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PACIFIC ENTERTAINMENT CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our results of operations, financial condition and liquidity and capital resources should be read in conjunction with our unaudited consolidated financial statements and related notes for the three months ended June 30, 2011 and 2010. In addition to historical consolidated financial information, the following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Forward Looking Statements This report on Form 10-Q contains forward-looking statements which involve assumptions and describe our future plans, strategies and expectations. When used in this statement, the words "may," "will," "expect," "anticipate," "continue," "estimate," "project," "intend," and similar expressions are intended to identify forward-looking statements regarding events, conditions, and financial trends that may affect the Company's future plans of operations, business strategy, operating results, and financial position. These statements are expressed in good faith and based upon a reasonable basis when made, but there can be no assurance that these expectations will be achieved or accomplished. Persons reviewing this report are cautioned that any forward-looking statements are not guarantees of future performance and are subject to risks and uncertainties and actual results may differ materially from those included within the forward looking statements as a result of various factors. Such factors include, among other things, uncertainties relating to our success in judging consumer preferences, financing our operations, entering into strategic partnerships, engaging management, seasonal and period-to-period fluctuations in sales, failure to increase market share or sales, inability to service outstanding debt obligations, dependence on a limited number of customers, increased production costs or delays in production of new products, intense competition within the industry, inability to protect intellectual property in the international market for our products, changes in market condition and other matters disclosed by us in our public filings from time to time. Forward-looking statements speak only as to the date they are made. The Company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made. Overview The MD&A is based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make certain estimates and judgments that affect the reported amounts of assets, liabilities and expenses and related disclosure of contingent assets and liabilities. Management bases its estimates on historical experience and on various other assumptions that are believed 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 are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions and conditions. 15--------------------------------------------------------------------------------Our Business Pacific Entertainment Corporation ("we", "us", "our" or the "Company") commenced operations in January 2006, assuming all of the rights and obligations of its Chief Executive Officer, Klaus Moeller, under an Asset Purchase Agreement between the Company and Genius Products, Inc., in which we obtained all rights, copyrights, and trademarks to the brands "Baby Genius", "Little Genius", "Kid Genius", "Child Genius", "123 Favorites" and "Wee Worship", and all then existing productions under those titles. We create and provide family entertainment and music-based products that we believe will be entertaining, educational and beneficial to the well-being of infants and young children. We create, market and sell children's DVDs, CD music, toy, and book products in the United States by distribution at wholesale to retail stores and outlets. We also license the use of our brands domestically and internationally to others to manufacture, market and sell products based on our characters and brand, whereby we receive advances and royalties. The Company released two new music products, "50 Classic Lullabies & Soothing Songs" and "Favorite Guitar and Piano Melodies" in June 2010 and released another new music title, "Best of Baby Genius" in January 2011. We also began production of a new DVD based on the concept of shapes and colors. In August 2009, the Company launched a line of Baby Genius pre-school toys. The line of 24 Baby Genius toys, manufactured by toy manufacturer Battat Incorporated, includes musical, activity, and role-play toys that incorporate the Baby Genius principle of music as a core learning tool to engage and encourage children to communicate, connect, discover, and use their imagination. The Company cancelled the agreement in December 2010 according to the terms of the contract, permitting Battat to continue selling the current line of toys until late spring 2011. The Company received no royalty revenue from Battat during the three month period ended June 30, 2011. On January 11, 2011, the Company signed a world-wide license agreement with Jakks Pacific's Tollytots® division for a new toy line. As a result of the five-year agreement, Tollytots® will immediately begin development on a comprehensive line of musical and early learning toys, incorporating the music, characters and themes from the Baby Genius series of videos and music CDs. The new toy line will cover a broad range of exclusive categories, including learning and developmental toys, most plush toys, and musical toys, as well as several other non-exclusive categories. As part of the development of the new products, the Company has engaged in the creation of several new characters as well as updating the existing characters. Due to a gap between the termination of the Battat license and subsequent end of the extended sell off period and the introduction of the Jakks Pacific toy line 2012, we anticipate a reduction in royalty revenue during the remainder of 2011 and first half of 2012. As we cannot state with any certainty what the revenue would have been from the Battat toy line nor predict the sales for the new line of Jakks Pacific toys, we are unable to state the amount of the overall reduction for our licensed revenue category. The Company, in partnership with Dr. Shulamit Ritblatt, has developed "Circle of Education," an early childhood education curriculum using music as the basis for skills required to prepare pre-school children for Kindergarten. Circle of Education, LLC ("COE") was formed on September 24, 2010, pursuant to a joint venture agreement between the Company and Dr. Ritblatt. The Company obtained an initial voting and economic interest of seventy-five percent of the outstanding units of the newly formed company in exchange for the contribution of all intellectual property rights the Company had in the Circle of Education program. The results for COE are consolidated within our financial statements. The Company also obtains licenses for other select brands we feel we can market and sell through our distribution channels. During 2010, the Company launched a line of DVDs including classic movies and television programs under the brand "Pacific Entertainment Presents". Initially consisting of seven titles, each focusing on a specific genre such as Horror, Western, SciFi, Action, Mystery, War, and Gangster, an additional six titles were added in late 2010 expanding the line with the Super Hero's collection as well as Family Favorites. In 2011, we obtained the rights to distribute other studios' films on DVD, Blu-Ray, digital and broadcast formats under our brand which will be included in our product catalog starting in the third quarter of 2011. The agreements vary in length from three to five years. 16 --------------------------------------------------------------------------------Results of Operations Three and Six Month Period Ended June 30, 2011 Compared to June 30, 2010 Our summary results of operations are presented below: Three Months Ended June 30, Six Months Ended June 30, 2011 2010 2011 2010 Revenues $ 835,736 $ 711,717 $ 2,142,912 $ 1,687,317 Costs and expenses (1,528,707 ) (923,679 ) (2,932,714 ) (2,045,071 ) Depreciation and Amortization (54,265 ) (167,706 ) (109,094 ) (337,106 ) Loss from Operations (747,236 ) (379,668 ) (898,896 ) (694,860 ) Other Income 10,641 10,313 21,057 20,512 Interest Expense (29,733 ) (12,588 ) (64,739 ) (23,848 ) Total Other Income (19,092 ) (2,275 ) (43,682 ) (3,336 ) Net Loss (766,328 ) (381,943 ) (942,578 ) (698,196 ) Net Loss attributable to Noncontrolling Interest 977 - 4,421 - Net Loss attributable to Pacific Entertainment Corporation $ (765,351 ) $ (381,943 ) $ (938,157 ) $ (698,196 ) Net Loss per common share $ (0.01 ) $ (0.01 ) $ (0.02 ) $ (0.01 ) Weighted average shares outstanding 59,490,691 54,595,407 56,215,116 54,595,407 Revenues. Revenues by product segment and for the Company as a whole were as follows: Three Months Ended June 30, Six Months Ended June 30, 2011 2010 2011 2010 Direct PEC Product Sales $ 432,758 $ 451,745 $ 1,076,476 $ 825,203 Licensed and Distributed Products 358,810 111,881 608,383 482,182 Licensing & Royalties 44,168 148,091 458,053 379,932 Total Revenue $ 835,736 $ 717,717 $ 2,142,912 $ 1,687,317 Direct product sales represent items in which the Company holds the patents and/or copyrights to the characters and which are manufactured and sold by the Company directly at wholesale to retail stores and outlets. The decrease of $18,987 (4.2%) for the three months ended June 30, 2011 compared to the three months ended June 30, 2010, was due to the slightly lower DVD sales. The increase of $251,273 (30.4%) for the six month period ended June 30, 2011 compared to the six month period ended June 30, 2010 is due to sales through a direct to consumer offering with Groupon. Management believes that the Company is on target to increase direct product sales volumes over 2010, although economic and retail conditions in the market could impact our future sales in a negative manner and we are unable to guarantee increased sales. We continue to explore additional sales opportunities with retail and distribution customers; however, there is no guarantee that our products will be accepted by these new customers. 17-------------------------------------------------------------------------------- The licensed and distributed product sales category includes items for which we license rights from other companies to copyrights and trademarks of select brands we feel will do well within our distribution channels as well as overstock inventory from other studios which we sell and from which we receive income. For the three months ended June 30, 2011, the category increased by $246,929 (220.7%) over the same period in 2010 as a result of an increase in outside overstock studio product acquired and sold. The increase of $126,201 (26.2%) for the six months ended June 30, 2011 compared to the six months ended June 30, 2010 is due to increases in licensed DVD products and an increase in outside overstock studio product acquired and sold. The timing of the sales of overstock product is intermittent and unpredictable as it is determined by the availability of excess inventory from outside studios. Licensing and royalties is revenue for our brands licensed to others to manufacture and/or market, both internationally and domestically. For the three months ended June 30, 2011 compared to the same period in 2010, the decrease of $103,923 (70.2%) was caused by the termination of the toy license with Battat. For the six months ended June 30, 2011 compared to the six months ended June 30, 2010 the category increased $78,121 (20.6%) primarily due to the toy line which was launched in August 2009. There may be fluctuation in licensing revenue due to economic conditions in the sales territory. We believe this revenue source will decrease during the remainder of 2011 through the first two quarters of 2012 due to the cancellation of the Battat toy license agreement, then show increases in late 2012 and in the subsequent years with the introduction of the new toy line currently in development with Jakks Pacific's Tollytots® division. We cannot guarantee that the new toy line will be accepted nor that the royalty revenue will increase. Our products compete in the pre-school music, books, DVDs, and toy categories. We believe we compare favorably in the quality of our products, as well as competitive price point. In spite of the global economic decline we have exhibited revenue growth in 2011. We continue to market direct to retailers and are exploring new domestic and international licensing opportunities. We are investigating additional relevant external brands to license, adding to the diversity of our product line, while maintaining the integrity of our core mission of educating and entertaining children. The Company's business is subject to the effects of seasonality, causing revenues to fluctuate with consumer purchasing behavior, competition, and the timing of holiday periods. The 2011 economic outlook remains challenging, however, we anticipate continued sales growth through our actions to improve our existing products, maintaining highly competitive price points, and adding content to our product catalog. Costs. Costs and expenses, excluding depreciation and amortization, consisting of cost of sales, marketing and sales expenses, and general and administrative costs, increased $605,048 (65.5%) for the three months ended June 30, 2011, compared to the three months ended June 30, 2010 and $887,665 (43.4%) for the six months ended June 30, 2011 compared to the six months ended June 30, 2010. Three Months Ended June 30, Six Months Ended June 30, 2011 2010 2011 2010 Cost of Sales $ 575,814 $ 354,036 $ 1,129,722 $ 824,407 18-------------------------------------------------------------------------------- Cost of sales increased $221,778 (62.6%) and $305,315 (37.0%) during the three months and six months ended June 30, 2011 compared to the three months and six months ended June 30, 2010, respectively, as a result of increased sales volumes, product mix variations, and shipping costs. Selling, General and Administrative ("SG&A") expenses predominately consists of salaries, employee benefits and stock based compensation as well as other expenses associated with executive management, finance, legal, facilities, marketing, rent, and other professional services. Costs associated with these categories are detailed as follows: Three Months Ended June 30, Six Months Ended June 30, 2011 2010 2011 2010 General and Administrative $ 808,617 $ 453,071 $ 1,288,901 $ 875,408 Marketing and Sales 142,120 115,994 506,672 344,678 Product Development 2,156 578 7,419 578 Total Selling, General, and Administrative $ 952,893 $ 569,643 $ 1,802,992 $ 1,220,664 General and administrative costs increased $355,546 (78.5%) for the three months ended June 30, 2011 compared to the three months ended June 30, 2010. This is a primarily the result of increases in salaries and related expenses of $84,477, partially offset by a decrease in accounting services expense of $22,118 due to the hiring of accounting staff previously outsourced, increased stock compensation expense of $244,536, increased legal fees of $35,482 predominately expended for the filing of the registration statement with the U.S. Securities & Exchange Commission, and increased investor relations expenses of $24,914. For the six months ended June 30, 2011 compared to the six months ended June 30, 2010, general and administrative expenses increased $413,493 (47.2%). This increase is due in part to increased salaries of $393,201, a decrease in outside accounting services of $47,959, increased legal costs in the amount of $62,905, and increases in investor relations of $47,100, less a reduction for rental expense of $16,238. Increases in the stock compensation expenses were the result of options to purchase shares of the Company's common stock granted to officers as part of the employment agreements and to a consultant for services (see Note 8 to financial statements for more detail). Marketing and sales expenses include trade shows, public relations firms, sales and royalty commissions and personal contact. Marketing expenses exhibit some fluctuation due to timing of trade shows attended. For the three months ended June 30, 2011 compared to the same period in the prior year the total expense increased $26,126 (22.5%), due to attending the International Licensing Show and a reduction for a common marketing fund which was discontinued in January 2011. During the six month period ended June 30, 2011 compared to the six month period ended June 30, 2010, marketing and sales expenses increased $161,994 (47.0%). This increase was a result of increases in commission expense on royalty income of $210,860 and trade show costs of $24,154, with reductions in the common marketing fund of $46,739 and public relations expenditures of $13,000. Product development expenses are for routine and periodic alterations to existing products. For the three and six months ended June 30, 2011 compared to June 30, 2010, these expense increased $1,578 (273.0%) and $6,841 (1183.6%), respectively. All costs for new product development and significant improvements to existing products are capitalized in accordance with FASB Accounting Standards Codification Topic 350, Intangible Assets and Topic 730, Research and Development. Expenditures for SG&A are not generally seasonal and require consistent cash outflows. 19 --------------------------------------------------------------------------------Interest Expense. Interest expense resulted from related party loans and debentures. The Company borrowed funds from four of the Officers of the Company during the years 2007 to 2009 and issued promissory notes in favor of the Officers. The proceeds from the notes were used to pay operating obligations of the Company. Interest expense was recorded in the three months ended June 30, 2011 and 2010 in the amounts of $3,096 and $5,908, respectively. For the six month period ended June 30, 2011 and 2010, interest expense was recorded in the amounts of $7,104 and $11,755, respectively. The decreases were due to partial repayments made in February 2011, April 2011 and the last half of 2010. On February 1, 2008, Isabel Moeller, sister of our Chief Executive Officer, Klaus Moeller, loaned $310,000 to the Company at an interest rate equal to 8% per annum. The funds were borrowed from Ms. Moeller in order to reduce outstanding obligations due to Genius Products, Inc. at that time. Subsequent agreements extended the maturity date to December 31, 2010 and reduced the stated interest rate to six (6%) percent per annum. Repayments on the principle balance were made in the aggregate of $24,000 during February and April 2011. On April 1, 2011, Ms. Moeller agreed to convert $200,000 of the outstanding balance to shares of common stock of the Company. The interest expense for the three months ended June 30, 2011 and June 30, 2010 was $2,184 and $5,494, respectively. For the six months ended June 30, 2011 and 2010, the interest expense recorded was $7,478 and $10,906, respectively. On September 30, 2010, four of the Officers agreed to convert accrued but unpaid salaries through September 30, 2010 to subordinated long term notes payable. In February 2011, as a result of an agreement by each of the four Officers to retroactively decrease the amount of the annual salary for 2010 from $125,000 per annum per Officer to $80,000, the amount of the notes were reduced to an aggregate of $1,620,137. The notes have a maturity of December 31, 2012 and a stated interest rate of six percent (6%) per annum, said interest accruing from October 1, 2010. For the three months ended June 30, 2011 and June 30, 2010, interest expense was recorded in the amount of $24,453 and $0. Interest expense was recorded for the six months ended June 30, 2011 and 2010 in the amounts of $49,012 and $0, respectively. Liquidity and Capital Resources Three and Six Months Ended June 30, 2011 Compared to Three Months Ended June 30, 2010 To date, we have relied on a combination of revenue, loans from officers and private offerings of stock to meet our cash requirements. Currently, our principal source of liquidity is cash in the bank. Management believes that its increasing revenues and cash generated by operations, together with funds available from short-term related party advances, will be sufficient to fund planned operations for the next twelve months. However, there can be no assurance that operations and operating cash flows will continue at the current levels or improve in the near future. If the Company is unable to obtain profitable operations and positive operating cash flows sufficient to meet scheduled debt obligations, it may need to seek additional funding through equity and related party loans or be forced to scale back its development plans or to significantly reduce or terminate operations. 20 -------------------------------------------------------------------------------- Cash totaled $739,232 and $119,208 at June 30, 2011 and 2010, respectively. The change in cash is as follows: Three Months Ended June 30, 2011 2010 Change Cash provided (used) by operations $ (82,736 ) $ (41,077 ) $ (41,659 ) Cash provided (used) in investing activities (124,142 ) (110,941 ) (13,201 ) Cash provided (used) in financing activities 738,230 22,973 715,257 Increase (decrease) in cash and cash equivalents $ 531,352 $ (129,045 ) $ 660,397 Our cash flow is very seasonal and a vast majority of our sales historically occur in the last two quarters of the year as retailers expand inventories for the holiday selling season. Cash used by operations in the six months ended June 30, 2011, compared to 2010, increased by $41,659 due to an increase in the prepaid expenses and a decrease in the accounts payable balance mitigated by a decrease in accounts receivable and an increase in the other accrued expenses. Cash used in the same periods for investing activities relates to investment in additional music and DVD products. The cash provided by financing activities for the six months ended June 30, 2011 of $738,230, is a result of sales of common stock pursuant to a private placement offering of $858,230 after related expenses offset by the partial repayment of related party notes in the aggregate of $120,000. On April 6, 2010, the Company commenced a private placement offering to certain accredited investors pursuant to Rule 506 for up to 12,500,000 shares of common stock at a purchase price of $.40 per share. On July 13, 2010, the Board of Directors amended the offering to include the issuance of a warrant to purchase one additional share of common stock for each share of common stock sold through the offering. Each warrant expires three years from the date of purchase and has a stated exercise price of $0.40 per share. As of December 31, 2010, a total subscription of $188,443 had been received and 471,108 shares have been issued and warrants have been issued to purchase an additional 471,108 shares. Costs of the offering in the amount of $17,396 were offset against the common stock account through December 31, 2010. The offering has expired. During March and April 2011, we conducted a private placement to certain accredited investors only under Rule 506. As a result of the offering, the Company received subscriptions in the total amount of $860,000 during the six months ended June 30, 2011, reduced by offering costs of $1,770, and 5,300,000 shares were issued at a purchase price of $0.20 per share. Notes were issued in favor of four of the Officers for loans to the Company at various times during the years 2007 through 2009. Partial repayments were made during the six months ended June 30, 2011in the aggregate amount of $96,000. Interest expense was recorded in the six months ended June 30, 2011 and 2010 in the amounts of $7,104 and $11,755 for these officer notes, respectively. On September 30, 2010, four of the Officers agreed to convert the amounts outstanding as unpaid salaries through September 30, 2010 to notes payable. The notes, in the aggregate amount of $1,870,337, have a maturity of December 31, 2012 and a stated interest rate of six percent (6%) per annum, said interest accruing from October 1, 2010 on the unpaid balance of principal and interest. There is no prepayment penalty. These loans are classified as long term liabilities and are subordinated debt. For the six months ended June 30, 2011 and June 30, 2010, interest expense was recorded in the amount of $49,012 and $0, respectively. On March 31, 2011, an additional 32,300 shares were issued in exchange for services valued at $9,690, or $0.30 per share. 21 --------------------------------------------------------------------------------Critical Accounting Policies The Company's accounting policies are described in Note 1: The Company and Significant Accounting Policies of the notes to the Company's financial statements in Item 1 above. Below is a summary of the critical accounting policies, among others, that management believes involve significant judgments and estimates used in the preparation of its financial statements. Revenue Recognition - The Company recognizes revenue related to product sales when (i) the seller's price is substantially fixed, (ii) shipment has occurred causing the buyer to be obligated to pay for product, (iii) the buyer has economic substance apart from the seller, and (iv) there is no significant obligation for future performance to directly bring about the resale of the product by the buyer as required by Revenue Recognition Topic 605 of the FASB Accounting Standards Codification. Revenues associated with the sale of branded CDs, DVDs and other products, are recorded when shipped to customers pursuant to approved customer purchase orders resulting in the transfer of title and risk of loss. Cost of sales, rebates and discounts are recorded at the time of revenue recognition or at each financial reporting date. The Company's licensing and royalty revenue represent variable payments based on net sales from brand licensees for exclusive content distribution rights. Revenue from licensed products is recognized when realized or realizable based on royalty reporting received from licensees. Principles of Consolidation - The consolidated financial statements include the financial statements of the Company, and its 75% owned subsidiary: Circle of Education LLC. All inter-company balances and transactions have been eliminated in consolidation. Other Estimates - The Company estimates reserves for future returns of product based on an analysis that considers historical returns, changes in customer demand and current economic trends. The Company regularly reviews the outstanding accounts receivable balances for each account and monitors delinquent accounts for collectability. The Company reviews all intangible assets periodically to determine if the value has been impaired by recent financial transactions using the discounted cash flow analysis of revenue stream for the estimated life of the assets. Reclassifications - Certain amounts in the condensed consolidated financial statements as of December 31, 2010 have been reclassified to conform to the presentation as of June 30, 2011. |