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PRVT > SEC Filings for PRVT > Form 10-K on 23-May-2013All Recent SEC Filings

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Form 10-K for PRIVATE MEDIA GROUP INC


23-May-2013

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

You should read this section together with the consolidated financial statements and the notes and the other financial data in this Report. The matters that we discuss in this section, with the exception of historical information, are forward-looking statements within the meaning of the Private Securities Reform Act of 1995. Such forward-looking statements are subject to risks, uncertainties and other factors which could cause our actual results to differ materially from those expressed or implied by such forward-looking statements. Potential risks and uncertainties that may cause results to differ materially from our expectations and projections, please refer to the Risk Factors section of this Form 10-K.

Overview

We acquire worldwide rights to adult media produced for us by independent producers and then process this content into products suitable for popular physical media formats such as print publications, DVDs, digital media platforms (such as internet websites, mobile telephony and transactional television), and broadcasting (which includes cable, satellite and IPTV). Our branded adult media is available at physical retail locations and through electronic retailers as well as on mobile devices, transaction television platforms and over the Internet. In addition, we provide adult entertainment films to thousands of major hotels around the world. To a lesser extent, in addition to branded adult media products, we also market and distribute branded leisure and novelty products oriented to the adult entertainment lifestyle and generate additional sales through the licensing of our Private trademark to third parties.

On January 20, 2009 we expanded our internet operations through the acquisition of Game Link LLC and its affiliates. Game Link is engaged in digital distribution of adult content over the Internet and in eCommerce development, primarily in the United States. On October 29, 2009 we continued the expansion of our digital media platform through the acquisition of Sureflix and its affiliates. These companies, based in Canada, were engaged in the business of digital distribution of premium gay adult content.

As described elsewhere in this Annual Report, after a change in management and as part of new management's plan to reorganize and recapitalize this Company, we divested ourselves of the Game Link and Sureflix companies in 2012. Although the disposition of Game Link and Sureflix was consummated in 2012, for accounting purposes, the assets and liabilities of Game Link and Sureflix are listed as assets/liabilities "held for shareholder claims" in the consolidated balance sheets included in this Annual Report, and the operating results of Game Link and Sureflix are included in the Consolidated Statements of Income (Loss) and Comprehensive Income (Loss) for the fiscal year ended December 31, 2011 as "profit contributed by operations held for settlement of claims." Accordingly, the net sales, cost of sales, selling, general and administrative expenses and certain other operating information of Game Link and Sureflix are included in the appropriate line items in the consolidated income statement of the Company for the fiscal year ended December 31, 2010. However, the net sales, cost of sales, selling, general and administrative expenses, etc. of the Game Link and Sureflix companies are not included in the consolidated income statement line items for the fiscal year ended December 31, 2011. Instead, the net results of the Game Link and Sureflix companies for the fiscal year ended December 31, 2011 are listed in income statement as "profit contributed by operations held for settlement of claims," and the results of these two former subsidiaries are shown separately in the footnotes to the financial statements.


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Commencing in July 2010 and continuing through 2011, former management was engaged in a number of lawsuits with its major shareholders and certain creditors. In addition, former management was involved in a proxy contest involving both the 2010 and 2011 annual meetings of shareholders (the 2011 annual meeting was eventually held in January 2012). The various lawsuits and shareholder proceedings negatively affected the Company's operations and financial condition in 2011 and thereafter.

We operate in a highly competitive market that is subject to numerous new and on-going changes in business, economic and competitive conditions. Although we believe our brand and our products are well-established in the adult entertainment industry, we compete with numerous entities selling adult-oriented products via any type of distribution network, including the Internet. Over the past few years, the adult entertainment industry and the media formats in which adult content is disseminated have undergone significant change. The introduction of a large number of free content internet sites that allow users to access large libraries of content free of charge has created an even more challenging environment where both sales volume and margins have decreased substantially. In addition, the recent recession has shown that the adult industry is not immune to economic cycles.

We generate revenues primarily through:

internet e-commerce, subscriptions and licensing;

the broadcasting of movies through IPTV (Internet Protocol Television), cable, satellite and hotel television programming;

sales of DVDs and magazines; and

sales of adult mobile content (wireless).

Over time, we expect net sales from DVDs & magazines to continue to decline as a percentage of net sales in relation to total net sales from the Internet, broadcasting and wireless. We expect net sales from internet and direct-to-consumer digital sales to be the principal area of growth during the coming years.

We generally provide extended payment terms to our established distributors of between 90 and 180 days. Although our extended payment terms increase our exposure to accounts receivable write-offs, we believe our risk is minimized by our generally long-term relationships with our distributors.

Our primary expenses include:

web page development costs;

acquisition and licensing of content for our library of photographs and videos;

printing, processing and duplication costs; and

selling, general and administrative expenses.

Over the years, our cost of sales has fluctuated relative to net sales due to our use of new mediums for the dissemination of our products, such as the Internet, broadcasting and wireless and the different cost structure of those new mediums. We also incur significant web page development expenses annually in connection with the amortization of our library of photographs and movies and capitalized development costs. We amortize these assets on a straight-line basis for periods of between three and five years.

Critical Accounting Estimates

General

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally


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accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amount of assets and liabilities revenues and expenses. On an ongoing basis, we evaluate our estimates, including those related to impairment of the library of photographs and videos and other long lived assets, allowances for doubtful debts, income taxes and contingencies and litigation. Accounts receivable and sales related to certain products are, in accordance with industry practice, subject to distributors' right of return to unsold items. We base our estimates on historical experience and on various 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 available from other sources. Management periodically reviews such estimates. Actual results may differ from these estimates as a result of unexpected changes in trends.

We believe the following critical accounting policies are significantly affected by judgments and estimates used in the preparation of our consolidated financial statements.

Recognition of Revenue

The Company's primary sources of revenue are the sale of content delivered via the Internet, broadcasting, DVD and magazines and mobile phones.

Internet video-on-demand offerings are sold directly via the Company's websites and are paid for almost exclusively by credit card. The Company recognizes revenue from video-on-demand when the service is rendered and collectability is reasonably assured, specifically, when the customer's credit card is charged, which is, in most cases, simultaneous with delivery of the on-demand video. Credit card payments accelerate cash flow and reduce the Company's collection risk, subject to the merchant bank's right to hold back cash pending settlement of the transactions.

Revenues from the sale of subscriptions to the Company's internet website are deferred and recognized rateably over the subscription period.

IPTV and satellite and cable broadcasting revenues are recognized upon delivery when the following conditions have been met (i) license period of the arrangement has begun and the customer can begin its exploitation, exhibition, or sale (ii) the arrangement fee is fixed or determinable and (iii) collection of the arrangement fee is reasonably assured. Such revenues may be generated by either a fixed license fee or as an agreed percentage of sales, based on sales reported each month by the Company's IPTV, cable and satellite affiliates. The affiliates do not report actual monthly sales for each of their systems to the Company until approximately 60-90 days after the month of service ends. This practice requires management to make monthly revenue estimates based on historical experience for each affiliated system. Revenue is subsequently adjusted to reflect the actual amount earned upon receipt. Adjustments made to adjust revenue from estimated to actual have historically been immaterial.

DVDs and magazines (physical products) are sold both to wholesalers, on firm sale basis, and via national newsstand distributors, with the right to return. Our physical products are generally produced in multiple languages and the principal market is in Europe. Revenues from the sale of physical products where distributors are not granted rights-of-return are recognized upon transfer of title, which generally occurs upon delivery. Revenues from the sale of physical products under consignment agreements with distributors are recognized based upon reported sales by the Company's distributors. Revenues from the sale of physical products under agreements that grant distributors rights-of-return are recognized upon transfer of title, which generally occurs on delivery, net of an allowance for returned product. Distributors with the right to return are primarily national newsstand distributors. Most of our products are bi-monthly (six issues per year) and remain on sale at a newsstand for a period of two months. Normally, all unsolds are reported to us within a period of four to six months from delivery. There are normally two to four national newsstand distributors for all newspapers and periodicals operating in each country. The Company uses specific return percentages per title and distributor


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based on estimates and historical data. The percentages vary from 50-80%. Percentages are reviewed on an on-going basis. In view of the high retail price, the margin and the physical quality of the magazines and the fact that the content has a very long "shelf-life" since it is not particularly linked to time, trends, fashion or current events, the Company historically has collected the returns from newsstands, repackaged them, and them made them available for sale again. The Company operates scheduled re-distribution of returned magazines, via national newsstand distributors, together with DVDs as magazine/DVD packs as a way of increasing DVD distribution. Since the national newsstand distributors have the right to return, the DVD packs are returned in order to be sold via an additional scheduled re-distribution. Magazine returns not re-distributed as per above are sold on a firm sale basis to wholesalers as back issues at a lower price than new issues. The Company has historically sold all returned copies at an average price higher than, or equal, to cost.

Revenues from mobile content (wireless) sales are recognized based on sales reported each month by mobile operators via aggregators. The aggregators do not report actual monthly sales for each of their operators to the Company until approximately 60-90 days after the month of service ends. This practice requires management to make monthly revenue estimates based on historical experience for each affiliated system. Revenue is subsequently adjusted to reflect the actual amount earned upon receipt. Adjustments made to adjust revenue from estimated to actual have historically been immaterial.

Accounts receivable

We are required to estimate the collectability of our trade receivables and notes receivable. A considerable amount of judgment is required in assessing the ultimate realizable value of these receivables including the current credit-worthiness of each customer. Significant changes in required reserves have been recorded in the past and may occur in the future due to the current market environment.

Management reviews the allowance for doubtful accounts on at least a quarterly basis and adjusts the balance based on their estimate of the collectability of specific accounts as well as a reserve for a portion of other accounts which have been outstanding for more than 180 days. This estimate is based on historical losses and information about specific customers. After collection attempts have failed, the Company writes off the specific account.

Goodwill and Other Intangible Assets

Goodwill represents the excess of the purchase price paid over the fair value of the net assets of businesses acquired.

Other Intangible Assets represents the value attributable to: a) Customer base, which was acquired from two of the Company's former distributors in the U.S. and in Canada in 2001 and 2003, respectively, for which the amortization expense is calculated on a straight-line basis over 10 years for each acquisition; b) Broadcasting asset, which was acquired in 2003 and which, at the time of acquisition, was deemed to have an indefinite life and therefore not subject to amortization; and c) Trade and Domain names which, at the time of acquisition, were deemed to have an indefinite life and therefore not subject to amortization (see, Note 8 of the financial statements included in this Annual Report).

Goodwill and indefinite lived intangible assets are reviewed annually for impairment (or more frequently if indicators of impairment arise). See Note 8 of the financial statements. Further separable intangible assets that are not deemed to have an indefinite life are amortized over their expected useful lives.

During 2010 and 2011 the Company had impairment charges of EUR 1,562,000 and EUR 13,327,000 respectively, see Note 8 of the financial statements included in this Annual Report. Subsequent to year end, as described in Note 20 of the financial statements included in this Annual Report, the Company divested itself of Game Link and Sureflix for nil consideration and accordingly the remaining related goodwill was provided against in full as at December 31, 2011.


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Impairment of Long-Lived Assets

The Company evaluates the carrying value of its long-lived assets when events or circumstances indicate the carrying value may not be recoverable through the estimated undiscounted cash flows from the use of the asset. An impairment loss is then measured as the amount by which the carrying value of the asset exceeds its estimated fair value. In 2010 the Company had impairment charges of EUR 548,000 relating to developed website technology and in 2011 the Company had impairment charges of EUR 1,089,000 related to the divestment of Game Link and Sureflix, see Note 20 of the financial statements included in this Annual Report. Going forward additional impairment charges may occur, see Note 6 of the financial statements included in this Annual Report.

Inventories

Inventories are valued at the lower of cost or market, with cost principally determined on an average basis. Inventories principally consist of DVD's and magazines held for sale or resale. The inventory is written down to the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those anticipated by management, write-downs may be required.

Results of Operations

Fiscal Year Ended December 31, 2011 compared to Fiscal Year Ended December 31, 2010

As described more fully elsewhere in this Annual Report, we have divested ourselves of the Game Link and Sureflix subsidiaries. For accounting purposes, the net sales, cost of sales, selling, general and administrative expenses, etc. of Game Link and Sureflix are included in the consolidated net sales, cost of sales, selling, general and administrative expenses, etc., line items in the income statement for the fiscal year ended December 31, 2010. However, for the fiscal year ended December 31, 2011, the net sales, cost of sales, selling, general and administrative expenses, etc. of Game Link and Sureflix are not listed in the income statement line items. Instead, the net results of Game Link and Sureflix for the fiscal year ended December 31, 2011 contained in income statement as "profit contributed by operations held for settlement of claims," and the net sales, cost of sales, selling, general and administrative expenses, etc. of these two former subsidiaries are shown separately in the footnotes to the financial statements. As of December 31, 2011 Game Link and Sureflix did not qualify for discontinued operations presentation. As a result, certain of the results of operations for the fiscal year ended December 31, 2011 cannot be directly compared to the results of the operations of the Company for the fiscal year ended December 31, 2010.

Net sales. Net sales for the fiscal year ended December 31, 2011 ("fiscal 2011") decreased from net sales in the fiscal year ended December 31, 2010 ("fiscal 2010") by EUR 15,341,000, or 65.9%. The decrease in net sales is attributable to both (a) the exclusion of EUR 11,423,000 of net sales Game Link and Sureflix in 2011, which net sales were excluded from net sales in fiscal 2011 because of the divestiture of those two subsidiaries, and (b) an overall decrease in net sales in our core "Private" branded operations. Since our divestment of Game Link and Sureflix, we have continued to operate the historical "Private" brand. The decrease in our core "Private" operations in 2011 was due in part to
(i) decisions made by prior management, (ii) the disruption caused by shareholder and creditor lawsuits and the disputed proxy contests in both 2010 and 2011 (the 2011 annual meeting of shareholders was eventually held in January 2012), and (iii) industry in the adult entertainment industry in general (such as the proliferation of free adult content provided over the Internet, which has reduced our internet sales, and the continuing decline of printed magazine sales). In addition, on August 25, 2011 the Nevada State Court appointed a receiver for the Company for the purposes of preserving Private Media's assets and business. While the receiver was successful in preserving the Company's assets and business, prior management's resistance to the receiver's involvement and supervision further impeded the Company's operations and business during the last four months of 2011. In 2011 (excluding Game Link and Sureflix), broadcasting represented 36% of our net sales, internet represented 26% of net sales, DVDs and magazine sales represented 25% of net sales, and wireless represented 13%. Prior management's relations with certain of the Company's primary creditors and customers negatively affected net sales in 2011.


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Cost of Sales. Our cost of sales was EUR 6,649,000 in fiscal 2011 compared to EUR 16,848,000 in fiscal 2010. Included in cost of sales is cost of operating our internet, broadcasting and wireless businesses, the cost of printing, processing and duplication, and the amortization of library. The decrease in fiscal 2011 is due in large part to the exclusion of EUR 6,882,000 of cost of sales incurred by Game Link and Sureflix. However, cost of sales at our core "Private" operations did not decrease in fiscal 2011 as much as our net sales decreased in fiscal 2011 compared to 2010 in large part because of the increase in the amortization of our library of photographs and videos. As a result, our cost of sales as a percentage of net sales increased to 84% in fiscal 2011 from 72% in fiscal 2010.

Gross Profit. In the twelve months ended December 31, 2010, we realized a gross profit of EUR 6,422,000, or 28% of net sales compared to EUR 1,280,000, or 16% of net sales for the twelve months ended December 31, 2011.

Selling, general and administrative expenses. Our selling, general and administrative expenses for fiscal 2011 decreased to EUR 7,362,000 from EUR 12,599,000 in fiscal 2010. In 2011, Game Link and Sureflix had selling, general and administrative expenses of EUR 3,976,000 which amounts have been excluded from the fiscal 2011 calculations. The selling, general and administrative expenses in fiscal 2010 included the costs of a larger workforce that we reduced by 34% from 168 to 112 employees during 2010-the effects of which were not fully realized until 2011. These reductions are partially offset in fiscal 2011 by significant litigation expenses related to prior management's dispute with the Company's shareholders and creditors.

Impairment of goodwill and other intangible assets. During the twelve month period ended December 31, 2010, we recorded impairment charges of EUR 1,562,000, which impairment related to primarily to the acquisition of Game Link and Sureflix. In fiscal 2011, we recorded impairment charges of EUR 13,368,000 as all remaining goodwill and related intangible assets of Game Link and Sureflix were written off because of the divestment in 2012 and which also includes an impairment charge for assets relating to the Company's video distribution company in the Benelux countries.

Provision for shareholders' and creditor claims. In fiscal 2011, we established a provision of EUR 5,830,000 for shareholders' and creditor claims. This provision includes an increase in the amount due under the Commerzbank Note, the legal fees and costs that the Nevada State Court ordered the Company to pay to the plaintiffs, the legal fees and costs we were required to pay Consipio because of the New York lawsuit, and amounts that we originally owed third parties, which obligations were acquired by Consipio. No such provision was established in fiscal 2010.

Change in fair value of contingent consideration payable. During the twelve-month period ended December 31, 2010, we recorded a EUR 4,189,000 gain from change in fair value of contingent consideration payable as a result of the performance of Game Link and Sureflix. The fair values of the amounts owed for the Game Link and Sureflix purchases were adjusted because prior management concluded that those companies had not reached the earnout targets set for 2009 and 2010. The EUR 184,000 benefit in fiscal 2011 reflects an adjustment to the final settlement made in 2012

Operating loss. Our operating loss in fiscal 2011 increased by EUR 20,998,000 to EUR 25,407,000 primarily because of the EUR 13,368,000 impairment of goodwill and intangible assets (mostly related to the divestment of Game Link and Sureflix) and the EUR 5,830,000 provision for shareholders' and creditor claims. Even if the two foregoing adjustments are excluded, the Company would have incurred an operating loss in 2011 because of the decrease in net sales, the decrease in gross margins, and the high selling, general and administrative expenses. Since the end of fiscal 2011, new management has initiated steps to stabilize the decrease in net sales, to reduce cost of sales, and to reduce selling, general and administrative expenses.

Interest expense. Interest expense in fiscal 2011 remained relatively unchanged from fiscal 2010. Subsequent to the fiscal 2011, current management has converted the Commerzbank Note into Series B Preferred


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Stock and has restructured its EUR 1,000,000 institutional line of credit. These actions are expected to reduce the Company's future interest payment obligations. However, since the end of fiscal 2011, the Company has also obtained loans in the amount of EUR 800,000 that bear interest at a rate of 9.9% per annum.

Income tax expense/benefit. We reported an income tax benefit of EUR 92,000 for the twelve months ended December 31, 2010 because of the utilization of a tax loss carryforward. In fiscal 2011, we recorded an income tax expense of EUR 4,454,000 to reflect the write-off of EUR 4,454,000 of the EUR 5,014,000 deferred income tax asset on the balance sheet as at December 31, 2010. Because much of the EUR 4,454,000 income tax benefit related to U.S. taxes, these benefits were dependent upon future income to be generated in the United States. Since we disposed of Game Link and Sureflix, we would no longer be generating sufficient taxable income in the United States that could benefit from the income tax asset. As a result, EUR 4,454,000 of our income tax asset was written off in fiscal 2011.

Net loss. Our net loss of EUR 29,324,000 for fiscal 2011 compared to the net loss of EUR 4,335,000 in fiscal 2010 reflects the large provisions and write offs taken in fiscal 2011 due to the divestment of Game Link and Sureflix, the settlement of certain shareholder and creditor claims and the deterioration in the Company's operations in 2011 under prior management and the supervision of the court-appointed receiver.

Liquidity and Capital Resources

Historically, we have funded our liquidity and capital resources from cash generated by our operating activities and from borrowings from third parties. As of December 31, 2011, we had a working capital deficit of EUR 11,438,000. As described elsewhere in this Annual Report, since 2011 we have converted short-term debt and other accrued liabilities into shares of our newly issued Series B Preferred Stock.

Operating Activities

Despite having a net loss of EUR 29,324,000, in fiscal 2011 we generated EUR 2,715,000 of net cash from our operating activities. The principal non-cash adjustments that enabled us to have positive net cash flow from operations included (1) impairment of goodwill and other intangible assets of EUR 12,279,000, (2) provision for shareholders' and creditor claims of EUR 5,830,000, (3) deferred income taxes EUR 4,432,000, (4) provision for doubtful accounts of EUR 1,072,000, (5) impairment of long-lived assets of EUR 1,089,000,
(6) amortization of web pages of EUR 1,681,000, (7) amortization of photographs and videos of EUR 3,887,000, and (8) depreciation of EUR 1,047,000. These adjustments were partially offset by increases in trade accounts payable (EUR 1,149,000) and income taxes payable (EUR 267,000).

Investing Activities

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