Crest Animation Studios Ltd Management Discussions

CREST ANIMATION STUDIOS LIMITED ANNUAL REPORT 2011-2012 MANAGEMENT DISCUSSION AND ANALYSIS INDUSTRY OVERVIEW: Time and again a question comes to the fore. Is the Animation Industry Recession Proof Rs. Animation has not only survived but grown in geometrical progression over decades because it has bred very competent and skilled artists, producers and animation studios where they collaborate to produce quality work at very predictable intervals. With the advent of 3D CGI animation the dynamics have stayed intact. It is an industry with its very own distinct sensibilities and nuances. Over the last year, emergence of well loved movies franchises like Ice Age, Madagascar, Kung Fu Panda, Lorax, just to name a few, many upstart entrepreneurs and visionary artists decided to create 3D animation studios of their own. The hype continues without reaching a bubble status. After all, demand continues for these kinds of entertaining, colorful family oriented films. Having said that, the global financial crisis did not just hit the realty projects and banking firms. It did have a trickling effect on the animation industry but limited itself to geography. Europe. How hard hit was the animation industry Rs. It is no secret that the UK animation industry is in a tight spot right now. According to securing the future of UK animation released recently by Animation UK, as much as 40% of the animation companies located in the territory were either just breaking even or losing money in 2011. And 28% of UK animation companies have gone out of business or left animation in the last three years. Arguably, this could be attributed to the deep financial turmoil in the European markets. But realistically it is due to growing overseas competition. It is important to note that a majority of those animation studios who never quite make the cut ventured into the industry because of the promise of easy money and not because of the love of the art. Art without heart seldom prospers and that goes for mediums such as paintings, music, literature etc. In the Euro Zone, France and Germany are predominantly in TV animation and largely supported by Government tax breaks and subsidys. TV is very crowded and noticeably the licensing fees by broadcasters are dwindling thereby making most shows financially un-viable. It is one thing to state that the animation industry is encountering hard times. It is, however, another thing to label the industry is bust like the dot-com crash of the early 21st century. No, not just yet-not with all the new technologies and procedures coming the way of 3D animators. If anything, these tough times will only separate the cream of the crop from lame pretenders. Also, the difficulties created by global recession has translated to higher quality of animated movies. Interestingly, United States continues to dominate the animated theatrical segment. Not only in producing animated content but also in world-wide distribution. Another very interesting fact to note is the prominence that China & India are getting in the global animation industry. These two countries out of Asia are being positioned as the front runners in both outsourcing as well as original IP creation. Major studios like Walt Disney, Dreamworks etc have been expressing this very transparently through various media. CGI animated theatrical releases continue to dominate the World Box Office and is poised to do even better as more releases are planned over the next few years. With the increase in theatres (multiplexes), TV channels and use of digital satellites, the rapid growth of the Internet and a wide variety of other new technologies (including advances in stereoscopic and large- format projection), distributors and programmers in nearly every country require more content than ever to fill consumer demand. The general pace of international roll-outs is quicker than in the past. Films are launched simultaneously around the world and this is becoming common place. Distributors and exhibitors continue to innovate, find new ways to expand the Box Office pool. The animation industry in India is witnessing a new revenue model, which otherwise only existed in mature markets like North America, Europe, Japan etc. Merchandising and Character licensing is a fast rising industry in Asia today, particularly India. An obvious recent example is Chotta Bheem. Though the product does not fall into 3D CGI category, this animated brand is facilitating the markets to mature. India is also witnessing new horizons, different applications of animation, especially in gaming, live search maps, medicine, surgery and other simulations. COMPANY OUTLOOK AND OVERVIEW: The year 2011-12 was extremely challenging. After the initial set back, we pulled up our sleeves and re-grouped to strategies our way forward. The services product mix had to have all the three formats viz work-for-hire for TV, DVD and Feature. We began our journey with doing fresh tests, for TV series and over the first six months of the financial year demonstrated to the world markets that we continue to lead in quality as we were the only studio, out of many in India, to have qualified. We were successful in converting these prospects to customers. We were the natural choice for Dreamworks Animation, Brown Bag Films and Moonscoop. Brown Bag Films, based out of Ireland, is a two time Academy award nominated studio and are producing some of the finest shows for Disney, BBC etc. Moonscoop, erstwhile Mike Young Productions was pleased to come back to us and Dreamworks Animation needs no introduction. It is common knowledge that we faced operational challenges due to irregular cash-flows largely due to the following reasons: A US client declaring Chapter 11, default in Norm funding and lack of new service contracts. In-spite of this challenge the entire staff demonstrated true grit and moved forward with the belief that the situation prevailing was temporary. During the year under review, the company once again began multiple TV series and a DVD production in full steam. Octonauts a 52 episode TV series, GLoE a TV series for Moonscoop is in full production. Sony, one of the largest studio in US was extremely happy with our quality on the Swan Princess 4 DVD delivery and quickly greenlit Swan Princess 5 DVD which is in production. We also began production of one of the most complex TV series ever made for Dreamworks Animation but had to abandon due to cost/profitability issue. By and large TV series as a product mix has lower margins but if managed diligently it helps in operational cash-flows. During the year under review, the company had a special request from Redchillies, a production house owned by Mr. Shahrukh Khan, to help them finish animation for their Bollywood film called Ra.One. This task was to be accomplished in approximately two weeks and when we delivered the client was so happy that they insisted on giving us credit in the main title. During the year under review, the company continued its work on the feature Ribbit and the final retakes are just being delivered. A few sequences of this film was shown to prospective distributors in Cannes Film Festival and it has bagged some major European territory sales guarantees. This film is slated for theatrical release during this calendar/financial year. On the project Indian Feature Film front, status quo was maintained as there was no movement during the year. The company recruited over 150 personnel and put them through rigorous training in multiple software and skills and they have all become productive in a very short span of time. They are all absorbed in various TV episodical deliveries. The company has also been in talks with a few overseas animation studios for a strategic/dedicated relationship and this could see some fruition in the near future. SEGMENT-WISE OR PRODUCT-WISE PERFORMANCE: The Company is engaged in providing 3D/CGI Animation i.e. full-service studio specializing in the development and production of digital animated properties for theatrical, television, home entertainment and interactive distribution for the global entertainment industry. Management believes that the risks and returns from these services are not predominantly different from one another and hence considers the Company to operate in a single business segment. However management has identified geographical segment disclosures based on location of the Companys customers in case of revenue. Further, disclosures of carrying amount of segment assets and cost incurred to acquire segment assets are based on geographical location of segment assets. As per Accounting standard AS (17) on segment reporting, segment information has been provided under the notes to consolidated financial statements. INTERNAL CONTROL SYSTEMS AND THEIR ADEQUACY: The company through its management is responsible for establishing and maintaining adequate internal control over financial reporting commensurate with its size and nature of business. Our internal control systems are effective to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of our financial statements for external purposes in accordance with the generally accepted principles of accounting. The internal control systems provide for well-defined policies, guidelines, authorizations and approval procedures. Due to its inherent limitations, internal control over financial reporting related to projections of any evaluation of effectiveness to future periods are subject to the risks that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Our independent registered accounting firms M/s Ernst & Young & M/s Chaturvedi & Shah has audited financial statements and has issued its report on the effectiveness of internal control over financial reporting which is included herein. DISCUSSION ON FINANCIAL PERFORMANCE WITH RESPECT TO OPERATIONAL PERFORMANCE: During the year company started production on two television series titled Gloe and Octonauts as well as two Direct to Video projects, Swan Princess - 5 and Alpha & Omega. The company generated total income of Rs. 192.45 Million as compared Rs.376.76 Million for the previous year. The companys EBIDTA stood at Rs.(89.11) as compared Rs. 59.35 Million for the previous year. The loss after tax of the company for the year 2011-12 was Rs. 205.59 Million as against loss of Rs. 1,711.52 Million. The loss for previous year included impairment of goodwill on amalgamation of Rs. 1,610.61 Million. The Financial performance of the Company can be reviewed in two parts as under: 1. Crest Animation Studios Limited (Standalone), which excludes the performance of subsidiaries. 2. Crest Animation Studios Limited (Consolidated), which includes performance of subsidiary companies, mainly Crest Animation Inc. and its subsidiary. 1. Standalone:- During the year the loss after tax of the company for the year 2011-12 was Rs. 205.59 Million as against loss of Rs. 1,711.52 Million during the previous financial year. The loss during previous year was primarily due to one time exceptional item of impairment of goodwill on amalgamation of Rs.1,610.61. During the current year lower revenue was due to Inventory & Debtor write - downs of Rs. 23.47 Million and Rs. 2.09 Million respectively (due to discontinuation of one project) which contributed to the higher loss. Revenues during the year are down primarily due to new contracts being commissioned only during the second and third quarter of the year. The companys operating revenues have been generated by production service fees out of the work for hire contract for Television series Gloe & Octonauts and Direct to Video projects Swan Princess -5. 2. Consolidated:- During the year, revenue fell by 55% from Rs. 422.03 Million to Rs. 189.06 Million. The consolidated loss stood at Rs. 199.94 Million as compared to Rs. 1,713.09 Million. The loss during previous year was due to impairment of goodwill on amalgamation of Rs. 1,610.61 Million, write down of properties, provision of debtors due to filing of Chapter 11 by one of our clients in USA. During the current year the decrease in revenue of 55% caused due to funding issues pertaining to second feature film Norm of the North project is mainly responsible for the higher loss. OPPORTUNITY, THREATS, RISKS AND CONCERNS: India for Animation - analyzing the opportunities, threats and challenges. SWOT Internal Factors Strengths:- 1. Low cost of animation services 2. Attractive destination for outsourced animation production for international players 3. Increase in institutions providing animation education 4. Well equipped animation studios 5. English speaking talent 6. Growing awareness of Indian Animation talent Among international studios Weaknesses:- 1. Manpower shortage 2. Protection of intellectual property 3. Attrition and poaching loss of experienced professionals 4. Very little awareness of career in animation 5. Minimal government support or incentives 6. Funding problems, Salary issues and constant retaining of professionals Opportunities:- 1. Increasing awareness of Indian Animation talent amongst international studios 2. Increasing animation budgets 3. Increasing acceptance of animation content in domestic entertainment 4. Increasing capex on building world class animation studio 5. Tremendous opportunity of tapping international animation market Threats:- 1. Competition from other countries like Taiwan, Philippines, Korea and China 2. Ever changing technology 3. Lack of awareness in foreign countries 4. Inadequate funding for capex and investment in manpower 5. Lack of support from government RISKS Macro Economic Risk: The global economy is witnessing significant contraction with an unprecedented lack of availability of business and consumer credits. This current decrease and any future decrease in economic activity in the United States and other regions in the world, in which we do business, could significantly impact our results operationally and financially. The business risks are both inherent and perceived. The business of entertainment being a High Risk - High Return business does test our patience, commitment and convictions time and again. The markets are getting increasingly competitive, Technological obsolescence and lack of skilled & trained human resources demand sustained and enhanced levels of investments in both depreciating as well as appreciating assets. Our success is primarily dependent on the audience accepting our products which is extremely difficult to predict or guarantee. The revenue derived from a feature film does not necessarily bear any correlation to the production or distribution cost incurred. The companys business is dependent on the availability of work for hire projects and/or ability to co-produce projects. Unexpected delays in the commencement of work for hire projects or the commercial failures in co- production project would have a material adverse affect on our financial results. Further, as a result of the global economic infirmity, the markets are increasingly meandering towards co-financing models of business association, which stipulate large capital outlay, further necessitating the need for innovative financial structuring of deals. The business is substantially affected by the prevailing global economic conditions. Increases in interest rates, inflation, changes in tax, trade, scarcity of credit are some of the factors which impede the growth of the business. The economic downturn has left no public limited company unaffected which is reflected in the performance of our stock. However given the resilience of the economy in the face of recession as well as its strong fundamentals, the company does not expect to be significantly affected by this risk in the long term. Business Model Risk: We currently operate principally on one business segment i.e. 3D/CGI animation and our lack of diversified business could adversely affect us. Many times business of the Company is also subject to risks such as overall economic and political events etc. The Company is providing services in three areas Filmed entertainment/DVD/TV episodes. Hence, the risks vary for each business area. Filmed entertainment: The success depends on viewers acceptance of the film which is almost impossible to predict and therefore, risky. The financial success of film also depends on other factors like public acceptance of competitors film, other forms of leisure and entertainment available to public etc. Economic/Financial success of theatrical performance also has a huge impact on other revenue streams like DVD/TV/Merchandise etc. Most importantly one cannot assure that the film will generate enough revenue to cover costs like distribution, marketing, production etc. which means the net revenue could get affected. Home entertainment (DVD): This business stream is currently experiencing significant change due to rapid technological shifts and thereby consumer preferences and behavior is changing. Since, this also becomes unpredictable, there is an inherent risk involved on profitability. Internet, You Tube, Mobile devices continue to evolve rapidly due to technology and therefore we are constantly adapting to new distribution channels. TV episodes: This segment is governed and driven largely by broadcasters/networks. As compared to live action, number of networks dedicated to children is relatively lesser and also the license fee, over the years, is continuously reducing. The number of suppliers in this segment are much higher and exist across all geographical regions. Competition especially from other Asian regions (in the animation outsourcing space) like China/Malaysia/Singapore/Korea etc. is growing in geometric progression and their pricing is relatively more aggressive than Indian counterparts. This puts a pressure on Ebitda margins and therefore over a period in time one might have to exit this format and therefore putting a risk on overall lower revenue. To mitigate the risk in our business model, we consciously ensure that we maintain a mix of work-for-hire projects along with ownership of content/intellectual property rights on projects in addition to strongly exploring the Gaming and Digital asset management. Geographic Risk: We are significantly dependent on the US & European markets and any change in the nature and structure of these markets would adversely affect our financials. We do believe that the US & European markets are adequate enough to provide us with continuous and sustainable business opportunities for the foreseeable future, the Asian markets are also warming up to the possibilities of the CGI Industry and we have already made a headway in establishing strategic relationship with producers of repute in these emerging markets. Financial Risk: The production of animated products is capital intensive and our capacity to generate revenues from our work for hire projects may be insufficient to meet our anticipated cash requirements. The companys revenue is predominantly denominated in USD and given the volatility of the Indian Rupee; the financials of the company can swing significantly. To mitigate the risk the company has through proactive and effective risk management techniques entered in forward contracts to hedge its foreign currency receivables. The company has through its strategic initiatives and sustained reconnaissance established formidable relationship in the financial markets that facilitate innovative financial arrangement to provide for its capital requirements. Regulatory and Compliance Related Risk: The Companys transactions are though predominantly in the US, it also transacts with other countries. As the Company pursues towards a global reach the risk of ensuring 100% compliance with the regulations and laws also increases. The Company has an institutionalized structure to ensure regulatory and legal compliance to mitigate such risks. Reputation Risk: The reputation of an entertainment Company is built on various factors including the Credentials of the Creative Directors, The Actors, The success of the products as measured through BOX OFFICE collections etc. We mitigate such risks by endeavoring towards and ensuring that we work with the most reputed of Brands, Creatively Competent Directors of Repute and Properties that appeals to a wide range of audience and has a Long Shelf life. Operational Risk: We cannot predict the impact the rapidly changing technology or alternative forms of entertainment may have on us. Animated products are expensive to produce and the uncertainties inherent in their production could result in the expenditure of significant amounts on projects that are abandoned or delayed for reasons beyond our control. We try to mitigate these risks by investing in developing proprietary tools that enable increase in efficiencies and standardization of processes. We also ensure that we stay abreast with the changes in technology and constantly upgrade the capabilities and capacities of our human resources as well as technological resources. The production completion of animated projects is subject to number of uncertainties, including delays and increased expenditures in lieu of creative and technical difficulties, availability of talent, cost technology and increase in wages. As a result the projected production cost at the commencement of the project may increase, the date of completion may be substantially delayed or the project may even be abandoned by the producer causing the write off of expenses incurred with respect to the project. We mitigate these risks through an effective amalgamation of operational planning & management, enhancing creative and technological competence as well as good Corporate Governance. The company has implemented and would continue to implement changes in its production processes & systems in order to produce stereoscopic projects as and when required. These changes will increase the cost of producing a project, which may have an impact on the realization of profits. We rely on technology that we license from third parties, including software. There is no assurance that these third party technological licenses will continue to be available to us on commercially reasonable terms or at all. The loss or delay to maintain any of these technology licenses could result in delays in the completion of a project and could materially adverse our business, financial conditions or results of operations. Our success also depends on some key employees including Management personnels, Creative & Technical Personnels. We do have employment agreements with these key personnels; however it doesnt guarantee the continued services of such personnels. MATERIAL DEVELOPMENTS IN HUMAN RESOURCES/INDUSTRIAL RELATIONS FRONT, INCLUDING NUMBER OF PEOPLE EMPLOYED: We believe our people are our biggest asset. Animation is a manpower intensive business and it requires a seamless conjugation of creative brilliance and technical capabilities. The companys Human Resources policies are aimed towards encouraging ownership, building a culture of learning & development. We have initiated processes towards building organization capabilities that would help set benchmarks for the industry, enable our artists to show case their creative potentials and enhance productivity for propelling business growth and profitability. The key HR attributes of the Company include: a. A strong team of Competent, Committed and Passionate CGI artist who are ever ready to meet the growing demands of the business. b. Strategic initiatives undertaken to ensure we are able to attract & retain the best talent. c. Zero non - compliance with regards to any statutory compliance. d. No employer - employee litigations in any court of law. Cautionary Statement: Statements in this report on Management Discussion and Analysis describing the Companys Objective, projection, estimates, predictions and expectations may be forward looking statements within the meaning of applicable laws and regulations. These statements are based on certain assumptions and expectations of future events. Actual results could, however, differ materially & substantially from those expressed or implied. The company, The Directors & Management assumes no responsibility with regards to the forward looking statement herein which may change on the basis of subsequent developments, information or events. Observations made on the industry and other players also reflect an opinion by the management and the management accepts no liability on such opinions.