ITEM 1. BUSINESS
RECENT EVENTS
On March 29, 2007, we entered into a definitive agreement with BTP Acquisition Company, LLC (“BTP”), an investor group led by David Bergstein, to sell Image in a transaction valued at approximately $132 million, including the assumption of a replication advance in excess of $9 million and the repayment of approximately $24 million of debt. Under the terms of the agreement, Image stockholders will receive $4.40 per share in cash. The agreed-upon acquisition price represents a 27% premium to Image’s closing share price of $3.46 on March 29, 2007, and a 35% premium to the 30-day average price ended March 29, 2007. Stockholders owning a total of approximately 38% of our outstanding shares of common stock have agreed to vote their shares in favor of the transaction. Completion of the transaction is subject to customary closing conditions, including regulatory review and the approval of the transaction by our stockholders.
On June 27, 2007, we amended our merger agreement with BTP. Under the terms of the amended merger agreement, our stockholders will receive the same aggregate cash consideration as under the original merger agreement, plus they will retain between 5% and 9% of their shares in the surviving company. The exact percentage of shares that will be retained by our stockholders will be determined by BTP not later than two business days prior to the filing of our definitive Proxy Statement with the Securities and Exchange Commission (“SEC”) in connection with the transaction. BTP will base its determination on, among other things, the ability to meet the applicable listing standards for continued listing of our common stock on the NASDAQ National Market (“NASDAQ”) following the closing of the merger. The transaction is expected to close by September 30, 2007.
The buyer group is led by film financier and producer David Bergstein, who recently purchased U.K.-based Capitol Films, an international film distributor, and Thinkfilm, a North American film distributor. Our board of directors (“Board”) unanimously approved the merger agreement and the amended merger agreement, and has recommended that our stockholders vote in favor of the transaction. For more information on this potential transaction, please refer to our Current Report on Form 8-K filed with the SEC on April 2, 2007. For more information on the risks related to this potential transaction, please refer to “Item 1A.
ITEM 1A. RISK FACTORS
You should carefully consider and evaluate all of the information in this Annual Report, including the risk factors listed below. If any of these risks occur, our business, results of operations and financial condition could be harmed, the price of our common stock could decline, and future events and circumstances could differ significantly from those anticipated in the forward-looking statements contained in this Annual Report.
Risks Relating to Our Business
The Residual Effects of the Prolonged Proxy Contest with Our Former Second-Largest Shareholder and Our Special Committee’s Strategic Process May Adversely Affect Our Retail Sales. As a result of the proxy contest with our former second-largest shareholder, Lions Gate, and our special committee’s strategic process, retail sales may be adversely affected due to retail buyers’ uncertainty regarding our future. Consequently, retail buyers may further reduce their new purchases and existing inventories of our programming in order to address this uncertainty and this may have negative result on our business and results of operations. There can be no assurance that we will be able to persuade our retail buyers of our ability to operate independently, or that our retail buyers will increase their purchases of our programming in the future.
The Transitioning of Our Warehousing and Distribution Services to Sonopress May Disrupt or Delay Our Business Activities. We are currently in the process of transitioning all of our warehousing and distribution services to Sonopress’ facility in Pleasant Prairie, Wisconsin. Although we have an existing relationship with Sonopress, who replicates our DVDs, and although Sonopress has hired key people from our previous replicator who were already very familiar with our company and business, distribution is still a new business initiative for Sonopress. Accordingly, there may be delays and inefficiencies as they enter into this sector. Additionally, as with any major transition, there may be delays and inefficiencies inherent within the transitioning process. Any failure of Sonopress to warehouse and distribute our products in a timely manner and with the same consistent quantity and quality that we and our customers have come to expect, may adversely affect our revenues and profits.
We Have a High Concentration of Sales to Relatively Few Customers Which May Result In Significant Uncollectible Accounts Receivable Exposure. For the year ended March 31, 2007, Amazon.com, Inc., AEC One Stop Group, and Anderson Merchandisers (who supplies Wal-Mart) accounted for 12%, 12% and 10%, respectively, of our net revenues. For the year ended March 31, 2006, Anderson Merchandisers accounted for 11% of our net revenues. For the year ended March 31, 2005, Anderson Merchandisers, Best Buy and AEC One Stop Group accounted for approximately 17%, 12%, and 10%, respectively, of our net revenues. At March 31, 2007, AEC One Stop Group and Anderson Merchandisers accounted for 20% and 17%, respectively, of our gross accounts receivables. At March 31, 2006, Anderson Merchandisers and AEC One Stop accounted for 13% and 12%, respectively, of our gross accounts receivables. Additionally, our top five customers accounted for over 42% of our fiscal 2007 net revenues. Any combination of these customers filing for bankruptcy or significantly reducing their purchases of our programming would have an adverse effect on our financial condition, results of operations, and liquidity. Our top 25 customers accounted for approximately 82% of our fiscal 2007 net revenues.
We are not an exclusive supplier to any of our retail customers, and there is no guarantee that we will continue recognizing significant revenue from sales to any particular customer. If we are unable to maintain the sale of our titles at their current levels to any these five customers, and are unable to find other customers to replace these sales, there would be a negative impact on our revenues and future profitability. In addition, we face credit exposure from our retail customers and may experience uncollectible receivables from these customers should they face financial difficulties. On August 20, 2006, our long-term customer MTS, Inc., parent of Tower Records, filed for Chapter 11 bankruptcy. We estimated our net expense relating to the ultimate uncollectible accounts receivables from Tower and recorded a net charge of $432,000. Our net revenues with Tower for the six months ended September 30, 2006, were $987,000, or 2.2% of overall net revenues. Our net revenues with Tower for the fiscal year ended March 31, 2006, were $4.3 million, or 3.9% of our overall net revenues for the year. Tower represents the second of our significant retail customers to recently file for bankruptcy. Musicland Stores filed bankruptcy in January 2006 and we took a net charge to expense of $1.6 million. With a high concentration of sales to relatively few customers, we cannot assure you that our other retail customers will not experience financial difficulties leading to uncollectible accounts receivable.
Our Recent Layoff May Disrupt or Delay Our Business Activities. On November 9, 2006, we eliminated 29 positions, including our UK office, and lost six employees through attrition, representing approximately 17% of our total personnel. Although we have reassigned the duties associated with these eliminated positions to other personnel, inefficiencies related to task unfamiliarity, heavier workloads, loss of knowledge and unfilled gaps may arise, especially if we are unable to effectively manage and implement the transition. Any such inefficiency may cause disruption or delay in our business activities.
Relativity Media’s Failure to Deliver the Expected Number or Quality of Motion Pictures May Adversely Affect Our Business. We do not control the timing or manner in which Relativity Media will finance, produce and deliver programs to us. Relativity Media’s decisions regarding the selection, delivery and timing of release of theatrical and direct-to-video motion picture titles will have a significant effect on our future revenues. We also do not control the theatrical distributors’ level of promotion of major motion pictures, and domestic box office performance is likely to affect the film’s subsequent performance in home video. Any decision by producers or theatrical distributors not to deliver, distribute or adequately promote films, or to promote our competitors’ motion pictures to a greater extent than they promote ours, could have a material adverse effect on our business, results of operations and financial condition.
In addition, due to the substantially higher projected revenues from home video distribution of theatrical motion pictures, our distribution costs for each film will be greater, thus exposing us to greater risk in the event that any or all of the pictures do not sell as well as projected. Our success depends on the commercial success of motion pictures which is unpredictable, and failure to achieve projected sales could have a material adverse effect on our business, results of operations and financial condition.
Failure to Effectively Manage Any Potential Future Growth from the Relativity Media Agreement or the Merger with BTP, or Both, May Adversely Affect Our Business. We will face substantial challenges in expanding our distribution capabilities to adequately meet the anticipated increase in our average sales per title and our overall sales as a result of major motion pictures to be delivered to us for home video and digital distribution over the ten-year term of our agreement with Relativity Media, and as a result of our expected merger with BTP. Expanding to meet these needs could require us to incur significant costs and cause the diversion of management’s time and resources. We may not handle the expansion effectively and efficiently, it may be unsuccessful or take longer than anticipated, and we may not realize the anticipated benefits from the transaction, which could result in write-offs and other related expenses. Any of the foregoing could have a material adverse effect on our business, results of operations and financial condition.
In addition, we will be financially responsible for the funding of post production, development of ancillary materials, package design, disc replication, marketing and advertising and distribution costs for each of the Relativity Media and BTP-controlled titles. We may require increased funding to meet our increased requirements, which we may not be able to obtain in sufficient time, on acceptable terms, or at all. Our ability to grow, maintain and expand our distribution of motion pictures and fund increased operating expenses may depend upon our ability to obtain funds through equity financing, debt financing (including credit facilities) or the sale or syndication of some or all of our interests in film projects or other assets. If we do not have access to financing, and if other funding does not become available on terms acceptable to us, there could be a material adverse effect on our business, results of operations and financial condition.
Failure of Our Strategic Alliances Could Have a Material Adverse Affect on Our Business. We have co-produced motion pictures with Dark Horse, Graymark, Amicus and Sisters Wooster, Inc., and, should we have adequate capital resources, we plan to continue our strategy of developing key alliances with other third party content producers. We will rely on our co-producers to develop and produce films. Particularly when produced by independent filmmakers, each film is a separate business venture with its own management, employees, equipment and budgetary requirements. There are substantial risks associated with film production, including contract problems with, or disability of, directors, actors and other key artistic and technical personnel, weather and other delays, damage to sets, equipment or film, and the inability of production personnel to comply with budgetary or scheduling requirements. Such problems could materially increase the cost of production, increase the amount of time between our expenditure of funds and receipt of revenues, or cause the project to be abandoned at any stage if further expenditures do not appear commercially feasible. Accordingly, there is no assurance that we will be successful in our strategic alliances, and any failure of our present and future alliances to produce commercially viable content at an acceptable cost could have a material adverse effect on our business. Additionally, there is no assurance that we will be able to find further desirable strategic alliances as we continue pursuing new co-production deals and similar relationships, or have sufficient capital to fund them.
We Have a High Concentration of Sales From Relatively Few Titles. Our top five fiscal 2007 new release exclusive titles Jeff Dunham: Arguing with Myself DVD and CD, Katt Williams Live DVD and CD, the original Twilight Zone TV series: Complete Definitive Collection DVD, Yanni Live: The Concert Event DVD and CD and Criterion’s Dazed and Confused DVD accounted for approximately 11% of our fiscal 2007 net revenues. Our top ten fiscal 2007 new release exclusive titles accounted for approximately 17% of our fiscal 2007 net revenues. Although catalogue sales of these titles continue to be relatively strong, sales for these titles nevertheless have decreased over time and will probably continue to do so until our rights expire. Net revenues from new release DVD titles, where a new release title is defined as released during fiscal 2007, accounted for approximately 58% of fiscal 2007 net DVD revenues and net revenues from catalogue DVD titles, where catalogue is defined as a title first released in a previous fiscal year, accounted for approximately 42% of fiscal 2007 net DVD revenues. Revenues from new release DVD titles accounted for approximately 51% and 65% of fiscal 2006 and 2005 net DVD revenues, respectively. Revenues from catalogue DVD titles accounted for 49% and 35% of fiscal 2006 and 2005 net DVD revenues, respectively. If we cannot acquire titles of equal or greater strength and popularity, our future net revenues would be negatively impacted.
We May Need Additional Funding to Continue Acquiring Desirable Programming. Availability of working capital is a substantial factor in our ability to produce and/or acquire new content. Therefore, maximizing available working capital is critical to our business operations. We may need to raise additional funds to acquire the rights to content or to create content we find desirable. Should additional funds be raised through the issuance of equity or convertible debt securities, the percentage ownership of our existing stockholders may be reduced. If adequate funds are not available or unavailable on acceptable terms, we may find we are unable to fund expansion, continue offering products and services, take advantage of acquisition opportunities, develop or enhance services or products, and/or respond to competitive pressures in the industry.
Our Current DVD and CD Genre Revenue Concentrations May Become Unpopular With Our Retail Customers and End-Consumers, Which May Adversely Affect Our Business. During fiscal 2007 and 2006, our DVD title genre revenue concentration was heavily weighted toward comedy, music and television-related DVD programming. In 2005, our DVD title genre revenue concentration was heavily weighted toward music-related DVD programming. We may not be able to successfully continue producing or acquiring content in the same genres, or achieve the same strength within the genres we were successful with in fiscal 2007. If we cannot compete successfully in the home entertainment market for higher-profile DVD and CD content, our business may be adversely affected.
Inventory Obsolescence May Adversely Affect Our Business. We maintain a substantial investment in DVD and CD inventory, and if we overestimate the demand for a particular title, we may retain significant quantities of that title in our warehouse. Retained inventory occupies valuable storage space and may become obsolete as our distribution term for the title expires. Although we may sell such inventory at a deeply discounted price toward the end of the distribution term in order to recoup our manufacturing, storage and other costs, there is no guarantee that a market will exist for a given title, even at the deeply discounted price. Alternatively, we may renew the exclusive distribution rights to an expiring title, but there is no guarantee that we will be able to do so, or do so on terms acceptable to us. Additionally, our license and/or distribution agreements sometimes contain terms, such as minimum royalties per unit and music publishing fees, which effectively prevent us from steeply discounting the price on some titles. We have a strong history of renewing our exclusive rights under license and distribution agreements.
Problems Distributing Our Programming Internationally May Adversely Affect Our Business. We distribute our programming internationally. As a result, our business may be subject to various risks inherent in international trade, many of which are beyond our control. Risks faced in distributing our programming internationally include: cancellation or renegotiation of contracts, changes in laws and policies affecting international trade (including taxes), credit risk, fluctuating foreign exchange rates and controls, civil strife, acts of war, guerilla activities, insurrection, terrorism, changing retailer and consumer tastes and preferences with regard to our programming, differing degrees of protection of our intellectual property, cultural barriers, and potential instability of foreign economies and governments, which may adversely affect our international sales. To date, we have not entered into foreign currency exchange contracts.
The Majority of International Revenues Are Generated By Three Sublicensees. Revenues generated from our international business segment are primarily derived from the sales efforts of Sony BMG, Warner Music Group and Digital Site. Should any of Sony BMG, Warner or Digital Site default on their respective sublicense agreements with us or fail to successfully perform, an important part of our business strategy, financial condition, results of operations and cash flows could be negatively impacted.
We Have Direct and Indirect Foreign Currency Exchange Risk. Although our Sony BMG and Digital Site sublicense agreements are U.S. Dollar denominated, with these parties reporting to us and paying us in U.S. Dollars, the underlying Sony BMG sales transactions are in Euros and the underlying Digital Site sales transactions are in Yen. On June 9, 2007, the Euro was equivalent to approximately U.S. $1.34 and the Yen was equivalent to approximately U.S. $0.00824. Should the U.S. Dollar strengthen compared to either the Euro or the Yen, our sublicensors’ reported royalties to us on a title-by-title basis and in the aggregate would decline (assuming consistent unit sales) and thus reduce our revenues recognized.
We Have an Accumulated Deficit and May Incur Additional Losses. We sustained net losses in fiscal 2007 and 2006, and were profitable in fiscal 2005. Our accumulated deficit at March 31, 2007 was $22.3 million. Due to the inherent unpredictability of high-profile content acquisition and competition for limited retail shelf space, we may incur losses again in the future.
Inability to Maintain Relationships with Our Program Suppliers and Vendors May Adversely Affect Our Business. We receive a significant amount of our revenue from the distribution of those DVDs for which we already have exclusive agreements with program suppliers. We can give no assurances, however, that titles in production which have been financed by us will be timely delivered as agreed or of the expected quality. Delays or inadequacies in delivery, including rights clearances, could negatively impact the performance of any given quarter or fiscal year. We can give no assurance that such content will ultimately be purchased in internally forecasted quantities by our retail customers or ultimately desired by end-consumers. We also cannot assure you that we will be able to renew these exclusive rights as existing agreements with program suppliers expire, that our current program suppliers will continue to support the DVD format in accordance with our exclusive agreements, that our current content suppliers will continue to license titles to us on the current terms or on terms favorable to us, or that we will be able to establish new beneficial supplier relationships to ensure acquisition of exclusive titles in a timely and efficient manner.
The Full Exploitation of Our Rights Requires Us to Conduct Business in Areas Where Our Expertise Is Limited. In order to fully exploit some of the rights we have acquired, we are required to conduct business in sectors (e.g. Internet, rental, broadcast, video on demand, in-flight, satellite) where we are not as experienced as we are in the DVD and home video sectors. Accordingly, when exploiting such sectors in which we are less experienced, we may realize a greater proportion of costs, or we may not realize as much of a proportion of revenue, as we would in the DVD and home video sectors.
Loss of Key Personnel May Adversely Affect Our Business. Our success greatly depends on the performance of our executive management, including President and Chief Executive Officer Martin Greenwald, Chief Operating Officer David Borshell and Chief Financial Officer Jeff Framer. The loss of the services of key persons of our executive management could have a material adverse effect on our operating results and financial condition.
Occurrence of Events for Which We Are Not Insured May Adversely Affect Our Business. We maintain insurance to protect ourselves against various risks related to our operations. This insurance is maintained in types and amounts that we believe to be reasonable depending upon the circumstances surrounding each identified risk. However, we may elect to limit coverage or not to carry insurance for some risks because of the high premiums associated with insuring those risks or for various other reasons. For example, we do not carry earthquake insurance in light of the steep increase in premiums in Southern California after the Northridge earthquake on January 17, 1994. Occurrence of events for which we are not insured may affect our cash flows and overall profitability.
Risks Relating to Our Industry
DVD Sales Are Not Sustaining the Same Level of Growth as Before. We believe that consumer interest in the DVD format is partly due to interest in building the consumer’s personal DVD library of desired entertainment programming. Although our exclusive titles have generally shown stable sales over extended periods, as consumers build their DVD libraries, or with the introduction of new home entertainment formats, DVD sales may decline and adversely affect our operations. In addition, the leveling off of DVD player penetration has clearly resulted in a similar leveling off in DVD sales growth. For more information regarding the trend of DVD sales growth, see “Item 1. Business - Industry Trends” above.
Decreasing Retail Prices for DVDs May Negatively Impact Our Revenues. The home entertainment programming market in which we compete is rapidly evolving and intensely competitive. Many of our competitors, including major studios, are increasingly offering programming, particularly DVD programming, at lower prices. They may be able to produce or secure content on more favorable terms and may be able to adopt more aggressive pricing policies than we are able to adopt. While we strive to improve our operating efficiencies and leverage our fixed costs so that we can afford to pass along these savings to our customers in the form of lower prices, the industry trend of lowering prices may, over time, lead to higher levels of competition and, therefore, lost sales, decreased profit margins or decreased overall revenues.
Failure to Effectively Expand Vendor Managed Inventory (VMI) May Adversely Affect Our Business. Many large retailers allow approved suppliers to manage inventory within VMI systems whereby suppliers like us are responsible for planning, monitoring, stocking and fulfilling directly to individual retail stores and outlets. We have fully implemented all of the necessary VMI software and systems and are currently engaged in providing this service to three significant customers who require VMI in order to continue direct shipments with them. We are evaluating additional opportunities to deploy our VMI system with other retail customers. We cannot assure you that implementation of VMI with other customers will be done in a timely or effective manner, or that the VMI software we have implemented will be acceptable to other retail customers. Implementation of VMI requires capital expenditures for initial setup, installation and integration. In addition, we are incurring ongoing fees for software maintenance and support, item planning, order management and picking, packing, labeling and shipping of product. Failure to implement VMI in a timely manner with other customers could result in decreased opportunities for shelf space or decreased margins, and may require us to sell to VMI customers indirectly through third-parties who have already implemented VMI. While we should be able to add other customers without significant additional costs or time, there can be no assurance this will be the case, and VMI implementation may require additional freight charges as inventory is sent directly to retail stores and outlets in smaller packages with greater frequency.
Our Success Depends on the Commercial Success of Our Programming. Operating in the entertainment industry involves a substantial degree of risk. Each music performance, feature film or other programming title is an individual artistic work, and unpredictable audience reactions primarily determine commercial success. The commercial success of a title also depends upon the quality and acceptance of other competing programs or titles released into the marketplace, critical reviews, the availability of alternative forms of entertainment and leisure activities, general economic conditions and other tangible and intangible factors, all of which are subject to change and cannot be predicted with certainty. Our success will depend in part on the popularity of our content which, in turn, depends on our ability to gauge and predict expected popularity. Even if a film achieves success during its theatrical release, the popularity of a particular program and its ratings may diminish over time, which may have a material adverse affect on our business, results of operations or financial condition. Timing and timeliness are also sometimes relevant to a program’s success, especially when the program concerns a recent event or historically relevant material (e.g. an anniversary of a historical event which focuses media attention on the event and accordingly spurs interest in related content).
Decreasing Retail Shelf Space May Limit Sales of Our Programming. We face increasing competition from major motion picture studios, music labels and other independent content suppliers for limited retail shelf space and retailer open to buy dollars. Although the amount of retail shelf space for DVDs had previously been growing in approximate correlation to the growth rate in penetration of DVD players, the leveling off of DVD player penetration has resulted in a similar leveling off in retail shelf space growth. It is within this changing environment that our exclusive content competes for a finite amount of shelf space against a growing supply of entertainment content. Because the new DVD releases of major studios often have extremely high visibility and sales velocity in the millions of units, which typically require more shelf space to support, we may not be able to afford or obtain the product placement necessary to maximize sales, particularly among the limited number of major retailers that are our core customers, which could result in decreased revenues and gross margins. For more information regarding decreasing retail shelf space due to DVD releases of major studios, see “Item 1. Business - Competition” above.
Our Film Production Efforts May Not be Financially Successful. Our co-produced films are more expensive to create than our music and stand-up comedy event DVD co-productions, and the time between our expenditure of funds and receipt of revenues is longer. While much of our programming is sold to retailers on a sell-through basis, the financial success of our filmed programming will depend on our ability to generate higher sales to retailers who primarily rent programming such as Blockbuster, Movie Gallery, Hollywood Entertainment (now a wholly-owned subsidiary of Movie Gallery) and Netflix, as well as to mass merchants such as Wal-Mart, Costco and Target. Our filmed programming may not ultimately be as desirable to our target customers as we would hope, which would lead to lower than expected sales, decreased profit margins or losses.
Conflicting High-Definition DVD Formats May Cause Inefficiencies. Currently, two major platforms are competing to become the dominant high-definition format, and talks to unify the platforms have been unsuccessful. The HD-DVD and Blu-ray Disc® platforms have both recently launched. For many of our titles, we hold rights to both platforms, but simultaneously supporting both platforms will cause increased production costs and decreased efficiencies with respect to inventory management and sales. Moreover, competing platforms may cause a delay in high-definition player market penetration, and mainstream acceptance of high-definition DVD in general, as consumers may decide to wait and see which platform prevails before purchasing a player.
We May Not Be Able to Keep Pace with Technological Advances. The entertainment industry in general, and the music and motion picture industries in particular, are continuing to undergo significant changes, primarily due to technological developments. Because of the rapid growth of technology, shifting consumer tastes and the popularity and availability of other forms of entertainment, it is impossible to predict the overall effect these factors could have on potential revenue from, and profitability of, distributing entertainment programming. It is also impossible to predict the overall effect these factors could have on our ability to compete effectively in a changing market.
An Increase In Product Returns May Adversely Affect Our Business. As with the major studios and other independent companies in this industry, we experience a relatively high level of product returns as a percentage of our revenues. Our allowances for sales returns may not be adequate to cover potential returns in the future, particularly in the case of consolidation within the home video retail marketplace which, when it occurs, tends to result in inventory consolidation and increased returns. Our experience over two of the past three years has been one of increasing return rates, and we expect this trend to continue.
Illegal Piracy May Reduce Our Revenues. The music industry is facing a major challenge in the form of illegal piracy resulting from Internet downloading and/or CD recorders. This piracy has negatively affected industry revenues and profits. Although we currently derive only 4% of our revenues from audio CDs, we are hopeful that our proportional revenues in this sector will increase. Additionally, according to Nielsen Media Research, just over 17% of U.S. TV households now have a digital video recorder (DVR). According to In-Stat, DVRs are gradually gaining greater market penetration: shipments of DVRs are estimated to be 19.8 million units for calendar 2006. As DVD recorders, DVRs and high-speed Internet connections become more popular, and the storage capacity of personal computers increases, we may face greater piracy concerns with respect to our core DVD business.
Others’ Failure to Promote Our Programming May Adversely Affect Our Business. Decisions regarding the timing of release and promotional support of programming which we license and distribute are important in determining the success of a particular music concert, feature film or related product. We may not control the manner in which a particular artist, film or related product is marketed and promoted, and we may not be able to fully control our corresponding DVD or CD release. Although artists, record companies, studios and producers have a financial interest in the success of any such concerts or films distributed by us, any marketing or promotional decision or restriction by such persons may negatively affect the success of our titles. Additionally, the availability of retailer programs relating to product placement, co-op advertising and market development funds, and our ability and willingness to pay for such programs, are also important with respect to promoting our exclusive titles.
If DVD Cannot Compete Successfully with Other Formats of Home Entertainment, Our Revenues May Be Negatively Impacted. The DVD format competes with other formats of in-home entertainment, such as network, syndicated, cable and pay-per-view television, and home satellite systems. The DVD format also competes with new and emerging technologies in the entertainment industry, such as entertainment programming on the Internet, video on demand, high-definition television, digital videotape, and optical discs with greater storage capacity. These alternate home entertainment formats and emerging content delivery technologies could negatively impact the overall market for our DVD sales, especially if we are unable to continue to adapt and exploit the development and advancement of such technology.
If We Cannot Continue to Secure DVD License and Distribution Rights, Our Business May Be Materially Adversely Affected. We cannot assure you that we will be able to continue to secure DVD and other license and distribution rights on terms acceptable to us. For more information regarding our continuing ability to obtain DVD license and distribution rights, see “Item 1. Business - Competition” above. Major motion picture studios have normally not granted, nor are they expected to grant, exclusive DVD licenses to us for new releases and popular catalogue titles. Instead, the major motion picture studios will most likely continue to sell DVD titles directly to retailers. We expect to continue to license exclusive DVD and other home entertainment format content, but we cannot assure you that we can remain competitive against licensing entities with greater financial resources or that independent program suppliers will not distribute their programming themselves. In addition, our success will continue to be dependent upon our ability to identify and secure rights to exclusive content that appeal to consumers.
We May Not Possess Satisfactory Rights in Our Properties. Although we require satisfactory chain of title information to our exclusively licensed content, the risk exists that some programs may have a defective chain of title. The validity and ownership of rights to some titles can be uncertain and may be contested by third parties.
Protecting and Defending against Intellectual Property Claims May Have a Material Adverse Effect on Our Business. Our ability to compete in the home entertainment industry depends, in part, upon successful protection of our proprietary and intellectual property. We protect our property rights to our productions through available copyright and trademark laws and licensing and distribution arrangements with reputable international companies in specific territories and media for limited durations. Despite these precautions, existing copyright and trademark laws afford only limited practical protection in some jurisdictions. In some jurisdictions of our distribution, there are no copyright and/or trademark protections available. As a result, it may be possible for unauthorized third parties to copy and distribute our productions or portions or applications of our intended productions. In addition, litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others or to defend against claims of infringement or invalidity. Any such litigation could result in substantial costs and the resulting diversion of resources could have an adverse effect on our business, operating results or financial condition. From time to time, we may also receive claims of infringement of other parties’ proprietary rights. Regardless of the validity or the success of the claims, we could incur significant costs and diversion of resources in defending against such claims, which could have an adverse effect on our business, financial condition or results of operations.
Risks Relating to Our Stock
Failure to Consummate the Merger with BTP May Result in a Material Decrease in the Market Price of Our Common Stock. The announcement of our execution of the merger agreement with BTP on March 29, 2007, resulted in a jump in our stock price to levels approaching the $4.40 per share described in the merger agreement. In the event we are unable to consummate the merger with BTP for any reason, our stock price may drop to the prices we were trading at prior to the announcement of the merger agreement with BTP, or perhaps even lower, and you may lose all or a substantial part of your investment.
Our Stock Price May Be Subject to Substantial Volatility, and You May Lose All or a Substantial Part of Your Investment. Our common stock is traded on The NASDAQ Global Market®. There is a limited public float, and trading volume historically has been limited and sporadic. Over the last year through June 14, 2007, the closing price of our common stock ranged between $3.05 and $4.29 per share on volume ranging from 1,350 to over 5.3 million shares per day. As a result, the current price for our common stock is not necessarily a reliable indicator of our fair market value. The price at which our common stock will trade may be highly volatile and may fluctuate as a result of a number of factors, including, without limitation, the number of shares available for sale in the market, quarterly variations in our operating results, actual or anticipated announcements of new releases by us or competitors, the gain or loss of significant customers, changes in the estimates of our operating performance, and market conditions in our industry and the economy as a whole.
Any Future Sales of Equity May Significantly Impact the Market Price of Our Common Stock. We currently have S-3 and S-4 registration statements for the issuance of our securities in exchange for either cash or other securities on file with the SEC. Future sales of substantial amounts of our common stock, including shares that we may issue upon exercise of outstanding options and warrants, could adversely affect the market price of our common stock. Further, if we raise additional funds through the issuance of common stock or securities convertible into or exercisable for common stock, the percentage ownership of our stockholders will be reduced and the price of our common stock may fall.
We May Incur Increased Costs as a Result of Laws and Regulations Relating to Corporate Governance Matters. Laws and regulations affecting public companies, including the provisions of the Sarbanes-Oxley Act of 2002 and rules adopted or proposed by the SEC and by NASDAQ, will result in increased costs to us as we evaluate the implications of any new rules and respond to their requirements. We will become subject to additional regulatory requirements in our next annual report, including Section 404 of Sarbanes-Oxley which will require us to include in our annual report for the period ending March 31, 2008, a report by management on our internal controls over financial reporting. The additional costs and efforts to do so could be substantial. New rules could make it more difficult or more costly for us to obtain certain types of insurance, including director and officer liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. The impact of these events could also make it more difficult for us to attract and retain qualified persons to serve on our Board, our Board committees or as executive officers. We cannot predict or estimate the amount of the additional costs we may incur or the timing of such costs to comply with any new rules and regulations.
Risks Relating to the Proposed Merger with BTP
As described elsewhere in this Annual Report, we have entered into an agreement to merge with BTP. Our ability to complete the merger with BTP is subject to risks and uncertainties, including, but not limited to, the risk that a condition to closing of the transaction may not be satisfied, the risk that a regulatory approval that may be required for the transaction is not obtained or is obtained subject to conditions that are not anticipated, and other risks to consummation of the transaction. Additional risk factors associated with the proposed merger with BTP are as follows.
Our Business Could Be Adversely Impacted By Uncertainty Related to the Proposed Merger with BTP. Whether or not the merger is completed, the announcement and pendency of the merger could impact or cause disruptions in our business, which could have an adverse effect on our results of operations and financial condition, including:
• our current clients may experience uncertainty associated with the merger and may attempt to negotiate changes in existing business relationships and/or consider entering into business relationships with parties other than us, either before or after completion of the merger, and we may face additional challenges in competing for new and renewal business;
• our employees may experience uncertainty about their future roles with the combined company, which might adversely affect our ability to retain and hire key managers and other employees;
• the attention of our management may be directed toward the completion of the merger and transaction-related considerations and may be diverted from the day-to-day business operations of our business; and
• the uncertainty of retaining business with our suppliers and vendors can be further exacerbated by the merger, and delay in the completion of the merger or termination of the merger agreement could have an adverse effect on our business, financial condition, results of operations or prospects if the merger is not completed.
Failure To Complete the Merger Could Negatively Impact Our Stock Price and Our Future Business and Financial Results. If the proposed merger is not completed, our business may be adversely affected and we will be subject to several risks, including:
• being required, under certain circumstances under the BTP merger agreement, to pay a termination fee;
• having incurred certain costs relating to the proposed merger that are payable whether or not the merger is completed;
• the attention of our management will have been diverted to the merger instead of on our operations and pursuit of other opportunities that could have been beneficial to us; and
• customer perception may be negatively impacted which could affect our ability to compete for, or to win, new and renewable business in the marketplace.
Even If the Proposed Merger is Completed, the Combined Company Will Be Subject to Certain Risks Associated with the Merger. In particular, the stock price and the business of the combined company could be adversely affected by certain risks associated with the merger, including:
• the combined company may be unable to successfully integrate ours and BTP’s operations or to realize the anticipated cost savings and other benefits of the merger;
• the combined company may be unable to retain key employees, and key employees may depart because of issues relating to uncertainty or difficulty of integration or a desire not to remain with the combined company; and
• the combined company will incur significant transaction and merger related costs in connection with the merger.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2. PROPERTIES
Our headquarters are located in Chatsworth, California and consist of approximately 62,000 square feet on one floor of a multi-tenant building. The monthly rent is $1.29 per square foot, on a gross basis, or approximately $80,000 per month, and increases approximately 3% annually. The office lease has an initial 10-year term with two five-year options. The lease commenced on July 1, 2004. 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.
We also lease our 76,000 square foot warehouse and distribution facility located in Las Vegas, Nevada. The monthly rent is approximately $43,000, subject to annual adjustment based on increases in the consumer price index. The lease expires on November 4, 2012. In addition, we lease approximately 4.07 acres of adjacent vacant land in the event we need to expand our current warehouse and distribution facility. The monthly rent for the vacant land is approximately $9,000 and the lease expires on November 4, 2007. Beginning in January 2004, we leased an additional 10,000 square foot warehouse storage space in Las Vegas, Nevada for a monthly rent of approximately $6,000 for an initial term of two years and later extended to April 30, 2007. We moved all inventory from this storage space to Sonopress as of the lease termination date on April 30, 2007. Beginning in October 2005, we leased an additional 5,000 square foot warehouse storage space in Las Vegas, Nevada for a monthly rent of approximately $3,000 on a month to month basis. As of May 31, 2007, the inventory from this storage space was shipped to Sonopress and we then terminated this lease. As discussed above, we are closing our warehouse and distribution facility and Sonopress will be warehousing and fulfilling our DVD and CD orders out of its facility in Pleasant Prairie, Wisconsin. On March 29, 2007, we notified our Las Vegas landlord of our intent to vacate the facility and sublease the space. Our landlord is open to various options, including potential termination of the lease, if an appropriate new tenant is found.
We signed an exclusive representation agreement with IPG, a commercial real estate broker, for the potential sublease of the facility on or about May 11, 2007. Fees to the agent will be 5% of lease rentals or 4% if both sides of the sublease transaction are done by IPG. We have been informed by Las Vegas-based real estate professionals that our lease is below current market rates, thus providing compelling sublease and/or lease exit options for us. Beginning at the end of May 2007, IPG began marketing the facility to prospective tenants under a sublease. It is currently anticipated that the facility will be available to a new tenant, assuming one is found, by October 2007.
Image UK leases office space located at 77 Oxford Street, London W1D 2ES. The lease term is one year and commenced on August 28, 2006, at a rate of approximately £4,750 (approximately $9,000) per month, which rate includes VAT, utilities, cleaning, security, insurance and other fees. As of December 2006, Image removed all property from this location in connection with the layoffs and closure of the Image UK office. Image will continue to pay the lease through its expiration in August 2007.
We believe that our current office and warehouse space is adequate to meet our needs, and that additional facilities will be available for lease, if necessary, to meet our future needs.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
On April 10, 2007, a purported class action shareholder complaint entitled Henzel v. Image Entertainment, Inc., et al. was filed against us and certain of our officers and members of our Board in the Superior Court of the State of California, County of Los Angeles. The named plaintiff proposes to represent a class of our stockholders and claims, among other things, that in connection with the proposed business combination transaction with BTP, the directors breached their fiduciary duties of due care, good faith and loyalty by failing to maximize stockholder value and by creating deterrents to third-party offers. Among other things, the complaint seeks class action status, and a court order enjoining the consummation of the merger and directing us to take appropriate steps to maximize stockholder value. While the lawsuit is in its preliminary stage, we believe that the claims in the lawsuit are without merit and intend to vigorously defend it.
In the normal course of business, we are subject to proceedings, lawsuits and other claims, including proceedings under government laws and regulations relating to employment and tax matters. While it is not possible to predict the outcome of these matters, it is the opinion of management, based on consultations with legal counsel, that the ultimate disposition of known proceedings will not have a material adverse impact on our financial position, results of operations or liquidity.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Our common stock trades on The NASDAQ National Market® under the symbol DISK. The table below presents the quarterly high and low closing prices on the NASDAQ during the past two fiscal years.
Fiscal Year Ended March 31, 2007 High Low
Quarter ended June 30, 2006 $ 3.950 $ 3.500
Quarter ended September 30, 2006 $ 3.850 $ 3.420
Quarter ended December 31, 2006 $ 3.650 $ 3.260
Quarter ended March 31, 2007 $ 4.190 $ 3.050
Fiscal Year Ended March 31, 2006 High Low
Quarter ended June 30, 2005 $ 5.360 $ 2.700
Quarter ended September 30, 2005 $ 4.430 $ 2.680
Quarter ended December 31, 2005 $ 4.150 $ 3.020
Quarter ended March 31, 2006 $ 3.730 $ 3.200
Stockholders
As of June 11, 2007, there were approximately 21,717,955 shares of our common stock issued and outstanding, which were held by approximately 1,218 holders of record. As of June 1, 2007, we estimate there were 2,755 beneficial owners of our common stock.
Dividend Policy
Our Amended and Restated Loan and Security Agreement with Wells Fargo Foothill (“Wells Fargo”), which was replaced in May 2007 by our Loan and Security Agreement with Wachovia Capital Finance Corporation (Western) (“Wachovia”), both prohibit our payment of dividends. For more information on these restrictions, please refer to “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources.” We have never paid a cash dividend on our common stock, and we presently intend to retain future earnings (if any) for business development.
Stock Performance Graph
The graph below compares our cumulative total return, the NASDAQ U.S. Market Index and our selected peer group for the five-year period ended March 31, 2007. The new peer group consists of Handleman Company, Trans World Entertainment Corporation, Navarre Corporation, Lions Gate Entertainment Corp. and Genius Products, Inc. We added Genius Products, Inc., an entertainment products distribution company that distributes, licenses, acquires and produces entertainment programming on DVD and emerging entertainment platforms. Genius Products was added to our new peer group as most of their business parallels our own. The old peer group consisted of Handleman Company, Trans World Entertainment Corporation, Navarre Corporation and Lions Gate Entertainment Corp. The graph assumes an initial investment in us of $100 on March 31, 2002, in the NASDAQ U.S. Market Index, and in the peer group. The graph also assumes reinvestment of dividends, if any. The stockholder return shown on the graph below should not be considered indicative of future stockholder returns, and we will not make or endorse any predictions of future stockholder returns.
COMPARISON OF FIVE YEAR CUMULATIVE TOTAL RETURN*
AMONG IMAGE ENTERTAINMENT, INC., THE NASDAQ U.S. MARKET INDEX,
OUR NEW PEER GROUP AND OUR OLD PEER GROUP
* $100 invested on 3/31/02 in stock or index-including reinvestment of dividends. Fiscal year ending March 31.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data presented below was derived from our consolidated financial statements and should be read in conjunction with the financial statements, the notes thereto and the other financial information included therein, all of which is contained in complete form in “Item 8. Financial Statements and Supplementary Data.”
Includes a $2.2 million write-off of assets relating to our distribution agreement with Source Entertainment, Inc. which filed for bankruptcy protection in May 2007. Also includes $1.4 million in legal, investment banking and other expenses associated with negotiating the BTP merger agreement. Also includes $634,000 in fees and expenses associated with the Lion’s Gate proxy contest and special committee of our Board. Also includes $488,000 in severance and UK office closure costs associated with a November 2006 cost reduction plan. Also includes a net $432,000 charge associated with the Chapter 11 filing MTS (Tower Records).
Includes a $1,566,000 charge associated with the Chapter 11 filing of Musicland Holding Corp. and a $248,000 impairment charge associated with software not utilized. Also includes a $562,000 credit to cost of sales from the reversal of an over accrual for music publishing liabilities associated with a DVD series.
Includes a $499,000 non-recurring noncash credit related to the discontinuation of our international distribution of DVDs through subdistributors.
Income tax expense reflects the use of net operating losses against taxable income.
Income tax expense reflects establishing a valuation allowance against 100% of net deferred tax assets.
Includes the reduction to gross margin of $480,000 for estimated subdistributor returns and inventory write downs as a result of our transition from direct European distribution to European sublicense.
Includes a provision for a valuation allowance against deferred tax assets of $551,000 relating primarily to foreign tax credits.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis should be read together with our disclaimer on “Forward-Looking Statements,” “Item 1. Business,” “Item 1A. Risk Factors,” “Item 6. Selected Financial Data” and the consolidated financial statements, the related notes thereto and other financial information contained elsewhere in this Annual Report.
Overview
Revenue Sources. Our primary source of revenues continues to be derived from the acquisition and distribution of exclusive DVD content in North America, which accounted for approximately 93% of our overall net sales in fiscal 2007. A complementary source of revenues in fiscal 2007 was derived from the distribution of CD content in North America, which accounted for over 4% of our fiscal 2007 net revenues.
Internationally, we primarily receive royalty income from sublicenses with Sony BMG, Warner Music and Digital Site for the distribution of our exclusive DVD content.
Revenues from digital distribution of our exclusive content rights are beginning to grow. Net revenues generated by Egami totaled $1,214,000 in fiscal 2007, up 582% from $178,000 in fiscal 2006, Egami’s first full year of operation.
Cost Structure. Our most significant costs and cash expenditures relate to acquiring content for exclusive distribution and, more recently, the funding of content production or co-production for exclusive distribution, and expenses related to the Lions Gate lawsuit, the proxy contest and our proposed merger with BTP. Additionally, the costs of consumer advertising, product promotion and market development funds provided to our retail customers continue to increase. Other significant costs include DVD and CD manufacturing, employee compensation and freight expense.
Acquisition of Exclusive Rights. We intend to maintain our content rights acquisition focus on genres that have been successful in the past, even while seeking out early trend opportunities in advance of mainstream acceptance in an effort to keep acquisition costs lower by bringing titles to market before spikes in demand drive up acquisition costs, especially in growing genres such as urban and Latin where we possess significant expertise. We obtain our content from a variety of sources, including, but not limited to, content rights holders, producers, business management firms, law firms, talent agencies, independent film studios and record labels, the artists themselves and content finders.
Fiscal 2007 Highlights:
• Net revenues decreased 10.9% to $99,751,000, compared to $111,902,000 in fiscal 2006.
° Digital distribution revenues grew to $1,214,000, compared to $178,000.
° We experienced a lack of break-out titles in fiscal 2007, compared to the BBC’s television production of The Chronicles of Narnia in fiscal 2006.
• Gross profit margins decreased 7% to 17.8%, compared to 24.8% for fiscal 2006.
° The gross profit margins above are inclusive of the $2.2 million write-off of assets relating to our distribution agreement with Source Entertainment, Inc., which filed for bankruptcy protection in May 2007. The Source asset impairment write-down negatively impacted gross profit margins by 2.2%.
• Selling expenses increased to 10.5% of net revenues, up from 9.6% of net revenues for fiscal 2006.
° These expenses include $225,000 in employee termination costs in accordance with management’s November 2006 cost reduction plan.
• General and administrative expenses were $17,407,000 in absolute dollars for fiscal 2007, as compared to $16,460,000 for fiscal 2006. Significant comparative differences in the expenses in fiscal 2007 versus 2006 are as follows:
° $1.4 million in legal and investment banking expense associated with negotiating the BTP merger agreement in fiscal 2007.
° $634,000 in expenses and fees associated with the process of evaluating strategic alternatives, including our potential sale, and the Lions Gate contested proxy vote in fiscal 2007 compared to $247,000 in fiscal 2006.
° $432,000 net charge as a result of retail customer Tower Records’ bankruptcy filing in fiscal 2007 compared to a $1.6 million net charge as a result of retail customer Musicland Stores’ bankruptcy filing in fiscal 2006.
° $263,000 in employee termination and UK office closure costs in accordance with management’s November 2006 cost reduction plan.
° $90,000 in fees associated with investment banker analysis of the Relativity Media agreement.
° $248,000 asset impairment write-down in fiscal 2006 relating to abandoned software.
• Non-cash interest expense totaled $1,071,000 associated with our manufacturing advance and convertible debt and warrant issues. See “Disc Replication Agreement and Related Advance” and “Private Placement of Senior Convertible Note and Warrant” below.
• Net loss was $12,611,000, or $.59 per diluted share, compared to net loss of $207,000, or $.01 per diluted share for fiscal 2006.
° Net loss in fiscal 2007 includes:
• $.10 per diluted share for the Source asset impairment write-down.
• $.03 for legal and investment banking expenses associated with the special committee process and the Lion’s Gate proxy contest.
• $.06 per diluted share for legal and investment banking expenses associated with the negotiation of the BTP merger agreement.
• $.02 in severance and office closure costs associated with management’s November 2006 plan to reduce operating costs.
• $.05 in non-cash interest costs associated with our manufacturing advance and convertible debt and warrant issues.
° Net loss in fiscal 2006 includes a $.07 charge per diluted share as a result of the January 12, 2006, Chapter 11 bankruptcy filing by our customer Musicland Holding Corp.
• Total liabilities increased to $61.1 million as compared to $46.0 million for fiscal 2006.
• On June 30, 2006, we received an interest-free $10 million advance from Sonopress against future replication, to be repaid at $0.20 per disc manufactured plus a $0.042 administrative charge per disc manufactured until the advance is fully repaid.
• On August 11, 2006, we entered into a 10-year exclusive distribution agreement with Relativity Media for the DVD and digital rights to a minimum of three Relativity Media motion pictures in calendar 2007 and a minimum of seven thereafter.
• On August 20, 2006, our retail customer Tower Records filed for bankruptcy.
• On August 30, 2006, in a private offering, we issued to Portside Growth and Opportunity Fund (“Portside”) a senior convertible note in the principal amount of $17 million and a related warrant to purchase 1,000,000 shares of our common stock, and on November 10, 2006, we entered into an Amendment and Exchange Agreement with Portside, which agreement modified certain terms in the transaction documents and provided for a replacement warrant to be issued in exchange for the warrant previously issued to Portside.
• On October 10, 2006, our stockholders elected our members of the Board, ending the proxy contest with Lions Gate.
• On November 9, 2006, we put in place certain cost cutting initiatives, which are more fully described under “Update on Management’s Plan to Reduce Operating Costs” below.
• On January 5, 2007, we sent a 120-day notice of termination to Wells Fargo to terminate our revolving line of credit facility, and on January 11, 2007, we further amended our credit facility to reduce the availability during the remaining term of the loan.
• On March 15, 2007, we received a commitment letter from Wachovia to replace our existing revolving line of credit facility with Wells Fargo.
• On March 29, 2007, we entered into a merger agreement with BTP, which was subsequently amended on June 27, 2007. The merger remains subject to stockholder approval.
• On May 4, 2007, we entered into a three-year Loan and Security Agreement with Wachovia, which provides us with a revolving line of credit of up to $15 million based upon eligible receivables.
The highlights above are intended to identify some of our more significant events and transactions during our fiscal year 2007, and recent events which occurred after the fiscal year end. However, these highlights are not intended to be a full discussion of our results for the year. These highlights should be read in conjunction with the following discussion of “Results of Operations” and “Liquidity and Capital Resources” and with our consolidated financial statements and footnotes accompanying this Annual Report.
We will continue seeking the highest-quality programming available to independents such as ourselves to market and distribute in many genres. The following list identifies some of our higher-profile titles released in fiscal 2007, as well as some projected higher-profile titles scheduled for release in fiscal 2008:
See following page
Titles Released in Fiscal Year 2007 Features/Other:
DVD Titles Bullet Boy
Men Cry in the Dark
Comedy: Evil Aliens (ContentFilm)
Wilderness Survival for Girls (ContentFilm)
Jeff Dunham: Arguing with Myself The Hunt (Graymark)
Katt Williams: Live Patlabor: The Movie 1 & 2 (Anime)
Wanda Sykes: Sick and Tired Her Majesty
Jamie Kennedy: Unwashed: The Stand-Up Special Goodnight, Joseph Parker
The Pee-wee Herman Show: Live at the Roxy Theatre Rising Son: The Legend of Skateboarder Christian Hosoi (QD3 Collection)
The Complete Kathy and Mo Show
Bob & Tom Radio: The Comedy Tour Criterion Branded:
TV: Seven Samurai / Reissue
Mr. Arkadin: The Complete (Orson Welles)
Discovery Channel’s Deadliest Catch: Season 1 Essential Arthouse: 50 Years of Janus Films
Elvis Presley: The Ed Sullivan Shows YoJimbo/Sanjuro: 2 Films by Kurosawa
Twilight Zone: Complete Definitive Collection Double Life of Veronique
Tommy Lee Goes to College Grey Gardens 2-Disc Edition
Combat!: “Best of” Series Brazil / Reissue
Fists in the Pocket
Music-Related: Eric Rohmer’s Six Moral Tales
Pandora’s Box
Chuck Berry: Hail! Hail! Rock ’n’ Roll Monsters & Madmen
R. Kelly Live!: The Light It Up Tour Dazed and Confused
Korn: Live on the Other Side Harlan County USA
Yanni: Live! The Concert Event Kicking and Screaming
Megadeth: That One Night Live
Bastards of Young CD Titles
Austin City Limits Music Festival 2005
Yes: 9012 Live Yanni: Live from Las Vegas
Four Tops: 50th Anniversary Concert Tamia: Between Friends
Who the Hell is Pete Doherty? KRS One: Life
Grey Gardens: Original Cast Recording
Urban: Phil Lesh and Friends: Live at the Warfield
Billboard Latin Music Awards
Russell Simmons Presents: Hip Hop Laws of Success Austin City Limits Music Festival 2005
One Love 3: Pure Heat Gigantour
Just For Kicks. Englebert Humperdinck: Totally Amazing
Black and Blue: Legends Of The Hip-Hop Cop (QD3 Collection) John Popper
Art of 16 Bars (QD3 Collection) Jamie Kennedy: Unwashed: The Stand-Up Special
Beef Box Set (QD3 Collection) Billy Gilman
Live at Billy Bob’s Texas: Multiple Titles
Projected Titles for Fiscal Year 2008
DVD Titles
Features/Other:
Comedy:
Bug’s (Created for IMAX Theatres)
Jeff Dunham: Spark of Insanity Darwin’s Nightmare (HVE)
Joe Rogan Live David and Lisa (HVE)
The Axis of Evil Comedy Tour Zatoichi: The Blind Swordsman Vol. 1-4 (HVE)
Comedians of Comedy Hunchback of Notre Dame: The Ultimate Edition (Silent Lon Chaney Classic)
Steven Wright: When the Leaves Blow Away Shaolin Family Soccer (Foreign)
Daniel Tosh: Completely Serious 51 Birch Street
Gabriel Iglesias: Hot & Fluffy Cabinet of Dr. Caligari (2005)
Mike Marino: New Jersey’s Bad Boy of Comedy Nailed (Horror)
Bob & Tom Comedy All Stars Tour Surveillance (Graymark)
Tommy Tiernan: Something Mental Splinter (Dark Horse)
Doug Stanhope: No Refunds Soul’s Midnight (Graymark)
Bill Burr Caligula: Imperial Edition
Kevin Hart Driftwood (Dark Horse)
TV (Discovery Channel): Criterion Branded:
Survivorman The Last Emperor
Shark Week: 20th Anniversary Collection Stranger Than Paradise
Dirty Jobs Collections 1 & 2 Sansho the Bailiff
Man vs. Wild The Third Man
Mythbusters: Collection 2 Ace in the Hole
Deadliest Catch: Seasons 2 & 3 La Jetee: Sans Soleil
Passport to Europe with Samantha Brown: Multiple Titles House of Games
Army of Shadows
Music-Related: Robinson Crusoe on Mars
Dinosaur Jr.: Live in the Middle East CD Titles
Sammy Hagar: Live in St. Louis
Beatles’ Biggest Secrets Megadeth: That One Night: Live in Buenos Aires
Moody Blues: Classic Artists Tamia’s Christmas
Yes: Classic Artists Mint Condition (Second Studio Album)
Gigantour 2 Willie Nelson: Live at Billy Bob’s Texas: Limited Edition CD/DVD
Dionne Warwick Live Gigantour 2
Junior Wells: Blues Legends The Source Presents Hip Hop Hits Volume 11
Urban:
The Notorious B.I.G.: Bigger Than Life
Beef 4 (QD3 Collection)
Holla at Me
Lord Help Us
Ganked
Bling
Death Toll (DMX)
Update on Management’s Plan to Reduce Operating Costs
In an effort to reduce operating costs and achieve profitability, management embarked on several initiatives that are expected to reduce annual expenses by approximately $3.8 million.
• On November 9, 2006, we laid off 27 employees spread throughout various departments. Along with an additional six employees who recently left us through attrition and were not replaced, our overall personnel headcount was reduced by 33, resulting in an approximately 16% reduction in our U.S.-based workforce. Annual expense savings from this reduction in force, including salary and benefits, total an estimated $2.2 million. The expense savings will be reflected primarily in selling and general and administrative expenses and amortization of non-recoupable production costs (cost of sales) on a go-forward basis.
• We laid off both of our two UK employees and closed our Image UK content acquisitions office in November 2006, saving annual expenses of approximately $400,000. Of the $400,000 in savings, $235,000 is compensation related and is not included in the $2.2 million in annual expense savings from reduced headcount discussed above. The expense savings will be reflected in general and administrative expenses on a go-forward basis. The UK office was used primarily as a focal point for the acquisition of programming outside of North America. We believe that a realignment of our acquisition strategy allowed us to close this satellite office without any material negative effect on our overall acquisition efforts. We are continuing to use one of the employees as a consultant tasked with the acquisition of programming outside of North America.
• We made changes in our freight policy and reduced distribution facility expenses, such as temporary labor, employee overtime, utilities and cost of supplies. We expect an immediate annual expense savings from these initiatives of approximately $500,000. The expense savings will be reflected in cost of sales on a go-forward basis.
• We successfully implemented our vendor management inventory (VMI) system, which affords us approximately $200,000 in annual savings based upon overall reduced freight costs.
• We appointed Sonopress as our exclusive provider of warehousing and distribution services, which we expect to reduce our replication and distribution costs. See “Sonopress Fulfillment Services Agreement and Planned Closure of Las Vegas Facility” below.
• We have reduced third-party professional services that will save us approximately $180,000 annually beginning January 1, 2007.
• We have implemented our content rights management system and expect future comparative savings from outside consultants to be $300,000 annually beginning in our fourth quarter ended March 31, 2007.
We recorded one-time charges for severance associated with the layoff of our employees and accrued for the remaining rent of our Image UK office totaling approximately $488,000 in our third quarter ended December 31, 2006. The one-time charges were reflected in selling expenses in the amount of approximately $225,000, and general and administrative expenses in the amount of approximately $263,000, in the statements of operations for fiscal 2007.
Disc Replication Agreement and Related Advance
On June 30, 2006, we entered into a five-year disc replication agreement with Sonopress. Sonopress serves as the exclusive manufacturer of our DVDs. This will ultimately include the HD-DVD and Blu-ray Disc® high-definition formats as well. Sonopress is also the primary manufacturer of our CD requirements. On June 30, 2006, we received an interest-free $10 million advance against future DVD manufacturing from Sonopress, to be repaid at $0.20 per DVD manufactured, plus payment of a $0.04 administrative fee per DVD manufactured until the advance is fully repaid. See “Liquidity and Capital Resources” below.
Sonopress Fulfillment Services Agreement and Planned Closure of Las Vegas Facility
In conjunction with our July 2006 strategy to transition replication services from Deluxe to Sonopress, we conducted a strategic analysis that assessed the potential benefits of also transferring all warehousing and distribution operations from our Las Vegas distribution center to a distribution facility located in Pleasant Prairie, Wisconsin (previously owned and operated by Deluxe) that Sonopress acquired on April 1, 2007. Our analysis showed expanded distribution capabilities and reduced operating expenses and freight costs. Moreover, the potential scalability of distribution services without corresponding capital expenditures was extremely attractive to us, especially as we seek to move into home video distribution of theatrical motion pictures.
We expect to realize freight savings as a result of the move to Sonopress’ facility being centrally located in the Midwest, and because of the help from Sonopress’ well-developed transportation management services group. In addition, we anticipate that operating expenses will decrease as a result of the termination of approximately 45 full-time employees plus temporary labor in Las Vegas, the anticipated sublease of our Las Vegas facility, and the elimination of costs related thereto. Ultimately, the recently acquired yet historically tested Sonopress facility provides us with a strategic means to increase our distribution throughput, eliminate capital expenditure requirements and capitalize on cost savings.
One-time termination benefits totaling approximately $365,000 will be provided to current employees who are involuntarily terminated under the terms of this restructuring. These employees will be required to render service until a specific date in order to receive the termination benefits. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 146 “Accounting for Costs Associated with Exit or Disposal Activities,” a liability for the termination benefits shall be measured initially at the communication date, which was April 20, 2007, based on the fair value of the liability as of the termination date. The resulting liability will be recognized ratably over the future service period.
We plan on using our warehouse assets as we to continue to store and distribute our products until the transfer of inventories to Sonopress is complete, now estimated to be by July 31, 2007. The decision to restructure our distribution operations by engaging Sonopress triggered an asset impairment as determined under SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” Much of our warehouse and distribution equipment will be abandoned before the end of its previously estimated useful life. In accordance with SFAS No. 146, depreciation and amortization estimates will be revised to reflect the use of the assets over their shortened useful lives. At March 31, 2007, the net book value of assets that we estimate will be abandoned after the cessation of warehousing and distribution activities in Nevada totaled approximately $620,000. We continue to classify these assets as a component of property, equipment and improvements and separately classify the accelerated depreciation expense as “Restructuring Expense” within continuing operating expenses. As this is not a discontinued operation, but rather a closing of a plant and related activities, the net book value will be amortized and depreciated down to its estimated salvage value.
We notified our Las Vegas landlord of our intent to vacate the facility and sublease the space on March 29, 2007. Our landlord is open to various options, including potential termination of the lease, if an appropriate new tenant is found. We signed an exclusive representation agreement with IPG, a commercial real estate broker, for the potential sublease of the facility on or about May 11, 2007. Fees to the agent will be 5% of lease rentals or 4% if both sides of the sublease transaction are completed by IPG. We have been informed by Las Vegas-based real estate professionals that our lease is below current market rates, thus providing compelling sublease and/or lease exit options for us. Beginning at the end of May 2007, IPG began marketing the facility to prospective tenants under a sublease. It is currently anticipated that the facility will be available to a new tenant, assuming one is found, by October 2007. In accordance with SFAS No. 13 “Accounting for Leases,” we will recognize a liability at the date we cease using the facility at its fair value. As the lease is an operating lease, we will determine fair value based on the remaining lease payments reduced by actual or estimated sublease rentals. We estimate our cease-use date to be September 30, 2007.
Private Placement of Senior Convertible Note and Warrant
On August 30, 2006, in a private offering, we issued to Portside a senior convertible note in the principal amount of $17,000,000 and a related warrant to purchase 1,000,000 shares of our common stock, and on November 10, 2006, we entered into an Amendment and Exchange Agreement with Portside, which agreement modified certain terms in the transaction documents and provided for a replacement warrant to be issued in exchange for the warrant previously issued to Portside. See “Liquidity and Capital Resources” below.
Exclusive Distribution Agreement with Relativity Media and Planned Issuance of Common Shares
Distribution Agreement. On August 11, 2006, we entered into a 10-year distribution agreement with Relativity Media. The agreement calls for Relativity Media to provide us with the exclusive home video and digital distribution rights to motion pictures wholly financed through or otherwise under the control of Relativity Media, in exchange for which we will be solely responsible for all distribution services for the DVD home video and digital release of each film.
Relativity Media is a financing, consulting and production company that utilizes both traditional and non-traditional channels in order to raise production and distribution funds, both for major studios and independent production entities. To date, Relativity Media has structured and consummated more that $4 billion in production slate financings. It most recently provided financing for:
• Smokin’ Aces
• Catch and Release
• Talladega Nights: The Ballad of Ricky Bobby
• RV
• The Fast and Furious: Tokyo Drift
• Monster House
Based in part on the advice of our financial advisors and our expectations of the production budget size and type of talent associated with the titles that are to be delivered under the agreement, we project this North American home video and digital distribution output agreement will generate significant DVD and digital revenues over the next few years, assuming Relativity Media delivers titles to us per our contract.
The agreement called for Relativity Media to provide us with the names of three titles within seven days after the execution of the agreement. Relativity Media has not yet delivered titles for us to release under the agreement. The first group of theatrical motion pictures to be released by us under the agreement was initially projected to be in the second half of calendar 2007, or during our fiscal 2008. This timing is dependent upon Relativity securing titles for us in the near term.
The agreement calls for us to exclusively distribute all home video and digital video formats for motion pictures controlled by Relativity Media that are not part of a finance package provided to a major studio or their affiliates, propelling us beyond our existing position as a leading supplier of independent DVD programming to become a significant provider of major motion pictures to the home entertainment industry. Per the agreement, Relativity Media is to deliver us a minimum of three titles in calendar 2007, and a minimum of seven titles each year thereafter. Each title distributed throughout the ten-year output term will carry a ten-year exclusive distribution term from the date of release. We will oversee post production-specifically authoring and compression and development of ancillary materials-creative design, replication, marketing and advertising, sales, distribution and collections for each picture.
On August 16, 2006, in connection with the Relativity Media agreement, we issued a warrant to a third-party exclusive rights finder. The term of the warrant was 4.37 years and had a strike price of $3.81, the closing price of our common stock on the date of grant. The fair value of the warrant was $194,000, using the Black-Scholes valuation model. The warrant has been converted via cashless exercise into 11,230 shares of our common stock as of June 12, 2007. We capitalized the fair value of the warrant as a component of other assets with a corresponding credit to additional paid in capital. We will amortize the asset to cost of sales over the related revenues generated from the Relativity Media titles.
Stock Purchase Agreement. As a material inducement to enter into the distribution agreement, we agreed to issue Relativity Media 3,400,000 shares of our common stock, which are registered on a registration statement on Form S-3. In order to secure Relativity Media’s performance under our agreement, we have been granted a security interest in the shares pursuant to a security agreement, the shares have been pledged to us pursuant to a stock pledge agreement, and a restrictive legend will be placed on the stock certificates representing the shares restricting their transfer until designated title delivery, box office performance, financial and/or payment requirements are met. To date, Relativity Media has not provided us with the first titles to be released under the agreement and to date, we have not physically issued the shares to Relativity Media.
Liquidity and Capital Resources
Our working capital has historically been generated from the following sources:
• operating cash flows
• availability under our revolving line of credit
• private placement of debt and equity instruments
• advances from our disc manufacturer
Sony BMG Recoupment of Royalty Advance for International Sublicense Rights. We received a $3.0 million initial royalty advance under the Sony BMG agreement in March 2003, fully recoupable from revenues generated by Sony BMG against quarterly royalties due to us under the agreement. Based upon actual quarterly sales of our programming in the territories, Sony BMG recoups quarterly royalties from the $3.0 million previously advanced. Sony BMG had provided additional quarterly royalty advances such that for the first three years of the agreement term through December 31, 2005, the advance outstanding to us at any given time was maintained at $3.0 million.
During fiscal 2007 and according to our agreement, Sony BMG reduced, through recoupment, the outstanding royalty advance without making additional quarterly royalty advances. Once the entire royalty advance is recouped, Sony BMG will continue to pay quarterly royalties based on revenues generated. We must repay any outstanding unrecouped royalty advance within 30 days following the final Sony BMG reporting at the end of Sony BMG’s term and sell-off period. At March 31, 2007, approximately $800,000 of the last $3 million advance is classified as a component of deferred revenue in the accompanying balance sheet.
Subsequent Event - New Revolving Credit and Term Loan Facility. On May 4, 2007, we entered into a three-year Loan and Security Agreement with Wachovia, which provides us with a revolving line of credit up to $15 million, with an accordion feature to increase the line to $20 million at our option, subject to the terms and conditions of the agreement. Actual borrowing availability is based on eligible trade accounts receivable levels. The Wachovia revolving credit facility replaces the existing facility with Wells Fargo.
Borrowings bear interest at either the Prime Rate plus up to 0.25% or, at our option, LIBOR plus up to 2.25%, subject to minimum borrowing levels. The level of interest rate margin to Prime or LIBOR is dependent upon our future financial performance as measured by EBITDA, earnings before interest, taxes, depreciation and amortization, as defined in the agreement. The targets under the agreement exempt certain expenses, including costs incurred in our corporate sale process.
The Wachovia agreement is subject to early termination fees, based upon the initial maximum facility amount of $15 million, of 1% if terminated within the first year of the term and 0.75% if terminated thereafter through the end of the three-year term. The agreement also imposes restrictions on such items as encumbrances and liens, payment of dividends, other indebtedness, stock repurchases and capital expenditures and requires us to comply with minimum financial and operating covenants. Any outstanding borrowings are secured by our assets.
At March 31, 2007, we had cash of $2,341,000 and borrowing availability of $5.0 million under our revolving credit facility with our then-lender Wells Fargo. Comparatively, at March 31, 2006, we had cash of $1,079,000 and borrowing availability of $6.6 million and $1 million, respectively, under our revolving credit and term loan facilities with Wells Fargo. At March 31, 2007, we had no borrowings under the revolving credit facility with Wells Fargo.
Other Sources and Uses of Working Capital for Fiscal 2007. The following factors contributed to the use of $11.3 million in operating cash and $1.6 million in investing cash during fiscal 2007:
• Our pretax loss from operations was $12.6 million for fiscal 2007.
° Includes the write-off of $2.2 million in assets associated with our distribution agreement with Source Entertainment as a result of their bankruptcy filing.
° Includes legal, investment banking and other expenses of $1.4 million associated with the negotiation of the BTP merger agreement.
° Includes $634,000 in expenses associated with the Lions Gate proxy contest and special committee of our Board, as well as the ongoing process of evaluating strategic alternatives, including our potential sale.
• We funded feature film production of $2.9 million.
• We had a $3.9 million increase in trade payables and accrued liabilities offset in part by our paid down of accrued royalties, distribution fees and music publishing fees by $3.4 million.
• Approximately $1.5 million in royalties previously advanced to us and classified as deferred revenues were recouped by Sony BMG during fiscal 2007.
° Beginning with our fourth quarter ended March 31, 2006, and in accordance with our agreement, Sony BMG has been recouping their initial $3 million royalty advance to us and not providing us with replacement advances as they had done prior to the quarter ended March 31, 2006. Through March 31, 2007, Sony BMG has recouped $2.2 million, instead of re-advancing us this amount.
• We incurred $1.6 million in capital expenditures in our continuing effort to improve our information technology and distribution system infrastructure.
• Adding to the uses of cash above, our gross trade accounts receivables (gross of reserves for sales returns and allowances, and doubtful accounts) increased to $28.3 million at March 31, 2007, compared to $26.3 million at March 31, 2006, as a result of timing of sales within the March quarter.
We financed these expenditures through operating cash flows, our revolving line of credit, borrowings from our new disc manufacturer Sonopress and a private placement of debt. While we had no current outstanding borrowings under our revolving line of credit with Wells Fargo (since replaced by our new Wachovia line), our long-term outstanding borrowings from the private placement and the manufacturing advance from Sonopress totaled $26.9 million (of which $1.2 million in related fees were deducted from the proceeds of the private placement). The $26.9 million outstanding, of which $17 million may incrementally become due beginning in February 2009 and $10 million of which is incrementally due as discs are manufactured (we estimate $2.3 million will be due in the next 12 months) represents an increase of approximately $28.3 million from the $11.5 million borrowed and classified as a current liability at March 31, 2006.
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 find attractive corporate acquisitions, we may seek additional debt or equity financing in order to fund the transaction, in the form of bank financing, convertible debt, or the issuance of convertible preferred or common stock.
Contractual Obligations and Commercial Commitments. The following table summarizes our contractual obligations at March 31, 2007, and the effects such obligations are expected to have on liquidity and cash flow in future periods:
Advances and guarantees included in the table above, under “Licensing and exclusive distribution agreements,” are prepaid and thus recoupable against future royalties, distribution fees and profit participations 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, our existing bank line of credit, and other working capital.
We do not expect our obligations for property and equipment expenditures, including information technology related expenditures, to exceed $2.5 million per year.
Vendor Managed Inventory. Under the VMI system, product suppliers are responsible for monitoring, stocking, and fulfilling directly to individual retail stores and outlets. Larger retailers, who have been transacting business via VMI with the major studios for years, are starting to require smaller independents (i.e. product suppliers other than major studios, music labels and “mini-majors”) to adopt this method of inventory management. See “Change in Buying Patterns - Best Buy Vendor Managed Inventory (VMI) Program” above.
Our VMI systems provide timely and accurate sales and inventory data and allow us to maintain proper stocking levels at retail. In our largest consortium-based VMI engagement, with Best Buy, we have seen reduced returns and increased inventory turns. With respect to long-term benefits, we expect the implementation of VMI relationships with retail customers to:
• sell more units and reduce returned items by better matching inventory to real-time demand
• reduce potential overproduction and excess inventory quantities by more accurately forecasting orders
• reduce processing and warehousing fees by maintaining a leaner supply chain
• increase our importance as a direct supplier of participating retail partners
Source Entertainment, Inc. Chapter 11 Bankruptcy Filing and Related Asset Impairment. We have written down the net book value of assets related to our distribution agreement with Source Entertainment at March 31, 2007, as facts and circumstances lead us to conclude that recoverability of the net book value is in now in doubt.
We have paid and accrued approximately $1.6 million for mechanical licensing fees for audio programs that we now believe have not been paid by Source as contractually required. In previous reported periods we also recorded a corresponding recoupable music publishing advance for these anticipated music publishing payments, which we were to recoup according to a February 8, 2006 settlement agreement with Source. This agreement granted us the exclusive right to distribute as many additional Source-branded titles as necessary to fully recoup any outstanding unpaid mechanical licensing and other unrecouped costs. Under the settlement agreement, we would have continued to receive our standard distribution fee on all units sold. The agreement also gave us the right but not the obligation to discharge any unpaid music publishing fees required. As we were in control of future Source-branded programming and could cross-promote our CD compilation releases within Source’s periodic magazine, we believed we could recover all of the distribution and music publishing advances through profit participations from future titles and future sales of previously released titles from Source-branded programming.
The Source affiliate with whom we have the settlement agreement filed for Chapter 11 bankruptcy in May 2007. While we will continue to seek to operate under the terms of the settlement agreement, we will attempt to perfect this agreement within the bankruptcy courts. In January 2006, we purchased all of Source’s rights in the Source Programs at a UCC sale. Through this foreclosure sale, we purchased Source’s entire right, title and interest in the already released The Source Presents Hip Hop Hits Volumes 8, 9 and 10 and the yet to be produced future titles The Source Presents Hip Hop Hits Volume 11, 5 Mics, 25th Anniversary and 30th Anniversary CDs (four titles yet to be released). Given the uncertainty associated with the Source’s bankruptcy, we believe that the net book value of our Source-related assets is now impaired. Accordingly, we have written down the unamortized assets related to our expectation of future profits associated with the release of the four titles we purchased in the foreclosure sale. Accordingly, we recorded a write-down of $2.2 million in the fourth quarter of fiscal 2007. The expense is included in cost of sales in the accompanying statement of operations for fiscal 2007.
Long-Term Debt. Long-term debt at March 31, 2007 and 2006 consisted of the following:
Debt Instruments and Related Covenants. Our loan agreement with Wachovia requires us to comply with minimum financial and operating covenants. We were not required to be in compliance with the covenant establishing a minimum EBITDA, as defined by Wachovia, as of March 31, 2007. We were in compliance with all financial and operating covenants at March 31, 2007, and expect to be in compliance with all covenants for the foreseeable future.
Off-Balance Sheet Arrangements. We currently do not have any off-balance sheet arrangements.
Critical Accounting Policies
The discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. Generally accepted accounting principles require management to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and the disclosure of contingent assets and liabilities. We base our estimates on experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that may not be readily apparent from other sources. Our actual results may differ from those estimates.
We consider our critical accounting policies to be those that involve significant uncertainties, require judgments or estimates that are more difficult for management to determine, or that may produce materially different results when using different assumptions. We consider the following accounting policies to be critical:
Revenue Recognition. We recognize revenue upon meeting the recognition requirements of American Institute of Certified Public Accountants Statement of Position (“SOP”) 00-2, “Accounting by Producers or Distributors of Films” and Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition.” Revenues from home video distribution are recognized net of an allowance for estimated returns, as well as related costs, in the period in which the product is available for sale by our customers (at the point that title and risk of loss transfer to the customer, which is generally upon receipt by the customer, and in the case of new releases, after “street date” restrictions lapse). We recognize revenues from domestic and international broadcast licensing and home video sublicensing, as well as associated costs, when the titles are available to the licensee and other recognition requirements of SOP 00-2 are met. We defer fees received in advance of availability, usually in the case of advances received from Sony BMG, Digital Site, Warner Music Group and other international home video sublicensees, and for broadcast, until other revenue recognition requirements have been satisfied. Provisions for uncollectible accounts receivable are provided at the time of sale. As of March 31, 2007, deferred revenue totaled $5,039,000, down from $5,751,000, at March 31, 2006.
Royalty and Distribution Fees. For each reporting period, we estimate the ultimate total revenues to be received throughout a title’s exclusive license or distribution period from exploitation of that title in multiple home entertainment formats. While we charge royalty and distribution fee advances to operations as related revenues are earned, estimates of ultimate revenues are important in determining whether we should record additional royalty and distribution fee expense as cost of sales in any given reporting period. We amortize royalty and distribution fee advances to expense in the same ratio that the current period revenues for a title or group of titles bear to the estimated remaining unrecognized ultimate revenues for that title. Additionally, in circumstances required by SOP 00-2, we recognize additional amortization to the extent that capitalized advance royalty and distribution fees exceed their estimated fair value in the period when estimated.
We base our estimates of ultimate revenue for each title on the historical performance of that title, similar titles and specific genre performance. We attempt to reflect in our estimates the most current available information on the title. We update such estimates based upon the actual results of each format’s revenue performance. Estimates of ultimate revenues on a title-by-title basis are subject to substantial uncertainty. Factors affecting future actual performance include focus from the sales and marketing department (including advertising, promotions and price reductions), availability of retail shelf space, retail customer product placement and advertising, maintenance of adequate inventory levels, concert touring by the artist in the case of music-related DVDs and CDs, retail sell-through, and ultimately continued end-user consumer demand. Any of the above factors can contribute to a title’s actual performance exceeding our expectations prior to release or failure to meet pre-release expectations. Overestimation of ultimate revenues would cause unamortized costs to be amortized at a slower rate or a delay in adjusting costs to their fair value until such time estimates are reduced, causing unamortized costs to be overstated and increased amortization of costs in a later period. Underestimation of ultimate revenues would cause unamortized costs to be amortized more quickly until ultimate revenue estimates are increased, causing unamortized costs to be understated and decreased amortization of costs in a later period.
Inventory Valuation. For each reporting period, we evaluate our ending inventories for excess quantities and obsolescence. This evaluation includes analysis of historical sales levels by title, format and genre, and projections of future demand. In addition, we write down inventories that are considered obsolete or overstocked. Remaining inventory balances are adjusted to approximate the lower-of-cost or market value, and result in a new basis in such inventory until sold. If future demand or market conditions are less favorable than our projections, additional inventory write downs may be required, and would be reflected in cost of sales in the period the revision is made. Future demand will be dependent upon the continued retail customer acceptance of our content, future demand by end-user consumer, advertising, promotions and price reductions, market conditions (either favorable or unfavorable) and future warehouse storage limitations. Should projections of future inventory demand be overstated, the value of inventory would be overstated and current cost of sales understated, with future cost of sales overstated. Conversely, should projections of future demand be understated, the value of inventory would be understated and the current cost of sales overstated, with future cost of sales understated.
Allowance for Sales Returns and Doubtful Accounts Receivable. For each reporting period, we evaluate product sales and accounts receivable to estimate their effect on revenues due to product returns, sales allowances and other credits given and delinquent accounts. Our estimates of product sales that will be returned and the amount of receivables that will ultimately be collected require the exercise of judgment and affect reported revenues and net earnings. In determining the estimate of product sales that will be returned, we analyze historical returns (quantity of returns and time to receive returned product), historical pricing and other credit memo data, current economic trends, and changes in customer demand and acceptance of our products, including reorder activity. Based on this information, we reserve a percentage of each dollar of product sales where the customer has the right to return such product and receive a credit memo. Actual returns could be different from our estimates and current provisions for sales returns and allowances, resulting in future charges to earnings. Estimates of future sales returns and other credits are subject to substantial uncertainty. Factors affecting actual returns include retailer financial difficulties, the perception of comparatively poor retail performance in one or several retailer locations, limited retail shelf space at various times of the year, inadequate advertising or promotions, retail prices being too high for the perceived quality of the content or other comparable content, the near term release of similar titles, and poor responses to package designs. Underestimation of product sales returns and other credits would result in an overstatement of current revenues and lower revenues in future periods. Conversely, overestimation of product sales returns would result in an understatement of current revenues and higher revenues in future periods.
Similarly, we evaluate accounts receivable to determine if they will ultimately be collected. In performing this evaluation, significant judgments and estimates are involved, including an analysis of specific risks on a customer-by-customer basis for our larger customers and an analysis of the length of time receivables have been past due. Based on this information, we reserve an amount that we believe to be doubtful of collection. If the financial condition of our customers were to deteriorate or if economic conditions were to worsen, additional allowances might be required in the future. Underestimation of this allowance would cause accounts receivable to be overstated and current period expenses to be understated. Overestimation of this allowance would cause accounts receivable to be understated and current period expenses to be overstated.
Valuation of Deferred Income Taxes. Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. We must assess the likelihood that our deferred tax assets will be recovered from future taxable income, and to the extent that it is more likely than not that such deferred tax assets will not be realized, we must establish a valuation allowance. The establishment, or increase, of a valuation allowance increases income tax expense for such year. We have a valuation allowance against 100% of our net deferred tax assets, which are composed primarily of net operating loss (“NOL”) carryforwards. Even though we have fully reserved these net deferred tax assets for book purposes, we would still be able to utilize them to reduce future income taxes payable should we have future earnings. To the extent such deferred tax assets relate to NOL carryforwards, the ability to use such NOLs against future earnings will be subject to applicable carryforward periods. As of March 31, 2007, we had NOL carryforwards for Federal and state tax purposes of $16,653,000 and $4,837,000, respectively, which are available to offset taxable income through 2027 and 2017, respectively.
Results of Operations
Net Revenues
Approximately 94% of consolidated net revenues were generated from our worldwide sale of DVDs during fiscal 2007, compared to 90% and 89% in fiscal 2006 and 2005, respectively. CDs contributed approximately 4% of consolidated net revenues for fiscal 2007, compared to 8% and 10% of fiscal 2006 and 2005, respectively. The following table presents consolidated net revenues by reportable business segment for the fiscal years ended March 31:
Fiscal 2007 Compared to 2006 and 2005
Domestic Revenues. During fiscal 2007, our DVD and CD new release schedules did not perform as well as expected and were not as strong as fiscal 2006 and 2005. Our catalogue revenues were also lower, most likely the result of the factors discussed below. Our top ten new release DVD and CD titles for fiscal 2007, 2006 and 2005 together generated net revenues of $16.5 million, $18.8 million and $33.2 million, respectively. New releases totaled $59.2 million, $61.1 million and $76.8 million for fiscal 2007, 2006 and 2005, respectively.
We had a great deal of success during the fiscal 2006 holiday selling season third quarter, with such higher-priced boxed sets as the BBC production of The Chronicles of Narnia (containing The Lion The Witch And The Wardrobe, The Silver Chair and Prince Caspian and The Voyage Of The Dawn Treader), The Bill Jeff Larry and Ron Box Set (Featuring Bill Engvall, Jeff Foxworthy, Larry the Cable Guy and Ron White) and the Twilight Zone: Definitive Edition Seasons 4 and 5. We could not capitalize similarly on our fiscal 2007 holiday selling season third quarter due to a weaker performing release schedule.
The DVD marketplace for independent DVD suppliers such as us has been negatively impacted by a maturing and slowing DVD sell-through market. Major motion picture studios are offering more of their catalogue programming to retail at reduced prices, taking up more precious shelf space from the independent suppliers. The larger retailers use discounted DVDs to drive consumer traffic to their stores which have weakened other stand-alone DVD and CD retailers. Retail shelf space is at a premium and with the January 2006 and August 2006 bankruptcy filings of Musicland and Tower (both significant customers of ours), the number of retail store fronts has decreased.
Our customer Trans World Entertainment purchased approximately 400 of the approximately 800 Musicland stores, closed approximately 55 of those purchased and absorbed the inventories from all of the purchased stores, which included inventories originally purchased by Musicland from us. While our sales of product to Trans World have increased for fiscal 2007, as compared to fiscal 2006, they have not covered the revenues lost as a result of Musicland bankruptcy.
Tower was purchased by a liquidator which liquidated the chain with going-out-of-business sales. Tower’s inventory, including inventories originally purchased by Tower from us, was deeply discounted to consumers during our third quarter of fiscal 2007.
As retail store fronts shrink and shelf space becomes more constrained, we are seeing sales to our Internet retailers growing. Sales to Amazon, Infinity Resources (including Critics’ Choice Video and DeepDiscount.com), and NetFlix have increased for fiscal 2007, by 17.6%, 9.6% and 74.9%, respectively, as compared to fiscal 2006. Internet retailers offer virtual shelf space, which is of critical importance to an independent software supplier.
Finally, we believe that the uncertainty of our future as an independent supplier of DVD programming has created retail buyer insecurity. As a result, we believe retailers have decreased their inventories of our programming and reduced new purchases of our programming since Lions Gate launched their proxy contest. In multiple face-to-face meetings with retail buyers, our sales force has been asked to comment on “what’s going on with Lions Gate” and has also been asked in various ways whether or not we would continue operating distinctly as Image Entertainment in any post-acquisition scenario. Retailers want assurances that they will be able to return unsold inventory, and we believe retail buyers do not like the uncertainty that accompanies the possibility of new ownership. In the absence of such assurances, retail outlets have reacted to this insecurity by limiting their inventory and purchasing of our programming - thus reducing their financial exposure - until they are reassured as to our future.
We anticipate that the high definition DVD market will ultimately help energize overall DVD sales, as well as generate revenues for us from our high definition assets. We have over 120 high-definition masters that can be released on either the HD-DVD or Blu-ray Disc® formats, and through the conversion process we also have access to many more titles in our catalog.
Digital Distribution Revenues. Egami offers near- and medium-term opportunities. Increasing broadband Internet access and the consumer’s growing expectation that they will be able to consume entertainment content exactly the way they want, where they want, and how they want, will play an extremely important role in how quickly digital distribution grows. We believe the speed in which key industry players move to embrace the transition to digital distribution will most likely determine how quickly video on demand, digital download and streaming revenues grow. Our wholly-owned subsidiary Egami Media is growing its revenues as the digital video market continues to develop. Our digital distribution revenues for fiscal 2007 grew to $1,214,000, from $178,000 in fiscal 2006, Egami’s first full year of operations. We anticipate continued growth of both our digital library and digital revenues.
International Revenues. Our internationally generated revenues have significantly decreased over the last several years due to lower royalty revenues reported by our international sublicensees. Because of language barriers and cultural differences, much of our successful new release programming - particularly urban and comedy titles - has not been released internationally or has not sold as well as in North America.
We continue our efforts to acquire programming that sells well not only domestically, but also internationally. Music-related DVDs have done well internationally and we believe the urban music and documentary genres have revenue growth potential overseas.
Broadcast sales were $970,000, $494,000, and $487,000 for fiscal 2007, 2006 and 2005, respectively. Fiscal 2007 benefited from higher revenues generated from HVE, comedy and music event titles.
Cost of Sales
The following table presents consolidated cost of sales by reportable business segment and as a percentage of related-segment net revenues for the fiscal years ended March 31:
Domestic Gross Profit Margins. Gross margins for the domestic segment, as a percentage of segment net revenues, decreased to 17.8% for fiscal 2007, from 24.8% for fiscal 2006 and 25.3% for fiscal 2005. The $2.2 million write-down of assets related to our distribution agreement with Source Entertainment negatively impacted gross margins for the domestic segment, as a percentage of segment net revenues, by 2.3% for fiscal 2007. See “Liquidity and Capital Resources - Source Entertainment, Inc. Chapter 11 Bankruptcy Filing and Related Asset Impairment” above.
Our gross margins are impacted by the sales mix of titles within the respective periods. Each of our exclusive agreements has differing terms. We have exclusive license agreements and exclusive distribution agreements. For license agreements, which typically generate higher gross margins, we pay a royalty based on sales, and for distribution agreements we generally retain a fee, recoup our costs and split back-end profits, if any. The average gross margin recognized is then reduced by expenses classified as cost of sales, such as the expenses generated by our distribution facility, amortization of non-recoupable production costs, freight out and market development funds contributed to our retailers to get placement for our product. When the average gross margin for a period is lower, these additional costs of sales items will further reduce the gross margins recognized.
Other items affecting our average gross margins include:
• the strength of a title’s sales performance
• the selling price of a title
• the costs that we are responsible for, including disc manufacturing costs
• third party net profit participations, specifically the royalty rates, distribution fees retained and profit splits inherent in the agreements
• increased amortization of recoupable production costs and royalty advances as a result of reducing ultimate revenue projections for a title or a cross-collateralized group of titles
Some specific factors contributing to the decrease in segment gross profit margins for fiscal 2007, as compared to fiscal 2006 and fiscal 2005 were:
• As a percentage of net revenues, we experienced a significant increase in net revenues generated by exclusively distributed content in fiscal 2007 versus exclusively licensed content, as compared to fiscal 2006 and 2005. Historically, a higher percentage of revenues are generated from higher-margin exclusively-licensed titles. Because our revenues included such a high percentage of lower-margin exclusively distributed programming, our average gross margins for all of our titles were lower, prior to the deduction of the other cost of sales items discussed above.
• We experienced lower gross margins on some of our exclusively distributed DVD and CD product, attributable to higher amortization of recoupable production costs as a result of lowering ultimate revenue forecasts in light of recent, slowing DVD marketplace trends.
• At lower revenue levels, fixed costs included in cost of sales represent a higher percentage of net revenues, negatively impacting our gross margin percentage.
• We increased the amount of market development funds provided to our customers, which is recorded as a reduction of revenues and thus has a negative effect on gross margins. These market development fund expenditures, as percentages of domestic net revenues, were 4.8%, 4.7% and 3.8%, before reduction for such market development funds, for fiscal 2007, 2006 and 2005, respectively. We expect the trend of increased market development funds paid to customers to continue for the foreseeable future.
International Gross Profit Margins. Gross margins for the international segment are based upon royalty income generated by sales of our exclusive programming by our sublicensees. The gross margins we report will fluctuate depending upon the sales mix of titles sold by our sublicensees and royalty rates to our content suppliers based upon those reported royalties. We expect gross margins for this segment to continue to fluctuate higher and lower in future periods as a result of the factors mentioned above.
Selling Expenses
The following tables present consolidated selling expenses by reportable business segment and as a percentage of related segment net revenues for the fiscal years ended March 31:
Fiscal 2007 Compared to 2006 and 2005
Domestic Selling Expenses. The reduction in selling expenses in absolute dollars for fiscal 2007 as compared to fiscal 2006 was primarily due to the following factors:
• Severance costs incurred from the November 9, 2006, involuntary termination of employees as part of management’s plan to reduce operating costs totaled $225,000 for fiscal 2007.
• Our compensation expense, exclusive of severance costs, was down $108,000 for fiscal 2007 as compared to fiscal 2006 as a result of our November 2006 plan to reduce operating costs. Fiscal 2006 compensation expense was up $486,000 over fiscal 2005 due to additional personnel and annual raises.
• Advertising and promotional expenses were down approximately $642,000 due to reduced customer advertising and fewer shipments of screeners, catalogs and mailers, offset by greater third-party publicity consultants on several of our new DVD and CD releases for fiscal 2007.
° As a percentage of revenues, advertising and promotional expenses were 4.3% of segment net revenues, down slightly from 4.4% for fiscal 2006, due primarily to lower consumer advertising in 2007.
° Domestic selling expenses for fiscal 2006 reflect higher advertising expenses as a percentage of net revenues than fiscal 2005, primarily television and radio spots and co-op advertising expenses, offset by lower expenses for print advertising and mailers.
• Egami selling expenses were up $113,000 in fiscal 2007 as compared to 2006, primarily due to increased compensation expenses.
° Egami selling expenses were $196,000 for fiscal 2006, its first full year of operation, consisting primarily of personnel costs. There were minimal Egami selling expenses in fiscal 2005.
Domestic selling expenses were higher in fiscal 2007, as a percentage of segment revenues, due to the allocation of comparable absolute dollars over comparatively lower revenues for fiscal 2007.
International Selling Expenses. Our international selling expenses are not significant because Sony BMG, Digital Site and Warner Music Group, our primary international sublicensees, are responsible for the majority of selling expenses relating to sales of our programming internationally.
General and Administrative Expenses
The following tables present consolidated general and administrative expenses by reportable business segment and as a percentage of related segment net revenues for the fiscal years ended March 31:
Fiscal 2007 Compared to 2006 and 2005
Domestic General and Administrative Expenses. General and administrative expenses were higher in absolute dollars yet higher as a percentage of net revenues for fiscal 2007 as compared to fiscal 2006 and 2005. The changes in expenses for fiscal 2007 as compared to fiscal 2006 and 2005 are discussed below:
• Legal and investment banking expenses associated with the BTP acquisition agreement of $1.4 million during fiscal 2007.
• Expenses associated with the Lions Gate proxy contest and special committee of our Board totaling $634,000 and $247,000 for fiscal 2007 and 2006. These costs include investment banking, special committee and legal fees in 2007 and 2006 and proxy solicitor fees, financial printer fees, press release costs, and independent proxy vote processor fees in 2007.
• Net charge of $496,000 associated with Tower’s bankruptcy filing in fiscal 2007. In November 2006, we assigned our right, title and interest in our general unsecured trade receivable bankruptcy claim against Tower to a third-party financial institution for a cash payment of approximately $135,000. Accordingly, we recorded a $64,000 recovery of the previously written off bad debt charge as a credit to general and administrative expenses for fiscal 2007.
° In fiscal 2006, we incurred a bad debt charge of $1.6 million as a result of the January 12, 2006, bankruptcy filing of Musicland.
• Temporary labor expenses of $438,000 for fiscal 2007 associated with inputting and auditing the data entered into our content rights management system and for the auditing of contractual data prior to it being entered into our new royalty and distribution system.
• Severance and UK office closure costs related to the November 9, 2006, involuntary termination of employees as part of management’s plan to reduce operating costs totaled $263,000.
• In fiscal 2007, we had increased expenses of $145,000 for consulting and professional services in connection with information technology systems and accounting.
° In fiscal 2006 we had reduced expenses in this category as compared to fiscal 2005.
• Insurance expenses, primarily for medical and directors and officers liability, were higher by $125,000 in fiscal 2007 as compared to fiscal 2006.
• Compensation expense, exclusive of severance and UK office closure costs, were up approximately $86,000 in fiscal 2007 as compared to fiscal 2006, reflecting savings from our November 2006 plan to reduce operating costs.
° In fiscal 2006, we incurred increased personnel costs of $484,000 due to additional personnel and annual raises as compared to fiscal 2005.
° In fiscal 2006, we did not have performance-based bonuses. This resulted in compensation expense savings of $679,000 as compared to fiscal 2005.
• Investment banking fees and expenses of $90,000 associated with an investment banking firm’s review of the Relativity Media agreement in the third quarter of fiscal 2007.
• In fiscal 2006, we incurred an impairment charge for the cumulative cost of a third-party software program totaling $248,000.
• Egami general and administrative expenses were up $95,000 in fiscal 2007 as compared to 2006, primarily due to increased compensation expense.
° In fiscal 2006, our general and administrative expenses of Egami and Image UK totaled $202,000 and $409,000, respectively, their first full year of operation. Expenses for Egami are primarily personnel and expenses for Image UK are primarily personnel and rent and utilities associated with the leased office space. There were minimal fiscal 2005 general and administrative expenses associated with Egami and Image UK.
• Depreciation expense was down $700,000 in fiscal 2007 as compared to fiscal 2006. Many Las Vegas distribution facility assets became fully depreciated in fiscal 2007, reducing comparative depreciation expense in fiscal 2007.
For more information on our general and administrative expenses for fiscal 2007, see “Update on Management Plan to Reduce Operating Costs” above.
Other Income and Expenses
We had no other income in fiscal 2007. Other income for fiscal 2006 was minimal. Other expenses for fiscal 2005 consisted primarily of losses on disposal of fixed assets.
Interest Expense
Interest expense for fiscal 2007 was higher as a result of higher weighted-average interest bearing debt levels and interest rates for the period, as well as significant noncash interest expense recorded from the amortization of debt discounts and deferred financing costs. Net noncash charges to interest expense, representing amortization of the Sonopress manufacturing advance debt discount, convertible note debt discount and deferred financing costs for fiscal 2007, totaled $1,273,000. We expensed approximately $152,000 of our remaining Wells Fargo unamortized deferred financing costs as a result of accelerating the maturity of our revolving line of credit during fiscal 2007. Noncash amortization of the Wells Fargo deferred financing costs to interest expense for fiscal 2007 totaled $202,000. Of our total interest expense for fiscal 2007, 52% represented noncash interest expense.
Income Taxes
We recorded a Federal tax benefit in fiscal 2007 for alternative minimum taxes recorded in fiscal 2006 and recorded state minimum income and franchise taxes for fiscal 2007. In fiscal 2006 and 2005, we recorded Federal and California state alternative minimum taxes as we utilized NOL carryforwards to offset taxable earnings which we anticipated would result in alternative minimum tax due to limitations on the utilization of these NOLs.
Even though we have fully reserved our net deferred tax assets for book purposes, we would still be able to utilize them to reduce future income taxes payable, should we have future earnings. To the extent such deferred tax assets relate to NOL carryforwards, the ability to use such NOL carryforwards against future earnings will be subject to applicable carryforward periods. As of March 31, 2007, we had NOL carryforwards for Federal and state tax purposes of $16,653,000 and $4,837,000 respectively, which are available to offset taxable income through 2027 and 2017, respectively.
Consolidated Net Earnings (Loss)
Net loss for fiscal 2007 and 2006 was $12,611,000, or $.59 per diluted share, and $207,000, or $.01 per diluted share, respectively. Net earnings for fiscal 2005 were $5,127,000, or $.26 per diluted share.
Recently Issued Accounting Pronouncements
In February 2007, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” SFAS No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS No. 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007. Early adoption is permitted as of the beginning of a fiscal year that begins on or before November 15, 2007, provided we also elect to apply the provisions of SFAS No. 157, “Fair Value Measurements.” We have not yet determined the impact of adopting SFAS No. 159 on our financial position.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 defines fair value, establishes a framework for measuring fair value in GAAP and requires enhanced disclosures about fair value measurements. SFAS No. 157 does not require any new fair value measurements. The pronouncement is effective for fiscal years beginning after November 15, 2007. The guidance in SFAS No. 157 will be applied prospectively with the exception of: (i) block discounts of financial instruments; and (ii) certain financial and hybrid instruments measured at initial recognition under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” These exceptions are to be applied retrospectively as of the beginning of initial adoption (a limited form of retrospective application). We will change how we estimate fair value starting in fiscal 2009.
In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109” (“FIN 48”), which clarifies the accounting for uncertainty in income tax positions. This Interpretation requires that we recognize in our consolidated financial statements the impact of a tax position that is more likely than not to be sustained upon examination based on the technical merits of the position. FIN 48 contains extensive disclosure requirements. The provisions of FIN 48 will be effective as of the beginning of our 2008 fiscal year (April 1, 2007), with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. We are currently evaluating the impact of adopting FIN 48 on our consolidated financial statements.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the potential loss arising from adverse changes in market rates and prices, such as interest rates and foreign currency exchange rates. Changes in interest rates and changes in foreign currency exchange rates have an impact on our results of operations.
Interest Rate Fluctuations
At March 31, 2007, we did not have any outstanding borrowings subject to changes in interest rates. Borrowings under our Wachovia revolving line of credit will be subject to changes in interest rates. We presently do not use derivatives to manage this risk.
Management believes that moderate changes in the prime rate would not materially affect our operating results or financial condition.
Foreign Exchange Rate Fluctuations
At March 31, 2007, our accounts receivable related to international distribution and denominated in foreign currencies were minimal. They are subject to future foreign exchange rate risk and could become significant in the future. We distribute some of our licensed DVD programming (for which we hold international distribution rights) internationally through sublicensees. Additionally, we exploit international broadcast rights to some of our exclusive entertainment programming (for which we hold international broadcast rights). Management believes that moderate changes in foreign exchange rates will not materially affect our operating results or financial condition. To date, we have not entered into foreign currency exchange contracts.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets as of March 31, 2007 and 2006
Consolidated Statements of Operations for the years ended March 31, 2007, 2006 and 2005
Consolidated Statements of Shareholders’ Equity for the years ended March 31, 2007, 2006 and 2005
Consolidated Statements of Cash Flows for the years ended March 31, 2007, 2006 and 2005
Notes to Consolidated Financial Statements
Schedule II - Valuation and Qualifying Accounts for the years ended March 31, 2007, 2006 and 2005
Report of Independent Registered Public Accounting Firm
Board of Directors and Shareholders
Image Entertainment, Inc.
Chatsworth, California
We have audited the accompanying consolidated balance sheets of Image Entertainment, Inc. as of March 31, 2007 and 2006, and the related consolidated statements of operations, shareholders’ equity and cash flows for the years ended March 31, 2007, 2006 and 2005. We also have audited the schedule as listed in the accompanying index. These consolidated financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Image Entertainment, Inc. as of March 31, 2007 and 2006, and the results of its operations and its cash flows for each of the years then ended in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the schedule presents fairly, in all material respects, the information set forth therein.
As discussed in the notes to the consolidated financial statements, effective April 1, 2006, the Company adopted the provisions of the Statement of Financial Accounting Standard No. 123(R) - An Amendment of FASB Statement No. 123.
/s/ BDO SEIDMAN LLP
Los Angeles, California
June 29, 2007
CONSOLIDATED BALANCE SHEETS
March 31, 2007 and 2006
ASSETS
See accompanying notes to consolidated financial statements.
CONSOLIDATED BALANCE SHEETS, CONTINUED
March 31, 2007 and 2006
LIABILITIES AND SHAREHOLDERS’ EQUITY
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF OPERATIONS
For the Years Ended March 31, 2007, 2006 and 2005
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
For the Years Ended March 31, 2007, 2006 and 2005
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Years Ended March 31, 2007, 2006 and 2005
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED
For the Years Ended March 31, 2007, 2006 and 2005
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED
For the Years Ended March 31, 2007, 2006 and 2005
SUPPLEMENTAL DISCLOSURES OF NONCASH OPERATING, INVESTING AND FINANCING ACTIVITIES:
As of March 31, 2007 and 2006, we accrued approximately $1.5 million and $3.8 million, respectively, to accrue royalty advances and distribution fees for committed unpaid royalty and production advances where future payment is based upon the release of the program or the passage of time.
In August 2006, we issued warrants with a fair value of $1,900,000 in connection with a convertible debt financing. The warrant was recorded as a discount to the related $17 million debt and a long-term liability. See “Note 5. Long-Term Debt - Private Placement of Senior Convertible Note and Warrant.”
In August 2006, we issued a warrant to a finder in connection with the Relativity Media agreement. The warrant had a fair value of $194,000 and was recorded as a component of other assets and as additional paid in capital. See “Note 4. Exclusive Distribution Agreement with Relativity Media and Planned Issuance of Common Shares.”
In June 2006, we recorded a deferred manufacturing credit of $1,945,000 with an offsetting discount on the $10 million manufacturing advance from Sonopress. See “Note 5. Long-Term Debt - New Disc Replication Agreement and Related Advance.”
On March 29, 2006, the Compensation Committee of our Board of Directors and our full Board approved the acceleration of vesting for all outstanding unvested stock options granted under our equity compensation plans. In connection with the vesting acceleration we recorded a charge of $16,100 based on our estimate that 10% of employees with options will terminate their employment prior to the end of the original vesting periods. We accrued the charge to additional paid in capital at March 31, 2006.
As of March 31, 2006, we accrued approximately $1.6 million for music publishing fees for audio programs that we believe were not paid by our content provider Source Entertainment as contractually required. We recorded a corresponding recoupable music publishing advance included as a component of royalty and distribution fee advances in the accompanying balance sheet, as of March 31, 2006.
During fiscal 2006, a former financial consultant exercised their warrant to purchase 100,000 shares issued in fiscal 2002 by surrendering approximately 58,000 shares in a cashless exercise, an option in the original warrant agreement. The value of the original warrant was fully amortized by March 31, 2003.
On August 1, 2005, we acquired Home Vision Entertainment for $8,000,000 in cash.
See accompanying notes to consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Basis of Presentation and Summary of Significant Accounting Policies.
Basis of Presentation and Principles of Consolidation. The accompanying consolidated financial statements include the accounts of Image Entertainment, Inc., its subsidiaries Egami Media, Inc., Image Entertainment (UK), Inc., Home Vision Entertainment, Inc., DVDPlanet, Inc. (which was dissolved as of December 31, 2004) and Aviva International, LLC (which was dissolved as of December 31, 2004) (collectively, “we,” “our” or “us”). All significant inter-company balances and transactions have been eliminated in consolidation. Aviva International, LLC ceased active operations effective December 31, 2002. DVDPlanet ceased operations for us in December 2003 subsequent to the sale of substantially all of its assets in September 2003.
Business. We engage primarily in the domestic acquisition and wholesale distribution of home entertainment content for release on DVD, and in other home entertainment formats, via exclusive license and distribution agreements. We also distribute our exclusive DVD programming internationally, primarily by relying on sublicensees (particularly Sony BMG, Warner Music Group and Digital Site), from whom we receive revenues in the form of royalty income.
Use of Estimates in Preparation of Financial Statements. The preparation of our consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements. The significant areas requiring the use of management estimates are related to provisions for lower-of-cost or market inventory write downs, doubtful accounts receivable, unrecouped royalty and distribution fee advances, valuation of deferred taxes, and sales returns. Although these estimates are based on management’s knowledge of current events and actions management may undertake in the future, actual results may ultimately differ from those estimates.
Cash and Cash Equivalents. Cash and cash equivalents include all cash balances and highly liquid investments with an initial maturity of three months or less. We place our temporary cash investments with high credit quality financial institutions. At times our cash deposits may be in excess of the Federal Deposit Insurance Corporation (FDIC) insurance limit.
Fair Value of Financial Instruments. The carrying amount of our financial instruments, which principally include cash, trade receivables, accounts payable and accrued expenses, approximates fair value due to the relatively short maturity of such instruments. The fair value of our debt instruments approximate the amount of future cash flows associated with each instrument.
Revenue Recognition. Revenue is recognized upon meeting the recognition requirements of American Institute of Certified Public Accountants Statement of Position (“SOP”) 00-2, Accounting by Producers or Distributors of Films and Staff Accounting Bulletin (“SAB”) No. 104, Revenue Recognition. Revenues from home video distribution are recognized net of an allowance for estimated returns, as well as related costs, in the period in which the product is available for sale by our customers (at the point that title and risk of loss transfer to the customer, which is generally upon receipt by the customer and in the case of new releases, after “street date” restrictions lapse). Revenues from domestic and international broadcast licensing and home video sublicensing, as well as associated costs, are recognized when the programming is available to the licensee and other recognition requirements of SOP 00-2 are met. Fees received in advance of availability, usually in the case of advances received from Sony BMG, Digital Site, other international home video sublicensees and for broadcast programming, are deferred until earned and all revenue recognition requirements have been satisfied. Provisions for uncollectible accounts receivable are provided at the time of sale. As of March 31, 2007, and March 31, 2006, deferred revenue totaled $5,039,000 and $5,751,000, respectively.
Inventories. Inventories consist primarily of finished products for sale (which are stated at the lower-of-cost or market, with cost being determined on an average cost basis) and unamortized non-recoupable production costs (which are stated at fair value).
Non-Recoupable Production Costs. The costs to produce licensed content for domestic and international distribution include the cost of converting film prints or tapes into the optical disc format. Costs also include menu design, authoring, compression, subtitling, closed captioning, service charges related to disc manufacturing, ancillary material production, product packaging design and related services, and the overhead of our creative services and production departments. A percentage of the capitalized production costs is amortized to expense each month based upon: (i) a projected revenue stream resulting from distribution of new and previously released exclusive programming related to such production costs; and (ii) management’s estimate of the ultimate net realizable value of the production costs. Estimates of future revenues are reviewed periodically and amortization of production costs is adjusted accordingly. If estimated future revenues are not sufficient to recover the unamortized balance of production costs, such costs are reduced to their estimated fair value.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Royalty and Distribution Fee Advances, Recoupable Production Advances. Royalty and distribution fee advances represent fixed minimum payments made to program suppliers for exclusive content distribution rights. A program supplier’s share of exclusive program distribution revenues is retained by us until the share equals the advance(s) paid to the program supplier plus recoupable production costs. Thereafter, any excess is paid to the program supplier. In the event of an excess, we record, as a cost of sales, an amount equal to the program supplier’s share of the net distribution revenues. Royalty and distribution fee advances are charged to operations as revenues are earned. Royalty distribution fee advances and recoupable production costs are amortized to expense in the same ratio that current period revenue for a title or group of titles bears to the estimated remaining unrecognized ultimate revenue for that title. Revenue and cost forecasts are continually reviewed by management and revised when warranted by changing conditions. When estimates of total revenues and costs indicate that an individual title or group of cross-collateralized titles which we exploit via home entertainment formats (such as home video, CD or broadcast) will result in an ultimate loss, an impairment charge is recognized to the extent that capitalized advance royalties and distribution fees and recoupable production costs exceed estimated fair value, based on discounted cash flows, in the period when estimated.
Property, Equipment and Improvements. Property, equipment and improvements are stated at cost less accumulated depreciation and amortization. Major renewals and improvements are capitalized; minor replacements, maintenance and repairs are charged to current operations. Some costs in developing internal use software are capitalized pursuant to the SOP 98-1, Accounting for Costs of Computer Software Developed or Obtained for Internal Use. Depreciation and amortization are computed by applying the straight-line method over the estimated useful lives of the machinery, equipment and software (3-7 years). Leasehold improvements are amortized over the shorter of the useful life of the improvement or the 10-year life of the related leases. See “Note 2. Sonopress Fulfillment Services Agreement and Planned Closure of Las Vegas Facility.”
Advertising Costs. Our advertising expense consists of expenditures related to advertising in trade and consumer publications, product brochures and catalogs, booklets for sales promotion, radio advertising and other promotional costs. In accordance with SOP 93-7, Reporting on Advertising Costs, we expense advertising costs in the period in which the advertisement first takes place. Product brochures and catalogs and various other promotional costs are capitalized and amortized over the expected period of future benefit, but generally not exceeding six months. Our co-op advertising is expensed in accordance with Emerging Issues Task Force (“EITF”) 01-09, Accounting for Consideration Given by a Vendor to a Customer or a Reseller of the Vendor’s Products. At March 31, 2007 and 2006, there were no prepaid advertising costs. For fiscal 2007, 2006 and 2005, advertising and promotion expense was $4,319,000, $4,904,000 and $4,632,000, respectively.
Market Development Funds. In accordance with EITF 01-09, Accounting for Consideration Given by a Vendor to a Customer or a Reseller of the Vendor’s Products, market development funds, including funds for specific product positioning, taken as a deduction from payment for purchases by customers are classified by us as a reduction to revenues. The following reductions to consolidated net revenues have been made in accordance with the guidelines of this issue: $5,036,000 for fiscal 2007, $5,329,000 for fiscal 2006 and $4,530,000 for fiscal 2005.
Allowances Received From Vendors. In accordance with EITF 02-16, Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor, we classify consideration received as a reduction in cost of sales in the accompanying statements of operations unless we receive an identifiable benefit in exchange for the consideration, or the consideration represents reimbursement of a specific, identifiable cost incurred by us in selling the vendor’s product.
Shipping Income and Expenses. In accordance with EITF 00-10, Accounting for Shipping and Handling Fees and Costs, we classify amounts billed to customers for shipping fees as revenues, and classify costs related to shipping as cost of sales in the accompanying statements of operations.
Major Customers and Suppliers. Amazon.com, Inc., AEC One Stop Group, and Anderson Merchandisers (who supplies Wal-Mart) accounted for 12%, 12% and 10%, respectively, of our net revenues for the year ended March 31, 2007. Anderson Merchandisers accounted for 11% of our net revenues for the year ended March 31, 2006. Anderson Merchandisers, Best Buy and AEC One Stop Group accounted for approximately 17%, 12%, and 10%, respectively, of our net revenues for the year ended March 31, 2005. No other customers accounted for more than 10% of net revenues in fiscal 2007, 2006 and 2005. At March 31, 2007, AEC One Stop Group and Anderson Merchandisers accounted for 20% and 17%, respectively, of our gross accounts receivables. At March 31, 2006, Anderson Merchandisers and AEC One Stop accounted for 13% and 12%, respectively, of our gross accounts receivables.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
In June 2006, we entered into an agreement with Sonopress LLC for a five-year replication agreement to replace Deluxe as our exclusive manufacturer of DVD product. We source all of our DVD manufacturing with Sonopress. See “Note 5. Long-Term Debt - New Disc Replication Agreement and Related Advance.”
Goodwill. Goodwill is not amortized, but instead is tested for impairment at least annually. Intangible assets continue to be amortized over their respective estimated useful lives ranging from three to five years. We have no intangible assets with indefinite useful lives.
Impairment of Long-Lived Assets. We review for the impairment of long-lived and specific, identifiable intangible assets whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. An impairment loss would be recognized when estimated undiscounted future cash flows expected to result from the use of the asset and its eventual disposition is less than its carrying amount. We incurred an impairment charge for the cumulative cost of a third-party software program totaling $248,000 during our quarter ended December 31, 2005. The third-party developer has failed to provide adequate resources necessary to cause the software to function as designed. It was unclear as to whether they had the ability and resources to continue to support the process necessary to correct functionality to original design specifications and provide adequate future maintenance had we ultimately gone into live production. As a result of increased uncertainty experienced by us during the December 2005 quarter, we believed it was prudent to take the charge.
In May 2007, a content provider, Source Entertainment, filed for bankruptcy protection. Accordingly, we recognized an impairment loss equal to approximately $2.2 million. See “Note 11. Source Entertainment Inc. Chapter 11 Bankruptcy Filing and Related Asset Impairment Write-Down.”
On March 29, 2007, we entered into a fulfillment services agreement with our DVD and CD manufacturer Sonopress and plan to close our Las Vegas Nevada warehouse and distribution facility. See “Note 2. Sonopress Fulfillment Services Agreement and Planned Closure of Las Vegas Facility.”
Foreign Currency Transactions. Foreign currency denominated transactions are recorded at the exchange rate in effect at the time of occurrence, and the gains or losses resulting from subsequent translation of the corresponding receivable or payable at current exchange rates are included as a component of other income and expenses in the accompanying statements of operations. To date, we have not entered into foreign currency exchange contracts.
Income Taxes. We account for income taxes pursuant to the provisions of SFAS No. 109, Accounting for Income Taxes, whereby deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amount of existing assets and liabilities and their respective tax bases and the future tax benefits derived from operating loss and tax credit carryforwards. We provide a valuation allowance on our deferred tax assets when it is more likely than not that such deferred tax assets will not be realized. We have a valuation allowance against 100% of our net deferred tax assets at March 31, 2007 and 2006.
Earnings/Loss per Share. Basic earnings/loss per share are computed using the weighted average number of common shares outstanding during the period. Diluted earnings per share are computed using the combination of dilutive common share equivalents and the weighted average shares outstanding during the period. Diluted loss per share is equivalent to basic loss per share as inclusion common share equivalents would be anti-dilutive.
Comprehensive Income (Loss). Comprehensive income (loss) consists of two components, net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) refers to revenue, expenses, gains and losses that under generally accepted accounting principles are recorded as an element of stockholders’ equity but are excluded from net income (loss). Our other comprehensive income (loss) is comprised of foreign currency translation adjustments arising from cash accounts maintained in England by our subsidiary Image UK. Our comprehensive loss was $12,608,000 and $211,000 for the years ended March 31, 2007 and 2006, respectively. Comprehensive income was $5,127,000 for the year ended March 31, 2005.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Stock Options. In December 2004, the Financial Accounting Standards Board (FASB) issued revised Statement of Financial Accounting Standards (SFAS) No. 123(R) (123R) “Share-Based Payment - an Amendment of SFAS No.‘s 123 and 95.” SFAS 123(R) establishes standards with respect to the accounting for transactions in which an entity exchanges its equity instruments for goods or services, or incurs liabilities in exchange for goods or services, that are based on the fair value of the entity’s equity instruments, focusing primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. SFAS No. 123(R) requires public entities to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award (with limited exceptions) and recognize the cost over the period during which an employee is required to provide service in exchange for the award. Through March 31, 2006, we accounted for stock options granted to employees in accordance with Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees, and related interpretations.
On April 1, 2006, we adopted SFAS No. 123R using the “modified prospective” method. Under this method, SFAS No. 123R requires that we measure the cost of employee services received in exchange for an award of equity instruments based on the fair value of the award on the grant date for all awards granted after March 31, 2006. Such cost will be recognized over the period during which an employee of ours is required to provide service in exchange for the award (i.e. the vesting period). Subsequent to our adoption of SFAS No. 123R, we have not granted any stock-based compensation except for standard grants of Restricted Stock Units to our Board and our Chief Marketing Officer, and we are currently evaluating our future plans to do so, which at this time do not include issuing stock-based compensation in the form of employee stock options.
On March 29, 2006, the Compensation Committee of our Board of Directors approved, and our full Board ratified, the acceleration of vesting for all outstanding unvested stock options granted under our equity compensation plans. In connection with the vesting acceleration, the Compensation Committee and the Board also imposed a holding period on the shares underlying the accelerated options, which would prevent the sale or other transfer of such shares until the date the shares would have vested under the original vesting schedule of the respective option, except that the holding period will end upon the close of a change in control transaction. Approximately 402,500 unvested stock options were accelerated with an exercise price below the closing price of $3.73 on March 29, 2006 (i.e. in-the-money), and approximately 724,830 unvested stock options were accelerated with an exercise price above the closing price (i.e. out-of-the-money). The action to accelerate the vesting of unvested stock options enables us to minimize recognizing future compensation expense associated with our outstanding options upon our adoption of SFAS No. 123R. The fair value of such stock-based compensation that would have been recorded as compensation expense over the remaining vesting periods for the fiscal 2006-2011 periods, had we not accelerated the vesting, totaled $1,883,000 (approximately $650,000 for our 2007 fiscal year, beginning April 1, 2006, and approximately $1,233,000 over the remaining vesting period of the options). The pro-forma compensation expense is reflected in the table below, which illustrates the effect on net earnings (loss) and earnings (loss) per share for fiscal year 2006 as if Image had applied the fair value recognition provisions of SFAS No. 123R to stock-based employee compensation. The weighted average difference between the exercise price of the 402,500 in-the-money option shares and the closing stock price on March 29, 2006, was $0.40 per share, and totaled $161,000 for all shares. Based on an estimated 10% of employees with options who we estimate will terminate their employment prior to the end of the original vesting periods, we expensed $16,100 during the fourth quarter ended March 31, 2006.
There were no stock option grants in fiscal 2007, other than a grant to a former member of the Board that was subsequently cancelled. We granted restricted stock units for 25,920 shares during fiscal 2007. The closing market price of those shares on the date of grant are being amortized to general and administrative expense over their respective vesting periods.
As noted above, prior to April 1, 2006, we accounted for stock options granted to employees in accordance with APB No. 25. Because the exercise price of all options granted by us was greater than or equal to the market price of the underlying common stock on the date of the grant, no compensation expense was recognized. If we had accounted for stock options issued to employees in accordance with SFAS No. 123R, our pro forma net earnings (loss) and net earnings (loss) per share would have been reported as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The fair value of the options at the date of grant was estimated using the Black-Scholes model with the following assumption:
Recently Issued Accounting Standards. In February 2007, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” SFAS No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS No. 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007. Early adoption is permitted as of the beginning of a fiscal year that begins on or before November 15, 2007, provided we also elect to apply the provisions of SFAS No. 157, “Fair Value Measurements.” We have not yet determined the impact of adopting SFAS No. 159 on our financial position.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. SFAS 157 defines fair value, establishes a framework for measuring fair value in GAAP and requires enhanced disclosures about fair value measurements. SFAS 157 does not require any new fair value measurements. The pronouncement is effective for fiscal years beginning after November 15, 2007. The guidance in SFAS 157 will be applied prospectively with the exception of: (i) block discounts of financial instruments; and (ii) certain financial and hybrid instruments measured at initial recognition under SFAS 133. These exceptions are to be applied retrospectively as of the beginning of initial adoption (a limited form of retrospective application). We will change how we estimate fair value starting in fiscal 2009.
In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109 (“FIN 48”), which clarifies the accounting for uncertainty in income tax positions. This Interpretation requires that we recognize in the consolidated financial statements the impact of a tax position that is more likely than not to be sustained upon examination based on the technical merits of the position. FIN 48 contains extensive disclosure requirements. The provisions of FIN 48 will be effective as of the beginning of our 2008 fiscal year, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. We are currently evaluating the impact of adopting FIN 48 on the consolidated financial statements.
Reclassifications. Some fiscal 2006 and 2005 balances have been reclassified to conform to the fiscal 2007 presentation.
Note 2. Sonopress Fulfillment Services Agreement and Planned Closure of Las Vegas Facility.
On March 29, 2007, we entered into an agreement whereby Sonopress would become our exclusive provider of warehousing and distribution services. We are currently in the process of integrating Sonopress’ logistics and warehouse management systems with Image’s order management and inventory control software as well as transitioning all of our warehousing and distribution services to Sonopress’ facility in Pleasant Prairie Wisconsin.
One-time termination benefits totaling approximately $365,000 will be provided to current employees who are involuntarily terminated under the terms of this restructuring. These employees will be required to render service until a specific date in order to receive the termination benefits. In accordance with SFAS No. 146 “Accounting for Costs Associated with Exit or Disposal Activities,” a liability for the termination benefits shall be measured initially on the April 20, 2007, communication date to our employees based on the fair value of the liability as of the termination date. The resulting liability will be recognized ratably over the future service period.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
We plan on using our warehouse assets as we to continue to store and distribute our products until the transfer of inventories to Sonopress is complete, now estimated to be by July 31, 2007. The decision to restructure our distribution operations by engaging Sonopress triggered an asset impairment as determined under SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets”. Much of our warehouse and distribution equipment will be abandoned before the end of its previously estimated useful life. In accordance with SFAS No. 146, depreciation and amortization estimates will be revised to reflect the use of the assets over their shortened useful lives. At March 31, 2007, the net book value of assets that we estimate will be abandoned after the cessation of warehousing and distribution activities in Nevada totaled approximately $620,000. We continue to classify these assets as a component of property, equipment and improvements and separately classify the accelerated depreciation expense as “Restructuring Expense” within continuing operating expenses. This is not a discontinued operation but rather a closing of a plant and related activities. The net book value will be amortized and depreciated down to its estimated salvage value.
We notified our Las Vegas landlord of our intent to vacate the facility and sublease the space on March 29, 2007. In accordance with SFAS No. 13 “Accounting for Leases,” we will recognize a liability at the date we cease using the facility at its fair value. As the lease is an operating lease, we will determine fair value based on the remaining lease payments reduced by actual or estimated sublease rentals. We estimate our cease-use date to be September 30, 2007.
Note 3. Fiscal 2007 and 2006 Bad Debt Charges Due to Bankruptcy Filings.
MTS Incorporated and its subsidiaries and divisions, including Tower Records (“Tower”), an independent music and entertainment retailer which owned and operated 89 Tower Records stores in 20 states nationwide, announced on August 20, 2006, its intent to sell the company through a process under Section 363 of the Bankruptcy Code. As of the bankruptcy date, we had approximately $883,000 in trade receivables outstanding from Tower. During our second quarter ended September 30, 2006, we recorded a bad debt charge of approximately $496,000 to general and administrative expenses. This charge reflected the net expense after reversing royalties and distribution fees otherwise payable by us had we collected the Tower trade receivable. We wrote off as uncollectible the entire Tower trade receivable balance at September 30, 2006. In November 2006, we assigned our right, title and interest in our general unsecured trade receivable bankruptcy claim against MTS to a third-party financial institution for a cash payment of approximately $135,000. Accordingly, we recorded a $64,000 recovery of the previously written off bad debt charge as a credit to general and administrative expenses for the fiscal year ended March 31, 2007.
On January 12, 2006, Musicland Holding Corp. filed for Chapter 11 bankruptcy protection. We had approximately $2.6 million in trade receivables outstanding from Musicland at December 31, 2005. We have recorded a bad debt charge of approximately $1.6 million to general and administrative expenses for the year ended March 31, 2006. This charge reflects the net expense, after reversing royalties and distribution fees otherwise payable by us had we collected the Musicland trade receivable. We wrote off as uncollectible the entire Musicland trade receivable balance at March 31, 2006.
Note 4. Exclusive Distribution Agreement with Relativity Media and Planned Issuance of Common Shares
On August 11, 2006, we entered into a 10-year distribution agreement with Relativity Media, LLC. The agreement calls for Relativity to provide us with the exclusive home video and digital distribution rights to motion pictures wholly financed through or otherwise under the control of Relativity, in exchange for which we will be solely responsible for all distribution services for the DVD home video and digital release of each film.
As a material inducement to enter into the distribution agreement, we agreed to issue Relativity 3,400,000 shares of our common stock, which are registered on our Form S-3 shelf registration statement. In order to secure Relativity’s performance under our agreement, we have been granted a security interest in the shares pursuant to a security agreement, the shares have been pledged to us pursuant to a stock pledge agreement, and a restrictive legend will be placed on the stock certificates representing the shares and restricting their transfer until designated title delivery, box office performance, financial and/or payment requirements are met.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Shares will be released to Relativity as follows:
A. 1,800,000 shares upon the earlier of any of the following:
(1) Qualifying Pictures. 100,000 shares, upon our home video release of each qualifying picture (that achieved at least $25 million in reported gross domestic box office in its initial release) through December 31, 2010, after our release of the first 50 qualifying pictures;
(2) Annual Profits. One share, for each $38.00 by which our annual net profits from Relativity pictures for any calendar year through December 31, 2010 exceed $50 million;
(3) Cumulative Profits. One share, for each $38.00 by which our cumulative net profits from Relativity pictures at any time through December 31, 2010 exceeds $150 million;
(4) Payment and Delivery. 60,000 shares, upon delivery to us of each theatrical picture at any time through December 31, 2010, upon payment of a release amount of $3.80 per share within four years after the delivery of each picture; and
(5) Change in Control. 1,800,000 shares, upon a change in control at any time through December 31, 2010, upon payment of a release amount of $3.80 per share.
B. 600,000 shares, upon payment of a release amount of $3.80 per share at any time through December 31, 2010.
C. 1,000,000 shares upon the earlier of any of the following:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) Cumulative Profits. 1,000,000 shares, upon our earning total cumulative net profits from Relativity pictures of at least $500 million at any time prior to the end of the term;
(2) Cumulative Box Office. 1,000,000 shares, upon delivery of pictures to Image with total cumulative box office of at least $5 billion at any time prior to the end of the term; and
(3) Change in Control. 1,000,000 shares, upon the closing of a change of control during the term of the distribution agreement, plus payment of a release amount equal to the number of such shares multiplied by the greater of $4.00 or the following percentage of the total consideration per share received in connection with or as a result of the change of control:
(a) 80%, if on or before December 31, 2007;
(b) 60%, if on or before December 31, 2008; and
(c) 40% thereafter.
Any of the shares provided for above that are not released to Relativity by the end of each of the specified periods will be transferred back to Image.
As we are to receive motion pictures for DVD and digital exploitation in exchange for common stock which is deemed unvested and forfeitable for accounting purposes in accordance with Emerging Issues Task Force (EITF) No. 96-18 Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, we will treat our common stock as unissued for accounting purposes until each title is delivered. Consequently, there will be no recognition at the measurement date and no entry will be recorded.
The stock issued to Relativity will be included in the computation of basic earnings per share as of the date that all necessary conditions have been satisfied. With respect to diluted earnings per share, the Relativity stock will be included in the computation of diluted earnings per share when contingencies other than payment of the release amount for the shares have been satisfied. To date, Relativity has not provided us the first titles to be released under the agreement and to date, we have not issued the shares to Relativity.
On August 16, 2006, in connection with the Relativity agreement, we issued a warrant to a third party exclusive rights finder. The term of the warrant was 4.37 years and had a strike price of $3.81, the closing price of our common stock on the date of grant. The fair value of the warrant was $194,000, using the Black-Scholes valuation model. The warrant has been converted via cashless exercise into 11,230 shares of our common stock as of June 12, 2007. We capitalized the fair value of the warrant as a component of other assets with a corresponding credit to additional paid in capital. We will amortize the asset to cost of sales over the related revenues generated from the Relativity titles.
Note 5. Long-Term Debt.
New Disc Replication Agreement and Related Advance. On June 30, 2006, we entered into a five-year disc replication agreement with Sonopress LLC. Sonopress serves as our exclusive manufacturer of our DVD requirements. This includes the HD-DVD and Blu-ray Disc® high-definition formats. They also manufacture the majority of our CD requirements. On June 30, 2006, we received an interest-free $10 million advance against future DVD manufacturing from Sonopress, to be repaid at $0.20 per DVD manufactured, plus payment of a $0.04 administrative fee per DVD manufactured until the advance is repaid. In July 2006, the proceeds from the Sonopress advance were used to reduce then-outstanding borrowings under our revolving line of credit facility. All outstanding amounts under the advance are subordinated to all of our obligations outstanding to Wachovia Capital Corporation (Western). Sonopress has taken a security interest in all of our assets in second position behind Wachovia. As the obligation is non-interest bearing, we initially imputed and recorded a debt discount of $1,945,000 to the $10 million face amount of the advance based upon our then-borrowing rate with our bank. The deferred manufacturing credit is classified in other long-term liabilities, net of current portion, at March 31, 2007. We amortize the deferred credit as a reduction to inventory purchase cost based upon actual discs manufactured by Sonopress. Additionally, we amortize the debt discount, using the effective interest method, to interest expense. We additionally record the $0.04 administrative fee per disc manufactured as an additional inventory manufacturing cost. Amortization of the debt discount is a noncash interest expense and totaled $534,000 for the fiscal 2007. Amortization of the deferred manufacturing credit totaled $195,000 for fiscal 2007.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Private Placement of Senior Convertible Note and Warrant. On August 30, 2006, we issued to Portside Growth and Opportunity Fund (“Portside” or “holder”), in a private placement, a senior convertible note in the principal amount of $17,000,000 and a related warrant to purchase 1,000,000 shares of our common stock, and on November 10, 2006, we entered into an Amendment and Exchange Agreement with Portside, which agreement modified certain terms in the transaction documents and provided for a replacement warrant to be issued in exchange for the warrant previously issued to Portside. The note accrues interest at a rate of 7.875% per annum with accrued interest payable quarterly in arrears in either cash or stock. The note has a term of five years and is convertible into 4,000,000 shares of our common stock at a conversion price of $4.25 per share, subject to the antidilution adjustments. The related warrant is exercisable for an aggregate of 1,000,000 shares of our common stock at an exercise price of $4.25 per share, subject to the antidilution adjustments described below. The warrant has a term of five years from the issuance date. Portside has taken a security interest in all of our assets in third position behind Wachovia Capital Corporation (Western) and Sonopress.
Beginning thirty months following closing, the holder may require bi-annual payments, each in the amount of $4,000,000 principal, plus interest. If the average weighted trading price of our common stock is greater than $4.00 per share for the twenty trading days immediately prior to the due date for the first payment, then we can delay the first payment until the thirty-sixth month following the closing.
Following the first anniversary of the closing but before the second anniversary, we may force conversion if the weighted average trading price is at least $6.38 per share (or 150% of the then-conversion price) for twenty trading days. Following the second anniversary of the closing, we may force conversion if the weighted average trading price is at least $7.65 per share (or 180% of the then-conversion price) for twenty trading days. In no event can we force the holder to acquire by conversion more than 4.99% of the issued and outstanding shares of our common stock.
If we sell new securities during the first year following closing for a price less than $4.25 (or such other conversion or exercise price then in effect), then the conversion price of the note and exercise price of the warrant will be reduced to an amount equal to the price of the new securities sold. If we sell new securities after the first year following closing for a price less than $4.25 (or such other conversion or exercise price then in effect), then the conversion price of the note and exercise price of the warrant will be reduced to a weighted average amount pursuant to the formula contained in the note and warrant; provided, however, the exercise price of the warrant has a floor price of $3.67 until we receive any necessary stockholder approval as provided in the warrant. The holder has the right to participate in any future sale of securities for two years following closing. Pursuant to a registration rights agreement, during the December 2006 quarter, we filed a registration statement for the resale of the shares underlying the note and warrant.
In the event of a change of control, the holder has the right to redeem the outstanding principal balance of the note at 120% of par and the warrant at the then-current Black Scholes value. On November 10, 2006, at our request, the holder amended the note and warrant, which, among other provisions, gives Image the right but not the obligation, in the event of a change of control with a private acquiring company, to redeem the outstanding principal balance of the note at 125% of par and the warrant at the then-current Black Scholes value. The amendment also removes restrictive covenants from the note in a change of control transaction, should the note be assumed by the acquiring company.
The instruments issued as part of this transaction contain several embedded derivatives which we have valued in accordance FASB Statement No. 133, Derivative Instruments and Hedging Activities. The embedded derivatives included the holder’s right to redeem the note in the event of a change of control and Image’s right to redeem the note in the event of a change of control to a private company. KPMG LLP’s Economic and Valuation Services practice assisted in the valuation of warrant and derivatives. The net fair value of all of the derivatives was not material. The fair value of the warrant was $1,900,000, which was recorded as a discount on the $17 million note liability with an offsetting credit to warrant liability in accordance with SFAS 150 Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity and FSP 150-1 Issuer’s Accounting for Freestanding Financial Instruments Composed of More Than One Option or Forward Contract Embodying Obligations under FASB Statement No. 150. The accrued warrant liability is included as a component of other long-term liabilities in the accompanying balance sheet at March 31, 2007. We will revalue at least annually and when circumstances indicate the value would materially change. We will re-address liability classification each quarterly reporting period.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Additionally, direct costs of $1,187,000 relating to the private placement were recorded as asset-deferred financing costs and are amortized as additional noncash interest expenses using the effective interest rate method over the life of the related private placement debt. Amortization of the debt discount and the deferred financing costs using the effective interest method is a noncash charge to interest expense and totaled $537,000 for fiscal 2007.
Long-term debt at March 31, 2007 and 2006, consisted of the following:
Note 6. Subsequent Event - New Revolving Credit Facility.
We entered into a three-year Loan and Security Agreement dated as of May 4, 2007, with Wachovia Capital Finance Corporation (Western) (“Wachovia”). The agreement provides us with an up to $15 million revolving line of credit, with an accordion feature to increase such amount to $20 million at our option, subject to the terms and conditions of the agreement. Actual borrowing availability is based on eligible trade accounts receivable levels.
Borrowings bear interest at either the Prime Rate plus up to 0.25% or, at our option, LIBOR plus up to 2.25%, subject to minimum borrowing levels. The level of interest rate margin to Prime or LIBOR is dependent upon our future financial performance as measured by EBITDA, earnings before interest, taxes, depreciation and amortization, as defined in the Agreement. The targets under the Agreement exempt certain expenses, including costs incurred in our corporate sale process.
The Wachovia revolving credit facility replaced our facility with Wells Fargo Foothill, Inc.
The Agreement is subject to early termination fees, based upon the initial maximum facility amount of $15 million, of 1% if terminated within the first year of the term and 0.75% if terminated thereafter through the end of the three-year term.
The Agreement imposes restrictions on such items as encumbrances and liens, payment of dividends, other indebtedness, stock repurchases and capital expenditures. Any outstanding borrowings are secured by our assets. The Agreement also requires us to comply with minimum financial and operating covenants.
At March 31, 2007, we had cash of $2,341,000 and borrowing availability of $5 million under our revolving credit facility with our then-lender Foothill. Comparatively, at March 31, 2006, we had cash of $1,079,000 and borrowing availability of $6.6 million and $1 million, respectively, under our revolving credit and term loan facilities with Foothill. At March 31, 2007, we had no borrowings under the revolving credit facility with our then lender Foothill.
Note 7. Recoupment of Sony BMG Royalty Advance Received for International Sublicense Rights.
We received a $3.0 million initial royalty advance under the Sony BMG agreement in March 2003, fully recoupable from revenues generated by Sony BMG against quarterly royalties due to us under the agreement. Based upon actual quarterly sales of our programming in the territories, Sony BMG recoups quarterly royalties from the $3.0 million previously advanced. Sony BMG had provided additional quarterly royalty advances such that for the first three years of the agreement term through December 31, 2005, the advance outstanding to us at any given time was maintained at $3.0 million.
During fiscal 2007 and according to our agreement, Sony BMG reduced, through recoupment, the outstanding royalty advance without making additional quarterly royalty advances. Once the entire royalty advance is recouped, Sony BMG will continue to pay quarterly royalties based on revenues generated. We must repay any outstanding unrecouped royalty advance within 30 days following the final Sony BMG reporting at the conclusion of Sony BMG’s sell-off period after expiration of the five-year term. At March 31, 2007, approximately $800,000 of the last $3 million advance is classified as a component of deferred revenue in the accompanying balance sheet.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 8. Inventories.
Inventories at March 31, 2007 and 2006, are summarized as follows:
Non-recoupable production costs are net of accumulated amortization of $10,553,000 and $11,485,000 at March 31, 2007 and 2006, respectively. We expect to amortize approximately 71% of the March 31, 2007 unamortized production costs by March 31, 2009.
Note 9. Investment in Film Production.
Investment in film production at March 31, 2007 and 2006, are summarized as follows:
At March 31, 2007, we have completed eight motion pictures. We released our lowest budget films, Monarch of the Moon and The Hunt (our funded budget commitment was $111,000 and $214,000, respectively), on DVD during the fourth quarter ended March 31, 2007. We plan to release Surveillance and Soul’s Midnight on DVD during fiscal 2008 and are investigating the possibility of limited theatrical releases for Splinter, Sisters, Driftwood and Fingerprints. The eight completed titles are as follows:
• Sisters -produced by Ed Pressman and starring Stephen Rea (V For Vendetta) and Chloe Sevigny (Big Love - TV series)
• Dark Horse Entertainment:
° Driftwood, directed by Tim Sullivan (2001 Maniacs), starring Ricky Ullman (Phil of the Future -TV series), Talan Torriero (Laguna Beach -TV series) and Diamond Dallas Page (WWF and WCW Professional Wrestler)
° Splinter, directed by Michael D. Olmos, starring Tom Sizemore (Saving Private Ryan) and Edward James Olmos (Battlestar Galactica -TV series)
° Monarch of the Moon
• Graymark Productions:
° Surveillance, directed by Fritz Kiersch (Children of the Corn) and starring Armand Assante
° The Hunt, directed by Fritz Kiersch
° Soul’s Midnight, starring Armand Assante
° Fingerprints, starring Kristin Cavallari (Laguna Beach - TV series) and Lou Diamond Phillips
We have two titles in post production. They are:
• Dark Horse Entertainment’s My Name is Bruce, directed by and starring Bruce Campbell (Evil Dead series, Army of Darkness, and Bubba Ho-tep)
• Amicus Entertainment’s Stuck, directed by Stuart Gordon (Re-Animator and Masters of Horror) and starring Mena Suvari (American Beauty) and Stephen Rea
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 10. Property, Equipment and Improvements.
Property, equipment and improvements at March 31, 2007 and 2006, are summarized as follows:
Depreciation and amortization expense for the years ended March 31, 2007, 2006 and 2005, was $1,902,000, $2,603,000 and $2,568,000, respectively. See “Note 2. Sonopress Fulfillment Services Agreement and Planned Closure of Las Vegas Facility” for a discussion regarding the asset impairment triggered by our restructuring of our warehousing and distribution operations in Las Vegas, Nevada.
Note 11. Source Entertainment, Inc Chapter 11 Bankruptcy Filing and Related Asset Impairment Write-Down
In May 2007, our content provider Source Entertainment filed for bankruptcy protection. Accordingly, we believe there is substantial doubt as to the recoverability of the net book value of assets associated with the exclusive distribution agreement. During the fourth quarter of fiscal 2007, we recognized an impairment loss equal to the difference between the present value of expected profits to be recognized on two Source-branded titles that we expect to release in the coming twelve months and the net book value of assets related to the exclusive distribution agreement. The write-down totaled $2.2 million and is recorded as a component of cost of sales for fiscal 2007.
Note 12. Commitments and Contingencies.
Operating Leases
Our headquarters are located in Chatsworth, California and consist of approximately 62,000 square feet on one floor of a multi-tenant building. The monthly rent is $1.29 per square foot, on a gross basis, or approximately $80,000 per month, and increases approximately 3% annually. The office lease has an initial 10-year term with two five-year options. The lease commenced on July 1, 2004. 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, excluding utilities, insurance and real estate taxes.
We also lease our 76,000 square foot warehouse and distribution facility located in Las Vegas, Nevada. The monthly rent is approximately $43,000, subject to annual adjustment based on increases in the consumer price index. The lease expires on November 4, 2012. In addition, we lease approximately 4.07 acres of adjacent vacant land in the event we need to expand our current warehouse and distribution facility. The monthly rent for the vacant land is approximately $9,000 and the lease expires on November 4, 2007. Beginning in January 2004, we leased an additional 10,000 square foot warehouse storage space in Las Vegas, Nevada for a monthly rent of approximately $6,000 for an initial term of two years and later extended to April 30, 2007. We moved all inventory from this storage space to Sonopress as of the lease termination date of April 30, 2007. Beginning in October 2005, we leased an additional 5,000 square foot warehouse storage space in Las Vegas, Nevada for a monthly rent of approximately $3,000 on a month to month basis. As of May 31, 2007, the inventory from this storage space was shipped to Sonopress and we then terminated this lease. As previously discussed, we are closing our warehouse and distribution facility and Sonopress will be warehousing and fulfilling our DVD and CD orders out of its facility in Pleasant Prairie, Wisconsin. On March 29, 2007, we notified our Las Vegas landlord of our intent to vacate the facility and sublease the space. Our landlord is open to various options, including potential termination of the lease, if an appropriate new tenant is found.
We signed an exclusive representation agreement with IPG, a commercial real estate broker, for the potential sublease of the facility on or about May 11, 2007. It is currently anticipated that the facility will be available to a new tenant by October 2007.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Future minimum annual rental payments by year under operating leases at March 31, 2007, are approximately as follows:
Rent expense was $1,689,000, $1,553,000 and $1,455,000 for fiscal 2007, 2006, and 2005, respectively.
Lease Guarantee. In connection with the fiscal 2004 asset sale of DVDPlanet, Planet Entertainment assumed the obligations under DVDPlanet’s leases for its retail store and various other liabilities related to the assets being acquired and its parent Infinity Resources guaranteed Planet Entertainment’s obligations. 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 $89,000 through December 2007.
Employment Agreements. Future contractual obligations under employment agreements totaled $2,469,000 and $1,293,000 for fiscal years ending March 31, 2008 and 2009, respectively.
Other. At March 31, 2007, our future obligations by year for royalty advances, minimum royalty guarantees and exclusive distribution fee guarantees under the terms of our existing licenses and exclusive distribution agreements, respectively, are as follows:
Legal Proceedings. On April 10, 2007, a purported class action shareholder complaint entitled Henzel v. Image Entertainment, Inc., et al. was filed against Image and certain of its officers and members of its board of directors in the Superior Court of the State of California, County of Los Angeles. The named plaintiff proposes to represent a class of Image’s stockholders and claims, among other things, that in connection with the proposed business combination transaction with BTP, the directors breached their fiduciary duties of due care, good faith and loyalty by failing to maximize stockholder value and by creating deterrents to third party offers. Among other things, the complaint seeks class action status, and a court order enjoining the consummation of the merger and directing the defendants to take appropriate steps to maximize stockholder value. While the lawsuit is in its preliminary stage, we believe that the claims in the lawsuit are without merit and intend to vigorously defend it.
In the normal course of business, we are subject to proceedings, lawsuits and other claims, including proceedings under government laws and regulations relating to employment and tax matters. While it is not possible to predict the outcome of these matters, it is the opinion of management, based on consultations with legal counsel, that the ultimate disposition of known proceedings will not have a material adverse impact on our financial position, results of operations or liquidity.
Note 13. Shareholders’ Equity.
Convertible Note Payable in Image Common Stock. On August 30, 2006, we signed a Convertible Note with Portside Growth and Opportunity Fund for gross proceeds of $17 million convertible into 4,000,000 shares of our common stock valued at $4.25 per share. See “Note 5. Long-Term Debt Private Placement of Senior Convertible Note and Warrant.”
Agreement to Issue Common Stock. On August 11, 2006, we entered into an agreement to issue 3,400,000 restricted shares of our common stock in exchange for the rights to distribute selected titles for Relativity Media. In order to secure Relativity’s performance under our agreement, we have been granted a security interest in the shares pursuant to a security agreement, the shares have been pledged to us pursuant to a stock pledge agreement, and a restrictive legend will be placed on the stock certificates representing the shares restricting their transfer until designated title delivery, box office performance, financial and/or payment requirements are met. To date, Relativity has not provided us the first titles to be released under the agreement and to date, we have not physically issued the shares to Relativity. See “Note 4. Exclusive Distribution Agreement with Relativity Media and Planned Issuance of Common Shares.”
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
On August 16, 2006, in connection with the Relativity agreement, we issued a warrant to a third party exclusive rights finder. The term of the warrant is 4.37 years and has a strike price of $3.81, the closing price of our common stock on the date of grant. The fair value of the warrant was $194,000, using the Black-Scholes valuation model. The warrant has been converted via cashless exercise into 11,230 shares of our common stock as of June 12, 2007. We have capitalized the fair value of the warrant as a component of other assets with a corresponding credit to additional paid in capital. We will amortize the asset to cost of sales over the related revenues generated from the Relativity titles.
Fiscal 2005 Private Placement of Image Common Stock. On December 20, 2004, we sold 2,904,763 shares of our common stock in a private placement at $5.25 per share for gross proceeds of $15.25 million. We also issued three-year warrants to the investors to purchase up to 726,189 shares at $6.56 per share. The warrants are currently exercisable. The expenses of the private placement were approximately $1,052,000, which includes the cash fee paid to our exclusive placement agent, and legal, accounting and other related expenses. We also issued the placement agent a three-year warrant to purchase up to 58,095 shares of common stock on the same terms as the investors, except this warrant includes a cashless exercise provision. We used the net proceeds of the transaction to pay down outstanding obligations under our credit facility with Wells Fargo Foothill, Inc. The remaining proceeds were used for working capital and general corporate purposes, including content acquisition.
Stock Awards, Options and Warrants. In September 2004, our shareholders approved an incentive compensation plan (the “2004 Plan”) pursuant to which an additional 1,000,000 shares of our common stock were made available for annual incentive and specific performance awards, including options. The 2004 Plan provides for awards to our employees and directors. Options (incentive as well as non-qualified), restricted stock units, stock appreciation rights, performance share awards, stock bonuses and stock units can be awarded under the 2004 Plan. The limitation on overall number of shares of stock reserved and available for delivery in connection with awards under the 2004 Plan shall be the sum of 1,000,000 shares, plus the number of shares with respect to awards previously granted under the 2004 Plan that terminate without being exercised, expire, are forfeited or canceled, and the number of shares of stock that are surrendered in payment of any awards, or any tax withholding with regard thereto. The 2004 Plan requires that the exercise price for any incentive or non-qualified option be at least 100% of the closing price of our common stock on the date such option is granted. The maximum term allowed for an option is 10 years and a stock unit shall either vest or be forfeited not more than 10 years from the date of grant.
In October 2006, an aggregate of 19,104 shares of restricted stock units were granted to our directors under our 2004 Plan, and subsequently 3,184 restricted stock units were cancelled due to a director resignation. In October 2006, we began amortizing the fair value of the restricted stock units as of the date of grant of $55,000 ratably over the one-year vesting period. In January 2007, an aggregate of 10,000 shares of restricted stock units were granted to our newly hired officer under our 2004 Plan. In January 2007, we began amortizing the total value of $35,000 for the restricted stock units on the date of grant ratably over the three-year vesting period. These restricted stock units were payable solely in common shares. Compensation expense relating to these stock units for fiscal 2007 was approximately $26,000.
In July 1999 and 1998, an aggregate of 91,662 and 88,359 shares, respectively, of restricted stock units were granted to our officers under our 1998 incentive plan. These grants vested annually in increments of 20% over the five-year period commencing June 30, 2000 and 1999, respectively. There were no restricted stock units granted to officers during fiscal 2001 through 2006. These restricted stock units were payable solely in shares. We amortized the total value of the restricted stock units on the date of grant ($622,000 for the fiscal 2000 grant and $592,000 for the fiscal 1999 grant) ratably over the five-year vesting period as compensation expense. Compensation expense relating to these stock units for fiscal 2005 was approximately $25,000.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
See “Note 1. Basis of Presentation and Summary of Significant Accounting Policies - Stock Options” regarding our acceleration of vesting of all outstanding unvested stock options on March 29, 2006.
Stock option transactions, including our former plans, for the three years ended March 31, 2007, are as follows:
Of the options reflected as outstanding on March 31, 2007, options to purchase approximately 2,429,000 shares of common stock were exercisable. At March 31, 2007, there were approximately 256,000 shares of common stock available for new awards, including stock options, to our directors and employees.
The following table summarized significant ranges of outstanding and exercisable options at March 31, 2007:
The following table summarized significant ranges of outstanding and exercisable warrants at March 31, 2007:
Stockholder Rights Plan. On October 31, 2005, we adopted a stockholder rights plan. The plan is intended to protect the interests of the stockholders from coercive, abusive or unfair takeover tactics. We believe the rights plan represents a sound and reasonable means of addressing the complex issues of corporate policies. Issuance of the rights does not in any way adversely affect our financial strength or interfere with our business plan. The issuance of the rights has no dilutive effect, will not affect reported earnings per share, is not taxable to the company or to stockholders, and will not change the way in which stockholders can trade our shares. The rights will only become exercisable upon the occurrence of certain triggering events, and are then intended to operate to protect stockholders against being deprived of their rights so they can share in the full measure of our long-term potential.
Shelf Registrations. We continue to seek out viable acquisition targets to enhance our library of exclusive programming, distribution channels and sources of revenue. On September 23, 2005, we filed a shelf registration statement that gives us the ability to sell our common stock in one or more offerings to raise cash for acquisitions, debt repayment or working capital and other general corporate purposes. We also filed an acquisition shelf registration statement with the Securities and Exchange Commission to ensure that registered shares of our common stock are available to use as consideration in connection with our acquisition of the assets, businesses or securities of other companies, whether by purchase, merger or other form of business combination. The shares may be offered in separate transactions or, in the aggregate, in a single transaction.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 14. Net Earnings (Loss) per Share Data.
The following is a reconciliation of the numerators and denominators used in computing basic and diluted net earnings (loss) per share for the three years ended March 31, 2007:
Outstanding common stock options and warrants not included in the computation of diluted net earnings (loss) per share totaled 2,429,000, 2,538,000 and 1,443,000, respectively, for the years ended March 31, 2007, 2006 and 2005 as their effect would be antidilutive.
Note 15. Income Taxes.
Income tax expense (benefit) for the years ended March 31, 2007, 2006 and 2005, are summarized as follows:
The tax effects of temporary differences that give rise to a significant portion of the net deferred tax assets at March 31, 2007 and 2006, are presented below:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SFAS No. 109 requires that we assess the likelihood that our deferred tax assets are realizable, and to the extent that it is more likely than not that all, or a portion, of such deferred tax assets will not be realized, a valuation allowance, increasing tax expense for the year, must be established. We have had pretax losses in five of our last six years and accordingly maintain a valuation allowance against 100% of our net deferred assets.
Even though we have fully reserved our net deferred tax assets, we would still be able to utilize them to reduce future income taxes payable should we have future earnings. To the extent such deferred tax assets relate to net operating loss (“NOL”) carryforwards, the ability to use such NOL carryforwards against future earnings will be subject to applicable carryforward periods.
As of March 31, 2007, we had NOL carryforwards for Federal and state income tax purposes of $16,653,000 and $4,837,000 , respectively, which are available to offset future taxable income through 2027 and 2017, respectively.
Expected income tax expense (benefit) based on Federal statutory rates for the three years ended March 31, 2007, differed from actual tax expense (benefit) as follows:
Note 16. Other Items - Statements of Operations.
Fourth Quarter Adjustments
Fiscal 2007. During the fourth quarter we wrote-off $2.2 million of asset net book value relating to our distribution agreement with Source Entertainment which filed for bankruptcy protection in May 2007.
Additionally, during the fourth quarter we incurred $1.2 million in legal, investment banking and other expenses associated with negotiating the BTP agreement to acquire Image.
Fiscal 2006. During the fourth quarter we reversed an overaccrual of music publishing liabilities on a DVD series. During the fourth quarter we were notified by a content holder that the actual negotiated music publishing rate for DVD titles licensed from this content supplier was lower than the rate at which we accrued. Without the actual rate known at the time of release of the related DVDs, we accrue music publishing liability at the estimated maximum rate as we sell the programs. Accordingly, we reversed approximately $562,000 in accrued music publishing as a credit to cost of sales during the fourth quarter to reflect the comparably lower actual negotiated music publishing rate.
Fiscal 2005. During the fourth quarter we reduced estimated publishing liabilities relating to our international distribution of DVDs through subdistributors. Approximately $499,000 was recorded as non-recurring, noncash, pretax credit to cost of sales in the accompanying consolidated statement of operations for fiscal 2005. Our joint venture Aviva International, LLC was dissolved and Sony BMG became responsible for publishing for the European territories under our sublicense agreement.
Note 17. Employee Benefit Plan.
We have a 401(k) savings plan covering substantially all of our employees. Eligible employees may contribute through payroll deductions. We match employees’ contributions at the rate of 50% of the first 4% of salary contributed. Our 401(k) savings plan matching expenses for fiscal 2007, 2006 and 2005 were $117,000, $120,000 and $143,000, respectively.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 18. 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 90% of our net revenue for fiscal 2007, 87% for fiscal 2006 and 85% for fiscal 2005. Management currently evaluates segment performance based primarily on net revenues, operation costs and expenses and income (loss) before income taxes. Interest income and expense is evaluated on a consolidated basis and not allocated to our business segments.
For the Year Ended March 31, 2007:
For the Year Ended March 31, 2006:
For the Year Ended March 31, 2005:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 19. Quarterly Financial Data. (Unaudited)
Summarized quarterly consolidated financial data for fiscal 2007 and 2006 is as follows:
Net earnings (loss) per share are computed independently for each of the quarters represented in accordance with SFAS No. 128. Therefore, the sum of the quarterly net earnings (loss) per share may not equal the total computed for the fiscal year or any cumulative interim period.
Includes a $562,000 credit to cost of sales from the reversal of an overaccrual for music publishing liabilities associated with a DVD series.
Includes a $2.2 million write-off of assets relating to our distribution agreement with Source Entertainment, Inc. which filed for bankruptcy protection in May 2007 and $1.2 million in legal, investment banking and other expenses associated with negotiating the BTP agreement to acquire Image in fiscal 2007.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
As of the end of the period covered by this Annual Report, we carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information required to be included in our periodic Securities and Exchange Commission reports.
There have been no changes in our internal controls over financial reporting or in other factors that has materially affected, or is reasonably likely to materially affect, those controls subsequent to the date of this most recent evaluation.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
The information required by Items 10 through 14 of Part III is incorporated herein by reference to our definitive Proxy Statement to be filed with the SEC pursuant to Regulation 14A for our 2007 Annual Meeting of Stockholders. Such Proxy Statement involves the election of directors and we tentatively plan to file such Proxy Statement no later than 120 days after our 2007 fiscal year end. If the Proxy Statement is not filed with the SEC within such 120-day period, the items comprising the Part III information will be filed as an amendment to this Annual Report no later than the end of the 120-day period.
Our Code of Ethics Policy which is applicable to all employees including our principal executive officer, principal financial officer and principal accounting officer, as well as our Insider Trading Policy, Corporate Governance Guidelines, the written Charters for our Audit, Compensation, and Nominations and Governance Committees, and periodic and current reports filed with the SEC are available on our website www.image-entertainment.com, and are available in print to any shareholder upon request. Such information is incorporated herein by reference.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
THE FOLLOWING DOCUMENTS ARE FILED AS A PART OF THIS REPORT. Page
(a) Financial Statements:
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets as of March 31, 2007 and 2006
Consolidated Statements of Operations for the years ended
March 31, 2007, 2006 and 2005
Consolidated Statements of Shareholders’ Equity for the years ended
March 31, 2007, 2006 and 2005
Consolidated Statements of Cash Flows for the years ended
March 31, 2007, 2006 and 2005
Notes to Consolidated Financial Statements
(b) Financial Statement Schedule:
Schedule II - Valuation and Qualifying Accounts
(c) Exhibits:
2.1 Agreement and Plan of Merger, dated as of March 29, 2007, among BTP Acquisition Company, LLC a Delaware limited liability company, IEAC, Inc., a Delaware corporation and a wholly-owned subsidiary of BTP Acquisition Company, LLC, and the Registrant. Filed as Exhibit 2.1 to the Registrant’s Form 8-K dated April 2, 2007, and incorporated by reference herein.
3.1 Certificate of Incorporation. Filed as Exhibit B of Appendix B of the Registrant’s Proxy Statement dated July 29, 2005, as amended by a certificate of correction as reflected in the Registrant’s Form 8-K filed on May 15, 2006, each incorporated by reference herein.
3.2 Bylaws. Filed as Exhibit C of Appendix B of the Registrant’s Proxy Statement dated July 29, 2005, and incorporated by reference herein.
4.1 Specimen Common Stock certificate. Filed as Exhibit 4.1 to the Registrant’s Registration Statement on Form S-3/A (No. 333-128487), effective October 21, 2005, and to the Registrant’s Registration Statement on Form S-3 (No. 333-138701), effective December 13, 2006, and incorporated by reference herein.
4.2 Rights Agreement dated as of October 31, 2005, by and between the Registrant and Computershare Trust Company, Inc. Filed as Exhibit 4.1 to the Registrant’s Form 8-K/A dated November 2, 2005, and incorporated by reference herein.
4.2(a) Amendment No. 1 to Rights Agreement, dated as of March 29, 2007, by and between the Registrant and Computershare Trust Company, N.A., a Delaware corporation, as Rights Agent. Filed as Exhibit 4.1 to the Registrant’s Form 8-K dated April 2, 2007, and incorporated by reference herein.
4.3 Securities Purchase Agreement, dated as of August 30, 2006, between the Registrant and the buyers named therein. Filed as Exhibit 10.1 to the Registrant’s Form 8-K dated August 31, 2006, and incorporated by reference herein.
4.4 Registration Rights Agreement, dated as of August 30, 2006, between the Registrant and the buyers named therein. Filed as Exhibit 10.4 to the Registrant’s Form 8-K dated August 31, 2006, and incorporated by reference herein.
4.5 Form of Senior Convertible Note. Filed as Exhibit 10.2 to the Registrant’s Form 8-K dated August 31, 2006, and incorporated by reference herein.
4.6 Form of Warrant. Filed as Exhibit 10.3 to the Registrant’s Form 8-K dated August 31, 2006, and incorporated by reference herein.
4.7 Amendment and Exchange Agreement, dated November 10, 2006, by and between the Registrant and Portside Growth and Opportunity Fund. Filed as Exhibit 4.6 to the Registrant’s Registration Statement on Form S-3 (No. 333-138701), effective December 13, 2006, and incorporated by reference herein.
4.8 Warrant Issued Pursuant to Amendment and Exchange Agreement. Filed as Exhibit 4.7 to the Registrant's Registration Statement on Form S-3 (No. 333-138701), effective December 13, 2006, and incorporated by reference herein.
10.1 Amended and Restated Loan and Security Agreement, dated as of August 10, 2005, by and between the Registrant and Wells Fargo Foothill, Inc. Filed as Exhibit 10.1 to the Registrant’s Form 10-Q for the quarter ended June 30, 2005, and incorporated by reference herein.
10.2 Amendment No. 1 to Amended and Restated Loan and Security Agreement, dated as of November 3, 2005, by and between the Registrant and Wells Fargo Foothill, Inc. Filed as Exhibit 10.1 to the Registrant’s Form 10-Q for the quarter ended September 30, 2005, and incorporated by reference herein.
10.3 Amendment No. 2 to Amended and Restated Loan and Security Agreement, dated as of June 23, 2006, by and between the Registrant and Wells Fargo Foothill, Inc. Filed as Exhibit 10.3 to the Registrant’s Form 10-K for the fiscal year ended March 31, 2006, and incorporated by reference herein.
10.4 Amendment No. 3 to Amended and Restated Loan and Security Agreement, dated as of August 9, 2006, by and between the Registrant and Wells Fargo Foothill, Inc. Filed as Exhibit 10.1 to the Registrant’s Form 10-Q for the quarter ended June 30, 2006, and incorporated by reference herein.
10.5 Amendment No. 4 to Amended and Restated Loan and Security Agreement, dated as of November 13, 2006, by and between the Registrant and Wells Fargo Foothill, Inc. Filed as Exhibit 10.1 to the Registrant’s Form 10-Q for the quarter ended September 30, 2006, and incorporated by reference herein.
10.6 Amendment No. 5 to Amended and Restated Loan and Security Agreement, dated as of January 11, 2007, by and between the Registrant and Wells Fargo Foothill, Inc. Filed as Exhibit 10.1 to the Registrant’s Form 10-Q for the quarter ended December 31, 2006, and incorporated by reference herein.
10.7 Amendment No. 6 to Amended and Restated Loan and Security Agreement, dated as of January 11, 2007, by and between the Registrant and Wells Fargo Foothill, Inc. Filed as Exhibit 10.2 to the Registrant’s Form 10-Q for the quarter ended December 31, 2006, and incorporated by reference herein.
10.8 Warrant, dated March 24, 2003, between the Registrant and Image Investors Co. Filed as Exhibit 99.2 to the Registrant’s Form 8-K dated March 26, 2003, and incorporated by reference herein.
10.9 Employment Agreement, dated as of April 1, 2004, between the Registrant and Martin W. Greenwald. Filed as Exhibit 10.42 to the Registrant’s Form 10-K for the fiscal year ended March 31, 2004, and incorporated by reference herein.
10.9(a) Amendment No. 1 to Employment Agreement, dated as of June 1, 2004, by and between the Registrant and Martin W. Greenwald. Filed as Exhibit 10.42(a) to the Registrant’s Form 10-K for the fiscal year ended March 31, 2004, and incorporated by reference herein.
10.9(b) Amendment to Employment Agreement, dated as of March 29, 2007, by and between the Registrant and Martin W. Greenwald. Filed as Exhibit 10.1 to the Registrant’s Form 8-K dated April 2, 2007, and incorporated by reference herein.
10.9(c) Amendment to Employment Agreement, dated as of May 31, 2007, by and between the Registrant and Martin W. Greenwald. Filed as Exhibit 10.1 to the Registrant’s Form 8-K dated June 1, 2007, and incorporated by reference herein.
10.10 Employment Agreement, dated as of April 1, 2004, between the Registrant and David A. Borshell. Filed as Exhibit 10.43 to the Registrant’s Form 10-K for the fiscal year ended March 31, 2004, and incorporated by reference herein.
10.10(a) Amendment to Employment Agreement, dated as of March 29, 2007, by and between the Registrant and David Borshell. Filed as Exhibit 10.2 to the Registrant’s Form 8-K dated April 2, 2007, and incorporated by reference herein.
10.10(b) Amendment to Employment Agreement, dated as of May 31, 2007, by and between the Registrant and David Borshell. Filed as Exhibit 10.2 to the Registrant’s Form 8-K dated June 1, 2007, and incorporated by reference herein.
10.11 Employment Agreement, dated as of April 1, 2004, between the Registrant and Jeff M. Framer. Filed as Exhibit 10.44 to the Registrant's Form 10-K for the fiscal year ended March 31, 2004, and incorporated by reference herein.
10.11(a) Amendment to Employment Agreement, dated as of March 29, 2007, by and between the Registrant and Jeff Framer. Filed as Exhibit 10.3 to the Registrant’s Form 8-K dated April 2, 2007, and incorporated by reference herein.
10.11(b) Amendment to Employment Agreement, dated as of May 31, 2007, by and between the Registrant and Jeff Framer. Filed as Exhibit 10.3 to the Registrant’s Form 8-K dated June 1, 2007, and incorporated by reference herein.
10.12 Employment Agreement, dated as of January 22, 2007, between the Registrant and Jeffrey Fink. Filed as Exhibit 10.3 to the Registrant’s Form 10-Q for the quarter ended December 31, 2006, and incorporated by reference herein.
10.13 Form of Purchase Agreement, dated December 20, 2004, between the Registrant and investors. Filed as Exhibit 99.1 to the Registrant’s Form 8-K dated December 21, 2004, and incorporated by reference herein.
10.14 Form of Warrant, dated December 20, 2004, between the Registrant and investors. Filed as Exhibit 99.2 to the Registrant’s Form 8-K dated December 21, 2004, and incorporated by reference herein.
10.15 Image Entertainment, Inc. 2004 Incentive Compensation Plan. Filed as Exhibit A to the Registrant’s Notice of Annual Meeting and Proxy Statement dated July 29, 2004, and incorporated herein by this reference.
10.16 Egami Media, Inc. 2005 Incentive Compensation Plan. Filed as Exhibit 10.14 to the Registrant’s Form 10-K for the fiscal year ended March 31, 2005, and incorporated by reference herein.
10.17 Form of Indemnification Agreement, between the Registrant and its directors and officers. Filed as Exhibit 10.1 to the Registrant’s Form 8-K dated October 24, 2005, and incorporated by reference herein.
10.18 Form of Stock Unit Award Grant Notice and Agreement for the Image Entertainment, Inc. 2004 Incentive Compensation Plan. Filed as Exhibit 10.4 to the Registrant’s Form 10-Q for the quarter ended December 31, 2006, and incorporated by reference herein.
10.19 Form of Option Agreement Amendment, between the Registrant and its optionees. Filed as Exhibit 10.1 to the Registrant’s Form 8-K dated March 29, 2006, and incorporated by reference herein.
10.20 Form of Support Agreement by and between BTP Acquisition Company, LLC, a Delaware limited liability company, and certain of the Registrant’s stockholders. Filed as Exhibit 99.2 to the Registrant’s Form 8-K dated April 2, 2007, and incorporated by reference herein.
10.21* Loan and Security Agreement, dated as of May 4, 2007, by and between Wachovia Capital Finance Corporation (Western) and the Registrant.
14.1 Code of Ethics Policy, dated November 1, 2003. Filed as Exhibit 10.45 to the Registrant’s Form 10-K for the fiscal year ended March 31, 2004, and incorporated by reference herein.
21* Subsidiaries of the Registrant.
23.1* Consent Letter of BDO Seidman LLP, Independent Registered Public Accounting Firm.
31.1* Certification by the Chief Executive Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2* Certification by the Chief Financial Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1* Certification by the Chief Executive Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2* Certification by the Chief Financial Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
* Exhibit(s) not previously filed with the Securities and Exchange Commission.
 Management Contracts, Compensatory Plans or Arrangements.
SCHEDULE II
- Valuation and Qualifying Accounts -
For the Years Ended March 31, 2007, 2006 and 2005
Reconciliation to Consolidated Balance Sheets
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
IMAGE ENTERTAINMENT, INC.
A Delaware corporation
Dated: June 29, 2007 /s/ MARTIN W. GREENWALD
MARTIN W. GREENWALD
Chairman of the Board, President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Dated: June 29, 2007 /s/ MARTIN W. GREENWALD
MARTIN W. GREENWALD
Chairman of the Board, President and Chief Executive Officer
(Principal Executive Officer)
Dated: June 29, 2007 /s/ JEFF M. FRAMER
JEFF M. FRAMER
Chief Financial Officer (Principal Financial and Accounting Officer)
Dated: June 29, 2007 /s/ DAVID CORIAT
DAVID CORIAT
Director
Dated: June 29, 2007 /s/ IRA EPSTEIN
IRA EPSTEIN
Director
Dated: June 29, 2007 /s/ GARY HABER
GARY HABER
Director
Dated: June 29, 2007 /s/ M. TREVENEN HUXLEY
M. TREVENEN HUXLEY
Director
Dated: June 29, 2007 /s/ ROBERT J. MCCLOSKEY
ROBERT J. MCCLOSKEY
Director