United States
SECURITIES AND EXCHANGE COMMISSION

 

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

Commission File Number 0-11071

 

 

IMAGE ENTERTAINMENT, INC.

(Exact name of registrant as specified in its charter)

 

 

California		84-0685613
(State or other jurisdiction of incorporation)		(I.R.S. Employer Identification Number)
20525 Nordhoff Street, Suite 200, Chatsworth, California 91311
(Address of principal executive offices, including zip code)
(818) 407-9100
(Registrant’s telephone number, including area code)

 

Securities registered pursuant to Section 12(b) of the Act:  None

 

Securities registered pursuant to Section 12(g) of the Act:  Common Stock, no par value

 

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

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).  Yes o  No ý

 

Number of shares outstanding of the registrant’s common stock on November 4, 2004: 18,278,597

 

 

PART I - FINANCIAL INFORMATION

 

ITEM 1.                                                     Financial Statements

 

IMAGE ENTERTAINMENT, INC.

 

Consolidated Balance Sheets

(unaudited)

 

September 30, 2004 and March 31, 2004

 

ASSETS

 

(In thousands)		September 30, 2004				March 31, 2004 *
Current assets:
Cash		$	1,908			$	540
Accounts receivable, net of allowances of $8,733 - September 30, 2004; $7,413 - March 31, 2004		26,264				21,742
Inventories		16,408				13,725
Royalty and distribution fee advances		7,972				7,540
Prepaid expenses and other assets		1,047				887
Total current assets		53,599				44,434
Noncurrent inventories, principally production costs		2,495				2,604
Noncurrent royalty and distribution advances		11,190				11,037
Property, equipment and improvements, net		7,219				5,782
Other assets		185				275
		$		74,688		$		64,132

 

* The March 31, 2004 consolidated balance sheet has been derived from the consolidated financial statements included in the Company’s 2004 annual report on Form 10-K.

 

See accompanying notes to consolidated financial statements

 

1

 

IMAGE ENTERTAINMENT, INC.

 

Consolidated Balance Sheets

(unaudited)

 

September 30, 2004 and March 31, 2004

 

LIABILITIES AND SHAREHOLDERS’ EQUITY

 

(In thousands, except share data)		September 30, 2004			March 31, 2004 *
Current liabilities:
Accounts payable		$	9,659		$	8,124
Accrued liabilities		3,402			2,472
Accrued royalties and distribution fees		13,328			9,255
Accrued music publishing fees		5,004			5,196
Deferred revenue		3,298			3,360
Revolving credit and term loan facility		13,101			10,218
Current portion of long-term debt		1,464			1,592
Current portion of capital lease obligations		235			247
Total current liabilities		49,491			40,464
Long-term debt, less current portion		668			1,224
Capital lease obligations, less current portion		—			109
Total liabilities		50,159			41,797
Shareholders’ equity:
Preferred stock, $1 par value, 3,366,000 shares authorized; none issued and outstanding		—			—
Common stock, no par value, 30,000,000 shares authorized; 18,279,000 and 18,268,000 issued and outstanding at September 30, 2004 and March 31, 2004, respectively		33,231			33,142
Additional paid-in capital		3,774			3,774
Accumulated deficit		(12,476		)	(14,581		)
Net shareholders’ equity		24,529			22,335
		$	74,688		$	64,132

 

* The March 31, 2004 consolidated balance sheet has been derived from the consolidated financial statements included in the Company’s 2004 annual report on Form 10-K.

 

See accompanying notes to consolidated financial statements

 

2

 

IMAGE ENTERTAINMENT, INC.

 

Consolidated Statements Of Operations

(unaudited)

 

For the Three Months Ended September 30, 2004 and 2003

 

(In thousands, except per share data)		2004			2003
NET REVENUES		$	28,556		$	20,316
OPERATING COSTS AND EXPENSES:
Cost of sales		21,250			15,798
Selling expenses		2,253			1,446
General and administrative expenses		3,576			3,015
		27,079			20,259
EARNINGS FROM OPERATIONS		1,477			57
OTHER EXPENSES (INCOME):
Interest expense		240			216
Other		(7		)	(104		)
		233			112
EARNINGS (LOSS) FROM CONTINUING OPERATIONS BEFORE INCOME TAXES		1,244			(55		)
INCOME TAX EXPENSE (BENEFIT)		29			(20		)
EARNINGS (LOSS) FROM CONTINUING OPERATIONS		1,215			(35		)
DISCONTINUED OPERATIONS (Note 4):
Loss from operations of discontinued retail distribution segment (less tax benefit of $310 in 2003)		—			(552		)
Loss on sale of retail distribution segment (less applicable income tax benefit of $252 in 2003)		—			(447		)
LOSS FROM DISCONTINUED OPERATIONS		—			(999		)
NET EARNINGS (LOSS)		$	1,215		$	(1,034	)
NET EARNINGS (LOSS) PER SHARE:
Continuing operations – basic		$	.07		$	(.00	)
Continuing operations – diluted		.06			(.00		)
Discontinued operations – basic and diluted		—			(.06		)
Net earnings (loss) – basic		$	.07		$	(.06	)
Net earnings (loss) – diluted		$	.06		$	(.06	)
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING:
Basic		18,278			18,248
Diluted		18,697			18,248

 

See accompanying notes to consolidated financial statements

 

3

 

For the Six Months Ended September 30, 2004 and 2003

 

(In thousands, except per share data)		2004			2003
NET REVENUES		$	55,097		$	35,480
OPERATING COSTS AND EXPENSES:
Cost of sales		41,365			28,063
Selling expenses		4,133			2,674
General and administrative expenses		7,013			5,986
		52,511			36,723
EARNINGS (LOSS) FROM OPERATIONS		2,586			(1,243		)
OTHER EXPENSES (INCOME):
Interest expense		444			392
Other		(13		)	(179		)
		431			213
EARNINGS (LOSS) FROM CONTINUING OPERATIONS BEFORE INCOME TAXES		2,155			(1,456		)
INCOME TAX EXPENSE (BENEFIT)		50			(528		)
EARNINGS (LOSS) FROM CONTINUING OPERATIONS		2,105			(928		)
DISCONTINUED OPERATIONS (Note 4):
Loss from operations of discontinued retail distribution segment (less tax benefit of $480 in 2003)		—			(853		)
Loss on sale of retail distribution segment (less applicable income tax benefit of $252 in 2003)		—			(447		)
LOSS FROM DISCONTINUED OPERATIONS		—			(1,300		)
NET EARNINGS (LOSS)		$	2,105		$	(2,228	)
NET EARNINGS (LOSS) PER SHARE:
Continuing operations – basic		$	.12		$	(.05	)
Continuing operations – diluted		.11			(.05		)
Discontinued operations – basic and diluted		—			(.07		)
Net earnings (loss) – basic		$	.12		$	(.12	)
Net earnings (loss) – diluted		$	.11		$	(.12	)
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING:
Basic		18,273			18,237
Diluted		18,615			18,237

 

See accompanying notes to consolidated financial statements

 

4

 

IMAGE ENTERTAINMENT, INC.

 

Consolidated Statements of Cash Flows

(unaudited)

 

For the Six Months Ended September 30, 2004 and 2003

 

(In thousands)		2004			2003
CASH FLOWS FROM CONTINUING OPERATING ACTIVITIES:
Net earnings (loss)		$	2,105		$	(2,228	)
Adjustments to reconcile net earnings (loss) to net cash provided by (used in) continuing operating activities:
Loss from discontinued operations, net of tax benefit		—			853
Loss from sale of discontinued retail distribution segment, net of tax benefit		—			447
Amortization of production costs		2,036			1,985
Depreciation and other amortization		1,251			1,103
Amortization of restricted stock units		—			79
Provision for sales returns, other credits and doubtful accounts		2,046			192
Provision for lower of cost or market inventory writedowns		371			71
Deferred income taxes – continuing operations		—			(528		)
Changes in assets and liabilities associated with continuing operating activities:
Accounts receivable		(6,568		)	1,905
Inventories		(3,100		)	(945		)
Royalty and distribution fee advances		(585		)	(660		)
Production cost expenditures		(1,881		)	(1,607		)
Prepaid expenses and other assets		(70		)	323
Accounts payable, accrued royalties, fees and liabilities		6,346			(238		)
Deferred revenue		(62		)	(1,402		)
Net cash provided by (used in) continuing operating activities		1,889			(650		)
CASH FLOWS FROM CONTINUING INVESTING ACTIVITIES:
Net cash used in continuing investing activities – capital expenditures		$	(2,688	)	$	(971	)
CASH FLOWS FROM CONTINUING FINANCING ACTIVITIES:
Borrowings under revolving credit facility		$	54,959		$	46,404
Repayments of borrowings under revolving credit facility		(52,076		)	(44,810		)
Repayments of long-term debt		(684		)	(683		)
Principal payments under capital lease obligations		(121		)	(337		)
Exercise of employee stock options		89			26
Net cash provided by continuing financing activities		2,167			600
INCREASE (DECREASE) IN CASH:		1,368			(1,021		)
Cash used in discontinued operations		—			(239		)
NET INCREASE (DECREASE) IN CASH:		1,368			(1,260		)
Cash at beginning of period		540			2,672
Cash at end of period		$	1,908		$	1,412
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the period for:
Interest		$	414		$	400
Income taxes		$	25		$	6

 

See accompanying notes to consolidated financial statements

 

5

 

Supplemental Disclosures of Noncash Continuing Operating, Investing and Financing Activities:

 

On July 1, 2004 and June 30, 2003, we issued 9,524 and 19,577 shares, respectively, of common stock to officers (net of shares withheld for payment of related income taxes) in connection with the vesting of restricted stock units.  We increased common stock at July 1, 2004, and June 30, 2003, by approximately $87,000 and $186,000, respectively, representing the value of the total vested shares as of the grant dates, less the value of shares withheld for payment of related income taxes on the vesting dates.

 

See accompanying notes to consolidated financial statements

 

6

 

Image Entertainment, Inc.
Notes to Consolidated Financial Statements

(Unaudited)

 

Note 1.                                  Basis of Presentation

 

The accompanying unaudited interim condensed consolidated financial statements for Image Entertainment, Inc. and its controlled subsidiaries have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and do not include all information and notes required for complete financial statements.  All significant intercompany balances have been eliminated in consolidation.

 

In the opinion of management, all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation have been included.   Due to the seasonal nature of our business and other factors such as the strength of our new release schedule, interim results are not necessarily indicative of the results that may be expected for the entire fiscal year.  The accompanying financial information should be read in conjunction with the financial statements and the notes thereto in our most recent Annual Report on Form 10-K.  Certain prior year balances have been reclassified to conform to the current presentation.

 

Note 2.                                  Subsequent Event - Japan Sublicense Agreement and $2 million Advance

 

On October 6, 2004, we entered into an exclusive five-year home video sublicense agreement with Digital Site Corporation, for exclusive distribution of Image programming in Japan.  Some of our programming is distributed in Japan by various third parties on a title-by-title basis under existing sublicense agreements.

 

Under the terms of the output agreement, Digital Site will be responsible for all sales, marketing, manufacturing and distribution in Japan.  The agreement includes our available existing catalogue, as well as previously-sublicensed titles as they become available and future new releases through the end of 2009.  The distribution term for each program is five years or the expiration date of Image’s rights.  Programming will be marketed and released under the brand, “Image Entertainment Japan.”  The first releases under the agreement are scheduled for January 2005.

 

Royalty payments are set at a percentage of suggested retail price, and any overages will be paid after recoupment of the $2 million non-refundable advance received in October 2004.  The advance will be recorded as deferred revenue during the quarter ending December 31, 2004, and will be recognized as revenue when royalties are earned, as reported to us on a quarterly basis.

 

Note 3.                                  Accounting for Stock-Based Compensation

 

We account for stock options granted to employees in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations.  Because the exercise price of all options we have granted was greater than or equal to the market price of the underlying common stock on the date of the grant, no compensation expense is recognized.  Compensation expense related to stock options granted to non-employees is accounted for under Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, which requires us to recognize an expense based on the fair value of the related awards.  If we had accounted for stock options issued to employees in accordance with SFAS No. 123, pro forma net earnings (loss) and earnings (loss) per share would have been reported as follows:

 

7

 

		Three Months Ended September 30,						Six Months Ended September 30,
(In thousands, except per share data)		2004			2003			2004			2003
Consolidated net earnings (loss), as reported		$	1,215		$	(1,034	)	$	2,105		$	(2,228	)
Add: Stock-based employee compensation expense included in the reported consolidated net earnings (loss), net of related tax effects		—			—			—			—
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(117		)	(87		)	(234		)	(175		)
Pro forma consolidated net earnings (loss)		$	1,098		$	(1,121	)	$	1,871		$	(2,403	)
Consolidated net earnings (loss) per share:
As reported – basic		$	.07		$	(.06	)	$	.12		$	(.12	)
As reported – diluted		$	.06		$	(.06	)	$	.11		$	(.12	)
Pro forma – basic and diluted		$	.06		$	(.06	)	$	.10		$	(.13	)

 

The fair value of the stock options at the date of grant was estimated using the Black-Scholes pricing model with the following assumptions for the six months ended September 30, 2004 and 2003, respectively:

 

		2004		2003
Expected life (years)		2.5-5.0		5.0
Interest rate		2.76-3.88	%	1.20-3.34	%
Volatility		60-67	%	74-79	%
Dividend yield		0.00	%	0.00	%

 

Note 4.                                  Discontinued Operations – Retail Distribution Segment

 

On September 23, 2003, Image’s wholly-owned subsidiary DVDPlanet, Inc. sold substantially all of its assets to Planet Entertainment, Inc., an unrelated third party.  DVDPlanet incurred a loss of $699,000 on the sale of the assets.  The following is summary financial information for our discontinued retail distribution segment:

 

		Three Months Ended September 30,						Six Months Ended September 30,
(In thousands)		2004			2003			2004			2003
Net revenues		$	—		$	4,303		$	—		$	8,991
Pretax loss from discontinued operations		—			(862		)	—			(1,333		)
Pretax loss from the sale of the retail distribution segment		—			(699		)	—			(699		)
Income tax benefit		—			562			—			732
Net loss from discontinued operations		$	—		$	(999	)	$	—		$	(1,300	)

 

Note 5.                                  Inventories

 

Inventories at September 30, 2004, and March 31, 2004, are summarized as follows:

 

(In thousands)		September 30, 2004			March 31, 2004
DVD		$	11,464		$	10,037
Other		2,481			1,180
		13,945			11,217
Production costs, net		4,958			5,112
		18,903			16,329
Less current portion of inventories		16,408			13,725
Noncurrent inventories, principally production costs		$	2,495		$	2,604

 

DVD and other inventories consist primarily of finished DVD, CD and VHS product for sale and are stated at the lower of average cost or market.

 

8

 

Production costs consist of capitalized costs to produce licensed programming for domestic and international distribution and include the costs of film and tape conversion to the optical disc format, menu and packaging design, authoring, compression, mastering and the overhead of our creative services and production departments.  Production costs are reflected net of accumulated amortization of $12,918,000 and $16,422,000 at September 30, 2004, and March 31, 2004, respectively.

 

Note 6.                                  Debt

 

Revolving Credit and Term Loan Facilities.  On September 30, 2004, we amended our credit facility with Wells Fargo Foothill, Inc.  The maximum revolving credit availability under the agreement was increased $6 million, from $17 million to $23 million.  Actual borrowing availability under the line remains substantially based upon eligible trade accounts receivable levels.  While the interest rate remains at the prevailing prime rate plus 0.75% (5.50% at September 30, 2004), the interest rate floor was reduced from 5.75% to 5.00%.  We now also have the option to borrow at LIBOR plus 3.50%.  The maximum capital expenditure limit covenant was increased for fiscal 2005 to $3.25 million (plus $359,000 unused from fiscal 2004) from $2.5 million plus the $359,000.  The covenant maximum drops to $2.5 million in fiscal 2006, plus any unused carryover from fiscal 2005.  The term of the agreement was extended two years through December 28, 2007.  At September 30, 2004, we had $12,772,000 outstanding under our $23 million revolving credit facility with Foothill bearing interest at 5.50%, and had $329,000 in borrowings outstanding under our $1 million capital expenditure term loan facility with Foothill bearing interest at 5.75% and maturing through July 2009.  At September 30, 2004, we had borrowing availability of $9,178,000 under the revolving credit facility and $671,000 under the term loan facility, and were in compliance with all financial and operating covenants.

 

Long-term debt at September 30, 2004, and March 31, 2004, consists of the following:

 

(In thousands)		September 30, 2004			March 31, 2004
Subordinated note payable – Ritek Taiwan		$	2,005		$	2,561
Note payable to bank		127			255
		2,132			2,816
Current portion of long-term debt		1,464			1,592
Long-term debt less current portion		$	668		$	1,224

 

Note 7.                                  New Office Facilities Commitment

 

As of the end of August 2004, we had fully relocated to our new corporate facility and ceased paying rent for our previous corporate facility.  Our new ten-year lease commitment with two five-year options, with initial rent at $1.23 per square foot for approximately 62,000 square feet, began in July 2004.  The annual rent of approximately $900,000 will increase at 3% per year over the lease term.  We are expensing the total rent commitment, including the scheduled rent increases, on a straight-line basis over the term of the lease.  Although a base level of operating expenses is included in the rent payment, we will be responsible for a percentage of actual annual operating expense increases capped at 5% annually.

 

Note 8.                                  Net Earnings (Loss) per Share Data

 

The following presents a reconciliation of the numerators and denominators used in computing basic and diluted net earnings (loss) per share for the three and six months ended September 30, 2004 and 2003:

 

9

 

		Three months ended September 30,						Six Months ended September 30,
(In thousands, except per share data)		2004			2003			2004			2003
Earnings (loss) from continuing operations		$	1,215		$	(35	)	$	2,105		$	(928	)
Loss from discontinued operations		$	—		$	(999	)	$	—		$	(1,300	)
Net earnings (loss) – basic and diluted numerator		$	1,215		$	(1,034	)	$	2,105		$	(2,228	)
Weighted average common shares outstanding – basic denominator		18,278			18,248			18,273			18,237
Effect of dilutive securities		$	419		$	—		$	342		$	—
Weighted average common shares outstanding – diluted denominator		18,697			18,248			18,615			18,237
Net earnings (loss) per share:
Continuing operations – basic		$	.07		$	(.00	)	$	.12		$	(.05	)
Continuing operations – diluted		.06			(.00		)	.11			(.05		)
Discontinued operations – basic and diluted		—			(.06		)	—			(.07		)
Net earnings (loss) per share – basic		$	.07		$	(.06	)	$	.12		$	(.12	)
Net earnings (loss) per share – diluted		$	.06		$	(.06	)	$	.11		$	(.12	)

 

Outstanding common stock options not included in the computation of diluted earnings per share for the three and six months ended September 30, 2004, totaled 654,000 and 1,947,000, respectively.  They were excluded because their inclusion would have an antidilutive effect on earnings per share.  Outstanding common stock options and warrants not included in the computation of diluted net loss per share totaled 2,141,000, for the three and six months ended September 30, 2003.  They were also excluded as their effect would be antidilutive.

 

Note 9.                                  2004 Incentive Compensation Plan

 

Our 2004 Incentive Compensation Plan was approved at our annual meeting of shareholders held on September 10, 2004.  There are 1,000,000 shares of common stock authorized for issuance under the plan.  Stock option grants under the plan may be intended to qualify as incentive stock options under Section 422 of the Tax Code, may be non-qualified stock options governed by Section 83 of the Tax Code, restricted stock units, or other forms of equity compensation.  Subject to earlier termination by our Board of Directors, the plan will remain in effect until all awards have been satisfied or terminated under the terms of the plan.

 

Note 10.                           Segment Information

 

In accordance with the requirements of SFAS No. 131, Disclosures about Segments of and Enterprises and Related Information, selected financial information regarding our reportable business segments, domestic and international, are presented below.  Domestic wholesale distribution of home entertainment programming on DVD accounted for approximately 91% and 85% of our net revenue for the three and six months ended September 30, 2004, respectively, and over 83% and 85% of our net revenue for the three and six months ended September 30, 2003, respectively.  Management currently evaluates segment performance based primarily on net revenues, operating costs and expenses and earnings (loss) before income taxes.  Interest income and expense is evaluated on a consolidated basis and not allocated to our business segments.

 

10

 

For the Three Months Ended September 30, 2004:

 

		2004
(In thousands)		Domestic			International			Inter-segment Eliminations			Consolidated
NET REVENUES		$	27,084		$	1,472		$	—		$	28,556
OPERATING COSTS AND EXPENSES		25,837			1,242			—			27,079
EARNINGS FROM OPERATIONS		1,247			230			—			1,477
OTHER EXPENSES (INCOME)		235			16			(18		)	233
EARNINGS FROM CONTINUING OPERATIONS BEFORE INCOME TAXES		$	1,012		$	214		$	18		$	1,244

 

For the Three Months Ended September 30, 2003:

 

		2003
(In thousands)		Domestic			International			Inter-segment Eliminations			Consolidated
NET REVENUES		$	18,267		$	2,049		$	—		$	20,316
OPERATING COSTS AND EXPENSES		18,543			1,716			—			20,259
EARNINGS (LOSS) FROM OPERATIONS		(276		)	333			—			57
OTHER EXPENSES (INCOME)		216			8			(112		)	112
EARNINGS (LOSS) FROM CONTINUING OPERATIONS BEFORE INCOME TAXES		$	(492	)	$	325		$	112		$	(55	)

 

For the Six Months Ended September 30, 2004:

 

		2004
(In thousands)		Domestic			International			Inter-segment Eliminations			Consolidated
NET REVENUES		$	52,441		$	2,656		$	—		$	55,097
OPERATING COSTS AND EXPENSES		50,150			2,361			—			52,511
EARNINGS FROM OPERATIONS		2,291			295			—			2,586
OTHER EXPENSES (INCOME)		436			17			(22		)	431
EARNINGS FROM CONTINUING OPERATIONS BEFORE INCOME TAXES		$	1,855		$	278		$	22		$	2,155

 

For the Six Months Ended September 30, 2003:

 

		2003
(In thousands)		Domestic			International			Inter-segment Eliminations			Consolidated
NET REVENUES		$	32,830		$	2,650		$	—		$	35,480
OPERATING COSTS AND EXPENSES		34,088			2,635			—			36,723
LOSS FROM OPERATIONS		(1,258		)	15			—			(1,243		)
OTHER EXPENSES (INCOME)		392			(64		)	(115		)	213
EARNINGS (LOSS) FROM CONTINUING OPERATIONS BEFORE INCOME TAXES		$	(1,650	)	$	79		$	115		$	(1,456	)

 

		As of
(In thousands)		September 30, 2004			March 31, 2004
TOTAL ASSETS:
DOMESTIC		$	73,893		$	62,638
INTERNATIONAL		795			1,494
CONSOLIDATED TOTAL ASSETS		$	74,688		$	64,132

 

11

 

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

 

You should read the following discussion and analysis in conjunction with our condensed consolidated financial statements and notes in Item 1 above and with our audited consolidated financial statements and notes, and with the information under the headings “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Risk Factors” in our most recent Annual Report on Form 10-K.

 

Forward-looking Statements

 

This report includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 regarding, among other things, goals, plans and projections regarding our financial position, results of operations, market position, product development and business strategy.  These statements may be identified by the fact that they use words such as “will,” “expect,” “plan,” “believe,” and other words of similar meaning in connection with any discussion of future performance.  Such forward-looking statements are based on management’s current expectations and involve inherent risks and uncertainties, including factors that could delay, divert or change any of them, and could cause action outcomes and results to differ materially from current expectations.

 

These factors include, among other things, our inability to raise additional working capital, changes in debt and equity markets, increased competitive pressures, changes in our business plan, and changes in the retail DVD and entertainment industries.  For further details and a discussion of these and other risks and uncertainties, see “Forward-Looking Statements” and “Risk Factors” in our most recent Annual Report on Form 10-K.  Unless otherwise required by law, we undertake no obligation to publicly update any forward-looking statement, whether as a result of new information, future events or otherwise.

 

Overview

 

We are an integrated home entertainment company, primarily engaged in the acquisition, production and wholesale distribution of programming for release on DVD.  We acquire and exploit exclusive distribution rights to a diverse array of general and specialty programming, including music concerts, urban, youth culture/lifestyle, stand-up comedy, television and theatrical, foreign and silent films, in DVD, CD and other home entertainment formats.  We may also acquire related broadcast rights as well, including video-on-demand, broadband streaming, digital download, pay-per-view, in-flight, radio, satellite, cable and broadcast television, and we exploit and plan to exploit these rights as opportunities and technologies allow.  We acquire programming mainly by entering into exclusive licensing or distribution arrangements with producers and other content providers, which we often supplement by designing and producing additional content and value-added features, such as interactive menus, featurettes, audio commentaries, packaging and marketing materials.  We also produce and co-produce our own original entertainment programming, focused on live performance music concerts, urban, direct-to-video features, comedy, live theater and more.  We will seek to co-produce live-action, genre-specific, low budget feature films through first-look agreements with Dark Horse Entertainment, Inc. and ContentFilm Plc.  We strive to grow a stream of revenues by maintaining and building a library of titles that can be exploited in a variety of formats and distribution channels.  Our active DVD catalogue currently contains over 2,600 exclusive titles.

 

•                  In the quarter ended September 30, 2004, revenues were significantly higher compared to the quarter ended September 30, 2003, and we realized earnings compared to a loss in the same quarter last year.  The increase in revenues and earnings is primarily attributable to strong revenue performance from new exclusive DVD and CD releases as well as continued strong sales of previously released programming.

 

•                  Second quarter new exclusive DVD releases included stand-up comedy from Bill Engvall, the urban documentary Beef II, and the classic television series Combat: Season 1: Campaigns 1 & 2.

 

•                  Second quarter new exclusive audio releases included a live country music concert from Merle Haggard: Live At Billy Bob’s and a studio CD from Ronnie Milsap.

 

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We continued to experience significantly increased sales to large retailers, particularly Wal-Mart and Target, who purchased more titles in greater quantities than in previous quarters.  Highlights of the most recently completed fiscal quarter are identified below:

 

•                                          Earnings from continuing operations of $1,215,000 ($.06 per diluted share), compared to a loss from continuing operations of $35,000 ($.00 per diluted share) for the second quarter of fiscal 2004.

 

•                                          Net revenues increased 40.6% to $28,556,000, compared with net revenues of $20,316,000 for the second quarter of fiscal 2004.

 

•                                          Gross profit margins, which are now disclosed net of amortization of production costs, were 25.6%, up from 22.2% for the second quarter of fiscal 2004 (primarily due to a higher percentage of exclusively licensed programming sold, compared to lower-margin exclusively distributed non-licensed programming).

 

•                                          We are now classifying production cost amortization as a component of cost of sales, resulting in a reduction to gross profit margins for all periods presented.  We previously amortized production costs as a separate line item within operating costs and expenses.  Because we disclose programming production costs as a component of inventory, we believe classification of the related expense of these costs as a component of cost of sales is more meaningful.  Amortization of production costs, as a percentage of net revenues, for the three months ended September 30, 2004 and 2003, were 3.5% and 4.8%, respectively.

 

•                                          Selling, general and administrative expenses of approximately 20.4% of net revenues, down from 22.0% of net revenues for the second quarter of fiscal 2004, due primarily to the spreading of fixed costs over higher net revenues for the September 2004 quarter.

 

•                                          Net earnings of $1,215,000 ($.06 per diluted share), compared to a net loss of $1,034,000 ($.06 per diluted share) for the second quarter of fiscal 2004.  The fiscal 2004 second quarter net loss included a loss from discontinued operations of $999,000, or $.06 per diluted share, net of tax benefit.

 

•                                          Total liabilities increased 20.0% to $50.2 million, from $41.8 million at March 31, 2004.  Accrued royalties and distribution fees increased as a result of the significant increased revenues from exclusive programming, and increased inventory levels to accommodate forecasted customer demand associated with the impending holiday-selling season also contributed to the increase in total liabilities.

 

•                                          Interest bearing debt less cash on hand was $13.6 million, up from $12.9 million at March 31, 2004.

 

•                                          We had $12.8 million outstanding under our $23 million revolving credit facility with Wells Fargo Foothill, Inc. at September 30, 2004, with $9.2 million in borrowing availability.  We amended the terms of our credit facility to increase the maximum borrowing availability, reduce the interest rate floor and extend the term as described in more detail below.

 

•                                          We entered into a five-year sublicense agreement with Digital Site Corporation for distribution of our exclusive programming in Japan, for which we received a $2 million nonrefundable but recoupable advance in October 2004.

 

The highlights above are intended to identify to the reader some of our more significant events and transactions during the quarter ended September 30, 2004 (except for the Digital Site agreement, which was executed in October).  However, these highlights are not intended to be a full discussion of our results for the quarter.  These highlights should be read in conjunction with the following discussion of Results of Operations and Liquidity and Capital Resources and with our condensed consolidated financial statements and footnotes accompanying this report.

 

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We are increasing our previously disclosed revenue guidance.  We believe that revenue growth for the fiscal year will be 26% to 32%, up from previous guidance of 18% to 24%, which, if realized, would result in fiscal 2005 net revenues approximately ranging between $107 and $112 million, up from previous guidance of between $100 and $105 million.  We have not provided specific earnings guidance but continue to anticipate that we will report earnings for fiscal 2005.

 

Liquidity and Capital Resources

 

Our working capital generally comes from two sources:  (1) operating cash flows; and (2) availability under our revolving line of credit and term loan facilities with Wells Fargo Foothill, Inc.

 

On September 30, 2004, Foothill amended our credit facility.  The maximum revolving credit availability under the agreement was increased $6 million, from $17 million to $23 million.  Actual borrowing availability under the line remains substantially based upon eligible trade accounts receivable levels.  While the interest rate remains at the prevailing prime rate plus 0.75% (5.50% at September 30, 2004), the interest rate floor was reduced from 5.75% to 5.00%.  We now also have the option to borrow at LIBOR plus 3.50%.  The term of the agreement was extended two years through December 28, 2007.

 

At September 30, 2004, we had cash of $1,908,000 and borrowing availability of $9,178,000 and $671,000, respectively, under our revolving credit and term loan facilities with Foothill.  Comparatively, at March 31, 2004, we had cash of $540,000 and borrowing availability of $6,245,000 and $1,000,000, respectively, under our revolving credit and term loan facilities.

 

We received a nonrefundable but recoupable royalty advance of $2 million in October 2004, related to our Japan sublicense agreement, which we used to pay down amounts outstanding under our revolving credit facility in October.

 

Our pretax earnings from continuing operations were $2.2 million for the six months ended September 30, 2004.  Net revenue growth during the six months ended September 30, 2004, contributed to an increase in net trade accounts receivables to approximately $26.3 million at September 30, 2004, as compared to $21.7 million at March 31, 2004.  In anticipation of forecasted customer demand for our new release and catalogue programming for the upcoming holiday-selling season, we increased our inventory levels as of September 30, 2004, as compared to March 31, 2004.  We incurred $2,688,000 in capital expenditures in our continuing effort to improve information technology infrastructure and business systems, including the conversion from our legacy sales order management and production/creative services systems to Oracle, as well as expenditures for furniture, fixtures, equipment, hardware infrastructure and leasehold improvements for our new corporate headquarters.  The final phase, which went live in September 2004, completes the replacement of our Qantel system with Oracle.

 

We paid down long-term debt and capital lease obligations by $805,000 during the six-month September 2004 period.  As a result of our net revenue growth, our trade accounts payable and accrued royalties, distribution fees and music publishing fees grew by $6,346,000 at September 30, 2004, from levels at March 31, 2004.  We financed these expenditures from cash flows from operations and through our revolving line of credit and term loan facility.  The outstanding borrowings under the revolving and term loan facility increased to $12,772,000 and $329,000, respectively, at September 30, 2004, from $10,218,000 and none, respectively, at March 31, 2004.

 

We believe that projected cash flows from operations, borrowing availability under our revolving line of credit, cash on hand, and trade credit will provide the necessary capital to meet our projected cash requirements for at least the next 12 months.  Should we be in a position to acquire significantly higher-profile content or libraries of content for exclusive distribution above our historical normal costs of acquistion, or should we find an attractive synergistic corporate acquisition, we would most likely need to seek additional debt or equity financing in order fund the transactions.  We believe financing could come in the form of vendor debt financing or convertible debt, convertible preferred stock or straight equity issuance, however there are no assurances that financing would be available, or available on terms acceptable to us.

 

We continue to consider raising additional financing to provide additional funds in order to strengthen our

 

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ability to acquire exclusive programming.  Should additional funds be raised through the issuance of equity or convertible debt securities, the percentage ownership of our existing shareholders will be reduced.  We can give no assurance that we will successfully obtain additional financing.

 

Japan Sublicense Agreement and $2 million Advance

 

On October 6, 2004, we entered into an exclusive five-year home video sublicense agreement with Digital Site Corporation, for exclusive distribution of Image DVD programming in Japan.  Some of our programming is distributed in Japan by various third parties on a title-by-title basis under existing sublicense agreements.

 

Under the terms of the output agreement, Digital Site will be responsible for all sales, marketing, manufacturing and distribution in Japan.  The agreement includes our available existing catalogue, as well as previously-sublicensed titles as they become available and future new releases through the end of 2009.  The distribution term for each program is five years or the expiration date of Image’s rights.  Programming will be marketed and released under the brand, “Image Entertainment Japan.”  The first releases under the agreement are scheduled for January 2005.

 

Royalty payments are set at a percentage of suggested retail price, and any overages will be paid after recoupment of the $2 million non-refundable advance received in October 2004.  The advance will be recorded as deferred revenue during the quarter ending December 31, 2004, and will be recognized as revenue when royalties are earned, as reported to us on a quarterly basis.

 

Contractual Obligations and Commercial Commitments

 

The following table summarizes our contractual obligations at September 30, 2004, and the effects such obligations are expected to have on liquidity and cash flow in future periods:

 

		Payments due by period
(in thousands)		Remainder of 2005				2006				2007				2008				2009				Thereafter				Total
Contractual obligations:
Long-term debt obligations		$		907		$		1,225		$	—			$	—			$	—			$	—			$	2,132
Capital lease obligations		126				109				—				—				—				—				235
Operating lease obligations		764				1,531				1,573				1,615				1,658				8,100				15,241
Licensing and exclusive distribution agreements		5,648				5,223				260				338				—				—				11,469
Employment Agreements		772				1,199				1,173				—				—				—				3,144
Total		$	8,217			$	9,287			$		3,006		$		1,953		$		1,658		$		8,100		$		32,221

 

Advances and guarantees included in the table above, under licensing and exclusive distribution agreements, are recoupable against future royalties and distribution fees earned by our exclusive program suppliers in connection with revenues generated by those rights.  As we have historically, we expect to fund these commitments through recoupment of existing advances, existing bank lines of credit, and other working capital.

 

New Office Facilities Commitment.  As of the end of August 2004, we had fully relocated to our new corporate facility and ceased paying rent for our previous corporate facility.  Our new ten-year lease commitment, with initial rent at $1.23 per square foot for approximately 62,000 square feet, began in July 2004.  The annual rent of approximately $900,000 will increase at 3% per year over the lease term.  We are expensing the total rent commitment, including the scheduled rent increases, on a straight-line basis over the term of the lease.  Although a base level of operating expenses is included in the rent payment, we will be responsible for a percentage of actual annual operating expense increases capped at 5% annually.

 

Lease Guarantee.  In connection with the asset sale of DVDPlanet, Planet Entertainment assumed the obligations under DVDPlanet’s lease for its retail store and its parent company Infinity Resources, Inc. guaranteed Planet Entertainment’s obligations under the lease.  We remain a guarantor in the event that Planet Entertainment and Infinity default on their financial obligations under the lease.  The remaining payments under the lease total approximately $580,000 through the lease’s expiration December 2007.

 

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Long-Term Debt

 

Long-term debt at September 30, 2004, and March 31, 2004, consisted of the following:

 

(In thousands)		September 30, 2004			March 31, 2004
Subordinated note payable – Ritek Taiwan		$	2,005		$	2,561
Note payable to bank		127			255
		2,132			2,816
Current portion of long-term debt		1,464			1,592
Long-term debt less current portion		$	668		$	1,224

 

Debt Instruments and Related Covenants

 

Our loan agreements with Foothill require us to comply with minimum financial and operating covenants.  At September 30, 2004, we amended our capital expenditures covenant for fiscal 2005.  The maximum capital expenditure limit covenant was increased for fiscal 2005 to $3.25 million (plus $359,000 unused from fiscal 2004) from $2.5 million plus the $359,000.  The covenant maximum drops to $2.5 million in fiscal 2006, plus any unused carryover from fiscal 2005.  At September 30, 2004, we were in compliance with the financial and operating covenants under the loan agreement.  We believe that we will be able to achieve the minimum requirements going forward.

 

Results of Operations

 

The accompanying consolidated financial information for the three and six months ended September 30, 2004, should be read in conjunction with the Consolidated Financial Statements, the Notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the fiscal year ended March 31, 2004.

 

We currently have two business segments:

 

•                                          Domestic

 

•                                          International

 

Our domestic segment includes domestic wholesale distribution, program licensing and production.  Our international segment includes our international sublicense agreement with BMG Music International Service, GmbH for the distribution for our products throughout Europe, the Middle East and Africa, a wholesale distribution agreement with BMG Entertainment Mexico, S.A. for Mexico and Central America,our new sublicense agreement with Digital Site, sublicense agreements with third parties in other international territories, and worldwide broadcast rights exploitation.

 

Revenue

 

Sales of DVD and CD programming, domestically and internationally, accounted for approximately 92% and 6%, respectively, of net revenues for the quarter ended September 30, 2004, and 86% and 12%, respectively, of net revenues for the six months ended September 30, 2004.  Sales of CD programming increased to $1.8 million for the September 2004 quarter, from $1.4 million for the September 2003 quarter, and to $6.7 million for the six months ended September 30, 2004, from $2.6 million for the six months ended September 30, 2003.

 

The following table presents consolidated net revenues by reportable business segment for the three and six months ended September 30, 2004 and 2003, respectively:

 

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		Three Months Ended September 30,								Six Months Ended September 30,
		2004			2003			% Change		2004			2003			% Change
		(in thousands)								(in thousands)
Net revenues
Domestic		$	27,084		$	18,267		48.3	%	$	52,441		$	32,830		59.7	%
International		1,472			2,049			(28.2	)	2,656			2,650			(0.2	)
Consolidated		$	28,556		$	20,316		40.6	%	$	55,097		$	35,480		55.3	%

 

Consolidated net revenues for the three months ended September 30, 2004, were $28,556,000, up 40.6% from $20,316,000 for the three months ended September 30, 2003.  Consolidated revenues for the six-month period ended September 30, 2004, were $55,097,000, up 55.3% from $35,480,000 for the six months ended September 30, 2003.

 

Domestic Revenue

 

Domestic net revenues for the quarter ended September 2004 increased 48.3% to $27,084,000, from $18,267,000 for the same quarter last year.  Net revenues from this segment for the six months ended September 30, 2004, increased 59.7% to $52,441,000, from $32,830,000 for the same period last year.

 

Net revenues were significantly higher for the three and six months ended September 30, 2004, as compared to the three and six months ended September 30, 2003.  The increase in revenues for the three- and six- month periods was primarily attributable to strong revenue performance from new exclusive DVD and CD releases as well as comparatively strong sales of previously released programming.

 

Second quarter exclusive DVD new releases included: 

 

•                  stand-up comedy from Bill Engvall: Here’s Your Sign and Jamie Foxx’s Laffapalooza! #1 & 2;

•                  family friendly comedies from Kel Mitchell (from the Kenan and Kel Nickelodeon show) Kel Videos Live: Is That The Mitchell’s Boy? and This Face Belongs on the Tube;

•                  the urban music documentary Beef II;

•                  television shows and series Nick and Jessica Variety Hour and Saved By The Bell: The College Years: Season #1;

•                  the classic television series Combat: Season 1: Campaigns 1 & 2; and

•                  music concerts The Ramones: Raw and Doors Of The 21^st Century: L.A. Woman Live.

 

Second quarter exclusive CD new releases included:

 

•                  Merle Haggard: Live At Billy Bob’s: Ol’ Country Singer;

•                  Ronnie Milsap: Just For A Thrill;

•                  Stephen Sondheim’s Assassins: The Broadway Cast Recording; and

•                  Collin Raye: Live At Billy Bob’s.

 

First quarter ended June 30, 2004, exclusive DVD new releases contributing to increased net revenues for the six months ended September 30, 2004, were

 

•                  Larry the Cable Guy: Git R Done;

•                  Ron White: They Call Me Tater Salad;

•                  The Dick Van Dyke Show: Seasons 4 and 5; and

•                  The Lost World: Season 2.

 

First quarter exclusive CD new releases were

 

•                  The Source Presents Hip Hop Hits: Volume 8;

•                  Willie Nelson: Live at Billy Bob’s; and

•                  Power of Soul: Jimi Hendrix Tribute.

 

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