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[June 27, 2014]
FAB UNIVERSAL CORP. - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations.
(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis should be read in conjunction with the information set forth under the caption entitled "Item 6. Selected Financial Data" and the consolidated financial statements and related notes included in this Form 10-K.
Safe Harbor Statement.
Statements made in this Form 10-K which are not purely historical are forward-looking statements with respect to the goals, plan objectives, intentions, expectations, financial condition, results of operations, future performance and business of FAB, including, without limitation, (i) our ability to gain a larger share of the distribution of Chinese copyright protected media content and podcast hosting and distribution industries, our ability to continue to develop products acceptable to that industry, our ability to retain our business relationships, and our ability to raise capital and the growth of the FAB brand, and (ii) statements preceded by, followed by or that include the words "may", "would", "could", "should", "expects", "projects", "anticipates", "believes", "estimates", "plans", "intends", "targets" or similar expressions.
Forward-looking statements involve inherent risks and uncertainties, and important factors (many of which are beyond FAB's control) that could cause actual results to differ materially from those set forth in the forward-looking statements, including the following, in addition to those contained in our reports on file with the SEC: general economic or industry conditions, nationally and/or in the communities in which FAB conducts business, changes in the interest rate environment, legislation or regulatory requirements, conditions of the securities markets, changes in the industries in which we operate, the development of products that may be superior to the products offered by FAB, demand for financial services, competition, changes in the quality or composition of FAB's products, our ability to develop new products, our ability to raise capital, changes in accounting principles, policies or guidelines, financial or political instability, acts of war or terrorism, other economic, competitive, governmental, regulatory and technical factors affecting FAB's operations, products, services and prices.
30 -------------------------------------------------------------------------------- Accordingly, results actually achieved may differ materially from expected results in these statements. Forward-looking statements speak only as of the date they are made. FAB does not undertake, and specifically disclaims, any obligation to update any forward-looking statements to reflect events or circumstances occurring after the date of such statements.
Company Overview Below is an update of our entire business, from our wholly-owned subsidiary, Digital Entertainment International Ltd. ("DEI") to our media business of podcast services, apps and premium subscriptions. We believe our business of selling and distributing copyright protected media and content in China from digital platforms will grow and generate profits due to the brand recognition of FAB in China as well as the continued support of the government for copyright protection in China. We believe our Media business will also continue to grow and generate profits due to the size of our podcast operations, our market leadership position, our presence in iTunes and the monetization of the content we distribute through our publishing platform, advertising, sale of Apps and paid subscriptions for content. The network growth of our media operation has occurred faster than initially expected, and it is management's opinion that we are seeing the flow of quality content coming to the Internet increase and audiences showing increased interest in the medium. FAB Universal believes that our network and relevance in our industry will continue to grow and that we are positioned to be one of the leading companies in the podcast monetization business. Our business is broken into three segments: Retail, Wholesale and Digital (FAB Licensing/Podcasting/ Subscription TV). In September 2013, FAB entered into an agreement with Future TV Co. Ltd. to distribute its copyright protected media content through pay TV terminals used in the home by Future TV's subscribers.
Retail FAB has conducted the retail business through its flagship stores since 2003.
We currently operate a 30,000 sq. ft. store in the prestigious Joy City shopping mall and an entertainment superstore in SoShow. Each store has over 20,000 square feet in size and carries the largest selection of copyright protected audio and video products in China, including CDs, VCDs, DVDs, blu-rays, books, magazines and portable electronic devices. The flagship stores are recognized by many Chinese consumers as the right place to buy copyright protected products.
The 20,000 square foot entertainment superstore is located in the Beijing shopping district of SoShow. The store is designed to satisfy the tastes of a swiftly emerging middle class with maturing entertainment expectations. FAB's SoShow store provides Beijing shoppers with its first audio-video "hypermarket." As a preferred venue for product announcements, publishing parties, studio releases, author readings, movie showings, live promotional performances and concerts, FAB's SoShow outlet is one of China's first ultra-modern entertainment destination for music lovers, film buffs, game enthusiasts, and early electronic adopters.
The SoShow flagship store offers many new electronic digital products and mobile storage devices while serving as a center for the 5C download supermarket of traditional copyright protected audio-video products. Consumers can download movies, songs, games, e-books and applications to mobile storage devices through the intelligent 5C Kiosk. Additionally, the 5C download supermarket also offers coupon printing, self-service payments, membership points checking, map searching and other consumer functions.
The Joy City Flagship store, located in the core area in Xidan, Beijing, has superior geographic advantages. In the fourth quarter of 2013 the Joy City store was remodeled, and reopened in the middle of December, 2013. After the remodeling, FAB has increased various kinds of digital facilities, such as electric display screens, enhancing functions of social networks and digitalizing promotional tools.
As the Company gradually transitions the stores to dedicate a larger portion of each store to digital services, as well as a move to selling higher margin products, we anticipate a decrease in revenue within our stores. This store transformation away from selling mostly traditional audio and video products to individualized items such as covers for mobile devices, and electronics combined with digital experience is anticipated to be a temporary reduction in revenue.
Also, our plans are to open a third store during the third quarter of 2014 in Beijing.
Wholesale FAB wholesale distribution provides audio-video products such as compact discs, video compact discs and digital video discs as well as books and magazines to audio-video products retailers. FAB distributes these media products to over 80 31 -------------------------------------------------------------------------------- customers including Sohu, Dangdang and Century Outstanding Information Technology Company, a subsidiary of Amazon.com. FAB's wholesale business caters to three types of customers: large retail stores, FAB license stores and small wholesale/resellers. Customers place orders by telephone, through the internet or in-person and fulfillment is handled by FAB's vehicle fleet or through direct warehouse access.
The ecommerce business is growing much faster than originally anticipate in China. With this change, many of our retailers are going to transition their retail stores similar to the changes we have made with our retail stores. With our customers move away from the traditional hard goods of audio and video, the outlook for 2014 would be that revenue generated by our Wholesale business will experience a decrease throughout 2014.
Digital Licensing and Media The twin components of our strategy are to increase our portfolio of content and expand the number of distribution channels. During 2013, we signed seven copyright licensing agreements with several well-known distributors for additional content. Many of these distributors have long-term cooperation agreements with over 80 independent film producers in the United States. The terms of these agreements range from one to ten years and some are revenue sharing based agreements. This content is expected to be distributed across multiple distribution channels, primarily through digital platforms, thereby leveraging our cost of acquisition.
Through these agreements, we obtained the right to distribute an additional 500 songs, 800 hours of TV series, 100 hours of documentaries and over 1,500 movies, of which over 70% were produced in countries outside of China including Million Dollar Baby, Crouching Tiger Hidden Dragon, Roman Holiday and other popular Oscar, Cannes and Golden Globe winners and nominees. In addition we signed a copyright licensing agreement with the Universal Audio Publishing House to purchase this Chinese company's highly regarded unique music teaching courses.
These music teaching courses are very popular in China and are divided into 71 sets with more than 1,000 curricula delivered by well-known teachers from China's Central Conservatory of Music. We also signed an agreement to distribute over 300 hours of South Korean variety shows with the Seoul Broadcasting System.
With our established media, new distribution opportunities and entertainment distribution platform and the power of the FAB brand we believe that we have the fundamentals in place to continue to drive growth as we increase our content offerings across an expanding number of distributions channels. In order to distribute content over mobile phones and the internet, the Chinese Government requires an internet publishing license which is granted by the General Administration of Press and Publication, the National Agency of Radio, Film and Television. FAB was granted a license by China's Ministry of Commerce to license its business model.
FAB has grown its business through its licensing and regional agent programs and has sold 17,944 brand licenses, which allows the licensees to use FAB's brand on the kiosks.
FAB generates revenues from the sale of FAB Brand licenses, as well as advertising, and FAB membership card sales.
FAB, to date, has sold 40 Regional Agent licenses. The Regional Agent pays an upfront fee of RMB 1,200,000, and a deposit of RMB 100,000. The license fee is non-refundable after 7 days and the contract period is five years. The Regional Agent is responsible for selling the individual licenses in each of their locations and for the development of the business with each licensee.
For each kiosk licensed outside of Beijing, the Licensee pays an upfront RMB 30,000 license fee upon signing the contract. The license fee is non-refundable after three days. The total contract period is five years. FAB pays 20% of each single license fee received (20% of RMB 30,000 = RMB 6,000) to the Regional Agent. The Licensee looks to the Regional Agent for assistance with acquisition of the kiosk, maintenance and operation of the kiosk, and development of the business.
FAB obtained an Internet Publishing License by China's General Administration of Press and Publication, the national agency of radio, film and television. This license grants FAB Universal the right to distribute both its exclusive and acquired copyright protected audio and video digital content over the Internet and mobile phone networks.
32 -------------------------------------------------------------------------------- FAB Membership - Beijing Only In order to retain customers and increase cross-sales, FAB launched its client retention program, the FAB membership program, in 2008. This program entitles customers to download digital content from FAB. The membership provides bonus points for member's purchasing products in any of the flagship stores. The bonus points can be exchanged for non-cash gifts.
Cross-Platform Video Operation The use of digital consumption channels for media in China is growing more rapidly than anticipated. With this change we will transition our business more quickly than previously thought to provide digital content for consumption across multiple channels. This transition will take place starting in 2014.
The Cross-Platform Video Operation business will generate revenue from the distribution of FAB copyright-protected content across various digital platforms. These platforms include digital TV, IPTV, Smart TV, OTT, mobile and the Internet. Initial targets for partners for these platforms will be those with large, existing consumer bases.
Content FAB has purchased the licenses or has the rights to distribute and broadcast movies, TV shows, and educational programming. FAB will continue to acquire the rights to this type content in 2014.
The distribution of this content will be through the various channels described below and will target large consumer bases through partnerships. During 2014, FAB will pursue agreements with various channels for user paid subscriptions of the purchased content. We will acquire content for which we have the exclusive rights as well as sub-licensing rights for distribution. FAB will also acquire content for which we will have non-exclusive rights for distribution. Some of the agreements for non-exclusive content allow FAB to sub-license the content and others will not.
Digital and Internet TV One-time view TV Services: Fees will be generated through paid one-time access to individual content through Pay Per view (PPV) where a viewer must access the programming at a specific broadcast time and True Video on Demand (TVOD) where the programming is available any time. PPV and TVOD fees range from RMB 3 to 9 and FAB would receive a 50% split.
Subscription TV Services Content is also offered on a monthly subscription basis for both Paid Channels of content (PTV) and Subscription Video on Demand (SVOD). Fees for these subscriptions range from RMB 10 to 25 and FAB would receive a 50 % split.
While these fees are not significant per charge, there is a very large consumer base in China, and we will target channel providers with a large number of consumers, such as Tongzhou Electronics TV Terminals and as we have with Future TV.
In September 2013, FAB entered into an agreement with Future TV Co. Ltd. to distribute its copyright-protected media content through pay TV terminals used in the home by Future TV's subscribers, and the trial operation kicked off in November 2013. The agreement with Future TV is a significant milestone for FAB, marking the launch of our subscription TV business and further extending our multi-channel distribution plans. Our goal is to have our Subscription TV network reach the majority of the households in China in five to ten years.
This can be accomplished with our technical and management team, through the integration of digital TV (via cable network operators), IPTV and OTT (via telecom operators, and content aggregation licensing providers).
Mobile Phones and Tablets With the increasing trend towards mobile device use and growing consumer base, FAB will also partner with China's top mobile companies to distribute video.
FAB copyright-protected content will be distributed to mobile users via mobile phones and tablets. This market segment is large and will continue to grow.
For example, China Mobile Video Innovation base 33 -------------------------------------------------------------------------------- reaches an average of 130 million monthly users. Revenues from partnerships with mobile carriers will be based on revenue share for paid content and will be in the range of a 50/50 revenue share.
Internet Content will be offered for free via the Internet on destination web sites. The web sites are ad-supported through display advertisements on the site as well as advertising inserted within in the videos themselves. The Advertising revenue split is normally 50/50.
FAB will partner with Baidu a leading destination web site for video. Baidu is the largest Chinese search engine with their video web side having accounted for over 75% of the entire network traffic distribution in China. The APP activated users has accumulate to approximately 100 million, with 20 million daily active users. Baidu also offers paid content packaging through user subscriptions for premium packaged content where FAB content can be included for a revenue share.
Libsyn Libsyn is the subsidiary for our digital media and entertainment business.
Libsyn is currently the industry's largest network of independent and professional digital media publishers utilizing RSS (podcasting) as a distribution method for episodic, audio and video shows. The Libsyn Network received over 1.6 billion download requests for shows in 2012 and 1.9 billion in 2013 to approximately 34 million monthly audience members in the fourth quarter of 2013. Libsyn's publishing platform hosted 16,241 shows in 2013. Management believes that Libsyn offers the best podcast publishing platform in the industry and is one of only a few podcast publishing platforms that are able to charge publishers for use of the service. The majority of podcast publishing platforms offer their service for free, in hopes of making money exclusively from advertising sales. Management believes that our ability to charge for the services we provide is a testament to the quality of service. The total number of episodes on the network totaled 1,688,057 in 2013, all of which are available for immediate distribution. With the continuing success of iPods, iPhones, iPads, Android's mobile phones, Blackberry's smartphones, we expect the number of content publishers using our service and the number of consumers watching the shows to continue to grow rapidly on an annual basis. LibsynPRO Enterprise service had 124 network publishers in 2013. As Libsyn derives a portion of its revenues through data transfer from PRO customers, our feature rich version of the PRO publishing platform provides management with the tools to grow the number of PRO publishers and thereby revenues associated with our data transfer business. For 2013, revenue from data transfer totaled $480,723.
LIBSYN - PUBLISHING SERVICES Hosting, Distribution Network, Content, Platform Development In 2013 the Libsyn Network received approximately 1.9 billion download requests for podcast episodes vs. 1.6 billion download requests in 2012, from a wide variety of distribution outlets to which Libsyn syndicates content. The Libsyn network received over 5.3 million requests for shows per day throughout 2013.
Our network reaches over 34 million people around the world, creating what management believes is a strong media asset and a very compelling platform for advertisers as well as smartphone App sales. Download requests are calculated by counting the number of shows requested for download by audience members.
Libsyn works to generate profits by inserting advertisements in the shows in partnership with the show's publishers, charging for the use of our publishing platform and through the sale of Apps. As the online digital media industry is in the emerging stages, the majority of these shows are distributed without advertising and the total download requests listed above are provided to give an understanding of the potential size of advertising inventory available for Libsyn's third party advertising partners and its in-house advertising sales team to fill.
Currently, Libsyn distributes digital shows for our producers to a variety of web portals and content aggregators, for both download and streaming.
Approximately 70% of the shows Libsyn distribute reach audiences using Apple's iTunes platform which includes iTunes on the computer, iPods, iPads, iPhones and Apple TV. It is management's opinion that the Libsyn Network's substantial presence in the iTunes Podcast Store is one of the Company's valuable assets as consumers using iTunes are early adopters and spend money regularly on digital media. We believe this provides FAB with a unique offering for advertisers seeking that type of consumer and provides FAB with monetization opportunities for its podcast publishers through the sale of individual and network wide Apps.
34 -------------------------------------------------------------------------------- Early in 2013, we debuted the next-generation Libsyn platform (Libsyn 4). In the fourth quarter of 2013, the most significant aspects of the system were developed for Libsyn 4, including content management, publishing, and statistics.
Previously existing content management components were redesigned to improve usability on tablets, and a file manager was introduced to allow producers to view all files associated with their shows in a single location.
The publishing workflow was streamlined and redesigned for an improved overall user experience. The previous publishing system was divided into two modes: basic and advanced. With Libsyn 4, the publishing workflow provides a single interface that collapses advanced features that producers may expand if needed.
This design choice should decrease user confusion and thus the need for technical support.
New advanced statistics for Libsyn 4 were introduced in the fourth quarter of 2013, allowing producers to observe trends in geographic regions. This geographic trend analysis is particularly useful to producers who schedule events (e.g. comedians), and these trends may prove useful in the future for localized advertising.
The Libsyn platform allows producers to automatically publish to many social media platforms (referred to as "OnPublish") including Facebook and Twitter.
With the Libsyn 4 release, the usefulness of OnPublish was improved.
First, social media services issue temporary authorizations for Libsyn producers to send them content. These authorizations must be renewed by the user from time to time. A dashboard widget was added to Libysn 4 to show the status of these authorizations so they can be quickly renewed. Additionally, the functionality of the Libsyn 4's technology stats now shows the numbers of Facebook likes and Twitter re-tweets that come as a result of content released through OnPublish.
In the fourth quarter of 2013, Libsyn also introduced a new app to both the Windows Store and Windows Phone Store markets called "The Podcast Source." This app serves as a place for people to subscribe to and consume podcasts. The Podcast Source enables audiences to enjoy podcasts from not only Libsyn, but from any podcast that has an RSS feed. The app also supports MyLibsyn premium content, thus making the premium offering more visible to all subscribers of premium shows.
LIBSYN - APPS Apps are small software applications that users can purchase and download to their mobile devices with relative ease. App categories include video games, sports, productivity, entertainment, education and health & fitness. Some of these Apps are free, while others have to be purchased. These Apps range in price from $.99 to $100.00, with the average price under $4.99.
Sale of Podcast Apps Libsyn created Apps that work on the iPhone and Android platforms and are currently for sale in the iTunes App Store, Verizon Store, Windows Store and the Amazon App Store. Libsyn currently has approximately 4,400 Apps for sale.
Podcasters then market their very own App to their show's audience, many of whom use iPhones, iPods and Android phones.
Libsyn also offers Apps as a free monetizational tool to podcasters on the Libsyn Network as long as they have a qualifying monthly account. Currently, there are approximately 16,241 shows on the Libsyn Network and approximately 34 million audience members who consume podcasts. Libsyn submits each App for approval, which is not guaranteed and is based on the respective terms of service and approval process of the App Store, and manages the collecting of the revenue and distribution of the podcaster's share of the revenues. Libsyn expects to retain approximately 35% of the sale price that ranges from $.99 to $4.99 in most cases. These Apps are currently being sold around the world via Apple's App Store, the Verizon Store, Windows Store and the Amazon App Store.
Throughout 2013, revenue from App and subscription sales totaled $587,329.
Libsyn developed a "Network App" which allows for hundreds of podcast Apps inside one fully functional App. This is very similar to Amazon's Kindle App that includes tens of thousands of books inside one App. This Network App allows us to: 1) continue our business plan to offer App monetization tools to all producers in a streamlined, efficient process; 2) comply with the continually evolving and sometimes inconsistent App approval standards and their desire not to have 'cookie-cutter' Apps for all podcasts in iTunes in the App Store causing approval delays and rejections; 3) have more control 35 -------------------------------------------------------------------------------- over the actual marketing of the podcast Apps through expanded distribution of the Network App and cross promotional opportunities; 4) focus more time and attention on podcast shows with larger audiences that sell more apps than the smaller podcast shows.
Sale of Podcast Subscriptions and Episodes Via Custom Podcast Apps Once a podcaster has successfully marketed an App to its audience and has created a significant install base, the podcaster offers new content on a subscription basis or release a special episode, in addition to its normal podcast episodes, and charge a nominal fee ($1 - $3) for that episode or episodes to its audience. By having a successful, extremely easy to use micropayment platform in iTunes/iPhone/iPod Touch, Android and Amazon, the podcast audiences are willing to pay a nominal fee ($1.99), from time to time, for special episodes of their favorite podcast and even sign up for inexpensive subscriptions ($.99 a month; $8.99 for 12 months) for new content. Libsyn earns a portion of the subscription and episode revenue for administering the App account and delivering the content to the consumer.
LIBSYN - ADVERTISING In 2013, Libsyn executed multiple national brand advertising campaigns for companies including Audible, Hover and Ting. These campaigns run across multiple shows, with different advertisers, resulting in $948,631 in 2013 advertising revenue.
In order to increase the percentage of filled advertising inventory we must continue to execute on our advertising sales strategy, integrate third party ad networks and portals and create relationships with more advertising agencies and their clients. Management believes that most advertisers prefer to deal with a few companies with large reach rather than many companies with smaller reach as it makes their advertising 'buys' and tracking easier to monitor.
Critical Accounting Policies and Estimates Revenue Recognition - Revenue is recognized when earned. The Company's revenue recognition policies are in compliance with Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") Topic 605, 985 Software - Revenue Recognition and the Securities and Exchange Commission Staff Accounting Bulletin No. 101 and 104.
Product revenue is recognized when title to the product has transferred to customers in accordance with the terms of the sale; the sales price to the customer is fixed or determinable, and collectability is reasonably assured.
Revenues are recorded net of applicable sales taxes.
The Company derives revenue from retail sales, sales to retailers, and Digital sales. Revenue from Digital sales includes advertisement revenue, membership card revenue, download revenue and licensing revenue.
Revenue from retail sales is recognized at the point-of-sale. Revenue from sales to retailers is recognized at the point of delivery of the product. Download service revenue is recognized when substantially all material services or conditions relating the sales have been performed or satisfied, and the Company has no obligation to refund any payment (cash or otherwise) received. Revenue generated from Membership sales is non-refundable. Membership card revenue is amortized over the life of the membership period, membership cards with par value of RMB 100 have an expiration period of three months, and par value of RMB 200, 300, 400 and 500 have an expiration period of twelve months. Advertisement revenue is recognized over the contract period. Licensing revenue is amortized ratably over the term of the agreement which is generally five years. Deferred revenue represents unearned revenues related primarily to sales of licenses and FAB Membership cards.
The Company recognizes revenue from providing podcast hosting services when the services are provided and the sale of apps when collection is received. The Company sells packaged and custom software products and related speech recognition product development consulting. Software product revenues are recognized upon shipment of the software product only if no significant Company obligations remain, the fee is fixed or determinable, and collection is received or the resulting receivable is deemed probable. Revenue from package software products is recorded when the payment has been received and the software has been shipped. Revenue is recognized, net of discount and allowances, at the time of product 36 -------------------------------------------------------------------------------- shipment. Revenue from non-recurring programming, engineering fees, consulting service, support arrangements and training programs is recognized when the services are provided.
Accounts Receivable - We evaluate the creditworthiness of our customers based on their financial information, if available, as well as information obtained from suppliers and past experiences with customers. Accounts receivable consist of trade receivables arising in the normal course of business. Any allowance established is subject to judgment and estimates made by management. The Company determines the allowance based on known troubled accounts, historical experience, and other currently available evidence. We established an allowance for doubtful accounts of $14,000 at December 31, 2013 and 2012.
Goodwill and Other Intangible Assets - The Company accounts for Goodwill and finite-life intangible assets in accordance with provisions of FASB -ASC Topic 350, Intangibles--Goodwill and Other. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but instead are tested for impairment at least annually in accordance with the provisions of Topic 350. Impairment losses arising from this impairment test, if any, are included in operating expenses in the period of impairment. Topic 350 requires that intangible assets with finite lives be amortized over their respective estimated useful lives, and reviewed for impairment in accordance with Topic 360, criteria for recognition of an impairment of Long-Lived Assets.
Fair Value of Financial Instruments - The Company accounts for fair value measurements for financial assets and financial liabilities in accordance with FASB ASC Topic 820. The authoritative guidance, which, among other things, defines fair value, establishes a consistent framework for measuring fair value and expands disclosure for each major asset and liability category measured at fair value on either a recurring or nonrecurring basis. Fair value is defined as the exit price, representing the amount that would either be received to sell an asset or be paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, the guidance establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value as follows: • Level 1. Observable inputs such as quoted prices in active markets for identical assets or liabilities; • Level 2. Inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and • Level 3. Unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions.
Unless otherwise disclosed, the fair value of the Company's financial instruments including cash, accounts receivable, prepaid expenses, accounts payable, accrued expenses, current deferred revenue and notes payable approximates their recorded values due to their short-term maturities. Long-term deposits represent cash and therefore, their carrying value represents fair value. The fair value of the Company's long-term deposits, non-current deferred revenue, long-term bond payable and other liabilities has no material difference with the book values based on the calculated results.
Stock-based Compensation - The Company accounts for options in accordance with the provisions of Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") ASC Topic 718, Compensation - Stock Compensation.
For the years ended December 31, 2013 and 2012, the Company recorded stock-based employee compensation expense of $423,796 and $5,086 for vesting of stock options, respectively, and stock-based compensation expense to employees and consultants of $329,600 and $4,159,800, respectively, for options that were issued and immediately exercised. The plans are more fully described in Note 13 of our consolidated financial statements.
Estimating the fair value of options granted requires us to utilize valuation models and to establish several underlying assumptions. The fair value of option grants was estimated using the Black-Scholes option valuation model based on the following weighted average assumptions: 2013 2012 Dividend yield 0% 0 % Expected life 11 yrs 0 yrs Expected volatility 82.76% 0% Risk-free interest rate 2.17% 0.00% 37 -------------------------------------------------------------------------------- The risk-free interest rate is the implied yield available for zero-coupon U.S.
government issues with a remaining term equal to the expected life of the options.
The expected lives of the options are determined based on the Company's expectations of individual option holders anticipated behavior and the term of the option.
Volatility is based upon price performance of the Company over an equivalent term of the issued options to determine potential volatility of the issued options.
Income Taxes - The Company is subject to the Income Tax Laws of U.S. and the PRC. The Company accounts for income taxes in accordance with ASC 740, "Income Taxes". ASC 740 requires an asset and liability approach for financial accounting and reporting for income taxes and allows recognition and measurement of deferred tax assets based upon the likelihood of realization of tax benefits in future years. Under the asset and liability approach, deferred taxes are provided for the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. A valuation allowance is provided for deferred tax assets if it is more likely than not these items will either expire before the Company is able to realize their benefits, or that future deductibility is uncertain. The components of deferred tax assets are individually classified as current and non-current based on their characteristics.
ASC 740-10-25 prescribes a more-likely-than-not threshold for consolidated financial statement recognition and measurement of a tax position taken (or expected to be taken) in a tax return. It also provides guidance on the recognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, years open for tax examination, accounting for income taxes in interim periods and income tax disclosures. (See note 13 - Capital Stock and note 16- Contingencies).
Recent Accounting Pronouncements - The Company has adopted all recently issued accounting pronouncements that management believes to be applicable to the Company. The adoption of these accounting pronouncements, including those not yet effective, is not anticipated to have a material effect on the Company's financial position or results of operations.
Variable Interest Entity ("VIE") FAB, through its wholly owned subsidiary and its VIE, is engaged in marketing and distributing various officially licensed digital entertainment products under the "FAB" brand throughout the PRC, including but not limited to audiovisual products such as Compact Discs, Video Compact Discs and Digital Video Disks as well as books, magazines, mobile phone accessories and cameras.
The Company's products and services are primarily distributed through its flagship stores, licenses, proprietary "FAB" kiosks and online virtual stores.
FAB kiosks, located in high-traffic areas of office buildings, shopping malls, retails stores and airports, are self-service terminals that provide a range of entertainment and business applications.
FAB's organizational structure consists of Digital Entertainment International Limited ("DEI"), which is FAB's wholly-owned subsidiary; DEI's wholly owned subsidiary, Beijing Dingtai Guanqun Culture Co., Ltd. ("DGC"), and Beijing FAB Culture Media Co., Ltd. ("FAB Media") which is a variable interest entity ("VIE") of DGC and its wholly owned subsidiary, Beijing FAB Digital Entertainment Products Co., Ltd. ("FAB Digital").
In March 2012, a series of contractual arrangements were entered into between DGC, FAB Media and the individual shareholders of FAB Media. Such arrangements include an Exclusive Service Agreement; an Equity Pledge Agreement; a Call Option Agreement; and a Shareholders' Voting Right Proxy Agreement.
Pursuant to these agreements, DGC has the exclusive right to provide to FAB Media consulting services related to its business operation and management. The terms of these agreements are summarized below: Exclusive Service Agreement Under the exclusive service agreements among DGC, a Wholly Foreign-Owned Enterprise ("WFOE"), FAB Media, as well as the respective registered shareholders of FAB Media, the registered shareholders of FAB Media have agreed: 38 -------------------------------------------------------------------------------- • to irrevocably entrust the right of management and operation of FAB Media and the responsibilities and authorities of their shareholders and board of directors to the WFOE in accordance with the terms and conditions of the Exclusive Service Agreement.
• the WFOE, as the entrusted manager, shall provide full management to FAB Media's operations.
• the WFOE possesses its exclusive rights in nominate and approve the directors, chairman, general managers, financial controllers or other senior managers of FAB Media.
• the WFOE, for its provision of services, shall be paid a service fee by FAB Media, which equals 100% of the residual return of FAB Media, and which can be waived by the WFOE from time to time in its sole discretion.
Call Option Agreement DGC entered into call option agreement with FAB Media and its respective registered shareholders, who irrevocably granted to DGC or its designated person exclusive options to purchase, when and to the extent permitted under PRC law, all of the equity interests in FAB Media. The exercise price for the options to purchase all of the equity interests in FAB Media is the minimum amount of consideration permissible under the applicable PRC law. The agreements have an initial term of ten years and are renewable at DGC's sole discretion. These call option agreements provide, among other things, that without DGC's prior written consent: • the registered shareholders of each VIE may not transfer, encumber, grant a security interest in, or otherwise dispose of in any way any equity interests in their VIE; • FAB Media may not sell, transfer, mortgage or otherwise dispose of in any way its assets, business or income, nor may it create any security interest therein (other than created in the ordinary course of its business); • no shareholders resolution should be passed to increase or reduce the registered capital of each VIE or otherwise alter the capital structure of such VIE; • FAB Media may not declare or pay any dividends to its registered shareholders; • FAB Media may not merge with any third parties, or purchase or transfer any assets or businesses from or to any third parties; • FAB Media may not engage in any transactions that may cause substantially adverse effects on its assets, obligations, operations, share capital and other rights; • FAB Media may not incur any indebtedness, except where transactions were entered into in the ordinary course of business; Equity Pledge Agreement Under DGC's Equity Pledge Agreement with FAB Media and its respective registered shareholders, the registered shareholders of FAB Media pledged all of their respective equity interests in FAB Media to DGC to secure the performance of the registered shareholders', FAB Media's obligations under the various VIE agreements, including the Exclusive Service Agreement and other agreements described above.
If FAB Media or any of its respective registered shareholders breaches any of their respective contractual obligations under these agreements, DGC, as pledgee, will be entitled to certain rights, including the right to sell the pledged equity interests.
The registered shareholders of FAB Media agreed not to transfer, sell, pledge, dispose of or otherwise create any new encumbrance on their respective equity interests in FAB Media, as the case may be, without DGC's prior written consent.
Unless terminated at DGC's sole discretion, each Equity Pledge Agreement has a term of ten years and will be automatically renewed upon the expiration of the term.
Shareholder's Voting Right Proxy Agreement Each registered shareholder of FAB Media has executed a power of attorney to appoint DGC to be his or her attorneys, and irrevocably authorize DGC to vote on his or her behalf on all of the matters concerning FAB Media, as the case may be, that may require shareholders' approval.
39 -------------------------------------------------------------------------------- The following schematic diagram illustrates the relationships between the various FAB entities: FAB Universal Corp. (FAB) Colorado Corp Digital Entertainment International Limited (DEI) a Hong Kong Co.
100% Owned by FAB Outside PRC Inside PRC Beijing Dingtai Guanqun Culture Co. Ltd (DGC) a PRC Co.
100% Owned by DEI Beijing FAB Culture Media Co., Ltd (FAB Media) a PRC Co.
VIE Contract with DGC Beijing FAB Digital Entertainment Products Co., Ltd (FAB Digital) a PRC Co.
100% Owned by FAB Media Beijing FAB Interactive Culture Media Co. Ltd.
(BFICM) a PRC Co.
100% owned by FAB Digital FAB Media conducts businesses relating to value-added telecommunications services and distribution of audio-visual products. The Catalog for the Guidance of Foreign Investment Industries (the "Catalog") as promulgated and amended from time to time by the Ministry of Commerce and the National Development and Reform Commission, is the principal guide to foreign investors' investment activities in the PRC. The most updated version of the Catalog became effective in January 2012; both businesses relating to value-added telecommunications services and businesses relating to distribution of audio-visual products fall within the scope of foreign investment restricted industries. Furthermore, in accordance with the Provisions on Administration of Foreign Invested Telecommunications Enterprises promulgated by the State Council, the foreign equity ownership in a value-added telecommunications services provider must not exceed 50%. In accordance with the Measures on Administration of Sino-foreign Audio-visual Product Distribution Enterprises, the percentage of foreign equity ownership in such enterprises distributing audio-visual products cannot be higher than 49%. Due to such regulatory restrictions, the FAB parties have to operate their businesses in a VIE structure.
40 -------------------------------------------------------------------------------- We have obtained an opinion of counsel regarding the enforceability of the VIE Agreements. The form of the legal opinion from FAB counsel includes the following opinions, among others: (i) each of the VIE Agreements has been duly executed and is legally binding on each of the parties thereto under PRC Laws; (ii) each of the parties to the VIE Agreements has full power, authority and legal capacity to enter into, execute and perform its obligations thereunder; (iii) the execution and delivery by each party of the VIE Agreements does not, and the performance by each party of its obligations thereunder will not, violate or breach any governmental authorization or any PRC Laws or the organizational documents or any other agreement or obligation of such party; and (iv) to the knowledge of opining counsel, there is no issue, fact or circumstance that would lead it to believe that any government agency would revoke the VIE Agreements or any transaction thereunder.
FAB Universal Corp. is the parent company and conducts its business through its wholly owned subsidiary, Beijing Dingtai Guanqun Culture Co., Ltd. ("DGC"), which is a wholly foreign-owned enterprise ("WFOE") with limited liability incorporated in the PRC in March 2011. DGC has entered into a series of contractual agreements with the owners of FAB Media.
In March 2012, a series of contractual arrangements were entered into among DGC, FAB Media and its individual shareholders. Such arrangements include the above-referenced Exclusive Service Agreement, Share Pledge Agreement, Option Agreement and Voting Right Proxy Agreement.
Pursuant to these agreements, DGC has the exclusive right to provide to FAB Media consulting services related to business operation and management. The key terms of these agreements include: · DGC has the sole discretion to make all operating and business decisions for FAB Media on behalf of the equity owners, including business operations, policies and management, approving all matters requiring shareholder approval; · FAB Media has agreed to pay all of the operating costs incurred by DGC, and intends to transfer 100% of the income earned to DGC; DGC also has the right to determine the amount of the fees it will receive; · During the term of these agreements, DGC will retain the rights to the intellectual properties if they are created by DGC; · FAB Media may not enter into any other agreements with any third party to receive consulting service without the prior consent of DGC; · The equity owners pledge their respective equity interests in the FAB Media as a guarantee for the payment of technical and consulting services fees under the Exclusive Service Agreement; · The shareholders of FAB Media have irrecoverably and unconditionally granted to DGC or its designee an exclusive option to purchase, to the extent permitted by PRC laws, all or any portion of equity interest of the FAB Media.
All these contractual agreements obligate DGC to absorb a majority of the risk of loss from FAB Media's activities and entitle DGC to receive a majority of its residual returns. In essence, DGC has gained effective control over FAB Media.
Based on these contractual arrangements, the Company believes that FAB Media should be considered as variable interest entity ("VIE") under the FASB Accounting Standards Codification ("ASC") 810, "Consolidation." Accordingly, management believes that the accounts of these two entities should be consolidated with those of DGC, the primary beneficiary. Each of the VIE agreements is discussed in more detail above.
DEI is effectively controlled by the majority shareholders of FAB Media. DEI has 100% equity interest in DGC. Accordingly, DGC and FAB Media are effectively controlled by the same majority shareholders. Therefore, DGC and FAB Media are considered to be under common control. The consolidation of DGC and FAB Media has been accounted for at historical cost and prepared on the basis as if the aforementioned exclusive contractual agreements between DGC and FAB Media had become effective as of the beginning of the first period presented in the accompanying consolidated financial statements.
There are risks involved with the operation of our business in reliance on the VIE agreements, including the risk that the VIE agreements may be determined by PRC regulators or courts to be unenforceable. DEI believes the VIE agreements are binding and enforceable under applicable law. However, if the VIE agreements were for any reason determined to be in breach of any existing or future PRC laws or regulations, the relevant regulatory authorities would have broad discretion in dealing with such breach, including: 41 -------------------------------------------------------------------------------- · imposing economic penalties; · discontinuing or restricting the operations of the DGC, and/or FAB Media; · imposing conditions or requirements in respect of the VIE agreements with which DGC may not be able to comply; · requiring the various entities to restructure the relevant ownership structure or operations; and · taking other regulatory or enforcement actions that could adversely affect the companies' businesses.
Moreover, FAB Media could violate the VIE agreements, go bankrupt, suffer from difficulties in its businesses or otherwise become unable to perform its obligations under the VIE agreements. Due to the above-referenced uncertainties surrounding the treatment of VIE arrangements under PRC law, we may have difficulty enforcing the VIE agreements and, as a result, our operations, reputation, business and stock price could be severely adversely affected.
Reverse Split - On February 22, 2012, the Company effected a 1-for-12 reverse stock split. All references to stock issuances and per share data have been reflected in the accompanying share data.
Results of Operations.
Year Ended December 31, 2013 Compared to Year Ended December 31, 2012 FAB Universal derives its revenue from the sale of copyright protected media, FAB Brand licenses, advertising sales and FAB Membership cards sold in mainland China as well as from our podcast hosting fees, podcast advertising sales, and subscription sales.
During 2013, FAB recorded revenues of $110.9 million, an increase of $83.4 million, from our revenues of $27.5 million in 2012. This increase was driven by an increase in revenue from first full year of operation since the acquisition of DEI in September 2012. During the fourth quarter of 2012, DEI reported $22.9 million of revenue. During 2013, revenue from the wholesale segment generated $60.4 million in revenue with the retail segment providing $9.0 million and Digital Media/licensing delivering $41.5 million. Within the Digital segment, Advertising delivered $17.3 million, FAB Memberships delivered $11.3 million and FAB Brand Licensing delivered $7.7 million, while content download revenue was minimal and the Libsyn business generated $5.0 million. The Libsyn business saw significant increases in hosting fees, ad revenue and the addition of subscription revenue. The increase in hosting fees was due to the increase in the number of producers using our services.
During 2013, our cost of revenue was $63.5 million, an increase of $47.1 million over the 2012 figure of $16.4 million. This increase was driven by the addition of the DEI business and cost of revenue for the sale of copyright protected media. During the 2013, cost of revenue from the wholesale segment was $48.5 million with the retail segment incurring $6.5 million and Digital Media/licensing totaling $8.4 million. FAB generated a gross profit of $47.4 million in 2013, versus a gross profit of $11.0 million in 2012.
In 2013, FAB had operating expenses of $17.5 million, as compared to $13.8 million in 2012. Our operating expenses consisted of: Selling expenses increased to $4.7 million in 2013, from $2.2 million in the prior year. The increase was due to the addition of DEI, adding $2.5 million of incremental selling expense.
General and administrative expenses increased to $11.0 million in 2013, from $8.5 million in the prior year. The increase was driven due to the reporting of three additional quarters for DEI in 2013. For 2012, the expense was driven due to the issuance of stock to employees, officers and directors for the work associated with the acquisition of DEI. Also, consulting fees were $1.6 million in 2013 compared to $2.8 million in 2012.
42 -------------------------------------------------------------------------------- Research and development costs for 2013 were $302,361 versus $269,562 for 2012.
These are expenses associate with continued work for the podcast hosting business.
Other expense increased to $2.7 million in 2013 from $79,136 in 2012. This increase is due to recording $1.2 million of interest expense on the long-term bond, $1.2 million for the contingent loss for the settlement of the lawsuit regarding rent, and the amortization of the financing costs totaling $111,387.
Net income available to common stockholders increased to $20.7 million in 2013, as compared to a net loss available to common stockholders of $4.0 million in 2012. This increase in net income available to common stockholders for 2013 is a result of adding the acquisition of DEI for a full year in 2013. Basic and diluted income per common share was $0.99 in 2013, compared to a loss per share of $0.34 in 2012.
Liquidity and Capital Resources.
2013 compared to 2012 Current assets at December 31, 2013 included $108.8 million in cash and accounts receivable, an increase of $82.2 million, from our cash and accounts receivable of $26.6 million at December 31, 2012. The increase in cash was primarily contributed as a result of the operations from DEI.
During fiscal 2013, our operating activities provided cash of $54.4 million, as compared to $8.9 million in net cash provided by operating activities during 2012. This increase was driven from our net income, delivering 21.9 million as well as management of our inventory contributing $4.6 million, and the sale of FAB Brand license fees providing $ 29.5 million in cash.
In 2013, depreciation and amortization expense was $6.9 million, which increased from $2.0 million in 2012. This increase was attributed to the amortization of intangible assets during all of 2013 versus the fourth quarter of 2012.
Net cash provided by investing activities was $3.6 million for 2013 versus cash used of $8.2 million in 2012. The decrease was driven by the acquisition of DEI in 2012 providing $13.4 million in cash with the acquisition off-set by payment of long-term deposits to customers in the fourth quarter of 2012 totaling $4.9 million. During 2013, the Company experience a net return of long-term deposits totaling $5.2 million off-set by the purchase of equipment and copyrights.
In 2013, net cash provided by financing activities was $20.1 million, versus $1.5 million in 2012. During 2013, the Company received proceeds of $16.3 million for the issuance of bonds bearing interest at 11% annually, and borrowed net funds on traditional notes totaling $ 5.2 million. In 2012, the warrant holders exercised 341,208 warrants at $3.25 per share for 341,207 shares of the Company's common stock. The Company received proceeds of $1,108,923.
At December 31, 2013, the Company had working capital of $76.1 million, as compared to working capital of $11.3 million at December 31, 2012. This increase in working capital is due to cash received with the addition of the DEI operations and the issuance of long-term debt instruments.
Contractual Obligations Not applicable to smaller reporting companies.
Off-Balance Sheet Arrangements We have operating leases for certain facilities, but otherwise do not have any off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our financial condition, results of operations, liquidity, or capital resources.
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