The Daily Magic Formula Stock for 02/28/2008 is New Frontier Media Inc. According to the Magic Formula Investing Web Site, the ebit yield is 15% and the EBIT ROIC is 75-100%.
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New Frontier Media, Inc. is a leader in the production and distribution of adult themed and general motion picture entertainment. Our key customers are large cable and satellite television operators in the United States who sell our products to their retail customers via Pay-Per-View (â€śPPVâ€ť) and Video-on-Demand (â€śVODâ€ť) technology. We earn revenue through contractual percentage splits of the retail price.
New Frontier Media is organized into three reporting segments:
Pay TV Group â€” Our Pay TV Group aggregates and distributes branded adult television programming to cable and satellite television companies via pay-per-view and video-on-demand technology.
Film Production Group â€” Our Film Production Group produces original adult themed movies, series and events for distribution to the same cable and satellite companies which are customers of our Pay TV Group. The Film Production Group also delivers original programming to premium television services such as Cinemax, Showtime and Starz!. Additionally, our Film Production Group represents domestic, third-party films in international and domestic markets. Our Film Production Group was created on February 10, 2006, when we completed an acquisition of MRG Entertainment, Inc., its subsidiaries and a related company, Lifestyles Entertainment, Inc. (collectively â€śMRGâ€ť).
Internet Group â€” Our Internet Group distributes adult content via the internet and wireless devices. Our Internet Group derives its revenue primarily from direct consumer subscriptions to its broadband web site, www.ten.com.
PAY TV GROUP
Under our registered trademark The Erotic Networks Â®, our Pay TV Group digitally distributes adult entertainment programming to cable and satellite television companies. The National Cable & Telecommunciations Association (â€śNCTAâ€ť) estimates that there are nearly 95 million cable and satellite television homes in the United States, of which approximately 60 million are digital subscribers. 100% of all satellite homes are digital and, according to the NCTA, the number of digital cable subscribers has increased to 32.6 million as of December 31, 2006 from 28.5 million as of December 31, 2005, representing an increase of 14% and resulting in digital cable penetration of over 50% of total basic cable subscribers.
Cable and satellite television providers distribute our Pay TV Groupâ€™s content on a pay-per-view basis. Pay-per-view offers consumers access to a timed block of programming â€” for example, a movie or an event â€” for a set fee payable to the cable or satellite providers. Our pay-per-view programming is offered on linear channels that are available to viewers through the same electronic program guides that display basic cable channels. A pay-per-view transaction allows access to the channel for a given period of time and is executed either by telephone or instantly through the use of the viewersâ€™ remote control. Our Pay TV Groupâ€™s products typically retail for a price between $8.99 and $12.99 for a single movie or event. Some of our distributors offer our Pay TV Groupâ€™s programming on a monthly subscription basis as well.
Cable television operators also offer our Pay TV Groupâ€™s programming via their video-on-demand platforms. Video-on-demand presents viewers with nested menus, similar to what is traditionally found in hotel room television offerings. These menus allow users to interactively select a movie or event and then view it immediately upon execution of the transaction. Video-on-demand products typically sell for prices similar to those of pay-per-view. Video-on-demand tends to have an accretive impact on our Pay TV Groupâ€™s business because instant start times assure that an impulse demand results in a transaction, whereas with pay-per-view, the scheduled start time may not be synchronized to a viewerâ€™s requirements. As of March 31, 2007, our distribution data indicates that video-on-demand is available to an estimated 28 million U.S. homes. Our Pay TV Group presently provides programming to 26 million video-on-demand homes in the U.S. MAGNA Global Research estimates that the number of video-on-demand households will grow to 63.0 million by the year 2010.
Pay-per-view and video-on-demand programming competes well with other forms of entertainment because it is offered conveniently in the comfort of usersâ€™ homes, in high quality, and at a reasonable price point. Kagan Research LLC (â€śKaganâ€ť) estimates that adult pay-per-view and video-on-demand revenue generated by cable and satellite providers in 2004 was $761 million (most recent data available). As the number of cable operators that offer adult content increases and distributors continue to expand their offerings, Kagan projects revenues from the adult product category will grow to $1.4 billion by the year 2014. During our fiscal years ended March 31, 2005, 2006 and 2007, 94%, 92% and 75%, respectively, of our consolidated revenues was attributed to our Pay TV Group.
As of March 31, 2007, our Pay TV Group distributed content to nearly every television provider in the United States, including:
â€˘ The two largest providers of Direct Broadcast Satellite services (â€śDBSâ€ť), EchoStar Communications Corporationâ€™s DISH Network (â€śDISH Networkâ€ť) and The DIRECTV Group (â€śDirecTVâ€ť). According to public filings, these providers serve approximately 28.0 million customers in the U.S. Kagan estimates that the number of DBS subscribers will grow to 35.4 million by the year 2015.
â€˘ Nine of the top ten largest operators of cable television systems in the U.S. (Multiple System Operators or â€śMSOsâ€ť). Together, these operators control access to 55.4 million, or 84%, of the total basic cable household market. According to the NCTA, as of December 2006 cable MSOs delivered service to 65.6 million basic cable households in the U.S. As of March 31, 2007, the only major MSO not under contract with our Pay TV Group has delivery capability to approximately 3.1 million basic cable customers in the New York City metropolitan area. We anticipate launching our video-on-demand content on this MSOâ€™s platform during the first half of our 2008 fiscal year.
The Erotic Networks
Our Pay TV Group delivers its services to operators as well as consumers under the trademark The Erotic Networks Â® (â€śTENâ€ť). Primary research conducted during our 2007 fiscal year for our Pay TV Group by a leader in programming research revealed that â€śThe Erotic Networksâ€ť is, by many measures, the most appealing trademark within the adult entertainment competitive set. For example, the research demonstrated that end users were more likely to select â€śThe Erotic Networksâ€ť as a program choice than they were any other tested trademark (including, among others, â€śPlayboy,â€ť and â€śSpiceâ€ť).
Unlike its competitors (such as Playboy Enterprises, Inc. which is a major producer of explicit content), our Pay TV Group does not produce its own content â€” nor does it seek to. We believe that content production forces distributors to pay undue attention to company-owned productions and, therefore, limits viewer quality and variety. Instead, our Pay TV Group screens thousands of hours of content from many independent producers each year. We then strategically select and license only those movie titles which fit into our proprietary programming strategy. The result is a wide range of premium content which, in terms of consumer purchase, consistently outperforms our competition. Independent tracking research conducted by Rentrak Corporation demonstrates that our Pay TV Group content outperforms its closest competition by a rate of at least 25%. This research is consistent with other data that our Pay TV Group receives from its cable and satellite partners.
The Erotic Networksâ€™ programming is designed to provide the widest variety of content to consumers while at the same time supporting an efficient use of our content library. Because The Erotic Networks does not duplicate titles across its channels or between pay-per-view and video-on-demand in a single month, we are able to give our consumers access to more unique titles, a wider variety of talent, and a greater variety of studio representation than any of our competitors. We focus on prime time viewing blocks and program specific types of content in those blocks to create an appointment-viewing calendar designed to drive viewers to traditionally less popular nights of the week for viewing adult content. All networks are counter-programmed to one another, creating an even greater level of variety for consumers with access to multiple channels. Presently, we have 2.5 services per unique household served.
Description of Networks
Our Pay TV Group provides the following 24-hour per day, seven days per week, adult pay-per-view television networks: Pleasure, TEN Â® , TEN*Clips Â® , TEN*Blue Â® , TEN*Blox Â® , and Xtsy Â® .
(1) TEN and TEN*Clipsâ€™ addressable household numbers include 61,000 C-Band addressable households for the year ended March 31, 2007. Xtsy and TEN*Clipsâ€™ addressable household numbers include 0.1 million and 0.2 million C-Band addressable households for the years ended March 31, 2006 and 2005, respectively. During the 2007 fiscal year, we began to program TEN in two editing standards to better serve the C-Band, DBS and cable markets.
(2) Reflects network household distribution. A household will be counted more than once when determining total network households if the home has access to more than one of the Pay TV Groupâ€™s services, since each service represents an incremental revenue stream. The Pay TV Group estimates its unique household distribution as of March 31, 2007, 2006, and 2005 to be 27.2 million, 23.6 million, and 23.1 million cable homes, respectively, and 28.6 million, 12.2 million, and 11.0 million DBS homes, respectively.
(3) TEN*Max was renamed TEN*Clips during the fiscal year ended March 31, 2007 and is now programmed in two editing standards to better serve the C-band, DBS and cable markets.
(4) We launched a new network in May 2007 called Real Â® . This service is distributed to cable MSOs and DBS providers and will replace our Pleasure service in many markets. We anticipate that Pleasure will no longer be distributed by the end of our 2008 fiscal year.
Pay TV Groupâ€™s Content Delivery System
Our Pay TV Group delivers its video programming to cable and satellite operators via satellite. Satellite delivery of video programming is accomplished as follows:
Video programming is distributed directly from our Pay TV Groupâ€™s Boulder, Colorado Digital Broadcast Center (â€śDBCâ€ť). The program signal is encrypted so that the signal is unintelligible unless it is passed through the properly authorized decoding devices. The signal is transmitted (uplinked) by a third party earth station to a designated transponder on a third party commercial communications satellite. The transponder receives the program signal uplinked by the earth station, amplifies the program signal and then broadcasts (downlinks) it to commercial satellite dishes located within the satelliteâ€™s area of signal coverage. The signal coverage of the domestic satellites that we use is the continental United States, Hawaii, Alaska, and portions of the Caribbean, Mexico, and Canada.
Our Pay TV Groupâ€™s programming is downlinked by MSOs and DBS providers at their headends and uplink centers. This programming is received in the form of a scrambled signal. We provide these operators with decoder equipment which allows them to decode the signal and then re-distribute it via their own systems.
Our Pay TV Group maintains satellite transponder lease agreements for two full-time analog transponders with Intelsat USA Sales Corporation (Intelsat) on its Intelsat Americas 6 satellite and 20.5 MHz of total bandwidth allocation on a digital transponder on its Intelsat Americas 13 satellite. These transponders provide the satellite transmission necessary to broadcast each of our Pay TV Groupâ€™s networks.
Our Pay TV Group delivers its VOD service to cable MSOs via Comcast Media Center (â€śCMCâ€ť). CMC is a business unit of Comcast Cable, which is a division of Comcast Corporation (â€śComcastâ€ť). CMC delivers content to headends currently serving Comcastâ€™s VOD-enabled cable systems. In addition, our Pay TV Group has agreements with iN DEMAND L.L.C. (â€śIn Demandâ€ť), TVN Entertainment and Global Digital Media Xchange to deliver video-on-demand content to other cable MSOs.
Digital Broadcast Center
Our Pay TV Group operates a 12,000 square foot DBC that allows us to ingest, encode, edit, play out, and digitally deliver our pay-per-view and video-on-demand services. The DBC is also home to our content library comprising over 10,000 hours of digital content.
The DBC is a scalable, state of the art infrastructure, which includes playlist automation for all channels; SeaChange MPEG 2 encoding and playout to air; a storage area network for near-line content movement and storage; archiving capability in a digital format; and complete integration of our proprietary media asset management database for playlist automation and program scheduling.
We acquire our feature-length broadcast programming for each network by licensing the exclusive domestic broadcast rights from over forty-five independent producers. These licenses generally cover a five-year term. We do not produce any of our own feature content for our networks. We acquire new premiere titles each month. In addition, we may license entire content libraries on an as-needed basis, or in order to facilitate a larger transaction. Library content are titles that have generally been produced within the last three years but have never been broadcast on a cable television or DBS platform in the U.S.
Once we license a title, it undergoes rigorous quality control processes prior to broadcast in order to ensure compliance with strict internal broadcasting standards. We obtain age verification documentation for each title we license, including two forms of photo identification for each cast member in the film. This documentation is maintained on site for the duration of the license term in accordance with 18 U.S.C. Â§ 2257.
We maintain an office in California that ensures all legal documentation is obtained for each title licensed (i.e., cast lists, talent releases and two photo identifications for each cast member), screens the content to ensure the commercial and broadcast viability of the title, and once the title is deemed acceptable, this office ships the title, related documentation and promotional content to our Boulder location. Our Pay TV Groupâ€™s in-house programming and editing departments in Boulder, Colorado conduct preliminary screening of potentially licensable content, licenses acceptable content, conforms content into appropriate editing standards (i.e., partially edited, least edited and most edited) and programs the monthly schedules for all networks and video-on-demand services.
Historical competition has come from Playboy Enterprises, Inc. (â€śPlayboyâ€ť) which, through its PlayboyTV service and its Spice Digital Networks, has a long operating history in this space. We compete with Playboy with respect to all aspects of our contractual relationships with distributors. Almost all of our Pay TV Groupâ€™s growth in the pay-per-view and video-on-demand marketplace has come at the expense of Playboy. We believe that since inception, our services have replaced Playboy services in more than 60 million network homes.
In order for Playboy to maintain its shelf space on numerous platforms, it has reduced the contractual percentage split it earns from operators to a level below that of our Pay TV Group. As revealed in exhibits attached to Playboyâ€™s Form 10-K for the period ending December 31, 2006, it has also made extravagant minimum revenue guarantees to operators which we believe will result in further decreases in the effective rate operators pay to Playboy. We believe that as a result of these guarantees, some operators will pay a zero license fee for Playboyâ€™s services. While we believe that our products continually outperform Playboyâ€™s, we cannot predict the long term impact of Playboyâ€™s price cutting strategy.
Other competitors such as Hustler and Playgirl have entered the video-on-demand market. While there can be no assurance that our Pay TV Group will be able to maintain its current distribution and fee structures in the face of competition, we believe that the quality and variety of our programming, and our ability to generate higher buy rates for our programming, are the critical factors which have influenced cable operators and DBS providers to choose our programming over our competition.
We face competition in the adult entertainment arena from other providers of adult programming including producers of adult content, adult video/DVD rentals and sales, books and magazines aimed at adult consumers, telephone adult chat lines, adult-oriented internet services and adult-oriented wireless services. Our Pay TV Group also faces general competition from other forms of non-adult entertainment, including sporting and cultural events, other television networks, feature films, and other programming.
FILM PRODUCTION GROUP
Our Film Production Group is a multi-faceted film production and distribution company, which we acquired in February 2006. We acquired the Film Production Group to expand our portfolio to the rapidly growing and higher margin market for less explicit erotic content. This acquisition also provides established relationships in international markets and provides access to a library of content that can be monetized through our current distribution networks.
The Film Production Group derives revenue from two principal businesses: the production and electronic distribution of original motion pictures (â€śowned productâ€ť) and the licensing of domestic third party films in international and domestic markets where it acts as a sales agent for the product (â€śrepped productâ€ť).
Our Film Production Group develops and produces original, erotic thriller movies and series, as well as adult themed events and reality programming. Our customers include cable and satellite companies in the U.S., Canada, and the U.K., as well as premium movie services (such as Cinemax and Showtime) in the U.S., Europe, and Latin America.
Our Film Production Group provides movie and event content to cable and satellite television companies for distribution on a pay-per-view and video-on-demand basis. The content that is distributed through pay-per-view appears on unbranded linear channels within the mainstream or adult pay-per-view movie neighborhood of the platformâ€™s electronic programming guide. Revenue is impacted by the number of plays that each distributor programs on a monthly basis. Content that is distributed through video-on-demand appears within menu categories such as â€śuncensored.â€ť Our movies and events are sold to end users at retail prices ranging from $3.99 to $14.95. We generally receive a percentage share of the revenue derived from sales on these platforms. Revenue splits for this business segment are greater than those earned by our Pay TV Group due to the more mainstream nature of this content.
Movies provided to premium movie services are sold for a flat license fee and are used as part of the servicesâ€™ late-night programming and within their subscription video-on-demand product.
The Film Production Group produced 40 - 50 hours of new content with an annual production budget of approximately $2.6 million during the fiscal year ended March 31, 2007. The group uses outside production companies to shoot the content while providing in-house oversight of all critical areas such as scripting, casting, shoot location, and post production.
Sales Agency (Repped Product) Business
Our Film Production Group establishes relationships with high-quality, independent mainstream filmmakers to license international and domestic rights to their movies under its Lightning Entertainment label. Today, the Lightning portfolio consists of over 40 titles. In addition, we have 50 third party titles that we represent under our Mainline Releasing label. Most recently, our Film Production Group acquired the international distribution rights for Junebug, winner of a Special Jury Prize at the 2005 Sundance Film Festival, Walmart: The High Cost of Low Prices, and Conversations with God.
We earn a commission for licensing the rights on behalf of these producers. In addition, we earn a marketing fee for most titles that we represent. Each contract allows for the recoupment of costs incurred in preparing the title for market, including advertising costs, screening costs, costs to prepare the trailer, box art, screening material, and any costs necessary to ensure the movie is market ready.
For our owned content, we compete primarily with one small, privately-owned company and with other branded content such as Girls Gone Wild and Jerry Springer Uncensored. With respect to our international sales agency business, we compete with approximately 30 privately-owned companies. We compete with these companies based on licensing fees charged, content quality, ability to deliver our products on time, relationships with decision makers in the industry, and the professionalism of our sales team.
Our Internet Group derives revenue mainly via subscriptions to its broadband content site at www.ten.com . This site features over 2,000 hours of video content. Content for the site comes mainly via the licensing agreements executed by our Pay TV Group for broadcast rights. Ten.com is offered to consumers on a monthly subscription basis for $19.95.
Traffic to ten.com is derived via a targeted network of affiliates which direct traffic to ten.com and are compensated when traffic converts into paying members. Ten.com also gets â€śtype-inâ€ť traffic in which users navigate directly to the site, by typing the address into their web browsers. In addition, our Internet Group has begun developing relationships with satellite and cable providers in which traffic from internet sites owned by these providers is directed to ten.com.
Monthly subscription revenue declined during the fiscal year ended March 31, 2007, as the Internet Group was not attracting enough new traffic to ten.com to offset the churn of its recurring membership base. Revenue also declined in connection with a price change from $29.95 to $19.95 which occurred at the end of our current fiscal year.
Our Internet Group is also focused on the exploitation of wireless technology for the delivery of content. We have taken a multi-faceted approach to wireless including efforts in on-platform wireless content, which is deployed by the wireless carriers themselves, efforts focused on content aggregators which sell to wireless platforms, the deployment of a mobile version of our ten.com web site, as well as development of multiple programs which employ Short Message Service technology (â€śSMSâ€ť).
An October 2005 report by the Yankee Group, a research and consulting firm, forecasts that the mobile adult content market in the U.S. could reach $0.8 billion by 2009. This estimate assumes that adult content providers can use the carriersâ€™ billing systems easily and that consumers can easily sign up for and use these services. A report by Strategy Analytics, an independent global research and consulting firm, forecasts that the mobile adult services market is set to reach $5 billion worldwide by 2010.
The market for mobile content is continuously evolving. We believe that the â€śalways onâ€ť capability of the phone will drive the market for mobile content. In addition, improvements in user interfaces will make it easier to obtain content, making it more intuitive and more like that of the internet, making it simpler to purchase content with fewer button-clicks. Further, the continued rollout of third-generation (3G) mobile phones will also drive the market for video mobile content.
To date, the market for wireless adult content has been challenging in light of a range of factors including difficulty in attaining direct relationships with wireless carriers, lower margins connected when transacting with aggregator intermediaries and slow growth in adult content connected with carrier unwillingness to carry such content on their platforms. This last obstacle is particularly acute in the North American market, and less so in parts of Europe. At this time we have determined that further investment in this category cannot be justified with an appropriate return on investment.
The adult internet industry is highly competitive and highly fragmented given the relatively low barriers to entry. The leading adult internet companies are constantly vying for more members while also seeking to hold down member acquisition costs paid to webmasters.
We believe that the primary competitive factors in the adult internet industry include the quality of content, technology, pricing, and sales and marketing efforts.
We derived 21%, 14%, 13%, and 12% of our total revenue for the year ended March 31, 2007 from DISH, Comcast, DirecTV, and Time Warner Cable (â€śTime Warnerâ€ť), respectively. DISH, Comcast, DirecTV, and Time Warner are customers of our Pay TV Group. DISH, DirecTV and Comcast are also customers of our Film Production Group. The loss of any of these major customers would have a material adverse effect on the Pay TV and Film Production Group segments and upon the Company as a whole.
As of the date of this report, we had 162 employees. Our employees are not members of a union, and we have never suffered a work stoppage. We believe that we maintain a good relationship with our employees.
Financial Information about Segments and Geographic Areas
Our revenue is primarily derived from within the United States. Financial information about segments and geographic areas is incorporated herein by reference to Note 11 â€śSegment Informationâ€ť of the Notes to the Consolidated Financial Statements that appears in Item 8 of this Form 10-K.
We file annual, quarterly and current reports, proxy statements and other information with the Securities and Exchange Commission (â€śSECâ€ť). You may read and copy any document the Company files at the SECâ€™s public reference room at Room 1580, 100 F Street, NE, Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for information on the public reference room. The SEC maintains a web site (www.sec.gov) that contains annual, quarterly and current reports, proxy statements and other information that issuers (including the Company) file electronically with the SEC.
We make available, free of charge through our web site (www.noof.com), our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, Forms 3, 4 and 5 filed on behalf of directors and executive officers, and any amendments to those reports filed or furnished pursuant to the Securities Exchange Act of 1934 as soon as reasonably practicable after such material is electronically filed with, or furnished to, the SEC. The information on our web site is not incorporated by reference into this report.
Michael Weiner. Mr. Weiner was appointed President of New Frontier Media in February 2003 and was then appointed to the position of Chief Executive Officer in January 2004. Prior to being appointed President, he held the title of Executive Vice President and co-founded the Company in 1995. As Executive Vice President, Mr. Weiner oversaw content acquisitions, network programming, and all contract negotiations related to the business affairs of the Company. In addition, he was instrumental in securing over $20 million to finance the infrastructure build-out and key library acquisitions necessary to launch the Companyâ€™s seven television networks.
Mr. Weinerâ€™s experience in entertainment and educational software began with the formation of Inroads Interactive, Inc. in May 1995. Inroads Interactive, based in Boulder, Colorado, was a reference software publishing company dedicated to aggregating still picture, video, and text to create interactive, educational-based software. Among Inroad Interactiveâ€™s award winning releases were titles such as Multimedia Dogs, Multimedia Photography, and Exotic Pets. These titles sold over 1 million copies throughout the world through its affiliate label status with Broderbund Software and have been translated into ten different languages. Mr. Weiner was instrumental in negotiating the sale of Inroads Interactive to Quarto Holdings PLC, a UK-based book publishing concern.
Prior to this, Mr. Weiner was in the real estate business for 20 years, specializing in shopping center development and redevelopment in the Southeast and Northwest United States. He was involved as an owner, developer, manager, and syndicator of real estate in excess of $250 million.
Karyn L. Miller. Ms. Miller joined New Frontier Media in February 1999 as Chief Financial Officer. She began her career at Ernst & Young in Atlanta, Georgia and brings eighteen years of accounting and finance experience to the Company. Prior to joining the Company, Ms. Miller was the Corporate Controller for Airbase Services, Inc. a leading aircraft repair and maintenance company. Previous to that she was the Finance Director for Community Medical Services Organization and Controller for Summit Medical Group, P.L.L.C. Before joining Summit Medical Group, P.L.L.C., Ms. Miller was a Treasury Analyst at Clayton Homes, Inc., a former $1 billion NYSE company which was purchased by Berkshire Hathaway, Inc. in 2003. Ms. Miller graduated with Honors with both a Bachelors of Science degree and a Masters in Accounting from the University of Florida and is a licensed CPA in the state of Colorado.
Ken Boenish. Mr. Boenish is an 18-year veteran of the cable television industry. In October 2000, he was named President of The Erotic Networks and in June 2005 he was named President of New Frontier Media. Mr. Boenish joined The Erotic Networks as the Senior Vice President of Affiliate Sales in February 1999. Prior to joining the Company, Mr. Boenish was employed by Jones Intercable (â€śJonesâ€ť) from 1994 to 1999. While at Jones he held the positions of National Sales Manager for Superaudio, a cable radio service serving more than 9 million cable customers. He was promoted to Director of Sales for Great American Country, a new country music video service, in 1997. While at Great American Country, Mr. Boenish was responsible for adding more than 5 million new customers to the service while competing directly with Country Music Television, a CBS cable network. From 1988 to 1994 he sold cable television advertising on systems owned by Time Warner, TCI, COX, Jones, Comcast and other cable systems. Mr. Boenish holds a B.S. degree in Marketing from St. Cloud State University.
Ira Bahr. Mr. Bahr joined New Frontier Media in January 2006 as Vice President of Marketing and Corporate Strategy and was named Chief Operating Officer in April 2007. Prior to joining New Frontier Media he served in a number of positions with Echostar Communications Corporation including Senior VP of Marketing for Dish Network and President of BingoTV, an interactive game channel owned by Echostar. Previous to his tenure with Echostar, Mr. Bahr was the number two executive at Sirius Satellite Radio serving as the companyâ€™s Senior VP, Marketing, Alliances, and Communications. At Sirius, Mr. Bahr was the executive responsible for forging the companyâ€™s relationships with automobile and radio manufacturers. In addition, he was instrumental in the acquisition of over $1 billion in capital financing and was the driving force behind the companyâ€™s name change from CD Radio in 1999.
From 1985 to 1998, Mr. Bahr was a senior executive at BBDO Worldwide, one of the worldâ€™s largest advertising and marketing firms. At BBDO, he developed domestic and international marketing plans and communications programs for a range of companies including GE, Pepsi Cola, and FedEx. Mr. Bahr holds a Bachelor of Arts degree from Columbia University.
Scott Piper . Mr. Piper joined New Frontier Media, Inc. in February 2007 as Chief Information Officer. Mr. Piper has been an IT professional for approximately 18 years and has held senior IT eadership roles for the past 11 years. He has extensive experience in IT infrastructure design and delivery for large scale enterprises, including the implementation of over fifteen customer contact centers, some with as many as 1,500 seats. He was responsible for one of the first successful large Voice over IP (â€śVoIPâ€ť) contact centers in the U.S.
Prior to joining New Frontier Media, Mr. Piper was employed from 1994 to 2006 by EchoStar Satellite L.L.C., the parent company to the DISH Network. While employed in a variety of roles during his tenure at EchoStar, he most recently held the title of Vice President of IPTV. Mr. Piper was responsible for the launch of DISH Networkâ€™s web based entertainment portal prior to his departure.
Mr. Piper holds a Bachelor of Science in Marketing and Finance from the University of Colorado and a Masters in Science in Telecommunications from the University of Denver.
Compensation Philosophy and Objectives
Our executive compensation program is designed to attract, retain, and motivate superior executive talent and to align their interests with those of our shareholders and support our growth and profitability. Consistent with those purposes, our compensation philosophy embodies the following principles:
â€˘ the compensation program should reward the achievement of our strategic initiatives and short- and long-term operating and financial goals, and provide for consequences for underperformance;
â€˘ compensation should reflect differences in position and responsibility;
â€˘ compensation should be comprised of a mix of cash and equity-based compensation that aligns the short- and long-term interests of our executives with those of our shareholders; and
â€˘ the compensation program should be understandable and transparent.
In structuring a compensation program that implements these principles, we have developed, with the assistance of an executive compensation consulting firm, Mercer Human Resource Consulting, the following objectives for our executive compensation program:
â€˘ overall compensation levels should be competitive and should be set at levels necessary to attract and retain talented leaders and motivate them to achieve superior results;
â€˘ a portion of total compensation should be contingent on, and variable with, achievement of objective corporate performance goals;
â€˘ total compensation should be higher for individuals with greater responsibility and greater ability to influence our achievement of operating and financial goals and strategic initiatives;
â€˘ the number of different elements in our compensation program should be limited, and those elements should be understandable and effectively communicated to executives and shareholders; and
â€˘ compensation should be set at levels that promote a sense of equity among all employees and appropriate stewardship of corporate resources, while giving due regard to our industry and any premiums that may be necessary in order to attract top talent at the executive level.
Our compensation committee engaged Mercer Human Resource Consulting in 2006 to assist it in confirming that the pay-for-performance objectives of our executive compensation program were effective and modifying our compensation program to the extent necessary to promote enhanced implementation of our compensation philosophy and principles. In its report to the committee, Mercer compared the compensation paid to our chief executive officer, chief financial officer and president to two peer groups, each comprised of 12 publicly-held companies, to assist us in ascertaining where our historical compensation practices were relative to market levels. Comparisons were made to a primary peer group of similarly sized companies in the entertainment and media industry (excluding book and magazine publishers), and to a secondary peer group of similarly sized, highly profitable companies exhibiting financial performance similar to ours (regardless of industry). Mercerâ€™s quantitative benchmarking analyses for these purposes included comparisons of executive base salary compensation, total cash compensation (base salary plus bonus), and total direct compensation (total cash compensation plus long-term incentive awards), as well as short- and long-term incentive targets and relative dilution levels for such awards, during 2005 and 2004. We believe Mercerâ€™s analysis as provided in its report supports our conclusion that our historical pay-for-performance objectives were effective, but could be improved.
Because our financial performance was consistently in the top quartile of the peer groups for all of the measured metrics other than sales (measured metrics were sales, EBITDA, net profit margin (net of extraordinary items), return on equity, and total shareholder return) and because of Mercerâ€™s perception that executive officers in our industry would likely require compensation premiums, Mercer anticipated that the total cash compensation for our executives would also be in the top quartile of the peer companies. And, with respect to our executives as a group, aggregate historical total cash compensation was consistent with the 75% level. The aggregate historical base salary compensation and total direct compensation for the group was, however, below the 75% level. In fact, the aggregate compensation for the group in those categories was at or only modestly above the market median.
Improvements recommended by Mercer in its report included that we adopt formal short- and long-term incentive targets for our executive officers. In that regard, Mercer noted that the historical long-term incentive levels for our president and chief financial officer were above the 75% level in relation to our peer groups, and that their long-term incentive share of total direct compensation was higher than that of the peer groups. Significantly, our chief executive officer had not received in the three years prior to the report any long-term incentive awards, which reduced the total direct compensation percentage level of our executive officers as a group. As a result, our dilution levels relative to long-term incentive compensation awarded to our executives is below our peer median. As discussed below, based in part on Mercerâ€™s recommendation, we have recently adopted objective, long-term incentive targets for our executives to enhance our executive compensation practices.
All decisions regarding compensation of our executive officers have been made by our compensation committee, approved by the compensation committee subcommittee to the extent deemed necessary, and ratified by our full board of directors.
Elements of Executive Compensation
Our executive compensation program is comprised of base salary, performance-based cash bonuses, long-term equity incentive awards, perquisites, and post-employment compensation arrangements. These elements of compensation are supplemented by the opportunity to participate in benefit plans that include employer matching contributions and are generally available to all of our employees, such as our 401(k) plan. In determining these elements of compensation, we considered not only the guidance of Mercer Human Resource Consulting, but also the compensation paid to executive officers of competitors in our industry.
Historically, the amount of equity-based compensation paid by us to our executive officers, and in particular to our chief executive officer, we believe has been low. It is anticipated that, if the shareholders approve our new 2007 Stock Incentive Plan proposed to be adopted at this yearâ€™s annual meeting of shareholders, the equity-based compensation component of executive compensation will be increased for our executive officers, making a larger portion of their annual total direct compensation dependent on long-term stock appreciation. Shifting a larger share of executive compensation to equity incentives should, we believe, further align the executive officersâ€™ goals with those of our shareholders and encourage long-term retention and operational and financial success.
We provide our executive officers with base salary under negotiated employment agreements to provide them with a fixed base amount of compensation for services rendered during a fiscal year. We believe this is consistent with competitive practices and will help assure our retention of qualified leadership in those positions. We intend to maintain base salaries at competitive levels in the marketplace for comparable executive ability and experience, taking into consideration changes from time to time in the consumer price index and whether competitive adjustments are necessary to assure retention. Consideration is also given, in each case, to the historical results achieved by each executive and the Company during each executiveâ€™s tenure, to whether each executive is enhancing the team oriented nature of the executive group, the potential of each executive to achieve future success, and the scope of responsibilities and experience of each executive. In addition, evaluations are made regarding the competencies of each executive officer that are considered essential to our success.
The compensation committee evaluated the historical performance of our executive officers and considered the compensation levels and programs at the peer group companies included in the Mercer report before it made its most recent compensation recommendations to the full board, which included recommendations to increase the base salaries of our executive officers as reflected in their November 2006 employment agreement extensions. The terms of the employment periods under the employment agreements of each of our executive officers (other than our chief operating officer) were extended through March 31, 2009. Our chief operating officerâ€™s employment period expires at midnight on July 31, 2008. Relative to the base salaries paid to the executive officers at the peer group companies included in the Mercer report, under the employment agreements our executive officersâ€™ base salaries other than our presidentâ€™s are below the 75 th percentile. Our presidentâ€™s base salary is in the top quartile under his agreement because of, among other things, the importance of his role to our success as an enterprise, the significant role he plays in maintaining and expanding our relationships with our major customers and also with managing our relationship with investors and the market generally, and because of perceived competitive pressures in the marketplace in particular at the time of the extension of his employment agreement.
Performance-Based Cash Bonus Incentives
Our rationale behind performance-based cash incentive compensation is rooted in our desire to encourage achievement of goals established for our short- and long-term financial and operating results, and to reward our executive officers for consistent performance in achieving or assisting us in achieving such goals. For our fiscal year ended March 31, 2007, our executive officers were eligible only for discretionary bonuses that were based on subjective and objective performance criteria as determined by our compensation committee and subcommittee. In an effort to enhance our executive compensation practices, bonus opportunities for our named executive officers in future fiscal years will be based one-third (in the case of our chief executive officer), one-half (in the case of our president and chief financial officer), and one-quarter (in the case of our chief operating officer) on the achievement of performance criteria established within 90 days after the beginning of each fiscal year by our compensation committee and subcommittee, with the remaining percentage of available bonuses in the discretion of the compensation committee based on each executiveâ€™s individual performance as measured against objective and subjective criteria established by the compensation committee at the time of the bonus award. Named executive officer bonus opportunities are capped as provided below under the caption â€śEmployment Contracts of Named Executive Officersâ€ť. For the fiscal year ending March 31, 2008, the performance-based objective bonus criteria as established by our compensation committee and compensation subcommittee will be based upon an increase in the following financial factors: (1) revenue; (2) cash flow; (3) earnings per share; and (4) share price. No discretion is exercised to increase or decrease payouts with respect to that portion of any bonus that is based on pre-established, objective performance criteria. Although the compensation committee does not use a fixed formula in determining discretionary annual incentive bonuses, it does link them to financial objectives of importance to us, including revenue and earnings growth, return on invested capital, and creation of shareholder value. The compensation committee focuses on individual performance, which enables it to differentiate among executives and emphasize the link between personal performance and compensation.
Long-Term Equity Incentives
We intend to place increasing emphasis on compensation tied to the market price of our common stock. To that end, we are asking our shareholders to approve a new 2007 Stock Incentive Plan that will replace all of our existing incentive plans and allow the compensation committee to make equity awards to our executive officers as well as to our other employees. The terms of the new plan were approved by our compensation committee and its subcommittee after its review of and based on the recommendations of the Altman Group, as described below. We believe that increasing the equity-based element of our compensation program will allow our executive officers to earn additional compensation based on the appreciation of the stock and will facilitate the retention of our executive officers. We also believe that these incentives will align managementâ€™s interest with the interests of our shareholders. Although our chief executive officer has been eligible to receive stock options granted under our existing stock option plans, we have not granted any stock options to him during the past three fiscal years. If the shareholders approve the new 2007 Stock Incentive Plan, the compensation committee may in the future grant stock options or other equity incentive awards to our executive officers.
We provide our executive officers perquisites to enhance our compensation package and to make it more attractive to our executive officers relative to our competition. Perquisites are also provided to enable and motivate our executive officers to perform more easily and routinely services on behalf of the Company when they are out of the office. The perquisites provided to our executive officers are automobile allowances, payment of long-term disability insurance premiums, reimbursement for cable or direct broadcast services at home, reimbursement for high-speed internet service at home, airport terminal airline club membership fees and, in the case of our chief executive officer, payment of long-term care insurance premiums and personal use of administrative staff.
Post Employment Compensation
All of our executive officers are employed on an â€śat willâ€ť basis, meaning we or any executive officer may terminate employment at any time. As such, there is no contractual notice period required prior to termination of employment and there is no requirement to pay severance outside the contractual requirements of each executive officerâ€™s employment agreement. The employment agreements provide for the payment of additional compensation and benefit continuation in the event of a termination of employment by the employee after a change in control because of a material change in the executive officerâ€™s title, the relocation of our executive offices outside of the Boulder, Colorado area, or the assignment of duties not reasonably consistent with the duties imposed at the beginning of the executive officerâ€™s employment term. The severance and change in control payment arrangements were agreed upon in order to maintain management stability, especially during times of organizational stress due to possible business transactions facing the company that could have resulted in a change of ownership, and to ensure that our executive officers are either acknowledged by a future owner as valuable executives going forward or rewarded for their efforts in creating value in connection with any such change in control transaction.
Our executive officers are also eligible to participate in our 401(k) plan on the same terms as the rest of our employees are eligible to participate in our 401(k) plan. We provide matching contributions to the same extent for our executive officers as we do for our other employees.
MANAGEMENT DISCUSSION FROM LATEST 10K
We are a leading producer and distributor of adult themed television and general motion picture entertainment. Our key customers are large cable and satellite operators in the United States. Our products are sold to these operators who then transact them to retail customers via pay-per-view and video-on-demand technology. We earn revenue through contractual percentage splits of the retail price.
We are organized into three reporting segments:
â€˘ Pay TV Group â€” Our Pay TV Group aggregates and distributes branded adult television programming to cable and satellite television companies via pay-per-view and video-on-demand technology.
â€˘ Film Production Group â€” Our Film Production Group produces original, adult themed movies, series and events for distribution to the same cable and satellite companies that are customers of our Pay TV Group. The Film Production Group also delivers original programming to premium television services such as Cinemax, Showtime and Starz!. Additionally, our Film Production Group represents domestic, third-party films in international and domestic markets. Our Film Production Group was created on February 10, 2006, when we completed an acquisition of MRG Entertainment, Inc., its subsidiaries and a related company, Lifestyles Entertainment, Inc.
â€˘ Internet Group â€” Our Internet Group distributes adult content via the internet and wireless devices. Our Internet Group derives its revenue primarily from direct consumer subscriptions to its broadband web site, www.ten.com.
During our fiscal year ended March 31, 2007, we continued our focus on attaining leadership in the market for adult themed broadcast entertainment. Key accomplishments included:
â€˘ The launch of two of our pay-per-view services on the largest DBS platform in the U.S. in April 2006;
â€˘ Finalization of a new contract with the second largest DBS provider in the U.S. for the continued distribution of three of our pay-per-view networks. This contract adjusted our historical revenue splits downward;
â€˘ The addition of 5.0 million households to The Erotic Networksâ€™ video-on-demand distribution;
â€˘ Numerical validation of our performance advantage versus key competition;
â€˘ Conclusion of two proprietary studies of consumer behavior in the pay-per-view and video-on-demand markets. Data from these studies has had a substantial impact on our business decisions; and
â€˘ The introduction of content from our Film Production Group to nearly 14.0 million U.S. cable video-on-demand households.
Pay TV Segment
Our Pay TV segment is focused on the distribution of its pay-per-view networks and video-on-demand service to U.S. cable MSOs and DBS providers. Our Pay TV Group earns a percentage of revenue on each pay-per-view, subscription, or video-on-demand transaction related to its services. Revenue growth occurs as we launch our services to new cable MSOs or DBS providers, experience growth in the number of digital subscribers for systems where our services are currently distributed, and launch additional services to our existing cable/DBS partners. Revenue growth also occurs as we are able increase the buy rates for our products and as operators increase retail prices.
Revenue growth for our Pay TV Group for the year ended March 31, 2007 was impacted by:
â€˘ The launch of two of our pay-per-view services on the largest DBS platform in the U.S. in April 2006;
â€˘ Finalization of a new contract with the second largest DBS provider in the U.S. for the continued distribution of three of our pay-per-view networks. This contract adjusted our historical revenue splits downward; and
â€˘ Increased revenue from new cable video-on-demand launches and improved performance from existing platforms.
During the 2007 fiscal year we executed two large statistical studies of adult entertainment viewing habits in the U.S. From these studies, we learned, among other things, that consumers are more likely to choose The Erotic Networks Â® than any other major adult PPV or VOD brand. In addition, we learned what drives adult consumer purchases and why adult consumers purchase content through both the internet and their multi-channel provider. These studies led to multiple changes in the way in which we market and distribute our products.
We also executed content output agreements with two of the largest adult studios in the U.S., Digital Playground, Inc. and Ninn Worx. These long-term content agreements provide us with exclusive, high-quality content that is unique, compelling and innovative.
Looking forward, management has identified certain challenges and risks that could impact our Pay TV Groupâ€™s future financial results including the following:
â€˘ Increased competition from other, more established adult companies;
â€˘ Increased pressure on license fees;
â€˘ Increased regulation of the adult industry;
â€˘ Slowing growth of the overall adult category and limited incremental distribution opportunities within the U.S.; and
â€˘ Continued product commoditization.
Each of these challenges and risks has the potential to have a material adverse effect on our business. However, we believe that we are well positioned to appropriately address these challenges and risks.
We believe that many opportunities accompany these challenges and risks. Among these opportunities, we believe the following exist for the Pay TV Group:
â€˘ Future international distribution opportunities in Canada, Latin America, and Europe;
â€˘ Implementation of technologies that will allow for distribution of our content on new platforms that are controlled by our existing customers. These include Internet Protocol Television (â€śIPTVâ€ť) which is an application in which the television set top boxes are able to access content from the internet;
â€˘ â€śPush Video-on-Demandâ€ť distribution through DISH and Direct TV in which the operator forward deploys content to user hard drives for on-demand viewing;
â€˘ Increased video-on-demand shelf space on current cable platforms;
â€˘ Continued increase in the number of digital customers able to view our pay-per-view and video-on-demand content as cable operators transition analog customers to their digital platforms;
â€˘ Movement by cable MSOs and DBS providers to more appealing content standards; and
â€˘ Improvements to video-on-demand user interfaces.
Film Production Segment
We acquired the Film Production segment during the fourth quarter of our 2006 fiscal year. Our Film Production Group derives its revenue from two principal businesses: the production and distribution of original motion pictures known as â€śerotic thrillersâ€ť and erotic, event-styled content (â€śowned productâ€ť) and the licensing of domestic third party films in international and domestic markets where we act as a sales agent for the product (â€śrepped productâ€ť).
We generate revenue by licensing our content for a one-time fee to premium TV services. In addition, we license our erotic thrillers and adult event content to cable operators and satellite providers on a revenue share basis with license fees that are greater than those earned by our Pay TV Group due to the more mainstream nature of the content. We also license our original content to international premium TV services primarily in Europe and other countries. International content rights are licensed on a flat-fee and revenue share basis.
In addition, we generate revenue by establishing relationships with high-quality, independent mainstream filmmakers to license the rights to their movies under the Lightning Entertainment and Mainline Releasing labels. Most recently, we acquired the international distribution rights for Junebug, winner of a Special Jury Prize at the 2005 Sundance Film Festival, Walmart: The High Cost of Low Prices, and Conversations with God. We earn a commission for licensing the international and domestic rights on behalf of these producers as well as a marketing fee.
Prior to being acquired, the Film Production Group had acted as a contract film producer to one major Hollywood studio. Most often these productions involved the sequels to successful releases such as â€śSingle White Femaleâ€ť where we produced â€śSingle White Female 2.â€ť During the 2007 fiscal year we did not produce a film for this studio. However, we expect that we will produce one, and possibly two, sequels for this studio during the 2008 fiscal year.
During our 2007 fiscal year, we signed agreements with several top ten cable MSOs in the U.S. for the video-on-demand distribution of our event and erotic thriller content. As of the end of our 2007 fiscal year we had launched our content with two top ten U.S. cable MSOs and we expect to launch our content with at least three other top ten U.S. cable MSOs in the first quarter of our 2008 fiscal year. Based on current and committed launch dates, our Film Production Groupâ€™s content will reach 22.0 million VOD homes in the U.S. by the end of the first quarter of our 2008 fiscal year.
During our 2007 fiscal year we also launched our content with one Canadian DBS provider and we expect to launch our content with three additional Canadian multi-channel providers during the first quarter of our 2008 fiscal year.
We believe that we can increase our Film Production Groupâ€™s revenue in the following ways:
â€˘ Distribution of our content to European cable video-on-demand platforms;
â€˘ Development of unique, original programming franchises;
â€˘ Increase in the number of movies and events distributed through U.S. cable video-on-demand platforms;
â€˘ Increase investment in higher quality titles to represent through our Lightning Entertainment label;
â€˘ Distribution of our content through internet platforms such as iTunes, Real Networks, and portals like MSN or Google; and
â€˘ Increase distribution of our content with DISH by leveraging the Pay TV segmentâ€™s relationship.
Our Internet Group generates revenue by selling monthly memberships to our website, www.ten.com, by earning a percentage of revenue from third-party gatekeepers like On Command for the distribution of www.ten.com to their customer base, by selling pre-packaged video and photo content to webmasters for a monthly fee, and by distributing content to wireless platforms both internationally and domestically. Over 80% of revenue from our Internet Group continues to be generated from monthly memberships to www.ten.com.
During our 2007 fiscal year, our Internet Group focused on instituting significant changes in the management and operation of our internet businesses as well as on refinement of our strategy in the wireless marketplace. As more and more consumers turn to the internet for their consumption of video content not only through a computer, but via television as well, we believe that it is important that we be a viable and formidable competitor in this space. Given our technological infrastructure and content assets, we believe that this should be an area where we can have a thriving, profitable business.
During the fourth quarter of our 2007 fiscal year, we decreased the monthly membership price of our site to $19.95. This price point is more competitive with other adult websites and provides a more compelling retail proposition to our customers. This new price point applies only to new members joining our site. We also began a significant program to improve all aspects of our internet product in terms of site design, site navigation, site features, site content, and site performance. We expect these changes to have a positive impact on our business during our 2008 fiscal year.
To date, the market for wireless adult content has been challenging in light of a range of factors including difficulty in attaining direct relationships with wireless carriers, lower margins when transacting with aggregator intermediaries and slow growth in adult content connected with carrier unwillingness to carry such content on their platforms. This last obstacle is particularly acute in the North American market, and less so in parts of Europe.
At this time we have determined that further investment in our wireless activities cannot be justified with an appropriate return on investment. We will continue to distribute our content to a small number of wireless platforms in the U.S. and Europe during our 2008 fiscal year, but we do not anticipate a significant amount of revenue to be generated. We have reallocated resources from our wireless distribution segment to our other business activities, and we expect to break even or generate a small operating profit from this area in the 2008 fiscal year.
Critical Accounting Policies
Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires that we make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, we evaluate our estimates and judgments, including those related to revenue recognition, income tax expense and accruals, accounting for investments in debt and equity securities, goodwill impairment, prepaid distribution rights (content licensing) and film costs, and stock-based compensation. We base our estimates and judgments on historical experience and on various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
We believe that the following critical accounting policies, among others, affect our more significant judgments and estimates used in the preparation of our consolidated financial statements. We have discussed with our Audit Committee the development, selection, and disclosure of our critical accounting policies and estimates and the application of these policies and estimates.
Revenues generated by the Pay TV Group are primarily related to the sale of our pay-per-view and video-on-demand services to Cable/DBS and hotel affiliates. These customers do not report actual monthly pay-per-view or video-on-demand sales for each of their systems to the Pay TV Group until 30-90 days after the month of service ends. This practice requires management to make monthly revenue estimates based on the Pay TV Groupâ€™s historical experience for each affiliated system. The Pay TV Group subsequently adjusts its revenue to reflect the actual amount earned upon receipt of the cash. Historically, any differences between the amounts estimated and the actual amounts received have been immaterial due to the overall predictability of revenues.
The recognition of revenue for the Pay TV, Film Production, and Internet Groups is partly based on our assessment of the probability of collection of the resulting accounts receivable balance. As a result, the timing or amount of revenue recognition may have been different if different assessments of the probability of collection of accounts receivable had been made at the time the transactions were recorded in revenue.
Income Tax Expense and Accruals
Our annual tax rate is based on our income, statutory tax rates and tax planning opportunities available to us. Significant judgment is required in determining our annual tax rate and in evaluating our tax positions. We establish reserves at the time that we determine that it is probable that we will be liable to pay additional taxes related to certain matters. We adjust these reserves, including any impact on the related interest and penalties, in light of changing facts and circumstances, such as the progress of a tax audit.
A number of years may elapse before a particular matter, for which we have established a reserve, is audited and finally resolved. The number of years with open tax audits varies depending on the tax jurisdiction. While it is often difficult to predict the final outcome or the timing of resolution of any particular tax matter, we record a reserve when we determine the likelihood of loss is probable. Such liabilities are recorded in the line item income taxes payable/receivable in our consolidated balance sheets. Settlement of any particular issue would usually require the use of cash. Favorable resolutions of tax matters for which we have previously established reserves are recognized as a reduction to our income tax expense, or Additional Paid in Capital if appropriate, when the amounts involved become known.
Tax law requires items to be included in the tax return at different times than when these items are reflected in the consolidated financial statements. As a result, our annual tax rate reflected in our consolidated financial statements is different than that reported in our tax return (our cash tax rate). Some of these differences are permanent, such as expenses that are not deductible in our tax return, and some differences reverse over time, such as depreciation expense. These timing differences create deferred tax assets and liabilities. Deferred tax assets and liabilities are determined based on temporary differences between the financial reporting and tax bases of assets and liabilities. The tax rates used to determine deferred tax assets or liabilities are the enacted tax rates in effect for the year in which the differences are expected to reverse. Based on the evaluation of all available information, we recognize future tax benefits, such as net operating loss carryforwards, to the extent that realizing these benefits is considered more likely than not.
We evaluate our ability to realize the tax benefits associated with deferred tax assets by analyzing our forecasted taxable income using both historical and projected future operating results, the reversal of existing temporary differences, taxable income in prior carry-back years (if permitted) and the availability of tax planning strategies. A valuation allowance is required to be established unless management determines that it is more likely than not that the Company will ultimately realize the tax benefit associated with a deferred tax asset.
In June 2006, the Financial Accounting Standards Board (â€śFASBâ€ť) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxesâ€”an interpretation of SFAS No. 109 . The provisions are effective beginning in the first quarter of our 2008 fiscal year. See Note 1: Organization and Summary of Significant Accounting Policies in Part II, Item 8 of this Form 10-K for further discussion.
Accounting for Investments in Debt and Equity Securities
We hold investments in debt securities that are classified as available-for-sale under the requirements of Statement of Financial Accounting Standards (â€śSFASâ€ť) No. 115, Accounting for Certain Investments in Debt and Equity Securities (â€śSFAS 115â€ť). In accordance with SFAS 115, available-for-sale securities are recorded at fair value, with unrealized gains and losses, net of the related tax effect, excluded from earnings and initially recorded as a component of accumulated other comprehensive loss in our consolidated balance sheet. Adjustments to the available for sale securities fair value impact the consolidated financial statements by increasing or decreasing assets and shareholdersâ€™ equity. Realized gains and losses are determined on the specific identification method and are reflected in income.
Goodwill represents the excess of cost over the fair value of the net identifiable assets acquired in a business combination. In accordance with SFAS No. 142, Goodwill and Other Intangibles (â€śSFAS 142â€ť), goodwill and intangible assets with an indefinite useful life are no longer amortized, but are tested for impairment at least annually.
We perform an annual review in the fourth quarter of each year, or more frequently if indicators of potential impairment exist, to determine if the recorded goodwill is impaired. Our impairment process compares the fair value of each reporting unit to its carrying value, including the goodwill related to the reporting unit. We concluded for the 2005, 2006, and 2007 fiscal years that the fair value of our reporting units exceeded the carrying values and no impairment charge was required.
If actual operating results or cash flows are different than our estimates and assumptions, we could be required to record impairment charges in future periods.
Prepaid Distribution Rights (Content Licensing) and Film Costs
Our Pay TV Groupâ€™s film and content libraries consist of film licensing agreements. We account for the licenses in accordance with SFAS No. 63, Financial Accounting by Broadcasters (â€śSFAS 63â€ť). Accordingly, we capitalize the costs associated with the licenses and certain editing costs and amortize the costs on a straight-line basis over the life of the licensing agreement (usually 1 to 5 years). Pursuant to SFAS 63, the costs associated with the license agreements should be amortized in a manner that is consistent with expected revenues to be derived from such films.
We have determined that it is appropriate to amortize these costs on a straight-line basis under the assertion that each usage of the film is expected to generate similar revenues. We regularly review and evaluate the appropriateness of amortizing film costs on a straight-line basis and assess if an accelerated method would more appropriately reflect the revenue generation of the content. Through our analysis, we have concluded that the current policy of recognizing the costs incurred to license the film library on a straight-line basis most accurately reflects the revenue generated by each film.
We periodically review our film library and assess if the unamortized cost approximates the fair market value of the films. In the event that the unamortized costs exceed the fair market value of the film library, we will expense the excess of the unamortized costs to reduce the carrying value of the film library to the fair market value.
Our Film Production Group capitalizes its share of direct film costs in accordance with the AICPAâ€™s Statement of Position No. 00-2, Accounting by Producers or Distributors of Films (â€śSOP 00-2â€ť). Capitalized costs of film and television product (â€śfilm costsâ€ť), which are produced or acquired for sale or license, are stated at the lower of cost, less accumulated amortization, or fair value. Film costs consist of direct production costs and production overhead and include costs associated with completed titles and those in development. Interest expense is not capitalized as the production runs are short-term in nature. Film cost valuation is reviewed on a title-by-title basis when an event or change in circumstance indicates the fair value of a title is less than the unamortized cost. Estimated losses, if any, are provided in the current period earnings on an individual film forecast basis when such losses are estimated.
Once a film is released, capitalized film production costs are amortized based on the proportion of revenue recognized during the period for each film relative to the estimated ultimate revenues, for a period not exceeding ten years, to be received from all sources under the individual-film-forecast- computation method as defined in SOP 00-2. Estimates of ultimate revenues can change significantly due to a variety of factors, including the level of market acceptance of film and television product. Accordingly, revenue estimates are reviewed periodically and amortization is adjusted on a prospective basis, as necessary. Such adjustments could have a material effect on results of operations in future periods.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
We are a leader in transactional television as well as general motion picture entertainment. Our key customers are large cable and satellite operators in the United States. Our products are sold to these operators who then distribute them to retail customers via pay-per-view and video-on-demand technology. We earn revenue through contractual percentage splits of the retail price. Our three principal businesses are reflected in the Transactional TV (formerly referred to as the Pay TV segment), Film Production and Internet operating segments. Our most profitable business lines are the Transactional TV and Film Production segments. Our Internet business has recently been operating at or near break-even as we update and redesign our consumer websites in an effort to increase traffic and the conversion rate of this traffic to paying members. The operations of each of our segments are described below.
TRANSACTIONAL TV SEGMENT
Our Transactional TV segment is focused on the distribution of its pay-per-view and video-on-demand service to MSOs and DBS providers. We earn a percentage of revenue, or â€śsplitâ€ť, from our content for each pay-per-view, subscription, or video-on-demand transaction that is purchased on our customerâ€™s platform. Revenue growth occurs as we launch our services to new cable MSOs or DBS providers, experience growth in the number of digital subscribers for systems where our services are currently distributed, when we launch additional services with existing cable/DBS partners, and when we take market share away from our competitors. Revenue growth can also occur when operators increase retail prices. Alternatively, our revenue could decline if we experience lower buy rates, if the revenue splits we receive from our customers decline, or if additional competitive channels are added to our customersâ€™ platforms.
FILM PRODUCTION SEGMENT
Our Film Production segment derives its revenue from two principal businesses: (1) the production and distribution of original motion pictures known as â€śerotic thrillersâ€ť and erotic, event styled content (â€śowned productâ€ť); and (2) the licensing of domestic third party films in international and domestic markets where it acts as a sales agent for the product (â€śrepped productâ€ť). We generate revenue by licensing our content for a one-time fee to U.S. and international premium TV services and by licensing our content to U.S. and international cable operators and satellite providers on a revenue share basis. In addition, we earn a commission and marketing fee for licensing the international television, DVD and theatrical rights as well as the domestic television rights on behalf of the producers that we represent as a sales agent. This segment also periodically enters into arrangements to act as a contract producer for major Hollywood studios for film production. We entered into a contract producer arrangement during the current fiscal year and recognized revenue and cost of sales for the related arrangement during this quarter. We may from time to time pursue contract producer arrangements as a source for revenue in the future.
We have recently begun to distribute our event and erotic thriller content on the video-on-demand platforms of six U.S. cable MSOs. As of December 31, 2007, our content was distributed to over 26 million unique U.S. cable households. In addition, we have increased our distribution of event and erotic thriller content to approximately 4 million unique Canadian DBS and cable MSO households.
Our Internet segment generates revenue primarily by (1) selling monthly memberships to our consumer websites, (2) earning a percentage of revenue from third-party gatekeepers for the distribution of our consumer websites to their customer base, (3) selling pre-packaged video and photo content to webmasters for a monthly fee, and (4) distributing our content to wireless platforms both internationally and domestically. Approximately 75% of the revenue from the Internet segment is related to the sale of monthly memberships to www.ten.com. We are currently working to improve all aspects of our internet product in terms of site design, navigation, features, content and performance in an effort to increase traffic to the website and the conversion of that traffic into paying members. Additionally, we plan to launch a new version of the ten.com website during fiscal year 2009 that will provide potential customers with new functionality and the opportunity to participate in a virtual website community.
CRITICAL ACCOUNTING POLICIES
The significant accounting policies set forth in Note 1 to our audited consolidated financial statements included in our Annual Report on Form 10-K for the fiscal year ended March 31, 2007 and Item 7, Managementâ€™s Discussion and Analysis of Financial Condition and Results of Operations, appropriately represent, in all material respects, the current status of our critical accounting policies, and are incorporated herein by reference, other than set forth below.
Accounting for Uncertainty in Income Taxes
Effective at the beginning of the first fiscal quarter of 2008, we adopted the provisions of Financial Accounting Standards Interpretation (â€śFINâ€ť) No. 48, Accounting for Uncertainty in Income Taxesâ€”an interpretation of FASB Statement No. 109. FIN No. 48 contains a two-step approach to recognizing and measuring uncertain tax positions accounted for in accordance with SFAS No. 109, Accounting for Income Taxes. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount that is more than 50% likely of being realized upon ultimate settlement.
The adoption of FIN No. 48 did not affect our liability for unrecognized tax benefits as no new uncertain tax positions were recognized. The total amount of gross unrecognized tax benefits as of the date of adoption was $1.9 million and is classified as long-term income taxes payable. $0.4 million of these gross unrecognized tax benefits would affect the effective tax rate if realized. Our policy to include interest related to unrecognized tax benefits within interest expense and income tax penalties as income tax expense on the consolidated statements of income did not change as a result of implementing the provisions of FIN No. 48. As of the date of adoption of FIN No. 48, we had $0.2 million and $0 accrued for the payment of interest and penalties, respectively, relating to unrecognized tax benefits.
We file U.S. federal and state income tax returns. We are no longer subject to examination of our federal and state income tax returns for years prior to fiscal 1999.
Our Film Production segment periodically acts as a producer-for-hire for certain customers. Through these arrangements, we provide services and incur costs associated with the film production, and we earn a fee for our services once the film has been delivered and accepted by the customer. Although we maintain no ownership rights for the produced content, we are responsible for the management and oversight of the project and incur significant economic risk until the project is completed, delivered and accepted by the customer. Revenue for these arrangements is recognized when persuasive evidence of an arrangement exists, the film has been delivered and accepted by the customer, the fee is fixed and determinable and collection is probable. The costs incurred for production in these arrangements are initially recorded as a deferred cost within the current assets section of the balance sheet, and the deferred costs are subsequently recorded as a cost of sales in the period in which we recognize revenue for the related services. During the quarter ended December 31, 2007, we completed and recognized revenue and cost of sales for a producer-for-hire arrangement. At December 31, 2007, we have no deferred costs recorded in connection with undelivered producer-for-hire arrangements.
PPV â€” Cable/DBS
PPV â€” Cable/DBS revenue declined during the quarter and nine months ended December 31, 2007 due to a decrease in our revenue from the second largest DBS provider in the U.S. following the renegotiation of our contract with that customer in the third quarter of fiscal year 2007. Under the terms of the renegotiated agreement, we receive a lower revenue split as compared to prior periods.
Revenue from the largest DBS platform in the U.S. was slightly lower during the nine months ended December 31, 2007 due to an increase in competition on the platform and because our competitors have historically been distributing less edited content. We believe the distribution of less edited content has resulted in, and will continue to result in, higher consumer buy rates. We executed an amended contract with the customer described above in the second quarter of fiscal year 2008 which allows us to distribute less edited content through our existing channels and expanded the number of services carried from two channels to three channels. During the quarter ended December 31, 2007, our total revenue from this customer increased as compared to the prior year quarter due to the addition of the third channel. However, the increase in revenue from the third channel was offset by a decline in the revenue we generate on the already existing channels resulting from increased competition on the platform.
Our VOD revenue increased during the three and nine month periods ended December 31, 2007 as a result of an improvement in the services we provide to the largest U.S. cable MSO. Revenue also increased as a result of improved performance on the second largest cable MSO platform in the U.S. and other top ten cable MSO platforms in the U.S.
Our C-Band revenue declined during the three and nine month periods ended December 31, 2007 due to customer conversions from C-Band â€śbig dishâ€ť analog satellite systems to smaller digital DBS satellite systems, and from our discontinuation of the C-Band service during the current quarter. The deterioration in subscribers made this service unprofitable and as a result, we discontinued the C-Band services during the current quarter. We did not incur, nor do we expect to incur going forward, any material costs associated with discontinuing these services.
COST OF SALES
Our cost of sales consists of expenses associated with our digital broadcast center, satellite uplinking, satellite transponder leases, programming acquisitions, video-on-demand transport, and amortization of content licenses. These costs also included in-house call center operations related to the C-Band business that was discontinued in the current period.
Cost of sales during the three and nine month periods ended December 31, 2007 has remained relatively flat as compared to the same periods in the prior year. The video-on-demand transport fees we pay to our primary transport provider have increased as compared to the prior year due to the execution of an amended contract in early fiscal year 2008. These higher fees were offset by a decline in costs from the cancellation of the transponder service used to distribute our Plz network and the discontinuation of our C-Band service.
Operating expenses during the quarter ended December 31, 2007 declined 9% as compared to the prior year quarter primarily due to a reduction in certain prior year advertising costs associated with efforts to improve buy rates on distribution platforms. The 16% increase in operating expenses during the nine months ended December 31, 2007 was primarily due to a) an increase in costs associated with promotion and marketing activities for new channel launches; b) a $0.2 million loss for the early disposition of equipment used within our digital broadcast center; c) the impact from writing off $0.1 million in tenant improvements associated with a prospective facility that proved inadequate for our requirements; and d) an increase in costs related to improving the segmentâ€™s IT infrastructure.
Revenue increased during the three months ended December 31, 2007 primarily from the delivery of a thirteen episode series to a premium channel customer. In the prior fiscal year, we also delivered a thirteen episode series but the series was delivered during the first six months of that year. Revenue was also higher during the current quarter due to our delivery of content to the video-on-demand platforms of six major U.S. cable MSOs as well as the distribution of content through the second largest DBS provider in the U.S. These improvements in revenue were partially offset by a decline in revenue from a general reduction in the number of films delivered during the quarter as well as lower revenue from the largest DBS platform in the U.S. due to a less favorable license fee structure and a change in the location of our content on that platformâ€™s electronic programming guide.
During the nine months ended December 31, 2007, the decline in owned product revenue was primarily attributable to the delivery of fewer film titles to customers during the third quarter of fiscal year 2008 as compared to the same quarter in the prior fiscal year. During the third quarter of the prior fiscal year, we executed agreements and delivered films to several large customers. We executed fewer of these large customer agreements during the third quarter of fiscal year 2008. This year-over-year decline in revenue was partially offset by an increase in video-on-demand revenue from our distribution of content on six major U.S. cable MSOs.
Repped product revenue includes revenue from the licensing of film titles that we represent (but do not own) under international sales agency relationships with various independent film producers. The revenue we generated from four titles accounted for approximately 50% of the total repped product revenue during the third quarter of fiscal year 2008. During the nine months ended December 31, 2007, eight titles have accounted for approximately 50% of the repped product revenue.
Other revenue relates to amounts earned through producer-for-hire arrangements, music royalty fees and the delivery of other miscellaneous film materials to distributors. This revenue increased during the three and nine month periods ended December 31, 2007 as a result of our completion during the current quarter of a producer-for-hire arrangement with a major Hollywood studio.
COST OF SALES
Our cost of sales is comprised of the amortization of our owned product film costs as well as delivery and distribution costs related to that content. These expenses also include the costs we incur to provide producer-for-hire services. There is no significant cost of sales related to the repped product business.
The increase in cost of sales during the quarter ended December 31, 2007 is due to previously deferred expenses that were realized in connection with our completion of a producer-for-hire arrangement with a major Hollywood studio this period. Film cost amortization as a percentage of the related owned content revenue during the three month periods ended December 31, 2007 and 2006 was 36% and 41%, respectively. The decline in film costs as a percentage of owned content revenue is primarily due to our continued monetization of films that were produced after the acquisition of this segment in 2006. Films that were produced prior to the MRG acquisition typically have a higher cost of sales.
Cost of sales during the nine months ended December 31, 2007 were lower primarily due to the above-mentioned monetization of films produced subsequent to the MRG acquisition. Film cost amortization as a percentage of the related owned content revenue during the nine month periods ended December 31, 2007 and 2006 was 35% and 57%, respectively. Film costs have also declined during the nine months ended December 31, 2007 due to the delivery of a larger proportion of older titles whose film costs had been fully amortized in prior periods. This decline in costs was partially offset by the increase in cost of sales from expenses realized in connection with the completion of a producer-for-hire arrangement.
Operating expenses during the three months ended December 31, 2007 were higher as compared to the same prior year period primarily as a result of a $0.7 million impairment charge incurred for two film events. The film costs for the events were initially established at the time of our acquisition of MRG in 2006 and were based on the expected future benefits to be derived from these films. In the current quarter, we lowered our estimate of the expected future benefits to be derived from these two films. As a result and in accordance with our process to continually validate our estimates for all films in our library, we recorded an impairment charge for these two films equal to the difference in the remaining unamortized event costs and the expected future benefits to be derived.
The increase in expenses resulting from the $0.7 million impairment charge was partially offset by the reversal of $0.5 million in earn-out payments for 2007 that had been accrued in the previous nine month period ended September 30, 2007. The MRG purchase agreement provided that if certain annual performance targets were achieved by MRG for the twelve month performance period ended December 31, 2007, the former principals of MRG would receive an additional earn-out payment of $0.7 million. During the previous nine month period ended September 30, 2007, we had estimated that these performance targets would be met. However, actual results for MRG were not sufficient to achieve the second annual performance target. As a result, the previously accrued expenses of $0.5 million were reversed in the current quarter. Although the principals of MRG are entitled to recoup this earn-out for 2007 if actual results for the twelve month period ending December 31, 2008 exceed the performance target by the amount of the shortfall in 2007, we do not currently estimate that this will occur based on historical performance data. If actual performance or estimates for the twelve month period ending December 31, 2008 indicate that an overachievement of the performance targets equal to the shortfall in 2007 is likely to occur, we may be required to re-accrue the expenses that were reversed in the current quarter in future periods.
During the nine month period ended December 31, 2007, operating expenses were higher as compared to the same prior year period as a result of the above-mentioned film event impairment charge. Operating expenses were also higher during the period due to (a) a $0.2 million reserve expense recorded for potentially unrecoupable costs incurred on older repped product titles; (b) a $0.2 million bad debt write-off related to an uncollectible customer account; and (c) an increase in trade show exhibition costs.