Kartoon Studios, Inc. quarterly report, Q2 FY2017

Business Context and Reporting Period

Genius Brands International, Inc. (now Kartoon Studios, Inc.) filed this unaudited Form 10-Q for the quarter and six months ended June 30, 2017. The company develops, licenses, distributes, and monetizes multimedia content and related consumer products, primarily for children’s media.

Key properties included Baby Genius, Rainbow Rangers, Llama Llama, SpacePop, Thomas Edison’s Secret Lab, Secret Millionaires Club, and the Kid Genius Cartoon Channel. The company reported 5,897,091 common shares outstanding at June 30, 2017 and 5,938,103 shares outstanding as of August 11, 2017.

Financial Performance and Position

Metric	Three Months Ended June 30, 2017	Six Months Ended June 30, 2017
Total revenue	$196,132	$394,221
Operating loss	$(1,255,930)	$(2,571,339)
Net loss attributable to common shareholders	$(1,251,543)	$(2,567,779)
Basic and diluted loss per share	$(0.22)	$(0.47)
Net cash used in operating activities	Not separately provided	$(3,558,638)

• Second-quarter revenue increased 11% year over year. Six-month revenue decreased 25%.
• Approximate operating and net loss margins were negative 640% and 638%, respectively, for the quarter, and negative 652% and 651%, respectively, for the six months.
• At June 30, 2017, cash and cash equivalents were $2,986,528, restricted cash was $1,000,000, and total cash, cash equivalents, and restricted cash were $3,986,528.
• Working capital was $2,482,734, compared with a working-capital deficit of $479,404 at December 31, 2016. Current assets were $4,689,434 and current liabilities were $2,206,700.
• Total assets were $20,762,458 and stockholders’ equity was $11,392,942. The accumulated deficit was $39,210,540.
• Net film and television costs increased to $3,806,578 from $2,260,964 at December 31, 2016, primarily reflecting production and development of SpacePop, Llama Llama, and Rainbow Rangers.
• The company had $2,697,048 of net borrowings under the Llama Llama production facility, with gross borrowings of $2,840,642. The facility bears interest at Prime plus 1% or applicable LIBOR plus 3.25%, and is secured by Netflix license fees and the series copyright.

Material Changes Versus Prior Comparable Period

• Quarterly revenue rose from $176,332 to $196,132, driven by a 39% increase in television and home entertainment revenue, a 4% increase in licensing and royalties, and the introduction of $4,514 in advertising revenue. Product sales declined 47%.
• Six-month revenue fell from $528,225 to $394,221, principally because television and home entertainment revenue declined 57%, reflecting fewer recognized licenses for Thomas Edison’s Secret Lab. Licensing and royalty revenue increased 4%, while advertising revenue began to contribute.
• Operating expenses declined 10% in the quarter and 18% for the six months. General and administrative expense declined 8% and 11%, respectively, partly because of lower share-based compensation.
• Six-month net loss improved from $2,832,669 to $2,567,779, despite the significant revenue decline, primarily due to lower operating expenses and the absence of certain prior-period costs. The 2016 period also included a $258,103 gain on distribution contracts.
• Operating cash use increased substantially, from $324,208 in the first six months of 2016 to $3,558,638 in the 2017 period. The increase reflected operating losses and $1,473,384 of additions to film and television costs.
• Financing activities provided $4,686,652, including $3,401,924 of net proceeds from a warrant exchange and $1,284,728 from the production facility, versus $82,500 in the prior-year period.
• Common shares outstanding increased from 4,010,649 at December 31, 2016 to 5,897,091 at June 30, 2017, primarily from warrant exercises, the Sony transaction, consultant issuances, and preferred-stock conversions.

Guidance, Outlook, Risks, Contingencies, and Unusual Items

• Management stated that anticipated cash balances, working capital, the production facility, and the deal pipeline were expected to fund operations for the next twelve months. Management also cautioned that operating cash flows may not improve and that additional funding, reduced development or production, or scaled-back operations could be required if profitability and positive operating cash flow are not achieved.
• The Llama Llama production facility is secured by expected Netflix license fees and the series copyright. The related $1,000,000 restricted cash balance may be used only for production of the series. The company reported compliance with the facility’s covenants at June 30, 2017.
• A $925,000 disputed trade payable remained recorded as a current liability. Management disputed the underlying claim and believed the applicable statute of limitations had expired.
• Total deferred revenue increased to $5,020,507 from $3,106,608, including Sony advances and amounts associated with expanded distribution rights. These balances will be recognized only when revenue-recognition criteria are met.
• The company had $10,365,805 of goodwill and $1,740,000 of indefinite-lived artistic-related intangible assets. No impairment had been recorded through June 30, 2017, but future impairment testing depends on estimates of forecast cash flows, growth rates, and discount rates.
• The company had 1,766,698 warrants outstanding and 1,357,467 stock options outstanding at June 30, 2017, creating potential future dilution.
• The company reported no material pending legal proceedings, no changes to the risk factors in its 2016 Form 10-K, and no off-balance-sheet arrangements.
• The company expected to adopt the new revenue standard, ASC 606, on January 1, 2018, using the modified retrospective method or potentially the full retrospective method. The impact was still under evaluation.
• Subsequent events included a new $225,000 annual employment agreement for the chief operating officer, issuance of 6,012 common shares to a consultant, and conversion of 105 preferred shares into 35,000 common shares.

Investor Verification Items

• Verify the sustainability and timing of revenue from SpacePop, Llama Llama, Rainbow Rangers, Netflix, Sony, and other licensing arrangements.
• Assess whether the $3.56 million six-month operating cash outflow can be reduced or funded without further equity dilution or additional debt.
• Review the terms, collateral, interest-rate exposure, and repayment requirements of the Llama Llama production facility.
• Evaluate the collectability and timing of deferred revenue, including Sony-related advances and distribution-rights consideration.
• Investigate the status and potential resolution of the disputed $925,000 trade payable.
• Quantify potential dilution from outstanding warrants, stock options, preferred stock conversions, and subsequent equity issuances.
• Review impairment sensitivity for goodwill, intangible assets, and capitalized film and television costs.