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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[x] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2003
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission File Number: 333-83448
PENTHOUSE INTERNATIONAL, INC.
-------------------------------------------------------
(Exact name of registrant as specified in its charter)
FLORIDA 65-1158257
- ------------------------- --------------------
(State of incorporation) (IRS Employer
Identification No.)
11 PENN PLAZA, NEW YORK, NY 10001
---------------------------------------
(Address of principal executive offices)
(212) 702-6000
-------------------------------
(Registrant's telephone number)
SECURITIES REGISTERED PURSUANT TO SECTIONS 12(b) OR 12(g) OF THE ACT: NONE
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 each 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 [X] NO [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
YES [ ] NO [X]
As of September 15, 2003, there were 151,690,000 shares outstanding of the
Registrant's common stock.
PENTHOUSE INTERNATIONAL, INC. AND SUBSIDIARIES
TABLE OF CONTENTS
PAGE
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements 3
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 22
Item 3. Quantitative and Qualitative Disclosures About Market Risk 48
Item 4. Controls and Procedures 48
PART II - OTHER INFORMATION
Item 1. Legal Proceedings 50
Item 2. Changes in Securities and Use of Proceeds 51
Item 3. Defaults Upon Senior Securities 53
Item 6. Exhibits and Reports on Form 8-K 54
Signatures 55
2
Item 1. Financial Statements
Penthouse International, Inc. and Subsidiaries
Condensed Consolidated Statements of Operations
(unaudited)
(amounts in thousands, except per share amounts)
Six months ended Three months ended
June 30, June 30,
------------------------------ -------------------------------
2002 2003 2002 2003
------------- ------------- -------------- -------------
Net revenue $ 30,282 $ 18,810 $ 16,074 $ 7,738
------------- ------------- -------------- -------------
Costs and expenses
Publishing - production, distribution, pictorial
and editorial 11,631 7,327 6,164 2,760
Entertainment and online 442 205 205 86
Selling, general and administrative 12,410 9,097 5,788 4,482
Leasehold improvement impairment charge - 1,061 - -
Bad debt expense 78 (161) 44 (123)
Rent expense from affiliated companies 333 215 218 90
Depreciation and amortization 273 188 131 69
------------- ------------- -------------- -------------
Total costs and expenses 25,167 17,932 12,550 7,364
------------- ------------- -------------- -------------
Income from operations 5,115 878 3,524 374
------------- ------------- -------------- -------------
Other income (expense)
Interest expense (3,791) (3,196) (1,849) (1,497)
Gain on sale of officer's life insurance 811 - 811 -
Interest income 61 4 23 2
------------- ------------- -------------- -------------
Total other income (expense), net (2,919) (3,192) (1,015) (1,495)
------------- ------------- -------------- -------------
Income/(Loss) before provision for income taxes 2,196 (2,314) 2,509 (1,121)
Income tax expense 13 12 7 6
------------- ------------- -------------- -------------
Income (loss) before minority interest 2,183 (2,326) 2,502 (1,127)
Minority interest (11) 11 (13) 5
------------- ------------- -------------- -------------
Net income (loss) 2,172 (2,315) 2,489 (1,122)
"Paid in kind" dividends on mandatorily redeemable
preferred stock, net of minority interest (706) (804) (355) (406)
Accretion of mandatorily redeemable preferred stock
to its liquidation preference, net of minority interest (168) (176) (84) (88)
------------- ------------- -------------- -------------
Net income (loss) applicable to common stock $ 1,298 $ (3,295) $ 2,050 $ (1,616)
============= ============= ============== =============
Net income (loss) per common share, basic and diluted $ 0.01 $ (0.02) $ 0.02 $ (0.01)
============= ============= ============== =============
Weighted average number of shares, basic and diluted 127,560,000 151,690,000 127,560,000 151,690,000
============= ============= ============== =============
See notes to condensed consolidated financial statements.
3
Penthouse International, Inc. and Subsidiaries
Condensed Consolidated Balance Sheets
(amounts in thousands)
December 31, June 30,
2002 2003
-------------- ---------------
(unaudited)
ASSETS
CURRENT ASSETS
Cash and cash equivalents $ 206 $ 391
Accounts receivable, net of allowance
for doubtful accounts 2,862 1,800
Inventories 3,355 2,362
Prepaid insurance 702 597
Prepaid expenses and other current assets 1,014 705
------------- -------------
Total current assets 8,139 5,855
WORKS OF ART AND OTHER COLLECTABLES 1,820 1,820
PROPERTY AND EQUIPMENT - AT COST;
net of accumulated depreciation and amortization 1,905 656
OTHER ASSETS
Rent security deposits 1,071 1,071
Cash surrender value of officers life insurance 1,036 960
Deferred subscription acquisition costs, net 248 185
Due from affiliated companies 1,153 -
Other - 74
------------- -------------
3,508 2,290
------------- -------------
$ 15,372 $ 10,621
============= =============
LIABILITIES AND STOCKHOLDERS' DEFICIENCY
CURRENT LIABILITIES
Current maturities of notes payable $ 43,147 $ 39,947
Accounts payable 7,894 10,083
Deferred revenue 7,602 7,445
Accrued Interest - notes payable 1,617 1,496
Accrued retail display allowance 1,653 1,298
Accrued expenses and other current liabilities 3,863 3,028
Due to affiliated companies - 368
Income tax payable 935 957
------------- -------------
Total current liabilities 66,711 64,622
DEFERRED REVENUE 1,013 788
OTHER LONG TERM LIABILITIES 867 756
MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED STOCK 11,256 12,236
COMMITMENTS AND CONTINGENCIES
MINORITY INTEREST 116 100
STOCKHOLDERS' DEFICIT
Series A Preferred Stock, $.0025 par value; 20,000,000 shares
authorized, 5,000 shares issued and outstanding - -
Series B Preferred Stock, $.0025 par value; 20,000,000 shares
authorized, none outstanding - -
Common stock, $.0025 par value; 250,000,000 shares authorized;
150,000,000 and 151,690,000 shares issued and outstanding,
respectively 375 379
Capital in excess of par value 5,987 5,008
Subscription receivable (22) (22)
Accumulated deficit (70,931) (73,246)
------------- -------------
(64,591) (67,881)
------------- -------------
$ 15,372 $ 10,621
============= =============
See notes to condensed consolidated financial statements.
4
Penthouse International, Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(unaudited)
(amounts in thousands)
Six months ended
June 30,
-------------------------
2002 2003
----------- ----------
Cash flows from operating activities
Net income / (loss) $ 2,172 $ (2,315)
Adjustments to reconcile net income (loss) to net
cash provided by (used in) operating activities:
Depreciation and amortization 273 188
Amortization of deferred revenue (228) (225)
Gain on sale of officer's life insurance policies (811)
Bad debt expense - (161)
Leasehold improvement impairment charge - 1,061
Change in operating assets and liabilities:
(Increase) decrease in:
Accounts receivable 173 1,108
Inventories 1,593 993
Prepaid insurance 452 105
Prepaid expenses and other current assets 299 309
Other assets 1,461 65
Increase (decrease) in:
Accounts payable, accrued expenses and other
current liabilities (4,539) 999
Accrued interest on notes payable (83) (121)
Income taxes payable (5) 22
Deferred revenue (1,446) (157)
Other long term liabilities (128) (111)
Minority interest 11 (11)
----------- ----------
Net cash (used in) provided by operations (806) 1,749
----------- ----------
Cash flows from investing activities
Proceeds from sale of officer's life insurance policies 935 -
----------- ----------
Net cash provided by investing activities 935 -
----------- ----------
Cash flows from financing activities
Principal payments on notes payable (2,185) (3,200)
Collections from affiliated companies - 1,636
Advances to affiliated companies (890) -
Repayments from shareholder 1,000 -
----------- ----------
Net cash used in financing activities (2,075) (1,564)
----------- ----------
Net (decrease) increase in cash and cash equivalents (1,946) 185
Cash and cash equivalents at beginning of period 2,431 206
----------- ----------
Cash and cash equivalents at end of period $ 485 $ 391
=========== ==========
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest $ 3,842 $ 3,319
Income taxes $ 11 $ 16
Supplemental disclosure of non-cash financing activities:
"Paid in kind" dividends on mandatorily redeemable
preferred stock $ 706 $ 800
Accretion of mandatorily redeemable preferred
stock to liquidation preference $ 168 $ 175
See notes to condensed consolidated financial statements.
5
Penthouse International, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
1. Basis of Presentation and Financial Status
The Company is the holder of 99.5% of the common stock of General Media, Inc.
(together with its subsidiaries, "General Media"). The Company is majority owned
by General Media International, Inc. ("GMI"). General Media historically
operated the adult oriented entertainment company formed in 1965, by Robert G.
Guccione, which caters to men's interests through various trademarked
publications, movies, the Internet, location-based live entertainment clubs and
consumer product licenses under the brand "Penthouse" and others. General Media
International, Inc. ("GMI") is the holder of 85% of the common stock of the
Company. On August 12, 2003, General Media and its direct and indirect
subsidiaries, General Media Art Holding, Inc., General Media Communications,
Inc., General Media Entertainment, Inc., General Media (UK), Ltd., GMCI Internet
Operations, Inc., GMI On-Line Ventures, Ltd., Penthouse Images Acquisitions,
Ltd. and Pure Entertainment Telecommunications, Inc., (collectively, the
"Debtors"), filed voluntary petitions for relief under Chapter 11 of Title 11 of
the United States Code (the "Bankruptcy Code") in the United States Bankruptcy
Court for the Southern District of New York (the "Bankruptcy Court"). The
Debtors are managing their properties and operate their businesses as
"debtors-in-possession" subject to the supervision and orders of the Bankruptcy
Court (Case No. 03-15078) pursuant to Sections 1107(a) and 1108 of the
Bankruptcy Code. The Debtors are developing but have not filed either a plan of
reorganization or a term sheet setting forth material terms of such plan. A
motion to convert the case to a Chapter 7 liquidation has been filed by the
Unsecured Creditors Committee which the Debtors have opposed.
The accompanying unaudited consolidated financial statements have been prepared
in accordance with accounting principles generally accepted in the United States
of America for interim financial information and with the instructions to Form
10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of
the information and footnotes required by accounting principles generally
accepted in the United States of America for complete financial statements. In
the opinion of management, all adjustments, consisting only of normal, recurring
adjustments considered necessary for a fair presentation, have been included.
The results of operations for the three and six months ended June 30, 2003 are
not necessarily indicative of results that may be expected for any other interim
period or for the full year. The balance sheet information for December 31, 2002
has been derived from the audited financial statements at that date. In
addition, the financial statement presentation does not yet reflect any
segregation of liabilities subject to compromise which may result from the above
described proceeding (the "Bankruptcy Proceeding") in accordance with the
American Institute of Certified Public Accountants Statement of Position 90-7,
"Financial Reporting by Entities in Reorganization ("SOP 90-7)". Such treatment,
if required, will be based upon the Debtors' plan of reorganization.
The consolidated financial statements do not purport to reflect or provide for
the consequences of the bankruptcy proceedings. In particular, such consolidated
financial statements do not purport to show (a) as to assets, their realizable
value on a liquidation basis or their availability to satisfy liabilities,
except as to an impairment provision relating to leasehold improvements; (b) as
to pre-petition liabilities, the amounts that may be allowed for claims or
contingencies, or the status and priority thereof; (c) as to stockholder
accounts, the effect of any changes that may be made in the capitalization of
the Company; or (d) as to operations, the effect of any changes that may be made
in its business.
6
Penthouse International, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
1. (Continued)
On September 18, 2003 the Unsecured Creditors Committee in the Bankruptcy
Proceeding filed a motion to convert the case from a Chapter 11 reorganization
to a Chapter 7 liquidation case. The Debtors promptly filed their opposition to
the motion and intend to resist the Unsecured Creditors Committee's motion.
Subject to the qualifications above, the accompanying financial statements have
been prepared in conformity with accounting principles generally accepted in the
United States of America, which contemplate continuation of the Company as a
going concern. At June 30, 2003, the Company's cash balance was $391,000 and the
Company's current liabilities exceeded current assets by $58,767,000. As further
explained in Note 4 of the Notes to Condensed Consolidated Financial Statements
and in the liquidity section of the management discussion section of this report
on Form 10-Q, the Company's subsidiary, General Media, was late in paying a
required interest payment under its 15% Senior Secured Debentures due 2004 (the
"Series C Notes") in the amount of $1,496,000 that was due on March 31, 2003.
The payment of this interest was made on June 3, 2003.
General Media also did not make a required principal payment in the amount of
$1,300,000 and a required interest payment of $48,000 that was due on June 29,
2003, did not make a required interest payment on the Notes of $1,447,000 that
was due on June 30, 2003 and has not yet delivered quarterly financial
statements for the period ending March 31, 2003 (the "Financial Statements") to
the holders of the Notes as required by the indenture (the "Indenture") defining
the relative rights of General Media and the Note holders. On July 3, 2003, the
holders of a majority of the principal amount of the Series C Notes (the
"Holders") sent a notice to General Media advising it of the failure to make the
required interest payment due on June 30, 2003, the failure to make required
principal payment of $1,300,000 that was due on June 29, 2003 and the failure to
deliver the required Financial Statements. On July 8, 2003, the trustee issued a
notice of event of default with respect to the principal payment and the Series
C Notes became callable. The Series C Notes require interest payments of
$5,679,000 (including the unpaid interest) and principal payments of $39,897,000
during the next twelve months plus default interest.
General Media and the other Debtors filed for protection under Chapter 11 after
negotiations with the Holders failed to obtain a waiver of the defaults or to
provide working capital for the Company's operations. In August 2003, two of the
Holders entered into an agreement with General Media to provide $5,000,000 of
debtor-in-possession financing with interest at 13% per annum (the "Agreement"
or "DIP Financing"). The Agreement limits the DIP Financing to $3,000,000 until
a final financing order is signed by the Bankruptcy Court. The Agreement also
limits the amount of advances to the amount of principal projected to be
outstanding on a weekly basis as was set forth on a budget provided by General
Media on a schedule to the Agreement. Under the Agreement, General Media has
drawn down approximately $2,100,000 as of September 19, 2003. The Debtors have
defaulted on certain covenants related to the DIP Financing and are negotiating
with the lenders for waivers. As a result of the Default, no additional advances
have been made, the full principal balance of the loan is due and the interest
due on the outstanding balance increased to 15% per annum.
The Debtors were overdue in payments to their vendors, but collection efforts
following August 12, 2003 are stayed by the Bankruptcy Proceeding. The Company
7
Penthouse International, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
1. (Continued)
was unable to distribute Penthouse, Penthouse Letters and Girls of Penthouse
magazines during May 2003 and all of its publications during June 2003 as a
result of the need to reach an agreement with printing contractors, paper
suppliers and magazine distributor regarding past due invoices. In September
2003, General Media's magazine distributor threatened to suspend distribution of
its publications and entered into negotiations with General Media to determine
the terms under which magazines will be distributed while the Debtors are
operating under Chapter 11 protection. On July 18, 2003, the Company postponed
for one week the payment of approximately seventy four percent of one of its
bi-weekly payroll due that week as a result of a shortage of cash at the time.
The Company paid the balance of the payroll to its employees on July 25, 2003.
General Media has fallen behind in making its monthly lease payments on its
principal offices in Manhattan. As a result, the landlord has obtained a
judgement from the Civil Court of The City Of New York (the "Court") for unpaid
rent in the amount of $449,000 and for the right to obtain a warrant of eviction
(See Note 7 of the Notes to Condensed Consolidated Financial Statements). The
landlord's efforts to seek a warrant of eviction have been stayed by the
Bankruptcy Proceeding. The Company is in the process of locating alternate
facilities while at the same time negotiating with the landlord for a possible
settlement of the case. The Company has provided for a fixed asset leasehold
improvement impairment charge in the amount of $1,061,000 in the Condensed
Consolidated Statements of Operations for the six months ended June 30, 2003
because it is uncertain that the Company will reach an agreement with the
landlord and remain in its office facilities to the end of the lease term.
There can be no assurance that alternative financing will be made available to
the Company, that the Debtors efforts to reorganize in bankruptcy will be
successful or that the Company will retain any equity in General Media as a
result of the planned reorganization.
The Company previously reported that the Securities and Exchange Commission
commenced an informal inquiry pertaining to its financial statements for the
year ended December 31, 2002 and the quarter ended March 31, 2003, the
accounting treatment of a website management agreement and the engagement and
termination of auditing services during 2002 and 2003. On July 23, 2003, the
Company's attorney received a formal order of investigation from the Securities
and Exchange Commission relating to the Company's March 2003 financial
statements initially filed with the Securities and Exchange Commission on May
23, 2003. The Company cannot predict how long this investigation will last or
its outcome. The Company is cooperating fully with the Securities and Exchange
Commission and intends to continue to do so.
In view of the matters described in the preceding paragraphs, substantial doubt
exists about the Company's ability to continue as a going concern. The financial
statements do not include any adjustments relating to the recoverability and
classification of recorded asset amounts or amounts and classification of
liabilities that might be necessary should the Company be unable to continue in
existence or if its equity in General Media is extinguished by the Bankruptcy
Proceeding.
Use of Estimates - The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities,
disclosure of contingent assets and liabilities at the date of the financial
statements, and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
8
Penthouse International, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
1. (Continued)
Net Income (Loss) Per Common Share - Basic income (loss) per common share is
calculated by dividing net income (loss) by the weighted average number of
common shares outstanding during the period. Diluted loss per common share
reflects the potential dilution that would occur if dilutive stock options and
warrants were exercised. These potentially dilutive securities were not included
in the calculation of income (loss) per share for the periods presented because
the Company incurred a loss during the periods in which the dilutive securities
have been outstanding and thus their effect would have been anti-dilutive.
Accordingly, basic and diluted loss per common share is the same for all periods
presented.
On May 13, 2003, the Company declared a 3 for 1 stock split (See Note 13 of the
Notes to Condensed Consolidated Financial Statements). Loss per common share
calculations for the three months ended March 31, 2003 and 2002 give
retro-active effect to the 3-for-1 split as if it occurred on January 1, 2002.
New Accounting Pronouncements
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated
with Exit or Disposal Activities," which requires companies to recognize costs
associated with exit or disposal activities when they are incurred rather than
at the date of a commitment to an exit or disposal plan. Such costs covered by
SFAS No. 146 include lease termination costs and certain employee severance
costs that are associated with a restructuring, discontinued operation, plant
closing, or other exit or disposal activity. SFAS No. 146 replaces the previous
accounting guidance provided by the EITF No. 94-3, "Liability Recognition for
Certain Employee Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring)." SFAS No. 146 is to be
applied prospectively to exit or disposal activities initiated after December
31, 2002. The Company does not expect that the adoption of SFAS No. 146 will
have a significant effect on the Company's financial statement presentation or
disclosures.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure". SFAS No. 148 amends SFAS No. 123,
"Accounting for Stock-Based Compensation", to provide alternative methods of
transition for a voluntary change to the fair value based method of accounting
for stock-based employee compensation. In addition, SFAS No. 148 amends the
disclosure requirements of SFAS No. 123 to require prominent disclosures in both
annual and interim financial statements about the method of accounting for
stock-based employee compensation and the effect of the method used on reported
results. SFAS No. 148 is effective for fiscal years beginning after December 15,
2002. The interim disclosure provisions are effective for financial reports
containing financial statements for interim periods beginning after December 15,
2002. The Company does not expect that the adoption of SFAS No. 148 will have a
significant effect on the Company's financial statement presentation or
disclosures.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity". SFAS No. 150
establishes standards for how an issuer classifies and measures in its statement
of financial position certain financial instruments with characteristics of both
liabilities and equity. SFAS No. 150 requires that an issuer classify a
financial instrument that is within its scope as a liability (or an asset in
some circumstances) because that financial instrument embodies an obligation of
the issuer. SFAS No. 150 is effective for financial instruments
9
Penthouse International, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
1. (Continued)
entered into or modified after May 31, 2003 and otherwise is effective at the
beginning of the first interim period beginning after June 15, 2003. SFAS No.
150 is to be implemented by reporting the cumulative effect of a change in
accounting principle for financial instruments created before the issuance date
of SFAS No. 150 and still existing at the beginning of the interim period of
adoption. Restatement is not permitted. The Company does not expect that the
adoption of SFAS No. 150 will have a significant effect on the Company's
financial statement presentation or disclosures.
2. Inventories
Inventories include the following:
December 31, June 30,
2002 2003
-------- In Thousands --------
(Unaudited)
Paper and printing $ 1,599 $ 651
Editorials and pictorial 1,456 1,469
Film and programming costs 300 242
------- --------
$ 3,355 $ 2,362
======= ========
3. Management Charge
Up until the filing of the Bankruptcy Proceeding on August 12, 2003, General
Media shared common indirect expenses for the benefit of GMI and affiliated
companies, including accounting, personnel, management information systems,
employee relations and other administrative services. During the six months
ended June 30, 2003, General Media charged GMI $150,000 for these shared
expenses. In addition, up until the filing of the Bankruptcy Proceeding, General
Media was charged by GMI and its subsidiaries for the benefit of other corporate
overhead costs, executive compensation and other costs, which principally relate
to office space. During the six months ended June 30, 2003, GMI charged General
Media $226,000 for these shared expenses. These allocations were based on
factors determined by management of the Company and GMI to be appropriate for
the particular item, including estimated relative time commitments of managerial
personnel, relative number of employees and relative square footage of all space
occupied. Management believes that the allocation method and amounts were
reasonable. As part of the DIP Financing, the arrangement has been suspended and
replaced by compensation payments to the Company's President / Principal
Executive Officer, and the Executive Vice President that may not exceed $41,667
and $12,500 per month, respectively, commencing August 2003.
10
Penthouse International, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
4. Notes Payable
On December 21, 1993, General Media issued $85,000,000 of Senior Secured Notes
(the "Notes") at an issue price equal to 99.387% of the principal amount of the
Notes. As part of the issuance of the Notes, General Media issued 85,000 common
stock purchase warrants to the purchasers of the Notes and sold to the
underwriter at a discount 102,506 warrants (the "Warrants"). The Warrants,
having an expiration date of December 22, 2000, entitled the holders to purchase
in the aggregate 25,000 shares of the General Media's common stock at the
exercise price of $0.01 per share. The Warrants also gave the holders the right
to require General Media to purchase for cash all of the Warrants at their fair
value. At the time of issuance, General Media recorded the Warrants at their
fair value.
The Notes were collateralized by a first priority security interest in all
intellectual property rights (including copyrights and trademarks) and
substantially all other intangible and tangible assets of General Media, other
than accounts receivable, inventory and cash equivalents.
In July 1995, General Media repurchased $5,000,000 face amount of its
outstanding Notes, including 5,000 warrants, for cash of $4,050,000. In May
1999, General Media repurchased $28,000,000 face amount of its outstanding Notes
for cash of $26,600,000. The remaining Notes matured on December 31, 2000 and
bore interest at 10-5/8% per annum, which was payable semiannually.
On December 22, 2000, 18,009 of the Warrants were exercised to purchase 2,401
shares of General Media's Common Stock and 104,076 Warrants expired without
being timely exercised in accordance with the Warrant agreement. The due date of
the remaining 60,421 Warrants held by holders of the Notes was extended as part
of the negotiations for refinancing the Notes. The exercise of the 18,009
Warrants was recorded in December 2000 as a reduction in redeemable warrants and
a contribution to capital of $173,000. The expiration of the 104,076 Warrants
was recorded in the financial statements in December 2000 as an extraordinary
gain from extinguishment of debt of $571,000, net of income tax of $465,000.
On March 29, 2001 (the "Closing Date"), General Media refinanced the Notes.
Under the refinancing agreement, General Media exchanged the $51,507,000 of
principal amount of Notes and any Warrants held by Noteholders (the "Consenting
Holders") for Series C Notes and mandatorily redeemable convertible preferred
stock (the "Preferred Stock") with a liquidation preference of $10,000,000 (see
Note 5) meeting certain specified terms and conditions. The remaining $493,000
principal amount of Notes that were not exchanged were retired by payments made
to the holders on March 29, 2001.
The Series C Notes mature on March 29, 2004, bear interest at a rate of 15% per
annum effective January 1, 2001 and require principal payments of $6,500,000
during 2003, with the balance due in 2004. In addition, further principal
payments equal to 50% of excess cash flow, as defined, in each year is required,
as well as any proceeds from the sale of certain real property owned by GMI
(after payment of existing debt obligations thereon) and any proceeds to General
Media from certain insurance policies (the "Policies") on the life of the
principal stockholder.
The Indenture has been extended to the March 29, 2004 maturity of the Series C
Notes. The original Indenture contained covenants, that will continue to the new
maturity date, which, among other things, (i) restrict the ability of General
Media to dispose of assets, incur indebtedness, create liens and make certain
investments, (ii) require General Media to maintain a consolidated tangible net
11
Penthouse International, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
4. (Continued)
worth deficiency of no greater than $81,600,000, and (iii) restrict General
Media's ability to pay dividends unless certain financial performance tests are
met. General Media's subsidiaries, which are guarantors of the Senior Secured
Notes under the Indenture, however, were and continue to be permitted to pay
intercompany dividends on their shares of common stock. The ability of General
Media and its subsidiaries to incur additional debt is severely limited by such
covenants. The Indenture was amended in conjunction with the issuance of the
Series C Notes to reflect the above mentioned payments, to reflect the March 29,
2004 maturity of the Series C Notes, to provide additional "Change of Control"
events (requiring the commencement of an offer to purchase Series C Notes), to
provide additional flexibility as to the nature of, but also to set a fixed
dollar limit for, "Owner Payments", and to require Noteholder consent to enter
into new lines of business or for sales or other conveyances of the Penthouse
trademark (other than ordinary course licensing) or other assets for net
proceeds in excess of $500,000. In addition, the related Security Agreement was
amended to grant additional security interests in inventory and accounts
receivable as well as a security interest in proceeds of the sale of certain
real property owned by GMI (after payment of existing debt obligations thereon)
and on any proceeds to General Media from certain Policies on the life of the
Company's principal beneficial owner.
On August 1, 2002, General Media and the holders of a majority of the principal
amounts of the Series C Notes (the "Holders") entered into a Third Supplemental
Indenture to amend the "Change of Control" events in the Indenture to add
further restrictions on the amount of "Owner Payments"; to substitute John
Orlando for John Prebich in the "Change of Control" provision; and to require
that new financial covenants (the "Financial Covenants") be added that require
General Media to achieve not less than 80% of the projected revenues and EBITDA
to be set forth in a business plan in a form and substance reasonably
satisfactory to the Holders. In addition, General Media agreed to allow the
Holders to audit the books and records of General Media and the payroll records
of GMI and to pay all the legal fees, costs and expenses, and audit fees of the
Holders (collectively the "Amendment Expenses") related to the agreement.
General Media recorded $214,000 of Amendment Expenses during the year ended
December 31, 2002. In exchange for these amendments the Holders agreed to waive
their prior contention that a "Change of Control" event had occurred with
respect to the termination of John Prebich, General Media's former President and
Chief Operating Officer.
On September 13, 2002, General Media submitted a business plan to the Holders
for approval in accordance with the requirements of the Third Supplemental
Indenture. The Holders notified General Media that they had accepted the
business plan effective October 4, 2002.
On November 12, 2002, General Media and the Holders entered into a Fourth
Supplemental Indenture to incorporate the Financial Covenants into the
Indenture.
John Orlando, General Media's President and Chief Operating Officer was
terminated on January 14, 2003. The Indenture requires that General Media hire a
replacement President and Chief Operating Officer reasonably satisfactory to a
majority of the Holders within ninety days of the date of either the resignation
or termination of John Orlando, to avoid a deemed "Change of Control" which in
turn requires that an offer to purchase be made by General Media to all Holders.
On March 28, 2003, a proposal was submitted to the Holders requesting
confirmation that Steven Gross would be reasonably satisfactory to them as a
replacement for John Orlando as General Media's President and Chief Operating
Officer.
12
Penthouse International, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
4. (Continued)
General Media made principal payments of $2,943,000 and $5,910,000 during the
years ended December 31, 2001 and 2002, respectively. The principal payments
during the year ended December 31, 2002 included $935,000 of proceeds from the
sale of certain officer's life insurance policies and approximately $475,000 of
proceeds from the sale of a work of art.
On March 29, 2003, General Media was required to make a principal payment of
$1,950,000. On April 14, 2003, the Indenture trustee issued a notice of event of
default with respect to the principal payment. On April 15 and 16, 2003 General
Media transferred additional funds (including the $185,000 made available
through the repayment of an intercompany balance from GMI) and fully paid the
$1,950,000 principal amount. On April 24, 2003, General Media and the Holders
completed a letter agreement that consented to the appointment of Stephen R.
Gross as president and chief operating officer of General Media, consented to
the filing of General Media's Form 10-K at any time on or before April 30, 2003,
consented to an amendment to the Indenture to change the date of the payment of
the $1,950,000 principal payment that was due on March 29, 2003 to April 17,
2003, and to acknowledge the payment in full of and the absence of any existing
or continuing violation, default or event of default under the Indenture with
respect to the $1,950,000 principal payment that was due on March 29, 2003. In
addition General Media and the Holders agreed to amend the "Change of Control"
events to substitute Stephen Gross for John Orlando, to eliminate any grace
periods with respect to future principal payments commencing with the principal
payment due June 29, 2003, to provide the Holders with a copy of the employment
agreement between General Media and Stephen Gross (the "Gross Employment
Agreement") by May 19, 2003, to liquidate no less than 50% of the aggregate book
value of all its artwork pieces in commercially reasonable sales (the "Sales")
on or before October 31, 2003 and to use 100% of the net proceeds of such Sales
to make additional principal redemption's of the Series C Notes. The agreement
was subject to approval by the Holders of the Gross Employment Agreement and the
completion of a supplemental indenture incorporating the terms of the letter
agreement on or before May 26, 2003. General Media, however, did not enter into
or supply the Gross Employment Agreement to the Holders and has not completed
the supplemental indenture incorporating the terms of the letter agreement and
as a result the letter agreement was terminated. In August 2003, the Company
terminated its relationship with Mr. Gross.
On March 31, 2003, General Media was required to make an interest payment in the
amount of $1,496,000, which was not made. As a result, the Series C Notes became
callable. On May 14, 2003, General Media and the Holders completed a letter
agreement in which the parties agreed that the Holders would forbear from
exercising certain rights and remedies under the Indenture in consideration for
the agreement of Mr. Guccione to contribute certain personal assets held by his
holding company, GMI, for the benefit of General Media, including the agreement
to:
a) execute and deliver to the trustee, on or before June 16,
2003, a mortgage and lien in a form satisfactory to the
Holders encumbering certain real estate owned by GMI (subject
to prior liens of not more than $25,000,000) and to pay costs
associated with the obtaining of the mortgage,
13
Penthouse International, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
4. (Continued)
b) cause GMI, on or before May 30, 2003, to provide a
non-recourse guaranty of the obligations of General Media (the
"Guaranty") and to secure its obligations under such Guaranty
with a pledge to the trustee of all of GMI's rights, title and
interest in the outstanding shares of common stock of PII
("PII Stock"), to deliver the PII Stock certificates and stock
powers to the trustee and to deliver a letter agreement
pursuant to which PII shall covenant that it will not sell,
pledge, transfer, assign or otherwise dispose of any of its
outstanding shares of common stock of General Media ("Common
Stock Obligation"),
d) pay the interest that is overdue on or before May 30, 2003,
e) provide the Holders with a detailed plan for the restructuring
of General Media's Series C Notes, together with supporting
computations, no later than June 30, 2003,
f) place a $100,000 deposit with the Holders by June 9, 2003
which shall be used to reimburse the Holders for the fees,
costs and expenses of their audit and legal counsel, and
g) allow the Holders to audit the books, records and assets of
General Media.
General Media paid the overdue interest on June 3, 2003 and has allowed the
Holders to audit the books, records and assets of General Media, but has failed
to comply with the other requirements of the letter agreement.
General Media also did not make a required principal payment in the amount of
$1,300,000 and a required interest payment of $48,000 that was due on June 29,
2003, did not make a required interest payment on the Series C Notes of
$1,447,000 that was due on June 30, 2003 and has not yet delivered the required
Financial Statements to the holders of the Series C Notes as required by the
Indenture defining the relative rights of General Media and the Note holders. On
July 3, 2003, the Holders sent a notice to General Media advising it of the
failure to make the required interest payment due on June 30, 2003, the failure
to make required principal payment of $1,300,000 that was due on June 29, 2003
and the failure to deliver the required Financial Statements. On July 8, 2003,
the trustee issued a notice of event of default with respect to the principal
payment and the Series C Notes became callable. The Series C Notes require
interest payments of $5,679,000 (including the unpaid interest) and principal
payments of $39,897,000 during the next twelve months plus default interest.
As stated in Note 1 of the Notes to Condensed Consolidated Financial Statements,
General Media and the other Debtors filed for protection under Chapter 11 after
negotiations with the holders of a majority of the principal amounts of the
Holders failed to obtain a waiver of the defaults or to provide working capital
for the Company's operations. In August 2003, two of the Holders entered into an
agreement with General Media to provide $5,000,000 of DIP Financing with
interest at 13% per annum. The Agreement limits the DIP Financing to $3,000,000
until a final financing order is signed by the Bankruptcy Court. The Agreement
also limits the amount of advances to the amount of principal projected to be
outstanding on a weekly basis as was set forth on a budget provided by General
Media on a schedule to the Agreement. Under the Agreement, General Media has
drawn down approximately $2,100,000 as of September 19, 2003. The Debtors have
14
Penthouse International, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
4. (Continued)
defaulted on certain covenants related to the DIP Financing and are negotiating
with the lenders for waivers. As a result of the Default, no additional advances
have been made, the full principal balance of the loan is due and the interest
due on the outstanding balance increased to 15% per annum.
5. Mandatorily Redeemable Convertible Preferred Stock
On March 29, 2001, General Media issued 9,905 shares of Preferred Stock to the
Consenting Holders at a fair value of $8,200,000. The Preferred Stock carries a
liquidation preference of $10,000,000, provides for "paid-in-kind" dividends at
a 13% per annum rate and is convertible at the option of the holders, after two
years following the Closing Date, into 10% of General Media's common stock on a
fully diluted basis in the third year, 12.5% of General Media's common stock on
a fully diluted basis in the fourth year, and 15% of such common stock on a
fully diluted basis during the fifth year. The Preferred Stock is mandatorily
redeemable by General Media (subject to the aforementioned conversion rights) at
its liquidation preference including the "paid-in-kind" dividends at the end of
the fifth year.
The Preferred Stock may be optionally redeemed by General Media during the
second year following the Closing Date at a redemption price of $10,000,000 and
at increasing premiums of 110%, 115% and 120% during the third, fourth and fifth
years, respectively, provided that the Series C Notes are paid in full at or
before the time of any redemption. The recorded value net of issuance costs is
being accreted up to the redemption value using the effective interest method
through the March 29, 2006 mandatory redemption date of the Preferred Stock. The
Company recorded $168,000 and $175,000 of such accretion for the six months
ended June 30, 2002 and 2003, respectively. The Company also recorded
"paid-in-kind" dividends of $706,000 and $804,000 for the six months ended June
30, 2002 and 2003, respectively. Both the accretion of the Preferred Stock and
the "paid-in-kind" dividends are reflected in the accompanying financial
statements as an increase in Mandatorily Redeemable Convertible Preferred Stock
and a decrease in Capital In Excess Of Par Value.
6. Income Taxes
The Company incurred a taxable loss of approximately $2,325,000 for the six
months ended June 30, 2003. In addition, the Company has a net operating loss
("NOL") carryover available from the prior year of approximately $2,682,000,
which can be used to reduce future taxable income. This NOL will expire in 2022.
The income tax provision for the six months ended June 30, 2003 is comprised of
state minimum taxes.
The Company and its subsidiaries are included in the consolidated Federal and
Combined New York State and New York City income tax returns of GMI. The
provision for income taxes (benefit) in the accompanying statements of
operations is allocated to the Company from GMI as if the Company filed separate
income tax returns. Since each member of a consolidated tax group is jointly and
severally liable for Federal income taxes of the entire group, the Company may
be liable for taxes of GMI or other members of the consolidated group. Under the
terms of a Tax Sharing and Indemnification Agreement (the "Agreement"), the
Company can utilize the net operating losses GMI ("GMI NOL's") to reduce its
income taxes as long as the Company is member of GMI's consolidated group. To
15
Penthouse International, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
6. (Continued)
the extent that the Company utilizes such GMI NOL's to reduce its income taxes,
it is required to pay GMI, within thirty days after the Company pays the group
consolidated tax liability, an amount that would have been paid in taxes had the
net operating losses of GMI not been available. At January 1, 2003, GMI had
available for Federal income tax purposes GMI NOL's aggregating approximately
$82,383,000 which can be used by the Company to reduce future income taxes, as
long as the Company is a member of GMI's consolidated group. These GMI NOL's
expire in tax years ending 2007 to 2022. The Company's ability to utilize net
operating losses may be limited in the future due to the additional issuance of
GMI's common stock or other changes in control, as defined in the Internal
Revenue Code and related regulations.
7. Commitments and Contingencies
Litigation
On May 8, 2002, an action was filed in United States District Court for the
Central District of California (the "California Court"), alleging, among other
things, that General Media published photographs (the "Photographs") of a woman
topless in the June 2002 issue of Penthouse Magazine (the "Magazine"), falsely
representing them to be pictures of the plaintiff when they were in reality
photographs of someone else. On July 10, 2003, a settlement was reached with the
plaintiff for an amount that both parties agreed to keep confidential. The
settlement will not have a material effect on the Company's financial statements
or results of operations.
On August 26, 2002, two individuals on behalf of themselves and all others
similarly situated (the "Class Action Plaintiffs") filed in the Circuit Court of
Cook County, Illinois, (the "Illinois Court") an action alleging that General
Media committed a breach of contract, a breach of express warranty and consumer
fraud when it published the Photographs, falsely representing them to be
pictures of the aforementioned plaintiff when they were in reality photographs
of someone else. On May 16, 2003, the Illinois Court dismissed the case. In June
2003 the Class Action Plaintiffs filed an amended complaint and asked for
reconsideration of the dismissal. The Company intends to vigorously defend
itself it against this claim.
On July 13, 2001, an employee filed a charge of discrimination (the "Charge")
against General Media with the U.S. Equal Employment Opportunity Commission
("EEOC"). On April 11, 2003, the District Director of the EEOC ruled that there
was reasonable cause to find that the employee had been subject to
discrimination on the basis of disability and age, and that she had been
constructively discharged. General Media and the EEOC have been conducting
meetings with the employee to determine what actions need to be taken to resolve
the Charge. On May 9, 2003, the EEOC recommended a settlement of various
institutional training for the Company and a monetary award of $700,000 for the
employee. The Company has rejected the EEOC's recommendation on legal and
factual grounds and intends to vigorously defend itself in this action. It is
too early to determine the possible outcome of the proceedings. Therefore
management cannot give an opinion as to the effect this action will have on the
Company's financial condition or results of operations. There can be no
assurance, however, that the ultimate liability from these proceedings will not
have a material adverse effect on its financial condition or results of
operations.
On March 28, 2003, a former employee of General Media who was terminated for
what General Media believes to be reasonable cause, filed a claim in the Supreme
16
Penthouse International, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
7. (Continued)
Court of the State of New York seeking damages of $75,000 plus an accounting of
their incentive compensation. The Company believes it has no liability to this
individual and is vigorously defending itself against this claim.
On March 10, 2003, a former employee of General Media filed a claim in the
Supreme Court of the State of New York seeking damages of $1,000,000 for an
alleged breach of her employment contract and loss of outside opportunities. The
plaintiff claims she was setting up an outside business venture to become a
consultant to General Media when she handed in her resignation. She claims that
she handed in her resignation, but was persuaded to withdraw it, was allegedly
offered her job back, following which her employment was terminated. The Company
denies the claims and is vigorously defending itself against this claim.
On June 20, 2003, Fraserside Holdings Limited and Milcap Media Limited filed a
claim in the Supreme Court of the State of New York, for an alleged breach of
contract regarding a 1999 agreement with General Media to jointly produce and
distribute a series of adult motion pictures. The complaint alleges damages of
$2,200,000 for breach of contract, breach of fiduciary responsibility, duty of
loyalty and fair dealing, and demands for an accounting of revenues and expenses
related to the pictures and a declaration that all property in the movies
belongs to the plaintiff. The Company believes the claims are without merit and
intends to vigorously defend itself in this claim.
In December 2002, General Media received correspondence from a third party that
transmission of video content on the Internet is a violation of patents that the
third party claims to own. The third party has demanded that General Media
execute a royalty agreement in favor of the third party with respect to revenue
from any videos that it displayed on its Internet Site. To the Company's
knowledge, no action has been instituted against it by the third party. The
Company believes that it does not owe any royalties to this third party and
intends to vigorously defend itself in any action brought against it by the
third party.
General Media has fallen behind in making its monthly lease payments on its
principal offices in Manhattan. As a result, the landlord has obtained a
judgement from the Civil Court of The City Of New York (the "Court") for unpaid
rent in the amount of $449,000 and for the right to obtain a warrant of
eviction. The landlord's efforts to seek a warrant of eviction have been stayed
by the Bankruptcy Proceeding. The Company is in the process of locating
alternate facilities while at the same time negotiating with the landlord for a
possible settlement of the case. The Company has provided for a fixed asset
leasehold improvement impairment charge in the amount of $1,061,000 in the
Condensed Consolidated Statements of Operations for the six months ended June
30, 2003 because it is uncertain that the Company will reach an agreement with
the landlord and remain in its office facilities to the end of the lease term.
There are various lawsuits claiming amounts against the Company. While the
outcome of these matters is currently not determinable, it is the opinion of the
Company's management that the ultimate liabilities, if any, from the outcome of
these cases will not have a material effect on the Company's financial
statements.
17
Penthouse International, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
8. Segment Information
The Company, through General Media, is currently engaged in activities in three
industry segments: publishing, online and entertainment. The publishing segment
of the Company is engaged in the publication of Penthouse magazine and four
affiliate magazines (the "Affiliate Publications" and, together with Penthouse
magazine, the "Men's Magazines"), the licensing of the Company's trademarks to
publishers in foreign countries, for use on various consumer products and
services, and, starting in 2002, for use in the operation of adult entertainment
clubs. The online segment is engaged in the sale of memberships to the Company's
Internet site (the "Internet Site"), the sale of advertising banners posted on
the Internet Site and the sale of adult-oriented consumer products through the
Company's online store. The entertainment segment of the Company produces a
number of adult-oriented entertainment products and services, including
pay-per-call telephone lines, digital video discs ("DVD's"), video cassettes and
pay-per-view programming.
18
Penthouse International, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
8. (Continued)
Corporate and
reconciling
Publishing Online Entertainment items Consolidated
------------------------------ ( in thousands)---------------------------------
Six Months Ended
June 30, 2003
Revenues from customers
Circulation $11,140 $11,140
Advertising 2,162 2,162
Online $3,042 3,042
Entertainment $739 739
Other 1,727 1,727
------- ------ ------ -------- --------
Total revenue from customers 15,029 3,042 739 18,810
Leasehold Improvement Impairment Charge
1,061 1,061
Depreciation and amortization 160 26 2 188
Income (loss) from operations 2,114 2,002 392 (3,630) 878
Interest expense 59 3,137 3,196
Interest income 4 4
Segment profit (loss) before income taxes 2,059 2,002 392 (6,767) (2,314)
Minority interest 11 11
Segment assets 5,870 72 364 4,315 10,621
Six Months Ended
June 30, 2002
Revenues from customers
Circulation $20,045 $20,045
Advertising 4,045 4,045
Online $3,962 3,962
Entertainment $877 877
Other 1,353 1,353
------- ------ ------ -------- --------
Total revenue from customers 25,443 3,962 877 30,282
Depreciation and amortization 234 37 2 273
Income (loss) from operations 8,153 2,242 279 (5,559) 5,115
Interest expense 147 3,644 3,791
Interest income 4 57 61
Segment profit (loss) before income taxes 8,010 2,242 279 (8,335) 2,196
Minority interest (11) (11)
Segment assets 8,873 156 743 9,583 19,355
19
Penthouse International, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
9. Leasehold Improvement Impairment Charge
The Company has provided for a fixed asset leasehold improvement impairment
charge in the amount of $1,061,000 on the Condensed Consolidated Statements of
Operations for the six months ended June 30, 2003 because it is uncertain that
the Company will reach an agreement with the landlord concerning unpaid rent on
its principal office facilities and be able to remain in these facilities to the
end of the lease term (See Note 7 of the Notes To Condensed Consolidated
Financial Statements).
10. Website Management Agreement
In May 2003, three of the Company's subsidiaries, General Media Communications,
Inc., GMCI Internet Operations, Inc. and General Media Entertainment, Inc. (the
"Subsidiaries") entered into a website management agreement (the "Website
Agreement") effective March 31, 2003 with Penthouse Financial LLC. Penthouse
Financial LLC is not owned, operated or an affiliate of the Company or GMI. As
consideration for the Subsidiaries to enter into the Website Agreement, an
affiliate of Penthouse Financial LLC was to pay a non-refundable, non-recoupable
fee of $1,000,000 (the "Fee") to the Subsidiaries. The Website Agreement
erroneously stipulated that the Fee was to be paid through the cancellation of a
loan that had been made by an affiliate of Penthouse Financial LLC to GMI.
Since the Website Agreement was executed in May 2003 and Penthouse Financial LLC
had not assumed responsibility for the management of the websites, there was no
financial statement impact as a result of the Website Agreement in the
accompanying financial statements as of June 30, 2003. The parties to the
Website Agreement terminated the Agreement on September 18, 2003.
11. Amendment To Distribution Agreement
On April 15, 2003, General Media signed an amendment to its agreements with its
magazine distributor, Curtis Circulation Company ("Curtis") that extended the
expiration date of its distribution agreement from November 8, 2005 to November
8, 2009 and eliminated the Company's right to terminate the distribution
agreement upon notice, as defined, in return for Curtis's agreement to allow GMI
and General Media to repay notes payable owed by GMI in the amount of $3,000,000
and accounts receivable owed by General Media in the amount of $75,000 by
payments of $50,000 per month until such time as General Media refinances not
less than 50% of its outstanding debt and $125,000 per month thereafter. The
amendment also provides for further extensions of the distribution agreement of
two months beyond the new expiration date for each month that payments made
under the amendment do not equal to $125,000 per month commencing on July 2003.
Curtis claims that it may deduct any amounts owed to it by GMI under the
agreement from monies owed to General Media under its distribution agreement
with Curtis and this claim is disputed by the Debtors. The Company acknowledged
that GMI and Robert C. Guccione had made certain guaranties at the foot of the
amendment. As of June 30, 2003 Curtis owed General Media $880,000 under its
distribution agreement, of which approximately $290,000 has been subsequently
collected. As of September 16, 2003 Curtis owed General Media $2,379,000.
Collection of this receivable is uncertain because of this claim. In September
2003, Curtis threatened to suspend distribution of General Media's publications
and entered into negotiations with General Media to determine the terms under
which magazines will be distributed while the Debtors are operating under
Chapter 11 protection.
20
Penthouse International, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
11. (Continued)
The Indenture governing General Media's Series C Notes restricts the Company
from issuing guarantees on any Indebtedness, as defined. The terms of the
amendment violated the Indenture covenant restricting the Company from issuing
guarantees. The distribution agreement is subject to the Court's jurisdiction in
the Bankruptcy Proceeding.
12. Letter Of Intent
The Company entered into a letter of intent with Fernando Molina ("Seller")
outlining the terms of a series of proposed transactions under which the Company
would form a subsidiary, Penthouse in Ixtapa, Inc., to acquire certain real
property consisting of 712 acres of ocean-front property in Mexico (the "Mexico
Property") from the Seller in consideration for 120,000 shares of Series C
Redeemable Preferred Stock with a face amount of $1,000 per share, 24,000,000
shares of common stock of the Company, a fee of 6,000,000 newly issued shares of
common stock of the Company to be issued to designated individuals of Ixtapa
Consultants, Inc. and the agreement of the principal shareholder of GMI, Robert
Guccione, to contribute ownership of the common stock of GMI, exclusive of GMI's
ownership of the Company, to the Company in exchange for 30,000,000 newly issued
shares of the common stock of the Company and 119,000 new issued shares of the
common stock of General Media. The letter of intent also provides that the
Company will use its best efforts to secure a third party loan, the net proceeds
of which are not less than $25,000,000, which are to be used to redeem a portion
of the Series C Redeemable Preferred Stock. The Series C Redeemable Preferred
Stock would be senior to all outstanding preferred stock of the Company, pay
dividends at the rate of 4% per annum, payable if and when declared by the board
of directors of the Company and carries a liquidation preference equal to the
lesser of (1) $1,000 per share, plus accrued but unpaid dividends, or, (2) the
proceeds from the sale of the Mexico Property or capital stock of Penthouse in
Ixtapa, Inc. To the extent any of the contemplated transactions involve any of
the Debtors, the transactions are subject to the jurisdiction of the Court in
the Bankruptcy Proceeding. The terms and conditions of the letter of intent are
not legally binding on either party and there is no assurance that any of the
contemplated transactions will occur.
13. Three For One Stock Split
On May 15, 2003 the Board of Directors of the Company declared a three for one
stock split of the Company's common stock by means of a 200% stock dividend. The
Company distributed two additional shares of common stock to the shareholders
through the distribution of a dividend of two additional shares for each share
owned on the record date of May 12, 2003. The stock split occurred on May 22,
2003. The accompanying financial statements have been restated effective January
1, 2002 to reflect the effect of the three for one stock split on the respective
periods.
14. Outstanding Shares
The number of shares outstanding includes 1,690,000 restricted shares which a
registered holder claims were lost or stolen. Despite receiving the affidavit of
loss and indemnification agreement from the registered holder, the Company's
transfer agent will not cancel the certificates without receipt of a indemnity
bond which the holder refuses to pay for. The Company will not permit the
transfer or make any distribution in respect of the shares represented by the
lost or stolen certificates and is investigating whether and under what
circumstances it would pay for an indemnity bond.
21
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
FORWARD LOOKING STATEMENTS
In addition to historical information, "Management's Discussion and Analysis of
Financial Condition and Results of Operations" contains forward-looking
statements as to expectations, beliefs, plans, objectives and future financial
performance, and assumptions underlying or concerning the foregoing. These
forward-looking statements involve risks and uncertainties and are based on
certain assumptions, which could cause actual results or outcomes to differ
materially from those expressed in the forward looking statements. The following
are important factors that could cause actual results or outcomes to differ
materially from those discussed in the forward-looking statements: (a) the
ability of the Company to reach an agreement with the Holders concerning the
defaults and events of default under the Series C Notes; (b) the ability of the
Company to reach an agreement with the landlord concerning unpaid rent owed by
the Company; (c) the ability of the Company to continue to obtain the
cooperation of its vendors in supplying goods and services while it makes
arrangements for financing its debts and operating needs; (d) the ability of the
Company to generate sufficient cash from future operations to make all the
payments required under the Series C Notes; (e) government actions or
initiatives, including (1) attempts to limit or otherwise regulate the sale of
adult-oriented materials, including print, video and online materials, (2)
regulation of the advertisement of tobacco products, or (3) significant changes
in postal regulations or rates; (f) increases in paper and printing prices; (g)
increased competition for advertisers from other publications and media or any
significant decrease in spending by advertisers generally, or with respect to
the adult male market; (h) effects of the consolidations taking place among
businesses which are part of the magazine distribution system; (i) uncertainty
with regard to the future market for entertainment, e-commerce and advertising
by way of the Internet; (j) the impact on advertising sales of a slow-down or
possible recession in the economy, an increasingly competitive environment and
competition from other content and merchandise providers; (k) the impact of the
reorganization of General Media, Inc., and its subsidiaries under Chapter 11 of
the Bankruptcy Code which involves substantially all of the Company's assets and
operations; (l) the ability of such entities to operate pursuant to the terms of
the debtor-in-possession financing facility; (m) the ability of such entities to
obtain court approval with respect to motions in the Chapter 11 proceeding made
by them from time to time; (n) the ability of such entities to develop, obtain
approval for and implement a plan of reorganization; (o) risks associated with
third parties seeking and obtaining court approval to terminate or shorten the
exclusivity period for the entities to propose and confirm a plan of
reorganization or to convert the case to a Chapter 7 case; (p) the ability of
the entities to obtain and maintain normal terms with vendors and service
providers; (q) the ability of the entities to maintain contracts that are
critical to its operations; and (r) the potential adverse impact of the Chapter
11 case on the entities liquidity or results of operations. Readers are
cautioned not to place undue reliance on these forward-looking statements, which
reflect management's opinions only as of the date hereof. We undertake no
obligation to revise or publicly release the results of any revision to these
forward-looking statements.
22
CHAPTER 11 BANKRUPTCY FILING
The Company is the holder of 99.5% of the common stock of General Media, Inc.
(together with its subsidiaries,General Media"). The Company is majority owned
by General Media International, Inc. ("GMI"). On August 12, 2003, General Media
and its direct and indirect subsidiaries, General Media Art Holding, Inc.,
General Media Communications, Inc., General Media Entertainment, Inc., General
Media (UK), Ltd., GMCI Internet Operations, Inc., GMI On-Line Ventures, Ltd.,
Penthouse Images Acquisitions, Ltd. and Pure Entertainment Telecommunications,
Inc., (collectively, the "Debtors"), filed voluntary petitions for relief under
Chapter 11 of Title 11 of the United States Code (the "Bankruptcy Code") in the
United States Bankruptcy Court for the Southern District of New York (the
"Bankruptcy Court"). The Debtors are managing their properties and operate their
businesses as "debtors-in-possession" subject to the supervision and orders of
the Bankruptcy Court (Case No. 03-15078) pursuant to Sections 1107(a) and 1108
of the Bankruptcy Code. The Debtors are developing but have not filed either a
plan of reorganization or a term sheet setting forth material terms of such
plan.
On September 18, 2003 the Unsecured Creditors Committee in the Bankruptcy
Proceeding filed a motion to convert the case from a Chapter 11 reorganization
to a Chapter 7 liquidation case. The Debtors promptly filed their opposition to
the motion and intend to resist the Unsecured Creditors Committee's motion.
OVERVIEW
We are a brand-driven global entertainment company founded in 1965 by Robert C.
Guccione. We cater to men's interests through various trademarked publications,
movies, the Internet, location-based live entertainment clubs and consumer
product licenses. Our flagship Penthouse brand is widely identified with premium
entertainment for adult audiences. Our trademarks are licensed to third parties
worldwide in exchange for recurring royalty payments.
Beginning in 1995, we developed our Internet website with the introduction of
Penthousemag.com through which we began digitally distributing our proprietary
content. Today we operate through the domain names www.Penthouse.com and
www.Penthousefetish.com where members pay subscription fees for access to our
content.
General Media also holds significant intellectual property and other intangible
assets. We own various trademarks developed over 37 years, which we believe are
commercially valuable, including Penthouse, Forum, Variations, Penthouse
Letters, the Three Key Logo, the One Key Logo, Pet of the Year, Penthouse Pet,
Mind & Muscle Power, Hot Talk, Penthouse Comix and Penthouse Men's Adventure
Comix. Through the publication of our magazines we have also accumulated a
library of approximately one million photographic images. We seek to protect our
trademarks through registration and periodic infringement enforcement. We
regularly evaluate requests to license our brands, our video library or to
participate in other commercial ventures by contributing our trademarks,
including events with our Penthouse Pets. Our trademarks and copyrights are
critical to the success and potential growth of all of our businesses.
Beginning in the third quarter of 2002, we began to license our trademarks to
select luxury gentlemen's clubs, referred to as Location-based Entertainment, in
consideration for a percentage of the gross revenue of the clubs.
23
We are currently generating revenues in three industry segments: publishing,
online and entertainment. The publishing segment is engaged in publication of
Penthouse magazine and the Affiliate Publications, the licensing of our
trademarks to publishers in foreign countries, for use on various consumer
products and, starting in 2002, for use in the operation of adult clubs. The
online segment is engaged in the sale of memberships to our Internet Site, the
sale of advertising banners posted on the Internet Site and, starting in 2001,
the sale of adult-oriented consumer products through our online store. The
entertainment segment provides a number of adult-oriented entertainment products
and services, including pay-per-call telephone lines, digital video discs,
videocassettes and pay-per-view programming.
During the six months ended June 30, 2003, net revenues declined by 37.9%. This
decline is primarily attributable to General Media being unable print and
distribute Penthouse, Penthouse Letters and Girls of Penthouse magazine during
May 2003 and all of our publications in June 2003 (the "Delayed Publications).
These delays were caused by General Media's inability, because of liquidity
problems, to reach a settlement of past due invoices with its printing
contractors, paper suppliers and magazine distributor. Other factors negatively
effecting revenue were the weak economy and the impact of the war in Iraq and
troop deployment that caused an industry wide decrease in newsstand magazine
sales, as well as, the unusually severe weather in many parts of the country
during the period.
Management was successful in reducing selling, general and administrative during
the six months ended June 30, 2003, by 26.7% as a result of cost reduction
measures implemented during 2002 and 2003 and tight controls over cash spending
in 2003.
Income from operations decreased 82.8% during the period ended June 30, 2003,
primarily as a result of the effect of the lost revenue from delayed issuance of
the magazines and an impairment charge for leasehold improvements (the
"Impairment") in the amount of $1.1 million during the period ending June 30,
2003 which resulted from an uncertainty that the we would remain in our current
principal office to the end of the lease term, partially offset by reduced
selling, general and administrative expenses.
Operating margins decreased from 16.9% to 4.7%, in the comparable quarters
ending June 30, 2002 and 2003, respectively, primarily as a result of the same
factors as the decrease in income from operations.
Net income was $2.2 million for the six months ended June 30, 2002, compared to
a net loss of $2.3 million for the six months ended June 30, 2003, a decrease of
$4.5 million, primarily as a result of the same factors given above.
EBITDA decreased from $6.2 million to $2.1 million, a decrease of $4.1 million
in the comparable quarters.
24
EBITDA during the six months ended June 30, 2002 and 2003 was as follows:
EBITDA (1)
Six Months
June 30,
(Unaudited)
2002 2003
---- ----
Net income (loss) $2.2 $(2.3)
Adjusted for:
Leasehold Improvement Impairment
Charge 1.1
Depreciation 0.3 0.2
Interest expense, net 3.8 3.2
Other (rounding) (0.1) (0.1)
---- -----
$6.2 $2.1
==== ====
(1) EBITDA represents income from operations before leasehold improvement
impairment charge, depreciation, interest expense and interest income. We
evaluate our operating results based on several factors, including EBITDA.
We consider EBITDA an important indicator of the operation strength and
performance of our ongoing businesses, including our ability to provide
cash flows to pay interest, service debt and fund capital expenditures.
EBITDA also eliminates the impact of how we fund our businesses and the
effect of changes in interest rates, which are not necessarily indicative
of our operating performance. EBITDA should not be considered an
alternative to any measure of performance or liquidity under accounting
principles generally accepted in the United States of America. EBITDA
should not be inferred as more meaningful than any of those measures.
The following table sets forth our selected quarterly data for the six months
and three months ended June 30, 2002 and 2003:
Six Months Three Months
June 30, June 30,
---------------- --------------
2002 2003 2002 2003
---- ---- ---- ----
Net revenues $30.3 $18.8 $16.1 $7.7
Income from operations 5.1 0.9 3.5 0.4
Net income (loss) 2.2 (2.3) 2.5 (1.1)
The Company has undertaken or is planning the following actions during 2003,
which are primarily directed at improving its revenue generating capability,
with the intention of improving its cash flow:
o The Company is in the process of developing a reorganization
plan for its operations as part of the filing of the Chapter
11 Bankruptcy Proceeding by the Debtors on August 12, 2003.
o The Company is expanding royalty income through the licensing
of its trademarks to additional adult entertainment clubs. A
new club in New York, New York was opened by a licensee in
June 2003;
25
o Through the club licensing agreements, the Company has been
able to attract capital in the form of upfront license
payments and has also attracted indirectly additional risk
capital for the construction of branded club facilities,
including the New York facility, which will assist in growing
its licensing income;
o The Company has entered into a new video distribution
agreement with a digital cable provider to the cruise ship
industry that delivers on demand pay-per-view entertainment;
o The Company is evaluating opportunities to establish
partnerships with third party content companies to produce a
larger number of movies to be distributed using the Penthouse
trademarks;
o The Company is evaluating opportunities to expand the
licensing of its trademarks;
o The Company is also exploring the possibility of establishing
relationships with other companies to find better ways to
generate revenue from its large collection of pictorial
inventory and to reach a wider audience on the Internet;
Results of Operations (Three Months Ended June 30, 2003 vs. 2002)
Net Revenues
Total net revenues were $16.1 million for the three months ended June 30, 2002,
compared to revenues of $7.7 million for the three months ended June 30, 2003, a
decrease of $8.4 million. This decrease was a combination of $7.9 million from
our Publishing Segment, $0.1 million from our Entertainment Segment and $0.4
million for the Online Segment.
Net Revenue
Three Months
June 30,
2002 2003
---- ----
Publishing Segment $13.7 $5.8
Online Segment 1.9 1.5
Entertainment Segment 0.5 0.4
----- ----
$16.1 $7.7
===== ====
Publishing Segment
The decrease in revenue in the publishing segment was primarily attributable to
a decrease in Newsstand revenues, as a result of a decrease in the number of
copies of Penthouse magazine and the Affiliate Publications sold. Newsstand
revenues decreased $5.2 million, from $8.5 million in 2002 to $3.3 million for
the three months ended June 30, 2003. This decrease is primarily attributable to
our being unable to distribute the Delayed Publications in the months of May and
June described in the Overview above, which was caused by our liquidity
problems. In addition, newsstand sales have been adversely affected by the
continued weakness in the economy, the impact of the war in Iraq which caused an
industry wide decrease in magazine sales, the unusually severe weather in many
26
parts of the country during the first two months of 2003 and by the continued
loss of newsstand distribution outlets due to the change in social climate
towards men's magazines, advances in electronic technology, including the
proliferation of retail video outlets and the increased market share of cable
television and the internet, as well as ongoing acquisitions and consolidations
of companies in the magazine distribution industry which have for several years
resulted in a reduction in the number of outlets carrying our magazines. To
attempt to offset this decline, we have implemented special marketing strategies
aimed at developing new outlets for our magazines and rewarding growth in sales
by distributors.
Advertising revenue represented $1.7 million of the publishing segment revenue
decrease, dropping from $2.5 million for the three months ended June 30, 2002 to
$0.8 million for the three months ended June 30, 2003. This decrease is
primarily attributable to our being unable to distribute the Delayed
Publications in the months of May and June 2003. This decrease is also
attributable to a decrease in the number of advertising pages sold per issue and
a decrease in the average rate per page of advertising pages sold in Penthouse
magazine and the Affiliate Publications.
Subscription revenue accounted for $1.3 million of the decrease in our
publishing segment, decreasing from $2.2 million for the three months ended June
30, 2002 to $0.9 million for the three months ended June 30, 2003 due primarily
to our inability to distribute the Delayed Publications in the months of May and
June 2003. In addition, the decrease is partially attributable to a decrease in
the number of subscription copies sold per issue as a result of a decrease in
the number of subscription acquisition direct mailings done in the current year
and a slight decrease in the rate per copy sold of Penthouse magazine.
Revenues from licensing of foreign editions increased from $0.4 million for the
three months ended June 30, 2002 to $0.5 million for the three months ended June
30, 2003.
Online Segment
The decrease in revenue in the online segment is primarily attributable to a
decrease in revenue from the sale of memberships to the Internet Site of $0.4
million. The decrease in revenue resulted from a decrease in the average price
of the memberships sold and a decrease in the number of members as compared to
the prior year. Sales of memberships have been adversely affected by the
weakness in the economy and declining circulation of the Company's magazines
that provide a major source of advertising for the site. In October 2002, we
increased the price of memberships to the Internet Site and eliminated some
lower priced options in order to increase the average price paid for memberships
going forward. We also redesigned the site to add more features and content to
make it more appealing to members. These changes have helped to encourage
members to retain their memberships for longer periods of time and increase the
average price of memberships. However, the increased pricing has also lead to a
decrease in the number of members. We expect the average price of memberships to
continue to increase as new members are added at the higher prices. We also plan
to enter into cross-marketing programs with other web sites to increase the
amount of traffic coming to the Internet Site.
27
Entertainment Segment
The decrease in revenue in the entertainment segment was primarily due to our
video business. Revenues of the video business were $0.3 million for the three
months ended June 30, 2002 compared to $0.2 million for the three months ended
June 30, 2003, a decrease of $0.1 million. Revenues for the three months ended
June 30, 2003 were lower due to fewer new movies being produced and released for
sale during the last 12 months. The amount of video business revenues earned in
each period varies with the timing of new contracts for the production and
distribution of movies.
Revenues from the Company's pay-per-call business were $0.1 million for the
three months ended June 30, 2002 compared to $0.2 million for the three months
ended June 30, 2003, an increase of $0.1 million.
Publishing - production, distribution, pictorial and editorial
Publishing-production, distribution, pictorial and editorial expenses were $6.2
million and $2.8 million for the three months ended June 30, 2002 and 2003,
respectively, a decrease of $3.4 million. The decrease is primarily due to our
inability to print and distribute the Delayed Publications in the months of May
and June 2003, as explained above. In September, 2003, the distributor of our
magazines has threatened to suspend distribution of General Media's publications
and entered into negotiations with General Media to determine the terms under
which magazines will be distributed while the Debtors are operating under
Chapter 11 protection.
Paper costs were $2.1 million and $0.9 million for the three months ended June
30, 2002 and 2003, respectively, representing $1.2 million of the decrease.
Printing costs were $2.3 million for the three months ended June 30, 2002,
compared to $0.9 million for the three months ended June 30, 2003, representing
$1.4 million of the decrease. These decreases are primarily the result of our
being unable to distribute the Delayed Publications in the months of May and
June 2003, as explained above. In addition, the decreases were the result of
negotiating reductions in the price of paper and printing costs, by changing the
grades of paper used to produce the magazines and by changing their design to
improve production efficiencies.
Distribution costs were $1.1 million and $0.5 million for the three months ended
June 30, 2002 and 2003, respectively, a decrease of $0.6 million. The decrease
is primarily the result of our being unable to distribute the Delayed
Publications in the months of May and June 2003, as explained above
Pictorial and editorial costs were $0.7 million and $0.4 million for the three
months ended June 30, 2002 and 2003, respectively, a decrease of $0.3 million.
The decrease is primarily the result of our being unable to distribute the
Delayed Publications in the months of May and June 2003, as explained above.
Online - direct costs
Direct costs for the online segment were $26,000 and $15,000 for the three
months ended June 30, 2002 and 2003, respectively, a decrease of $11,000. The
decrease is primarily attributable to a decrease in fees paid to content
providers.
Entertainment - direct costs
Entertainment direct costs were $0.2 million for the three months ended June 30,
2002 and $0.1 million for the three months ended June 30, 2003.
28
Selling, general and administrative
Selling, general and administrative expense was $5.8 million for the three
months ended June 30, 2002, compared to $4.5 million for the three months ended
June 30, 2003, a decrease of $1.3 million. The decrease is primarily due to a
decrease in salaries and benefits of $0.4 million, subscription acquisition
expenses of $0.3 million, legal expense of $0.3 million, bank charges of $0.1
million, rent expense of $0.1 million, promotional expense of $0.1 million and
fulfillment expense of $0.1 million. This was partially offset by an increase in
insurance expense of $0.1 million for the three months ended June 30, 2003.
Selling, general and administrative expenses for the Publishing Segment were
$2.5 million for the three months ended June 30, 2002, compared to $2.0 million
for the three months ended June 30, 2003, a decrease of $0.5 million. The
decrease is primarily due to a decrease in subscription acquisition expenses of
$0.3 million, fulfillment expense of $0.1 million and promotional expense of
$0.1 million during the three months ended June 30, 2003.
Selling general and administrative expenses for the online segment were $0.7
million for the three months ended June 30, 2002, compared to $0.5 million for
the three months ended June 30, 2003, a decrease of $0.2 million. The decrease
is primarily attributable to a decrease in salaries and benefits of $0.1 million
and bank charges of $0.1 million during the three months ended June 30, 2003.
Selling, general and administrative expenses for the entertainment segment were
$0.1 million for both the three months ended June 30, 2002 and June 30, 2003,
respectively.
Included in selling, general and administrative expenses are corporate
administrative expenses which includes executive, legal, human resources,
finance and accounting, management information systems, costs related to the
operation of the corporate and executive offices and various other expenses.
Corporate administrative expenses were $2.7 million for the three months ended
June 30, 2002, compared to $2.0 million for the three months ended June 30,
2003, a decrease of $0.7 million. This decrease is primarily attributable to
decreased salaries and benefits of $0.4 million, legal expense of $0.3 million,
and rent expense of $0.1 million. This decrease was partially offset by an
increase in insurance expense of $0.1 million for the three months ended June
30, 2003.
Bad debt expense
Bad debt expense was $0.1 million for the three months ended June 30, 2002,
compared to recoveries of bad debts of $0.1 million for the three months ended
June 30, 2003, an decrease of $0.2 million. The decrease is primarily due to
collections of subscription receivables that had previously been reserved for,
as their collectability was uncertain.
Rent expense from affiliated companies
Rent expense from affiliated companies represents charges from an affiliated
company for our use of the affiliate's facilities. The charge is based upon our
proportionate share of the operating expenses of such facilities. Rent expense
from affiliated companies was $0.2 million and $0.1 million for the three months
ended June 30, 2002 and 2003, respectively.
29
Depreciation and amortization
Depreciation and amortization expense was $0.1 million for both the three months
ended June 30, 2002, and June 30, 2003, respectively.
Income from operations
As a result of the above-discussed factors, income from operations was $3.5
million for the three months ended June 30, 2002, compared to $0.4 million for
the three months ended June 30, 2003.
Interest expense
Interest expense was $1.8 million for the three months ended June 30, 2002,
compared to $1.5 million for the three months ended June 30, 2003, a decrease of
$0.3 million. This decrease is due to a decrease in the total outstanding
principal amount of General Media's Series C Notes.
Gain of sale of officer's life insurance
For the three months ended June 30, 2002 we recognized a gain of $0.8 million on
the sale of certain insurance polices on the life of our principal shareholder.
Interest income
Interest income was $23,000 for the three months ended June 30, 2002, compared
to $2,000 for the three months ended June 30, 2003, a decrease of $21,000. The
decrease is due to a decrease in the amount of cash available for investment
during the current year.
Income before the provision for income taxes
As a result of the above discussed factors, income before income tax expense for
the three months ended June 30, 2002 was $2.5 million, compared to a loss before
income tax expense of $1.1 million for the three months ended June 30, 2003.
Results of Operations (Six Months Ended June 30, 2003 vs. 2002)
Net Revenues
Total net revenues were $30.3 million for the six months ended June 30, 2002,
compared to revenues of $18.8 million for the six months ended June 30, 2003, a
decrease of $11.5 million. This decrease was a combination of $10.5 million from
our Publishing Segment, $0.1 million from our Entertainment Segment and $0.9
million for the Online Segment.
Net Revenue
Six Months
June 30,
--------------------
2002 2003
---- ----
Publishing Segment $25.5 $15.0
Online Segment 3.9 3.0
Entertainment Segment 0.9 0.8
----- -----
$30.3 $18.8
===== =====
30
Publishing Segment
The decrease in revenue in the publishing segment was primarily attributable to
a decrease in Newsstand revenues, as a result of a decrease in the number of
copies of Penthouse magazine and the Affiliate Publications sold. Newsstand
revenues decreased $6.9 million, from $15.7 million in 2002 to $8.8 million for
the six months ended June 30, 2003. This decrease is primarily attributable to
our being unable to distribute the Delayed Publications in the months of May and
June 2003, as explained above, the continued weakness in the economy, the impact
of the war in Iraq which caused an industry wide decrease in magazine sales, the
unusually severe weather in many parts of the country during the first two
months of 2003 and by the continued loss of newsstand distribution outlets due
to the change in social climate towards men's magazines, advances in electronic
technology, including the proliferation of retail video outlets and the
increased market share of cable television and the internet, as well as ongoing
acquisitions and consolidations of companies in the magazine distribution
industry which have for several years resulted in a reduction in the number of
outlets carrying our magazines. To attempt to offset this decline, we have
implemented special marketing strategies aimed at developing new outlets for our
magazines and rewarding growth in sales by distributors.
Over the last several years, the number of newsstand copies of Penthouse
magazine and the Affiliate Publications sold per issue has been decreasing. From
June 30, 1999 to June 30, 2003, Penthouse magazine and the Affiliate
Publications domestic average monthly newsstand circulation decreased by 59%.
The decrease in circulation was due to our inability to distribute the Delayed
Publications in the months of May and June 2003, as explained above, the impact
of the war in Iraq which caused an industry wide decrease in magazine sales, the
unusually severe weather in many parts of the country during the first two
months of 2003, the loss of several newsstand distribution outlets due to the
change in the social climate towards men's magazines, advances in electronic
technology, as outlined above, and ongoing acquisitions and consolidations of
companies in the magazine distribution industry. Newsstand sales during 2003
have also been negatively impacted by the economic recession that began in 2001
and the failure of the economy to make a significant recovery during 2002 and
2003. We have raised the cover prices of the magazines and reduced production
costs to partially offset the decline in newsstand circulation. We are
attempting to increase newsstand sales though the use of special marketing
strategies we have implemented aimed at developing new outlets for its magazines
and rewarding growth in sales by distributors. We employ a direct newsstand
sales force to call on wholesalers and retailers to promote our magazines and to
provide information back to our corporate office on the success of our marketing
efforts. However our newsstand sales have fallen below that of the prior year
due to the negative factors listed above and the weakness of the economy over
the past few years that has resulted in an increase in the number of
bankruptcies or near bankruptcies of companies within the magazine distribution
system. As stated in Note 4 to the Notes to Condensed Consolidated Financial
Statements and the debt section of this management discussion and analysis, the
Debtors have defaulted on certain covenants related to the DIP Financing which
has resulted in a suspension of further advances under the DIP Financing and has
caused further delays in the printing of magazines because of the need to
negotiate with the printer, paper suppliers and magazine distributor concerning
methods of payment. In September 2003, the Company's magazine distributor
threatened to suspend distribution of its publications and entered into
negotiations with the Company to determine the terms under which magazines will
be distributed while the Company is operating under Chapter 11 protection. We
therefore expect newsstand sales for the third and fourth quarters and the year
to be lower than the prior year as a result of these factors.
31
Advertising revenue represented $2.2 million of the publishing segment revenue
decrease, dropping from $4.4 million for the six months ended June 30, 2002 to
$2.2 million for the six months ended June 30, 2003. This decrease is
attributable to a decrease in the number of advertising pages sold and a
decrease in the average rate per page of advertising pages sold in Penthouse
magazine and the Affiliate Publications.
Advertising revenue for the first six months of 2003 was adversely affected by
inability to distribute the Delayed Publications in the months of May and June
2003, as explained above The advertising revenues of Penthouse magazine and the
Affiliate Publications have been declining over the past several years. The
primary reason for the decrease in advertising revenue has been the decrease in
the average monthly circulation of our magazines, which has the effect of
decreasing advertising rates and making our magazines less attractive to
advertisers. In addition, many advertisers scaled back advertising in Penthouse
magazine during 2002 and the early part of 2003 as a result of the continuing
weakness in the economy, and many cigarette companies have either suspended or
scaled back advertising in magazines as a result of increased pressure from
regulatory agencies and concerns over litigation against tobacco companies.
There has also been a steady decrease in pay-per-call advertising over the past
several years as competition in the pay-per-call industry has caused rates per
minute to decrease and as pay-per-call services have attracted less of an
audience in recent years. In addition, the delays in the distribution of the
magazines and negative affects of our Chapter 11 bankruptcy filing on customer
goodwill have adversely affected our sales efforts. We are also pursuing
advertisers in many other industries in an attempt to improve our advertising
revenue. We believe, however, that due to the above mentioned negative factors,
2003 advertising revenues will fall below 2002 revenue.
Subscription revenue accounted for $1.7 million of the decrease in our
publishing segment, decreasing from $4.0 million for the six months ended June
30, 2002 to $2.3 million for the six months ended June 30, 2003. The decrease is
attributable to a decrease in the number of subscription copies sold per issue
as a result of a decrease in the number of subscription acquisition direct
mailings done in the current year, and by a slight decrease in the rate per copy
sold of Penthouse magazine. This was partially offset by a slight increase in
the rate per copy sold of the Affiliate Publications.
We have experienced a steady decline in the number of sales of subscription
copies of Penthouse magazine and the Affiliate Publications over the past
several years. We believe the reasons for the decrease are similar to the
reasons for the declining newsstand sales. Subscription revenue also decreased
as a result of a decrease in the number of subscription acquisition direct
mailings done over the past two years. In the first quarter of 2003 we decreased
the subscription prices of the magazines in an effort to attract more
subscribers and we have elected to delay subscription direct mailings that had
been planned for the first half of 2003 due to our liquidity problems. The level
of expected revenue from subscriptions is heavily dependent on the number of
subscription acquisition direct mailings done during the year. We also expect a
decrease in new customer orders as a result of the delays in the distribution of
the magazines mentioned above and the negative affects of our Chapter 11
bankruptcy filing on customer goodwill, although the impact of these factors is
not yet known. We therefore expect subscription revenues to fall below that of
2002. Also, the 11.6% increase in postal rates that went into effect in July
2002 is expected to reduce the profitability of subscription sales by
approximately $350,000 on an annualized basis.
32
Revenues from licensing of foreign editions increased from $0.8 million for the
six months ended June 30, 2002 to $1.0 million for the six months ended June 30,
2003.
We expect revenue from foreign licensing to increase moderately in 2003 as a
result of two new agreements with licensees that have been completed in 2003 and
several others that are in the process of being negotiated. However, this result
is partially dependent on the strength of the economy in the foreign countries
that we have existing and potential new licensees during 2003, which is
uncertain at this time.
Online Segment
The decrease in revenue in the online segment is primarily attributable to a
decrease in revenue from the sale of memberships to the Internet Site of $0.8
million. The decrease in revenue resulted from a decrease in the average price
of the memberships sold and a decrease in the number of members as compared to
the prior year. Sales of memberships have been adversely affected by the
weakness in the economy, declining circulation of the Company's magazines that
provide a major source of advertising for the site and the war in Iraq, that is
believed to have temporarily taken attention away from the site. In October
2002, we increased the price of memberships to the Internet Site and eliminated
some lower priced options in order to increase the average price paid for
memberships going forward. We also redesigned the site to add more features and
content to make it more appealing to members. These changes have helped to
encourage members to retain their memberships for longer periods of time and
increase the average price of memberships. However, the increased pricing has
also lead to a decrease in the number of members. We expect the average price of
memberships to continue to increase as new members are added at the higher
prices. We also plan to enter into cross-marketing programs with other web sites
to increase the amount of traffic coming to the Internet Site.
Revenues from the online segment, which began declining during 2001, primarily
as a result of the use of more aggressive credit card validation methods
required to comply with Visa's requirements, continued to decline in 2002 as a
result of decreases in the pricing of its memberships. As explained above,
revenue has decreased in the first six months of 2003 as compared to the prior
year. Revenue in the third quarter has been negatively impacted by temporary
disruptions in operations caused by problems with vendors and service providers
because of past due invoices as a result of our liquidity problems and
subsequent bankruptcy filing, as well as weakness in the economy which has
caused revenue to fall below that of the prior year. Revenue in the fourth
quarter of 2003 will depend on the strength of the economy during the remainder
of 2003, which is uncertain at this time and our ability to maintain normal
operations while we develop, obtain approval for and implement a reorganization
plan under Chapter 11 of the Bankruptcy Code. Visa has recently announced a
tightening of its chargeback limits effective October 1, 2003. We do not believe
we will need to improve our validation methods any further to meet the new
requirements and the change will have no material effect on the sales of
memberships to the Internet Site. However, Visa has the right to modify the
maximum allowable chargeback level at any time. Should Visa decide to reduce the
maximum chargeback level, we may need to intensify our validation methods
further to meet the new requirements, which would result in a decrease in the
number of customers who would be accepted as members of the Internet Site.
MasterCard established its own regulations for maximum chargeback and refund
levels that went into effect in April 2002. Our chargeback and refund levels
have remained well within those required by MasterCard's regulations and these
regulations have had no material effect on the sales of memberships to the
Internet Site. There is also the possibility that one or more of the credit card
companies may decide to stop processing adult on-line internet transactions
altogether, which most likely would result in a decrease in online revenues. We
believe revenues from the advertising banners in the Internet Site for 2003 will
fall below that of 2002. However we have added several links to other sites in
place of traditional ads, that are generating revenue roughly equivalent to the
amounts generated by traditional advertisements sold in the prior year. The
revenue from these links is expected to offset any decline experienced from the
decrease in advertising banners. Revenue from the online store in 2003 is
expected to remain fairly consistent with that of 2002.
33
Entertainment Segment
The decrease in revenue in the entertainment segment was primarily due to our
video business. Revenues of the video business were $0.6 million for the six
months ended June 30, 2002 compared to $0.4 million for the six months ended
June 30, 2003, a decrease of $0.2 million. Revenues for the six months ended
June 30, 2003 were lower due to fewer new movies being produced and released for
sale during the last 12 months. The amount of video business revenues earned in
each period varies with the timing of new contracts for the production and
distribution of movies.
Revenues from the Company's pay-per-call business were $0.3 million for both the
six months ended June 30, 2002 and 2003, respectively.
Revenues from the Entertainment Segment have been declining over the past few
years as a result of decreases in our video business revenues and demand for
pay-per-call services. Our video business revenues for the six months ended June
30, 2003 have decreased over the prior year for the reasons stated above. We are
in the process of establishing new business relationships to increase our video
business revenue for 2003 and thereafter. However results for 2003 will depend
on how quickly we are able to reach agreements with prospective partners in
producing and distributing the movies, the timing of the movie releases and our
ability to maintain normal operations while we develop, obtain approval for and
implement a reorganization plan under Chapter 11 of the Bankruptcy Code. We are
also working with our pay-per-call service provider to increase the revenue of
the pay-per-call business through improved marketing and coordination efforts by
the two companies.
Publishing - production, distribution, pictorial and editorial
Publishing-production, distribution, pictorial and editorial expenses were $11.6
million and $7.3 million for the six months ended June 30, 2002 and 2003,
respectively, a decrease of $4.3 million. The decrease is primarily due to our
being unable to distribute the Delayed Publications in the months of May and
June 2003, as explained above.
Paper costs were $4.0 million and $2.4 million for the six months ended June 30,
2002 and 2003, respectively, representing $1.6 million of the decrease. Printing
costs were $4.2 million for the six months ended June 30, 2002, compared to $2.7
million for the six months ended June 30, 2003, representing $1.5 million of the
decrease. These decreases are primarily the result of our being unable to
distribute the Delayed Publications in the months of May and June 2003, as
explained above. In addition, the decreases were the result of negotiating
reductions in the price of paper and printing costs, by changing the grades of
paper used to produce the magazines and by changing their design to improve
production efficiencies.
34
Distribution costs were $2.0 million and $1.3 million for the six months ended
June 30, 2002 and 2003, respectively, a decrease of $0.7 million. These
decreases are primarily the result of our being unable to distribute the Delayed
Publications in the months of May and June 2003, as explained above.
Pictorial and editorial costs were $1.4 million and $1.0 million for the six
months ended June 30, 2002 and 2003, respectively, a decrease of $0.4 million.
These decreases are primarily the result of our being unable to distribute the
Delayed Publications in the months of May and June 2003, as explained above.
We have been steadily reducing our publishing-production, distribution and
editorial expenses over the past several years by reducing the number of copies
printed, reducing the number of pages per issue, negotiating reductions in paper
and printing costs. We have also changed the grades of paper used to produce the
magazines and changing their design to improve production efficiencies. We
expect these expenses to fall below that of 2002 as a result of the our being
unable to distribute the Delayed Publications in the months of May and June
2003, due to the cost saving measures taken during 2002 and further reductions
in the number of copies printed, partially offset by increases in printing costs
as a result of increases for inflation contained in contracts with our printers.
Paper prices are expected to remain stable for the near future. However, paper
prices tend to be volatile and a large increase in prices could have a material
adverse affect on our cash flows and profitability.
Online - direct costs
Direct costs for the online segment were $84,000 and $36,000 for the six months
ended June 30, 2002 and 2003, respectively, a decrease of $48,000. The decrease
is primarily attributable to a decrease in fees paid to content providers of
$57,000, partially offset by an increase in expenditures for content purchased
for the Internet Site of $9,000 for the six months ended June 30, 2003. Direct
costs are expected to increase at about the same rate as inflation in future
years.
Entertainment - direct costs
Entertainment direct costs were $0.4 million for the six months ended June 30,
2002 and $0.2 million for the six months ended June 30, 2003, a decrease of $0.2
million. The decrease in entertainment direct costs was due to lower levels of
production of films during the first six months of 2003. Direct costs for the
remainder of 2003 are expected to increase due to increased levels of production
of films and inflation.
Selling, general and administrative
Selling, general and administrative expense was $12.4 million for the six months
ended June 30, 2002, compared to $9.0 million for the six months ended June 30,
2003, a decrease of $3.4 million. The decrease is primarily due to a decrease in
salaries and benefits of $1.6 million, subscription acquisition expenses of $0.8
million, legal expense of $0.4 million, bank charges of $0.1 million, rent
expense of $0.1 million, data processing expenses of $0.1 million, service
contract expense of $0.1 million, security expense of $0.1 million, commission
expense of $0.1 million, and promotional expense of $0.1 million. This was
partially offset by an increase in meals and travel expense of $0.1 million for
the six months ended June 30, 2003.
35
Selling, general and administrative expenses for the Publishing Segment were
$5.5 million for the six months ended June 30, 2002, compared to $4.2 million
for the six months ended June 30, 2003, a decrease of $1.3 million. The decrease
is primarily due to a decrease in subscription acquisition expenses of $0.8
million, salaries and benefits of $0.3 million, commission expense of $0.1
million, and promotional expense of $0.1 million during the six months ended
June 30, 2003.
Selling general and administrative expenses for the online segment were $1.6
million for the six months ended June 30, 2002, compared to $1.0 million for the
six months ended June 30, 2003, a decrease of $0.6 million. The decrease is
primarily attributable to a decrease in salaries and benefits of $0.4 million,
bank charges of $0.1 million and data processing expense of $0.1 million during
the six months ended June 30, 2003.
Selling, general and administrative expenses for the entertainment segment were
$0.2 million for both the six months ended June 30, 2002 and June 30, 2003,
respectively.
Included in selling, general and administrative expenses are corporate
administrative expenses which includes executive, legal, human resources,
finance and accounting, management information systems, costs related to the
operation of the corporate and executive offices and various other expenses.
Corporate administrative expenses were $5.3 million for the six months ended
June 30, 2002, compared to $3.8 million for the six months ended June 30, 2003,
a decrease of $1.5 million. This decrease is primarily attributable to decreased
salaries and benefits of $0.9 million, legal expense of $0.4 million, security
expense of $0.1 million, service contract expense of $0.1 million and rent
expense of $0.1 million. This decrease was partially offset by an increase in
meal and travel expense of $0.1 million for the six months ended June 30, 2003.
In future years we expect selling, general and administrative expenses to
increase at about the same rate as inflation.
Leasehold improvement impairment charge
We provided for a leasehold improvement impairment charge of $1.1 million for
the six months ended June 30, 2003 because it is uncertain that we will be able
to reach an agreement with our landlord concerning unpaid rent on our principal
office facilities and be able to remain in these facilities to the end of the
lease term.
Bad debt expense
Bad debt expense was $0.1 million for the six months ended June 30, 2002,
compared to recoveries of $0.2 million for the six months ended June 30, 2003, a
decrease of $0.3 million. The decrease is primarily due to lower reserves for
advertising accounts receivable of $0.2 million due to decreased advertising
revenue during 2003 and collections of subscription receivables of $0.1 million
that had previously been reserved for as their collectability was uncertain.
Rent expense from affiliated companies
Rent expense from affiliated companies represents charges from an affiliated
company for our use of the affiliate's facilities. The charge is based upon our
proportionate share of the operating expenses of such facilities. Rent expense
from affiliated companies was $0.3 million and $0.2 million for the six months
ended June 30, 2002 and 2003, respectively.
36
Depreciation and amortization
Depreciation and amortization expense was $0.3 million for the six months ended
June 30, 2002, compared to $0.2 million for the six months ended June 30, 2003,
a decrease of $0.1 million. The decrease was due to decreased spending on fixed
assets.
Income from operations
As a result of the above-discussed factors, income from operations was $5.1
million for the six months ended June 30, 2002 as compared to a loss of $0.9
million for the six months ended June 30, 2003.
Interest expense
Interest expense was $3.8 million for the six months ended June 30, 2002,
compared to $3.2 million for the six months ended June 30, 2003, a decrease of
$0.6 million. This decrease is due to a decrease in the total outstanding
principal amount of General Media's Series C Notes.
Gain of sale of officer's life insurance
For the six months ended June 30, 2002 we recognized a gain of $0.8 million on
the sale of certain insurance polices on the life of our principal shareholder.
Interest income
Interest income was $61,000 for the six months ended June 30, 2002, compared to
$4,000 for the six months ended June 30, 2003, a decrease of $57,000. The
decrease is due to a decrease in the amount of cash available for investment
during the current year.
Income before the provision for income taxes
As a result of the above discussed factors, income before income tax expense for
the six months ended June 30, 2002 was $2.2 million, compared to a loss before
income tax expense of $2.3 million for the six months ended June 30, 2003.
LIQUIDITY AND CAPITAL RESOURCES
On August 12, 2003, as a result of principal payments due on outstanding Series
C Notes and continuing operating losses, the Debtors, filed voluntary petitions
for relief under the Bankruptcy Code in the Bankruptcy Court.
Our ability to continue operations and execute any of the business plans
described below is subject to many uncertainties, including the Debtors ability
to formulate and obtain approval of a reorganization plan; the Debtors' ability
to resolve outstanding liabilities on favorable terms, the availability of
post-petition financing and the willingness of third parties to deal with the
Debtors while they are involved in the Bankruptcy Proceeding. Management cannot
presently predict the outcome of these matters or the extent by which our equity
ownership in General Media will be impaired under the Debtors' reorganization
plan.
37
At June 30, 2002, we had $0.5 million in cash and cash equivalents, as compared
to $0.4 million at June 30, 2003, a decrease of $0.1 million. During the six
months ended June 30, 2003 there was a net increase in cash and cash equivalents
of $0.2 million. The increase was due to $1.7 million in cash provided by
operations and $1.6 million in collections from affiliated companies, partially
offset by $3.2 million in mandatory principal payments for General Media's
Series C Notes. At June 30, 2003, our current liabilities exceeded current
assets by $58.8 million.
As of March 31, 2003, General Media was required to make principal and interest
payments on its Series C Notes totaling $3.5 million. On April 14, 2003, the
Indenture trustee issued a notice of default with respect to the principal
payment. On April 15 and 16, 2003, General Media transferred additional funds
(including $0.2 million made available through the repayment of an intercompany
balance from GMI) and has fully paid the $2.0 million principal amount. A
required interest payment in the amount of $1.5 million was not made timely. As
a result, the Series C Notes became callable. On May 14, 2003, General Media and
the Holders completed a letter agreement in which the Holders granted an
extension of time for the payment of the overdue interest to May 30, 2003 in
return for certain collateral and a guaranty from GMI (See Note 4 of the Notes
to Condensed Consolidated Financial Statements). General Media paid the overdue
interest on June 3, 2003, but failed to comply with several requirements of the
letter agreement.
General Media also did not make a required principal payment in the amount of
$1.3 million and a required interest payment of $48,000 that was due on June 29,
2003, did not make a required interest payment on the Series C Notes of $1.4
million that was due on June 30, 2003 and has not yet delivered quarterly
financial statements for the period ending March 31, 2003 and June 30, 2003 (the
"Financial Statements) to the holders of the Series C Notes as required by the
indenture (the "Indenture") defining the relative rights of General Media and
the Note holders. On July 3, 2003, the holders of a majority of the principal
amounts of the Series C Notes (the "Holders") sent a notice to General Media
advising it of the failure to make the required interest payment due on June 30,
2003, the failure to make required principal payment of $1.3 million that was
due on June 29, 2003 and the failure to deliver the required Financial
Statements. On July 8, 2003, the trustee issued a notice of event of default
with respect to the principal payment and the Series C Notes became callable.
The Series C Notes require interest payments of $5.7 million (including the
unpaid interest) and principal payments of $39.9 million during the next twelve
months plus default interest.
On August 12, 2003, General Media and the other Debtors filed for protection
under Chapter 11 after negotiations with the holders of a majority of the
principal amounts of the Holders failed to obtain a waiver of the defaults or to
provide working capital for our operations. In August 2003, two of the Holders
entered into an agreement with General Media to provide $5.0 million of DIP
Financing with interest at 13% per annum. The Agreement limits the DIP Financing
to $3.0 million until a final financing order is signed by the Bankruptcy Court.
The Agreement also limits the amount of advances to the amount of principal
projected to be outstanding on a weekly basis as was set forth on a budget
provided by General Media on a schedule to the Agreement. Under the Agreement,
General Media has drawn down approximately $2.1 million as of September 19,
2003. The Debtors have defaulted on certain covenants related to the DIP
Financing and are negotiating with the lenders for waivers. As a result of the
Default, no additional advances have been made, the full principal balance of
the loan is due and the interest due on the outstanding balance increased to 15%
per annum.
38
General Media has fallen behind in making its monthly lease payments on its
principal offices in Manhattan. As a result, the landlord has obtained a
judgement from the Civil Court of The City Of New York (the "Court") for unpaid
rent in the amount of $0.4 million and for the right to obtain a warrant of
eviction. The landlord's efforts to seek a warrant of eviction have been stayed
by the Bankruptcy Proceeding. We are in the process of locating alternate
facilities while at the same time negotiating with the landlord for a possible
settlement of the case.
There can be no assurance that we will be able to secure the financing necessary
to meet our obligations and operating needs or reach an agreement with the
landlord.
In connection with an amendment to the Distribution Agreement between Curtis
Circulation Company ("Curtis") and the Debtors, Curtis claims that it may deduct
any amounts owed to it by GMI under the Agreement from monies owed to General
Media under its distribution agreement with Curtis, which the Debtors dispute.
We have undertaken or are planning the following actions during 2003, which are
primarily directed at improving our revenue generating capability, with the
intention of improving our cash flow:
o We are in the process of developing a reorganization plan for
our operations;
o We are expanding our royalty income through the licensing of
its trademarks to additional adult entertainment clubs. A new
club was opened in New York, New York by a licensee in June
2003;
o Through the club licensing agreements, we have been able to
attract capital in the form of upfront license payments and
have also attracted indirectly additional risk capital for the
construction of club facilities owned and operated by
licensees, including the New York facility, which will assist
in growing its licensing income;
o We have entered into a new video distribution agreement with a
digital cable provider to the cruise ship industry that
delivers on demand pay-per-view entertainment;
o We are evaluating opportunities to establish partnerships with
third party content companies to produce a larger number of
movies to be distributed using the Penthouse trademarks;
o We are evaluating opportunities to expand the licensing of its
trademarks;
o We are also exploring the possibility of establishing
relationships with other companies to find better ways to
generate revenue from its large collection of pictorial
inventory, including reaching a wider audience on the
Internet.
39
Any or all of the above actions will be effected by the Chapter 11 bankruptcy
filing and will not generate sufficient improvements to cash flow to meet
current debt service requirements. We are contemplating additional actions, to
provide cash and reduce liabilities. All of such actions are subject to the
Bankruptcy Court's jurisdiction and the claims of various parties to the
Bankruptcy proceeding. However, there can be no assurances that we will be able
to achieve such a result.
Cash flows from operating activities
Net cash used in operating activities was $0.8 million for the six months ended
June 30, 2002, compared to net cash provided by operating activities of $1.7
million for the six months ended June 30, 2003. The primary reason for the
increase in cash flow from operating activities for the six months ended June
30, 2003 was the net loss for the six months, adjusted for increased collections
of advances from our magazine distributor due to the timing of magazine
distribution dates, decreased paper inventories and an increase in accounts
payable due to the timing of payments to vendors. The net cash provided by
operating activities for the six months ended June 30, 2002, was derived by
adjusting the net income for the period by a significant decrease in accounts
payable due to the timing of payments to vendors and decreases in deferred
revenues. This was partially offset by a decrease in inventories, prepaid
insurance and spending on subscription acquisition drives during the six months
ended June 30, 2002.
Cash flows from investing activities
Cash flows provided by investing activities were $0.9 million for the six months
ended June 30, 2002. The cash provided by investing activities was the result of
the sale of certain officer's life insurance policies to an unrelated third
party
Cash flows from financing activities
Cash flows used in financing activities were $2.1 million for the six months
ended June 30, 2002, compared to cash flows used in financing activities of $1.6
million for the six months ended June 30, 2003. Cash used in financing
activities for the six months ended June 30, 2003 was the result of payments of
$3.2 million in mandatory principal payments for General Media's Series C Notes,
partially offset by collections from GMI of $1.6 million. Cash used in financing
activities for the six months ended June 30, 2002 was the result of $2.2 million
in mandatory principal payments for General Media's Series C Notes and $0.9
million of advances to GMI, partially offset by $1.0 million in cash received in
repayment of a loan from our principal shareholder.
Affiliated company advances at June 30, 2003 decreased $1.5 million from
December 31, 2002. Up until the filing of the Bankruptcy Proceeding on August
12, 2003, General Media shared common indirect expenses for the benefit of GMI
and affiliated companies, including accounting, personnel, management
information systems, employee relations and other administrative services.
During the six months ended March 31, 2003, General Media charged GMI $0.2
million for these shared expenses. In addition, up until the filing of the
Bankruptcy Proceeding, General Media was charged by GMI and its subsidiaries for
the benefit of other corporate overhead costs, executive compensation and other
costs, which principally relate to office space. During the six months ended
June 30, 2003, GMI charged General Media $0.4 million for these shared expenses.
These allocations were based on factors determined by management of the Company
and GMI to be appropriate for the particular item, including estimated relative
time commitments of managerial personnel, relative number of employees and
relative square footage of all space occupied. Management believes that the
allocation method and amounts were reasonable. As part of the DIP Financing, the
arrangement has been suspended and replaced by compensation payments to our
President / Principal Executive Officer, and the Executive Vice President that
may not exceed $41,667 and $12,500 per month, respectively, commencing August
2003.
40
DEBT
Our debt includes General Media's Series C Notes, which are collateralized by
substantially all of our assets. The Series C Notes, which bear interest at a
rate of 15% per annum, have a maturity date of March 29, 2004. As of June 30,
2003, General Media's unpaid principal balance on the Series C Notes was
approximately $39.9 million.
The Series C Notes require amortization payments of $6.5 million during the
calendar year 2003, of which $1.9 million was paid in April 2003, with the
balance of the Series C Notes in the amount of $35.3 million due in 2004. In
addition, further amortization equal to 50% of excess cash flow in each year is
required, as well as any proceeds from the sale of certain real property owned
by GMI (after payment of existing debt obligations thereon) and any proceeds to
us from certain insurance policies on the life of the principal shareholder.
The Indenture has been extended to the March 29, 2004 maturity of the Series C
Notes. The original Indenture contained covenants, that continue to the new
maturity date, which, among other things, (i) restrict our ability to dispose of
assets, incur indebtedness, create liens and make certain investments, (ii)
require us to maintain a consolidated tangible net worth deficiency of no
greater than $81.6 million, and (iii) restrict our ability to pay dividends
unless certain financial performance tests are met. Our subsidiaries, which are
guarantors of the Series C Notes under the Indenture, however, were and continue
to be permitted to pay intercompany dividends on their shares of common stock.
The ability of General Media and its subsidiaries to incur additional debt is
severely limited by such covenants.
The Indenture was amended in conjunction with the issuance of the Series C Notes
to reflect the above mentioned payments, to reflect the March 29, 2004 maturity
of the Series C Notes, to provide additional "Change of Control" events
(requiring the commencement of an offer to purchase Series C Notes), to provide
additional flexibility as to the nature of, but also to set a fixed dollar limit
for, "Owner Payments", and to require Noteholder consent to entering into new
lines of business or for sales or other conveyances of the Penthouse trademark
(other than ordinary course licensing) or other assets for net proceeds in
excess of $0.5 million. In addition, the related Security Agreement was amended
to grant additional security interests in inventory and accounts receivable as
well as a security interest in the proceeds of the sale of certain real property
owned by GMI (after payment of existing debt obligations thereon) and on any
proceeds to us from certain insurance policies on the life of our principal
beneficial owner.
On August 1, 2002, General Media and the Holders entered into a Third
Supplemental Indenture to amend the "Change of Control" events in the Indenture
to add further restrictions on the amount of "Owner Payments"; to substitute
John Orlando for John Prebich in the "Change of Control" provision; and to
require that new financial covenants (the "Financial Covenants") be added that
require us to achieve not less than 80% of the projected revenues and EBITDA to
be set forth in a business plan in a form and substance reasonably satisfactory
to the Holders. In addition we agreed to allow the Holders to audit the books
and records of General Media and the payroll records of General Media and GMI
41
and to pay all the legal fees, cost and expenses, and audit fees (collectively
the "Amendment Expenses") related to the agreement. We recorded $0.1 million of
Amendment Expenses during the year ended December 31, 2002. In July 2002, we
also paid $0.1 million to the Holders as a deposit against Amendment Expenses
expected to be incurred by the Holders in completing the further amendments to
the Indenture required to incorporate the accepted business plan into the
financial covenants. In exchange for these amendments the Holders agreed to
waive their prior contention that a "Change of Control" event had occurred with
respect to the termination of John Prebich, one of General Media's former
President and Chief Operating Officer's.
On September 13, 2002, General Media submitted a business plan to the Holders
for approval in accordance with the requirements of the Third Supplemental
Indenture. The Holders notified us that they had accepted the business plan
effective October 4, 2002. On November 12, 2002, General Media and the Holders
entered into the Fourth Supplemental Indenture to incorporate the Financial
Covenants into the Indenture. As of June 30, 2003, we were unable to comply with
the Financial Covenants.
John Orlando, General Media's President and Chief Operating Officer was
terminated on January 14, 2003. The Indenture requires that the Company hire a
replacement President and Chief Operating Officer reasonably satisfactory to a
majority of the Holders within ninety days of the date of either the resignation
or termination of John Orlando, to avoid a deemed "Change of Control" which in
turn requires that an offer to purchase be made by General Media to all Holders.
On March 28, 2003, General Media hired Stephen Gross to replace John Orlando as
the General Media's President and Chief Operating Officer. A proposal was
submitted to the Holders on that date requesting confirmation that Mr. Gross
would be reasonably satisfactory to them as a replacement for John Orlando as
General Media's President and Chief Operating Officer.
On March 29, 2003, General Media was required to make a principal payment of
$2.0 million. On April 14, 2003, the Indenture trustee issued a notice of event
of default with respect to the principal payment. On April 15 and 16, 2003
General Media transferred additional funds (including the $0.2 million made
available through the repayment of an intercompany balance from GMI) and has
fully paid the $2.0 million principal amount. On April 24, 2003, General Media
and the Holders completed a letter agreement that consented to the appointment
of Stephen R. Gross as president and chief operating officer of General Media,
consented to the filing of General Media's Form 10-K at any time on or before
April 30, 2003, consented to an amendment to the Indenture to change the date of
the payment of the $2.0 million principal payment that was due on March 29, 2003
to April 17, 2003, and to acknowledge the payment in full of and the absence of
any existing or continuing violation, default or event of default under the
42
Indenture with respect to the $2.0 million principal payment that was due on
March 29, 2003. In addition General Media and the Holders agreed to amend the
"Change of Control" events to substitute Stephen Gross for John Orlando, to
eliminate any grace periods with respect to future principal payments commencing
with the principal payment due June 29, 2003, to provide the Holders with a copy
of the employment agreement between General Media and Stephen Gross (the "Gross
Employment Agreement") by May 19, 2003, to liquidate no less than 50% of the
aggregate book value of all its artwork pieces in commercially reasonable sales
(the "Sales") on or before October 31, 2003 and to use 100% of the net proceeds
of such Sales to make additional principal redemption's of the Series C Notes.
The agreement was subject to approval by the Holders of the Gross Employment
Agreement and the completion of a supplemental indenture incorporating the terms
of the letter agreement on or before May 26, 2003. General Media has not entered
into or supplied the Gross Employment Agreement to the Holders or completed the
supplemental indenture incorporating the terms of the letter agreement and as a
result the letter agreement was terminated. In August 2003, the Company
terminated its relationship with Mr. Gross.
On March 31, 2003, General Media was required to make an interest payment in the
amount of $1.5 million, which was not made. As a result, the Series C Notes
became callable. On May 14, 2003, General Media and the Holders completed a
letter agreement in which the parties agreed that the Holders would forbear from
exercising certain rights and remedies under the Indenture in consideration for
the agreement of Mr. Guccione to contribute certain personal assets held by his
holding company, GMI, for the benefit of General Media, including the agreement
to:
a) execute and deliver to the trustee, on or before June 16,
2003, a mortgage and lien in a form satisfactory to the
Holders encumbering certain real estate owned by GMI (subject
to prior liens of not more than $25.0 million) and to pay
costs associated with the obtaining of the mortgage,
b) cause GMI, on or before May 30, 2003, to provide a
non-recourse guaranty of the obligations of General Media (the
"Guaranty") and to secure its obligations under such Guaranty
with a pledge to the trustee of all of GMI's rights, title and
interest in the outstanding shares of common stock of PII
("PII Stock"), to deliver the PII Stock certificates and stock
powers to the trustee and to deliver a letter agreement
pursuant to which PII shall covenant that it will not sell,
pledge, transfer, assign or otherwise dispose of any of its
outstanding shares of common stock of General Media ("Common
Stock Obligation"),
c) pay the interest that is overdue on or before May 30, 2003,
d) provide the Holders with a detailed plan for the restructuring
of General Media's Series C Notes, together with supporting
computations, no later than June 30, 2003,
e) place a $0.1 million deposit with the Holders by June 9, 2003
which shall be used to reimburse the Holders for the fees,
costs and expenses of their audit and legal counsel, and
f) allow the Holders to audit the books, records and assets of
General Media,
43
General Media paid the overdue interest on June 3, 2003, but failed to comply
with several requirements of the letter agreement.
General Media also did not make a required principal payment in the amount of
$1.3 million and a required interest payment of $48,000 that was due on June 29,
2003, did not make a required interest payment on the Series C Notes of $1.4
million that was due on June 30, 2003 and has not yet delivered quarterly
Financial Statements to the holders of the Series C Notes as required by the
Indenture defining the relative rights of General Media and the Note holders. On
July 3, 2003, the Holders sent a notice to General Media advising it of the
failure to make the required interest payment due on June 30, 2003, the failure
to make required principal payment of $1.3 million that was due on June 29, 2003
and the failure to deliver the required Financial Statements. On July 8, 2003,
the trustee issued a notice of event of default with respect to the principal
payment and the Series C Notes became callable. The Series C Notes require
interest payments of $5.7 million (including the unpaid interest) and principal
payments of $39.9 million during the next twelve months plus default interest.
On August 12, 2003, General Media and the other Debtors filed for protection
under Chapter 11 after negotiations with the holders of a majority of the
principal amounts of the Holders failed to obtain a waiver of the defaults or to
provide working capital for our operations. In August 2003, two of the Holders
entered into an agreement with General Media to provide $5.0 million of DIP
Financing with interest at 13% per annum. The Agreement limits the DIP Financing
to $3.0 million until a final financing order is signed by the Bankruptcy Court.
The Agreement also limits the amount of advances to the amount of principal
projected to be outstanding on a weekly basis as was set forth on a budget
provided by General Media on a schedule to the Agreement. Under the Agreement,
General Media has drawn down approximately $2.1 million as of September 19,
2003. The Debtors have defaulted on certain covenants related to the DIP
Financing and are negotiating with the lenders for waivers. As a result of the
Default, no additional advances have been made, the full principal balance of
the loan is due and the interest due on the outstanding balance increased to 15%
per annum.
In connection with an amendment to the Distribution Agreement between Curtis
Circulation Company ("Curtis") and the Debtors, Curtis claims it may deduct any
amounts owed to it by GMI under the Agreement from monies owed to General Media
under its distribution agreement with Curtis and the Debtors dispute this claim.
The Company acknowledged at that GMI and Robert C. Guccione had made certain
guaranties at the foot of the amendment.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Securities and Exchange Commission Financial Reporting Release No. 60 requires
all companies to include a discussion of critical accounting policies or methods
used in the preparation of the consolidated financial statements. In addition,
Financial Reporting Release No. 61 requires all companies to include a
discussion to address, among other things, liquidity, off-balance sheet
arrangements, contractual obligations and commercial commitments. The following
discussion is intended to supplement the summary of significant accounting
policies included in Note 1 of the Notes To Consolidated Financial Statements
for the year ended December 31, 2002 included in the Company's annual report on
Form 10-K.
44
These policies were selected because they represent the more significant
accounting policies and methods that are broadly applied in the preparation of
the consolidated financial statements. Revenues, expenses, accrued liabilities
and allowances related to certain of these policies are initially based on our
best estimates at the time of original entry in our accounting records.
Adjustments are recorded when our actual experience differs from the expected
experience underlying the estimates. These adjustments could be material if our
experience were to change significantly in a short period of time. We make
frequent comparisons of actual experience and expected experience in order to
mitigate the likelihood of material adjustments.
a. Revenue Recognition - Sales of magazines for retail
distribution are recorded on the on-sale date of each issue
based on an estimate of the revenue for each issue of the
magazine, net of estimated returns. These estimates are based
upon several factors, including but not limited to historical
trends, days on sale and special editorial or pictorial
content. Estimated revenues are adjusted to actual revenues as
actual sales information becomes available. Actual sales
information generally becomes available ninety days after the
on-sale date for U.S. and Canadian sales and final settlement
occurs one hundred and eighty days after the off-sale date for
U.S., Canadian and international sales.
Advances in the amounts of $1.0 million and $3.0 million
relating to two distribution agreements for our magazines are
being recognized as revenue on a straight-line basis over the
ten year terms of each of the related contracts. An advance in
the amount of $0.9 million relating to a licensing agreement
for domestic sales of our digital video disc versions of our
video products is being recognized as revenue on a straight
line basis over the seven year term of the agreement.
b. Retail Display Allowances - Retail display allowances are
payments made to convenience stores, bookstores and newsstands
as an incentive to handle and sell magazines. The formula used
to calculate the allowance is negotiated on an individual
basis with each outlet owner and varies accordingly. However
each formula is based on a combination of a percentage of
sales dollars and an amount per copy sold. Accruals for retail
display allowances are recorded as a reduction of newsstand
revenues on the on-sale date based upon past experience using
the estimated sales of each issue, net of estimated returns.
As new information becomes available the accruals are adjusted
accordingly.
c. Taxes - In preparing our financial statements we make
estimates of our current tax exposure and temporary
differences resulting from timing differences for reporting
items for book and tax purposes. We recognize deferred taxes
by the asset and liability method of accounting for income
taxes. Under the asset and liability method, deferred taxes
are recognized for differences between the financial statement
and tax bases of assets and liabilities at enacted statutory
tax rates in effect for the years in which the differences are
expected to reverse. The effect on deferred taxes of a change
in tax rates is recognized in income in the period that
includes the enactment date. In addition, valuation allowances
are established when necessary to reduce deferred tax assets
to the amounts expected to be realized. In consideration of
our taxable loss in the current year and lack of historical
ability to generate taxable income to utilize our deferred tax
assets, we have recorded a full valuation allowance.
45
GMI, General Media and the Other GMI Subsidiaries are parties
to the Tax Sharing Agreement pursuant to which such parties
file consolidated federal, state and local income tax returns
so long as permitted by the relevant tax authorities. The Tax
Sharing Agreement sets forth the methodology for allocating
income taxes and the use of net operating losses ("NOLs")
between General Media, GMI and the Other GMI Subsidiaries. We,
however, are not required to pay income or franchise taxes
(except certain alternative taxes) to the extent that we can
utilize a portion of the NOLs of GMI and the Other GMI
Subsidiaries pursuant to the terms of the Tax Sharing
Agreement. Prior to 2000, we were not required to reimburse
GMI and the Other GMI Subsidiaries for the use of the NOLs
generated by these entities. In addition, the Tax Sharing
Agreement provides that GMI and the other GMI Subsidiaries
indemnify us from any income or franchise tax liabilities of
the consolidated group in excess of the $26 million arising
during years ending through December 31, 1993.
d. Other Loss Reserves - We have other loss exposures, such as
accounts receivable reserves and reserves for refunds that
would be required if we do not attain circulation levels
stipulated in contracts with advertisers. Establishing
allowances for doubtful accounts and loss reserves for these
matters requires the use of estimates and judgment in regards
to risk exposure and the ultimate liability. We estimate
losses using consistent and appropriate methods; however,
changes to our assumptions could materially affect our
estimate of allowances and losses. Where available we utilize
published credit ratings for our debtors to assist us in
determining the amount of required reserves.
Impact Of Recently Issued Accounting Pronouncements
Certain provisions of The Emerging Issues Task Force pronouncement EITF 01-9,
"Accounting for Consideration Given by a Vendor to a Customer (Including a
Reseller of the Vendor's Products)", are effective for fiscal periods beginning
after December 15, 2001. The Task Force reached a consensus that consideration
from a vendor to a reseller of the vendor's products is presumed to be a
reduction of the selling prices of the vendor's products and, therefore, should
be characterized as a reduction of revenue when recognized in the vendor's
income statement. Beginning January 2002 we adopted this policy as it relates to
retail display allowances. Retail display allowances had been included in
selling, general and administrative expenses prior to the adoption of this
policy. The effect on General Media of the adoption of the policy is a reduction
of newsstand revenue and an equivalent reduction in selling, general and
administrative expenses.
In June 2002, the FASB issued SFAS 146, "Accounting for Costs Associated with
Exit or Disposal Activities". This statement is effective for exit or disposal
activities initiated after December 31, 2002. The Company does not believe that
this statement will have a material effect on the Company's financial
statements.
46
In October 2002, the FASB issued SFAS 147, "Acquisitions of Certain Financial
Institutions". This statement is effective for acquisitions for which the date
of acquisition is on or after October 1, 2002. The Company does not believe that
this statement will have a material effect on the Company's financial
statements.
In December 2002, the FASB issued SFAS 148, "Accounting for Stock-Based
Compensation-Transition and Disclosure". The statement amends SFAS 123,
"Accounting for Stock-Based Compensation", and is effective for fiscal years
ending after December 15, 2002. The Company does not believe that this statement
will have a material effect on the Company's financial statements.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity". SFAS No. 150
establishes standards for how an issuer classifies and measures in its statement
of financial position certain financial instruments with characteristics of both
liabilities and equity. SFAS No. 150 requires that an issuer classify a
financial instrument that is within its scope as a liability (or an asset in
some circumstances) because that financial instrument embodies an obligation of
the issuer. SFAS No. 150 is effective for financial instruments entered into or
modified after May 31, 2003 and otherwise is effective at the beginning of the
first interim period beginning after June 15, 2003. SFAS No. 150 is to be
implemented by reporting the cumulative effect of a change in accounting
principle for financial instruments created before the issuance date of SFAS No.
150 and still existing at the beginning of the interim period of adoption.
Restatement is not permitted. The Company does not expect that the adoption of
SFAS No. 150 will have a significant effect on the Company's financial statement
presentation or disclosures.
Contractual Obligations and Commercial Commitments
The Company does not utilize off balance sheet financing other than operating
lease arrangements for office premises and related equipment. The following
table summarizes all commitments under contractual obligations as of June 30,
2003:
-----------------Obligations due-------------
Total 1 2-3 4-5 Over 5
Amount Year Years Years Years
-----------------(In millions)---------------
Senior Secured Notes $39.9 $39.9 $ - $ - $ -
Operating Leases 11.3 1.9 3.7 3.8 1.9
Other Long-Term Liabilities 0.7 0.2 0.3 0.2 -
Total Cash Obligations $51.9 $42.0 $4.0 $4.0 $1.9
Interest On Senior Secured Notes $ 5.7 $ 5.7 $ - $ - $ -
47
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
We are exposed to market risk from changes in interest rates. Management does
not believe that it has any foreign currency rate risk.
Interest Rates-As of December 31, 2000, we had debt of $52.0 million with a
fixed rate of 10 5/8%. On March 29, 2001 we exchanged $51.5 million of this debt
for new debt with a fixed rate of 15% and retired $0.5 million of the debt. In
July 2001, October 2001 and December 2001, we retired $0.7 million, $1.1
million, $0.7 million of the new debt, respectively, in accordance with the
requirements of the Series C Notes. In April, May, July, October and December
2002, we retired $1.3 million, $0.9 million, $1.3 million, $1.9 million and $0.5
million of the new debt, respectively, in accordance with the requirements of
the Series C Notes. In January and April 2003 we retired $1.3 million and $1.9
million of the new debt, respectively, in accordance with the requirements of
the Series C Notes. We are subject to market risk based on potential
fluctuations in current interest rates.
Foreign-Exchange Rate Risk - We do not believe we have exposure to foreign
exchange rate risk because all of our financial instruments are denominated in
U.S. dollars.
Item 4. CONTROLS AND PROCEDURES
We evaluated the effectiveness of the design and operation of our "disclosure
controls and procedures" ("Disclosure Controls") pursuant to Rules 13a-14(c) of
the Securities Exchange Act of 1934, as amended (the "Exchange Act") and our
"internal controls and procedures for financial reporting" (Internal Controls)
as of the end of the period covered by this report. This evaluation (the
"Controls Evaluation") was done under the supervision and with the participation
of management.
Disclosure Controls are procedures that are designed with the objective of
ensuring that information required to be disclosed in our reports filed under
the Exchange Act is recorded, processed, summarized and reported within the time
periods specified in the SEC's rules and forms. Disclosure Controls are also
designed with the objective of ensuring that such information is accumulated and
communicated to our management, including the President (Principal Executive
Officer) to allow timely decisions regarding required disclosure. Internal
Controls are procedures which are designed with the objective of providing
reasonable assurance that (1) our transactions are properly authorized; (2) our
assets are safeguarded against unauthorized or improper use; and (3) our
transactions are properly recorded and reported, all to permit the preparation
of our financial statements in conformity with generally accepted accounting
principles in the United States Of America.
Among other matters, we sought in our Controls Evaluation to determine whether
there were any "significant deficiencies" or "material weaknesses" in our
Internal Controls, or whether we had identified any acts of fraud involving
personnel who have a significant role in our Internal Controls. In professional
auditing literature, "significant deficiencies" are referred to as "reportable
conditions"; these are control issues that could have a significant adverse
effect on the ability to record, process, summarize and report financial data in
the financial statements. A "material weakness" is defined in the auditing
literature as a particularly serious reportable condition where the internal
control does not reduce to a relatively low level the risk that misstatements
caused by error or fraud may occur in amounts that would be material in relation
to the financials statements and not be detected within a timely period by
employees in the normal course of performing their assigned functions. We also
sought to deal with other controls matters in the Controls Evaluation, and in
each case if a problem was identified, we considered what revision, improvement
48
and/or correction to make in accord with our on-going procedures. The Company is
continuing to evaluate errors in procedure which led up to the unauthorized
initial filing of the Quarterly report for the period ended March 31, 2003 on
May 23, 2003 containing financial statements having inaccuracies and without the
completion of a review of the Company's principal independent auditor. Based on
this evaluation, the Company will attempt to improve its Disclosure Controls.
The President notes that, since the date of the Controls Evaluation to the date
of this Quarterly Report, there have been no significant changes in Internal
Controls or in other factors that could significantly affect Internal Controls,
and no corrective actions were required or taken with regard to significant
deficiencies and material weaknesses.
Based upon the Controls Evaluation, our President has concluded that there are
serious and material weaknesses in our Disclosure Controls which will have to
modified going forward. However, the existing Disclosure Controls when combined
with further investigation were found to be effective to ensure that material
information relating to the Company's financial statements and its consolidated
subsidiaries contained in this report was made known to management, including
the President.
49
Part II - Other Information
Item 1. Legal Proceedings
On May 8, 2002, an action was filed in United States District Court for the
Central District of California (the "California Court"), alleging, among other
things, that General Media published photographs (the "Photographs") of a woman
topless in the June 2002 issue of Penthouse Magazine (the "Magazine"), falsely
representing them to be pictures of the plaintiff when they were in reality
photographs of someone else. On July 10, 2003, a settlement was reached with the
plaintiff for an amount that both parties agreed to keep confidential. The
settlement will not have a material effect on the Company's financial statements
or results of operations.
On August 26, 2002, two individuals on behalf of themselves and all others
similarly situated (the "Class Action Plaintiffs") filed in the Circuit Court of
Cook County, Illinois, (the "Illinois Court") an action alleging that General
Media committed a breach of contract, a breach of express warranty and consumer
fraud when it published the Photographs, falsely representing them to be
pictures of the aforementioned plaintiff when they were in reality photographs
of someone else. On May 16, 2003, the Illinois Court dismissed the case. In June
2003 the Class Action Plaintiffs filed an amended complaint and asked for
reconsideration of the dismissal. The Company intends to vigorously defend
itself it against this claim.
On July 13, 2001, an employee filed a charge of discrimination (the "Charge")
against General Media with the U.S. Equal Employment Opportunity Commission
("EEOC"). On April 11, 2003, the District Director of the EEOC ruled that there
was reasonable cause to find that the employee had been subject to
discrimination on the basis of disability and age, and that she had been
constructively discharged. General Media and the EEOC have been conducting
meetings with the employee to determine what actions need to be taken to resolve
the Charge. On May 9, 2003, the EEOC recommended a settlement of various
institutional training for the Company and a monetary award of $0.7 million for
the employee. The Company has rejected the EEOC's recommendation on legal and
factual grounds and intends to vigorously defend itself in this action. It is
too early to determine the possible outcome of the proceedings. Therefore
management cannot give an opinion as to the effect this action will have on the
Company's financial condition or results of operations. There can be no
assurance, however, that the ultimate liability from these proceedings will not
have a material adverse effect on its financial condition or results of
operations.
On March 28, 2003, a former employee of General Media who was terminated for
what General Media believes to be reasonable cause, filed a claim in the Supreme
Court of the State of New York seeking damages of $0.1 million plus an
accounting of their incentive compensation. The Company believes it has no
liability to this individual and is vigorously defending itself against this
claim.
On March 10, 2003, a former employee of General Media filed a claim in the
Supreme Court of the State of New York seeking damages of $1.0 million for an
alleged breach of her employment contract and loss of outside opportunities. The
plaintiff claims she was setting up an outside business venture to become a
consultant to General Media when she handed in her resignation. She claims that
she handed in her resignation, but was persuaded to withdraw it, was allegedly
offered her job back, following which her employment was terminated. The Company
denies the claims and is vigorously defending itself against this claim.
50
On June 20, 2003, Fraserside Holdings Limited and Milcap Media Limited filed a
claim in the Supreme Court of the State of New York, for an alleged breach of
contract regarding a 1999 agreement with General Media to jointly produce and
distribute a series of adult motion pictures. The complaint alleges damages of
$2.2 million for breach of contract, breach of fiduciary responsibility, duty of
loyalty and fair dealing, and demands for an accounting of revenues and expenses
related to the pictures and a declaration that all property in the movies
belongs to the plaintiff. The Company believes the claims are without merit and
intends to vigorously defend itself in this claim.
In December 2002, General Media received correspondence from a third party that
transmission of video content on the Internet is a violation of patents that the
third party claims to own. The third party has demanded that General Media
execute a royalty agreement in favor of the third party with respect to revenue
from any videos that it displayed on its Internet Site. To the Company's
knowledge, no action has been instituted against it by the third party. The
Company believes that it does not owe any royalties to this third party and
intends to vigorously defend itself in any action brought against it by the
third party.
General Media has fallen behind in making its monthly lease payments on its
principal offices in Manhattan. As a result, the landlord has obtained a
judgement from the Civil Court of The City Of New York (the "Court") for unpaid
rent in the amount of $0.4 million and for the right to obtain a warrant of
eviction. The landlord's efforts to seek a warrant of eviction have been stayed
by the Bankruptcy Proceeding. The Company is in the process of locating
alternate facilities while at the same time negotiating with the landlord for a
possible settlement of the case. The Company has provided for a fixed asset
leasehold improvement impairment charge in the amount of $1.1 million in the
Condensed Consolidated Statements of Operations for the six months ended June
30, 2003 because it is uncertain that the Company will reach an agreement with
the landlord and remain in its office facilities to the end of the lease term.
There are various lawsuits claiming amounts against the Company. While the
outcome of these matters is currently not determinable, it is the opinion of the
Company's management that the ultimate liabilities, if any, from the outcome of
these cases will not have a material effect on the Company's financial
statements.
Unless modified by the Bankruptcy Court, pursuant to the automatic stay
provision of Section 362 of the Bankuptcy Code, all of the above described
pre-petition legal proceedings against the Debtors are currently stayed.
Item 2. Changes in Securities and Use of Proceeds
On March 29, 2003, the Company was required to make a principal payment of $2.0
million. On April 14, 2003, the Indenture trustee issued a notice of event of
default with respect to the principal payment. On April 15 and 16, 2003 the
Company transferred additional funds (including $0.2 million made available
through the repayment of an intercompany balance from GMI) and has fully paid
the $2.0 million principal amount. On April 24, 2003, the Company and the
Holders completed a letter agreement that consented to the appointment of
Stephen R. Gross as president and chief operating officer of the Company,
consented to the filing of the Company's Form 10-K at any time on or before
April 30, 2003, consented to an amendment to the Indenture to change the date of
the payment of the $2.0 million principal payment that was due on March 29, 2003
51
to April 17, 2003, and to acknowledge the payment in full of and the absence of
any existing or continuing violation, default or event of default under the
Indenture with respect to the $2.0 million principal payment that was due on
March 29, 2003. In addition the Company and the Holders agreed to amend the
"Change of Control" events to substitute Stephen Gross for John Orlando, to
eliminate any grace periods with respect to future principal payments commencing
with the principal payment due June 29, 2003, to provide the Holders with a copy
of the employment agreement between the Company and Stephen Gross (the "Gross
Employment Agreement") by May 19, 2003, to liquidate no less than 50% of the
aggregate book value of all its artwork pieces in commercially reasonable sales
(the "Sales") on or before October 31, 2003 and to use 100% of the net proceeds
of such Sales to make additional principal redemption's of the Series C Notes.
The agreement was subject to approval by the Holders of the Gross Employment
Agreement and the completion of a supplemental indenture incorporating the terms
of the letter agreement on or before May 26, 2003. The Company has not entered
or supplied the Gross Employment Agreement to the Holders or completed the
supplemental indenture incorporating the terms of the letter agreement and as a
result the letter agreement was terminated. In August 2003, the Company
terminated its relationship with Mr. Gross. On March 31, 2003, the Company was
required to make an interest payment in the amount of $1.5 million, which was
not made. As a result, the Series C Notes became callable. On May 14, 2003, the
Company and the Holders completed a letter agreement in which the parties agreed
that the Holders would forbear from exercising certain rights and remedies under
the Indenture in consideration for the agreement of Mr. Guccione to contribute
certain personal assets held by his holding company, GMI, for the benefit of the
Company, including the agreement to:
a) execute and deliver to the trustee, on or before June 16,
2003, a mortgage and lien in a form satisfactory to the
Holders encumbering certain real estate owned by GMI (subject
to prior liens of not more than $25.0 million) and to pay
costs associated with the obtaining of the mortgage,
b) cause GMI, on or before May 30, 2003, to provide a
non-recourse guaranty of the obligations of the General Media
(the "Guaranty") and to secure its obligations under such
Guaranty with a pledge to the trustee of all of GMI's rights,
title and interest in the outstanding shares of common stock
of PII ("PII Stock"), to deliver the PII Stock certificates
and stock powers to the trustee and to deliver a letter
agreement pursuant to which PII shall covenant that it will
not sell, pledge, transfer, assign or otherwise dispose of any
of its outstanding shares of common stock of the General Media
("Common Stock Obligation"),
c) pay the interest that is overdue on or before May 30, 2003,
d) provide the Holders with a detailed plan for the restructuring
of General Media's Series C Notes, together with supporting
computations, no later than June 30, 2003,
e) place a $0.1 million deposit with the Holders by June 9, 2003
which shall be used to reimburse the Holders for the fees,
costs and expenses of their audit and legal counsel, and
f) allow the Holders to audit the books, records and assets of
General Media.
52
General Media paid the overdue interest on June 3, 2003 and has allowed the
Holders to audit the books, records and assets of General Media, but has failed
to comply with the other requirements of the letter agreement.
General Media also did not make a required principal payment in the amount of
$1.3 million and a required interest payment of $48,000 that was due on June 29,
2003, did not make a required interest payment on the Series C Notes of $1.4
million that was due on June 30, 2003 and has not yet delivered quarterly
Financial Statements to the holders of the Series C Notes as required by the
Indenture defining the relative rights of General Media and the Note holders. On
July 3, 2003, the holders of a majority of the principal amounts of the Series C
Notes (the "Holders") sent a notice to General Media advising it of the failure
to make the required interest payment due on June 30, 2003, the failure to make
required principal payment of $1.3 million that was due on June 29, 2003 and the
failure to deliver the required Financial Statements. On July 8, 2003, the
trustee issued a notice of event of default with respect to the principal
payment and the Series C Notes became callable. The Series C Notes require
interest payments of $5.7 million (including the unpaid interest) and principal
payments of $39.9 million during the next twelve months plus default interest.
As stated in Note 2 of the Notes to Condensed Consolidated Financial Statements,
General Media and the other Debtors filed for protection under Chapter 11 after
negotiations with the holders of a majority of the principal amounts of the
Holders failed to obtain a waiver of the defaults or to provide working capital
for the Company's operations. In August 2003, two of the Holders entered into an
agreement with General Media to provide $5.0 million of DIP Financing with
interest at 13% per annum. The Agreement limits the DIP Financing to $3.0
million until a final financing order is signed by the Bankruptcy Court. The
Agreement also limits the amount of advances to the amount of principal
projected to be outstanding on a weekly basis as was set forth on a budget
provided by General Media on a schedule to the Agreement. Under the Agreement,
General Media has drawn down approximately $2.1 million as of September 19,
2003. The Debtors have defaulted on certain covenants related to the DIP
Financing and are negotiating with the lenders for waivers. As a result of the
Default, no additional advances have been made, the full principal balance of
the loan is due and the interest due on the outstanding balance increased to 15%
per annum.
Item 3. Defaults Upon Senior Securities
As of March 31, 2003, General Media had not made a required interest payment of
$1.5 million on its Series C Notes, that was due by that date. The Company had
until April 30, 2003 (30-day grace period) to make the interest payment, but was
unable to do so. On May 14, 2003, General Media and the Holders completed a
letter agreement in which the parties agreed that the Holders would forbear from
exercising their rights and remedies under the Indenture as a result of the
failure to pay the interest in return for certain concessions by General Media
and GMI. General Media paid the overdue interest on June 3, 1003, but failed to
comply with several requirements of the letter agreement as specified in Item 2
"Changes in Securities and Use of Proceeds" above.
General Media also did not make a required principal payment in the amount of
$1.3 million and a required interest payment of $48,000 that was due on June 29,
2003, did not make a required interest payment on the Series C Notes of $1.4
million that was due on June 30, 2003. As of August 12, 2003 the total amount
due is $2.9 million.
Following additional defaults and failed negotiations with the holders of the
Series C Notes, General Media, together with certain of its subsidiaries filed
for protection under Chapter 11 of the Bankruptcy Code on August 12, 2003.
In addition General Media has defaulted on certain covenants related to the DIP
Financing as more fully described above, in Notes 1 and 4 of the Notes to
Condensed Consolidated Financial Statements and in Item 2, Management's
discussion and analysis of financial condition and results of operations under
"Chapter 11 Bankruptcy Filing".
53
Item 6. Exhibits and Reports on Form 8-K
(a) The exhibits listed in the "Exhibit Index" are filed as part
of this report.
(b) Reports on Form 8-K.
1. Form 8-K dated May 29, 2003 filed May 30, 2003
reporting under Item 4 "Changes In Registrant's
Certifying Accountants," the resignation of Eisner
LLP and engagement of Weinberg & Co., P.A. as the
registrant's independent certified public
accountants, and related exhibits under Item 7
"Financial Statements and Exhibits, as amended June
16, 2003."
2. Form 8-K dated June 30, 2003 and filed June 13, 2003
reporting under Item 5 "Other Events," an informal
SEC investigation and the identification of defects
in the registrant's Form 10-Q for the period ended
March 31, 2003.
54
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.
Penthouse International, Inc.
(Registrant)
Dated: September 23, 2003 By: /s/ Robert C. Guccione
-------------------------------------------
Robert C. Guccione
Chairman of the Board and President
(Principal Executive and Financial Officer)
55
Exhibit Index
Exhibit No. Description
31.1 Certification of Chief Executive Officer of Periodic Report pursuant to
Rule 13a-14a and Rule 15d-14(a)
31.2 Certification of Chief Financial Officer of Periodic Report pursuant to
Rule 13a-14a and Rule 15d-14(a)
32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. -
Section 1350
32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C. -
Section 1350
56