Kartoon Studios, Inc. 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our results of operations, financial condition and liquidity and capital resources should be read in conjunction with our financial statements and related notes for the three and six months ended June 30, 2024 and June 30, 2023 . Certain statements made or incorporated by reference in this report and our other filings with the Securities and Exchange Commission, in our press releases and in statements made by or with the approval of authorized personnel constitute forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act, and are subject to the safe harbor created thereby. Forward-looking statements reflect intent, belief, current expectations, estimates or projections about, among other things, our industry, management’s beliefs, and future events and financial trends affecting us. Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “may,” “will” and variations of these words or similar expressions are intended to identify forward looking statements. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances, including any underlying assumptions, are forward looking statements. Although we believe the expectations reflected in any forward-looking statements are reasonable, such statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors. These differences can arise as a result of the risks described in the section entitled “Risk Factors” below in this Quarterly Report on Form 10-Q (the “Form 10-Q”) and in the section entitled “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2023, which was filed with the SEC on April 9, 2024 (the “2023 Annual Report”), and elsewhere in this report, as well as other factors that may affect our business, results of operations, or financial condition. Forward-looking statements in this report speak only as of the date hereof, and forward-looking statements in documents incorporated by reference speak only as of the date of those documents. Unless otherwise required by law, we undertake no obligation to publicly update or revise these forward-looking statements, whether as a result of new information, future events or otherwise. In light of these risks and uncertainties, we cannot assure you that the forward-looking statements contained in this report will, in fact, transpire. Overview Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to provide readers of our condensed consolidated financial statements with the perspectives of management. This should allow the readers of this report to obtain a comprehensive understanding of our businesses, strategies, current trends, and future prospects. It should be noted that the MD&A contains forward-looking statements that involve risks and uncertainties. Our Business Our Content Distribution business is focused on achieving scale across our networks, including Kartoon Channel! , Frederator, Ameba, and Kartoon Channel! Worldwide. Revenue growth will be driven by the continued focus on licensed content and exploitation of our current content such as Stan Lee, Shaq's Garage , Rainbow Rangers and many more. Continued profit growth will be realized the more we can scale the business across our platforms. In addition, we are looking at artificial intelligence (“AI”) tools to reduce the cost of operating distribution expenses such as dubbing expenses, video resolution upscaling and converting between 2D and 3D. Our Production Services business is focused on creating high-quality original and for hire content in the most efficient way possible. To achieve this, our Mainframe Studios division, the main driver of this business, is exploring more ways to improve operations by adopting a more flexible and efficient approach. This includes collaborating with outsource partners and utilizing AI technology to streamline processes and drive efficiencies within the organization. Our Licensing & Royalties business has the most upside and potential for the Company. We are looking to take advantage of our incredible set of Stan Lee assets to drive consumer products - both digitally and physically. We will be focused on utilizing all of our IP assets further in 2024 and beyond. Our Media Advisory & Advertising Services business is focused on driving deal flow opportunities and winning annuity business through retainers and projects. The team continues to focus on the toy business, but also expansion into tangential industries such as family and travel. The team has expanded their reach over the past 12-18 months by leveraging their relationships with influencers to promote products and provide bespoke marketing initiatives for the clients. 27 Table of Contents Results of Operations Our summary results for the three months ended June 30, 2024 and 2023 are below: Revenue Three Months Ended June 30, 2024 2023 Change % Change (in thousands, except percentages) Production Services $ 5,095 $ 7,033 $ (1,938) (28) % Content Distribution 2,396 3,012 (616) (20) % Licensing & Royalties 27 103 (76) (74) % Media Advisory & Advertising Services 866 890 (24) (3) % Total Revenue $ 8,384 $ 11,038 $ (2,654) (24) % Production Services revenue was generated specifically by Wow providing animation production services. Revenue for production services is recognized over time on a percentage of completion basis, therefore, as the projects are still in progress, we recognize revenue based upon the proportion of costs incurred cumulatively to total expected costs. Consequently, less revenue is recognized during the periods in which the projects are near completion or completed. Revenue for the three months ended June 30, 2024 was 28% lower than the Wow production services revenue recognized during three months ended June 30, 2023 primarily due to a lower volume of active service production projects in the current period versus the prior year period. Revenue related to Content Distribution on AVOD and SVOD, including advertising sales for the three months ended June 30, 2024, decreased by 20% as compared to the three months ended June 30, 2023. This was primarily due to a decrease in Frederator’s multi-channel network revenue of $0.6 million from YouTube due to reduced ad spending and a decline in RPM advertising rates. Revenue related to Licensing & Royalties for the three months ended June 30, 2024 decreased by 74% as compared to the three months ended June 30, 2023 primarily due to higher royalties earned for owned IP for the period ended June 30, 2023. Revenue generated by Media Advisory & Advertising services for the three months ended June 30, 2024 decreased by 3% as compared to the three months ended June 30, 2023 primarily due to lower net renewal activity and media purchases from clients. Expenses Three Months Ended June 30, 2024 2023 Change % Change (in thousands, except percentages) Marketing and Sales $ 292 $ 1,690 $ (1,398) (83) % Direct Operating Costs 5,845 9,541 (3,696) (39) % General and Administrative 6,908 8,370 (1,462) (17) % Total Expenses $ 13,045 $ 19,601 $ (6,556) (33) % The decrease in Marketing and Sales expenses for the three months ended June 30, 2024 as compared to the three months ended June 30, 2023 was primarily due to expenses incurred for stock issued for services of $1.2 million related to the Company’s Shaq’s Garage series that was not incurred during the current three months ended June 30, 2024 and decrease of $0.2 million in media expenses. Direct Operating Costs during the three months ended June 30, 2024 consisted primarily of salaries and related expenses for the animation production services employees of Wow and Frederator. Channel expenses, licensing and production of content costs, such as participation expenses related to profit sharing obligations with various animation studios, post-production studios, writers, directors, musicians or other creative talent that had rendered services and amortization, including any write-downs of film and television costs, make up the remainder of Direct Operating Costs. The decrease was primarily due to a $6.1 million reduction in salary costs from a decline in headcount as a result of lower 28 Table of Contents volumes of service production projects for the three months ended June 30, 2024, compared to the same period of the prior year, offset by a $2.1 million reduction in tax credits earned as correlated to the decrease in labor costs, and an increase of $0.5 million of production costs as new project contracts were signed during the current period. The decrease in General and Administrative expenses for the three months ended June 30, 2024 as compared to the three months ended June 30, 2023 was primarily due to a decrease of $1.0 million as a result of decreased use in equipment rentals and software licenses, a decrease of $0.6 million in share-based compensation expense, a decrease of $0.4 million in depreciation related to equipment leases that had ended prior to the current period, and a decrease in general administrative expenses related to our cost saving initiatives, offset by an increase of $0.7 million in litigation fees and an increase of $0.3 million in annual shareholder meeting expenses of holding the annual shareholder meeting during the quarter ended June 30, 2024 as opposed to later in the prior year. During the three months ended June 30, 2023, we reassessed our nonfinancial assets, including our definite-lived intangible assets, our indefinite-lived intangible assets and our remaining goodwill for impairment. As a result, we concluded that impairment charges to those assets were required. We concluded that there were no indications or triggering events that would further impair the assets during the three months ended June 30, 2024. Our summary results for the six months ended June 30, 2024 and 2023 are below: Revenue Six Months Ended June 30, 2024 2023 Change % Change (in thousands, except percentages) Production Services $ 7,858 $ 16,919 $ (9,061) (54) % Content Distribution 4,725 6,313 (1,588) (25) % Licensing & Royalties 127 149 (22) (15) % Media Advisory & Advertising Services 1,752 1,846 (94) (5) % Total Revenue $ 14,462 $ 25,227 $ (10,765) (43) % Production Services revenue was generated specifically by Wow providing animation production services. Revenue for production services is recognized over time on a percentage of completion basis, therefore, as the projects are still in progress, we recognize revenue based upon the proportion of costs incurred cumulatively to total expected costs. Consequently, less revenue is recognized during the periods in which the projects are near completion or completed. Revenue for the six months ended June 30, 2024 was 54% lower than the Wow production services revenue recognized during six months ended June 30, 2023 primarily due to a lower volume of active service production projects in the current period versus the prior year period. Revenue related to Content Distribution on AVOD and SVOD, including advertising sales for the six months ended June 30, 2024, decreased by 25% as compared to the six months ended June 30, 2023. This was primarily due to a decrease in Frederator’s multi-channel network revenue of $1.5 million from YouTube due to reduced ad spending and a decline in RPM advertising rates. Revenue related to Licensing & Royalties for the six months ended June 30, 2024 decreased by 15% as compared to the six months ended June 30, 2023 primarily due to higher royalties earned for owned IP for the period ended June 30, 2023. Revenue generated by Media Advisory & Advertising services for the six months ended June 30, 2024 decreased by 5% as compared to the six months ended June 30, 2023 primarily due to lower net renewal activity and media purchases from clients. 29 Table of Contents Expenses Six Months Ended June 30, 2024 2023 Change % Change (in thousands, except percentages) Marketing and Sales $ 736 $ 1,935 $ (1,199) (62) % Direct Operating Costs 10,170 20,826 (10,656) (51) % General and Administrative 14,511 17,595 (3,084) (18) % Impairment of Property and Equipment – 120 (120) — % Impairment of Intangible Assets – 4,023 (4,023) — % Impairment of Goodwill – 11,287 (11,287) — % Total Expenses $ 25,417 $ 55,786 $ (30,369) (54) % The decrease in Marketing and Sales expenses for the six months ended June 30, 2024 as compared to the six months ended June 30, 2023 was primarily due to expenses incurred for stock issued for services of $1.3 million related to the Company’s Shaq’s Garage series that was not incurred during the current three months ended June 30, 2024. Direct Operating Costs during the six months ended June 30, 2024 consisted primarily of salaries and related expenses for the animation production services employees of Wow and Frederator. Channel expenses, licensing and production of content costs, such as participation expenses related to profit sharing obligations with various animation studios, post-production studios, writers, directors, musicians or other creative talent that had rendered services and amortization, including any write-downs of film and television costs, make up the remainder of Direct Operating Costs. The decrease was primarily due to a $14.2 million reduction in salary costs as a result in a reduction in headcount due to a lower volume of service production projects for the six months ended June 30, 2024, compared to the same period of the prior year, partially offset by a $4.3 million reduction in tax credits earned as correlated to the decrease in labor costs. The decrease in General and Administrative expenses for the six months ended June 30, 2024 as compared to the six months ended June 30, 2023 was primarily due to a decrease of $1.5 million as a result of decreased use in equipment rentals and software licenses, a decrease of $1.2 million in share-based compensation expense, a decrease of $0.7 million in payroll related expenses, a decrease of $0.6 million in depreciation related to equipment leases that had ended prior to the current period, and a decrease in general administrative expenses related to our cost saving initiatives, partially offset by an increase of $1.0 million in litigation and legal fees and an increase of $0.3 million in annual shareholder meeting expenses due to holding the annual shareholder meeting earlier in the year versus the prior year. During the six months ended June 30, 2023, we reassessed our nonfinancial assets, including our definite-lived intangible assets, our indefinite-lived intangible assets and our remaining goodwill for impairment. As a result, we concluded that impairment charges to those assets were required. The Company concluded that there were no indications or triggering events that would further impair the assets during the six months ended June 30, 2024. 30 Table of Contents Other Expense, net Components of Other Expense, net are summarized as follows (in thousands): Three Months Ended June 30, Six Months Ended June 30, 2024 2023 2024 2023 Interest Expense (a) $ (246) $ (1,020) $ (449) $ (2,105) Warrant Incentive Expense (b) – (12,664) – (12,664) Gain on Revaluation of Warrants (c) 23 6,063 60 6,202 Loss on Revaluation of Equity Investment in YFE (d) (881) 4,322 (881) 3,427 Realized Loss on Marketable Securities Investments (e) (216) (720) (357) (2,257) Gain (Loss) on Foreign Exchange (f) (330) 35 (980) 355 Interest Income (g) 42 158 95 468 Finance Lease Interest Expense (h) (24) (54) (54) (104) Other (i) 370 2 534 3 Other Expense, net $ (1,016) $ (2,858) $ (1,583) $ (4,570) Three Months and Six Months Ended June 30, 2024 (a) Interest Expense during the three and six months ended June 30, 2024 primarily consisted of $0.2 million and $0.1 million, respectively, primarily due to interest incurred on bank indebtedness. (b) There was no warrant incentive expense in 2024. (c) The Gain on Revaluation of Warrants during the three and six months ended June 30, 2024 is primarily related to the changes in fair value of the remaining outstanding warrant classified as a liability due to decreases in market price. (d) As accounted for using the fair value option, the loss on the YFE investment revaluation during the three and six months ended June 30, 2024, excluding the impact of foreign currency recorded separately, is a result of a decrease in YFE’s stock price as of June 30, 2024. (e) The Realized Loss on Marketable Securities Investments during the three and six months ended June 30, 2024 reflects the loss that will not be recovered from the investments due to selling securities prior to maturity. (f) The Gain (Loss) on Foreign Exchange during the three and six months ended June 30, 2024 primarily related to the revaluation of the YFE investment, resulting in a loss of $0.2 million and $0.6 million, respectively due to the EURO fluctuation to USD as compared to the prior reporting period. The remaining balance is related to remeasurements of transactions made in foreign currencies that are outstanding as of the condensed consolidated balance sheet date. (g) Interest Income during the three and six months ended June 30, 2024 primarily consisted of interest income, net of premium amortization expense, recorded for the investments in marketable securities. (h) The Finance Lease Interest Expense during the three and six months ended June 30, 2024 represents the interest portion of the finance lease obligations for equipment purchased under an equipment lease line. (i) Other during the three and six months ended June 30, 2024 is primarily related to late fees from select clients on a payment plan. Three Months and Six Months Ended June 30, 2023 31 Table of Contents (a) Interest expense during the three and six months ended June 30, 2023 primarily consisted of $0.6 million and $1.3 million of interest incurred on the margin loan, respectively, and $0.4 million and $0.8 million, respectively, of interest incurred on production facilities loans and bank indebtedness assumed as part of the Wow Acquisition. (b) The Warrant Incentive Expense is related to the $12.7 million fair value of Exchange Warrants that were issued during the three months ended June 30, 2023 to certain existing warrant holders in exchange for previously issued outstanding warrants and $3.5 million recorded as the incremental expense of the 2021 Warrants immediately before and after the repricing. (c) The gain on warrant revaluation during the three and six months ended June 30, 2023 is primarily related to the $6.0 million change in fair value as of the end of the reporting period of the Exchange and SEG Warrants compared to the fair value at issuance date. (d) As accounted for using the fair value option, the gain on the YFE investment revaluation during the three and six months ended June 30, 2023, excluding the impact of foreign currency recorded separately, is a result of an increase in YFE’s stock price as of June 30, 2023. (e) The net realized loss on marketable securities reflects the loss that will not be recovered from the investments due to selling securities and issuers' prepayments of principals on certain mortgage-backed securities. (f) The gain on foreign currency exchange during the three and six months ended June 30, 2023 primarily related to the EURO weakening against the USD compared to the three and six months ended prior period. (g) Interest Income during the three and six months ended June 30, 2023 primarily consisted of cash interest received of $0.3 million and $0.7 million from the investments in marketable securities, respectively, net of premium amortization expense of $0.2 million and $0.3 million, respectively. (h) The finance lease interest expense represents the interest portion of the finance lease obligations assumed as part of the Wow Acquisition for equipment purchased under an equipment lease line. Prior to the acquisition of Wow, finance leases did not exist. (i) Other during the three and six months ended June 30, 2023 is primarily related to late fees from select clients on a payment plan. Liquidity and Capital Resources As of June 30, 2024, the Company had cash of $2.7 million, which decreased by $1.4 million as compared to December 31, 2023. The decrease was primarily due to cash used in financing activities of $4.8 million and cash used for operating activities of $2.7 million, offset by cash provided by investing activities of $5.5 million. The cash used in financing activities was primarily due to repayments of the production facilities, margin loan and bank indebtedness, net of proceeds from each, resulting in net cash used of $7.7 million, offset by proceeds from the Offering of $3.3 million. The cash provided by investing activities was due to sales of marketable securities of $5.5 million. As of June 30, 2024, the Company held available-for-sale marketable securities with a fair value of $6.5 million, a decrease of $5.5 million as compared to December 31, 2023 due to sales and maturities during the six months ended June 30, 2024. The available-for-sale securities consist principally of corporate and government debt securities and are also available as a source of liquidity. As of June 30, 2024 and December 31, 2023, the Company’s margin loan balance was $1.1 million and $0.8 million, respectively. During the six months ended June 30, 2024, the Company borrowed an additional $6.3 million from its investment margin account and repaid $6.0 million primarily with cash received from sales and maturities of marketable securities. The borrowed amounts were primarily used for operational costs. The interest rates for the borrowings fluctuate based on the Fed Funds Upper Target plus 0.60%. The weighted average interest rates were 0.82% and 0.98%, respectively, on average margin loan balances of $9.8 million and $27.4 million as of June 30, 2024 and December 31, 2023, respectively. For three months ended June 30, 2024 and June 30, 2023, the Company incurred interest expense on the loan of $12,429 and $0.6 million, respectively. The Company incurred interest expense on the loan of $31,061 and $1.3 million during the six months ended June 30, 2024 and June 30, 2023, respectively. The investment margin account borrowings do not mature but are collateralized by the marketable securities held by the same custodian and the custodian can issue a 32 Table of Contents margin call at any time, effecting a payable on demand loan. Due to the call option, the margin loan is recorded as a current liability on the Company’s condensed consolidated balance sheets. The Company is subject to financial and customary affirmative and negative non-financial covenants on the revolving demand facility and equipment lease agreements that have an aggregate total outstanding balance of $1.3 million $1.7 million. During March 2024, the Company amended the revolving demand facility, equipment lease line, and treasury risk management facility. As a result of the amendment, the revolving demand facility allows for draws of up to CAD 1.0 million to be made by way of CAD prime rate loans, CAD overdrafts, USD base rate loans or letters of credit up to a maximum of $200,000 in either CAD or USD and having a term of up to 1 year. The CAD prime borrowings and overdrafts bear interest at a rate equal to bank prime plus 2.00% per annum. The USD base rate borrowings bear interest at a rate equal to bank base rate plus 2.00% per annum. In addition, the equipment lease line was terminated, however, the Company has and will continue to make the regular principal and interest payments under the specific financing terms of the existing equipment lease agreements. The amendment removed the treasury risk management facility that allowed for advances of up to CAD 0.5 million. As of June 30, 2024 and the date of the amendment, there were no outstanding amounts drawn under the treasury risk management facility. The amendment also introduced revised financial covenants that are effective as of March 15, 2024. As of June 30, 2024 , the Company was not in compliance with two financial covenants. The financial covenants required the Company to maintain a minimum liquidity threshold and to complete a minimum equity raise by June 30, 2024. As a result of the covenant violations, the Company’s remaining equipment lease agreements with the lender of CAD 1.2 million (USD $0.9 million) are subject to repayment in the fourth quarter of 2024. As of August 14, 2024, the lender and the Company have agreed to a repayment plan for the equipment leases to be completed within the fourth quarter of 2024. The amendment and covenant violation did not have any impact on the Company’s production facilities that are separate from the revolving demand facility and are used for financing specific productions. Working Capital As of June 30, 2024, we had total current assets of $38.8 million, including cash of $2.7 million and marketable securities of $6.5 million, and our total current liabilities were $33.6 million. We had working capital of $5.2 million as of June 30, 2024 as compared to working capital of $11.5 million as of December 31, 2023. The decrease of $6.3 million was primarily due to a decrease in our cash and marketable securities position. During the six months ended June 30, 2024, we met our immediate cash requirements through existing cash balances and through the sale of marketable securities. Additionally, we used equity and equity-linked instruments to pay for services and compensation. We believe that our current cash balances and our investments in available for sale marketable securities are sufficient to support our operations for at least the next twelve months. To meet our short and long-term liquidity needs, we expect to use existing cash and marketable securities balances. Comparison of Cash Flows for the Six Months Ended June 30, 2024 and June 30, 2023 Our total cash as of June 30, 2024 and June 30, 2023 was $2.7 million and $4.8 million, respectively. Six Months Ended June 30, 2024 2023 Change (in thousands) Net Cash Used in Operating Activities $ (2,654) $ (10,587) $ 7,933 Net Cash Provided by Investing Activities 5,518 35,948 (30,430) Net Cash Used in Financing Activities (4,804) (27,941) 23,137 Effect of Exchange Rate Changes on Cash 586 (13) 599 Decrease in Cash $ (1,354) $ (2,593) $ 1,239 Net Non-cash Expenses Items necessary to reconcile from net loss to cash used in operating activities included net non-cash expenses of $4.8 million for the six months ended June 30, 2024 as compared to net non-cash expenses of $27.2 million for the six months ended June 30, 2023. The majority of the decrease of $22.4 million in non-cash expenses was primarily due to the 33 Table of Contents absence of the recognition of $15.4 million in impairment expenses of long-lived assets, intangible assets and goodwill and warrant incentive expense of $12.7 million, a decrease of realized losses from marketable securities of $1.9 million and a decrease in share-based compensation of $1.2 million. The decreases were partially offset by the six months ended June 30, 2023 reconciling non-cash items of $10.5 million related to gains from revaluations of our investment in YFE and warrants. Change in Operating Activities The net change in operating asset and liability activities provided by operating activities of $5.5 million as of June 30, 2024 compared to the net change in operating asset and liability activities used by operating activities of $1.4 million as of June 30, 2023 was primarily due to an increase in net receipts of tax credits during the current year of $4.6 million as credits were received for production completed in the prior year, a decrease in deferred revenue of $5.9 million, a decrease in accounts receivable, net of $1.9 million and a $1.4 million increase in accounts payable due to timing. Change in Investing Activities The decrease in cash provided by investing activities of $30.4 million was primarily due to a decrease in proceeds from the sales and maturities of marketable securities of $29.1 million during the six months ended June 30, 2024 as a result of selling less marketable securities during the current period. Change in Financing Activities The decrease in cash used in financing activities of $23.1 million was primarily due to a decrease in repayments of our margin loan of $35.8 million, offset by repayments during the current period, compared to proceeds from bank indebtedness during the prior year period, resulting in a net increase of cash used in financing of $5.6 million. In addition, we did not receive proceeds from a warrant exchange in the current period compared to the prior year period of $5.3 million. Material Cash Requirements We have entered into arrangements that contractually obligate us to make payments that will affect our liquidity and cash flows in future periods. Our material cash requirements from known contractual and other obligations primarily relate to our debt and lease obligations and our employment and consulting contracts. The aggregate amount of future minimum purchase obligations under these agreements over the period of next five years is approximately $27.2 million as of June 30, 2024, of which about $6.3 million could be owed within one year if the margin loan is called. We plan to utilize our liquidity (as described above) to fund our material cash requirements. As of June 30, 2024, we had $1.4 million in commitments for capital expenditures, related to equipment leases. Critical Accounting Estimates The preparation of the financial statements and related disclosures in conformity with U.S. generally accepted accounting principles and our discussion and analysis of our financial condition and operating results require our management to make judgments, assumptions and estimates that affect the amounts reported. Management bases its estimates on historical experience and on various other assumptions it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates, and such differences may be material. Note 2, “Summary of Significant Accounting Policies” in Part I, Item 1 of this Form 10-Q and in the Notes to Consolidated Financial Statements in Part II, Item 8 of our 2023 Annual Report, and “Critical Accounting Policies and Estimates” in Part II, Item 7 of the 2023 Annual Report describe the significant accounting policies and methods used in the preparation of our condensed consolidated financial statements. Off Balance Sheet Arrangements We have no off-balance sheet arrangements. Item 3. Quantitative and Qualitative Disclosures about Market Risk 34 Table of Contents As a “smaller reporting company,” as defined by Item 10 of Regulation S-K, we are not required to provide information required by this Item.