10-Q 1 a12-8932_110q.htm 10-Q

Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

x      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended March 31, 2012

 

OR

 

o         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                   to                  

 

Commission file number: 001-35325

 

Digital Domain Media Group, Inc.

(Exact name of registrant as specified in its charter)

 

Florida

 

27-0449505

(State or other jurisdiction of

 

(I.R.S. Employer

incorporation or organization)

 

Identification Number)

 

10250 SW Village Parkway

Port St. Lucie, FL 34987

(Address of principal executive offices)

(Zip Code)

 

(772) 345-8000

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (. § 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer o

 

Accelerated filer o

 

 

 

Non-accelerated filer x
(Do not check if a smaller reporting company)

 

Smaller reporting company o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o  No x

 

At May 10, 2012, there were 41,677,149 shares of Digital Domain Media Group, Inc.’s common stock outstanding.

 

 

 



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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

This Quarterly Report on Form 10-Q contains “forward-looking statements” that involve substantial risks and uncertainties. The statements contained in this Annual Report on Form 10-K that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), including, but not limited to, statements regarding our expectations, beliefs, intentions, strategies, future operations, future financial position, future revenue, projected expenses and plans and objectives of management. In some cases, you can identify forward-looking statements by terms such as “anticipate,” “believe,” “estimate,” “expect,” “intend,” “may,” “might,” “plan,” “project,” “will,” “would,” “should,” “could,” “can,” “predict,” “potential,” “continue,” “objective,” or the negative of these terms, and similar expressions intended to identify forward-looking statements. However, not all forward-looking statements contain these identifying words. These forward-looking statements reflect our current views about future events and involve known risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievement to be materially different from those expressed or implied by the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section titled “Risk Factors” included in this Quarterly Report on Form 10-Q. Furthermore, such forward-looking statements speak only as of the date of this report. Except as required by law, we undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements. We qualify all of our forward-looking statements by these cautionary statements. In addition, the industries in which we operate are subject to a high degree of uncertainty and risk due to a variety of factors including those described in the section entitled “Risk Factors.” These and other factors could cause our results to differ materially from those expressed in this Quarterly Report on Form 10-Q.

 

As used herein, “the “Company,” “we,” “our,” and similar terms refer to Digital Domain Media Group, Inc., unless the context indicates otherwise.

 

“Digital Domain” and other trademarks of ours appearing in this report are our property. This report contains additional trade names and trademarks of other companies. We do not intend our use or display of other companies’ trade names or trademarks to imply an endorsement or sponsorship of us by such companies, or any relationship with any of these companies.

 

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Table of Contents

 

Part I

Financial Information

 

 

 

 

Item 1

Financial Statements

 

 

 

 

 

 

 

 

a)

Condensed Consolidated Balance Sheets as of March 31, 2012 (unaudited) and December 31, 2011

1

 

 

 

 

 

 

 

b)

Condensed Consolidated Statements of Operations and Comprehensive Loss for the Three Months Ended March 31, 2012 and 2011 (unaudited)

3

 

 

 

 

 

 

 

c)

Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2012 and 2011 (unaudited)

4

 

 

 

 

 

 

 

d)

Notes to Condensed Consolidated Financial Statements

6

 

 

 

 

 

 

Item 2

Management’s Discussion and Analysis of Financial Condition and Results of Operations

22

 

 

 

Item 3

Quantitative and Qualitative Disclosures About Market Risk

32

 

 

 

Item 4

Controls and Procedures

33

 

 

Part II

Other Information

 

 

 

 

Item 1

Legal Proceedings

35

 

 

 

Item 1A

Risk Factors

35

 

 

 

Item 2

Unregistered Sales of Equity Securities and Use of Proceeds

35

 

 

 

Item 6

Exhibits

37

 

 

 

Signatures

 

 

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Table of Contents

 

Part I. Financial Information

 

Item 1. Financial Statements

 

DIGITAL DOMAIN MEDIA GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In Thousands, Except Share Data)

 

 

 

March 31,

 

December 31,

 

 

 

2012

 

2011

 

 

 

(Unaudited)

 

 

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

2,452

 

$

29,413

 

Cash, held in trust - short-term

 

2,490

 

2,449

 

Contracts and other receivable, net

 

9,893

 

3,110

 

Tax credits receivable

 

2,365

 

2,365

 

Prepaid expenses and other assets

 

4,500

 

5,335

 

Total current assets

 

21,700

 

42,672

 

Cash, held in trust - long-term

 

4,153

 

4,233

 

Restricted cash

 

71

 

71

 

Property and equipment - net

 

80,626

 

80,141

 

Trade name

 

15,410

 

15,410

 

Unpatented technology - net

 

19,459

 

20,106

 

Other intangible assets - net

 

6,889

 

7,105

 

Goodwill

 

18,081

 

18,081

 

Deferred debt issuance costs - net

 

2,363

 

3,022

 

Film inventory

 

21,341

 

6,925

 

Other assets

 

101

 

75

 

Total assets

 

$

190,194

 

$

197,841

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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DIGITAL DOMAIN MEDIA GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In Thousands, Except Share Data)

 

 

 

March 31,

 

December 31,

 

 

 

2012

 

2011

 

 

 

(Unaudited)

 

 

 

Liabilities, Preferred Stock and Stockholders’ Equity

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable and accrued liabilities

 

$

22,316

 

$

21,474

 

Advance payments and deferred revenue

 

11,121

 

8,442

 

Deferred grant revenue from governmental agencies, short-term

 

2,988

 

2,988

 

Deferred land grant revenue, short-term

 

525

 

525

 

Government lease obligation, short-term

 

4,382

 

3,399

 

Short-term convertible and other notes payable - net

 

6,182

 

17,612

 

Warrant and other debt-related liabilities, short-term

 

5,831

 

6,462

 

Earn out liability, short-term

 

494

 

400

 

Unearned revenue, short-term

 

395

 

361

 

Current portion of capital lease obligations

 

896

 

763

 

Total current liabilities

 

55,130

 

62,426

 

Capital lease obligations, net of current portion

 

390

 

530

 

Warrant and other debt-related liabilities

 

16,814

 

20,930

 

Deferred grant revenue from governmental agencies

 

11,050

 

9,547

 

Long-term convertible and other notes payable - net

 

18,126

 

455

 

Deferred income tax liability

 

6,189

 

6,189

 

Deferred revenue land grant, net of current portion

 

19,644

 

19,775

 

Earn out liability, net of current portion

 

2,131

 

2,774

 

Government lease obligation - net

 

34,787

 

36,155

 

Unearned revenue, net of current portion

 

3,082

 

3,172

 

Other long-term liabilities

 

3,083

 

 

Total liabilities

 

170,426

 

161,953

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

 

 

Convertible preferred stock, $0.01 par value, 25,000,000 shares authorized at March 31, 2012 and December 31, 2011, respectively; including Preferred Stock A series 100,000 designated, no shares issued or outstanding at March 31, 2012 and December 31, 2011, respectively

 

 

 

Stockholders’ equity:

 

 

 

 

 

Common stock, $0.01 par value at March 31, 2012 and December 31, 2011, respectively - 100,000,000 shares authorized, 41,553,702 and 39,515,326 shares issued, and 41,015,749 and 39,384,003 outstanding as of March 31, 2012 and December 31, 2011, respectively

 

406

 

396

 

Additional paid-in capital

 

216,553

 

213,651

 

Comprehensive income

 

71

 

34

 

Accumulated deficit

 

(198,634

)

(183,802

)

Treasury stock, at cost

 

(3,307

)

(829

)

Total stockholders’ equity before non-controlling interests

 

15,089

 

29,450

 

Non-controlling interests

 

4,679

 

6,438

 

Total stockholders’ equity

 

19,768

 

35,888

 

Total liabilities, preferred stock and stockholders’ equity

 

$

190,194

 

$

197,841

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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DIGITAL DOMAIN MEDIA GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS

(In Thousands, Except Share and Per Share Data)

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2012

 

2011

 

 

 

(Unaudited)

 

Statements of Operations

 

 

 

 

 

Revenues:

 

 

 

 

 

Production revenues

 

$

30,158

 

$

37,904

 

Grant revenues from governmental agencies

 

878

 

653

 

Licensing revenue

 

90

 

 

Tuition revenue

 

15

 

 

Total revenues

 

31,141

 

38,557

 

Costs and expenses:

 

 

 

 

 

Cost of revenues, excluding depreciation and amortization

 

32,922

 

30,922

 

Depreciation expense

 

3,631

 

2,870

 

Selling, general and administrative expenses

 

10,979

 

10,849

 

Amortization of intangible assets

 

863

 

863

 

Total costs and expenses

 

48,395

 

45,504

 

Operating loss

 

(17,254

)

(6,947

)

Other income (expenses):

 

 

 

 

 

Interest and finance (expense) credit:

 

 

 

 

 

Issuance of and changes in fair value of warrant and other debt-related liabilities

 

4,284

 

(28,965

)

Amortization of discount and issuance costs on notes payable

 

(1,599

)

(3,013

)

Interest expense on notes payable

 

(670

)

(502

)

Interest expense on capital and governmental lease obligations

 

(670

)

(318

)

Other income (expense), net

 

353

 

1,067

 

Loss before income taxes

 

(15,556

)

(38,678

)

Income tax expense

 

9

 

250

 

Net loss before non-controlling interests

 

(15,565

)

(38,928

)

Net loss (income) attributable to non-controlling interests

 

733

 

(197

)

Net loss attributable to common stockholders

 

$

(14,832

)

$

(39,125

)

 

 

 

 

 

 

Statements of Comprehensive Loss

 

 

 

 

 

Net loss attributable to common stockholders

 

$

(14,832

)

$

(39,125

)

Unrealized gain from foreign currency translation

 

37

 

63

 

Comprehensive loss

 

$

(14,795

)

$

(39,062

)

 

 

 

 

 

 

Weighted average number of common shares outstanding:

 

 

 

 

 

Basic

 

39,977,777

 

14,184,609

 

Diluted

 

42,839,565

 

14,184,609

 

 

 

 

 

 

 

Basic loss per share:

 

 

 

 

 

Loss before non-controlling interests

 

$

(0.39

)

$

(2.75

)

Net loss (income) attributable to non-controlling interests

 

0.02

 

(0.01

)

Basic loss per share attributable to Common Stockholders

 

$

(0.37

)

$

(2.76

)

 

 

 

 

 

 

Diluted loss per share:

 

 

 

 

 

Loss before non-controlling interests

 

$

(0.45

)

$

(2.75

)

Net loss (income) attributable to non-controlling interest

 

0.02

 

(0.01

)

Diluted loss per share attributable to Common Stockholders

 

$

(0.43

)

$

(2.76

)

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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DIGITAL DOMAIN MEDIA GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In Thousands)

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2012

 

2011

 

 

 

(Unaudited)

 

Cash flows from operating activities:

 

 

 

 

 

Net loss before non-controlling interests

 

$

(15,565

)

$

(38,928

)

Adjustments to reconcile net loss before non-controlling interests to net cash used in operating activities:

 

 

 

 

 

Depreciation and amortization of property and equipment and intangible assets

 

4,494

 

3,733

 

Amortization of discount on and issuance costs of notes payable

 

1,599

 

3,013

 

Interest added to principal on notes payable

 

171

 

 

Changes related to fair value of warrant and other debt - related liabilities

 

(4,284

)

28,965

 

Stock-based compensation

 

1,878

 

4,409

 

Interest on government obligations

 

(121

)

19

 

Decrease in earn out liability

 

(549

)

 

Changes in operating assets and liabilities:

 

 

 

 

 

Contracts receivable

 

(1,779

)

(8,272

)

Prepaid expenses and other assets

 

483

 

(1,149

)

Film inventory

 

(14,415

)

(322

)

Accounts payable and accrued liabilities

 

2,305

 

(510

)

Advance payments and deferred revenue

 

2,620

 

(8,080

)

Deferred revenue from governmental entities

 

1,372

 

(584

)

Unearned revenue

 

(57

)

 

Net cash used in operating activities

 

(21,848

)

(17,706

)

Cash flows from investing activities:

 

 

 

 

 

Purchases of property and equipment

 

(2,889

)

(3,727

)

Changes in restricted cash

 

 

(5

)

Net cash used in investing activities

 

(2,889

)

(3,732

)

Cash flows from financing activities:

 

 

 

 

 

Proceeds from sale of common stock

 

 

19,501

 

Proceeds from issuance of notes payable

 

3,000

 

 

Payments of stock issuance costs

 

 

(2,096

)

Deferred offering costs paid

 

 

(756

)

Repayments on notes payable

 

 

(554

)

Payments on capital and governmental lease obligations

 

(2,037

)

(434

)

Payments of debt issuance costs

 

(50

)

 

Purchase of treasury stock

 

(3,212

)

 

Net cash provided by (used in) financing activities

 

(2,299

)

15,661

 

Effect of exchange rates on cash and cash equivalents

 

75

 

84

 

Net decrease in cash and cash equivalents

 

(26,961

)

(5,693

)

Cash and cash equivalents at beginning of period

 

29,413

 

11,986

 

Cash and cash equivalents at end of period

 

$

2,452

 

$

6,293

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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DIGITAL DOMAIN MEDIA GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In Thousands)

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2012

 

2011

 

Supplemental disclosure of cash flow information - cash paid during the period for:

 

 

 

 

 

Interest

 

$

539

 

$

501

 

Non-cash investing and financing activities:

 

 

 

 

 

Increase in debt from debt restructuring

 

2,380

 

 

Deferred offering costs included in accounts payable and accrued liabilities at period end

 

50

 

 

Purchase of property and equipment in accounts payable at period end

 

1,891

 

4,301

 

Purchase of property and equipment with assets held in trust

 

 

3,902

 

Amortization of discount on bond obligation

 

195

 

19

 

Bond interest capitalized to construction-in-progress

 

 

495

 

Shares issued from exchange of subsidiary shares

 

1,034

 

15

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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DIGITAL DOMAIN MEDIA GROUP, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

1. COMPANY BACKGROUND AND OVERVIEW

 

Description of Business — Digital Domain Media Group, Inc., formerly known as Digital Domain Holdings Corporation and Wyndcrest DD Florida, Inc., a Florida corporation incorporated on January 7, 2009 (the “Inception Date”), and subsidiaries (collectively, “Digital Domain Media Group” or the “Company”)  is a digital production and animation company focused on the creation of original content animation feature films and the development of computer-generated imagery, including three-dimensional stereoscopic (“3D”) imagery, for large-scale feature films and transmedia advertising.

 

The common stock is listed on the New York Stock Exchange under the ticker symbol “DDMG”.

 

Liquidity and Capital Resources — The Company has a history of losses, including a $15.6 million and $144.2 million net loss before non-controlling interests, respectively, for the three months ended March 31, 2012 and the year ended December 31, 2011, respectively. The Company has a limited operating history, had negative working capital of $33.4 million and stockholders’ equity of $19.8 million as of March 31, 2012, and used $21.8 million to fund cash flows from operations during the three months ended March 31, 2012. For the year ended December 31, 2011, the Company used $44.4 million in cash flows from operations. The Company has worked to improve its working capital and its cash flow shortfalls through equity and debt funding and through the completion of its investment in the co-production of the feature film Ender’s Game. The Company raised gross proceeds of $19.5 million in equity capital in a private placement in February and March 2011, gross proceeds of $26.0 million in another private placement consummated in August 2011, and gross proceeds of $41.8 million in its initial public offering completed in November 2011. Furthermore, the Company invested $11.4 million in Ender’s Game during the three months ended March 31, 2012. Additionally, upon completion of the IPO, $94.0 million of convertible debt and warrant liabilities reflected on the Company’s balance sheet were automatically converted or exercised, as applicable, into the Company’s common stock.

 

2. COLLABORATIVE ARRANGEMENTS

 

Joint Marketing VFX Services Agreement

 

On July 8, 2011 Digital Domain Productions, Inc. (“DDPI”), a wholly owned subsidiary of our subsidiary Digital Domain Inc., (“Digital Domain” or “DD”), entered into a Joint Marketing and Production VFX Services Agreement with RelianceMediaWorks Limited (“RMW”), a film and entertainment services company headquartered in Mumbai, India. The term of this agreement is three years, subject to Digital Domain Productions, Inc.’s option to extend for a fourth year. Pursuant to the terms of this agreement, RMW is responsible for creating and staffing studio facilities in both Mumbai and London, England, through which DDPI is to provide VFX services to its clients worldwide. In consideration of RMW’s obligation to provide Digital Domain Productions, Inc. with turnkey studio facilities in these two cities, DDPI has agreed, pursuant to the terms of the agreement, to guarantee to RMW specified minimum monthly levels of production revenues generated at these facilities from DDPI’s VFX projects, in the following estimated annual amounts, based on the U.S. dollar/British pound exchange rate as of March 31, 2012, as applied to those payments under the agreement denominated in British pounds: $18.0 million for the first year of the term of the agreement, $27.5 million for the second year of such term, and $27.0 million for the third year of such term.

 

From the inception of these agreements through March 31, 2012, the Company recognized $6.2 million in expense, including $3.5 million expensed during the three months ended March 31, 2012.  Through that date, we had paid $2.3 million to RMW and the remaining $3.9 million is included in accounts payable and accrued liabilities on the accompanying condensed consolidated balance sheet.

 

Co-Production in Feature Film Project

 

On February 15, 2012, the Company entered into an Investment and Production Agreement with Ender’s Game Holdings LLC (“EGH”) and OddLot Entertainment LLC (“OLE”) effective as of April 18, 2011, to provide financing and production services to co-produce the VFX action movie Ender’s Game. Principal photography for Ender’s Game began February 27, 2012, in New Orleans. The picture has a production budget slightly in excess of $100 million and is scheduled for theatrical release in the fall of 2013. Distribution services are to be provided by Summit Entertainment. As of March 31, 2012 the Company had provided $13.6 million in financing, which is included in film inventory on the condensed consolidated balance sheet. See Note 10 for further discussion.

 

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Digital Domain Galloping Horse Studio

 

On March 30, 2012, the Company entered into an Amended and Restated Formation and Joint Venture Agreement (“the Agreement”) with Beijing Galloping Horse Film Co., Ltd. (“GH”), a corporation organized under the laws of the People’s Republic of China (the “PRC”) and a shareholder of the Company. Pursuant to the Agreement, the parties have agreed to form a joint venture company for the purpose of creating, owning and operating a studio to be located in the PRC to (i) provide computer-generated animation and digital visual effects (including high-quality 3D content and conversion into 3D of existing film and TV libraries originally created in 2D) (collectively, “VFX”) services (the “VFX Business”) in the PRC, Taiwan, Hong Kong and Macau (the “Territory”) for film projects originating in the Territory, and (ii) develop a range of media and entertainment services, including, without limitation, proprietary technologies and entertainment properties, as may be agreed upon by the parties (the “China Studio”). The Company and GH are each initially to own 50% of the equity interests in the Joint Venture.

 

Pursuant to the Agreement, (A) GH is obligated to (i) contribute and assign to the Joint Venture certain specified VFX contracts awarded to it, (ii) provide the land for the China Studio to the Joint Venture, under a nominal cost lease, (iii) fund the construction and build-out costs for the China Studio, in an amount not to exceed $50,000,000, and (iv) provide temporary professional facilities for the use of the China Studio under a nominal cost lease to the Joint Venture; and (B) the Company is obligated to (i) grant to the Joint Venture, for the term thereof, a royalty-free site license to use only in the Territory in connection with the VFX Business of the Joint Venture the intellectual property rights of the Company and its subsidiaries relating to the VFX Business, (ii) design and supervise the build-out of the China Studio’s professional facilities, and (iii) provide, training for the professional personnel to be employed by the Joint Venture. Pursuant to the Agreement, each of the Company and GH has agreed that the other party will be its exclusive partner for all VFX-related services that it performs in the Territory, the Company has agreed not to compete with the VFX Business of the Joint Venture in the Territory, and GH has agreed not to compete with the VFX Business of the Joint Venture in any location worldwide, including the Territory.

 

Additionally, the Company granted to GH the contractual right to require the Company (or its designee), with respect to the period commencing October 1, 2012 (or earlier, under certain specified circumstances) and ending December 31, 2012 (the “Measurement Period”), to purchase from GH, at a price of $8.50 per share (subject to adjustment in the event of stock splits, reverse stock splits and similar corporate events) (the “Exercise Price”), all or any portion of the 588,236 shares of the Company’s common stock currently owned by GH that are owned by GH on the date that it exercises this contractual right; provided, that, and only if, the rolling 15-day average closing price of such common stock on the New York Stock Exchange is less than the Exercise Price at any time during the Measurement Period, and subject to GH’s delivery of a valid exercise notice in writing to the Company on or before January 10, 2013.

 

As of March 31, 2012, the Company included $5.0 million in contracts and other receivables, $1.9 in warrant and other debt-related liabilities and $3.1 million in other long-term liabilities on the condensed consolidated balance sheet related to this transaction.

 

3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Basis of Presentation and Consolidation — The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“US GAAP”). In the opinion of management, these financial statements, including unaudited financial statements for the interim periods, contain all adjustments, consisting of normal recurring adjustments, necessary to present fairly the financial position, results of operations and cash flows for the periods presented. The results of operations for the interim periods presented are not necessarily indicative of the results that may be expected for the full years. Included are the following consolidated financial statements:

 

·                  Consolidated balance sheets as of March 31, 2012 (unaudited) and December 31, 2011, and

 

·                  Consolidated statements of operations and comprehensive loss and consolidated statements of cash flows for the three months ended March 31, 2012 and 2011, (unaudited).

 

The accompanying consolidated financial statements include the accounts of Digital Domain Media Group, Inc., its majority-owned subsidiaries, Digital Domain, Inc. and Digital Domain Institute, Inc. (“DDI”); and its wholly-owned subsidiaries Tradition Studio, Inc., Digital Domain Stereo Group, Inc., DDH Land Holdings LLC, DDH Land Holdings II, LLC, Digital Domain International, Inc., Digital Domain Media Group FZ, LLC and Digital Domain Tactical, Inc. All significant intercompany accounts and transactions have been eliminated in consolidation.

 

The accompanying consolidated financial statements include certain reclassifications of prior period amounts in order to conform to current period presentation.

 

Use of Estimates — US GAAP requires management to make estimates and assumptions in the preparation of these interim consolidated financial statements 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 revenue and expenses during the reporting period. Actual results could differ from these estimates.

 

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The most significant areas that require management judgment are fair values of consideration issued and net assets acquired in connection with business combinations; revenue and cost recognition; collectability of contracts receivable; deferred grant revenue; deferred income tax valuation allowances; amortization of long-lived assets and intangible assets; impairment of long-lived assets, intangible assets and goodwill; accrued expenses; advance payments and deferred revenue; recognition of stock-based compensation; calculation of the warrant and other debt-related liabilities; allocation of equity to non-controlling interests; debt modification accounting; and contingencies and litigation. The accounting policies for these areas are discussed in this Note and other notes to these consolidated financial statements.

 

Digital Imagery Revenue — The Company recognizes digital imagery revenue from fixed-price contracts, each consisting of an accepted written bid and agreed-upon payment schedule, for the development of digital imagery and image creation for the entertainment and advertising industries. Contracts to provide digital imagery are accounted for in accordance with FASB ASC Subtopic 605-35, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. Revenue recognition is initiated when persuasive evidence of an arrangement with a customer is established, which is upon entry by the Company, or Digital Domain (“DD”) and the customer into a legally enforceable agreement. In accounting for the contracts, the cost-to-cost measures of the percentage-of-completion method of accounting are utilized in accordance with FASB ASC Subtopic 605-35. Under this method, revenues, including estimated earned fees or profits, are recorded as costs are incurred. For all contracts, revenues are calculated based on the percentage of total costs incurred compared to total estimated costs at completion. Contract costs include direct materials, direct labor costs and indirect costs related to contract performance, such as indirect labor, supplies and tools. These costs are included in cost of revenues.

 

The customer contracts in the digital imagery business represent binding agreements to provide digital effects to the customers’ specifications. The contracts contain subjective standards applicable to the delivered digital effects and objective specifications that relate to the technical format for the digital effects delivered to customers. In all instances, the customer receives complete ownership rights in and to the digital effects as the effort progresses. In the event of a termination of a contract, ownership in the digital effects transfers to the customer, and the Company or DD as the contractor is entitled to receive reimbursement of costs incurred up to that point and a reasonable profit. The contracts contain production schedules setting forth a timeline for production and a final delivery date for the completed digital effects.

 

Payments for the services are received over the term of the contract, including payments required to be delivered in advance of work to fund a portion of the costs to produce the digital effects. Cash received from customers in excess of costs incurred and gross profit recognized on the related projects are recorded as advance payments. Unbilled receivables represent revenues recognized in excess of amounts billed. The digital effects produced are delivered to the customer at the end of the contract and the customer is not required to deliver the final scheduled payment until receipt and acceptance of the digital effects.

 

A review of uncompleted contracts is performed on an ongoing basis. Amounts representing contract change orders or claims are included in revenues only when they meet the criteria set forth in FASB ASC Subtopic 605-35. In the period in which it is determined that a loss will result from the performance of a contract, the entire amount of the estimated ultimate loss is charged against income. Changes in estimates of contract sales, costs and profits are recognized in the current period based on the cumulative effect of the changes on current and prior periods. Hence, the effect of the changes on future periods of contract performance is recognized as if the revised estimates had been the original estimates. A significant change in one or more projects could have a material adverse effect on the consolidated financial position or results of operations.

 

Assets Measured at Fair Value on a Non-Recurring Basis

 

The Company utilized the following assumptions for determination of the fair value of warrant and other-debt related liabilities as of March 31, 2012 and December 31, 2011, respectively (fair value of liabilities stated in thousands):

 

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Table of Contents

 

 

 

Comvest

 

Falcon

 

Comvest

 

Protective

 

 

 

 

 

Common Stock

 

Notes

 

Capital II

 

Put

 

Galloping

 

 

 

Conversion

 

Bridge

 

Protective

 

Redeemable

 

Horse

 

 

 

Rights

 

Warrants

 

Put

 

Features

 

Put

 

 

 

 

 

 

 

 

 

 

 

 

 

March 31, 2012 (unaudited)

 

 

 

 

 

 

 

 

 

 

 

Fair value of liability

 

$

15,131

 

$

3,914

 

$

6,622

 

$

(4,939

)

$

1,917

 

Term in months

 

51

 

24

 

51

 

51

 

9

 

Risk free interest rate

 

0.84

%

0.34

%

0.84

%

0.84

%

0.17

%

Volatility

 

55.25

%

38.81

%

55.25

%

55.25

%

55.18

%

Dividend rate

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2011

 

 

 

 

 

 

 

 

 

 

 

Fair value of liability

 

$

17,748

 

$

3,914

 

$

5,730

 

 

 

Term in months

 

54

 

24

 

54

 

 

 

Risk free interest rate

 

0.71

%

0.24

%

0.71

%

 

 

Volatility

 

75.93

%

39.59

%

75.93

%

 

 

Dividend rate

 

 

 

 

 

 

 

During 2010, the Company acquired two parcels of land in connection with grants from governmental entities. These parcels of land were valued on May 25, 2010 and September 27, 2010 for $10.5 million and $9.8 million, respectively. The valuations were determined using Level 3 inputs. These amounts are included in Property and equipment-net and deferred land grant revenue in the consolidated balance sheet as of March 31, 2012.  The Company moved into its new headquarters building in December 2011 where one of these parcels of land is located.  Accordingly, the Company began the recognition of the grant revenue related to this land grant in 2012.  The Company recognized $0.1 million of such grant revenue in the three months ended March 31, 2012.

 

As of March 31, 2012, Goodwill and intangible assets other than goodwill relate to the acquisition of Digital Domain, which occurred on October 15, 2009 and the acquisition of In-Three, which occurred on November 22, 2010. The fair value of Goodwill and intangible assets other than goodwill is subjective and based on estimates rather than precise calculations. The fair value measurement for Goodwill and intangible assets other than goodwill uses significant unobservable inputs that reflect management’s assumptions about the estimates that market participants would use in measuring fair value including assumptions about risk. A combination of valuation techniques is used, including (i) an income approach, which utilizes a discounted cash flow analysis using the Company’s weighted-average cost of capital rate, and (ii) the market approach, which compares the fair value of the subject company to similar companies that have been sold whose ownership interests are publicly traded.

 

The Company as of March 31, 2012 received a valuation of the earn-out liability as of that date, from an independent valuation firm, considering it a Level 3 input. Based on this valuation, the Company reduced the earn-out liability by $0.5 million. This reduction is included in selling, general and administrative expenses on the condensed consolidated statement of operations for the three months ended March 31, 2012. The inputs used by the Company in determination of the $2.6 million of earn out liability at March 31, 2012 included a term of 153 months, a risk-free interest rate of 3.0% and no dividends.

 

Earnings Per Share — Basic earnings per share is computed based upon the weighted-average number of shares outstanding, including nominal issuances of common share equivalents, for each period presented. Fully-diluted, earnings per share is computed based upon the weighted-average number of shares and dilutive share equivalents outstanding for each period presented. Due to the Company’s net losses for the three months ended March 31, 2012 and 2011, respectively, the inclusion of the dilutive common share equivalents listed below in the calculation of diluted earnings per share would be anti-dilutive. These common stock equivalents include stock options, warrants, convertible debt securities and rights to exchange shares of DDI’s common stock for shares of the Company’s Common Stock. Thus, the common share equivalents have been excluded from the computation of diluted earnings per share for the three months ended March 31, 2012 and 2011, respectively.

 

The potential dilutive securities outstanding that were excluded from the computation of diluted net loss per share for the following periods, because their inclusion would have had an anti-dilutive effect, are summarized as follows:

 

 

 

 

Three Months Ended March 31,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Stock options issued under 2010 stock plan

 

6,137,499

 

3,137,499

 

Investor warrants

 

1,012,502

 

1,012,502

 

Convertible stock of subsidiary

 

1,661,400

 

 

Convertible note payable

 

533,452

 

4,911,266

 

Convertible preferred stock

 

 

6,266,572

 

Placement agent and other warrants

 

1,889,853

 

3,607,537

 

Total

 

11,234,706

 

18,935,376

 

 

Certain dilutive share equivalents including a warrant and convertible note are dilutive in the calculation of diluted earnings per share. The effects of these dilutive share equivalents on loss per share, are summarized as follows:

 

 

 

Three Months Ended

 

 

 

2012

 

2011

 

 

 

(Unaudited)

 

Reconciliation of diluted loss per share:

 

 

 

 

 

Loss before non-controlling interests

 

$

(15,565

)

$

(38,928

)

Adjustment for effect of as-if converted securities, net of tax:

 

 

 

 

 

Convertible note

 

(3,474

)

 

 

 

(19,039

)

(38,928

)

Net loss attributable to non-controlling interests

 

733

 

(197

)

Net loss attributable to Common Stockholders

 

$

(18,306

)

$

(39,125

)

 

 

 

 

 

 

Weighted average number of common shares outstanding:

 

 

 

 

 

Basic

 

39,977,777

 

14,184,609

 

Adjustment for effect of as-if converted securities, net of tax:

 

 

 

 

 

Convertible note

 

2,861,788

 

 

Diluted

 

42,839,565

 

14,184,609

 

 

 

 

 

 

 

Diluted loss per share:

 

 

 

 

 

Loss before non-controlling interests

 

$

(0.45

)

$

(2.75

)

Net loss attributable to non-controlling interests

 

0.02

 

(0.01

)

Diluted loss per share attributable to Common Stockholders

 

$

(0.43

)

$

(2.76

)

 

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Table of Contents

 

Segment Reporting — Operating segments are defined as components of an enterprise for which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. The Company’s reportable segments are Feature Films, Commercials, and Animation. The management approach is used as the conceptual basis for identifying reportable segments and is based on the way that management organizes within the enterprise for making operating decisions, allocating resources, and monitoring performance, which is primarily based on the sources of revenue.

 

4. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

 

In September 2011, the FASB issued ASU No. 2011-08, Intangibles — Goodwill and Other (‘‘ASU No. 2011-08’’). This ASU amends current guidance to allow an entity to first assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test. Under this amendment, an entity would not be required to calculate the fair value of a reporting unit unless the entity determines, based on a qualitative assessment, that it is more likely than not that its fair value is less than its carrying amount. ASU No. 2011-08 applies to all companies that have goodwill reported in their financial statements. The provisions of this ASU are effective for reporting periods beginning after December 15, 2011. The adoption of this guidance is not expected to have a material impact on the Company’s consolidated financial statements.

 

In June 2011, the FASB issued ASU No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income (‘‘ASU No. 2011-05’’). This ASU improves the comparability, consistency, and transparency of financial reporting and increases the prominence of items reported in other comprehensive income (‘‘OCI’’) by eliminating the option to present components of OCI as part of the statement of changes in stockholders’ equity. The amendments in ASU No. 2011-05 require that all non-owner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. Under either method, adjustments must be displayed for items that are reclassified from OCI to net income, in both net income and OCI. This ASU does not change the current option for presenting components of OCI gross or net of the effect of income taxes, provided that such tax effects are presented in the statement in which OCI is presented or disclosed in the notes to the financial statements. Additionally, this ASU does not affect the calculation or reporting of earnings per share. For public entities, the amendments in this ASU are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011 and are to be applied retrospectively, with early adoption permitted. The adoption of this guidance is for disclosure purposes only and will not have any impact on the Company’s consolidated financial statements.

 

In May 2011, the FASB issued ASU No. 2011-04, Fair Value Measurements (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S.GAAP and IFRSs (‘‘ASU No. 2011-04’’). This ASU amends the wording used to describe many of the requirements in US GAAP for measuring fair value and disclosing information about fair value measurements. The amendments in ASU No. 2011-04 achieve the objectives of developing common fair value measurement and disclosure requirements in US GAAP and IFRSs and improving their understandability. Some of the requirements clarify the FASB’s intent about the application of existing fair value measurement requirements while other amendments change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements. The amendments in this ASU are effective prospectively for interim and annual periods beginning after December 15, 2011, with no early adoption permitted. The adoption of this guidance is for disclosure purposes only and will not have any impact on the Company’s consolidated financial statements.

 

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Table of Contents

 

5. NON-CONTROLLING INTERESTS

 

Changes in the non-controlling interest amounts of our subsidiaries for the three months ended March 31, 2012 (unaudited) were as follows (in thousands):

 

Balance at December 31, 2011

 

$

6,438

 

Issuance of common stock upon exchange of stock in subsidiary

 

(1,034

)

Net loss attributable to non-controlling interests

 

(733

)

Comprehensive income

 

8

 

Balance at March 31, 2012 (unaudited)

 

$

4,679

 

 

During the three months ended March 31, 2012, the Company’s subsidiary Digital Domain realized a net loss of $5.2 million. Pursuant to the requirements under FASB ASC Topic 810, Consolidation, the Company allocates Digital Domain’s earnings to non-controlling interests based on the percentage of common stock of Digital Domain not owned by the Company. Intercompany transactions are eliminated in consolidation but impact the net earnings of each of the respective entities and as such affect amounts allocated to non-controlling interests. During the three months ended March 31, 2012, $4.5 million of Digital Domain’s net loss was allocated to accumulated deficit representing the Company’s proportionate holdings in Digital Domain common stock outstanding (an average of 86.7%) and the remaining 13.3% of Digital Domain’s net loss, amounting to $0.7 million, was allocated to non-controlling interests.  During the three months ended March 31, 2011, $0.8 million of Digital Domain’s net income was allocated to accumulated deficit representing the Company’s proportionate holdings in Digital Domain common stock outstanding (an average of 81.0%), and the remaining 19.0% of Digital Domain’s net income, amounting to $0.2 million, was allocated to non-controlling interests.

 

In a similar manner, the Company’s subsidiary Digital Domain Institute, Inc. “(DDI”) incurred a net loss of $0.5 million during the three months ended March 31, 2012. Of this amount, $0.4 million was allocated to the accumulated deficit and $0.1 million was allocated to non-controlling interests.  During the three months ended March 31, 2012, certain stockholders of DDI exchanged 1,250,000 shares of DDI stock for 1,038,376 shares of the Company’s common stock.  Upon these exchanges, the Company reclassified $1.0 million of equity attributable to non-controlling interests to additional paid in capital.

 

6. CONTRACTS AND OTHER RECEIVABLE

 

The following shows the elements of accounts receivable from contracts as of March 31, 2012 (unaudited) and December 31, 2011 (in thousands):

 

 

 

March 31,

 

December 31,

 

 

 

2012

 

2011

 

 

 

(unaudited)

 

 

 

Costs incurred on uncompleted contracts

 

$

46,178

 

$

46,700

 

Accrued profit on uncompleted contracts

 

11,687

 

15,412

 

 

 

57,865

 

62,112

 

Less billings to date

 

(65,001

)

(68,404

)

Unbilled receivables and advance payments on uncompleted contracts

 

$

(7,136

)

$

(6,292

)

 

 

 

 

 

 

Unbilled Receivables:

 

 

 

 

 

Unbilled receivables

 

$

2,348

 

$

513

 

Advance payments

 

(9,484

)

(6,805

)

 

 

$

(7,136

)

$

(6,292

)

 

 

 

 

 

 

Summary:

 

 

 

 

 

Billed:

 

 

 

 

 

Completed contracts

 

$

776

 

$

900

 

Contracts in process

 

896

 

1,033

 

Retained

 

 

 

 

 

1,672

 

1,933

 

Unbilled

 

2,348

 

513

 

 

 

$

4,020

 

$

2,446

 

 

In addition to contract receivables, the Company had other receivables of $5.9 million as of March 31, 2012. Of that amount, $5.0 million of other receivables is for a joint venture agreement with Beijing Galloping Horse Film Co., Ltd. for future distribution rights

 

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within certain territories of the People’s Republic of China. See Note 2 for further discussion.  Additionally, other receivables include $0.6 million in foreign tax receivables and $0.3 million in grant and royalty receivables.

 

At March 31, 2011, the Company had other receivables of $0.2 million related to grant and royalty revenues.

 

7. GRANTS AND TAX INCENTIVES FROM GOVERNMENTAL ENTITIES

 

In November 2009, as amended on February 22, 2010, the Company entered into a Grant Agreement and a Lease Agreement with the City of Port St. Lucie, Florida (‘‘the City’’) calling for the City to provide to the Company a $10.0 million cash grant (‘‘City Cash Grant’’) and approximately $50.0 million in the form of a land donation and construction financing assistance (the ‘‘Building and Land Grant’’). These awards were granted as an incentive to locate operations in the State of Florida and specifically in Port St. Lucie, and to incent hiring activities, among other things, both of which will provide economic advantages to the general community.

 

In connection with the Building and Land Grant discussed above, the City issued bonds of $39.9 million on April 27, 2010 for the purpose of financing the construction of a building and installation of related equipment and certain associated expenses. The funds received under the bond issuance were deposited in a construction fund, which is used to fund construction expenses and equipment purchases.

 

The proceeds from the bonds were recorded in Cash, held in trust, and the obligation as Government lease obligation in the condensed consolidated balance sheet as of March 31, 2012. Through March 31, 2012 (unaudited) and December 31, 2011, the following activities have been recognized (in thousands):

 

 

 

Cash Held in
Trust

 

Payments From
Operating Cash

 

Property &
Equipment,
Net

 

Government
Lease
Obligation, Net

 

Accrued
Interest on
Bonds

 

Interest
Expense

 

Accrued
Construction
Expenses to be
Funded by
Cash, Held in
Trust

 

Balance at December 31, 2010

 

$

31,219

 

$

 

$

7,686

 

$

(38,301

)

$

(661

)

$

57

 

$

 

Construction in progress - paid by December 31, 2011

 

(18,644

)

 

18,644

 

 

 

 

 

Construction costs held in retainer

 

 

 

1,789

 

 

 

 

(1,789

)

Recognition of interest expense, capitalized and expensed, net

 

 

 

1,859

 

(413

)

(1,973

)

527

 

 

Purchase of property and equipment place into service

 

(3,920

)

 

3,920

 

 

 

 

 

Amortization of OID and issuance costs

 

 

 

117

 

(117

)

 

 

 

Issuance cost made available for construction uses

 

 

 

63

 

(63

)

 

 

 

Payment of accrued interest, net

 

(1,973

)

 

 

 

1,973

 

 

 

Balance at December 31, 2011

 

6,682

 

 

34,078

 

(38,894

)

(661

)

584

 

(1,789

)

Construction in progress - paid by March 31, 2012

 

(1,789

)

 

 

 

 

 

1,789

 

Payment to the City

 

2,740

 

(2,740

)

 

 

 

 

 

Recognition of interest expense, capitalized and expensed, net

 

 

 

 

 

(110

)

(495

)

605

 

 

Payment by the City for interest

 

(990

)

 

 

 

990

 

 

 

Balance at March 31, 2012 (unaudited)

 

$

6,643

 

$

(2,740

)

$

34,078

 

$

(39,004

)

$

(166

)

$

1,189

 

$

 

 

In addition to the amounts disclosed above, the Company incurred $0.7 million of primarily internal costs associated with the building project that are capitalized in accordance with ASC 310-20, and will pay approximately $0.4 million of costs over-runs accrued in the Company’s Consolidated Balance Sheet as of December 31, 2011, and March 31, 2012. The Company also incurred $3.0 million for leasehold improvements related to the building project. These cost are not included in the table above.

 

Upon completion of the project in December 2011, the Company evaluated the transaction under FASB ASC Subtopic 360-20 to determine whether a sale transaction had occurred such that the Company would record a sale-leaseback under FASB ASC 840-40. As the Company has retained substantially all the benefits and risks incident to ownership of the property sold and the Company has the option to purchase the building and equipment at the end of the lease term ASC 360-20-40-38 dictates that the transaction must be accounted for as a financing transaction.

 

In accordance with being considered the owner of the asset under construction during the construction phase of the project and continues to be deemed the owner upon occupancy of the building, the Company accounts for the building and equipment, related depreciation, lease obligations, accrued interest, and cash held in trust, on its consolidated balance sheets and in its statements of operations. Interest expense associated with the bonds is being recognized using an effective rate of 7.6% based on the Company’s cash flows to service the bonds requirements pursuant to the lease agreement. In accordance with FASB ASC 310-20, the Company considered the initial amounts held to service interest during the construction phase and the debt service reserve, as fees paid at the inception of the loan.

 

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8. PROPERTY AND EQUIPMENT

 

Property and equipment as of March 31, 2012 (unaudited) and December 31, 2011 consisted of the following (in thousands):

 

 

 

March 31,

 

December 31,

 

 

 

2012

 

2011

 

 

 

(Unaudited)

 

 

 

Building

 

$

27,590

 

$

27,590

 

Land

 

21,330

 

21,330

 

Computer equipment

 

25,691

 

23,763

 

Computer software

 

14,875

 

13,017

 

Leasehold improvements

 

7,013

 

6,902

 

Machinery and equipment

 

2,843

 

2,823

 

Office equipment, furniture and fixtures

 

5,063

 

4,864

 

Total property and equipment - cost

 

104,405

 

100,289

 

Less accumulated depreciation and amortization

 

(23,779

)

(20,148

)

Total property and equipment - net

 

$

80,626

 

$

80,141

 

 

Computer software in the table above includes capitalized costs related to internally developed computer software. There were no additions to such capitalized costs for the three months ended March 31, 2012 and 2011, respectively. The gross carrying amount of capitalized costs associated with internally developed computer software as of March 31, 2012 (unaudited) and December 31, 2011 were each $4.5 million. As of March 31, 2012 (unaudited) and December 31, 2011, the accumulated depreciation on the capitalized costs associated with internally developed computer software was $2.0 million and $1.8 million, respectively.

 

As of March 31, 2012 (unaudited) and December 31, 2011, the gross carrying amount of property and equipment recorded under capital leases were each $4.5 million. As of these dates, the accumulated depreciation on these leased assets was $3.3 million and $3.0 million, respectively.

 

Depreciation and amortization expense on property and equipment totaled $3.6 million, and $2.9 million, for the three months ended March 31, 2012 and 2011, respectively (unaudited).

 

On January 12, 2011, the Company acquired $8.5 million in equipment from an unrelated third party. During the three months ended March 31, 2012, the Company financed the first installment payment of $2.5 million through City of Port St. Lucie bond proceeds, paid $2.0 million from its general funds and paid $4.0 million using proceeds from equipment financing transactions.

 

9. INTANGIBLE ASSETS AND GOODWILL

 

Goodwill and indefinite-lived intangible assets are tested for impairment at least annually and more frequently if events or changes in circumstances indicate the assets may be impaired. The Company determined there were no events or changes in circumstances that indicate that carrying values of Goodwill, indefinite-lived intangible assets, or other intangible assets subject to amortization may not be recoverable as of March 31, 2012 and December 31, 2011.

 

The following table provides information regarding changes in Goodwill and indefinite-lived intangible assets during the three months ended March 31, 2012 (unaudited, in thousands):

 

 

 

Goodwill

 

Trademark

 

Goodwill & intangible assets not subject to amortization:

 

 

 

 

 

Balance, December 31, 2011

 

$

18,081

 

$

15,410

 

Changes recognized upon acquisitions or impairment

 

 

 

Balance, March 31, 2012 (unaudited)

 

$

18,081

 

$

15,410

 

 

The following tables present information regarding intangible assets with finite lives, all of which were recorded upon the acquisitions of Digital Domain and In-Three, at March 31, 2012 (unaudited) and December 31, 2011 (dollars in thousands):

 

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March 31, 2012 (Unaudited)

 

 

 

 

 

 

 

 

 

Remaining

 

 

 

Gross Carrying

 

Accumulated

 

 

 

Lives

 

 

 

Amount

 

Amortization

 

Net Amount

 

(Months)

 

Unpatented technology

 

$

25,910

 

$

(6,451

)

$

19,459

 

105

 

Patents

 

420

 

(35

)

385

 

165

 

Titanic participation rights

 

1,800

 

(300

)

1,500

 

150

 

Customer relationships

 

300

 

(50

)

250

 

150

 

Proprietary software

 

5,900

 

(1,146

)

4,754

 

210

 

Total identified intangible assets

 

$

34,330

 

$

(7,982

)

$

26,348

 

 

 

 

 

 

December 31, 2011

 

 

 

 

 

 

 

 

 

Remaining

 

 

 

Gross Carrying

 

Accumulated

 

 

 

Lives

 

 

 

Amount

 

Amortization

 

Net Amount

 

(Months)

 

Unpatented technology

 

$

25,910

 

$

(5,804

)

$

20,106

 

108

 

Patents

 

420

 

(28

)

392

 

168

 

Titanic participation rights

 

1,800

 

(270

)

1,530

 

153

 

Customer relationships

 

300

 

(45

)

255

 

153

 

Proprietary software

 

5,900

 

(973

)

4,927

 

213

 

Total identified intangible assets

 

$

34,330

 

$

(7,120

)

$

27,210

 

 

 

 

Amortization expense for intangible assets with finite lives was $0.9 million for the three months ended March 31, 2012 and 2011, respectively.

 

The estimated future amortization expense as of March 31, 2012 (unaudited) is as follows (in thousands):

 

 

 

March 31,

 

 

 

2012

 

 

 

(Unaudited)

 

2012 (remaining 2012 at March 31, 2012)

 

$

2,588

 

2013

 

3,451

 

2014

 

2,984

 

2015

 

2,984

 

2016

 

2,984

 

Thereafter

 

11,357

 

Total

 

$

26,348

 

 

10. FILM INVENTORY

 

Film inventory as of March 31, 2012 (unaudited) and December 31, 2011 are summarized as follows (in thousands):

 

 

 

March 31, 2012

 

December 31, 2011

 

 

 

(unaudited)

 

 

 

In-production:

 

 

 

 

 

Animation

 

$

6,932

 

$

3,926

 

Live-action

 

13,580

 

2,205

 

Total in-production

 

20,512

 

6,131

 

In-development

 

829

 

794

 

Total film inventory

 

$

21,341

 

$

6,925

 

 

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11. ACCOUNTS PAYABLE AND ACCRUED LIABILITIES

 

Accounts payable and accrued liabilities as of March 31, 2012 (unaudited) and December 31, 2011 are summarized as follows (in thousands):

 

 

 

March 31, 2012

 

December 31, 2011

 

 

 

(unaudited)

 

 

 

Accounts payable

 

$

5,036

 

$

6,491

 

Accrued wages and employee benefits

 

6,921

 

4,954

 

Accrued professional fees

 

200

 

1,302

 

Accrued outsource labor

 

4,837

 

2,149

 

Accrued tax credits

 

2,365

 

2,365

 

Other accrued expenses

 

2,957

 

4,213

 

Total accounts payable and accrued liabilities

 

$

22,316

 

$

21,474

 

 

12. INCOME TAXES

 

Deferred income taxes reflect the net tax effects of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and for income tax purposes. A deferred income tax asset is recognized if realization of such asset is more likely than not, based upon the weight of available evidence which includes historical operating performance and the Company’s forecast of future operating performance. The Company evaluates the realizability of its deferred income tax assets and a valuation allowance is provided, as necessary. During this evaluation, the Company reviews its forecasts of income in conjunction with the positive and negative evidence surrounding the realizability of its deferred income tax assets to determine if a valuation allowance is needed.

 

The Company recognized income tax expense of $ nil and $0.3 million for the three months ended March 31, 2012 and 2011, respectively for foreign income taxes based on the then expected effective income tax rate.  No federal, state and local tax benefit was recorded during the three month periods ended March 31, 2012 and 2011, respectively, for the Company’s pretax loss, because the future realizability of such benefits was not considered to be more likely than not.

 

13. NOTES PAYABLE AND RELATED FINANCING TRANSACTIONS

 

Summaries of convertible and other notes payable as of March 31, 2012 (unaudited) and December 31, 2011 are as follows (in thousands):

 

 

 

March 31, 2012 (Unaudited)

 

 

 

 

 

Comvest

 

Comvest

 

Comvest

 

Other

 

 

 

 

 

Convertible

 

Lender

 

Revolver

 

Notes

 

Net

 

 

 

Note Payable

 

Note Payable

 

Payable

 

Payable

 

Debt

 

Face amount

 

$

8,134

 

$

12,000

 

$

7,438

 

$

3,000

 

$

30,572

 

Unamortized discount

 

(4,937

)

(830

)

(497

)

 

(6,264

)

Net debt

 

3,197

 

11,170

 

6,941

 

3,000

 

24,308

 

Less current portion

 

(938

)

(1,386

)

(858

)

(3,000

)

(6,182

)

Long-term portion

 

$

2,259

 

$

9,784

 

$

6,083

 

$

 

$

18,126

 

 

 

 

December 31, 2011

 

 

 

Comvest

 

Comvest

 

Comvest

 

 

 

 

 

Convertible

 

Lender

 

Revolver

 

Net

 

 

 

Note Payable

 

Note Payable

 

Note Payable

 

Debt

 

Face amount

 

$

8,000

 

$

12,000

 

$

7,400

 

$

27,400

 

Unamortized discount

 

(7,545

)

(1,120

)

(668

)

(9,333

)

Net debt

 

455

 

10,880

 

6,732

 

18,067

 

Less current portion

 

 

(10,880

)

(6,732

)

(17,612

)

Long-term portion

 

$

455

 

$

 

$

 

$

455

 

 

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Principal maturities of debt at March 31, 2012 (unaudited) are as follows (in thousands):

 

Remaining 2012

 

$

4,273

 

2013

 

7,636

 

2014

 

7,636

 

2015

 

7,636

 

2016

 

3,391

 

Total face amount

 

30,572

 

Less amounts representing debt discount

 

(6,264

)

Net debt

 

$

24,308

 

 

The changes in net debt for the three months ended March 31, 2012 (unaudited) and the year ended December 31, 2011 are as follows (in thousands):

 

 

 

Comvest

 

Comvest

 

Comvest

 

Other

 

 

 

 

 

Convertible

 

Lender

 

Revolver

 

Notes

 

Total

 

 

 

Note Payable

 

Note Payable

 

Note Payable

 

Payable

 

Net Debt

 

Net debt, December 31, 2011

 

$

455

 

$

10,880

 

$

6,732

 

$

 

$

18,067

 

New borrowings

 

 

 

 

3,000

 

3,000

 

Recognition of discounts and deferred issue costs

 

(44

)

(65

)

(41

)

 

(150

)

Amortization of discounts and deferred issue costs

 

272

 

355

 

213

 

 

840

 

Capitalized interest

 

134

 

 

37

 

 

171

 

Debt restructuring

 

2,380

 

 

 

 

2,380

 

Net debt, March 31, 2012 (unaudited)

 

$

3,197

 

$

11,170

 

$

6,941

 

$

3,000

 

$

24,308

 

 

Interest and Financing Expense (Credit)— The components of interest expense (credit) for the three months ended March 31, 2012 and 2011 are as follows (unaudited, in thousands):

 

 

 

Three Months Ended March 31,

 

 

 

2012

 

2011

 

Changes in fair value of warrant and other debt-related liabilities

 

$

(4,284

)

$

28,965

 

Amortization of discount and issuance costs on notes payable

 

1,599

 

3,013

 

Interest expense on notes payable

 

670

 

502

 

Interest expense on capital and governmental lease obligations

 

670

 

318

 

Net interest expense (credit)

 

$

(1,345

)

$

32,798

 

 

Debt transactions in the three months ended March 31, 2012 — On February 23, 2012, the convertible note with Comvest was restructured.  This restructuring included amending a protective put right of Comvest (see Note 14) from $4.50 per share to $6.00 per share.  Additionally, certain loan covenants were amended or removed and Comvest forgave certain penalty interest payments due Comvest for breaches of loan covenants.  Among these, the Company’s minimum EBITDA covenant, as defined, was removed and a minimum cash covenant was instituted.  The Company also received a redemption feature to allow the Company to redeem 50% of the post-conversion shares of the convertible note at the purchase price of $6.00 per share prior to the expiration of the protective put.  The effect of this restructuring was to increase the carrying value of the Comvest convertible note by $2.4 million and decrease warrant liabilities by the same amount.  The increase to the carrying value of the convertible note is being amortized over the remaining life of the loan using the effective interest rate method.  The convertible note was exchanged for a subordinated convertible note on May 7, 2012, as discussed later in this section.

 

On March 19, 2012, the Company borrowed $3.0 million from Legend Pictures Funding, LLC (“Legend Pictures”).  This note bears simple interest at a rate of 8% per annum.  The maturity date of this note is July 18, 2012.  However, the note becomes due in full plus accrued interest earlier than that date upon an occurrence of an Event of Default (as defined) or if Legend Pictures at its sole discretion converts the note into shares of the Company’s common stock. This note is convertible into 533,452 shares of the Company’s common stock at March 31, 2012. Additionally, this note is personally guaranteed by the Company’s Chief Executive Officer.

 

On March 30, 2012, the Company recognized $0.2 million as additional debt discount and was allocated to the three Comvest notes based on the face value of the notes at that time.

 

The Comvest convertible note gives the Company the option to pay the interest expense each month in cash of in-kind by adding the monthly interest to the face amount of the note.  The Company elected this option for the months of February and March, 2012.  The Company pays monthly interest at the 10% per annum related to the Comvest revolver note payable.  Beginning January 1, 2012, the Company incurred an additional interest expense each month of 2% per annum for the Comvest revolver rate payable, which is added to the revolver note face value.  The total amount of capitalized interest recorded for these two loans during the three months ended March 31, 2012 aggregated $0.2 million.

 

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Sale and Issuance of Convertible Notes and Warrants

 

On May 6, 2012, Digital Domain Media Group, Inc. (the “Company”) entered into a securities purchase agreement (the “Purchase Agreement”) with a group of institutional investors (the “Purchasers”) pursuant to which the Company issued and sold to the Purchasers senior secured convertible notes in the aggregate original principal amount of $35.0 million (the “Senior Notes”) and warrants (the “Warrants”) to purchase up to 1,260,288 shares of the Company’s common stock for an aggregate purchase price of $35.0 million (the “Offering”).  The initial conversion price of the Senior Notes is $9.72, subject to adjustment as provided in the Senior Notes.  The initial exercise price of the Warrants is $9.72 per share, subject to adjustment as provided in the Warrants.  Such issuance and sale were consummated on May 7, 2012.

 

The indebtedness evidenced by the Senior Notes bears interest at 9.0% per annum, compounded quarterly, payable quarterly in arrears, and matures on the fifth anniversary of the issuance date. Upon the occurrence of an Event of Default (as such term is defined in the Senior Notes), the interest rate shall be adjusted to a rate of 15.0% per annum. The Purchasers may require the Company to redeem all or any portion of the Senior Notes upon the occurrence of an Event of Default (as such term is defined in the Senior Notes) or a Change of Control (as such term is defined in the Senior Notes).  The Senior Notes also contain, among other things, certain affirmative and negative covenants, including, without limitation, limitations on indebtedness, liens and restricted payments and certain financial covenants.

 

The Senior Notes will amortize in equal monthly installments commencing on the earlier of (i) the effective date of the initial registration statement filed in accordance with the terms of the Registration Rights Agreement (as defined below) or (ii) the six-month anniversary of the closing date. The Senior Notes may be converted into shares of the Company’s common stock, at the option of the holders thereof, at any time following issuance of the Senior Notes.  The Senior Notes are redeemable at the option of the Company if the Company’s common stock trades at a level equal to 175% of the initial conversion price for any 30 consecutive trading days commencing on the date of issuance of the Senior Notes.

 

On certain Adjustment Dates (as such term is defined in the Senior Notes), the conversion price applicable to the Senior Notes will be adjusted to the lesser of (a) the then-current conversion price and (b) the market price of the Company’s common stock on such date. The Senior Notes have anti-dilution protection in the event that the Company issues securities at an equivalent value less than the conversion price, and the conversion price is also subject to adjustment for stock splits, stock dividends, recapitalizations, and similar transactions. The Company has agreed to pay each amortization payment in shares of the Company’s common stock, provided that certain conditions are met. The conversion rate applicable to any amortization payment in shares of the Company’s common stock will be the lower of (a) the conversion price then in effect and (b) a price equal to 85.0% of (i) the aggregate of the volume-weighted average prices of the Company’s shares of common stock for each of the ten lowest trading days during the 20 consecutive trading day period ending on the applicable amortization payment date, divided by (ii) 10. The Company is generally prohibited from issuing shares of common stock upon conversion of the Senior Notes if such conversion would cause the Company to breach its obligations under the rules or regulations of the New York Stock Exchange, or such other stock market on which the Company’s common stock is then traded.

 

The obligations of the Company under the Senior Notes are secured pursuant to the terms of a security and pledge agreement (the “Security Agreement”) and a Canadian security and pledge agreement (the “Canadian Security Agreement”) covering all of the assets of the Company and its subsidiaries (other than inactive subsidiaries) (the “Collateral”) and conferring on the Purchasers, subject to Permitted Liens (as such term is defined in the Purchase Agreement), a first-priority security interest in the Collateral.  The Security Agreement also contains customary representations, warranties and covenants.  In addition, all of the obligations of the Company under the Senior Notes are guaranteed by certain of the Company’s subsidiaries pursuant to the terms of a guaranty (the “Guaranty”).

 

Under the terms of the Warrants, the holders thereof are entitled to exercise the Warrants to purchase up to an aggregate of 1,260,288 shares of the Company’s common stock at an initial exercise price of $9.72 per share, during the five-year period beginning on the closing date. On certain Adjustment Dates (as defined in the Warrants), the exercise price applicable to the Warrants will be adjusted to the lesser of (a) the then-current exercise price and (b) the market price of the Company’s common stock on such date. The exercise price of the Warrants is also subject to adjustment for stock splits, stock dividends, recapitalizations, and similar transactions. The Company is generally prohibited from issuing shares of common stock upon exercise of the Warrants if such exercise would cause the Company to breach its obligations under the rules or regulations of the New York Stock Exchange, or such other stock market on which the Company’s common stock is then traded.

 

In connection with the financing transaction described above, the Company entered into a registration rights agreement (the “Registration Rights Agreement”) pursuant to which it agreed to file a registration statement with the Securities and Exchange Commission (the “Commission”) relating to the offer and sale by the Purchasers of the shares of the Company’s common stock issuable upon the conversion of the Senior Notes and the exercise of the Warrants. Pursuant to the terms of the Registration Rights Agreement, the Company is required to file the registration statement within 30 days of the closing date and to use its reasonable best efforts for the registration statement to be declared effective 90 days after the closing date.

 

The Senior Notes and the Warrants were issued pursuant to an exemption from registration afforded by Section 4(2) of the Securities Act of 1933, as amended, as transactions not involving a public offering.  In connection with these transactions, the Company paid a placement agent fee of $2.4 million to the sole placement agent for the offering of the Senior Notes and the Warrants.

 

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As a condition to the sale of the Senior Notes and the Warrants, two persons who are directors, executive officers and greater than 5% shareholders of the Company, who beneficially own an aggregate of 11,937,984 shares of the Company’s common stock, entered into a voting agreement (the “Voting Agreement”), pursuant to which they agreed not to sell, pledge, hypothecate or otherwise transfer their shares during the six-month period commencing on the closing date of the financing transaction, subject to certain exceptions for estate planning and similar purposes.

 

Exchange of Outstanding Debt with Existing Lender

 

On May 6, 2012, concurrently with the execution and delivery of the Purchase Agreement, the Company entered into an Omnibus Consent and Agreement re Restructuring (the “Omnibus Agreement”) with Comvest, pursuant to which, among other things, the Company agreed to (i) use a portion of the proceeds received by it in connection with the financing transaction described above to make payments to Comvest with respect to the outstanding loans to the Company held by Comvest, such that the aggregate outstanding principal balance thereof was reduced to $8.0 million, and (ii) repurchase all but 145,000 shares (the “Retained Shares”) of the Company’s common stock received by Comvest upon full exercise of an outstanding warrant to purchase shares of the Company’s common stock held by Comvest. The aggregate amount paid to Comvest in satisfaction of outstanding indebtedness and in repurchasing such shares, as described above, was $22.5 million, plus certain fees and expenses that the Company agreed to pay.

 

In connection with the foregoing, the Company and Comvest entered into a Debt Exchange Agreement (the “Debt Exchange Agreement”), pursuant to which, among other things, the Company exchanged the remaining outstanding original principal balance under its outstanding loans held by Comvest for a new secured convertible note in favor of Comvest with an original principal amount of $8.0 million (the “Subordinated Note”), which Subordinated Note, inclusive of any and all accrued interest on the Subordinated Note and other fees, costs and amounts owing thereunder, is convertible into shares of the Company’s common stock, in accordance with the terms thereof. The debt exchange transaction was consummated on May 7, 2012.

 

The indebtedness evidenced by the Subordinated Note bears interest at 10.0% per annum, compounded quarterly, payable quarterly in arrears, and matures on June 30, 2016. Upon the occurrence of an Event of Default (as such term is defined in the Subordinated Note), the interest rate shall be adjusted to a rate of up to 21.0% per annum, with the actual rate of such penalty interest to be contingent upon the nature of the Event of Default.  Comvest may require the Company to redeem all or any portion of the Subordinated Note upon the occurrence of an Event of Default (as such term is defined in the Subordinated Note).  The Subordinated Note also contains, among other things, certain affirmative and negative covenants, including, without limitation, limitations on indebtedness, liens and restricted payments and certain financial covenants.

 

The initial conversion price under the Subordinated Note is (i) $2.50 per share for payment of any portion of the original principal amount and (ii) $5.50 per share for payment of any other amounts owing thereunder, subject to adjustment as provided in the Subordinated Note. The Subordinated Note has anti-dilution protection in the event that the Company issues securities at an equivalent value less than the applicable conversion price, and the conversion price is also subject to adjustment for stock splits, stock dividends, recapitalizations, and similar transactions. The Company is generally prohibited from issuing shares of common stock upon conversion of the Subordinated Note if such conversion would cause the Company to breach its obligations under the rules or regulations of the New York Stock Exchange, or such other stock market on which the Company’s common stock is then traded.

 

The obligations of the Company under the Subordinated Note are secured pursuant to the terms of a security and pledge agreement (the “Comvest Security Agreement”) and a Canadian security and pledge agreement (the “Comvest Canadian Security Agreement”) covering all of the Collateral and conferring on Comvest, subject to Permitted Liens (as such term is defined in the Debt Exchange Agreement), a security interest in the Collateral.  The Comvest Security Agreement also contains customary representations, warranties and covenants.  In addition, all of the obligations of the Company under the Subordinated Note are guaranteed by certain of the Company’s subsidiaries pursuant to the terms of a guaranty (the “Comvest Guaranty”).  The Company also entered into a subordination and intercreditor agreement (the “Subordination Agreement”) with Comvest and the collateral agent for the Senior Notes, setting forth the seniority and respective rights to collateral among Comvest and the holders of the Senior Notes.

 

In connection with the debt exchange transaction, the Company entered into a registration rights agreement with Comvest (the “Comvest Registration Rights Agreement”) pursuant to which it agreed to file a registration statement with the Commission relating to the offer and sale of the shares of the Company’s common stock issuable upon conversion of the Subordinated Note and the Retained Shares. Pursuant to the agreement, the Company is required to file the registration statement within 30 days of the closing date and to use its reasonable best efforts for the registration statement to be declared effective 90 days after the closing date of the debt exchange transaction.

 

As the Comvest debt was replaced with debt maturing in 2017, the Company reclassified $14.9 million of net debt from current liabilities to long-term liabilities as of March 31, 2012, in accordance with ASC 470-10-45-14. The Company has yet to determined the effects of these transactions on its consolidated financial statements.

 

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14. WARRANTS, OPTIONS AND OTHER DEBT-RELATED LIABILITIES

 

Summaries of warrant and other debt-related liabilities as of March 31, 2012 (unaudited) and December 31, 2011 are as follows (unaudited, in thousands):

 

 

 

March 31,

 

December 31,

 

 

 

2012

 

2011

 

Short-term warrant liabilities:

 

 

 

 

 

Comvest Capital II fee warrants

 

$

 

$

2,548

 

Galloping Horse put

 

1,917

 

 

Digital Domain Bridge Warrants

 

3,914

 

3,914

 

Total short-term warrant liabilities

 

5,831

 

6,462

 

Long-term warrant liabilities:

 

 

 

 

 

Comvest Capital II fee warrants

 

2,422

 

 

 

Comvest Capital II conversion warrants

 

12,709

 

15,200

 

Comvest Capital II protective put

 

6,622

 

5,730

 

Comvest redeemable feature

 

(4,939

)

 

Total long-term warrant liabilities

 

16,814

 

20,930

 

Total warrant liabilities

 

$

22,645

 

$

27,392

 

 

The following table summarizes the warrant and other debt-related liabilities transactions from December 31, 2011 through March 31, 2012 (unaudited, in thousands):

 

 

 

Comvest
Capital II

 

Galloping
Horse Put

 

Digital Domain
Bridge
Warrants

 

Total

 

Balance, December 31, 2011

 

$

23,478

 

$

 

$

3,914

 

$

27,392

 

Debt restructuring (see Note 15)

 

(2,380

)

 

 

(2,380

)

Recognition of put liability

 

 

1,917

 

 

1,917

 

Changes in fair value of warrants

 

(4,284

)

 

 

(4,284

)

Balance, March 31, 2011 (unaudited)

 

$

16,814

 

$

1,917

 

$

3,914

 

$

22,645

 

 

As discussed in Note 13, the Company reclassified the Comvest debt from current liabilities to long-term liabilities as of March 31, 2012.  The Company also reclassified the Comvest fee warrants aggregating $2.4 million from current liabilities to long-term liabilities on that date as well.

 

15. SEGMENT INFORMATION

 

Segment financial information for the three months ended March 31, 2012 and 2011, respectively, is as follows (unaudited, in thousands):

 

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Three Months Ended

 

 

 

March 31,

 

 

 

2012

 

2011

 

 

 

(Unaudited)

 

Revenues:

 

 

 

 

 

Digital Production:

 

 

 

 

 

Feature Films

 

$

27,588

 

$

31,605

 

Commercials

 

2,660

 

6,299

 

Animation

 

 

 

Corporate/Other

 

893

 

653

 

Total revenues

 

31,141

 

38,557

 

 

 

 

 

 

 

Costs and expenses:

 

 

 

 

 

Digital Production:

 

 

 

 

 

Feature Films

 

30,146

 

26,231

 

Commercials

 

3,131

 

5,144

 

Animation

 

 

 

Corporate/Other

 

15,118

 

14,129

 

Total costs and expenses

 

48,395

 

45,504

 

 

 

 

 

 

 

Operating (loss) income:

 

 

 

 

 

Digital Production:

 

 

 

 

 

Feature Films

 

(2,558

)

5,374

 

Commercials

 

(471

)

1,155

 

Animation

 

 

 

Corporate/Other

 

(14,225

)

(13,476

)

Net operating loss

 

$

(17,254

)

$

(6,947

)

 

 

 

 

 

 

Revenues:

 

 

 

 

 

United States

 

$

22,602

 

$

31,212

 

Canada

 

8,539

 

7,345

 

Total

 

$

31,141

 

$

38,557

 

 

16. COMMITMENTS AND CONTINGENCIES

 

Litigation

 

Wyndcrest DD Florida, Inc., et al adv. Carl Stork   On March 29, 2010, the Company (under the former name “Wyndcrest DD Florida, Inc.”) sued former Digital Domain Chief Executive Officer and director Carl Stork in Brevard County Florida Circuit Court to enforce a February 2010 stock purchase agreement pursuant to which the Company purchased Mr. Stork’s Digital Domain shares. The case was voluntarily dismissed on December 16, 2010. On September 8, 2010, Mr. Stork filed suit against the Company in Los Angeles County Superior Court seeking rescission of the agreement and compensatory and punitive damages. The case was removed to the United States District Court for the Central District of California. Mr. Stork has been paid the purchase price in full under the agreement. The Company is vigorously defending against the claims. The case is in discovery, and as such the Company cannot reliably predict the outcome. Trial has been set for June 2012.

 

JK-DD, LLC and Jeffrey Kukes v. John C. Textor, et al   On August 12, 2010 the plaintiffs, who are stockholders of Digital Domain, filed suit against the defendants in Palm Beach County, Florida, Circuit Court seeking rescission of a 2007 settlement agreement that resolved a prior partnership dispute between Mr. Kukes and Mr. Textor pursuant to which the plaintiffs obtained their shares of Digital Domain common stock. The plaintiffs also seek damages for alleged dilution of the value of such shares. The defendants believe the Complaint is an attempt to reverse a valid, binding settlement agreement and are aggressively defending against the claims. On September 27, 2010, the defendants filed a motion to dismiss the plaintiffs’ claims. The plaintiffs subsequently dismissed two of the three counts in their original complaint, mailed defendants a draft amended complaint naming the Company as a defendant, and filed a separate new action against Mr. Textor and his wife, individually. The plaintiffs’ draft amended complaint against the Company has not been filed. Both cases are in discovery, and as such the Company cannot reliably predict the outcome. No trial date has been set in either case.

 

4580 Thousand Oaks Boulevard Corporation v. In Three, Inc., et al.   On April 21, 2011, the plaintiff, the former commercial landlord of In-Three, Inc., filed suit in California Superior Court (Ventura County) seeking approximately $4.6 million in unpaid rent and operating expenses allegedly owed pursuant to a lease agreement between the plaintiff and In-Three. The subject lease pre-dated our acquisition of certain assets of In-Three and was specifically not assumed by us in that transaction. Notwithstanding, the plaintiff originally named the Company and its subsidiaries Digital Domain Productions and Digital Domain Stereo Group, Inc. (“DDSG”), formerly DD3D, Inc, a subsidiary of the Company, as defendants but voluntarily dismissed its claims against all Digital Domain defendants on June 24, 2011. Subsequently, on October 5, 2011, the

 

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plaintiff’s counsel sent a letter to us requesting that the Company voluntarily stipulate to a court order permitting the filing of an amended complaint which would have added us back into the lawsuit as a defendant. The Company has refused to stipulate to the filing of an amended complaint on the grounds that such an amendment would be futile as, in the Company’s judgment, no lawful basis exists for advancing any claims against the Company. The plaintiff responded by conducting additional discovery pertinent to the asset purchase transaction to determine whether sufficient evidence exists to support the proposed amended complaint.

 

In-Three has responded to such discovery, and the plaintiff, thus far, has chosen not to seek leave of court to file the proposed amended complaint. In consequence, we are not defendants in this litigation. The case is currently in trial only as to In-Three. In-Three has acknowledged its contractual indemnity obligation to us pursuant to the asset purchase transaction and, accordingly, will represent us in defense of this action if necessary.

 

Digital Domain Stereo Group, Inc. v. Prime Focus North America, Inc. and Prime Focus VFX USA, Inc.   DDSG currently holds the assets the Company purchased from In-Three, filed a complaint in the United States District Court for the Central District of California against Prime Focus in November 2011 for damages associated with Prime Focus’ infringement upon DDSG’s stereo 3D conversion patents. Prime Focus answered on February 17, 2012 denying DDSG’s claims, asserting various affirmative defenses and seeking a declaratory judgment of no infringement and patent invalidity, the standard defenses asserted by defendants in patent infringement cases. The case is in its initial stages and as such we cannot reliably predict the outcome. No trial date has been set for this case.

 

Other—The Company is involved from time to time in routine litigation arising in the ordinary course of conducting our business. In the opinion of management, no pending routine litigation will have a material adverse effect on our consolidated financial condition or results of operations.

 

17. STOCK OPTION EXPENSE

 

The Company recognized $1.9 million and $4.4 million in stock option compensation during the three months ended March 31, 2012 and 2011, respectively.

 

During the three months ended March 31, 2011, the Company granted stock options to the former Chief Executive Officer of the Company’s subsidiary Digital Domain to purchase shares of the Company’s Common Stock which vested immediately resulting in a charge of $3.3 million for that period. Stock option compensation expense for other participants were $1.9 million and $1.1 million for the three months ended March 31, 2012 and 2011, respectively.

 

18. SUBSEQUENT EVENTS

 

Subsequent events have been evaluated through the date on which the consolidated financial statements have been issued. The following subsequent events occurred:

 

Exchange Agreement

 

On April 5, 2012, certain shareholders of DDI exchanged 2,000,000 shares of common stock of DDI for an aggregate of 1,661,400 shares of the Company’s common stock, pursuant to an exchange option agreement entered into among DDI, DDMG, and such shareholder.

 

Comvest Waiver

 

On April 15, 2012, the Company and Comvest entered into an agreement which anticipated the senior convertible note financing described below.

 

Sale and Issuance of Convertible Notes and Warrants

 

On May 7, 2012, DDMG completed a $35 million senior convertible note offering to a group of institutional investors and issued an $8 million subordinated convertible note to Comvest to refinance existing debt held by Comvest. These transactions retired existing senior notes that would otherwise have been due in 2012.  The new senior convertible notes are convertible into the Company’s common stock at an initial conversion price of $9.72 per share, mature in five years and carry an interest rate of nine percent. The investors in the senior convertible note offering also received warrants to acquire 1.26 million shares of the company’s common stock at an initial exercise price of $9.72 for a term of five years. The new subordinated convertible note with stated interest of 10%, issued to Comvest replaces an existing convertible note held by Comvest that was issued in 2011 and is convertible into substantially the same number of shares of the company’s common stock as the original note. The new Comvest note also reduced the company’s fixed repayment obligations from $16 million due later this year under the original note to $8 million due in mid-2016.  See Footnote 13 “Notes Payable and Related Financing Transactions” for additional disclosure.

 

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Part I. Financial Information

 

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

You should read the following discussion of our financial condition and results of operations in conjunction with the condensed consolidated financial statements and the related notes included elsewhere in this Quarterly Report on Form 10-Q. The following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this Quarterly Report on Form 10-Q, particularly in “Special Note Regarding Forward-Looking Statements” and “Risk Factors.”

 

Overview

 

We are an award-winning digital production company. Since our inception in 1993, we have been a leading provider of computer-generated imagery animation and VFX for major motion picture studios and advertisers. Our company, work and employees have been recognized with numerous entertainment industry awards and nominations, including seven awards issued by the Academy of Motion Picture Arts and Sciences (‘‘Academy Awards’’) — three Academy Awards for Best Visual Effects and four awards for Scientific and Technical Achievement.

 

Our Business

 

Digital Production

 

We are one of the leading digital production companies. We offer our clients innovative, end-to-end solutions across multiple media platforms spanning the entire content production process from idea generation and pre-production to design, directing, live-action production and post-production. We have three key digital production business units: Digital Domain Productions, Inc. — VFX for feature films and advertising; Mothership Media, Inc. — digital advertising and marketing solutions; and Digital Domain Stereo Group, Inc.— creation and conversion of 3D content.

 

Animation Studio

 

Our animation feature film business focuses on the development of our original full-length, family-oriented CG animated feature films. Our business is led by a creative storytelling team of accomplished directors, producers, story artists and animators who joined us from leading companies in the family animation film industry. To house this business, we are currently leasing a 64,000 square foot building while we complete the construction of an 115,000 square foot facility. Since establishing our animation studio in 2009, we have executed Grant Agreements with the State of Florida and the City of Port St. Lucie, Florida to provide grant packages consisting of $80.0 million in cash, land and low interest financing to help us establish this studio. We have also been certified for $20.0 million in potential tax credits from the State of Florida to offset the expenses of producing our first several projects.

 

Education

 

We founded Digital Domain Institute, Inc. (“DDI”), a for-profit post-secondary educational institution in partnership with Florida State University, (“FSU”). In April 2011, we entered into agreements with FSU establishing what we believe is a first-of-its-kind public/private education partnership whereby DDI graduates will receive fully-accredited four-year Bachelor degrees from FSU. Working closely with FSU’s College of Motion Picture Arts and the Florida Department of Education, we have designed a curriculum for DDI that we expect will produce workforce-ready graduates possessing both traditional motion picture arts and state-of-the-art technical animation and visual effects CG skills. We expect to also provide our graduates with the skills to compete in the broader digital economy, which includes commercial applications such as military simulation, medical simulation, architecture, engineering, software development and related technologies. We believe this partnership between DDI and FSU represents a cutting-edge collaboration between an industry-leading technology and entertainment-company and one of the nation’s top film schools.

 

Key Metrics

 

We rely on certain key performance indicators to manage and assess our business activities. The key indicator described below assists us in evaluating growth trends, establishing budgets, recruiting and hiring employees, and assessing our overall

 

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operational efficiencies. We discuss revenue and cash flow from operating activities, respectively, under “Results of Operations” and “Liquidity and Capital Resources” below. An important measure of our quarterly and annual performance, Non-GAAP Adjusted EBITDA, is also discussed below.

 

Critical Accounting Policies

 

Our discussion and analysis of our financial condition and results of operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States, or U.S. GAAP. Accounting principles generally accepted in the United States of America require our management to make estimates and assumptions in the preparation of our condensed consolidated financial statements 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 revenue and expenses during the reporting period. Actual results could differ from these estimates.

 

The most significant areas that require management judgment are fair values of consideration issued and net assets acquired in connection with business combinations; revenue and cost recognition; collectability of contract receivables; deferred grant revenues; deferred income tax valuation allowances; amortization of long-lived assets and intangible assets; impairment of long-lived assets, intangible assets and goodwill; accrued expenses; advance billings and deferred revenue; recognition of stock-based compensation; calculation of the warrant and other debt-related liabilities; allocation of equity to non-controlling interests; debt modification accounting; and contingencies and litigation. The accounting policies for these areas are discussed in this section and in the notes to our accompanying consolidated financial statements. However, estimates inherently relate to matters that are uncertain at the time the estimates are made, and are based upon information presently available. Actual results may differ significantly from these estimates under different assumptions, judgments, or conditions.

 

Digital Imagery Revenue — We recognize digital imagery revenue from fixed-price contracts, each consisting of an accepted written bid and agreed-upon payment schedule, for the development of digital imagery and image creation for the entertainment and advertising industries. Contracts to provide digital imagery are accounted for in accordance with FASB ASC Subtopic 605-35, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. Revenue recognition is initiated when persuasive evidence of an arrangement with a customer is established, which is upon entry by us, or our subsidiary Digital Domain (“DD”), and the customer into a legally enforceable agreement. In accounting for the contracts, the cost to- cost measures of the percentage-of-completion method of accounting are utilized in accordance with FASB ASC Subtopic 605-35. Under this method, revenues, including estimated earned fees or profits, are recorded as costs are incurred. For all contracts, revenues are calculated based on the percentage of total costs incurred compared to total estimated costs at completion. Contract costs include direct materials, direct labor costs and indirect costs related to contract performance, such as indirect labor, supplies and tools. These costs are included in cost of revenues.

 

The customer contracts in the digital imagery business represent binding agreements to provide digital effects to the customers’ specifications. The contracts contain subjective standards applicable to the delivered digital effects and objective specifications that relate to the technical format for the digital effects delivered to customers. In all instances, the customer receives complete ownership rights in and to the digital effects as the effort progresses. In the event of a termination of a contract, ownership in the digital effects transfers to the customer, and we or DD, as the contractor, are entitled to receive reimbursement of costs incurred up to that point and a reasonable profit. The contracts contain production schedules setting forth a timeline for production and a final delivery date for the completed digital effects.

 

Payments for the services are received over the term of the contract, including payments required to be delivered in advance of work to fund a portion of the costs to produce the digital effects. Cash received from customers in excess of costs incurred and gross profit recognized on the related projects are recorded as advance payments. Unbilled receivables represent revenues recognized in excess of amounts billed. The digital effects produced are delivered to the customer at the end of the contract and the customer is not required to deliver the final scheduled payment until receipt and acceptance of the digital effects.

 

A review of uncompleted contracts is performed on an ongoing basis. Amounts representing contract change orders or claims are included in revenues only when they meet the criteria set forth in FASB ASC Subtopic 605-35. In the period in which it is determined that a loss will result from the performance of a contract, the entire amount of the estimated ultimate loss is charged against income.

 

Changes in estimates of contract sales, costs and profits are recognized in the current period based on the cumulative effect of the changes on current and prior periods. Hence, the effect of the changes on future periods of contract performance is recognized as if the revised estimates had been the original estimates. A significant change in one or more projects could have a material adverse effect on the consolidated financial position or results of operations.

 

Fair Value of Financial Instruments — We have adopted FASB ASC Subtopic 820-10, Fair Value Measurements, which clarifies the definition of fair value, establishes a framework for measuring fair value and expands the disclosure on fair value measurements.

 

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FASB ASC Subtopic 820-10 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. FASB ASC Subtopic 820-10 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. FASB ASC Subtopic 820-10 describes three levels of inputs that may be used to measure fair value:

 

Level 1: Quoted prices for identical assets or liabilities in active markets.

 

Level 2: Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

 

Level 3: Unobservable inputs that are supported by little or no market activity and that relate to financial instruments whose values are determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant judgment or estimation.

 

Our financial instruments, including Cash and cash equivalents; Cash, held in trust; Contract receivables; Accounts payable and accrued liabilities; Advance payments and deferred revenue and Contract obligations, are carried at amounts that approximate fair value due to the short maturity of such instruments.

 

Our loans are carried at the principal amount less unamortized discounts and debt issuance costs.

 

Certain non-financial assets are measured at fair value on a nonrecurring basis. Accordingly, these assets are not measured and adjusted to fair value on an ongoing basis but are subject to periodic impairment tests. These items primarily include long-lived assets, Goodwill and Other intangible assets.

 

Warrants and other debt-related liabilities are measured at fair value on a recurring basis using Level 3 inputs. In valuing warrant and other debt-related liabilities, a combination of valuation techniques is used including the income approach (based on the cash outlays estimated to be paid by us) and the market approach (which allocates the resulting value to various classes of equity using the option pricing method). The value of the warrants is then calculated by multiplying the resulting fair value per share of our Common Stock by the number of shares of our Common Stock into which the warrants are exercisable.

 

As of March 31, 2012 we received a valuation of the earn-out liability as of that date, from an independent valuation firm, considering it a Level 3 input. Based on this valuation, we reduced the earn-out liability by $0.5 million. This reduction is included in selling, general and administrative expenses on the condensed consolidated statement of operations for the three months ended March 31, 2012. The inputs used by us in determination of the $2.6 million of earn out liability at March 31, 2012 included a term of 153 months, a risk-free interest rate of 3.0% and no dividends.

 

Segment Reporting — Operating segments are defined as components of an enterprise for which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. Our reportable segments are Feature Films, Commercials and Animation. The management approach is used as the conceptual basis for identifying reportable segments and is based on the way that management organizes within the enterprise for making operating decisions, allocating resources, and monitoring performance, which is primarily based on the sources of revenue.

 

Non-GAAP Adjusted EBITDA

 

Non-GAAP Adjusted EBITDA represents net income (loss) adjusted for (1) interest expense, net of interest income, (2) income tax provision (benefit), (3) depreciation and amortization, (4) amortization of intangible assets, (5) stock-based compensation expense, (6) amortization of debt and equity issuance costs, (7) other (income) expense and (8) our grant receipts from government agencies that were received in a given period so that these receipts are reflected on a cash basis. Items (1) through (7) are excluded from net income (loss) internally when evaluating our operating performance. Item (8) is included as we believe this adjustment for grant receipts is indicative of our core operating performance both because it reflects our ability to secure and receive grant receipts in a given period and such receipts are matched with the expenses associated with initiating the business operations that those grant receipts were designed, in part, to offset. Management believes Non-GAAP Adjusted EBITDA allows investors to make a more meaningful comparison between our operating results over different periods of time, as well as with those of other companies in our industry, because it both includes grant receipts from government agencies and excludes items such as interest expense and other adjustments related to financing activities that we believe are not representative of our operating performance.

 

We believe that Non-GAAP Adjusted EBITDA, which is a non-GAAP financial measure, when viewed with our results under U.S. GAAP and the accompanying reconciliations, provides useful information about our operating performance and period-over-period growth, and provides additional information that is useful for evaluating our operating performance. Additionally, we believe that Non-GAAP Adjusted EBITDA provides a more meaningful comparison of our operating results against those of other companies in our industry, as well as on a period-to-period basis, because this measure both includes grant receipts from government agencies and matches such receipts with the expenses that those grant receipts were designed, in part, to offset and excludes items that are not representative of our operating performance, such as the fair value adjustments associated with our historical financings as a private company. We believe that including these costs and excluding cash grant receipts in our results of operations results in a lack of comparability between our operating results and those of our peers in the industry, the majority of which do not have comparable start-up costs or amortization costs related to intangible assets. However, Non-GAAP Adjusted EBITDA is not a measure of financial

 

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performance under U.S. GAAP and, accordingly, should not be considered as an alternative to net income (loss) as an indicator of operating performance.

 

A reconciliation of net income (loss), a U.S. GAAP measure, to Adjusted EBITDA, is provided in “— Results of Operations” presented below.

 

Results of Operations

 

The following table sets forth certain information regarding our unaudited condensed consolidated results of operations for the three months ended March 31, 2012 and 2011 (in thousands):

 

 

 

Three Months Ended March 31,

 

 

 

2012

 

2011

 

 

 

(Unaudited)

 

Revenues:

 

 

 

 

 

Revenues

 

$

30,158

 

$

37,904

 

Grant revenues from governmental agencies

 

878

 

653

 

Licensing revenue

 

90

 

 

Tuition revenue

 

15

 

 

Total revenues

 

31,141

 

38,557

 

Costs and expenses:

 

 

 

 

 

Cost of revenues, excluding depreciation and amortization

 

32,922

 

30,922

 

Depreciation expense

 

3,631

 

2,870

 

Selling, general and administrative expenses

 

10,979

 

10,849

 

Amortization of intangible assets

 

863

 

863

 

Total costs and expenses

 

48,395

 

45,504

 

Operating loss

 

(17,254

)

(6,947

)

Other income (expenses):

 

 

 

 

 

Interest and finance (expense) credit:

 

 

 

 

 

Issuance of and changes in fair value of warrant and and other debt-related liabilities

 

4,284

 

(28,965

)

Amortization of discount and issuance costs on notes payable

 

(1,599

)

(3,013

)

Interest expense on notes payable

 

(670

)

(502

)

Interest expense on capital and governmental lease obligations

 

(670

)

(318

)

Other income (expense), net

 

353

 

1,067

 

Loss before income taxes

 

(15,556

)

(38,678

)

Income tax expense

 

9

 

250

 

Net loss before non-controlling interests

 

(15,565

)

(38,928

)

Net (income) loss attributable to non-controlling interests

 

733

 

(197

)

Net loss attributable to common stockholders

 

$

(14,832

)

$

(39,125

)

 

A reconciliation of net loss before non-controlling interests, a U.S. GAAP measure, to Non-GAAP Adjusted EBITDA, a non-GAAP measure, is presented in the table below (in thousands):

 

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Three Months Ended March 31,

 

 

 

2012

 

2011

 

 

 

(Unaudited)

 

 

 

 

 

 

 

Net loss before non-controlling interests

 

$

(15,565

)

$

(38,928

)

Add back (reverse) charges (income) pertaining to:

 

 

 

 

 

Share-based compensation

 

1,878

 

4,409

 

Income tax expense

 

9

 

250

 

Interest expense, net

 

2,939