UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

FORM 10-Q

 

(Mark one)

For the quarterly period ended March 31, 2017.

For the transition period from ________ to ________.

Commission File Number 001-35675

 

RLJ ENTERTAINMENT, INC.

(Exact name of registrant as specified in its charter)

 

 

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    YES ☒    NO ☐

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

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.   ☐

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

Number of shares outstanding of the issuer’s common stock on May 4, 2017:  5,535,185

 

 

---

RLJ ENTERTAINMENT, INC.

INDEX TO FORM 10-Q

 

 

 

 

2

---

FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 2017, includes forward-looking statements that involve risks and uncertainties within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Other than statements of historical fact, all statements made in this Quarterly Report are forward-looking, including, but not limited to, statements regarding industry prospects, future results of operations or financial position, and statements of our intent, belief and current expectations about our strategic direction, prospective and future results and condition. In some cases, forward-looking statements may be identified by words such as “will,” “should,” “could,” “may,” “might,” “expect,” “plan,” “possible,” “potential,” “predict,” “anticipate,” “believe,” “estimate,” “continue,” “future,” “intend,” “project” or similar words.

Forward-looking statements involve risks and uncertainties that are inherently difficult to predict, which could cause actual outcomes and results to differ materially from our expectations, forecasts and assumptions. Factors that might cause such differences include, but are not limited to:

All forward-looking statements should be evaluated with the understanding of inherent uncertainty. The inclusion of such forward-looking statements should not be regarded as a representation that contemplated future events, plans or expectations will be achieved. Unless otherwise required by law, we undertake no obligation to release publicly any updates or revisions to any such forward-looking statements that may reflect events or circumstances occurring after the date of this Quarterly Report. Important factors that could cause or contribute to such material differences include those discussed in Part I, Item 1A. “Risk Factors” in our Annual Report on Form 10-K filed on March 23, 2017. You are cautioned not to place undue reliance on such forward-looking statements.

 

 

 

3

---

PART I - FINANCIAL INFORMATION

RLJ ENTERTAINMENT, INC.

CONSOLIDATED BALANCE SHEETS

March 31, 2017 (unaudited) and December 31, 2016

 

 

See accompanying notes to consolidated financial statements.

 

 

4

---

RLJ ENTERTAINMENT, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

Three Months Ended March 31, 2017 and 2016

 

 

See accompanying notes to consolidated financial statements.

 

 

5

---

RLJ ENTERTAINMENT, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(Unaudited)

Three Months Ended March 31, 2017 and 2016

 

 

See accompanying notes to consolidated financial statements.

 

 

6

---

RLJ ENTERTAINMENT, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(Unaudited)

Three months ended March 31, 2017

 

 

See accompanying notes to consolidated financial statements.

 

 

7

---

RLJ ENTERTAINMENT, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

Three Months Ended March 31, 2017 and 2016

 

 

See accompanying notes to consolidated financial statements.

 

 

8

---

RLJ Entertainment, Inc.

 

Notes To Consolidated Financial Statements

(Unaudited)

 

NOTE 1. DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION

Description of Business

RLJ Entertainment, Inc. (RLJE or the Company) is a premium digital channel company serving distinct audiences through its proprietary subscription-based digital channels (or Digital Channels), Acorn TV and UMC or Urban Movie Channel, and a direct presence in North America, the United Kingdom (or U.K.) and Australia with strategic sublicense and distribution relationships covering Europe, Asia and Latin America. RLJE was incorporated in Nevada in April 2012. On October 3, 2012, we completed the business combination of RLJE, Image Entertainment, Inc. (or Image) and Acorn Media Group, Inc. (or Acorn Media), which is referred to herein as the “Business Combination.” Acorn Media includes its U.K. subsidiaries RLJ Entertainment Ltd (or RLJE Ltd.), Acorn Media Enterprises Limited (or AME), and RLJE International Ltd (collectively, RLJE UK), as well as RLJ Entertainment Australia Pty Ltd (or RLJE Australia).  In February 2012, Acorn Media acquired a 64% ownership of Agatha Christie Limited (or ACL).  References to Image include its wholly-owned subsidiary Image/Madacy Home Entertainment, LLC.  “We,” “our” or “us” refers to RLJE and its subsidiaries unless otherwise noted.  Our principal executive offices are located in Silver Spring, Maryland, with an additional location in Woodland Hills, California. We also have international offices in London, England and Sydney, Australia.

We acquire content rights in various categories including, British mysteries and dramas, urban programming and full-length independent motion pictures.  We acquire this content in two ways:  

We market our products through a multi-channel strategy encompassing (1) direct relations with consumers via proprietary subscription-based video on demand (or SVOD) digital channels (our Digital Channels segment); (2) the licensing of original drama and mystery content managed and developed through our wholly-owned subsidiary, AME, and our majority-owned equity method investee, ACL, (our Intellectual Property, or IP, Licensing segment); and (3) exploitation through partners covering broadcast/cable, digital, mobile, ecommerce and brick and mortar outlets (our Wholesale Distribution segment).  

Our Digital Channels segment includes the sale of video content directly to consumers through our digital channels, such as Acorn TV and Urban Movie Channel (or UMC).

On June 24, 2016, we entered into a licensing agreement with Universal Screen Arts (or USA) whereby USA took over our Acorn U.S. catalog/ecommerce business becoming the official, exclusive, direct-to-consumer seller of Acorn product in the U.S. During 2016, we also ceased electronic email distribution of our Acacia catalogs. As a result of these actions, we have classified the U.S. catalog/ecommerce business as discontinued operations.

The IP Licensing segment includes intellectual property rights that we own or create and then sublicense for exploitation worldwide. Our Wholesale Distribution segment consists of the acquisition, content enhancement and worldwide exploitation of exclusive content in various formats, including broadcast (which includes cable and satellite), DVD, Blu-ray, digital, video-on-demand (or VOD), SVOD, downloading and sublicensing. The Wholesale Distribution segment exploits content through third-party vendors, which we also refer to as wholesale partners.

Our wholesale partners are broadcasters, digital outlets and major retailers in the United States of America (or U.S.), Canada, U.K. and Australia, including, among others, Amazon, Barnes & Noble, Costco, DirecTV, Hulu, iTunes, Netflix, PBS, Showtime, Starz, Target and Walmart.

RLJE’s management evaluates business performance based on these three distinctive reporting segments: (1) Digital Channels, (2) IP Licensing and (3) Wholesale Distribution. Operations and net assets that are not associated with any of these stated segments are reported as “Corporate” when disclosing and discussing segment information.  

9

---

RLJ Entertainment, Inc.

 

Notes To Consolidated Financial Statements

(Unaudited)

 

Basis of Presentation

Unaudited Interim Financial Statements

The consolidated financial information presented in the accompanying unaudited interim consolidated financial statements as of March 31, 2017 and for the three months ended March 31, 2017 and 2016 has been prepared in accordance with accounting principles generally accepted in the United States (or U.S. GAAP) and with the Securities and Exchange Commission’s (or SEC) instructions for interim financial reporting instructions for the Form 10-Q and Article 10 of Regulation S‑X of the SEC. Accordingly, they do not include all the information and footnotes required by U.S. GAAP for complete financial statements.

In management’s opinion, all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation have been included. Due to the seasonal nature of our business, with a disproportionate amount of sales occurring in the fourth quarter and other factors, including our content release schedule, interim results are not necessarily indicative of the results that may be expected for the entire fiscal year. The accompanying unaudited financial information should, therefore, be read in conjunction with the consolidated financial statements and the notes thereto in our Annual Report on Form 10-K filed on March 23, 2017 (or 2016 Form 10-K). Note 2, Summary of Significant Accounting Policies, of our audited consolidated financial statements included in our 2016 Form 10-K contains a summary of our significant accounting policies. As of March 31, 2017, we have made no material changes to our significant accounting policies disclosed in our 2016 Form 10-K.

Fair Value of Financial Instruments

The carrying amount of our financial instruments, which principally include cash, trade receivables, accounts payable and accrued expenses, approximates fair value due to the relative short maturity of such instruments.  The carrying amount of our debt under our senior credit agreement approximates its fair value as it bears interest at market rates of interest after taking into consideration the debt discounts.

Principles of Consolidation

The operations of ACL are subject to oversight by ACL’s Board of Directors. The investment in ACL is accounted for using the equity method of accounting given the voting control of the Board of Directors by the minority shareholder. We have included our share of ACL’s operating results as a separate line item in our consolidated financial statements.

Our consolidated financial statements include the accounts of all majority-owned subsidiary companies, except for ACL. We carry our investment in ACL as a separate asset on our consolidated balance sheet at cost adjusted for our share of the equity in undistributed earnings. Except for dividends and changes in ownership interest, we report changes in equity in undistributed earnings of ACL as “Equity earnings of affiliate” in our consolidated statements of operations.  All intercompany transactions and balances have been eliminated.

Earnings (Loss) per Common Share

Basic earnings/loss per share is computed using the weighted-average number of common shares outstanding during the period.  Diluted earnings per share are computed using the combination of dilutive common share equivalents and the weighted-average shares outstanding during the period.  For the periods reporting a net loss, diluted loss per share is equivalent to basic loss per share, as inclusion of common share equivalents would be anti-dilutive.

Liquidity

For the three months ended March 31, 2017 and 2016, we recognized a net loss of $6.1 million and $13.5 million, respectively. We used $3.0 million of cash for operating activities during the three months ended March 31, 2017.  During the three months ended March 31, 2016, we generated $1.4 million of cash from operating activities. At March 31, 2017, our cash balance was $4.0 million. At March 31, 2017, we had $42.2 million of term debt outstanding (see Note 7, Debt). We continue to experience liquidity constraints as we have several competing demands on our available cash and cash that may be generated from operations. We continue to have significant past-due vendor payables. These past-due payables are largely a result of significant past-due vendor payables acquired in 2012 when purchasing Image. As we work to catch up on the acquired past-due payables, we have fallen behind on other payables. We continue to work with our vendors to make payment arrangements that are agreeable with them and that give us flexibility in terms of when payments will be made. Additionally, we must maintain a certain level of expenditures to acquire new content that allows us to generate revenues and margins sufficient to meet our obligations.

10

---

RLJ Entertainment, Inc.

 

Notes To Consolidated Financial Statements

(Unaudited)

 

We continue to realize significant growth in our Digital Channels segment. Our Digital Channels revenues increased 103.7% to $6.0 million during the three months ended March 31, 2017 as compared to the same period in 2016 (see Note 2, Segment Information). After cost of sales and operating expenses, our Digital Channels segment contributed $2.6 million of income from continuing operations during the first quarter of 2017 compared to $1.0 million last year. Our expectation is that our digital channels will continue to grow, however there is no assurance that this will occur.

On October 14, 2016, we refinanced our senior debt (see Note 7, Debt). In January 2017, we amended our senior debt and borrowed an additional $8.0 million. The proceeds received were used to repay our subordinated notes payable. In addition to providing us liquidity, the new senior loan facility helps us address our liquidity constraints going forward in three ways: (1) it bears a substantially lower cash-interest rate that is approximately 800 basis points lower than before, (2) there are no required principal payments until 2019, and (3) the financial covenants have been reset to less restrictive levels that provide us the necessary flexibility to invest in our operations.

In 2016, we also took actions to improve our operating results and Adjusted EBITDA (as defined in Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations, Adjusted EBITDA) by exiting certain non-core operations that have been generating losses. During the first half of 2016, we closed our Acacia catalog operations. Further, on June 24, 2016, we entered into a licensing agreement to outsource the U.S. Acorn catalog/ecommerce business to USA (see our Discontinued Operations disclosure below). During 2016, our U.S. catalog/ecommerce business was fully transitioned to USA and we do not anticipate future losses from this line of business.  

We believe that our current cash at March 31, 2017 will be sufficient to meet our operating liquidity, capital expenditure and debt repayment requirements for at least the next one year from the date of issuance of these financial statements. However, there can be no assurances that we will be successful in realizing improved results from operations including improved Adjusted EBITDA, generating sufficient cash flows from operations or agreeing with vendors on revised payment terms.

Discontinued Operations

During December 2015, we committed to a plan to stop circulating our Acacia catalogs and to liquidate the catalog’s inventory. The last Acacia print catalogs were circulated in January 2016 and electronic email distribution continued through May 2016. On June 24, 2016, we entered into a licensing agreement to outsource our U.S. Acorn catalog and ecommerce business to USA. USA began selling Acorn video content during the third quarter of 2016.

Under the licensing agreement, USA became the official, exclusive, direct-to-consumer seller of U.S. Acorn product through catalogs and ecommerce. As such, USA received the rights to the Acorn catalog and related website for an 18-month period, subject to certain automatic renewals. To facilitate the transfer of the catalog to USA, we granted USA access to the catalog’s customer list and the Acorn brand. Going forward, we will also endeavor to provide USA with an exclusivity period for new Acorn releases. USA is responsible for all costs associated with their efforts. On an annual basis, USA will purchase from us a minimum of $1.2 million of inventory (Acorn video content) at pricing that is consistent with wholesale pricing. We also agreed to a one-time transfer of certain existing inventory to USA at cost. Further, we have been given meaningful consultation rights regarding sales prices of Acorn content listed in the catalog.

In addition to purchasing inventory from us, USA makes royalty payments to us for the various rights we have licensed. The royalty payments are not expected to be material. Further, all customer and marketing data obtained during the license period shall be jointly owned by both companies. During the three months ended March 31, 2017, our Wholesale segment recognized revenues of $0.4 million from its sale of inventory to USA. There were no sales to USA during the three months ended March 31, 2016.

We consider the outsourcing of the U.S. Acorn catalog to be a major strategic shift in our business. Future revenues and gross margins from our outsourced operations will decrease. However, operating profits will increase as we have historically incurred significant selling expenses that will be eliminated. Upon circulating the last Acacia catalog and entering into the licensing agreement with USA during the quarter ended June 30, 2016, we classified the U.S. catalog/ecommerce business (Acacia and U.S. Acorn catalogs) as discontinued operations.

11

---

RLJ Entertainment, Inc.

 

Notes To Consolidated Financial Statements

(Unaudited)

 

Major classes of line items constituting loss from discontinued operations, net of income taxes are:

 

 

There are no income taxes allocable to the discontinued operations as the discontinued operations reside in the U.S. for which there is no tax provision as a result of the overall U.S. operating loss for tax purposes.

Operating and investing cash flows of the discontinued operations are as follows:

 

 

 

12

---

RLJ Entertainment, Inc.

 

Notes To Consolidated Financial Statements

(Unaudited)

 

NOTE 2. SEGMENT INFORMATION

In accordance with the requirements of ASC 280 “Segment Reporting,” selected financial information regarding our reportable business segments, Digital Channels, IP Licensing and Wholesale Distribution, is presented below. Our reportable segments are determined based on the distinct nature of their operation. Each segment is a strategic business unit that is managed separately and either exploits our content over a different business model (subscription based vs. transactional) or acquires content differently. Our Digital Channels segment consists of our proprietary digital streaming channels. Our IP Licensing segment includes intellectual property (or content) owned or created by us, other than certain fitness related content, that is licensed for exploitation worldwide. The IP Licensing segment also includes our investment in ACL. Our Wholesale Distribution segment consists of the acquisition, enhancement and worldwide exploitation through our wholesale partners of exclusive content in various formats, including DVD, Blu-ray, digital, broadcast (including cable and satellite), VOD, streaming video, downloading and sublicensing. Our Wholesale Distribution segment also includes our U.K. mail-order catalog and ecommerce businesses.

Management currently evaluates segment performance based primarily on revenues and operating income (loss), including earnings from ACL. Operating costs and expenses attributable to our Corporate segment include only those expenses incurred by us at the parent corporate level, which are not allocated to our reporting segments and include costs associated with RLJE’s corporate functions such as finance and accounting, human resources, legal and information technology departments. Interest expense, change in the fair value of stock warrants and other derivatives, other income (expense) and provision for income taxes are evaluated by management on a consolidated basis and are not allocated to our reportable segments.

The tables below summarize the segment contribution for the three months ended March 31, 2017 and 2016. Operating costs and expenses exclude costs related to depreciation and amortization, as well as goodwill impairments, which are presented separately. The segment results exclude our discontinued operations. During 2016, we reclassified our U.K. mail-order catalog and ecommerce businesses into our Wholesale Distribution segment. As a result, for the three months ended March 31, 2016, we reclassified revenues of $0.6 million, operating costs and expenses of $0.7 million and depreciation and amortization of $15,000.

 

 

13

---

RLJ Entertainment, Inc.

 

Notes To Consolidated Financial Statements

(Unaudited)

 

 

A reconciliation of total segment contribution loss to loss from continuing operations before provision for income taxes is as follows:

 

 

Total assets for each segment primarily include accounts receivable, inventory and investments in content. The Corporate segment primarily includes assets not fully allocated to any other segment including consolidated cash accounts, certain prepaid assets and fixed assets used across all segments.

Total assets by segment, excluding assets of discontinued operations, are as follows:

 

 

 

NOTE 3. EQUITY EARNINGS OF AFFILIATE

In February 2012, Acorn Media acquired a 64% interest in ACL for total purchase consideration of £13.7 million or approximately $21.9 million excluding direct transaction costs. The acquisition gave Acorn Media a majority ownership of ACL’s extensive works including a variety of short story collections, more than 80 novels, 19 plays and a film library of over 100 made-for-television films.

We account for our investment in ACL using the equity method of accounting because (1) Acorn Media is only entitled to appoint one-half of ACL’s board members and (2) in the event the board is deadlocked, the chairman of the board, who is appointed by the directors elected by the minority shareholders, casts a deciding vote.

As of the Business Combination, our 64% share of the difference between ACL’s fair value and the amount of underlying equity in ACL’s net assets was approximately $18.7 million. This step-up basis difference is primarily attributable to the fair value of ACL’s copyrights, which expire in 2046. We are amortizing the basis difference through 2046 using the straight-line method. Basis difference amortization is recorded against our share of ACL’s net income in our consolidated statements of operations; however this amortization is not included within ACL’s financial statements presented below.

14

---

RLJ Entertainment, Inc.

 

Notes To Consolidated Financial Statements

(Unaudited)

 

The following summarized financial information is derived from the unaudited financial statements of ACL:

 

 

ACL's functional currency is the British Pound Sterling (the Pound). Amounts have been translated from the Pound to U.S. dollar using the average exchange rate for the periods presented.

 

 

NOTE 4. ACCOUNTS RECEIVABLE

Accounts receivable are primarily derived from:  (1) subscription revenues, which are processed by merchant banks or our channel partners such as Amazon, that have not cleared our bank as of period end, (2) video content we license to broadcast, cable/satellite providers and digital subscription platforms like Netflix, and (3) the sale of physical content to retailers and wholesale distributors, who ship to mass retail, and U.K. ecommerce and catalog sales. Our accounts receivable typically trends with retail seasonality.

 

 

Wholesale Distribution receivables are partially billed and collected by our U.S. distribution facilitation partner, Sony Pictures Home Entertainment (or SPHE). Each quarter, SPHE preliminarily settles their portion of our wholesale receivables assuming a timing lag on collections and an average-return rate. When actual returns differ from the amounts previously assumed, adjustments are made that give rise to payables and receivables between us and SPHE. Amounts vary and tend to be seasonal following our sales activity. As of March 31, 2017, SPHE owed us $0.2 million for receivables settled at quarter end. As of December 31, 2016, we owed SPHE $5.6 million for receivables settled as of year‑end. The Wholesale Distribution receivables are reported net of amounts owed to SPHE as these amounts are offset against each other when settling.

As of March 31, 2017, the net Wholesale Distribution payables due to SPHE were $1.6 million, which is included in accounts payable and accrued liabilities. As of December 31, 2016, the net Wholesale Distribution receivables with SPHE were $4.3 million, which is included in accounts receivable.

 

 

NOTE 5. INVENTORIES

Inventories are summarized as follows:

 

 

15

---

RLJ Entertainment, Inc.

 

Notes To Consolidated Financial Statements

(Unaudited)

 

For each reporting period, we review the value of inventories on hand to estimate the recoverability through future sales. Values in excess of anticipated future sales are booked as obsolescence reserve. Our obsolescence reserve was $9.4 million as of March 31, 2017 and $10.0 million as of December 31, 2016. We reduce our inventories with adjustments for lower of cost or market valuation, shrinkage, excess quantities and obsolescence. During the three months ended March 31, 2017 and 2016, we recorded impairment charges of $0.4 million and $0.3 million, respectively. These charges are included in cost of sales as manufacturing and fulfillment cost.

 

 

NOTE 6. INVESTMENTS IN CONTENT

 

 

Investments in content are stated at the lower of unamortized cost or estimated fair value. The valuation of investments in content is reviewed on a title-by-title basis when an event or change in circumstances indicates that the fair value of content is less than its unamortized cost. For the three months ended March 31, 2017 and 2016, impairment charges were $0.3 million and $0.3 million, respectively. These charges are included in cost of sales as part of content amortization and royalties.

In determining the fair value of content for impairments (Note 10, Fair Value Measurements), we employ a discounted cash flows (or DCF) methodology. Key inputs employed in the DCF methodology include estimates of ultimate revenue and costs as well as a discount rate. The discount rate utilized in the DCF analysis is based on a market participant's weighted average cost of capital plus a risk premium representing the risk associated with producing a particular type of content.

 

 

NOTE 7. DEBT

Debt consists of the following:

 

 

16

---

RLJ Entertainment, Inc.

 

Notes To Consolidated Financial Statements

(Unaudited)

 

Future minimum principal payments as of March 31, 2017 are as follows:

 

 

Senior Term Notes

On October 14, 2016, we entered into a $65.0 million Credit and Guaranty Agreement (the AMC Credit Agreement) with Digital Entertainment Holdings LLC, a wholly owned subsidiary of AMC Networks Inc. (or AMC).  Concurrent with entering into the AMC Credit Agreement, we also issued AMC three warrants (the AMC Warrants) to acquire a total of 20.0 million shares of our common stock at $3.00 per share. The entering of the AMC Credit Agreement, the issuance of the AMC Warrants and the associated transactions are referred to as the AMC Transaction.

The proceeds received from the AMC Credit Agreement were used to repay our prior senior secured term notes of $55.1 million, including accrued interest, and transaction expenses of approximately $1.7 million, which includes a prepayment penalty of $0.8 million. Initially, the AMC Credit Agreement consisted of (i) a term loan tranche in the principal amount of $5.0 million (or Tranche A Loan), which was due on October 14, 2017, and (ii) a term loan tranche in the principal amount of $60.0 million (or Tranche B Loan) of which 25% is due after five years, 50% is due after six years and the remaining 25% is due after seven years. The Tranche A Loan bears interest at a rate of 7.0% per annum and the Tranche B Loan bears interest at a rate of 6.0% per annum. Interest is payable quarterly whereby 4.0% is payable in cash and the balance is payable in shares of common stock determined using a per-share value of $3.00 per share. The loan is secured by a lien on substantially all of our consolidated assets.

On January 30, 2017, we amended the AMC Credit Agreement and borrowed an additional $8.0 million, thereby increasing our Tranche A loan from $5.0 million to $13.0 million. We also extended the maturity date for our Tranche A loan from October 14, 2017 to June 30, 2019. The additional $8.0 million borrowed was used to repay prior debt obligations under the subordinated notes payable. When doing so, we did not incur a prepayment penalty. This amendment also changed certain debt covenant ratios to reflect the extended maturity date and the increase of the Tranche A loan balance.

Subject to certain customary exceptions, the AMC Credit Agreement requires mandatory prepayments if we were to receive proceeds from asset sales, insurance, debt issuance or the exercise of the warrants (see Note 9, Stock Warrants). We may also make voluntary prepayments. Prepayments of the Tranche B Loan (either voluntary or mandatory) are subject to a prepayment premium of 3.0% if principal is repaid on or before October 14, 2018, and 1.5% if principal is repaid after October 14, 2018 but on or before October 14, 2019. No prepayment premium is due for amounts prepaid after October 14, 2019, and for mandatory prepayments made from proceeds received from the exercise of warrants.

The AMC Credit Agreement contains certain financial and non-financial covenants. Financial covenants are assessed annually and are based on Consolidated Adjusted EBITDA, as defined in the AMC Credit Agreement. Financial covenants vary by fiscal year and generally become more restrictive over time.

Financial covenants include the following:

 

 

17

---

RLJ Entertainment, Inc.

 

Notes To Consolidated Financial Statements

(Unaudited)

 

The AMC Credit Agreement contains events of default that include, among others, non-payment of principal, interest or fees, violation of covenants, inaccuracy of representations and warranties, bankruptcy and insolvency events, material judgments, cross defaults to certain other contracts (including, for example, business arrangements with our U.S. distribution facilitation partner and other material contracts) and indebtedness and events constituting a change of control or a material adverse effect in any of our results of operations or conditions (financial or otherwise). The occurrence of an event of default would increase the applicable rate of interest and could result in the acceleration of our obligations under the AMC Credit Agreement.

The AMC Credit Agreement imposes restrictions on such items as encumbrances and liens, payments of dividends, other indebtedness, stock repurchases, capital expenditures and entering into new lease obligations.  Additional covenants restrict our ability to make certain investments, such as loans and equity investments, or investments in content that are not in the ordinary course of business.  Pursuant to the AMC Credit Agreement, we must maintain at all times a cash balance of $1.0 million for 2016, $2.0 million in cash for 2017 and $3.5 million in cash for all years thereafter. As of March 31, 2017, we were in compliance with all covenants as stipulated in the AMC Credit Agreement.

Concurrent with entering into the AMC Transaction, we issued the AMC Warrants to acquire shares of our common stock. The first warrant is for 5.0 million shares of common stock and expires on October 14, 2021. The second warrant is for 10.0 million shares of common stock and expires on October 14, 2022. The third warrant is for 5.0 million shares of common stock, subject to adjustment, and expires on October 14, 2023. The AMC Warrants are subject to certain standard anti-dilution provisions, and may be exercised on a non-cash basis at AMC’s discretion.

The third warrant (the AMC Tranche C Warrant) contains a provision that may increase the number of shares acquirable upon exercising, for no additional consideration payable by AMC, such that the number of shares acquirable upon exercise is equal to the sum of (i) at least 50.1% of our then outstanding shares of common stock, determined on a fully diluted basis, less (ii) the sum of 15.0 million shares and the equity interest shares issued in connection with the AMC Credit Agreement. This provision provides AMC the ability to acquire at least 50.1% of our common stock for $60.0 million, provided that all warrants are exercised and AMC elects not to exercise on a non-cash basis. The third warrant with this guarantee provision is being accounted for as a derivative liability.

Subordinated Notes Payable

In October 2012, we issued unsecured subordinated promissory notes in the aggregate principal amount of $14.8 million to the selling preferred stockholders of Image (or Subordinated Note Holders). On May 20, 2015, and in connection with the sale of preferred stock and warrants, the Subordinated Note Holders exchanged approximately $8.5 million of subordinated notes for 8,546 shares of preferred stock and warrants to acquire approximately 855,000 shares of common stock. The notes bore interest at 12.0% per annum, except for a two-year period ending December 31, 2016, whereby the interest rate was adjusted to 1.5% per annum. On January 31, 2017, we repaid the outstanding principal and interest on these subordinated notes in full.

 

 

NOTE 8. REDEEMABLE CONVERTIBLE PREFERRED STOCK AND EQUITY

Redeemable Convertible Preferred Stock and 2015 Warrants

On May 20, 2015, we closed a transaction in which we sold 31,046 shares of preferred stock and warrants to acquire 3.1 million shares of common stock (the 2015 Warrants) for $22.5 million in cash and the exchange of $8.5 million in subordinated notes. Of the preferred shares and warrants sold, 16,500 shares of preferred stock and warrants to acquire 1.7 million shares of common stock were sold to certain board members or their affiliated companies. We used $10.0 million of the cash proceeds from this sale to make partial payment on our senior notes payable and approximately $1.9 million for prepayment penalties, legal and accounting fees, which include fees associated with our registration statement filed in July 2015 and other expenses associated with the transaction. The balance of the net cash proceeds was used for content investment and working capital purposes. Of the fees incurred, $0.9 million was recorded against the proceeds received, $0.5 million was recorded as additional debt discounts, $0.2 million was included as interest expense and the balance was included in other expense.

18

---

RLJ Entertainment, Inc.

 

Notes To Consolidated Financial Statements

(Unaudited)

 

On October 14, 2016 and concurrent with the close of our AMC Credit Agreement, we amended our preferred stock such that we were able to classify our preferred stock and its embedded conversion feature within our shareholders’ equity. Prior to the amendment, our preferred stock and its embedded conversion feature were recorded on our consolidated balance sheet outside of shareholders’ equity. The amended terms are disclosed below.

The preferred stock has the following rights and preferences:

We are increasing (or accreting) the carrying balance of our preferred stock up to its redemption value using the effective interest-rate method over a period of time beginning from the issuance date of May 20, 2015 to the required redemption date of May 20, 2020. During the three months ended March 31, 2017 and 2016, we recognized accretion of $0.4 million and $1.1 million, respectively. Accretion includes cumulative preferred dividends. As of March 31, 2017, the accumulated unpaid dividends on preferred stock were $4.9 million. During the three months ended March 31, 2017 and 2016 accumulated unpaid dividends increased by $0.7 million (or $22.60 per share of preferred stock) and $0.6 million (or $20.52 per share of preferred stock), respectively.

During 2016, two preferred shareholders converted a total of 849 shares of preferred stock and $0.1 million of accumulated dividends into 312,000 shares of common stock.

On July 9, 2015, we filed a registration statement with the Securities and Exchange Commission to register the shares issuable upon conversion of the preferred stock and exercise of the 2015 Warrants (see Note 9, Stock Warrants). The registration statement was declared effective in July 2015. We will use our best efforts to keep the registration statement effective. If we are in default of the registration rights agreement, and as long as the event of default is not cured, then we are required to pay, in cash, partial liquidation damages, which in total are not to exceed 6% of the aggregated subscription amount of $31.0 million.

19

---

RLJ Entertainment, Inc.

 

Notes To Consolidated Financial Statements

(Unaudited)

 

Restricted Stock-Based Compensation Grants

Compensation expense relating to our restricted stock-based grants for the three months ended March 31, 2017 and 2016 was $0.2 million and $0.3 million, respectively. Compensation expense related to restricted stock-based grants is included in general and administrative expenses. As of March 31, 2017, unrecognized stock-based compensation expense relating to these awards of $3.2 million is expected to be expensed ratably over the remaining vesting period with $1.0 million to be recognized in the next 12 months. The weighted-average remaining vesting period for non-vested shares is 2.3 years.

During the three months ended March 31, 2017, 807,131 shares of restricted stock-based awards were granted to executive officers and directors, 41,719 shares vested and 2,000 shares were forfeited based due to employee terminations. The shares were fair valued on the date of grant at $2.40 per share for a total value of $1.9 million, which will be expensed over the vesting period as a component of general and administrative expenses. The restricted stock awards generally vest over a three-year period for executive officers and a one-year period for directors. The restricted stock units generally vest over a three-year period for employees. The vesting of restricted stock awards and restricted stock units is subject to certain service criteria.

On March 13, 2017, the Compensation Committee approved the award of a stock-based compensation package to our chief executive officer consisting of the following:

The options to purchase 1.4 million shares of common stock are subject to the receipt of shareholder approval and are not considered granted until we receive shareholder approval. The restricted stock units have been granted and are included in the restricted stock-based award table below. Stock compensation expense for the options and performance-based stock units will be calculated using the Black-Scholes model, and stock compensation expense for the restricted stock units will be calculated based upon the last closing price of the common stock on the date of grant.

During the three months ended March 31, 2016, no shares of restricted stock-based awards were granted and all forfeitures were based upon the failure to achieve the 2015 performance criteria. A summary of the activity since December 31, 2016 is as follows:

 

 

 

20

---

RLJ Entertainment, Inc.

 

Notes To Consolidated Financial Statements

(Unaudited)

 

NOTE 9. STOCK WARRANTS

As of March 31, 2017, outstanding warrants to purchase shares of common stock are as follows:

 

 

Concurrent with entering into the AMC Credit Agreement, we issued AMC three warrants (the AMC Warrants) to acquire shares of our common stock at $3.00 per share. The first warrant is for 5.0 million shares of common stock and expires on October 14, 2021. The second warrant is for 10.0 million shares of common stock and expires on October 14, 2022. The third warrant is for 5.0 million shares of common stock, subject to adjustment, and expires on October 14, 2023. The AMC Warrants are subject to certain standard anti-dilution provisions, and may be exercised on a non-cash basis at AMC’s discretion.

The third warrant (the AMC Tranche C Warrant) contains a provision that may increase the number of shares acquirable upon exercising, for no additional consideration payable by AMC, such that the number of shares acquirable upon exercise is equal to the sum of (i) at least 50.1% of our then outstanding shares of common stock, determined on a fully diluted basis, less (ii) the sum of 15.0 million shares and the equity interest shares issued in connection with the AMC Credit Agreement. This provision provides AMC the ability to acquire at least 50.1% of our common stock for $60.0 million, provided that all warrants are exercised and AMC elects not to exercise on a non-cash basis. The third warrant with this guarantee provision is being accounted for as a derivative liability.

On May 20, 2015 and concurrent with our preferred stock placement, we issued warrants to our preferred stock holders to acquire 3.1 million shares of our common stock (the 2015 Warrants). The warrants have term of five years. On October 14, 2016 and in connection with the AMC Credit Agreement, we amended the anti-dilution and redemption provisions of the warrants to conform to the terms of the amended preferred stock. Because of the AMC transaction and the then-existing terms of the 2015 Warrants, the warrant exercise price was reduced from $4.50 to $3.00; however, the exercise price was further reduced down to $1.50 for warrants to acquire 1.5 million shares of common stock, and down to $2.37 for warrants to acquire 150,000 shares of common stock. Because of the October 14, 2016 amendment, we began accounting for the 2015 Warrants as equity awards and reclassified the carrying balance of the warrants to shareholders’ equity.

On October 3, 2012, we issued warrants with a term of five years that provide the warrant holder the right to acquire one share of our common stock for $36.00 per share (the 2012 Warrants). The warrants are redeemable by us for $0.03 per warrant share if our common stock trades at $52.50 or more per share for 20 out of 30 trading days. The warrants contain standard anti-dilution provisions.

The 2012 Warrants contain a provision whereby the exercise price will be reduced if RLJE reorganized as a private company.  The reduction in exercise price depends upon the amount of other consideration, if any; received by the warrant holders in the reorganization and how many years after the Business Combination reorganization is consummated. Generally, the reduction in exercise price would be between $18.00 and $27.00 assuming no additional consideration was received. Because of this adjustment provision, the 2012 Warrants are being accounted for as a derivative liability

 

 

21

---

RLJ Entertainment, Inc.

 

Notes To Consolidated Financial Statements

(Unaudited)

 

NOTE 10. FAIR VALUE MEASUREMENTS

Stock Warrant and Other Derivative Liabilities

Of our outstanding warrants, certain warrants are accounted for as derivative liabilities, which require us to carry them on our consolidated balance sheet at their fair value. Our derivative liability warrants consist of the AMC Tranche C Warrant to acquire 5.0 million shares of common stock and our 2012 Warrants to acquire 7.0 million shares of common stock. Prior to the amendment on October 14, 2016, our 2015 Warrants to purchase 3.1 million shares of our common stock and the preferred stock’s embedded conversion feature were being accounted for as derivative liabilities as well.

We determined the fair value of the AMC Tranche C warrant using a lattice model, which is classified as Level 3 within in the fair-value hierarchy. Inputs to the model include our publicly-traded stock price, our stock volatility, the risk-free interest rate and contractual terms of the warrant (which are remaining life of the warrant, exercise price and assumptions pertaining to increasing the number of acquirable shares of common stock to achieve 50.1% ownership). We use the closing stock price of our common stock to compute stock volatility. To quantify and value the possibility of increasing the number of acquirable shares, management took into consideration its current capital structure, the impact of the 20% penalty if we were to fail to meet certain equity issuance conditions, and management’s best estimates of the likelihood of being subject to the 20% penalty. The AMC Tranche C warrant was valued at $12.7 million as of March 31, 2017 and $9.8 million as of December 31, 2016. During the current quarter, the AMC Tranche C warrant increased in value as a result of an increase in our common stock price.

We determined the fair value of our 2012 Warrants using a Monte Carlo simulation model. Because the warrants are so far out-of-the-money (exercise price is $36.00 per share) and as they approach their expiration date (which is October 2017) their fair value is effectively zero as of December 31, 2016 and March 31, 2017.

Prior to the October 14, 2016 amendment, we were using a lattice model to value the 2015 Warrants, which was classified as Level 3 within the fair-value hierarchy. Inputs to the model were stock volatility, contractual warrant terms (which were remaining life of the warrant and the exercise price), the risk-free interest rate and management’s assessment of the likelihood of doing a down-round transaction.

Prior to the October 14, 2016 amendment, we were using the lattice model to value the preferred stock’s embedded conversion feature, which was classified as Level 3 within the fair-value hierarchy. Inputs to the model were stock volatility, contractual terms (which were remaining life of the conversion option and the conversion rate), the risk-free interest rate and management’s assessment of the likelihood of doing a down-round transaction.

The following tables represent the valuation of our warrant and other derivative liabilities within the fair-value hierarchy:

 

 

 

The following tables include a roll-forward of our warrant and other derivative liabilities classified within Level 3 of the fair-value hierarchy:

 

 

 

22

---

RLJ Entertainment, Inc.

 

Notes To Consolidated Financial Statements

(Unaudited)

 

 

 

Investments in Content

When events and circumstances indicate that investments in content are impaired, we determine the fair value of the investment; and if the fair value is less than the carrying amount, we recognize additional amortization expense equal to the excess. The following fair value hierarchy tables present information about our assets and liabilities measured at fair value on a non-recurring basis.

 

 

 

During the three months ended March 31, 2017 and 2016, the investments in content were impaired by $0.3 million and $0.3 million, respectively. In determining the fair value of our investments in content, we employ a discounted cash flow (or DCF) methodology. Key inputs employed in the DCF methodology include estimates of a film's ultimate revenue and costs as well as a discount rate. The discount rate utilized in the DCF analysis is based on our weighted average cost of capital plus a risk premium representing the risk associated with producing a particular film or television program. As the primary determination of fair value is determined using a DCF model, the resulting fair value is considered a Level 3 measurement.

 

 

NOTE 11. NET INCOME (LOSS) PER COMMON SHARE

We have outstanding warrants to acquire 30.1 million and 10.1 million shares of common stock as of March 31, 2017 and 2016, respectively, which are not included in the computation of diluted net loss per common share as the effect would be anti-dilutive.

During periods of reported net losses from continuing operations after adjusting for accretion on preferred stock, all reported net losses are allocated to our unrestricted common stock. This has the effect of excluding our outstanding restricted common stock from the computation of our net loss per common share. For the three months ended March 31, 2017 and 2016, we have weighted average unvested shares of 0.6 million and 0.4 million, respectively, of compensatory restricted common stock and restricted common stock units that were not included in the computation of diluted net loss per common share as the effect would be anti-dilutive.

When dilutive, we include in our computation of diluted loss per share the number of shares of common stock that is acquirable upon conversion of the preferred stock by applying the as-converted method per ASC 260, Earnings per Share. For the three months ended March 31, 2017 and 2016, we excluded 11.7 million and 11.1 million shares of common stock that are acquirable upon conversion of the preferred stock as they were anti-dilutive.

 

23

---

RLJ Entertainment, Inc.

 

Notes To Consolidated Financial Statements

(Unaudited)

 

 

NOTE 12. STATEMENTS OF CASH FLOWS

Supplemental Disclosures

 

 

 

NOTE 13. COMMITMENTS AND CONTINGENCIES

In the normal course of business, we are subject to proceedings, lawsuits and other claims, including proceedings under government laws and regulations relating to content ownership, copyright and employment matters. While it is not possible to predict the outcome of these matters, it is the opinion of management, based on consultations with legal counsel, that the ultimate disposition of known proceedings will not have a material adverse impact on our financial position, results of operations or liquidity. Accordingly, we record a charge to earnings based on the probability of settlement and determination of an estimated amount. These charges were not material to our results.

 

 

NOTE 14. RELATED PARTY TRANSACTIONS

Equity Investment in Affiliate

During the three months ended March 31, 2017 and 2016, we paid ACL $0.1 million and $0.2 million, respectively, for distribution rights for three titles, two of which were released as of December 31, 2016 and one which will be released in 2017. As we recognize revenues from these titles, and all other titles, we amortize our content advances resulting in the recognition of content amortization and royalty expense. For the three months ended March 31, 2017 and 2016, we recognized content amortization and royalty expense of $0.1 million; and $0.4 million, respectively. This amortization is included in our cost of sales as content amortization and royalties. As of March 31, 2017, our remaining unamortized content advance is $1.7 million.

In May 2017, ACL paid dividends to RLJE Ltd. of $1.2 million. Dividends received are recorded as a reduction to the ACL investment account.

Foreign Currency

We recognize foreign currency gains and losses, as a component of other expense, on amounts lent by Acorn Media to AME and RLJE Australia. As of March 31, 2017, Acorn Media had lent its U.K. subsidiaries approximately $5.1 million and its Australian subsidiary approximately $3.3 million. Amounts lent will be repaid in U.S. dollars based on available cash. Movement in exchange rates between the U.S. dollar and the functional currencies (which are the Pound and the Australian dollar) of those subsidiaries that were lent the monies will result in foreign currency gains and losses. During the three months ended March 31, 2017, we recognized foreign currency gains of $0.3 million and during the three months ended March 31, 2016 we recognized foreign currency gains of $27,000.

24

---

RLJ Entertainment, Inc.

 

Notes To Consolidated Financial Statements

(Unaudited)

 

The RLJ Companies, LLC

In June 2013, The RLJ Companies, LLC (whose sole manager and voting member is the chairman of our board of directors) purchased from one of our vendors $3.5 million of contract obligations that we owed to the vendor. These purchased liabilities, which are now owed to The RLJ Companies, LLC, are included in accrued royalties and distribution fees in the accompanying consolidated balance sheets.

Sale of Preferred Stock and Warrants

In May 2015, certain present and former board members and their affiliate companies, including RLJ SPAC Acquisition, LLC, which is owned by the chairman of our board of directors, purchased 16,500 shares of preferred stock and warrants to acquire 1.7 million share of common stock from us for $16.5 million.

 

 

 

25

---

 

The following discussion and analysis of our financial condition and results of operations contains forward-looking statements that involve risks and uncertainties, such as statements of our plans, objectives, expectations and intentions. As described at the beginning of this Quarterly Report under the heading “Forward-Looking Statements,” our actual results could differ materially from those anticipated in these forward-looking statements. Factors that could contribute to such differences include those discussed elsewhere in this Quarterly Report under the heading “Forward-Looking Statements.” You should not place undue reliance on these forward-looking statements, which apply only as of the date of this Quarterly Report. Except as may be required under federal law, we undertake no obligation to update publicly any forward-looking statements for any reason, even if new information becomes available or other events occur.

You should read the following discussion and analysis in conjunction with our consolidated financial statements and related footnotes included in Item 1 of this Quarterly Report and with our audited consolidated financial statements and notes thereto, and with the information under the headings entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Risk Factors” in our Annual Report on Form 10-K filed on March 23, 2017.

OVERVIEW

General

RLJ Entertainment, Inc. (RLJE or the Company) is a premium digital channel company serving distinct audiences through its proprietary subscription-based digital channels (or Digital Channels), Acorn TV and Urban Movie Channel (or UMC), and a direct presence in North America, the United Kingdom (or U.K.) and Australia with strategic sublicense and distribution relationships covering Europe, Asia and Latin America.  RLJE was incorporated in Nevada in April 2012. On October 3, 2012, we completed the business combination of RLJE, Image Entertainment, Inc. (or Image) and Acorn Media Group, Inc. (or Acorn Media), which is referred to herein as the “Business Combination.”  Acorn Media includes its U.K. subsidiaries RLJ Entertainment Ltd, Acorn Media Enterprises Limited (or AME), and RLJE International Ltd (collectively, RLJE UK), as well as RLJ Entertainment Australia Pty Ltd (or RLJE Australia). In February 2012, Acorn Media acquired a 64% ownership of Agatha Christie Limited (or ACL).  References to Image include its wholly-owned subsidiary Image/Madacy Home Entertainment, LLC. “We,” “our” or “us” refers to RLJE and its subsidiaries unless otherwise noted. Our principal executive offices are located in Silver Spring, Maryland, with an additional location in Woodland Hills, California. We also have international offices in London, England and Sydney, Australia.

We strive to be a preferred source and destination for entertainment for a variety of distinct audiences with particular and special programming interests. We acquire, develop and exploit television, film and other media content across all platforms of distribution. We actively manage all windows of exploitation to optimize the reach of our promotional efforts and maximize the value of our releases.

We acquire content rights in various categories, with particular focus on British mysteries and dramas, urban programming and full-length independent motion pictures. We also develop, produce and own original programming through our wholly-owned subsidiary, AME, and our 64%-owned equity method investee, ACL. We control an extensive program library in genres such as British mysteries and dramas, urban/African-American, action/thriller and horror, fitness/lifestyle and long-form documentaries.

We market our products through a multi-channel strategy encompassing (1) direct relations with consumers via proprietary subscription-based Digital Channels (Digital Channels segment); (2) the licensing of original drama and mystery content managed and developed through our wholly-owned subsidiary, AME, and our 64%-owned equity method investee, ACL, (IP Licensing segment); and (3) wholesale exploitation through partners covering broadcast and cable, digital, online and retail outlets (Wholesale Distribution segment). As a result, we view our operations based on these three distinctive reporting segments. Operations and net assets that are not associated with any of these stated segments are reported as “Corporate” when disclosing and discussing segment information. Our Digital Channels segment consists of our subscription-based digital streaming channels. The IP Licensing segment includes intellectual property rights that we own or create and then sublicense for exploitation worldwide. Our Wholesale Distribution segment consist of the acquisition, content enhancement and worldwide exploitation of exclusive content in various formats, including broadcast, DVD and Blu-ray and digital (which include VOD, SVOD, streaming and downloading). We also sublicense certain distribution rights to others to cover territories outside the U.S., the U.K. and Australia. Our Wholesale Distribution segment also includes our U.K. mail-order catalog and ecommerce businesses.

26

---

 

AME manages and develops our intellectual property rights on British drama and mysteries. Our owned content includes 28 Foyle’s War made-for-TV films; multiple instructional Acacia titles; and through our 64% ownership interest of ACL, the vast majority of the Agatha Christie library. ACL is home to some of the world’s greatest works of mystery fiction, including Murder on the Orient Express and Death on the Nile and includes all development rights to iconic sleuths such as Hercule Poirot and Miss Marple. The Agatha Christie library includes a variety of short story collections, more than 80 novels, 19 plays and a film library of over 100 made-for-television films. In 2014, ACL published its first book since the death of Agatha Christie, The Monogram Murders. In September 2016, ACL released another new book, Closed Casket.

The IP Licensing and Wholesale Distribution segments exploit content primarily through third-party vendors. Our wholesale partners are broadcasters, digital outlets and major retailers in the U.S., Canada, United Kingdom and Australia, including, among others:  Amazon, Barnes & Noble, Comcast, Costco, DirecTV, Hulu, iTunes, Netflix, PBS, Showtime, Starz, Target and Walmart. We work closely with our wholesale partners to outline and implement release and promotional campaigns customized to the different audiences we serve and the program genres we exploit. We have a catalog of owned and long-term licensed content that is segmented into brands such as Acorn (British drama/mystery, including content produced by ACL), RLJE Films (independent feature films, action/thriller horror), UMC (urban), Acacia (fitness), and Athena (documentaries).

On June 24, 2016, we entered into a licensing agreement with Universal Screen Arts (or USA) whereby USA took over our Acorn U.S. catalog/ecommerce business becoming the official, exclusive, direct-to-consumer seller of Acorn product in the U.S. During the quarter ended June 30, 2016, we also electronically distributed our last Acacia catalogs. As a result of these actions, we have classified the U.S. catalog/ecommerce business as discontinued operations. During the first quarter of 2016, these businesses were included in our Direct Channels segment. In the fourth quarter of 2016, we reclassified our remaining U.K. catalog/ecommerce business from Digital Channels to our Wholesale Distribution segment to reflect adjustments we made internally in terms of how we are viewing and managing our operations after the disposal of our U.S. ecommerce/catalog business. The reclassification for both our U.S. and U.K. catalog and ecommerce businesses were made retroactively for all periods presented.

HIGHLIGHTS

Highlights and significant events for the three months ended March 31, 2017 and 2016 are as follows:

The highlights above and the discussion below are intended to identify some of our more significant results and transactions during the three months ended March 31, 2017 and should be read in conjunction with our consolidated financial statements and related discussions within this Quarterly Report.

27

---

 

RESULTS OF OPERATIONS

A summary of our results of operations for the three months ended March 31, 2017 and 2016, as disclosed in our consolidated financial statements in Item 1, Financial Statements, is as follows:

 

 

Revenues

A summary of net revenues by segment for the three months ended March 31, 2017 and 2016 is as follows:

 

 

Revenues decreased $3.9 million for the three months ended March 31, 2017 compared to the same period in 2016. The decrease in revenues is primarily driven by our Wholesale Distribution segment, which declined by $6.9 million. This decrease was partially offset by a $3.0 million increase in revenues from our Digital Channels segment.

The increase in revenues from our Digital Channels segment primarily results from the 89.9% growth in paying subscribers. During 2016, we launched our Digital Channels on Amazon Channels, an add-on streaming video service available to Amazon Prime customers. This strategic expansion into third-party distribution of our digital streaming services resulted in significant subscriber growth. In addition, we are continually featuring new content on our Digital Channels, which we believe is a key factor in attracting new subscribers for all of our channels.

Our Wholesale Distribution segment’s revenue decline is attributable to decreases in U.S. revenues of $6.6 million and decreases in international revenues of $0.3 million. Wholesale Distribution segment’s revenues decreased because of less content being released during the current period compared to the same period last year. We had fewer large releases this quarter compared to several large releases during the same period last year. Our Wholesale Distribution segment’s revenues were also down due to a decline in demand for DVDs as more digital programming becomes available on demand.

28

---

 

Cost of Sales (“COS”) and Gross Margin

A summary of COS by segment and overall gross margins for the three months ended March 31, 2017 and 2016 is as follows:

 

 

COS decreased by $3.5 million to $9.1 million for the three months ended March 31, 2017 compared to the same period in 2016. The decrease in COS is attributed to lower sales of physical content in our Wholesale Distribution segment. Impairment charges and step-up amortization are recorded in our Wholesale Distribution segment. Impairment charges recorded for content investments and inventories total $0.7 million and $0.6 million for the three months ended March 31, 2017 and 2016, respectively. Our step-up amortization was 0.9 million and 0.5 million for the three months ended March 31, 2017 and 2016, respectively. The increase in step-up amortization is attributable to certain changes made in our estimation of future revenues related to older content that we did not renew.

As a percentage of revenues, our gross margin improved to 34.3% for the three months ended March 31, 2017 as compared to 28.7% for the same period last year. The improvement is primarily attributable to our Digital Channels segment due to the growth of our proprietary SVOD channels. Revenues from these channels for the three months ended March 31, 2017 account for 43.0% of our total revenues as compared to 16.5% for the three months ended March 31, 2016. This business generates a higher gross margin than our other businesses especially as its revenues increase.

Selling, General and Administrative Expenses (“SG&A”)

A summary of SG&A expenses for the three months ended March 31, 2017 and 2016 is as follows:

 

 

For the three months ended March 31, 2017, SG&A increased by $0.1 million compared to the same period in 2016. Selling expenses increased $0.2 million primarily due to the growth of our Digital Channels segment offset by decreased selling expenses attributable to our Wholesale Distribution segment. General and administrative expenses continue to decrease as a result of our efforts to reduce overhead and related costs. Depreciation and amortization expenses increased by $0.2 million which is primarily attributable to continued investment in our digital platforms to support the growth of our Digital Channels segment.

Equity Earnings of Affiliate

Equity earnings of affiliate (which is ACL) increased by $0.1 million for the three months ended March 31, 2017, when compared to the same period in 2016. During 2017, ACL’s income from operations is higher when compared to 2016. In addition, ACL’s gross profit margin is higher when compared to 2016. The increases are a result of higher publishing revenues in percentage terms of total revenues for the period compared to the same period last year.

Interest Expense

Interest expense decreased $0.3 million for the three months ended March 31, 2107, when compared to the same period in 2016. The decrease is a result of reduced interest rates on our senior debt partially offset by higher average outstanding debt balances during the first quarter of 2017 as compared to the first quarter of 2016.

29

---

 

Change in Fair Value of Stock Warrants and Other Derivatives

The change in the fair value of our warrant and other derivative liabilities impacts the statement of operations. A decrease in the fair value of the liabilities results in the recognition of income, while an increase in the fair value of the liabilities results in the recognition of expense. Changes in fair value are primarily driven by changes in our common stock price and its volatility. For the three months ended March 31, 2017 and 2016, we recognized expense of $2.9 million and $8.2 million, respectively, due to changes in the fair value of our stock warrants and other derivative liabilities.

Other Income (Expense)

Other income (expense) mostly consists of foreign currency gains and losses resulting primarily from advances and loans by our U.S. subsidiaries to our foreign subsidiaries that have not yet been repaid. Our foreign currency gains and losses are primarily impacted by changes in the exchange rate of the Pound relative to the U.S. dollar. As the Pound strengthens relative to the U.S. dollar, we recognize other income; and as the Pound weakens relative to the U.S. dollar, we recognize other expense. During the three months ended March 31, 2017, we recognized a foreign currency gain of $0.3 million compared to a foreign currency gain of $27,000 during the same period in 2016.

Income Taxes

We have fully reserved our net U.S. deferred tax assets, and such tax assets may be available to reduce future income taxes payable should we have U.S. taxable income in the future. To the extent such deferred tax assets relate to net operating losses (or NOL) carryforwards, the ability to use our NOL carryforwards against future earnings will be subject to applicable carryforward periods and limitations subsequent to a change in ownership.

We recorded income tax expense of $0.2 million and $41,000 for the three-month periods ended March 31, 2017 and 2016, respectively. Our tax provision primarily relates to our U.K. operations.  We are using an effective rate of 19.25% applied to pre-tax U.K. earnings, which includes our share of ACL earnings.

Loss from Discontinued Operations, Net of Income Taxes

Our loss from discontinued operations is attributable to the wind down of our U.S. catalog/ecommerce business which occurred during 2016 and was effectively complete as of September 30, 2016. For the three-month ended March 31, 2016, our losses were $1.1 million.

ADJUSTED EBITDA

Management defines Adjusted EBITDA as earnings before income tax, depreciation and amortization, non-cash royalty expense, interest expense, non-cash exchange gains and losses on intercompany accounts, goodwill impairments, severance costs, change in fair value of stock warrants and other derivatives, stock-based compensation, basis-difference amortization in equity earnings of affiliate and dividends received from affiliate in excess of equity earnings of affiliate

Management believes Adjusted EBITDA to be a meaningful indicator of our performance that provides useful information to investors regarding our financial condition and results of operations because it removes material non-cash items that allows investors to analyze the operating performance of the business using the same metric management uses. The exclusion of non-cash items better reflects our ability to make investments in the business and meet obligations. Presentation of Adjusted EBITDA is a non-GAAP financial measure commonly used in the entertainment industry and by financial analysts and others who follow the industry to measure operating performance. Management uses this measure to assess operating results and performance of our business, perform analytical comparisons, identify strategies to improve performance and allocate resources to our business segments. While management considers Adjusted EBITDA to be an important measure of comparative operating performance, it should be considered in addition to, but not as a substitute for, net income and other measures of financial performance reported in accordance with U.S. GAAP. Not all companies calculate Adjusted EBITDA in the same manner and the measure, as presented, may not be comparable to similarly-titled measures presented by other companies.

30

---

 

The following table includes the reconciliation of our consolidated U.S. GAAP net loss to our consolidated Adjusted EBITDA:

 

 

During 2016, we changed how we are computing our Adjusted EBITDA. Previously, we were adding back content amortization and royalty expense and deducting cash invested in content to arrive at an Adjusted EBITDA. We have now aligned our adjusted EBITDA definition to our peers in our industry and to the amended definition in our credit agreement.  The revised Adjusted EBITDA adds back our non-cash royalty expense, which consists of step-up amortization and impairments on content that was acquired as of the Business Combination.

For the three-month period ended March 31, 2017, our Adjusted EBITDA improved by $0.5 million compared to the same period last year. The increase reflects our improved operating results from continuing operations after adjusting for the above non-cash expenses. The improved performance primarily results from the growth of our Digital Channels segment which is becoming a larger portion of our business and is contributing the highest profit margins. The 2017 restructuring adjustment primarily includes our gain on extinguishment of debt and certain non-recurring transaction costs totaling $0.3 million.

BALANCE SHEET ANALYSIS

Assets

Total assets at March 31, 2017 and December 31, 2016, were $126.6 million and $136.0 million, respectively. The decline of $9.3 million in assets is primarily attributed to a decrease in accounts receivable, and a decrease in cash offset by an increase in investments in content. Our accounts receivable decreased by $9.3 million because of the seasonal nature of our wholesale segment business and follows the decline in wholesale segment revenues. Our cash decreased by $3.9 million and our investments in content increased by $3.6 million.

A summary of assets by segment is as follows:

 

 

Liabilities and Equity

The decrease in our liabilities and equity of $9.3 million to $126.6 million is primarily due to the net loss of $6.1 million for the three months ended March 31, 2017 that is included in accumulated deficit; along with decreases in accounts payable and accrued royalties of $7.1 million; partially offset by a $2.9 million increase in the valuation of our stock warrant and other derivative liabilities.

31

---

 

LIQUIDITY AND CAPITAL RESOURCES

Liquidity

A summary of our cash flow activity is as follows:

 

 

At March 31, 2017 and December 31, 2016, our cash and cash equivalents was $4.0 million and $7.8 million, respectively. During the three months ended March 31, 2017, our cash position was impacted by the following:

Our reported cash flow activities include the impacts of our discontinued operations. During the first quarter of 2016, our discontinued operations required a net use of cash from operating activities of $0.9 million.

We continue to realize significant growth in our Digital Channels segment. Our Digital Channels revenues increased 103.7% to $6.0 million during the three months ended March 31, 2017 as compared to the same period in 2016. After cost of sales and operating expenses, our Digital Channels segment contributed $2.6 million of income from continuing operations during the first quarter of 2017 compared to $1.0 million last year. Our expectation is that our digital channels will continue to grow, however there is no assurance that this will occur.

In October 2016, we refinanced our senior debt. In January 2017, we expanded our senior debt by $8.0 million, which we used to repay our subordinated notes payable. In addition to providing us liquidity, the new senior loan facility helps us address our liquidity constraints going forward in three ways: (1) it bears a substantially lower cash-interest rate that is approximately 800 basis points lower than before, (2) there are no required principal payments until 2019, and (3) the financial covenants have been reset to less restrictive levels that provide us the necessary flexibility to invest in our operations.

In 2016, we also took actions to improve our operating results and Adjusted EBITDA by exiting certain non-core operations that have been generating losses. During December 2015, we approved and implemented a plan to close our Acacia catalog operations. The last Acacia print catalogs were circulated in January 2016 and electronic email distribution continued through May 2016. Further, on June 24, 2016, we entered into a licensing agreement to outsource the U.S. Acorn catalog/ecommerce business to USA (see our Discontinued Operations disclosure above). During 2016, our U.S. catalog/ecommerce business was fully transitioned to USA and we do not anticipate future losses from this line of business.

We believe that our current cash at March 31, 2017, combined with our additional borrowing in January 2017 will be sufficient to meet our operating liquidity, capital expenditure and debt repayment requirements for at least the next one year from the date of issuance of these financial statements. However, there can be no assurances that we will be successful in realizing improved results from operations including improved Adjusted EBITDA, generating sufficient cash flows from operations or agreeing with vendors on revised payment terms.

32

---

 

Capital Resources

Cash

As of March 31, 2017 and December 31, 2016, we had cash of $4.0 million and $7.8 million, respectively.

Senior Term Notes

On October 14, 2016, we entered into a $65.0 million Credit and Guaranty Agreement (the AMC Credit Agreement) with Digital Entertainment Holdings LLC, a wholly owned subsidiary of AMC Networks Inc. (or AMC). The proceeds received were used to repay our prior senior secured term notes of $55.1 million, including accrued interest, and transaction expenses of approximately $1.7 million, which includes a prepayment penalty of $0.8 million. Initially, the AMC Credit Agreement consisted of (i) a term loan tranche in the principal amount of $5.0 million (or Tranche A Loan), which was due October 14, 2017, but was recently amended to June 30, 2019, and (ii) a term loan tranche in the principal amount of $60.0 million (or Tranche B Loan) of which 25% is due after five years, 50% is due after six years and the remaining 25% is due after seven years. The Tranche A Loan bears interest at a rate of 7.0% per annum and the Tranche B Loan bears interest at a rate of 6.0% per annum. Interest is payable quarterly whereby 4.0% is payable in cash and the balance is payable in shares of common stock determined using a per-share value of $3.00 per share. The loan is secured by a lien on substantially all of our consolidated assets.

On January 30, 2017, we amended the AMC Credit Agreement and borrowed an additional $8.0 million, thereby increasing our Tranche A loan from $5.0 million to $13.0 million. We also extended the maturity date for our Tranche A loan from October 14, 2017 to June 30, 2019. The additional $8.0 million borrowed was used to repay prior debt obligations under the subordinated notes payable. When doing so, we did not incur a prepayment penalty. This amendment also changed certain debt covenant ratios to reflect the extended maturity date and the increase of the Tranche A loan balance.

Subject to certain customary exceptions, the AMC Credit Agreement requires mandatory prepayments if we were to receive proceeds from asset sales, insurance, debt issuance or the exercise of warrants. We may also make voluntary prepayments. Prepayments of the Tranche B Loan (either voluntary or mandatory) are subject to a prepayment premium of 3.0% if principal is repaid on or before October 14, 2018, and 1.5% if principal is repaid after October 14, 2018 but on or before October 14, 2019. No prepayment premium is due for amounts prepaid after October 14, 2019, and for mandatory prepayments made from proceeds received from the exercise of warrants.

The AMC Credit Agreement contains certain financial and non-financial covenants. Financial covenants are assessed annually and are based on Consolidated Adjusted EBITDA, as defined in the AMC Credit Agreement. Financial covenants vary by fiscal year and generally become more restrictive over time.

Financial covenants include the following:

 

 

The AMC Credit Agreement contains events of default that include, among others, non-payment of principal, interest or fees, violation of covenants, inaccuracy of representations and warranties, bankruptcy and insolvency events, material judgments, cross defaults to certain other contracts (including, for example, business arrangements with our U.S. distribution facilitation partner and other material contracts) and indebtedness and events constituting a change of control or a material adverse effect in any of our results of operations or conditions (financial or otherwise). The occurrence of an event of default would increase the applicable rate of interest and could result in the acceleration of our obligations under the AMC Credit Agreement.

The AMC Credit Agreement imposes restrictions on such items as encumbrances and liens, payments of dividends, other indebtedness, stock repurchases, capital expenditures and entering into new lease obligations. Additional covenants restrict our ability to make certain investments, such as loans and equity investments, or investments in content that are not in the ordinary course of business. Pursuant to the AMC Credit Agreement, we must maintain at all times a cash balance of $1.0 million for 2016, $2.0 million in cash for 2017 and $3.5 million in cash for all years thereafter. As of March 31, 2017, we were in compliance with all covenants as stipulated in the amended AMC Credit Agreement.

33

---

 

Subordinated Notes Payable

In October 2012, we issued unsecured subordinated promissory notes in the aggregate principal amount of $14.8 million to the selling preferred stockholders of Image (or Subordinated Note Holders). On May 20, 2015, and in connection with the sale of preferred stock and warrants, the Subordinated Note Holders exchanged approximately $8.5 million of subordinated notes for 8,546 shares of preferred stock and warrants to acquire approximately 855,000 shares of common stock. The notes bore interest at 12.0% per annum, except for a two-year period ending December 31, 2016, whereby the interest rate was adjusted to 1.5% per annum. Each year, we paid 45% of the interest due in cash and added the remaining of 55% to the subordinated note balance. On January 31, 2017, we repaid the outstanding principal and interest on these subordinated notes in full.

Preferred Stock

On May 20, 2015, we closed a transaction in which we sold 31,046 shares of preferred stock and warrants to acquire 3.1 million shares of common stock (the 2015 Warrants) for $22.5 million in cash and the exchange of $8.5 million in subordinated notes. Of the preferred shares and warrants sold, 16,500 shares of preferred stock and warrants to acquire 1.7 million shares of common stock were sold to certain board members or their affiliated companies. We used $10.0 million of the cash proceeds from this sale to make partial payment on our senior notes payable and approximately $1.9 million for prepayment penalties, legal and accounting fees, which include fees associated with our registration statement filed in July 2015 and other expenses associated with the transaction. The balance of the net cash proceeds was used for content investment and working capital purposes. Of the fees incurred, $0.9 million was recorded against the proceeds received, $0.5 million was recorded as additional debt discounts, $0.2 million was included as interest expense and the balance was included in other expense.

On October 14, 2016 and concurrent with the close of the AMC Credit Agreement, we amended our preferred stock such that we were able to classify our preferred stock and its embedded conversion feature within our shareholders’ equity. Prior to the amendment, our preferred stock and its embedded conversion feature were recorded on our consolidated balance sheet outside of shareholders’ equity. The amended terms are disclosed below.

The preferred stock has the following rights and preferences:

34

---

 

We are increasing (or accreting) the carrying balance of our preferred stock up to its redemption value using the effective interest-rate method over a period of time beginning from the issuance date of May 20, 2015 to the required redemption date of May 20, 2020. During the three months ended March 31, 2017 and 2016, we recognized accretion of $0.4 million and $1.1 million, respectively. Accretion includes cumulative preferred dividends. As of March 31, 2017, the accumulated unpaid dividends on preferred stock were $4.9 million. During the three months ended March 31, 2017 and 2016 accumulated unpaid dividends increased by $0.7 million (or $22.60 per share of preferred stock) and $0.6 million (or $20.52 per share of preferred stock), respectively.

On July 9, 2015, we filed a registration statement with the Securities and Exchange Commission to register the shares issuable upon conversion of the preferred stock and exercise of the 2015 Warrants. The registration statement was declared effective in July 2015. We will use our best efforts to keep the registration statement effective. If we are in default of the registration rights agreement, and as long as the event of default is not cured, then we are required to pay, in cash, partial liquidation damages, which in total are not to exceed 6% of the aggregated subscription amount of $31.0 million.

RELATED PARTY TRANSACTIONS

In the ordinary course of business we enter into transactions with related parties, primarily our equity method investee and entities owned and controlled by the Chairman of our Board of Directors. Information regarding transactions and amounts with related parties is discussed in Note 14, Related Party Transactions of our consolidated financial statements in Item 1, Financial Statements.

OTHER ITEMS

Off-Balance Sheet Arrangements

We typically acquire content via separately executed licensing or distribution agreements with content suppliers. These contracts generally require that we make advance payments before the content is available for exploitation. Advance payments are generally due prior to and upon delivery of the related content. To the extent payment is not due until delivery has occurred, we do not recognize our payment obligations under our licensing and distribution agreements prior to the content being delivered. As of March 31, 2017, we had entered into licensing and distribution agreements for which we are obligated to pay $10.4 million once the related content has been delivered.

Critical Accounting Policies and Procedures

There have been no significant changes in the critical accounting policies disclosed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in our Annual Report on Form 10-K filed on March 23, 2017.

 

 

Item 3, Quantitative and Qualitative Disclosures about Market Risk is not required for smaller reporting companies.

The term “disclosure controls and procedures” is defined in Rules 13(a)-15(e) and 15(d)-15(e) of the Exchange Act. Disclosure controls and procedures refer to the controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company's management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.

We have evaluated, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report. Based on that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this Quarterly Report.

There have been no changes in our internal control over financial reporting that occurred during the quarter ended March 31, 2017 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

 

35

---

 

PART II - OTHER INFORMATION

In the normal course of business, we are subject to proceedings, lawsuits and other claims, including proceedings under government laws and regulations relating to employment and tax matters. While it is not possible to predict the outcome of these matters, it is the opinion of management, based on consultations with legal counsel, that the ultimate disposition of known proceedings will not have a material adverse impact on our financial position, results of operations or liquidity.

Our results of operations and financial condition are subject to numerous risks and uncertainties described in our Annual Report on Form 10-K filed on March 23, 2017. You should carefully consider these risk factors in conjunction with the other information contained in this Quarterly Report. Should any of these risks materialize, our business, financial condition and future prospects could be negatively impacted. As of March 31, 2017, there have been no material changes to the risk factors set forth in that Form 10-K.

 

36

---

 

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

 

37