Private Media Group 10-Q 2010
U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the quarterly period ended September 30, 2010
For the transition period from to
Commission file number 000-25067
PRIVATE MEDIA GROUP, INC.
(Exact Name of Registrant as Specified in its Charter)
537 Stevenson Street, San Francisco, California 94103
(Address of U.S. principal executive offices)
Calle de la Marina 16-18, Floor 18, Suite D, 08005 Barcelona, Spain
(Address of European principal executive offices)
U.S. (415) 575-9700, Europe 34-93-620-8090
(Issuers telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated file, a non-accelerated filer, or a smaller reporting company (as defined in Rule 12b-2 of the Act).
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
State the number of shares outstanding of each of the issuers classes of common equity, as of the latest practicable date
PART I - FINANCIAL INFORMATION
PRIVATE MEDIA GROUP, INC.
CONSOLIDATED BALANCE SHEETS
See accompanying notes to consolidated statements.
PRIVATE MEDIA GROUP, INC.
CONSOLIDATED STATEMENTS OF INCOME (LOSS)
AND COMPREHENSIVE INCOME (LOSS)
See accompanying notes to consolidated statements.
PRIVATE MEDIA GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to consolidated statements.
PRIVATE MEDIA GROUP, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY
See accompanying notes to consolidated statements.
PRIVATE MEDIA GROUP, INC.
NOTES TO THE CONSOLIDATED INTERIM FINANCIAL STATEMENTS
1. Basis of Presentation
The accompanying unaudited consolidated financial statements have been prepared in accordance with United States generally accepted accounting principles (U.S. GAAP) for interim financial information. Accordingly they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation of financial position and results of operations have been included. Operating results for the three months period ended September 30, 2010 are not necessarily indicative of the results that may be expected for the year ended December 31, 2010. For further information, refer to the consolidated financial statements and footnotes thereto included in the Companys annual report on form 10-K for the year ended December 31, 2009.
Solely for the convenience of the reader, the accompanying consolidated financial statements as of September 30, 2010 and for the nine months then ended have been translated into United States dollars (USD) at the rate of EUR 0.73 per USD 1.00 the interbank exchange rate on September 30, 2010. The translations should not be construed as a representation that the amounts shown could have been, or could be, converted into US dollars at that or any other rate.
On January 20, 2009, Private Media Group, Inc. (Private) completed the acquisition of 100% of the business of Game Link LLC and its affiliate, eLine, LLC collectively (GameLink). The GameLink companies are engaged in the business of digital distribution of adult content over the Internet and online eCommerce development.
The amounts of GameLinks revenue and earnings included in Privates consolidated income statement for the three and nine months ended September 30, 2009, and the pro forma revenue and earnings of the combined entity had the acquisition date been January 1, 2009, are:
On October 29, 2009, Private Media Group, Inc. (Private) completed the acquisition of 100% of the business of Entruphema Inc. and Sureflix Digital Distribution Inc.,(Sureflix). The Sureflix companies are engaged in the business of digital distribution of premium gay adult content over the Internet and online eCommerce development.
PRIVATE MEDIA GROUP, INC.
NOTES TO THE CONSOLIDATED INTERIM FINANCIAL STATEMENTS(Continued)
The pro forma revenue and earnings of the combined entity had the acquisition date been January 1, 2009, are:
Inventories consist of the following:
4. Earnings (loss) per share
The following table sets forth the computation of basic and diluted earnings per share:
For the three and nine months ended September 30, 2010, basic earnings per share include exchangeable shares equivalent to 1,300,000 shares of common stock outstanding in the period.
PRIVATE MEDIA GROUP, INC.
NOTES TO THE CONSOLIDATED INTERIM FINANCIAL STATEMENTS(Continued)
5. Stock-based compensation
The Company has an expired Employee Stock Option Plan (the 1999 Plan) and a new Equity Incentive Plan (the 2009 EIP) available as described below. The compensation cost charged against income for the nine-month periods ended September 30, 2009 and 2010 was EUR 2 thousand and EUR 2 thousand, respectively, which is included in selling, general and administrative expense. The charge of compensation cost had no impact on tax since none of the option beneficiaries are taxable in the U.S. and tax rules are different in the beneficiaries respective tax jurisdictions.
The 1999 Plan
The 1999 Plan, which was in effect until its expiration on March 1, 2009, allowed the Company to grant options to purchase common stock to designated employees, executive officers, directors, consultants, advisors and other corporate and divisional officers of Private Media Group. The 1999 Plan authorized the Company to grant stock options exercisable for up to an aggregate of 2,400,000 shares of common stock. No stock options may be granted under the 1999 Plan, following its expiration, on March 1, 2009.
Under the expired plan, the purchase price (exercise price) of option shares had to be at least equal to the fair market value of such shares on the date the stock option was granted. The stock option was exercisable for a period of ten years from the date of grant or such shorter period as was determined by the Company. Each stock option under the plan provided that it was exercisable in full or in cumulative or non-cumulative installments, and each stock option was exercisable from the date of grant or any later date specified in the option. Unless otherwise provided by the Company, an optionee could not exercise a stock option unless from the date of grant to the date of exercise the optionee remained continuously in the Companys employ. At September 30, 2010, options for 13,002 shares were still outstanding under the 1999 Plan.
The 2009 EIP
The 2009 EIP is shareholder approved and came into effect on December 16, 2009. It allows the Company to grant incentive stock options, non-statutory stock options, restricted stock, unrestricted stock and other equity-based awards, such as stock appreciation rights, phantom stock awards, and restricted stock units, which we refer to collectively as Awards. The Company may issue up to 2,066,667 shares of its common stock pursuant to Awards granted. Shares pursuant to Awards that have expired or are forfeited will be returned to the 2009 EIP.
The Company may grant Awards under the 2009 EIP to employees, directors and consultants of Private Media Group. No Awards may be granted after the 2009 EIP expires on December 15, 2019. The purchase price (exercise price) of option shares must be at least equal to the fair market value of such shares on the date the stock option is granted or such later date the Company may specify. Each Award may provide that it is exercisable in full or in cumulative or non-cumulative installments, and each Award is exercisable from the date of grant or any later date specified in the Award. Awards must expire within a period of ten years from the date of grant or such shorter period as is determined by the Company. Unless otherwise provided by the Company, an Award holder may not exercise an Award unless from the date of grant to the date of exercise the holder remains continuously in the Companys employ.
PRIVATE MEDIA GROUP, INC.
NOTES TO THE CONSOLIDATED INTERIM FINANCIAL STATEMENTS(Continued)
At September 30, 2010, Awards for 2,062,333 shares were available for future grant under the 2009 EIP. Awards become exercisable on their respective vesting dates with vesting terms determined by management and approved by the Companys compensation committee.
A summary of stock option activity for the nine month period ended September 30, 2010 is a follows:
Stock-based compensation cost for stock awards is measured based on the closing fair market value of the Companys common stock on the date of grant.
Stock-based compensation cost for option awards is measured on the date of grant using the Black-Scholes option pricing model. The following general assumptions are used: a) expected volatility is based on historical volatility of our stock, b) expected life is determined based on historical experience of similar awards, giving consideration to the contractual terms of the stock-based awards, vesting schedules and expectations of future employee behavior, c) risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant and d) dividend yield is zero based on the Companys current dividend policy. During the nine month periods ended September 30, 2009 and 2010 no grants were made.
As of September 30, 2010, there was USD 242 of total unrecognized compensation cost related to nonvested option granted under the Plan. The cost is expected to be recognized over a weighted-average period of 0.1 years. The total fair value of all options vested and outstanding at September 30, 2009 and 2010, was USD 0.4 million and USD 42 thousand, respectively.
6. Income Taxes
The Companys subsidiaries file income tax returns in numerous tax jurisdictions, including the United States, several U.S. states and several non-U.S. jurisdictions, primarily in Europe. The statute of limitations varies by the various jurisdictions in which we operate. Because of the number of jurisdictions in which we file tax returns, in any given year the statute of limitations in certain jurisdictions may lapse without examination within the 12-month period from the balance sheet date. Other than the recurring effect of changes in unrecognized tax benefits due to the lapse of the statute of limitations, none of which are
PRIVATE MEDIA GROUP, INC.
NOTES TO THE CONSOLIDATED INTERIM FINANCIAL STATEMENTS(Continued)
expected to be individually significant, management believe there are no other reasonably possible changes that will significantly impact the amount of tax benefits recognized in the Companys financial statements within the 12-month period from the balance sheet date. The Company has substantially concluded all US Federal and State income tax matters for years up to and including 2004 and 2002 respectively, and all foreign income tax matters for years up to 2003.
The Companys practice is to recognize interest and penalties related to income tax matters in interest and other expenses respectively. Interest and penalties amounting to EUR 552 thousand were accrued as of September 30, 2010, of which EUR 80 thousand was recognized as interest expense during the nine-month period then ended.
In December 1999 the Company received final notification from the Swedish Tax Authority assessing its subsidiary in Cyprus for the tax years 1995-1998 for a total amount of SEK 42,000,000 (approx. EUR 4.5 million) plus fines amounting to SEK 16,800,000 (approx. EUR 1.8 million) plus interest. The Swedish Tax Authority has taken the position that the subsidiary carried on business in Sweden from a permanent establishment during the period in question and should therefore be taxed on the income attributable to the permanent establishment. The Company is of the view that no permanent establishment is at hand in Sweden. However, the Administrative Court of Appeal has finally decided that a permanent establishment is at hand. In February 2009, the County Administrative Court reduced the assessment for the tax years 1995-1998 to a total amount of SEK 12,600,000 (approx. EUR 1.1 million) plus fines amounting to SEK 5,040,000 (approx. EUR 0.5 million) plus interest. In November 2010, the Administrative Court of Appeal decided that the County Administrative Courts decision should prevail. However, as a matter of fact, the tax claim on the Company has been extinguished according to Administrative Law. Following the November 2010 decision, the Company is considering to bring the matter to the Supreme Administrative Court. Due to the fact that the final outcome of this matter is still uncertain, and that there is no longer any claim at stake, no amounts have been provided in the Companys financial statements for this dispute.
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 relate to factors such as: (1) the timing of the introduction of new products and services and the extent of their acceptance in the market; (2) our expectations of growth in demand for our products and services; (3) our ability to successfully implement expansion and acquisition plans; (4) the impact of expansion on our revenue, cost basis and margins; (5) our ability to respond to changing technology and market conditions; (6) the effects of regulatory developments and legal proceedings with respect to our business; (7) the impact of exchange rate fluctuations; and (8) our ability to obtain additional financing. The foregoing list of factors is not exhaustive. For a more complete list of factors that may cause results to differ materially from projections, please refer to the Risk Factors section of this Form 10-K.
We are an international provider and distributor of adult media content. We acquire or license content from independent studios and directors and process these images into products suitable for popular media formats such as digital media content for Broadcasting, Mobile and Internet distribution, and print publications and DVDs. In addition to media content, we also 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, companies engaged in digital distribution of adult content over the Internet and eCommerce development. GameLink is a leading US adult entertainment VOD and eCommerce platform through its GameLink.com website. The sites installed user base represents over one million domestic and international customers and it serves over100,000 users daily. Including 70,000 video titles, GameLink has one of the largest libraries of digital and physical adult media and novelties in the United States.
On October 29, 2009 we continued the ongoing expansion of our global digital media platform through the acquisition of Sureflix Digital Distribution and its affiliates, companies engaged in the business of digital distribution of premium gay adult content. Sureflix is a leading global supplier of adult programming. The company operates a vast network of more than 100 pay-per-view VOD websites and has a North American broadcast presence. It represents premium production studios in global television broadcast (cable, satellite), mobile, IPTV and Internet VOD markets. Sureflix has not only in-depth knowledge of adult programming, but also significant VOD technology and marketing expertise.
We operate in a highly competitive, service-oriented market and are subject to changes in business, economic and competitive conditions. Nearly all of our products compete with other products and services that utilize adult leisure time and disposable income. Although we believe our products are well-established in the adult entertainment industry, we compete with entities selling adult oriented products via any type of distribution network, including the Internet. Many of these products are similar to ours. Over the past few years, the adult entertainment industry has undergone significant change. Traditional producers of softcore content as well as mainstream providers of media content have shifted to producing hardcore content. As a result, we face greater competition to distribute hardcore content. This shift has also led to industry consolidation, creating fewer, more financially formidable competitors. Recently, the introduction of a large
number of free content Internet sites that allow users to access large libraries of content has created an even more challenging environment where both sales volume and margins are decreasing substantially. In addition, the recent recession has shown that the adult industry is not immune to economic cycles.
Despite serious challenges in the market for online content, we expect growth going forward. There are many reasons to be optimistic about our opportunities and our Internet group has been working hard to position itself to take advantage of these opportunities.
The primary source of growth is expected to come from a significant increase in traffic to our online properties coupled with a much more sophisticated approach to traffic management. We have rebuilt our signature property, private.com, and are restructuring our affiliate programs in all properties to compete aggressively for affiliate traffic. In addition to our technical systems, we have restructured our departments with resources highly skilled in affiliate traffic development and shifted our emphasis from account management towards sales. We have also developed solutions for critical new markets: gay, international, and mobile. Finally, we have increased our efforts to defend against piracy of our content and the propagation of pirated content. The combination of the breadth of our premium assets and the scope of our market reach give us a unique and very defensible position.
During 2010, the DVD market has continued to shrink, with sales for our physical products declining by 35%. However, the DVD business is by no means dead even in this competitive landscape. The content providers that manage to survive the current clean out will control the DVD market going forward.
With respect to broadcasting, Private is a leading adult content provider in Europe currently partnering with 38 IPTV operators. In addition to this we are providing content to leading Pay-TV operators. Our strategic partnerships have proven to be solid and strong revenue generators and will continue to perform well.
Privates mobile on portal revenues declined again in 2009 after years of strong growth. We are still the most distributed adult brand in the world and will monetize existing distribution as best as we can by going live with the few outstanding carriers and replacing non-performing content aggregators with new ones. Throughout 2008 and 2009 there has been a huge increase in off-portal traffic. According to research firm Nielsen, the mobile Internet market has seen a 74% increase between February 2007 and February 2009. We have recently enabled smart phone users to browse, purchase and consume our library of content on all of our web properties and expect to generate substantial growth from this initiative going forward.
Through the acquisition of Gamelink and Sureflix, Private acquired a team of some of the most innovative and experienced developers in the adult industry who will lead a product development effort focused on a clear goal: increasing qualified traffic to our web properties. There are three key strategies: opening our services to third parties to develop products on top of our platform; developing applications that give our content hooks into emerging markets and devices; and developing widgets that will merge the unique data analytics we have with our vast product offering and enable sites to easily leverage our catalog and transactional capabilities to their customers.
One Movie All Screens: the VOD landscape is an endless field of format proliferation. Consumers are forced to purchase the same movie in a variety of different formats at various price points in order to view it on different devices. Our goal is to provide our customers with the ability to watch any movie in our catalog on any screen available to them.
In addition to our R&D efforts for traffic generation, we will continue to explore the most effective way to enable customers to view our movies on all screens. The primary focus of our R&D efforts will be on delivering content to the TV and enabling purchase and consumption on smart phones.
We generate revenues primarily through:
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 Internet, broadcasting and wireless. We expect net sales from Internet, wireless and broadcasting to grow during the coming years.
We recognize net sales on delivery (for further information, see Critical Accounting Estimates).
Even though we recognize net sales upon delivery, we generally provide extended payment terms to our 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. In addition, we view our extended payment terms as an investment in our distribution channels which are important to the growth of our business.
Our primary expenses include:
We released 72, 87 and 101 proprietary video titles during 2009, 2008 and 2007, respectively. The releases include both new and archival material. We plan to release approximately 72 proprietary video titles in 2010.
Over the years, our cost of sales has been fluctuating relative to net sales due to our use of new mediums for our products, such as the Internet, DVD broadcasting and wireless. We also incur significant intangible expenses in connection with the amortization of our library of photographs and movies and capitalized development costs, which include the Internet. We amortize these tangible and intangible assets on a straight-line basis for periods of between three and five years.
We have faced several organizational challenges during 2009 and 2010 as a result of the acquisitions and integration of the online businesses GameLink and Sureflix into the group. Parallel with the integration, we have rebuilt our signature property, private.com, and are restructuring our affiliate programs in all properties to compete aggressively for affiliate traffic. In addition, we have restructured our departments with resources highly skilled in affiliate traffic development and shifted our emphasis from
account management towards sales. We have also developed solutions for critical new markets: gay, international and mobile. Furthermore, as a response to decreased margins in the adult entertainment industry, we have reviewed, analyzed and continued to restructure the operations of the non-online part of the business in order to become more cost effective. All the aforementioned processes have had impact both in terms of lost sales and additional selling, general and administrative expenses. During 2010/2011, we expect to benefit from the restructuring and reduce costs and increase sales as we implement and launch new initiatives, such as fully combining our Internet assets, outsourcing major parts of our non-online operations and launching new Internet platforms.
Critical Accounting Estimates
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 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 bad debt, 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 Companys primary sources of revenue are the sale of content delivered via Internet, broadcasting, DVD & magazines and mobile phones.
Internet video on-demand offerings are sold directly via the Companys online retail 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 customers 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 Companys collection risk, subject to the merchant banks right to hold back cash pending settlement of the transactions. The Company also offers a prepaid video-on-demand service in which a customer purchases a number of minutes of on-demand video at a set rate per minute based on the number of minutes purchased. The rate per minute decreases as the number of prepaid minutes increases. The Company records revenue from pre-pay customers as deferred revenue prior to commencement of services and recognizes revenue as the services are rendered. Prepaid minutes purchased under this program do not expire.
The Company also offers a customer loyalty program under which each members purchase of video on-demand, DVDs, movie downloads, books, novelties or other items earns the member one point for each dollar spent. After accumulating 150 points, a customer may redeem the points for a $5 purchase. Points increase in value as they are accumulated and redeemed, with a maximum accumulation of 2,000
points, which may be redeemed for a $200 purchase. All of a customers points expire after 180 days of no purchase activity. Because the value of the award points is not significant in relation to the value of the services or products purchased by the customer, the Company records a liability for the estimated cost of the discounted services or products to be provided in the future.
Revenues from the sale of subscriptions to the Companys Internet website are deferred and recognized ratably over the subscription period.
IPTV (Internet Protocol Television), satellite & 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 Companys 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 & 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 multi-lingual 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 Companys 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. A majority of our national newsstand distributors are members of Distripress, the international organization for publishers and distributors, and carry out the distribution of the largest national and international newspapers and periodicals, including: Financial Times, Herald Tribune, Time, Newsweek, Vogue, etc. The Company uses specific return percentages per title and distributor based on estimates and historical data. The percentages vary from 50-80%. Percentages are reviewed on an on-going basis. Magazines have an approximate retail price of EUR 11.50 (USD 15.95) per copy and are printed on glossy high-quality paper at a cost of EUR 1.25 (USD 1.75). They are often shrink-wrapped in order to comply with local regulation or guidance for the sale of adult publications. 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 has always collected the returns from newsstands in order to make 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 and the magazines are broken out in order to be sold via an additional scheduled re-distribution as Megapacks and Superpacks (three different copies per pack). Returns from the sale of Megapacks and Superpacks are destroyed. The retail price for products sold via re-distribution vary between EUR 14.95-19.95 (USD 20.75-27.70). Magazine returns not re-distributed as per above are sold on a firm sale basis to wholesalers as back numbers 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.
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 realization 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.
Goodwill and indefinite lived intangible assets are reviewed annually for impairment (or more frequently if indicators of impairment arise). Further, separable intangible assets that are not deemed to have an indefinite life are amortized over their expected useful lives.
Impairment of Long-Lived Assets
The Company periodically evaluates the carrying value of long-lived assets including its library of photographs and videos for potential impairment. Upon indication of impairment, the Company will record a loss on its long-lived assets if the undiscounted cash flows that are estimated to be generated by those assets are less than the related carrying value of the assets. An impairment loss is then measured as the amount by which the carrying value of the asset exceeds the estimated discounted future cash flows. Managements estimated future revenues are based upon assumptions about future demand and market conditions and additional write downs may be required if actual conditions are less favorable than those assumed.
Inventories are valued at the lower of cost or market, with cost principally determined on an average basis. Inventories principally consist of DVDs 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 projected by management, additional write-downs may be required.
Results of Operations
Three months ended September 30, 2010 compared to the three months ended September 30, 2009
Net sales. For the three months ended September 30, 2010, we had net sales of EUR 5.9 million compared to net sales of EUR 5.8 million for the three months ended September 30, 2009, an increase of EUR 0.1 million. The increase was the result of increased Internet sales offset by decreases in sales of DVD & Magazines and Broadcasting. Internet sales increased EUR 0.8 million to EUR 3.7 million, which represents an increase of 29% compared to the same period last year. The increase in Internet sales was the result of our acquisitions last year. Discounting EUR 0.9 million in impact from the SureFlix acquisition, Internet Sales decreased EUR 0.1 million. DVD & Magazine sales decreased EUR 0.6 million, or 41%, to EUR 0.9 million. The reduction in DVD & Magazine sales was primarily attributable to an industry wide decrease in DVD sales. Broadcasting sales decreased EUR 0.1 million, or 6%, to EUR 0.9 million. Wireless sales stayed flat at EUR 0.4 million. Going forward, we expect Internet, wireless and Broadcasting sales to increase (see discussion under Outlook below).
Cost of Sales. Our cost of sales was EUR 3.8 million for the three months ended September 30, 2010 compared to EUR 3.6 million for the three months ended September 30, 2009. Included in cost of sales is Internet, broadcasting and wireless. printing, processing and duplication and amortization of library. Internet cost was EUR 2.1 million for the three months ended September 30, 2010 compared to EUR 1.5 million for the three months ended September 30, 2009. Internet cost as a percentage of related sales in the period was 57% compared to 51% in the same period last year. The increase of EUR 0.7 million was primarily the result of the acquisition of Sureflix, which represented EUR 0.6 million including amortization of acquisition fair value addition to website. Broadcasting and wireless cost was EUR 0.1 million for the three months ended September 30, 2010 compared to EUR 0.2 million for the three months ended September 30, 2009. Broadcasting and wireless cost as a percentage of related sales in the period was 5% compared to 13% in the same period last year. Printing, processing and duplication cost was EUR 0.4 million for the three months ended September 30, 2010 compared to EUR 0.5 million for the three months ended September 30, 2009, a decrease of EUR 0.1 million. Printing, processing and duplication cost as a percentage of DVD & Magazine sales was 50% for the three months ended September 30, 2010 compared to 33% in the same period last year. Amortization of library was EUR 1.2 million for the three months ended September 30, 2010 compared to EUR 1.5 million for the three months ended September 30, 2009, which represents a decrease of EUR 0.3 million. Amortization of library does not vary with sales since it reflects the amortization of our investments in content which has been available for sale for a period of three to five years.
Gross Profit. In the three months ended September 30, 2010, we realized a gross profit of EUR 2.1 million, or 35% of net sales compared to EUR 2.2 million, or 38% of net sales for the three months ended September 30, 2009. The decrease in gross profit was primarily the result of less gross profit from DVD & Magazine sales offset by increased gross profit from Internet and Broadcasting sales and reduced amortization of library.
Selling, general and administrative expenses. Our selling, general and administrative expenses were EUR 4.6 million for the three months ended September 30, 2010 compared to EUR 3.6 million for the three months ended September 30, 2009, an increase of EUR 0.9 million, or 26%. Discounting EUR 0.5 million in impact from the SureFlix acquisition last year, the company increased selling, general and administrative expenses by EUR 0.4 million, which were primarily related to severance expense for laying off employees.
Operating profit/loss. We reported an operating loss of EUR 2.5 million for the three months ended September 30, 2010 compared to an operating loss of EUR 1.5 million for the three months ended
September 30, 2009. The EUR 1.0 million reduction was the result of increased selling, general and administrative expenses and reduced gross profit.
Interest expense. We reported interest expense of EUR 0.1 million for the three months ended September 30, 2010, compared to EUR 0.1 million for the three months ended September 30, 2009.
Income tax expense/benefit. We reported no income tax expense or benefit for the three months ended September 30, 2010, compared to EUR 0.3 million in income tax benefit for the three months ended September 30, 2009.
Net income/loss. We reported net loss of EUR 2.6 million for the three months ended September 30, 2010, compared to a net loss of EUR 1.2 million for the three months ended September 30, 2009.
Nine months ended September 30, 2009 compared to the nine months ended September 30, 2008
Net sales. For the nine months ended September 30, 2010, we had net sales of EUR 18.3 million compared to net sales of EUR 17.7 million for the nine months ended September 30, 2009, an increase of EUR 0.5 million. The increase was the result of increased Internet sales offset by decreases in sales of DVD & Magazines and Wireless. Internet sales increased EUR 2.1 million to EUR 11.4 million, which represents an increase of 23% compared to the same period last year. The increase in Internet sales was the result of our acquisitions last year. Discounting EUR 3.2 million in impact from acquisitions, Internet Sales decreased EUR 1.1 million as a result of the rebuilding of our website private.com. Broadcasting sales remained flat at EUR 3.0 million. Wireless sales decreased EUR 0.1 million, or 9%, to EUR 1.2 million. DVD & Magazine sales decreased EUR 1.4 million, or 35%, to EUR 2.6 million. The reduction in DVD & Magazine sales was primarily attributable to an industry wide decrease in DVD sales. Going forward, we expect Internet, wireless and Broadcasting sales to increase (see discussion under Outlook below).
Cost of Sales. Our cost of sales was EUR 12.1 million for the nine months ended September 30, 2010 compared to EUR 11.2 million for the nine months ended September 30, 2009. Included in cost of sales is Internet, broadcasting and wireless. printing, processing and duplication and amortization of library. Internet cost was EUR 7.0 million for the nine months ended September 30, 2010 compared to EUR 4.7 million for the nine months ended September 30, 2009. Internet cost as a percentage of related sales in the period was 61% compared to 51% in the same period last year. The increase of EUR 2.2 million was primarily the result of the acquisition of GameLink and Sureflix. In addition, we have rebuilt our private.com membership site and as a result of this we have incurred increased costs, including accelerated amortization of the old site which was decommissioned in May 2010. Broadcasting and wireless cost was EUR 0.2 million for the nine months ended September 30, 2010 compared to EUR 0.4 million for the nine months ended September 30, 2009. Broadcasting and wireless cost as a percentage of related sales in the period was 6% compared to 9% in the same period last year. Printing, processing and duplication cost was EUR 1.2 million for the nine months ended September 30, 2010 compared to EUR 1.7 million for the nine months ended September 30, 2009, a decrease of EUR 0.5 million, or 27%. The decrease was primarily a reflection of the decrease in sales. Printing, processing and duplication cost as a percentage of DVD & Magazine sales was 46% for the nine months ended September 30, 2010 compared to 41% in the same period last year. Amortization of library was EUR 3.7 million for the nine months ended September 30, 2010 compared to EUR 4.4 million for the nine months ended September 30, 2009, which represents a decrease of EUR 0.7 million. Amortization of library does not vary with sales since it reflects the
amortization of our investments in content which has been available for sale for a period of nine to five years.
Gross Profit. In the nine months ended September 30, 2010, we realized a gross profit of EUR 6.2 million, or 34% of net sales compared to EUR 6.5 million, or 37% of net sales for the nine months ended September 30, 2009. The decrease in gross profit both in money and as a percentage of sales was primarily the result of the accelerated amortization of our old private.com membership site which was replaced in May 2010 and reduced DVD & Magazine sales offset by reduced amortization of library.
Selling, general and administrative expenses. Our selling, general and administrative expenses were EUR 11.1 million for the nine months ended September 30, 2010 compared to EUR 11.6 million for the nine months ended September 30, 2009, a decrease of EUR 0.5 million, or 5%. Discounting the EUR 1.8 million in impact from our acquisitions last year, the company reduced selling, general and administrative expenses by EUR 2.8 million, despite non-recurring severance expense of EUR 0.4 million in September 2010.
Change in fair value of contingent consideration payable. During the nine months ended September 30, 2010, we recorded a EUR 2.4 million gain from change in fair value of contingent consideration payable as a result of the performance of GameLink and Sureflix. The two recently acquired companies have not reached the earnout targets set for 2009 and expectations for reaching future earnout targets have been adjusted accordingly.
Operating loss. We reported an operating loss of EUR 2.5 million for the nine months ended September 30, 2010 compared to an operating loss of EUR 5.1 million for the nine months ended September 30, 2009. The EUR 2.5 million reduction in operating loss was the result of change in fair value of contingent consideration payable and reduced selling, general and administrative expenses, offset by reduced gross profit.
Interest expense. We reported interest expense of EUR 0.3 million for the nine months ended September 30, 2010, compared to EUR 0.3 million for the nine months ended September 30, 2009.
Income tax expense/benefit. We reported no income tax expense or benefit for the nine months ended September 30, 2010, compared to EUR 1.6 million in income tax benefit for the nine months ended September 30, 2009.
Net loss. We reported a loss of EUR 2.9 million for the nine months ended September 30, 2010, compared to EUR 3.6 million for the nine months ended September 30, 2009.
Liquidity and Capital Resources
We reported a working capital deficit of EUR 0.8 million at September 30, 2010, a decrease of EUR 2.0 million compared to the year ended December 31, 2009. The decrease is principally attributable to a decrease in current assets and an increase in current liabilities.
Net cash provided by operating activities was EUR 3.1 million for the nine months ended September 30, 2010, and was primarily the result of net income, as adjusted for non-cash transactions, and cash related to changes in operating assets and liabilities. The net loss of EUR 2.9 million was adjusted to reconcile net income to net cash flows from operating activities with depreciation of EUR 0.4 million, bad debt provision EUR 0.4 million, amortization of other intangible assets of EUR 0.1 million, amortization of web pages of EUR 2.2 million and amortization of photographs and videos of EUR 3.7 million, offset by EUR 2.4 million from change in fair value of contingent consideration payable, making a total of EUR 4.6 million, providing a net balance of EUR 1.7 million. The total of EUR 1.7 million was added to by changes in trade accounts receivable, inventories, accounts payable trade and accrued other liabilities totaling EUR 1.6 million offset by prepaid expenses and other current assets of EUR 0.2 million. Net cash provided by operating activities was EUR 3.3 million for the nine months ended September 30, 2009. The decrease in net cash provided by operating activities of EUR 0.2 million for the nine months ended September 30, 2010 compared to the same period last year was primarily the result of net income, as adjusted for non-cash transactions, and cash related to changes in operating assets and liabilities.
Net cash used in investing activities for the nine months ended September 30, 2010 was EUR 2.5 million. The investing activities were principally capital expenditure of EUR 1.2 million and investment in library of photographs and videos of EUR 1.5 million, which was carried out in order to maintain the 2010 release schedules. Net cash used in investing activities decreased EUR 0.8 million over the same period last year. The decrease is principally due to reduced investment in library of photographs and videos as a result of a lower cost per title for acquisitions of videos.
Net cash used in financing activities for the nine-month period ended September 30, 2010 was EUR 0.2 million. For the nine-month 2009 period EUR 0.1 million was used in financing activities.
In each of the past three years we have experienced losses from operations. As a result of our operating losses our independent registered public accounting firm has concluded that there is substantial doubt as to our ability to continue as a going concern, and have modified their report for the financial year ending December 31, 2009 in the form of an explanatory paragraph describing the events that have given rise to this uncertainty. Our ability to continue as a going concern is based on our ability to generate or obtain sufficient cash to meet our obligations on a timely basis and ultimately to attain profitable operations. We currently expect future growth and to return to profitability provided we are successful with the following objectives:
If we are not successful in implementing the above objectives, or if we otherwise do not successfully respond to changing conditions in the adult entertainment industry, we may continue to incur significant losses. There can be no assurance that we will be able to operate profitably in the future.
Although we expect that our available cash resources and cash generated from operations will be sufficient to meet our presently anticipated working capital and capital expenditure requirements for at least the next 12 months, we may need to raise additional funds to support more rapid growth or respond to unanticipated requirements. In this regard, we are presently engaged in litigation with a third party lender, Consipio Holding BV, regarding our obligations under a promissory note. An adverse outcome in this dispute would likely have a material impact upon our liquidity if we are unable to obtain additional debt or equity financing to satisfy any resulting liability. See Disputed Contractual Obligation below and Part II, Item I Legal Proceedings for further information regarding this litigation.
We currently have no additional availability under our existing credit facilities. The existence of a going concern exception by our auditors may make it more difficult to obtain additional bank financing if and when required. If additional funds are raised through the issuance of equity securities, our shareholders percentage ownership will be reduced, they may experience additional dilution, or these newly issued equity securities may have rights, preferences, or privileges senior to those of our current shareholders. Additional financing may not be available when needed on terms favorable to us, or at all. In this regard, in the past most of our bank financing has included the guaranty of affiliated companies of our Chairman and principal shareholder, Berth Milton, and a pledge of shares of common stock owned by him or his affiliated companies. We cannot assure you that Mr. Milton or his affiliated companies will guaranty future debt financings or that such guaranties will be sufficient to obtain future debt financings. If adequate funds are not available or are not available on acceptable terms, we may be unable to develop or enhance our products and services, take advantage of future opportunities, maintain the scope of our operations or respond to competitive pressures or unanticipated requirements, which could harm our business.
Disputed Contractual Obligation
In December 2001 the groups holding company, Private Media Group, Inc., borrowed $ 4.0 million from Commerzbank AG pursuant to a Note originally due on December 20, 2002. The Note bore interest at an annual rate of 7%, payable quarterly, with the entire principal amount and accrued interest originally due on December 20, 2002. The Note was guaranteed by Slingsby Enterprises Limited, an affiliate of Privates Chairman and principal shareholder, and the guaranty was secured by 1,650,000 shares of Private Media Group, Inc. Common Stock under a Pledge Agreement. In December 2002 Commerzbank AG agreed to
extend the maturity date of the Note to March 20, 2003. In April 2003 the Note was acquired by Consipio Holding B.V. from Commerzbank AG, and Consipio and Private reached an agreement-in-principle with Consipio to extend the maturity of the Note until April 2008. However, Consipio and Private were unable to reach final agreement on other terms and conditions relating to the restructured Note. Accordingly, in December 2003 Consipio notified Private and Slingsby Enterprises that Private was in default under the Note, and demanded $3.4 million as payment in full of all outstanding principal and interest under the Note. The Company continued to make regular payments on the Note, including principal and accrued interest, through February 2008. In April 2008 Consipio requested Private to pay the remaining balance of the Note, without indicating the amount due. Private in turn requested that Consipio provide a statement of the amount due and the basis for its calculation. In response, Consipio demanded payment of $3,194,000 as settlement in full of the Note, to be received by May 9, 2008. This calculation was made using an interest rate of 9.9%, as opposed to the 7% rate provided under the original terms of the Note. Consipio also advised that if payment was not received on such date it would institute litigation, in which event Consipio would claim that the amount due under the Note should be denominated in Euro, rather than U.S. dollars. Private believes that the amount due under the Note at May 9, 2008, including accrued interest, was no more than $2.4 million, utilizing an interest rate of 7%. In August 2008 Consipio notified Private that the Note was in default and that it intended to exercise its rights under the Note and the pledge of shares by Slingsby of Private Common Stock under the Pledge Agreement. No payments have been made under the Note since February 2008, and the Note provides for interest to accrue on the unpaid principal amount of the Note until paid in full. Private believes that the amount due under the Note at September 30, 2010, including accrued interest, was no more than $2.8 million (EUR 2.1 million), utilizing an interest rate of 7%.
On May 1, 2009, Consipio Holding BV filed a lawsuit against the Company and Slingsby asserting a claim for unspecified damages under the Note and the guaranty. The Company and Slingsby filed their Answer and asserted several affirmative defenses. On March 26, 2010, the Court dismissed the lawsuit, finding that U.S. federal courts did not have jurisdiction over the subject matter of the lawsuit.
On July 9, 2010, the Company received a notice from Consipio advising it that the Company continues to be in default under the Note and requesting Slingsby to deliver an additional 3,950,000 shares of common stock as collateral to Consipio under the terms of the Pledge Agreement. In addition, pursuant to such notice Consipio purported to exercise the right as pledgee to vote all of the collateral shares, including the 1,650,000 shares of common stock previously pledged as collateral, so long as an event of default has occurred and is continuing under the Note.
On August 12, 2010, the Company received notice that Consipio had refiled a Complaint against the Company and Slingsby to enforce the Note and guaranty in New York State Court, entitled Consipio Holding BV v. Private Media Group, Inc. and Slingsby Enterprises Limited (Case No. 650462/10). The new Complaint contained allegations and sought relief similar to the allegations and relief sought in the case previously filed on May 1, 2009, in U.S. federal court. On September 22, 2010, Slingsby notified Consipio that its rights under the guaranty and pledge agreement had expired, and therefore Consipio had no further rights under the guaranty or pledge agreement, including the right to vote the shares. On October 12, 2010, Slingsby Enterprises Limited filed a Motion to dismiss the claims against it under the guaranty and related pledge agreement based upon the position that Consipios claims against Slingsby are time barred under the statute of limitations. On October 29, 2010 the Company filed an Answer, which among other things asserted substantial offsets to the amounts due under the Note. Both the Company and Slingsby intend to vigorously defend against these claims.
During 2009 and 2010, We have developed Internet solutions for critical new markets: gay, international and mobile. Furthermore, as a response to decreased margins in the adult entertainment industry, we have reviewed, analyzed and continued to restructure the operations of the non-online part of the business in order to become more cost effective. Last years acquisitions of GameLink and SureFlix have also presented a challenge in terms of integration. All the aforementioned processes have had impact both in terms of lost sales and additional selling, general and administrative expenses. However, as part of these processes, we have as of September reduced our workforce this year by 36% from 168 to 107 employees and we expect to continue this process as we become more efficient and enjoy economies of scale from the aforementioned acquisitions. During the end of 2010 and the beginning of 2011, we expect to start benefiting from the restructuring and reduce costs while increasing sales as we implement and launch new initiatives, such as fully combining our Internet assets, outsourcing major parts of our non-online operations and completing the launching of our new Internet platforms.
As part of our digital strategy, we have established that the combination of Private with major online retailers and accomplished platform developers is the approach to achieving our goals in the rapidly changing business landscape. The combined content assets of Private and core competencies of GameLink and Sureflix offer a compelling new business model. We will be expanding our joint Internet strategies globally with additional formats and applications to be launched in 2011. In May this year we launched our new private.com membership platform which we have been building since mid 2009. The new platform features a number of proprietary sites and it is also available as a white label version, which we expect will attract adult content providers and affiliates worldwide. The new platform has already proved to have improved conversion rates and is forecasted to receive considerably more traffic compared to our previous membership platform. In addition, the new platform has been built to be substantially less labor intensive to operate compared to the previous one. Following the rollout of the new membership platform, we are launching a new video-on-demand platform following the same concept. Both of the new platforms will be available in localized versions with respect to language and payment options.
Additionally, we will be developing improved interactive functionality for new media platforms such as IPTV and mobile, and maximizing our content monetization with the existing vast Private library as well as aggregation of select international studios offering a wide range of content and genres for all platform needs. In April this year, GameLink, launched a proprietary mobile solution enabling users to instantly stream over 15,000 movies. The platform is initially available on Smartphones such as the iPhone and Android phones at the url: www.gamelink.com. The mobile Internet platform allows consumers to purchase and consume content instantly. All content is available for future viewing in the customers virtual media center, stored in the companys cloud. The platform has been optimized to work with Apple devices including the iPhone, iPod, the iPad as well as Android devices. In addition to streaming, consumers can choose to download their movies or purchase DVDs and novelties from the globally accessible platform. A white label version of the mobile platform is available and is being marketed to adult studios and affiliates worldwide. Our objective is to become the main provider of an off-portal mobile platform solution to all major content providers in our industry. In contrast to Privates existing mobile content business2, which is based on an on-portal model going through content aggregators and carriers, this new business is off-portal and provides substantially improved margins as content is sold directly by Private to the consumer. In August 2010, Sureflix launched a new mobile VOD platform based on the same
principles as the GameLink mobile platform for its Maleflixxx network of hundreds of sites. The new mobile platform, Maleflixxx Mobile, allows consumers to view gay content on all mobile devices, including the iPad, iPod Touch, iPhone and Android handsets. With the Smartphone market growing rapidly3, we expect to generate substantial growth from our mobile VOD initiatives going forward.
We are continuing to implement our media strategy for growth of VOD (Video-on-Demand) via IPTV and to date we have contracted with 38 major platform operators in 24 countries in Europe, as the leading supplier of adult content. We have gained more than 75% coverage of the European IPTV market and going forward we expect to increase our market share in this expanding market. In addition, the introduction of IPTV in Europe has challenged the Cable-TV industry and subsequently cable operators are rapidly upgrading their systems to provide the same functionality as IPTV. Last year we contracted with two leading cable operators in Western Europe and going forward we expect to add further Cable/VOD platforms to our portfolio.
Evaluation of Disclosure Controls and Procedures
The Company maintains disclosure controls and procedures designed to ensure that information required to be disclosed in reports filed under the Securities Exchange Act of 1934, is recorded, processed, summarized and reported within the specified time periods. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934 is accumulated and communicated to its management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. As of the end of the period covered by this report, the Companys management evaluated, with the participation of the Companys Chief Executive Officer and Chief Financial Officer, the effectiveness of the Companys disclosure controls and procedures. Based on the evaluation, the Companys Chief Executive Officer and Chief Financial Officer concluded that the Companys disclosure controls and procedures were effective as of September 30, 2010.
Changes in Internal Control Over Financial Reporting
There were no changes in the Companys internal control over financial reporting that occurred during the Companys fiscal quarter ended September 30, 2010, that have materially affected, or are reasonably likely to materially affect, the Companys internal control over financial reporting.
Inherent Limitations in Internal Control Over Financial Reporting
The Company does not expect that its disclosure controls and procedures will prevent all error and all fraud. A control procedure, no matter how well conceived and operated, can provide only reasonable not absolute, assurance that the objectives of the control procedure are met. Because of the inherent limitations in all control procedures, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any control procedure also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control procedure, misstatements due to error or fraud may occur and not be detected.
PART II OTHER INFORMATION
Termination of Ilan Bunimovitz as CEO and Subsequent Litigation
On July 19, 2010, Ilan Bunimovitz was terminated as Chief Executive Officer of Private Media Group, Inc. Mr. Bunimovitz was employed as CEO since 2009 pursuant to a written employment agreement, which agreement was terminated by the Company under provisions allowing it to terminate the agreement for cause (as defined in such agreement). Conduct of Mr. Bunimovitz constituting cause included breach of fiduciary duty, conflict of interest, material acts of dishonesty and violations of the Companys Code of Ethics. Mr. Bunimovitzs termination for cause was unanimously approved by all three independent directors and a majority of the disinterested directors. Mr. Bunimovitz continues to serve as a director of the Company for the remainder of his term, which expires at the Companys 2010 Annual Meeting of Shareholders.
Immediately following Bunimovitzs termination, he instituted two legal proceedings against the Company, both of which are without merit and are being contested vigorously by the Company. These legal proceedings are described below under Employment Arbitration and U.S. Department of Labor Claim and Nevada State Court Action.
Employment Arbitration and U.S. Department of Labor Claim
On July 23, 2010, Mr. Bunimovitz filed a Demand for Arbitration and related Statement of Claim against the Company with JAMS (Case No. 1100063395), a private arbitration service, pursuant to the dispute resolution provisions of his Employment Agreement, contesting his termination as CEO. In the Statement of Claim, Mr. Bunimovitz alleges that (1) his termination on July 19, 2010, was without cause under his written Employment Agreement; (2) the termination was taken in retaliation for Mr. Bunimovitz demanding an independent investigation of Berth Miltons alleged self-dealing transactions and was taken in an effort to silence him; and (3) the termination of employment was not properly authorized by the Board of Directors, and is therefore invalid. Mr. Bunimovitz seeks declaratory relief that the termination was without legal effect and unspecified compensatory and punitive damages. On August 6, 2010, the Company filed an Answer, denying Mr. Bunimovitzs allegations in all material respects. The Company and GameLink, a wholly owned subsidiary, have also filed a Cross-Claim against Mr. Bunimovitz for breach of contract and conversion, based upon his failure to return property belonging to Private which Bunimovitz had wrongfully refused to turn over to the Company at the time of his termination.
Although Bunimovitz claims that he was terminated in retaliation for demanding an independent investigation of self-dealing transactions on June 8, 2010, in fact both Mr. Bunimovitz and his personal legal counsel were aware of the request made by the Chairman to the Board of Directors to terminate Bunimovitz for cause since at least May 5, 2010. The alleged self-dealing transactions of which Mr. Bunimovitz complains include payment of rent for the Chairmans personal offices, the failure of the Chairman to repay a multi-million dollar loan from the Company and unauthorized cash payments that the Chairman be directed to himself, transactions which were under review by the independent directors since January 2010 and disclosed in the Companys SEC reports, to the extent required by SEC rules. In particular, Form 8-K filed with the SEC on March 11, 2010, addressed in detail payments made to Mr. Milton in 2009, and their approval by the Board of Directors. In addition, Item 13 in the Companys ANNUAL REPORT on Form 10-K filed with the SEC on May 25, 2010, addressed in detail the status of the loan transaction. Mr. Bunimovitz signed this ANNUAL REPORT on Form 10-K as CEO and director and personally certified the accuracy and completeness of this filing pursuant to the provisions of the
Sarbanes-Oxley Act of 2002. As required by Nasdaq corporate governance rules, all related party transactions involving directors and officers continue to remain under the ongoing review of the Audit Committee, comprised solely of three independent directors, to ensure fairness of these transactions to the shareholders.
On September 24, 2010, the Company received notice of Claims filed by Bunimovitz with the U.S. Department of Labor against Private (Case No. 9-3290-10-057) alleging that Bunimovitz was terminated as CEO by Private in violation of Section 806 of the Sarbanes-Oxley Act in retaliation for Bunimovitz raising questions about self-dealing transactions involving the Chairman of the Company and the accuracy of the Companys public disclosures in light of these transactions, and seeking reinstatement and unspecified compensatory and punitive damages. The Company has filed an Answer denying these claims.
Nevada State Court Action
On August 11, 2010, Mr. Bunimovitz, together with Consipio Holding BV and Tisbury Services Inc., filed a Complaint against Private Media Group, Inc. in Nevada County Court, Clark County, Nevada (Case No. A-10-622802-B) alleging mismanagement of the Companys business by the Companys three independent directors, Johan G. Carlberg, Peter Dixinger and Bo Rodebrandt, and Berth Milton, the Companys Chairman and CEO, and seeking to have Mr. Bunimovitz and another non-independent director, Eric Johnson, appointed as receivers to run the business and affairs of Private, to the exclusion of the other directors. The Complaint also sought an injunction which, if granted, would prevent Private from issuing any stock, borrowing any money or taking any other action outside the ordinary course of business. The Complaint does not name any defendant other than the Company. The matter was set by the Court for a Preliminary Hearing on September 3, 2010, to determine whether the Plaintiffs were entitled to any of the requested relief. On August 25, 2010, the plaintiffs amended the Complaint by adding an additional cause of action as a shareholder derivative suit against Messrs. Carlberg, Dixinger, Rodebrandt, and Milton, as well as the Companys CFO, Johan Gillborg, and Phil Christmas, the Financial Director of Privates principal operating subsidiary, alleging gross mismanagement and breach of fiduciary duty, arising out of transactions between the Company and Milton or his affiliates, including the failure of an affiliate of Milton, Slingsby Enterprises Limited, to repay a related party receivable in excess of EUR 7 million, and compensation paid to Milton in 2009 without prior Board approval. On September 3, the Company filed Counterclaims against Bunimovitz and Consipio, alleging that Bunimovitz breached his fiduciary duty as a director and CEO of Private by improperly conspiring with Consipio, a creditor of the Company, to take over control of the Company, and seeking unspecified damages.
On August 13, 2010, the Plaintiffs also requested the Court to grant a temporary injunction, to remain in effect until the Preliminary Hearing on September 3, which, if granted, would have prohibited the Company from engaging in any transaction outside the ordinary course of business. The Court denied the Plaintiffs requested temporary relief, but issued a temporary order, to remain in effect until the conclusion of a Preliminary Hearing, requiring Private to seek permission of the Court to hold any special Board meeting.
The Preliminary Hearing commenced on September 3, 2010 before Presiding Judge Elizabeth Gonzalez to determine whether the Plaintiffs were entitled to appointment of a receiver or other injunctive relief. On November17, 2010, following the conclusion of the Preliminary Hearing, the Court denied the Plaintiffs request for appointment of a receiver, determining that the statutory requirements to appoint a receiver to address alleged mismanagement were not met. The Court also modified its temporary order issued on August 13, 2010. As modified, the preliminary injunction requires Private to seek permission of the Court to hold any special Board of Directors meeting. The preliminary injunction also requires that all transactions outside of the ordinary course of business be approved by a majority of disinterested directors
without such directors receiving any advice from current management or its current outside legal counsel. Further, although the Preliminary Injunction contains a specific finding by the Court that it has found no violation of any federal rule or listing requirement regarding the issuance of shares, self-dealing or misappropriation, allegations contained in the Complaint, the Court made a preliminary finding that the failure of Private to demand repayment of related party receivables from Slingsby Enterprises Limited (currently 7.4 million EUR at September 30, 2010), much of which has been outstanding since at least 2002, is a violation by the Company of the provisions of Section 402 of the Sarbanes-Oxley Act, and that the Company has an obligation to bring legal proceedings to enforce repayment of the outstanding amount. This finding appears to be based upon an interpretation by the Court of Section 402 which the Company believes is erroneous. The Court seems to have concluded that because Mr. Milton may have indirectly personally benefitted from the extension of indebtedness to his controlled companies arising out of business transactions with the Company, the continued extension of this indebtedness constitutes a personal loan to or for the benefit of any director or executive officer within the meaning of Section 402 of SOX. The Company believes that this preliminary ruling misstates the scope and purpose of Section 402, which was to prohibit personal loans to affiliates, but not to prohibit incurring indebtedness in connection with bona fide business transactions between the Company and an affiliate.
The Preliminary Injunction also contains preliminary findings that notwithstanding approval by all three independent directors and a majority of the disinterested directors of a retention bonus of EUR139,000 awarded to Mr. Milton in March 2010, the retention bonus was improper and the bonus should be returned. Specifically, the Court made preliminary findings that this decision was improperly influenced by statements made by Mr. Milton in a Board of Directors meeting that he would resign and sell his position in the Company if he was not adequately compensated, and the advice of the Companys outside legal counsel that the directors should consider the advisability of granting a retention bonus, a subject that had not been considered by the directors prior to counsels advice.
The Company believes that the allegations in the Complaint against the Company and the named directors and officers and the findings of the Court in the Preliminary Injunction are without merit , and that the Company and the individual defendants will prevail upon the conclusion of this proceeding. The Company and the individual defendants also intend to file motions in this proceeding prior to trial seeking dismissal of the claims.
The Company further believes that this litigation is an improper attempt to circumvent valid and lawful actions of the disinterested majority of the Board of Directors, including all three independent directors, and to instead place control of the Company in the hands of a disgruntled former employee (Bunimovitz), his former subordinate employee (Eric Johnson) and a creditor (Consipio Holding BV) with whom the Company has been in a protracted and heavily litigated dispute reported in SEC filings since 2003. Consipio, in addition to being a creditor, is also an affiliate of a competitor of Private, Beate Uhse, AG, an adult entertainment company listed on the Frankfurt Stock Exchange. For further information regarding the other litigation with Consipio see Part I Item 2. - Managements Discussion and Analysis of Financial Condition and Results of Operations - Disputed Contractual Obligation appearing elsewhere in this Report, and Consipio Holding BV vs. Private Media Group, Inc. and Slingsby Enterprises Limited, New York State Supreme Court, County of New York, Case No. 650462/10, which appears in this Item 1 below.
The Company also believes that the actions of Mr. Bunimovitz as a director since he was terminated as CEO, including pursuing a lawsuit with a creditor with whom the Company is in protracted litigation, are a clear and serious breach of his fiduciary duties, and have been taken in bad faith to advance the personal
interests of Mr. Bunimovitz. Accordingly, the Company has filed counterclaims against Bunimovitz in this proceeding, discussed above, seeking monetary damages and other appropriate relief.
Consipio Holding BV vs. Private Media Group, Inc. and Slingsby Enterprises Limited, New York State Supreme Court, County of New York, Case No. 650462/10
On May 1, 2009, Consipio Holding BV filed a lawsuit against the Company asserting a claim for unspecified damages under a Note dated December 21, 2001 in the original principal amount of $4,000,000, which was guaranteed by Slingsby Enterprises Limited, an affiliate of the Companys Chairman and principal shareholder. The guarantee was secured by a pledge of 1,650,000 shares of the Companys common stock, and Slingsbys agreement to pledge an additional 3,950,000 upon the occurrence of an event of default. The Company filed its Answer and asserted several affirmative defenses. On March 26, 2010, the Court dismissed the lawsuit, finding that U.S. federal courts did not have jurisdiction over the subject matter of the lawsuit.
On August 12, 2010, the Company received notice that Consipio had refiled a Complaint against the Company and Slingsby to enforce the Note and guaranty in New York State Court, entitled Consipio Holding BV v. Private Media Group, Inc. and Slingsby Enterprises Limited (Case No. 650462/10). The new Complaint contained allegations and sought relief similar to the allegations and relief sought in the case previously filed on May 1, 2009, in U.S. federal court. Both the Company and Slingsby intend to vigorously defend against these claims. On October 12, 2010, Slingsby Enterprises Limited filed a Motion to dismiss the claims against it under the guaranty and related pledge agreement based upon the position that Consipios claims against Slingsby are time barred under the statute of limitations. In November 2010 the Company filed an Answer, and included affirmative defenses, including claims of substantial offsets to the amounts due under the Note. For additional information relating to this litigation see Part I Item 2. - Managements Discussion and Analysis of Financial Condition and Results of Operations - Disputed Contractual Obligation appearing elsewhere in this Report.
Pursuant to the requirements 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.