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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
FOR ANNUAL AND TRANSITION REPORTS
PURSUANT TO SECTIONS 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
For the transition period from _____________ to _____________
Commission file number 000-29642
FILM ROMAN, INC.
(Exact name of registrant as specified in charter)
DELAWARE 95-4585357
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization)Identification Number)
12020 CHANDLER BOULEVARD, SUITE 200
NORTH HOLLYWOOD, CALIFORNIA 91607
(Address of principal executive offices)(Zip Code)
Registrant's telephone number, including area code: (818) 761-2544
Securities registered pursuant to 12(b) of the Act:
NONE
Securities registered pursuant to 12(g) of the Act:
COMMON STOCK, $.01 PAR VALUE
PREFERRED STOCK PURCHASE RIGHTS
(Title of Class)
Check 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
at least the past 90 days. YES [ X ] NO [ ].
Check if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this 10-K or any amendment to this Form
10-K. [ ]
As of March 23, 1999, the aggregate market value of voting stock held by
nonaffiliates of the registrant was approximately $18,335,927 (based upon the
last reported sales price of the Common Stock as reported by the Nasdaq National
Market). Shares of Common Stock held by each executive officer, director,
holders of greater than 10% of the outstanding Common Stock of the registrant
and persons or entities known to the registrant to be affiliates of the
foregoing have been excluded in that such persons may be deemed to be
affiliates. This assumption regarding affiliate status is not necessarily a
conclusive determination for other purposes.
As of March 23, 1999, 8,522,190 shares of Common Stock, par value $.01
per share, were outstanding.
The Exhibit Index appears on page S-2.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement for the Registrant's 1999 Annual Meeting
of Stockholders to be held June 16, 1999 are incorporated by reference to Items
10, 11, 12 and 13 of Part III.
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TABLE OF CONTENTS
PART I
Item 1. Business......................................................... 4
Overview......................................................... 4
1998 Milestones.................................................. 4
Strategy......................................................... 5
The Company's 1999 Production Schedule........................... 6
Principal Elements of the Company's Business..................... 7
Government Regulations........................................... 12
Trademarks....................................................... 13
Employees........................................................ 13
Item 2. Properties....................................................... 13
Item 3. Legal Proceedings................................................ 14
Item 4. Submission of Matters to a Vote of Security Holders.............. 14
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder
Matters.......................................................... 14
Item 6. Selected Financial Data.......................................... 15
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations........................................ 17
Item 8. Financial Statements and Supplementary Data...................... 30
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure......................................... 30
PART III
Item 10. Directors and Executive Officers of the Registrant.............. 31
Item 11. Executive Compensation.......................................... 33
Item 12. Security Ownership of Certain Beneficial Owners and Management.. 33
Item 13. Certain Relationships and Related Transactions.................. 33
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on
Form 8-K. ..................................................... 33
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SPECIAL NOTE REGARDING FORWARD-LOOKING INFORMATION. This Report
contains statements that constitute "forward-looking statements" within the
meaning of Section 21E of the Securities Exchange Act, 1934, as amended, and
Section 27A of the Securities Act of 1933, as amended. The words "expect",
"estimate", "anticipate", "predict", "believe", "plan", "should", "will", "may",
"projects" and similar expressions and variations thereof are intended to
identify forward-looking statements. Such statements appear in a number of
places in this filing and include statements regarding the intent, belief or
current expectations of the Company, its directors or officers with respect to,
among other things, (a) trends affecting the financial condition or results of
operations of the Company, (b) the business and growth strategies of the
Company, and (c) the Company's objectives, planned or expected activities and
anticipated financial performance. The stockholders of the Company are cautioned
not to put undue reliance on such forward-looking statements. Such
forward-looking statements are not guarantees of future performance and involve
risks and uncertainties, and that actual results may differ materially from
those projected in this Report, for the reasons, among others, discussed in the
Sections - "Management's Discussion and Analysis of Financial Condition and
Results of Operations", and "Factors that may Affect Future Results". The
Company undertakes no obligation to publicly revise these forward-looking
statements to reflect events or circumstances that arise after the date hereof.
Readers should carefully review the risk factors described in other documents
the Company files from time to time with the Securities and Exchange Commission,
including the Quarterly Reports on Form 10-Q to be filed by the Company in
calendar years 1999 and 2000 and any Current Reports on Form 8-K filed by the
Company.
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PART I
ITEM 1. BUSINESS
OVERVIEW
Film Roman, Inc. ("Film Roman" or the "Company") develops, produces and
distributes a broad range of television programming for the television network,
cable television, first-run domestic syndication and international markets. In
1998, the Company expanded its operations to include, on a limited basis, the
development and production of feature-length theatrical motion pictures. The
Company, founded in 1984, is one of the leading independent animation studios in
North America, having produced numerous high quality animated series including
BOBBY'S WORLD, THE SIMPSONS, KING OF THE HILL, THE MASK, BRUNO THE KID, C-BEAR
AND JAMAL, THE TWISTED TALES OF FELIX THE CAT, MORTAL KOMBAT, GARFIELD &
FRIENDS, THE CRITIC and most recently FAMILY GUY and THE DOWNTOWNERS.
The worldwide animation marketplace (particularly that for "Saturday
morning" or "children's" programming, which has historically been the Company's
principal arena of operation) has experienced significant structural change over
the past several broadcast seasons. The vertical integration of major U.S.
studios into broadcasting and of broadcasters into animation production,
ownership, and distribution, has led to substantially reduced and limited
opportunities for the independent production studio community. The contraction
of the market for independent animation studios, combined with the continued
fragmentation in the marketplace of buyers seeking independent production, have
led to a substantial decrease in U.S. license fees. In addition, the
international marketplace has also experienced a recent realignment, as several
governments outside of the U.S., notably France, Canada, and Germany have
instituted or increased heavy production subsidies, tax credits, and, more
recently, local broadcast quotas. Consequently, it has become more difficult for
an independent animation studio which is not aligned with a major distribution
outlet, a television network, or a major studio, to obtain programming slots or
broadcast commitments.
In light of management's assessment of these fundamental changes in the
animation industry, the Company undertook a restructuring of its creative
direction during 1998 designed to diversify and expand its product focus. During
1998 the Company increased dramatically the level of its commitment to the
development and sale of live-action properties, while continuing to pursue its
fee-for-services "prime time" animation business. The Company believes that, to
compete effectively, it must leverage its success and reputation as a quality
producer and position itself as a creative force in the larger independent
production community.
To accomplish these objectives, the Company sought out and hired the
following new personnel: a new Emmy winning creative director to head all
animation creative development, a senior executive for domestic television sales
and distribution, a senior feature motion picture development executive, an
experienced operating and finance officer, a head of live action production with
several years experience, a number of experienced computer graphics personnel,
and a team of executives with experience in animation and live action
development for both television and feature films. In addition, the Company has
entered into contracts with two writing teams, one whose success and focus is in
the teen/family arena, and the other, a well known prime time television team.
1998 MILESTONES
o Continued the production and delivery of high quality prime time
animation. These two shows, KING of THE HILL (22 episodes delivered)
and THe SIMPSONS (22 episodes delivered) which continued to deliver
excellent ratings for the Fox Broadcast Network, even in its tenth
season.
o Began production of two new prime time animated work for hire series:
FAMILY GUY and THE DOWNTOWNERS.
o Reconfigured all of the creative and sales personnel and refocused our
business strategy.
o Produced 13 episodes of THE MR. POTATO HEAD SHOW, the Company's first
show to combine computer generated imagery (CGI), puppetry and
live-action production technology.
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o Entered into a deal with Jane Seymour and James Keach to produce a
children's animated direct-to-video production of THIS ONE 'N THAT ONE
based upon Ms. Seymour's popular children's book series.
o Established Level 13, to provide content for distribution on Launch (a
monthly subscription and advertising supported CD-ROM Magazine) and to
pursue other new media opportunities.
o Contracted with the Disney Channel for the production of JOHNNY
TSUNAMI, a live action movie-of-the-week currently in production.
STRATEGY
Building on the cornerstone of its reputation as a quality animation
supplier to the U.S. and international broadcast marketplace, the Company is
currently pursuing active development, both on a proprietary and
fee-for-services basis, of (i) animated and live action television programming,
(ii) major studio financed feature films, (iii) independent, low-budget feature
films, (iv) computer animation production and short subject acquisition, (v)
CD-ROM, and potentially Internet distribution and (vi) direct-to-video
production. The Company's current strategy can be summarized as follows:
o CREATE AND DEVELOP POPULAR PROPRIETARY PRODUCTIONS. With its track
record of producing high quality, popular animated programming and its
focus on creative freedom, the Company believes that it has the
capacity to create successful franchises in the live action
television, feature film, computer animation and direct-to-video
industries. The Company's reputation for high-quality animation and
artistic integrity helps it to attract premiere creative artists and
storytellers whose character and concepts when imaginatively developed
and artistically produced, have the potential of developing into
character franchises.
o EXPAND INTERNATIONAL DISTRIBUTION. The Company's programs are
currently licensed for broadcast in over fifty countries. The Company
seeks to continue to distribute its library product into international
markets. For the years ended December 31, 1997 and 1998, the Company's
international distribution activities generated revenues of $3.6
million and $1.4 million, respectively (or 8% and 4%, respectively, of
total revenue for such periods).
o PURSUE CO-PRODUCTION RELATIONSHIPS. The Company intends to continue to
pursue and evaluate potential business opportunities with domestic and
international co-financing partners, with the goal that risks may be
shared, complementary skills may be exploited and foreign subsidies
may be utilized in the production of new entertainment properties.
o EXPLORE ALTERNATIVE DISTRIBUTION ARRANGEMENTS. The Company is
exploring the alternative distribution of its programs. Given the
success of animated programs in the teen and young-adult marketplace,
the Company is analyzing the potential of distributing animated
shorts, designed to have wider appeal than its past Saturday morning
proprietary projects, under the banner of a newly formed subsidiary,
Level 13 Entertainment, Inc ("Level 13"). The Company's long term goal
is to try to establish Level 13 as a stand-alone, advertising
supported, broad band delivered animation destination on the World
Wide Web. As a test and prototype site, Level 13 currently provides
content for distribution on LAUNCH, a monthly subscription and
advertising supported CD-ROM Magazine focusing on contemporary music
and popular entertainment. At this time, Level 13 is only available on
LAUNCH. See "Animation Acquisition/Alternative Distribution".
The Company believes that the successful execution of its more aggressive
and broad based production strategy, as well as its international and potential
Internet distribution plans, may require it to increase its overall level of
investment. This increase could include, among other potential costs, additional
personnel to augment its development efforts in animated programming, computer
generated animated programming, live action television series, feature films and
direct-to-video films, the costs of programming acquisitions, and potential
Internet operations. There can be no assurance given that the Company will be
successful in implementing this strategy or any individual aspect or portion of
this strategy. The discussion of the Company's strategy contains certain
forward-looking statements within the meaning of Section 27A of the Securities
Act of 1933, as amended (the "Securities Act"), and Section 21E of the
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Securities Exchange Act of 1934, as amended (the "Exchange Act"). Actual results
could differ materially from those projected in these forward-looking statements
as a result of certain risk factors described elsewhere in this Report or other
factors. See "--Management's Discussion and Analysis of Financial Condition and
Results of Operations."
The Company is a Delaware corporation with its principal executive offices
located at 12020 Chandler Boulevard, Suite 200, North Hollywood, California
91607, and its telephone number is (818) 761-2544.
THE COMPANY'S 1999 PRODUCTION SCHEDULE
Historically, the Company's primary source of revenue has been the
development and production of high quality, prime time and Saturday morning
animated series.
The market for television programming is composed primarily of the
broadcast television networks (ABC, CBS, NBC, Fox Broadcasting Company, United
Paramount Network and Warner Bros., a division of Time Warner Entertainment
Company L.P.), syndicators of first-run programming (such as Columbia, Inc., and
Buena Vista Television) which license programs on a station-by-station basis,
and basic and pay cable networks (such as the Fox Family Channel).
For the 1998-1999 broadcast season, the Company produced 24 episodes of
KING OF THE HILL, 23 episodes of THE SIMPSONS and 13 episodes of THE MR. POTATO
HEAD SHOW for the Fox Broadcasting Company. The Company is currently scheduled
to produce the following programming for the 1999-2000 broadcast season.
THE SIMPSONS. The Company is scheduled to produce 22 new episodes of THE
SIMPSONS for exhibition over the Fox Broadcasting Network. Entering its eleventh
season and now the longest-running prime time animated series in television
history, THE SIMPSONS has been honored with a Peabody Award, 10 Emmy Awards,
seven Annie Awards, three Genesis Awards, three International Monitor Awards and
three Environmental Media Awards, among numerous other nods. THE SIMPSONS has
transformed the way the television industry and audiences perceive animation and
comedy series in general.
KING OF THE HILL. The Company is currently scheduled to produce 24 new
episodes of KING OF THE HILL to be exhibited on the Fox Broadcasting Network.
KING OF THE HILL is the hit half-hour, animated comedy, voted the Best
Television Show of 1997 by TV Guide and Entertainment Weekly, that tells often
hilarious stories about Hank Hill, his family and their neighbors in the
fictional suburb of Arlen, Texas, the heartland of America.
FAMILY GUY is a new half-hour, prime time television series which premiered
on the Fox Broadcasting Network in January of 1999. The Company is currently
scheduled to produce 13 new episodes of FAMILY GUY for broadcast on the Fox
Broadcasting Network during the Spring of 1999. This half-hour, irreverent and
offbeat animated series features an outrageous cast of personalities who,
despite their quirkiness, sympathetically mirror our own real-life American
families and culture in general. Led by thick-headed but good hearted dad Peter
Griffin, who is as tactless as he is clueless, this not-quite-so-average family
of middle-class New Englanders proves to be delightfully dysfunctional.
THE DOWNTOWNERS is a new half-hour, prime time television series which is
scheduled to be broadcast in the fall of 1999 on the Warner Bros. network. The
Company is currently scheduled to produce 13 episodes of THE DOWNTOWNERS. THE
DOWNTOWNERS is the first prime time animated comedy to focus on the lives of
twenty-somethings and teens, explores the world of four diverse roommates who
inhabit a downtown loft in a fictional big city. The Company is scheduled to
produce 13 new episodes of THE DOWNTOWNERS for The WB during the 1999 fall
season.
In addition to the television series described above, the Company is
currently in production for one movie-of-the-week, JOHNNY TSUNAMI, for the
Disney Channel, scheduled to be broadcast during the 1999-2000 broadcast season.
The Company has in various stages of development a slate of proprietary animated
programs, including prime time, Saturday morning, teen-oriented and feature film
products.
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There can be no assurance that any of these programs will be relicensed for
additional broadcast seasons through renewal of existing licenses or issuances
of new licenses or, if so, licensed, that the terms of the license agreements
will be as favorable to the Company as those of existing licenses.
PRINCIPAL ELEMENTS OF THE COMPANY'S BUSINESS
The Company's business of developing, producing and distributing high
quality television and filmed programming, together with the exploitation of any
proprietary rights controlled by the Company, is described in the sections below
and includes: (i) acquiring, creating and developing programming properties;
(ii) funding a portion of the production costs of proprietary programming; (iii)
producing programming; (iv) distributing its programming domestically and
internationally; and (v) building a library.
ACQUISITION, CREATION AND DEVELOPMENT OF PROGRAMMING
The Company pursues ideas and properties it believes contain unique and
commercial story lines and/or characters. These ideas and properties may
originate from a variety of sources. As a result of the Company's reputation and
position in the entertainment industry, many creators, rights holders, writers,
broadcasters, and studios bring new concepts to the Company for development and
production. The Company may enter into an option agreement to acquire rights to
an existing property, which the Company may then develop internally into either
an animation or live action program. The Company will then take the project to
the networks or the studios for further development, financing and/or
distribution.
Once the Company has created this new idea or acquired the rights to the
existing property, the Company continues the development process by preparing a
presentation to "pitch" the project to a domestic buyer (and, on some occasions,
to international broadcasters and/or theatrical distributors). These
presentations generally consist of treatments, story premises, scripts, artwork,
designs and/or character designs and/or test animation or presentations. With
respect to television production, if a broadcaster or cable network is
interested in developing the idea further, the broadcaster will generally
acquire an exclusive option to order the production of a certain number of
episodes based on the idea and will agree to reimburse the Company for all or a
portion of the development costs if it does not ultimately order production of
any episodes. A broadcaster generally collaborates in the later stages of
development and will have the right to approve the selection of the writers,
directors, artists, and actors, and the creation of a pilot script. The
creation, acquisition and development of a new program can take from three to
twelve months, and sometimes longer.
In the case of the animated shorts acquisition program, that the Company may
determine that it is in its best interest to finance 100% of the programming the
Company may make available to Launch or to Level 13, or produce a particular
program in its own facility.
The Company is currently developing:
o Live action series and specials, ranging from prime time dramas and
comedies to Saturday morning children's programs. In addition, the
Company has entered into a co-production agreement with Le Sabre
Productions and Canal Plus for the development and potential production
of CARIBE, an hour action drama series.
o A slate of proprietary animated programs including prime time, Saturday
morning, teen oriented, and feature film projects. These projects will
depend, in varying degrees, on the Company's ability to arrange for U.S.
broadcast, U.S. theatrical exhibition, worldwide distribution, and/or
international co-production.
o A slate of feature film projects which the Company intends to present to
the major studios, such as THERE GOES THE NEIGHBORHOOD, which the
Company developed with Universal Pictures/MCA and Dustin Hoffman's Punch
Productions. Film Roman is acquiring the rights to THERE GOES THE
NEIGHBORHOOD back in turnaround and will attempt to secure another
studio financier/distributor in conjunction with Dustin Hoffman's Punch
Productions.
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o A number of computer animated short films, which the Company believes
can be utilized as character tests and concept trials. These shorts, in
addition to those acquired from third parties, may serve as the basis
for new television series or feature films, and can be distributed via
the Company's arrangement with Launch Media, or over the Company's
planned internet animation destination (See "Alternative Distribution").
FUNDING PRODUCTION -- PROPRIETARY PROGRAMMING
Historically, the Company produced animated programming almost exclusively
on a "fee-for-services" basis. In 1995 the Company began producing proprietary
animated programming. The Company generally does not commence production on
proprietary programming-whether animated or live action- unless the Company has
obtained commitments to cover at least 50% of the Company's direct production
costs. The Company generally secures these commitments in one or both of the
following ways: (i) a combination of network, cable, syndication, or other
license fees for exploitation of the program in the United States, and (ii)
pre-sale to distributors and/or co-production partners in foreign territories.
The Company typically funds the balance of the production costs on a current
basis. As of December 31, 1998, the Company had delivered 96 half-hour episodes
and 12 one-hour episodes of proprietary programming.
The Company intends to approach the development and production of live
action proprietary programming in much the same way as it does animated
programming. In most cases the Company intends to have pre-negotiated
distribution for the project, which distribution commitments will be an integral
factor in financing and commencing production of such programming. The Company
currently intends only to invest in the production of a program if the Company
secures a guaranteed distribution agreement from a major television network,
cable network, syndication company, or in the case of a feature film, a portion
of the financing and distribution from a U.S. or international distributor. As
of December 31, 1998, the Company had no commitments to produce any new episodes
of proprietary television programming for the 1999-2000 television season.
In January 1999 the Company entered into an agreement to finance and
distribute a direct-to-video animated feature, THIS ONE 'N THAT ONE, based on a
character created by Jane Seymour and James Keach. Also in January 1999, the
Company entered into an arrangement with a third party animator for the
production of two shorts intended to be delivered to Level 13. The Company will
produce the shorts utilizing certain proprietary animation software developed by
the third party which has been licensed in perpetuity to the Company.
While the Company generally seeks to limit its financial risk associated
with its proprietary programming by obtaining commitments prior to production to
cover at least 50% of its direct production costs, there can be no assurance
that the Company will be able to cover this amount or the balance of its
production costs and overhead costs relating to production, licensing and
distribution through the exploitation of its remaining rights. The Company may
not cover its costs for the following reasons: (i) a proprietary program may be
cancelled; (ii) a proprietary program and/or its related licensed products may
not appeal to the Company's targeted audience or may not appeal to the same
audience targeted by a licensee; (iii) the Company and/or its licensee may not
effectively market and distribute the Company's programming domestically or
internationally; or (iv) the actual production costs may exceed the original
budget. Moreover, since certain international distribution arrangements and
other domestic and international licensing activities are conditioned upon the
United States broadcast of a minimum number of programming episodes on a network
or cable channel, no assurance can be given that any series will be broadcast in
the United States for a sufficient period in order to meet these contractual
conditions.
PRODUCTION
ANIMATED TELEVISION PRODUCTION. The Company generally commences production
of animated television programs during the first and second quarters of any
calendar year for delivery commencing during the third quarter, and to a greater
extent, the fourth quarter of that same year. The Company typically has seven to
nine months to produce and deliver an order of 13 half-hour episodes (the number
of episodes commonly ordered for the first year of a program). As discussed
above, the Company's animation strategy is to continue to pursue both
fee-for-services and proprietary production opportunities. While the processes
involved in producing an animated show are similar for both proprietary
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and fee-for-services programs, the Company may not be responsible (especially in
the case of fee-for-services work) for the entire production process as outlined
below.
The first step of the Company's production process is generally the creation
of the script. The Company will generally select a story editor to supervise the
preparation of each episode's script by various freelance script writers. The
artists depict the story and action in storyboards, which provide a blueprint
for the animation process. Voices and songs are recorded and the recordings are
analyzed and timed so that the animation can be synchronized to the voice track.
Based on the script and storyboard, the Company's artists create character
designs, as well as key background drawings and paintings. These essential
elements are assembled into a pre-production package for each episode which is
then shipped to an overseas subcontractor. Subcontractors use the pre-production
materials to perform most of the labor-intensive aspects of production. Most of
these subcontractors are located in low-cost labor countries in the Far East,
including South Korea, Taiwan, China and the Philippines. The subcontractor
ships the negative and work print for each episode to the Company. The film is
then taken through a post-production process, which includes editing the picture
and dialogue, transferring the filmed images to video tape, creating sound
effects, composing and producing the musical score and mixing and synchronizing
the sound to the picture. After the post production process, an episode is ready
for delivery.
LIVE ACTION TELEVISION PRODUCTION. Live action television productions
typically follow a production process similar to animation. Independent
producers such as the Company generally make sales presentations to the
broadcast networks and cable channels during the spring and fall seasons and
receive orders for production beginning in the early summer or early winter.
Once an initial series or pilot script has been ordered, the independent
producer hires a writer approved by the broadcaster, syndication company or
cable channel, that is, the distributor, to write the initial episodes of a
series or a pilot. Once the pilot script is delivered to the distributor, the
distributor decides whether to order a pilot or episodes to be produced. Most
broadcasters and cable channels order pilots before ordering multiple episodes
of a series, while a syndication company usually orders multiple episodes.
Generally the broadcast networks order a small number such as six to eight
episodes for a new series, while the cable networks or syndication company order
13 to 22 episodes. Once a pilot or multiple episodes are ordered, the
independent producer hires the staff of actors, writers and directors and a
sound stage with the light, camera and grip equipment necessary to produce a
live action series. All of the staff and the equipment involved in a live action
production are assigned to the specific production. The independent producer
edits the footage shot on the sound stage, mixing the video images with sound
and music, and delivers a finished program to the distributor.
COMPUTER ANIMATION PRODUCTION. In the fall of 1997, the Company took the
existing equipment and software licenses that were available to the Company from
the interactive division, which had been closed earlier that year, together with
some additional software and hardware, and created a computer animation
division. At that time, the Company hired a senior executive and creative and
technical personnel who have extensive experience in computer animation. At the
time management concluded that the growing trend in the world marketplace
towards the use of computer animation as both a complete delivery and production
process, as well as a way to reduce costs in the cel animation production
through digital ink and paint systems were trends the Company had to understand
and exploit. During 1998 the Computer Animation Department delivered six
animated short subjects, provided design, effects, rendering, and post
production services to the production of THE MR. POTATO HEAD SHOW, as well as
several tests, pitches, and design services. While the Company may from time to
time produce shorts in their entirety, and other computer animation projects, it
views this department as principally a creative laboratory. The Computer
Animation Department's function is primarily one of design and testing, and will
employ a limited number of permanent artists rather than a full production
staff. Once a project is scheduled for production, the Company may contract with
third party providers to produce the program on a fee-for-services basis or, may
elect to produce the program internally and will staff those projects
accordingly.
PURSUE FEE-FOR-SERVICES PRODUCTION. The Company intends to continue to
pursue production work on a fee-for-services basis, primarily for prime time
animated television programming, as well as in the other new areas of
production. During 1998 the Company delivered 22 episodes of THE SIMPSONS and 22
episodes of KING OF THE HILL, was engaged by Fox Television to produce the new
prime time animated series FAMILY GUY, and was engaged by Castle Rock
Productions to produce THE DOWNTOWNERS scheduled to air on the WB Network in the
Fall of 1999. In addition, the Company has
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been marketing its commercial production services and during 1998 created a
number of animated broadcast commercials for several buyers including a redesign
of the on-air look of SHAMU AND CREW for Anheuser Busch Entertainment.
Management believes that the fee-for-services business, in particular prime time
animation shows, will remain an important cornerstone for the Company's
business, and intends to pursue additional work as such shows become available.
FEATURE FILM PRODUCTION
The Company, together with Universal Pictures/MCA and Dustin Hoffman's Punch
Productions, has been in development on the feature film titled THERE GOES THE
NEIGHBORHOOD. Film Roman is acquiring the rights to THERE GOES THE NEIGHBORHOOD
back in turnaround and will attempt to secure another studio
financier/distributor in conjunction with Dustin Hoffman's Punch Productions.
The film, if produced, will feature a mixture of live action and animation
(similar to that of WHO FRAMED ROGER RABBIT?). While no assurance can be given
that THERE GOES THE NEIGHBORHOOD will be produced, the Company currently has a
number of other feature film projects in internal development. Although the
Company is not currently producing any feature films (nor has the Company
entered into any agreements to produce any such films), the Company intends to
obtain financing for its feature films through both strategic alliances with
major studios and independent film and video distribution companies. As a
result, the Company may be unable to retain control of all or a significant
portion of the rights associated with these feature films.
DISTRIBUTION OF PROPRIETARY PROGRAMMING
DOMESTIC TELEVISION DISTRIBUTION. Prior to commencing production of its
proprietary programming, the Company generally licenses broadcast rights to a
United States broadcaster. See "-- Funding Production -- Proprietary
Programming." License fees paid by networks and cable networks for the Company's
proprietary programming can cover as much as 50% of the Company's direct
production costs. In some cases, notably for Saturday morning type children's
programs, the license fees can be less than 20% of the Company's direct
production costs. License fees paid by first-run syndicators for the Company's
proprietary programming generally cover less than 50% of the Company's direct
production costs, and, under certain circumstances, first-run syndicators pay no
license fees. The Company may choose to enter into such a no-license-fee
arrangement when it can share in a portion of the revenues generated from the
sale of advertising aired by a syndicator during the broadcast of the Company's
programming and when the Company has obtained financing to cover a portion of
its direct production costs from sources other than the syndicator. If the
Company's program is highly rated in syndication, the Company may earn more in
revenues from advertisers (since those advertisers will often be willing to pay
higher fees to have their commercials aired during the broadcast of the
Company's program) than the Company would have earned in revenues from a license
fee arrangement with a syndicator that does not require the syndicator to share
advertising revenues with the Company. Conversely, however, if the Company's
program is poorly rated in syndication, the Company will likely earn less in
revenues than if it had negotiated to receive a license fee.
The license agreement typically includes provisions governing the license
fee, the term during which the program will be broadcast, the number of episodes
and the territories in which the episodes will be broadcast. Upon the expiration
of an initial broadcast license, the exhibition rights for the applicable
program revert to the Company and are available for re-licensing.
INTERNATIONAL DISTRIBUTION. Consistent with the Company's strategy to
broaden its line of proprietary programming is its desire to elevate the profile
of its international division and its ability to capture the economic benefits
of owning and controlling the international distribution rights to its
proprietary programming. Recently the international market for American filmed
entertainment product has become increasingly fractionalized and competitive,
similar to the changes experienced in the U.S. In the face of an increasingly
difficult international marketplace, the Company believes that owning and
controlling the international distribution rights to its programming, will be
necessary to: (i) successfully finance projects; (ii) generate significant
revenue from the licensing of such programming; and (iii) support its related
international licensing and merchandising efforts. Furthermore, a strong
international division provides the Company with direct access to market
information and feedback, which is increasingly necessary to produce programs
that are marketable on a worldwide basis. Since the establishment of its
international distribution division, the Company has
10
entered into audio-visual license arrangements with international broadcasters
and distributors to exhibit and distribute certain of the Company's proprietary
programming. For the years ended December 31, 1997 and 1998, the Company's
international distribution activities generated revenues of $3.6 million and
$1.4 million, respectively (or 8% and 4%, respectively, of total revenue for
such periods).
HOME VIDEO DISTRIBUTION. As described above, one part of the Company's
strategy to expand its product base is to enter the direct-to-video animation
and live action production and distribution business. The Company may provide,
in some cases, a portion of the production funds in return for distribution
guarantees and/or a substantial portion of the production funds from a major
home video distributor. The Company believes that it can create and develop high
quality popular direct-to-video animated and live action programming that can be
economically produced and exploited domestically and internationally.
ANIMATION ACQUISITION/ALTERNATIVE DISTRIBUTION. In late 1998 the Company
entered into a distribution agreement with Launch Media, Inc. ("Launch"). Launch
produces a subscription and advertising supported monthly magazine focusing on
the music and entertainment business, which is distributed on CD-ROM to
approximately 300,000 subscribers monthly, and on the World Wide Web. Launch
magazine is formatted as a cityscape and the Company has its own unique
site/building branded as Level 13 Entertainment on which it provides 5 minutes
of original animated programming monthly. Level 13 Entertainment is the
exclusive provider of animation programming and is currently the only third
party provider of proprietary programming to Launch. The Company and Launch
share in any advertising revenue generated by the Level 13 site, and the Company
has agreed to underwrite the first year's cost of its building site. Launch has
offered Level 13 a limited presence on the Launch Web site, and in 1999, Launch
will complete testing and initiate "broad band" delivery of its magazine, which
tests will include the Level 13 content. Separate from its agreement with
Launch, the Company has been exploring and evaluating its opportunity to
establish Level 13 as an independent, stand-alone, broad band delivered
animation destination on the World Wide Web. The nature of the programming
provided to Launch and anticipated to be available on Level 13's proposed Web
based destination, is expected to appeal to a different audience than its past
Saturday morning proprietary projects. The success of such shows as BEAVIS AND
Butthead and SOUTH PARK have led the Company and Level 13 to focus their
development and acquisition efforts on the twelve to twenty-five year old
viewer. The Company believes that the success of this effort will rely on its
ability to produce and acquire alternative and compelling material, drawing
viewers and ultimately, advertisers to the site. See "Management's Discussion
and Analysis of Financial Condition and Results of Operations-Risk Factors-Risk
Associated With Possible New Businesses".
11
LIBRARY
The Company has retained the proprietary rights set forth below associated
with the programs in its library. The Company holds the proprietary rights
associated with the ANIMATED CLASSIC SHOWCASE for fifteen years, and holds most
of the other proprietary rights for the programs listed in the table below in
perpetuity, subject to the rights granted to its licensees.
BUILD LIBRARY VALUE. The Company intends to continue to build a library of
proprietary entertainment product by continuing to produce high quality
programming, including, feature films and direct-to-video productions which can
be licensed and re-licensed in the world-wide television, film and video
marketplaces. A library of proprietary programming can provide a future revenue
stream as such programs are re-licensed for broadcast after the expiration of
the initial broadcast license. Programs in the Company's library can also be
licensed to new channels and outlets in emerging markets around the world. The
Company began building its library in 1993 with its partner Films by Jove,
through the production of Film Roman's ANIMATED CLASSIC SHOWCASE, a restoration
of existing classic Russian animation. The Company has added to its library
programs produced in both the 1995-1996 and 1996-1997 seasons. In 1997-1998 the
Company added 13 episodes of the THE MR. POTATO HEAD SHOW. Revenues generated
from the proprietary programs in the Company's library were $4.9 million
(including $1.0 million from domestic television distribution) and $3.3 million
(including $1.7 million from domestic television distribution) for the years
ended December 31, 1997 and 1998, respectively. The Company believes that
ownership and control of the distribution rights to its programming, built upon
its ability to create popular programming and popular characters, is its best
strategy for creating permanent and increasing value for the Company.
Number of Licensing
Series Episodes Domestic International and
TITLE PRODUCED DISTRIBUTION DISTRIBUTION MERCHANDISING INTERACTIVE
- ------------------------------------------------------------------------------------------------
TV Home TV Home
Video Video
- ------------------------------------------------------------------------------------------------
ANIMATED CLASSIC SHOWCASE 12 (x 1 hr.) / / / / / /
- ------------------------------------------------------------------------------------------------
THE TWISTED TALES OF 21 (x 2 hr.) / / / / * /
FELIX THE CAT
- ------------------------------------------------------------------------------------------------
C-BEAR AND JAMAL 13 (x 2 hr.) / / / / / /
- ------------------------------------------------------------------------------------------------
BRUNO THE KID 36 (x 2 hr.) / / / / / /
- ------------------------------------------------------------------------------------------------
MORTAL KOMBAT: DEFENDERS 13 (x 2 hr.) / / / /
OF THE REALM
- ------------------------------------------------------------------------------------------------
THE MR. POTATO HEAD SHOW 13 (x 2 hr.) / / *
- ------------------------------------------------------------------------------------------------
* The Company is entitled to certain licensing, merchandising, and toy revenue
associated with THE TWISTED TALES OF FELIX THE CAT and THE MR. POTATO HEAD
SHOW but does not control those rights.
GOVERNMENT REGULATIONS
The Federal Communications Commission ("FCC") repealed its financial
interest and syndication rules, effective as of September 21, 1995. Those FCC
rules, which were adopted in 1970 to limit television network control over
television programming and thereby foster the development of diverse programming
sources, had restricted the ability of the three established, major United
States television networks (ABC, CBS and NBC) to own (or to be owned by) a
syndicated television programmer and to own financial interests in programming
aired on their networks. As a consequence, broadcasters have continued to
increase in-house productions of television programming for the networks' own
use and in the network programs in which a network holds a financial interest.
The Company believes that this
12
change, compounded by the vertical integration discussed above, has had a
significant negative impact on the Company's core animation business to the
extent that the networks target children's programming.
Broadcast customers of the Company are subject to the provisions of the
Children's Television Act of 1990 and the implementing rules issued by the FCC.
These rules, which were amended in August 1996 and became fully effective in
September 1997, require television broadcast station licensees, over the term of
their licenses, to serve the educational and informational needs of children
through their overall programming and programming specifically designed to serve
such needs. The FCC strongly encourages broadcasters (through the license
renewal process) to air between the hours of 7:00AM and 10:00PM at least three
hours per week of regularly-scheduled programs each at least 30 minutes in
length that have as a significant purpose serving the educational and
informational needs of children aged 16 and under. Such programming must be
specifically identified as educational or informational programming. While the
Company is not subject to the direct jurisdiction of the FCC, these FCC
requirements may influence the content of the Company's programming in order for
the Company to place programs on FCC-licensed stations. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations -- Risk
Factors; Impact of FCC Regulations Requiring Educational Content Programming."
The Company may be subject to local content and quota requirements in the
international markets, which effectively prohibit or limit access to particular
markets. The Company also seeks to comply with self-regulatory rules relating to
children's programming of the Children's Advertising Review Unit of The Council
of Better Business Bureaus and of the national television networks by reviewing
the proposed content of each property prior to acquisition and acquiring rights
to and distributing only those children's properties for which there will be no
material restrictions on exhibition to children.
TRADEMARKS
The Company has a registered service mark for the Film Roman name and logo.
The Company has applications pending with the United States Patent and Trademark
Office to register several trademarks and service marks, including C-BEAR AND
JAMAL, BRUNO THE KID, BEARSY BEARS, ABBY ABELSKEVER, 21, DUMONT'S DOUBLE WIDE,
BIG B and the Level 13 Entertainment name and logo. In addition, the Company has
registered certain "URL" Internet related addresses. Pursuant to arrangements
with the owners of the programs it produces, the Company utilizes certain
trademarks and copyrighted materials, including THE SIMPSONS, GARFIELD, BOBBY'S
WORLD, FELIX THE CAT, THE MASK, RICHIE RICH, MORTAL KOMBAT, MIGHTY MAX and KING
OF THE HILL.
EMPLOYEES
As of December 31, 1998, the Company had approximately 354 full-time
employees . The Company also regularly engages numerous freelance creative staff
and other independent contractors on a project-by-project basis. The Company is
subject to the terms in effect from time to time of various industry-wide
collective bargaining agreements, including the Screen Actors Guild. The Company
believes that its relations with its employees are good.
ITEM 2. PROPERTIES
The Company conducts its operations through its 87,000 square foot studio
and headquarters located in North Hollywood, California. These facilities are
occupied pursuant to a lease that expires in August 2003 (and contains renewal
options). The Company also leases certain other production facilities nearby its
headquarters, none of which is considered material. The Company believes that
its current studio and headquarter's facilities are adequate to meet its needs
for the foreseeable future. If the company continues to grow or add new shows,
additional facilities may be needed.
13
ITEM 3. LEGAL PROCEEDINGS
The Company is not a party to any material legal proceedings and is not
aware of any pending or threatened litigation that, if decided adversely to the
Company, would have a material adverse effect upon the Company's business,
results of operations or financial condition.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the quarter
ended December 31, 1998.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
The Company's Common Stock is quoted on the Nasdaq National Market under the
symbol "ROMN." The following table sets forth the high and low closing sale
price per share for the Common Stock for each quarter since the quarter ended
December 31, 1996.
1997 HIGH LOW
---- ------ -------
1st Quarter $7.625 $1.875
2nd Quarter $2.625 $1.25
3rd Quarter $2.875 $1.375
4th Quarter $2.375 $1.375
1998
----
1st Quarter $1.750 $1.250
2nd Quarter $1.625 $1.250
3rd Quarter $1.625 $1.063
4th Quarter $1.563 $0.719
1999
----
1st Quarter
(through March 23, 1999) $4.375 $1.50
At March 19, 1999, there were 34 stockholders of record, excluding the
number of beneficial owners whose shares were held in street name. The Company
believes that the number of beneficial holders is significantly in excess of
this amount.
The Company has not paid dividends on its Common Stock since inception and
does not anticipate paying dividends in the foreseeable future. Management
anticipates that all earnings and other cash resources of the Company, if any,
will be retained by the Company for investment in the business.
14
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data set forth below as of December 31, 1994, 1995,
1996, 1997 and 1998 are derived from the Company's consolidated financial
statements audited by Ernst & Young LLP, independent auditors. The selected
financial data presented below and under "Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations" should be read in
conjunction with the Company's consolidated financial statements, including the
notes thereto, appearing elsewhere in this Report.
YEAR ENDED DECEMBER 31,
-----------------------------------------------------
1994 1995 1996 1997 1998
------- --------- ------- -------- --------
(IN THOUSANDS, EXCEPT PER SHARE AND SHARE DATA)
STATEMENT OF OPERATIONS DATA:
Revenue................................ $ 36,201 $ 34,341 $ 49,698 $ 42,296 $ 32,946
Expenses:
Cost of revenue...................... 33,190 33,156 50,779 43,013 32,670
Selling, general and administrative
expenses........................... 1,829 2,963 3,850 4,745 7,715
---------- ---------- ---------- ---------- ----------
Operating income (loss)................ 1,182 (1,778) (4,931) (5,462) (7,439)
Interest income (expense), net......... (28) 89 298 649 707
---------- ---------- ---------- ---------- ----------
Income (loss) before provision for
income taxes......................... 1,154 (1,689) (4,633) (4,813) (6,732)
Provision for income taxes ............ -- -- -- -- 145
Net income (loss)...................... 1,154 (1,689) (4,633) (4,813) (6,877)
Net income (loss) attributable to
common stock(1)...................... $ 1,154 $ (2,574) $ (9,267) $ (4,813) $ (6,877)
========== ========== ========== ========== ==========
Net income (loss) per common share(1)(2)
basic and diluted.................... $ 0.25 $ (0.55) $ (1.67) $ (0.57) $ (0.81)
========== ========== ========== ========== ==========
Pro forma net income (loss) per common
share (3) basic and diluted.......... $ 0.15 $ (0.43) $ -- $ -- $ --
========== ========== ========== ========== ==========
Weighted average number of shares
outstanding basic and diluted........ 4,653,750 4,653,750 5,553,094 8,453,440 8,507,026
========== ========== ========== ========== ==========
AS OF DECEMBER 31,
------------------------------------------------------
1994 1995 1996 1997 1998
-------- --------- --------- ---------- -------
BALANCE SHEET DATA: (IN THOUSANDS)
Cash and cash equivalents.............. $ 436 $ 5,176 $ 13,739 $ 15,986 $ 11,287
Film costs, net of amortization........ 12,382 12,379 21,269 16,084 20,904
Total assets........................... 13,694 18,950 42,817 34,379 34,749
Short-term debt........................ 1,363 1,737 -- -- --
Redeemable Preferred Stock............. -- 6,749 -- -- --
Stockholders' equity................... 1,691 1,832 23,787 18,974 12,098
15
(FOOTNOTES TO SELECTED FINANCIAL INFORMATION ON PREVIOUS PAGE.)
(1) For the year ended December 31, 1995, the net loss attributable to common
stock gives effect to the accretion of the difference between the carrying
value and the liquidation value of the Company's Class A Redeemable
Preferred Stock of $484,829 and to the accrual of dividends of $400,000 on
the Class A Redeemable Preferred Stock. For the year ended December 31,
1996, net loss attributable to common stock gives effect to the accretion of
the difference between the carrying value and the liquidation value of the
Class A Redeemable Preferred Stock of $757,544 and to the accrual of
dividends of $750,000 on the Class A Redeemable Preferred Stock, and the
excess of the price paid for the redemption of the Class A Redeemable
Preferred Stock over its carrying value of $3,126,755.
(2) For the years ended December 31, 1994 and 1995, the per share data is based
on the weighted average number of common and common equivalent shares
outstanding during the period giving effect to the conversion of the common
stock of the Company's predecessor ("Predecessor Common Stock") into 1.25
shares of Common Stock of the Company ("Common Stock") and are calculated in
accordance with a Staff Accounting Bulletin of the Securities and Exchange
Commission ("SAB") No. 98 whereby common stock, options or warrants to
purchase common stock or other potentially dilutive instruments issued for
nominal consideration must be reflected in basic and diluted per share
calculations for all periods in a manner similar to a stock split, even if
antidilutive. For the year ended December 31, 1996, the weighted average
number of common and common equivalent shares outstanding have been
calculated in accordance with the SAB No. 98 for the period prior to the
completion of the Company's initial public offering giving effect to the
conversion of Predecessor Common Stock into 1.25 shares of Common Stock and
in accordance with Statement of Financial Accounting Standards ("SFAS")
Number 128, Earnings per Share for the period after such offering. For the
years ended December 31, 1997 and 1998 the per share data has been
calculated in accordance with SFAS No. 128. Common equivalent shares,
consisting of outstanding stock options are not included since they are
antidilutive.
(3) The Company operated as an S Corporation until August 4, 1995. As an S
Corporation, the Company was subject to no federal income taxes and only
minimum state taxes. The pro forma income (loss) per common share amounts
reflect adjustments for additional income taxes that would have been
reported if the Company had been a C Corporation based upon an estimated
statutory rate of 40% in 1994 and 34% in 1995.
YEAR ENDED DECEMBER 31,
-----------------------------
1994 1995
---- ----
Net income (loss) attributable to common
stock as reported............................ $ 1,154 $ (2,574)
Pro forma provision for income taxes .......... (462) 574
Pro forma net income (loss) ................... $ 692 $ (2,000)
======= ========
Pro forma net income (loss) per common share
basic and diluted ........................... $ 0.15 $ (0.43)
======= ========
16
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
GENERAL
The Company develops, produces and distributes a broad range of television
programming, and in the past year has expanded its feature motion picture
development efforts. Historically, the Company has produced most of its
programming for third parties on a "fee-for-services" basis. Fees paid to the
Company for these production services generally range from $300,000 to $600,000
per episode and typically cover all direct production costs plus a profit
margin. The Company has begun to produce programming for which it controls some
of the "proprietary rights" associated with such programming (including, for
example, international distribution and licensing and merchandising rights).
Fees paid to the Company for these production services typically do not cover
all direct production costs. Generally, the Company seeks to cover at least 50%
of its production costs prior to production of its proprietary programs and
seeks to cover the remaining production costs through the exploitation of the
proprietary rights associated with these programs. As a result, the Company may
recognize revenue associated with its proprietary programming over a period of
years.
The Company produces a limited number of animated television series in any
year and is substantially dependent on revenues from licensing these programs to
broadcasters. The Company's future performance will be affected by issues facing
all producers of animated programming, including risks related to the limited
number of time slots allocated to children's and/or animated television
programming, the intense competition for those time slots, the limited access to
distribution channels (particularly for programs produced by independent
studios), the declining license fees paid to producers of programming by
broadcasters and the regulations implemented by the Federal Communications
Commission governing program content. While the Company seeks to limit its
financial risk associated with its proprietary programming by obtaining
commitments prior to production to cover at least 50% of its direct production
costs, there can be no assurance that the Company will be able to cover the
balance of its production costs and overhead costs relating to production,
licensing and distribution through the exploitation of its proprietary rights.
As a result of the foregoing risks, there can be no assurance that the Company
will be able to generate revenues that exceed its costs.
The Company is currently seeking to enter into new business areas beyond its
core business of animation television production such as live action television
production, feature film production (both live action and animation), computer
generated animation and direct-to-video production (both live action and
animation) and alternative forms of distribution. The Company's future
performance will be affected by unpredictable and changing factors that
influence the success of an individual television program, feature film or
direct-to-video release such as personal taste of the public and critics as well
as public awareness of a production and the successful distribution of a
production. Although the Company intends to attempt to limit the risks involved
with television, film and direct-to-video production, the Company will likely be
unable to limit all financial risk, and the level of marketing, promotional and
distribution activities and expenses necessary for such production cannot be
predicted with certainty. The Company has a very limited history of developing,
producing or distributing live action television, computer generated animation
or film productions, and there can be no assurance that the Company can compete
successfully with more established persons or entities. Live action production
involves many of the risks associated with animation production as well as
additional risks inherent to live action that are outside of the Company's
control. These risks include, but are not limited to, the risk of strike by
actors and film crew, increased union activity, delay in production due to
weather and other local conditions, inability to obtain proper permitting at a
desired site, at desired times and/or under desired terms, and accidents or
injury to actors and film crew. No assurance can be given that the Company will
produce any live action television, film or direct-to-video productions or that,
if produced, such productions will be profitable.
In the first quarter of 1998, the Company decided to reduce its fixed
overhead by outsourcing its licensing and merchandising, public relations,
promotion, and advertising to third party suppliers. The Company will consider
bringing these functions in-house again, should the volume indicate that such
action would be prudent.
17
REVENUE AND COST RECOGNITION
The Company follows FASB 53 for accounting practices related to revenue
recognition and amortization of production costs for its fee-for-services and
proprietary programming.
Revenues from license and production agreements, which may provide for the
receipt by the Company of nonrefundable guaranteed amounts, are recognized when
the license period begins and the programming is available pursuant to the terms
of the agreement, typically when the finished episode has been delivered to or
made available to and accepted by the customer. Amounts in excess of minimum
guarantees under such agreements are recognized when earned. Cash collected in
advance of the time of availability of programming is recorded as deferred
revenue ($19.7 million at December 31, 1998).
All costs incurred in connection with an individual program or film,
including acquisition, development, production and allocable production overhead
costs and interest are capitalized as film costs. At December 31, 1998, the
Company's capitalized film costs balance was $20.9 million. These costs are
stated at the lower of unamortized cost or estimated net realizable value.
Estimated total production costs for an individual program or film are amortized
in the proportion that revenue realized relates to management's estimate of the
total revenue expected to be received from such program or film. Estimated
liabilities for third party participations are accrued and expensed in the same
manner as film costs are amortized. Due to the inherent uncertainties of
forecasting both total revenue and total expense, at any time one or the other
can be overstated or understated, resulting in potential adjustments to the
amortization rate or net realizable value calculation.
The Company's cash flows are not necessarily related to revenue recognition
and amortization of production costs. Cash is received and costs are incurred
(and paid) throughout the year. Historically, in the fourth quarter, and to a
lesser extent the third quarter, cash used in operations typically exceeded cash
generated by operations as completed shows were delivered to broadcasters. The
Company expects that cash used in or provided by operations will fluctuate
greatly from quarter to quarter, due in part, to the international sales and
collections cycle related to the programs in its library.
OVERHEAD ALLOCATION
Overhead is allocated to particular productions on the basis of the total
allocable overhead times the ratio of direct production costs incurred on a
program to total production costs incurred during the period. Total allocable
overhead is determined on the basis of management's estimates of the percentage
of overhead costs which can be attributed to the productions in progress during
the period.
RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 1998 COMPARED WITH YEAR ENDED DECEMBER 31, 1997
Total revenue decreased by 22%, or $9.4 million, to $32.9 million for the
year ended December 31, 1998, from $42.3 million for the prior year. Total
revenue decreased in part, because the Company delivered fewer episodes of
programming in 1998 as compared to 1997. The Company delivered a total of 57
episodes of programming for the year ended December 31, 1998 as compared to 68
episodes delivered in 1997. However, the primary reason for the decrease in
total revenue is that in September 1997, United Paramount Network ("UPN") and
the Company entered into a settlement whereby UPN compensated the Company for a
portion of the costs associated with BLUES BROTHERS: THE ANIMATED SERIES
("Blues Brothers"). UPN had initially ordered the series and subsequently
cancelled its order while the series was in production. The Company's investment
amounted to approximately $6.0 million as of December 31, 1997, and the Company
received revenue of $4.0 million and recorded a write-off for the year ended
December 31, 1997, of approximately $2.0 million.
The Company delivered 44 "fee-for-services" episodes during the year ended
December 31, 1998, compared to 58 episodes in 1997. Fee-for-services revenue
decreased 13%, or $4.1 million, to $26.5 million for the year ended December 31,
1998, from $30.6 million in 1997 as a result of delivering no Saturday morning
episodes.
18
The Company delivered 13 "proprietary" episodes for the year ended December
31, 1998, compared to 10 episodes in 1997. "Proprietary revenue" consists of
revenue derived from the U.S. license fees paid upon the initial delivery of a
new episode of proprietary programming to a U.S. broadcaster and from the
exploitation of the proprietary rights (e.g., merchandising, licensing and/or
international distribution rights) associated with the proprietary episodes in
the Company's library that were initially delivered in prior periods.
"Proprietary" revenue decreased by 63%, or $5.6 million, to $3.3 million for the
year ended December 31, 1998, from $8.9 million in 1997. This decrease resulted
from Blues Brothers settlement revenue being included in 1997 but not 1998, and
lower international sales of the Company's library programming in 1998.
Other revenue increased by approximately $0.3 million for the year ended
December 31, 1998, as compared to the prior year, due primarily to higher
revenues from commercials and specials, and net profit participations, offset by
lower interactive revenue and other creative services revenue.
Total cost of revenue decreased by 24%, or $10.3 million, to $32.7 million
for the year ended December 31, 1998, from $43.0 million for the year ended
December 31, 1997. Total cost of revenue as a percentage of sales decreased by
3%, to 99% for the year ended December 31, 1998, from 102% for the year ended
December 31, 1997. Costs as a percentage of revenue decreased primarily because
the costs for the twelve months ended December 31, 1997 included a write-off
related to the Blues Brothers as discussed earlier. The overall decrease was
partially offset by a write-down to net realizable value as a result of changes
in the Company's estimated future revenues from certain of its episodic
programming.
Total selling, general and administrative expenses for the year ended
December 31, 1998 increased by $3.0 million to $7.7 million from $4.7 million
for the comparable period in 1997, due primarily to an increase in the cost of
the Company's development infrastructure and an increase in the expense of
certain development costs, as well as an accrual for the charges related to the
Company's termination of its employment contract with the founder of the
Company. These increases were partially offset by outsourcing the Company's
licensing and merchandising activities.
Operating loss was $7.4 million for the year ended December 31, 1998, as
compared to a loss of $5.5 million for the year ended December 31, 1997.
YEAR ENDED DECEMBER 31, 1997 COMPARED WITH YEAR ENDED DECEMBER 31, 1996
Total revenue decreased by 15%, or $7.4 million, to $42.3 million for the
year ended December 31, 1997, from $49.7 million for the prior year. Total
revenue decreased primarily because the Company delivered significantly fewer
episodes of programming in 1997 as compared to 1996. The Company delivered a
total of 68 episodes of programming for the year ended December 31, 1997 as
compared to 141 episodes delivered in 1996.
The Company delivered 58 "fee-for-services" episodes during the year ended
December 31, 1997, compared to 81 episodes in 1996. Fee-for-services revenue
increased 9%, or $2.6 million, to $30.6 million for the year ended December 31,
1997, from $28.0 million in 1996 as a result of delivering more prime time
episodes which generally generate higher per-episode fees than Saturday morning
episodes.
The Company delivered 10 "proprietary" episodes for the year ended December
31, 1997, compared to 60 episodes in 1996. "Proprietary revenue" consists of
revenue derived from the U.S. license fees paid upon the initial delivery of a
new episode of proprietary programming to a U.S. broadcaster and from the
exploitation of the proprietary rights (e.g., merchandising, licensing and/or
international distribution rights) associated with the proprietary episodes in
the Company's library that were initially delivered in prior periods.
"Proprietary" revenue decreased by 41%, or $6.1 million, to $8.9 million for the
year ended December 31, 1997, from $15 million in 1996. This decrease was a
result of significantly fewer "proprietary" episodes being delivered partially
offset by $4 million in revenue from the Blues Brothers settlement with UPN and
continued international sales of the Company's library programming.
19
Other revenue decreased by approximately $4.0 million for the year ended
December 31, 1997, as compared to the prior year, due primarily to lower
revenues from commercials and specials, interactive revenues and net profit
participations.
Total cost of revenue decreased by 15%, or $7.8 million, to $43.0 million
for the year ended December 31, 1997, from $50.8 million for the year ended
December 31, 1996. Total cost of revenue as a percentage of sales remained
constant at 102% for both 1997 and 1996.
Total selling, general and administrative expenses for the year ended
December 31, 1997 increased by $0.8 million to $4.7 million from $3.9 million
for the comparable period in 1996, due primarily to increased professional fees,
the write off of certain development costs and ongoing costs of operating a
public company.
Operating loss was $5.5 million for the year ended December 31, 1997, as
compared to a loss of $4.9 million for the year ended December 31, 1996.
LIQUIDITY AND CAPITAL RESOURCES
At December 31, 1998, the Company had cash and short-term investments of
approximately $11.3 million compared to $16.0 million at December 31, 1997 and
$13.7 million at December 31, 1996. The Company's cash and short-term investment
balances have continued to decline since December 31, 1998 and the Company
expects to experience further declining balances during the remainder of fiscal
1999. Management believes that its existing cash balances and short-term
investments, combined with anticipated cash flow from operations , will
nevertheless be sufficient to meet its cash requirements through the end of
fiscal 1999. However, if the Company is successful in the execution of its more
aggressive and broad production strategies, it will be required to make
additions to personnel and augment its development and production capabilities
in the areas of animated programming, computer generated animated programming,
live action television series, feature films and direct-to-video films. In such
a case, the Company may need to secure additional equity or debt financing prior
to the end of fiscal 1999 in order to fulfill its growth strategies. Recent
operating losses, the Company's declining cash balances, trends in the
entertainment industry adversely affecting independent production companies
similar to the Company, and the Company's historical stock performance may make
it difficult for the Company to attract equity investments on terms that are
deemed to be favorable to the Company. In addition, the losses in fiscal 1997
and fiscal 1998 make it more difficult for the Company to attract significant
debt financing. As a consequence, there can be no assurance that the Company
will be successful in arranging for additional equity or debt financing at
levels sufficient to meet its planned needs. The failure to obtain such
financing could have an adverse affect on the implementation of the Company's
growth strategies.
For the year ended December 31, 1996, net cash used in operating activities
was $8.1 million due to use of cash in connection with film production
activities offset by an increase in deferred revenue and fluctuations in other
operating assets and liabilities. For the year ended December 31, 1996, net cash
used for investing activities was $0.6 million due to additions to property and
equipment. Net cash provided by financing activities for the year ended December
31, 1996, was $17.2 million due primarily from the receipt of proceeds from the
offering.
For the year ended December 31, 1997, net cash provided by operating
activities was $2.5 million due to non cash amortization of film cost being
greater than cash spent on film cost additions and cash generated in connection
with a decrease in accounts receivable, offset by fluctuations in other
operating assets and liabilities. For the year ended December 31, 1997, net cash
used for investing activities was $0.3 million due to additions to property and
equipment. The Company had minimal financing activities during 1997.
For the year ended December 31, 1998, net cash used in operating activities
was $3.9 million primarily due to cash used in connection with film production
activities and a decrease in accounts payable offset by an increase in deferred
revenue and an increase in accrued expenses. For the year ended December 31,
1998, net cash used for investing activities was $0.8 million due to additions
to property and equipment. The Company had minimal financing activities during
1998.
20
The Company recognizes revenues in accordance with the provisions of
Financial Accounting Standards Board Statement No. 53 ("FAS 53"). Cash collected
in advance of revenue recognition is recorded as deferred revenue. As of
December 31, 1998, the Company had a balance in its deferred revenue account of
$19.7 million. The net cost to the Company (future receipts less future
expenditures) to finish the programs for which cash has been collected in
advance and included in deferred revenue is approximately $1.9 million.
Management believes that the Company's cash and cash equivalents and
anticipated cash flow from operations will be sufficient to fund the Company's
operating requirements for at least the next year.
IMPACT OF YEAR 2000
GENERAL OVERVIEW:
The Company's Year 2000 Project is currently proceeding on schedule. The
Company began its assessment in the Spring of 1998 in response to a need to
address the issue of older computer programs and embedded computer chips'
inability to distinguish between the year 1900 and the year 2000. Critical
programs with the Company were written to use two digits rather than four digits
to define the applicable year. As a result, those programs have time-sensitive
software that recognizes a date using 00 as the year 1900 rather than the year
2000. This programming method could cause a system failure or miscalculation
which could cause the disruption of operations, including, among other things, a
temporary inability to process transactions, send invoices or engage in similar
normal business activities.
The current assessment project schedule is to be Year 2000 compliant by
mid-1999 in all areas within the Company. Areas deemed critical with potential
to affect the Company's ability to do business (i.e. Computer Server Room,
Finance, Human Resources, Legal) are Year 2000 compliant at this time.
PROJECT:
The Company's Year 2000 Project is divided into three sections --
Applications Software, Communications systems (telephones, voicemail, etc.) and
Infrastructure.
The methodology used to assess these three primary sections includes: a)
prioritizing by critical area; b) inventorying for potential Year 2000 problems
(i.e. computer workstations, servers, software); c) repairing/recoding program
code (where applicable) and/or replacing hardware/software as necessary; d)
testing material items; and e) designing and implementing contingency and
business continuation plans for the Company.
As of March 1, 1999, the priority assessment has been completed as it
relates to the Company's computer systems. Year 2000 issues as they relate to
the physical premises (building power, incoming phone service, etc.) are outside
the Company's control and correspondence inquiring as to Year 2000 compliance
has been delivered to the principals of the building's property management,
phone system suppliers, alarm system suppliers and communications service
providers (i.e. MCI, Pacific Bell). The results thus far indicate that the
Company's internal alarm systems and communications systems are Year 2000
compliant. The concern now is whether or not incoming services are Year 2000
compliant. Because it is not possible to gauge the readiness of third-party
vendors, the Company is in the process of drafting a contingency plan in the
event that the Company's third-party vendors do not complete their Year 2000
implementations in time. This contingency plan is scheduled to be drafted and
implemented by mid-1999.
Inventorying of potential Year 2000 systems is approximately 80% complete
overall within the Company and 100% complete in areas deemed critical. The
Company is currently investigating Year 2000 inventorying systems that will
guarantee that all inventorying of non-critical areas will be completed by March
1999.
As of March 1, 1999, the main accounting system in use by the Company, Show
Auditor, has been recoded to comply with Year 2000 issues and has been tested as
compliant. Software changes have also been implemented within the Company's
network servers, Human Resources division, International Division and Legal
divisions to meet Year 2000 compliance. Compliance is also about 80% completed
at the desktop application level (word processing,
21
spreadsheets and operating systems) at each of the Company's computer
workstations. This has been accomplished by either installing the latest
software patches, upgrading software or replacing software as necessary. The
Company's communications systems are Year 2000 compliant as mentioned above;
therefore, recoding or replacing is not necessary at this time. The Company has
instituted a policy of buying only Year 2000 compliant computer systems and
applications to assure that all new machines are Year 2000 compliant. Further,
the Company acquired hardware technology from Micro2000, Inc. to insert into
older computer systems to make them Year 2000 compliant at the hardware level.
As of March 1, 1999, the Centurion Y2K hardware card has been tested and
implemented. All Infrastructure activities are expected to be completed by
mid-1999.
The Company expects to begin final testing on all internal Applications
Software and hardware systems by March 31, 1999. The purpose of this phase is to
assure that all Year 2000 compliance changes are in fact working as expected.
This phase will also involve the installation of any last minute software
patches as provided by software developers/manufacturers. Testing of
Communications systems and Infrastructure systems will also occur at this time.
The Company is involved in prioritizing non-computer-related systems to
assess their potential impact to the Company's operations. These systems would
include operations such as delivery services, materials suppliers, etc. A
contingency plan to address any of these systems which prove to be critical to
the Company's operations will be drafted by the Company and implemented by
mid-1999.
COSTS:
The total cost of the required modifications necessary to become Year 2000
compliant is not expected to be material to the Company's financial position and
is estimated at approximately $100,000. This does not include the Company's
potential share of Year 2000 costs that may be incurred by the Company by way of
partnerships and joint ventures in which the Company participates but is not the
controlling entity. Accordingly, the foreseeable costs arising from such
third-party relationships cannot be determined at this time. The total amount
expended on the Year 2000 Project through March 1, 1999 was $25,000 which was
related to the cost to repair or replace software and related hardware problems.
RISKS:
The failure to correct material Year 2000 problems could result in an
interruption in, or a failure of, certain normal business operations. These
failures could potentially materially affect the Company's results of operations
and financial condition; however, due to the general uncertainty which is
inherent in potential Year 2000 problems, resulting in part from the uncertainty
of the Year 2000 readiness of third-party suppliers, customers or partners, the
Company is unable to determine, at this time, whether the consequences of Year
2000 failures will have a material impact on the Company's results of operations
or financial condition.
The Year 2000 assessment project is the Company's response to this potential
problem and is expected to significantly reduce the Company's level of
uncertainty about the Year 2000 problem and the compliance and readiness of its
material third-party vendors. The Company believes that with the implementation
of new systems and completion of the Year 2000 project as scheduled, the
possibility of significant interruptions affecting the Company's operations
should be reduced.
Readers are cautioned that forward-looking statements contained in this Year
2000 disclosure should be read in conjunction with the Company's disclosures
under the heading, "Risk Factors". Readers should understand that the dates on
which the Company believes the Year 2000 project will be completed are based
upon Management's best estimates, which were derived utilizing numerous
assumptions of future events, including the availability of certain resources,
third-party modification plans and other factors. However, there can be no
guarantee that these estimates will be achieved, or that there will not be a
delay in, or increased costs associated with, the implementation of the
Company's Year 2000 compliance project. A delay in specific factors that might
cause differences between the estimates and actual results include, but are not
limited to, the availability and cost of personnel trained in these areas, the
ability to correct all relevant computer code, timely responses to and
corrections by third-parties and suppliers, the ability to implement interfaces
between the new systems and the systems not being replaced, and similar
uncertainties. Due to the general
22
uncertainty inherent in the Year 2000 problem, resulting in part from the
uncertainty of Year 2000 readiness of third-parties and the inter-connection of
national and international businesses, the Company cannot ensure that its
ability to timely and cost effectively resolve problems associated with the Year
2000 issue may not affect its operations and business, or expose it to
third-party liability.
RISKS FACTORS
DEPENDENCE ON A LIMITED NUMBER OF TELEVISION PROGRAMS.
Our revenue has historically come from the production of a relatively small
number of animated television programs. THE SIMPSONS, KING OF THE HILL, and THE
MR. POTATO HEAD SHOW accounted for approximately 40%, 41% and 6%, respectively,
of our total revenue for the year ended December 31, 1998. As audiences' tastes
change frequently, we cannot assure you that broadcasters will continue to
broadcast our "proprietary" or "fee-for-services" programs or that we will
continue to be engaged to produce. We currently enjoy limited profit
participation and/or limited licensing and merchandising participation in KING
OF THE HILL, FAMILY GUY, and THE DOWNTOWNERS. However, we cannot assure you
that:
o those shows will remain on the air,
o we will continue to produce them, or
o they will be sufficiently successful to generate participation to us
While we continually endeavor to develop new programming, there can be no
assurance that revenue from existing or future programming will replace a
possible loss of revenue associated with the cancellation of any particular
program.
IMPACT OF FCC REGULATIONS REQUIRING EDUCATIONAL CONTENT PROGRAMMING
Certain FCC rules may adversely affect the number of time slots available
for our productions. These regulations strongly encourage broadcasters (through
license renewal procedures) to (1) offer at least three hours per week of
programming specifically designed to serve the educational and information needs
of children ages 16 and under, (2) identify each program as educational, (3)
schedule this programming weekly, and (4) offer this programming in 30-minute
formats. While the full impact of the regulations on aggregate demand for
children's programming remains uncertain, we have experienced some significant
impact. CBS, one of our primary customers over the years, elected to change its
programming slate to conform to the FCC regulations. In its first year
implementing this strategy, CBS did not order any new animated programming from
us. In its second year of implementation, CBS reduced its license fees. In
addition, it is possible that programming qualifying for the new FCC
requirements will have a competitive advantage over non-qualifying programs.
This could further diminish the number of time slots available for our existing
programs, thus intensifying the strong competition for the remaining time slots.
RISKS OF VERTICAL INTEGRATION
Over the last decade, broadcasters, distributors and producers of televison
and motion picture programming have become increasingly integrated vertically
through mergers, acquisitions, partnerships, joint ventures or other
affiliations. We have not entered into any of these relationships. These
relationships, coupled with the recent repeal of certain regulations of the FCC
which had limited the ability of network broadcasters to control certain rights
in television programming, has resulted in broadcasters working with their
affiliated producers of animated programming. This result limits the number of
time slots available for other producers. We cannot assure you that the number
of time slots currently available for children's and/or animated programming
and, specifically, for animated programming supplied by independent animation
studios, will not decrease, or that we will compete successfully for available
time slots.
DECLINING VALUE OF LICENSE FEE AGREEMENTS AND INCREASING CONTROL OF
PROPRIETARY RIGHTS BY BROADCASTERS
Competition created by the emergence of new broadcasters (such as UPN, WB,
Nickelodeon and the USA Network) has provided television audiences with more
choices, thereby generally reducing the number of viewers watching any one
program. As a result, the market share of, and license fees paid by, FOX, CBS
and ABC have decreased. There
23
continues to be intense competition for the time slots offered by the networks,
especially FOX, CBS and ABC. This trend continues to depress license fees to a
level that may make it difficult for us to finance certain proprietary programs.
Moreover, broadcasters are demanding a greater percentage of the revenue
generated from the exploitation of proprietary rights associated with the
programs which they license. Broadcasters may also seek to control and exploit
all of the proprietary rights associated with the programs which they license.
We believe that these industry-wide trends may have a significant adverse impact
on our business, results of operations and financial condition.
IT IS POSSIBLE THAT OUR CURRENT PROGRAMS MAY NOT SUSTAIN THEIR POPULARITY
AND OUR NEW PROGRAMS MAY NOT BECOME POPULAR
We derive substantially all of our revenue from the production and
distribution of animated television programs. Each production is an individual
artistic work, and consumer reaction will determine its commercial success. We
cannot assure you that we will be able to continue to create entertaining
episodes for our existing programs or that we will be able to create new
programs that are appealing to broadcasters. When advertisers decide whether to
pay for advertising during a program's broadcast, they look closely at Neilsen
ratings. Broadcasters also consider Neilsen ratings when deciding whether to
renew a series or license a new series. Producers of syndicated programming,
like us, often receive payments from syndicators based on a share of the revenue
received from advertisers who advertise during a specific program. We try to
develop and produce programming that will perform well in the Nielsen ratings
system. Nielsen ratings for our programming depend on many factors beyond our
control, including:
o audience reaction,
o competing programming,
o availability of alternative forms of entertainment,
o time slots when aired and
o critical reviews
We cannot assure you that our programs will obtain favorable Nielsen ratings
or that broadcasters will license the rights to broadcast any of our programs in
development or will renew licenses to broadcast programs which we currently
produce. Even if a broadcaster renews the license to broadcast our programming,
we cannot guarantee that our program will remain popular. If our programming
becomes less popular, we will most likely derive less revenue which could impact
our financial condition.
OUR REVENUES RESULT FROM SALES TO A LIMITED NUMBER OF MAJOR CUSTOMERS.
During the year ended December 31, 1998, we derived approximately 80% and 5%
of our net sales from our top two customers, Twentieth Television (a Division of
Twentieth Century Fox) and Fox Kids Network. Neither of these customers is
contractually obligated to continue to do business with us. In order to be
successful, we must continue our relationships with these customers; we must
continue to develop relationships with new customers; and our existing programs
must continue to be broadcast. In the event our relationship with either of our
top customers terminates, we could experience an adverse impact on our business.
RISKS RELATED TO EXPANSION OF PRODUCTION OF PROPRIETARY PROGRAMMING
We produce substantially all of our programming on a "fee-for-services"
basis. As a result, we do not typically own or control licensing or distribution
rights, but may have profit participation rights based on a percentage of
adjusted gross profits or net profits earned by the owners of these distribution
rights. The fees we receive for these production services typically cover all
direct production costs plus a margin. We intend to expand our production of
programming for which we own or control licensing and/or distribution rights
("proprietary programming"). These rights may include domestic and international
broadcast distribution, home video distribution, licensing and merchandising,
feature film and interactive/game development ("proprietary rights"). While we
seek to limit the financial risk associated with our proprietary programming by
obtaining commitments prior to production to cover at least 50% of our direct
production costs, we cannot be sure that we will be able to recover the balance
of our production and overhead costs through the exploitation of our remaining
rights. We derived $4.9 million, and $3.3 million, in revenues from proprietary
24
programming for the years ended December 31, 1997 and 1998, respectively. Since
we only recently have begun to retain the proprietary rights associated with our
animated programs, we have a limited history of operations and experience
related to the exploitation of these rights.
RISK OF BUDGET AND COST OVERRUNS
We review cost reports and update our cost projections regularly. Although
we have generally completed each of our productions within its budget, we cannot
assure you that the actual production costs for our programming will remain
within budget. Risks such as production delays, higher talent costs, increased
subcontractor costs, political instability overseas, and other unanticipated
events may substantially increase production costs and delay completion of the
production of any one or more of our programs.
RISKS RELATED TO OVERESTIMATION OF REVENUE OR UNDERESTIMATION OF COSTS
We follow Financial Accounting Standards Board Statement No. 53, "Individual
Film Forecast" ("FASB 53"), regarding revenue recognition and amortization of
production costs. All costs incurred in connection with an individual program or
film, including acquisition, development, production and allocable production
overhead costs and interest, are capitalized as television and film costs. These
costs are stated at the lower of unamortized cost or estimated net realizable
value. We amortize our estimated total production costs for an individual
program or film in the proportion that revenue realized relates to management's
estimate of the total revenue expected to be received from such program or film.
As a result, if revenue or cost estimates change with respect to a program or
film, we may be required to write-down all or a portion of our unamortized costs
for the program or film. We cannot assure you that these write-downs will not
have a significant impact on our results of operations and financial condition.
SEASONALITY
Our results of operations depend on our production and delivery schedule of
television programs. Broadcasters typically make most of their annual
programming commitments in the first and second quarters of any calendar year so
that new programs will be ready for delivery in the third quarter and, to a
greater extent, the fourth quarter of that year. Producers typically recognize
revenues from license and production agreements when the producer delivers the
finished product to the customer and the customer accepts it. As a result of the
production cycle, we do not recognize revenue evenly throughout the year. We
typically recognize a significant portion of our revenue in the fourth quarter.
Our results of operations fluctuate materially from quarter to quarter and year
to year. The results of any one period do not necessarily indicate results for
future periods. Cash flows also fluctuate and do not necessarily correlate with
revenue recognition
COMPETITION
PROGRAMMING. The creation, development, production and distribution of
television programming, together with the exploitation of the proprietary rights
related to such programming, is a highly competitive business. We compete with
producers, distributors, licensors and merchandisers, many of whom are larger
and have greater financial resources than we do. Although the number of outlets
available to producers of animated programming has increased with the emergence
of new broadcasters, the number of time slots available to independent producers
of children's and animated programming remains limited. Moreover, because
license fees in the United States have dropped substantially recently, companies
that do not rely on U.S. broadcast license fees to finance the production of
animation programming, particularly international animation companies which
receive governmental subsidies, have achieved a competitive advantage. These
companies now serve as an additional source of competition for the limited slots
available to independent animation companies. We also believe that we face
competition from a variety of companies in three principal areas: (1) for the
time slots for animated programming offered by broadcasters, (2) for the
acquisition of characters, story lines, plots and ideas and (3) for the right to
license and distribute our products throughout the United States and
internationally.
25
CREATIVE PROPERTIES AND CREATIVE PERSONNEL. We compete with other
animation companies for characters, storylines, plots and ideas created by third
parties. Third parties select us based on their perception of whether we are
best able to create and develop a successful program from the initial idea or
character. We also compete with other animation companies (including the film
and television animation operations of major studios) for the animators,
writers, producers and other creative personnel needed to successfully develop
and produce animated programming. We believe that we compete for creative
properties and creative personnel with a variety of companies including The Walt
Disney Company, Warner Bros., Hanna-Barbera, DIC, Klasky-Csupo, Marvel
Entertainment, Saban Entertainment, Cinar Films, DreamWorks SKG, Nelvana,
Universal Cartoon Studios, Sony Cartoon Studios and Hyperion Productions, many
of which have greater financial resources to obtain creative properties and
creative personnel.
LICENSING AND MERCHANDISING. In the first quarter of 1998, we decided
to reduce our fixed overhead by outsourcing our licensing and merchandising
activities. However, we expect that the exploitation of our licensing and
merchandising rights will remain an important part of our strategy. We compete
with other owners of creative content who seek to license their characters and
properties to a limited number of distributors. In connection with our recent
initiatives to exploit the proprietary rights associated with our programming,
we have entered into several licensing and merchandising agreements. However,
for the year ended December 31, 1998, we derived no significant revenue from our
licensing and merchandising activities and we cannot assure you that we will
derive significant revenue in the future.
RISKS RELATED TO INTERNATIONAL OPERATIONS
RISKS OF INTERNATIONAL BUSINESS GENERALLY. Part of our strategy
involves our current and planned activities in a number of developing nations.
There are many risks inherent in our international business activities. Our
projects could be adversely affected by:
o reversals or delays in the opening of foreign markets to new
competitors,
o unexpected changes in regulatory requirements,
o export controls, tariffs and other barriers,
o currency fluctuations,
o investment policies,
o nationalization, expropriation and limitations on repatriation of cash,
and
o social and political risks
OVERSEAS SUBCONTRACTORS. Like other producers of animated programming, we
subcontract some of the less creative and more labor-intensive components of our
production process to animation studios located in low-cost labor countries,
primarily in the Far East. As the number of animated feature films and animated
television programs increases, the demand for the services of overseas studios
has increased substantially. This increased demand may lead overseas studios to
raise their fees which may result in increased animated programming production
costs or our inability to contract with our preferred overseas studios.
Many of the subcontractors we use are located in South Korea and, to a
lesser extent, Taiwan, the Philippines and China. Each of these areas has
recently experienced significant political and/or economic turmoil, such as, but
not limited to, devaluation of the won and other Asian currencies. The Asian
markets may continue to deteriorate, which could have a substantial impact on
our ability to contract favorably with studios in Asia. These conditions could
cause significant disruptions in the delivery of animation products to us. In
that event, we may be required to retain new subcontractors. We cannot assure
you that different subcontracting arrangements will be as favorable to us as our
current arrangements.
INTERNATIONAL SALES-MARKET FRACTIONALIZATION. We derived approximately
8% and 4% of our revenue for the years ended December 31, 1997 and 1998,
respectively, from licensing international distribution rights to our
proprietary programming. We anticipate that revenue from these activities will
not grow substantially until we produce additional proprietary programming for
which we own and control international distribution rights. Just as in the US,
there are an increasing number of broadcast outlets for animation in most major
international territories. While this has created more opportunities to sell
product, on the one hand, the total advertising dollars available is now being
spread amongst this larger number of outlets, so the revenues each broadcaster
receives and, consequently, the amount of the
26
license fees they can pay, has begun to diminish substantially. Our ability to
continue to expand our international business (as well as our ability to
contract upon favorable terms with overseas studios) depends, in part, on the
local economic conditions, currency fluctuations, local changes in regulatory
requirements, compliance with a variety of foreign laws and regulations, and
cultural barriers. In addition, political instability in a foreign nation may
adversely affect our ability to distribute our product in that country. As a
result, we cannot assure you that our international operations will be
profitable. See "Business -- Principal Elements of the Company's
Business -- Distribution of Proprietary Programming -- International
Distribution."
RISKS ASSOCIATED WITH POSSIBLE NEW BUSINESSES
Due in part to the recent changes in the television industry described in
this Report, we have made, and intend to continue to make a substantial
commitment to new business areas beyond our core business of animation
television production. We have begun live action television production, feature
film development with the expectation of production (both live action and
animation) and direct-to-video production (both live action and animation). Some
of this production may be on a "fee-for-services" or a "proprietary" basis. The
television, feature film and direct-to-video industries are highly speculative
and involve a substantial degree of risk. The success of an individual
television program, feature film or direct-to-video release depends upon
unpredictable and changing factors, such as personal tastes of the public and
critics. In addition, we are evaluating entering the Internet distribution
market through the Level 13 branded animation destination. This is a new
business for us that may require that we use significant resources in an effort
that may not be successful. Therefore, there is a substantial risk that our
projects will not be successful, resulting in costs not being recouped and
anticipated profits not being realized. Although we intend to limit the risks of
production through co-production, pre-sale financing and/or distribution
arrangements, we will likely be unable to limit all of the financial risk of a
television production, feature film or direct-to-video release. In addition,
because the success of a television production, feature film or direct-to-video
release, and Internet distribution depends upon consumer taste and critical
response, as well as public awareness and the successful distribution of a
production, we cannot predict the level of marketing, promotional and
distribution activities and expenses necessary in any particular instance.
Moreover, we have no history of developing, producing, or distributing live
action television or film productions, or with exhibition over the Internet and
we cannot assure you that we can compete successfully with more established
persons or entities. Live action production involves many of the risks
associated with animation production that are described in this Report, as well
as additional risks inherent to live action that are outside of our control,
including the risk of work stoppage or strike, increased union activity, delay
in production due to weather and other local conditions, inability to obtain
proper permitting to film at a desired site, at desired times and/or under
desired terms, and accidents or injury to actors and film crew. We cannot be
sure that we will produce any live action television or film projects or that,
if produced, that such projects will be profitable. The World Wide Web is an
evolving marketplace, and we cannot predict consumer taste or the underlying
technology. Likewise, we cannot assure you that we will be successful should we
decide to promote Level 13 as an independent animation destination/network.
TECHNOLOGICAL CHANGES; POSSIBLE CHANGES IN PRODUCTION OF OUR PRODUCTS
The proliferation of new production technologies may change the manner in
which we create and distribute programming. Recently, certain animators have
begun to use computer-generated animation, including three-dimensional digital
animation, instead of two-dimensional cel animation, to create their animated
programming. We cannot be sure that the introduction and proliferation of
three-dimensional digital animation or other technological changes will not
cause our historical methods of producing animation to become less cost
competitive or less appealing to our audiences. In addition, we cannot be sure
that we will be able to adapt to such changes in a cost-effective manner.
DEPENDENCE UPON KEY PERSONNEL
Our success depends to a significant extent upon the expertise and services
of David Pritchard, our President and Chief Executive Officer. The loss of the
services of Mr. Pritchard and/or other key management personnel could have an
adverse effect on our business, results of operations and financial condition.
We have employment agreements with Mr. Pritchard and certain of our other key
management personnel. We do not currently carry "key man" life insurance
policies on any of our executives. We cannot be sure that we will be able to
retain our existing management personnel.
27
In addition, our continued success is highly dependent on the artistic and
production capabilities of our creative staff. We are a signatory to the Screen
Actors Guild collective bargaining agreement and certain of our voice-over
actors are Screen Actors Guild members. We also have a wholly owned subsidiary,
Namor Productions Inc., which is a signatory to the Writer's Guild of America
collective bargaining agreement. We believe that our future success will depend,
in part, on our continuing ability to attract, retain and motivate qualified
personnel in both our existing and new businesses.
CASUALTY RISKS
Substantially all of our operations and personnel are located in our North
Hollywood headquarters, resulting in vulnerability to fire, flood, power loss,
telecommunications failure or other local conditions, including the risk of
seismic activity. If a disaster were to occur, our disaster recovery plans may
not be adequate to protect the Company and our business interruption insurance
may not fully compensate us for our losses.
POSSIBLE ADVERSE EFFECT OF ANTI-TAKEOVER PROVISIONS
Certain provisions of our certificate of incorporation, by-laws and Delaware
law (including a stockholders rights plan (sometimes referred to as a "poison
pill") which we adopted in 1998) could be used by our incumbent management to
make it substantially more difficult for a third party to acquire control of the
Company. These provisions could discourage potential takeover attempts and could
adversely affect the market price of our common stock.
In addition, our corporate documents authorize the Board of Directors to
issue shares of preferred stock and to establish the rights of that preferred
stock without stockholder approval. If the Board issues preferred stock, it
could have the effect of delaying or preventing a change in control of our
company, even if a change in control were in our best interests.
VOLATILITY OF STOCK PRICE
The market price of our common stock, which trades on the Nasdaq National
Market, could fluctuate significantly in response to our operating results and
other factors. In addition, the stock market in recent years has experienced
significant price and volume fluctuations that often have been unrelated or
disproportionate to the operating performance of particular companies. These
fluctuations, as well as a shortfall in sales or earnings compared to public
market analysts' expectations, changes in analysts' recommendations or
projections, additions or departures of key personnel, announcements by us or
our competitors of significant acquisitions, strategic partnerships, joint
ventures or capital commitments, and general economic and market conditions, may
adversely affect the market price of our common stock.
WE DO NOT INTEND TO PAY DIVIDENDS
We have never paid dividends and currently do not intend to declare or pay
dividends. We plan to follow a policy of retaining earnings to finance the
growth of our business. Whether or not we declare or pay dividends is up to our
Board of Directors and will depend on our results of operations, financial
condition, contractual and legal restrictions and other factors our Board deems
relevant at that time.
YEAR 2000 ISSUE RISKS MAY RESULT IN A MATERIAL ADVERSE EFFECT ON OUR BUSINESS
We are aware of the issues associated with the programming code in existing
computer systems as the year 2000 approaches. The year 2000 problem is pervasive
and complex. Virtually every computer operation will be affected in some way by
the rollover of the two digit year value to "00". The issue is whether computer
systems will properly recognize date-sensitive information when the year changes
to 2000. Systems that do not properly recognize such information could generate
erroneous data or cause a system to fail. We are reviewing both our information
technology and our non-information technology systems to determine whether they
are year 2000 compliant, and to date we have not identified any material systems
which are not year 2000 compliant. We have not made any material expenditures to
address the year 2000 problem and do not anticipate that we will be required to
make any such material expenditure in the future.
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We have contacted all of our significant suppliers and service providers to
determine the extent to which we are vulnerable to their failure to address the
year 2000 problem. Although we have received verbal assurances from some of
these third parties that their systems are year 2000 compliant, we have not yet
received written assurances from all of them. Although we do not believe our
operations will be significantly disrupted even if third parties with whom we
have relationships are not year 2000 compliant, we cannot guarantee you that any
year 2000 compliance problems of these third parties will not negatively affect
our financial performance. Because uncertainty exists concerning th