Kartoon Studios, Inc. annual report, FY2013

Kartoon Studios, Inc. (formerly Genius Brands International, Inc.) — Form 10-K Summary

Reporting period: Fiscal year ended December 31, 2013; the filing was signed April 15, 2014. The filing presents full-year results rather than a standalone fourth-quarter report. Historical share and per-share data were retrospectively adjusted for a one-for-one-hundred reverse stock split effective April 7, 2014.

Business context and material transactions

• The Company develops, produces, distributes and licenses children’s entertainment and related consumer products, including Baby Genius and properties acquired through the A Squared Entertainment transaction.
• On November 15, 2013, the Company acquired A Squared Entertainment in a stock-for-stock merger and issued 2,972,183 shares valued at $10.4 million. The transaction added programming aimed at children ages 6–11 and resulted in recognized goodwill of $10.4 million and identifiable artistic-related intangible assets of $1.7 million.
• Following the merger, Andrew Heyward became Chief Executive Officer, Amy Moynihan Heyward became President, and the former pre-merger executive team largely resigned or transitioned out of operating roles.

Financial performance and key metrics

Metric	2013	2012	Change
Revenue	$2.557 million	$6.570 million	Down 61%
Gross profit	$1.052 million	$1.734 million	Down 39%
Gross margin	41.2%	26.4%	Up approximately 14.8 percentage points
Loss from operations	$(2.362) million	$(1.962) million	Loss increased 20%
Operating margin	(92.4%)	(29.9%)	Lower
Net loss	$(7.216) million	$(2.068) million	Loss increased 249%
Net margin	(282.3%)	(31.5%)	Lower
Net loss per share	$(5.10)	$(3.00)	Based on adjusted share data
Cash used in operating activities	$(1.120) million	$(0.935) million	Use increased $0.185 million
Cash and cash equivalents	$0.527 million	$0.448 million	Up $0.080 million

• Revenue composition changed materially: product sales fell 73% to $1.683 million; television and home-entertainment revenue contributed $0.506 million following the merger; and licensing and royalties rose 26% to $0.368 million.
• Costs and operating expenses, excluding depreciation and amortization, declined 43% to $4.758 million. Cost of sales fell 69%, marketing and sales declined 58%, general and administrative expense was broadly flat, and product-development expense increased 324%.
• Interest expense increased to $1.664 million from $0.332 million, while related-party interest expense declined to $0.030 million from $0.050 million.
• Other expense included a $1.887 million derivative-valuation loss, $0.614 million loss on extinguishment of debt, $0.312 million loss on warrant exchange, and $0.251 million loss on disposition of assets. These items materially amplified the reported net loss.

Balance sheet, debt and liquidity

• Total assets were $14.592 million, including $10.366 million of goodwill and $1.866 million of net intangible assets recognized or carried after the merger.
• Current assets were $2.227 million versus current liabilities of $3.096 million, producing a working-capital deficit of approximately $0.869 million.
• Recorded notes payable and accrued interest were eliminated through conversions or settlements by year-end. However, the Company reported $0.517 million of interest-free, no-stated-maturity advances from its CEO as short-term related-party debt.
• Cash provided by investing activities was $0.213 million, primarily reflecting $0.283 million of cash acquired in the A Squared merger. Financing activities provided $0.987 million, including net proceeds from equity sales and bridge-note financing.
• During the fourth quarter, the Company sold 296,429 shares at $3.50 per share, generating gross proceeds of $1.038 million and incurring $0.069 million of offering costs.
• The Company had an accumulated deficit of $17.424 million and stated that it had incurred losses since inception. Management believed available cash, expected sales and reduced merger-related expenses would fund planned operations for the next twelve months, but acknowledged that additional financing might be required if operations did not become profitable or cash flow did not improve.

Material changes versus the prior comparable period

• Revenue declined sharply, primarily because of reduced demand for CDs and DVDs and lower product sales, despite new television and home-entertainment revenue from A Squared.
• The gross margin improved because cost of sales declined faster than revenue, but operating losses worsened because revenue contraction exceeded expense reductions and depreciation and amortization increased modestly.
• Net loss increased substantially due to higher interest expense and non-cash or unusual losses related to derivative valuation, debt settlement, warrant exchange and asset disposition.
• The merger significantly increased reported assets, equity and goodwill while also changing management, the board composition and the Company’s target audience and content portfolio.
• Outstanding common shares increased from 719,127 at December 31, 2012 to 5,918,704 at December 31, 2013, largely due to the merger, debt conversions, salary conversions and other stock issuances.

Guidance, outlook, risks and unusual items

• Management anticipated continued growth in product, television and licensing revenue in 2014, supported by new foreign sales agents, additional series production, expanded domestic distribution and increased digital downloading.
• The outlook was described as uncertain, and the filing provided no quantified revenue, earnings or cash-flow guidance.
• Key risks include continued operating losses, working-capital deficits, dependence on additional capital, customer and supplier concentration, uncertain content demand, intense competition, inventory obsolescence, technology and distribution changes, intellectual-property claims, and regulatory requirements affecting children’s content and online privacy.
• Three customers each represented more than 10% of 2013 revenue and collectively represented 55.0% of revenue, creating material customer-concentration risk.
• Management concluded that disclosure controls and internal control over financial reporting were ineffective at year-end due to three material weaknesses involving year-end cutoff and accruals, valuation of beneficial conversion features, and recording and disclosure of management and board actions. Management described remediation steps, including accounting consolidation, hiring a controller, expanded segregation of duties and use of outside technical accounting advisers.
• The independent auditor issued an unqualified opinion on the consolidated financial statements but did not express an opinion on internal control effectiveness.
• Subsequent events included a $0.750 million payment received from Sony DADC under an exclusive supply-chain agreement, a further $0.750 million due by January 17, 2015, $0.360 million of additional private-placement proceeds, repayment of $0.100 million of CEO advances, the CFO’s resignation and the April 2014 reverse stock split.

Most important facts for investors to verify

• Whether the A Squared acquisition produces sustained revenue growth and whether the $10.366 million goodwill balance remains recoverable.
• Whether the Company can convert its substantial content portfolio into positive operating cash flow and eliminate its working-capital deficit.
• The terms, repayment status and related-party implications of the $0.517 million CEO advance and any other post-year-end obligations.
• Progress in remediating the three material weaknesses in internal control over financial reporting.
• The commercial performance of digital distribution, television and licensing relative to declining physical CD/DVD sales.
• Customer concentration, collection of the $0.894 million accounts receivable balance, and the status of the $0.925 million disputed trade payable.
• The effect of the reverse stock split, subsequent equity issuance and potential future dilution on per-share value and trading liquidity.