billing periods for subscription services typically occur monthly, quarterly or annually, depending on the service purchased. Consumer Products and Services revenue increased in the quarter and nine months ended September 30, 2006 primarily due to increased revenue from: (1) increased sales of individual PC-based and mobile games, including increased sales resulting from our acquisition of Zylom; (2) growth in the number of subscribers to our Rhapsody and GamePass subscription services; (3) increased advertising revenue; and (4) increased revenue related to the distribution of third party products. Additional factors contributing to the increase are discussed below in the sections included within Consumer Products and Services revenue. We believe the growth in our music and games subscription services is due in part to the continued shift in our marketing and promotional efforts to these services as well as product improvements and increasing consumer acceptance and adoption of digital media products and services. While revenue and the aggregate number of subscribers related to our digital media subscription services have increased on a year-over-year basis, the number of subscribers and revenue growth for individual subscription services has fluctuated on a sequential quarterly basis. We cannot predict with accuracy how these subscription offerings will perform in the future, at what rate digital media subscription service revenue and number of subscribers will grow, if at all, or the nature or potential impact of anticipated competition.

     Technology Products and Solutions. Technology Products and Solutions primarily includes revenue from: sales of media delivery system software, including Helix system software and related authoring and publishing tools, both directly to customers and indirectly through OEM channels; support and maintenance services that we sell to customers who purchase our software products; broadcast hosting services; and consulting services we offer to our customers. These products and services are primarily sold to corporate, educational and governmental customers. Technology Products and Solutions revenue increased in the quarter ended September 30, 2006 due primarily to an increase in sales of upgrade and support services related to our system software products and an increase in sales through original equipment manufacturers (OEMs). This increase was partially offset by a decreases in revenue from the licensing of custom versions of our software and a decrease in sales of our system software products. Technology Products and Services revenue decreased slightly in the nine months ended September 30, 2006 due primarily to a decrease in revenue from sales of our system software products, which was partially offset by an increase in revenue from the licensing of custom versions of our software. We believe that sales of our business software products were substantially affected by Microsoft’s continuing practice of bundling its competing Windows Media Player and server software for free with its Windows operating system products. No

assurance can be given when, or if, we will experience increased sales of our Technology Products and Solutions to customers in these markets.

Consumer Products and Services Revenue

     A further analysis of our Consumer Products and Services revenue is as follows:

		Quarters Ended September 30,												Nine Months Ended September 30,
		2006				2005				Change				2006				2005				Change
		(Dollars in thousands)
Music		$	30,375			$	26,193				16	%		$	89,411			$	74,009				21	%
Media Software and Services			29,586				30,858				(4	)			82,990				92,004				(10	)
Games			22,536				14,699				53				62,349				40,536				54
Total Consumer Products and Services revenue		$	82,497			$	71,750				15	%		$	234,750			$	206,549				14	%

     Music. Music revenue primarily includes revenue from: our Rhapsody and RadioPass subscription services; sales of digital music content through our Rhapsody service and our RealPlayer music store; and advertising from our music websites. The increase in Music revenue during the quarter ended September 30, 2006 was due primarily to an increase in revenue from: (1) the increased number of subscribers to our Rhapsody subscription service, including our Rhapsody To Go service; (2) advertising on our music related web properties; and (3) the distribution of our Rhapsody radio product through internet service providers. These increases were partially offset by a decrease in revenue associated with our RadioPass subscription service and the online sale of individual tracks through our Rhapsody subscription service and through our RealPlayer Music Store. The increase in Music revenue during the nine months ended September 30, 2006 is due primarily to an increase in revenue from: (1) growth in subscribers to our Rhapsody subscription service, including our Rhapsody To Go service; (2) advertising on our music related web properties; (3) the distribution of our Rhapsody radio product through internet service providers; and (4) the online sale of individual tracks through our Rhapsody subscription service and our RealPlayer Music Store. These increases were partially offset by a decrease in revenue associated with our RadioPass subscription service. We believe the growth of our Music revenue during the first nine months of 2006 was due primarily to the broader acceptance of paid online music services and increased focus of our marketing efforts on our music offerings. While revenue and the aggregate number of subscribers related to our digital media subscription services have increased on a year-over-year basis, the number of subscribers and revenue growth for individual subscription services has fluctuated on a sequential quarterly basis. We cannot predict with accuracy how these subscription offerings will perform in the future, at what rate digital media subscription service revenue and number of subscribers will grow, if at all, or the nature or potential impact of anticipated competition.

     Media Software and Services. Media Software and Services revenue primarily includes revenue from: our SuperPass and stand-alone premium video subscription services; RealPlayer Plus and related products; sales and distribution of third-party software products; and all advertising other than that related directly to our Music and Games businesses. The decrease in revenue in the quarter and nine months ended September 30, 2006 was due primarily to the decrease in revenue from: (1) our SuperPass subscription service, resulting from a decrease in the number of subscribers; (2) discontinuation of certain stand-alone subscription services; and (3) certain of our premium and third-party consumer license products. These decreases were partially offset by an increase in revenue from advertising on our non-Music and non-Games related web properties and the increased revenue related to the distribution of certain third-party products. We believe that the decreases were due primarily to a shift in our marketing and promotional efforts towards our music and games subscription services, which we believe represent a greater growth opportunity for us.

     Games. Games revenue primarily includes revenue from: the sale of individual games through our RealArcade service and our games related websites including GameHouse, Mr. Goodliving and Zylom; our GamePass subscription service; and advertising through RealArcade and our games related websites. The increase in Games revenue during the quarter and nine months ended September 30, 2006 was due primarily to an increase in revenue from: (1) increased sales of individual games through our RealArcade service and our websites, including Zylom (subsequent to our acquisition of Zylom in January 2006); (2) growth in the number of subscribers to our GamePass subscription service; and (3) increased advertising on our Games related web properties. In addition, during the nine months ended September 30, 2006, Games revenue increased due to increased sales of games for mobile phones, primarily through our Mr. Goodliving product offerings (subsequent to our acquisition of Mr. Goodliving in May 2005). Additionally, we believe the growth in our Games revenue is due to the increased focus of our marketing efforts on our Games business and the addition of new game titles to our RealArcade and GamePass offerings.

Geographic Revenue

		Quarters Ended September 30,												Nine Months Ended September 30,
		2006				2005				Change				2006				2005				Change
		(Dollars in thousands)
United States		$	69,433			$	63,478				9	%		$	201,675			$	184,678				9	%
Europe			15,895				10,937				45				45,725				33,547				36
Rest of the World			8,348				7,818				7				22,287				23,266				(4	)
Total net revenue		$	93,676			$	82,233				14	%		$	269,687			$	241,491				12	%

		Quarters Ended September 30,								Nine Months Ended September 30,
		2006				2005				2006				2005
		(As a percentage of total net revenue)
United States			74	%			77	%			75	%			76	%
Europe			17				13				17				14
Rest of the World			9				10				8				10
Total			100	%			100	%			100	%			100	%

     Revenue generated in the United States increased for the quarter and nine months ended September 30, 2006 primarily due to the growth of our Music and Games businesses and increased revenue from distribution of third party products. See Consumer Products and Services Revenue — Games and — Music above for further discussion of the changes.

     Revenue generated in Europe increased for the quarter and nine months ended September 30, 2006 primarily due to the continued growth of our games business in Europe. The growth in our European games business was driven primarily by additional revenue from our Mr. Goodliving and Zylom product offerings subsequent to our acquisitions in May 2005 and January 2006, respectively. This increase was partially offset by a decrease in subscribers to our SuperPass subscription service. Revenue generated in Rest of the World increased for the quarter ended September 30, 2006 primarily due to an increase from the distribution of third party products, which was partially offset by a decrease in revenue from our SuperPass subscription service due to a decrease in subscribers. Revenue generated in Rest of the World decreased for the nine months ended September 30, 2006 primarily due to a decrease in subscribers to our SuperPass subscription service, which was partially offset by an increase in revenue from the distribution of third party products. Overall international revenue, which includes revenue from Europe and Rest of the World, increased as a percentage of overall revenue for the quarter and nine months ended September 30, 2006 driven mainly by the growth in our European games business.

Revenue

     In accordance with SEC regulations, we present our revenue based on License Fees and Service Revenue as set forth below.

		Quarters Ended September 30,												Nine Months Ended September 30,
		2006				2005				Change				2006				2005				Change
		(Dollars in thousands)
License fees		$	22,528			$	19,596				15	%		$	68,014			$	60,605				12	%
Service revenue			71,148				62,637				14				201,673				180,886				11
Total net revenue		$	93,676			$	82,233				14	%		$	269,687			$	241,491				12	%