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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-Q (X)
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the quarterly period ended September 30, 2004 or (  )
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 Commission File Number: 23346 EMAK WORLDWIDE, INC.  Delaware
(State or other jurisdiction of
incorporation or organization)
    
    13-3534145
(I.R.S. Employer
Identification No.)6330 San Vicente Blvd.
Los Angeles, CA
(Address of principal executive offices)
    
    90048
(Zip Code)
 (323) 932-4300
(Registrants telephone number, including area code) Equity Marketing, Inc.
(Former name, former address and former fiscal year, if changed since last
report) 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 periods 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 [  ] Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [  ] No [X] Indicate the number of shares outstanding of each of the issuers classes of
common stock, as of the latest practical date: Common
    Stock, $.001 par value, 5,758,888 shares as of November 11, 2004.




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EMAK WORLDWIDE, INC. Index To Quarterly Report on Form 10-Q
Filed with the Securities and Exchange Commission
September 30, 2004 PagePart I.
    
    Financial InformationItem 1. Financial Statements
    
    
    3Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    21Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    32Item 4. Controls and Procedures
    
    
    32Part II.
    
    Other InformationItem 2. Change in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
    
    
    33Item 6. Exhibits
    
    
    33Exhibit 31.1Exhibit 31.2Exhibit 32.1Exhibit 32.2
  Cautionary Statement Certain expectations and projections regarding our future performance discussed
in this quarterly report are forward-looking and are made under the safe
harbor provisions of the Private Securities Litigation Reform Act of 1995.
These expectations and projections are based on currently available
competitive, financial and economic data along with our operating plans and are
subject to future events and uncertainties. Readers should not place undue
reliance on any such forward-looking statements, which speak only as of the
date made. Actual results could vary materially from those anticipated for a
variety of reasons. We undertake no obligation to publicly release the results
of any revisions to these forward-looking statements which may be made to
reflect events or circumstances after the date hereof or to reflect the
occurrence of unanticipated events. Readers are advised to review
Managements Discussion and Analysis of Financial Condition and Results of
Operations  Cautionary Statements and Risk Factors. 2




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PART I. FINANCIAL INFORMATION 
 ITEM 1. FINANCIAL STATEMENTS EMAK WORLDWIDE, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS)
 (UNAUDITED)
 December 31,
    
    September 30,2003
    
    2004ASSETSCURRENT ASSETS:Cash and cash equivalents
    
    $
    19,291
    
    
    $
    8,057Accounts receivable (net of allowances of $2,143 and
$1,842 as of December 31, 2003 and September 30, 2004, respectively)
    
    
    36,765
    
    
    
    36,691Inventories (Note 2)
    
    
    15,099
    
    
    
    19,266Prepaid expenses and other current assets
    
    
    4,352
    
    
    
    4,699Total current assets
    
    
    75,507
    
    
    
    68,713Fixed assets, net
    
    
    3,809
    
    
    
    3,621Goodwill (Notes 2 and 6)
    
    
    41,893
    
    
    
    44,325Other intangibles, net (Notes 2 and 6)
    
    
    1,252
    
    
    
    3,250Other assets
    
    
    5,869
    
    
    
    6,431Total assets
    
    $
    128,330
    
    
    $
    126,340
 The accompanying notes are an integral part of these
unaudited condensed consolidated financial statements. 3




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EMAK WORLDWIDE, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
 (UNAUDITED)
 LIABILITIES, MANDATORILY REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS EQUITY December 31,
        
        September 30,2003
        
        2004CURRENT LIABILITIES:Short-term Debt
        
        $
        626
        
        
        $
        1,489Accounts payable
        
        
        28,239
        
        
        
        29,332Accrued liabilities
        
        
        17,195
        
        
        
        15,056Total current liabilities
        
        
        46,060
        
        
        
        45,877LONG-TERM LIABILITIES
        
        
        5,555
        
        
        
        4,797Total liabilities
        
        
        51,615
        
        
        
        50,674COMMITMENTS AND CONTINGENCIES
            (Note 9)Mandatorily redeemable
            preferred stock, Series A senior cumulative participating convertible,
            $.001 par value per share, 25,000 issued and outstanding, stated at
            liquidation preference of $1,000 per share ($25,000), net of issuance
            costs
        
        
        23,049
        
        
        
        22,518STOCKHOLDERS
            EQUITY:Preferred stock,
            $.001 par value per share, 1,000,000 shares authorized, 25,000 Series A
            issued and outstanding
        
        
        
        
        
        
        Common stock, $.001
            par value per share, 50,000,000 and 25,000,000 shares authorized, 5,684,953
            and 5,758,888 shares outstanding as of December 31, 2003 and
            September 30, 2004, respectively
        
        
        
        
        
        
        Additional paid-in
            capital
        
        
        23,886
        
        
        
        27,497Retained earnings
        
        
        45,138
        
        
        
        42,424Accumulated other
            comprehensive income
        
        
        3,334
        
        
        
        3,50072,358
        
        
        
        73,421LessTreasury stock, 3,150,708
            and 3,167,258 shares, at cost, as of December 31, 2003 and September 30,
            2004, respectively (Note 4)
        
        
        (17,458
        )
        
        
        (17,669
        )Unearned compensation
        
        
        (1,234
        )
        
        
        (2,604
        )Total stockholders
            equity
        
        
        53,666
        
        
        
        53,148Total liabilities,
            mandatorily redeemable preferred stock and stockholders equity
        
        $
        128,330
        
        
        $
        126,340
 The accompanying notes are an integral part of these
unaudited condensed consolidated financial statements. 4




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EMAK WORLDWIDE, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
 (UNAUDITED)
 Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2003
    
    2004
    
    2003
    
    2004REVENUES
    
    $
    48,948
    
    
    $
    58,055
    
    
    $
    153,468
    
    
    $
    161,645COST OF SALES
    
    
    35,513
    
    
    
    45,645
    
    
    
    112,566
    
    
    
    122,232Gross profit
    
    
    13,435
    
    
    
    12,410
    
    
    
    40,902
    
    
    
    39,413OPERATING EXPENSES:Salaries, wages and benefits
    
    
    6,141
    
    
    
    7,986
    
    
    
    17,539
    
    
    
    23,163Selling, general and administrative
    
    
    5,546
    
    
    
    6,087
    
    
    
    17,056
    
    
    
    18,143Integration costs
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    136Loss on Chicago lease
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    311Restructuring charge (gain)
    
    
    
    
    
    
    (25
    )
    
    
    
    
    
    
    80Total operating expenses
    
    
    11,687
    
    
    
    14,048
    
    
    
    34,595
    
    
    
    41,833Income (loss) from operations
    
    
    1,748
    
    
    
    (1,638
    )
    
    
    6,307
    
    
    
    (2,420
    )OTHER INCOME (EXPENSE), net
    
    
    188
    
    
    
    179
    
    
    
    495
    
    
    
    (181
    )Income (loss) before provision (benefit) for income taxes
    
    
    1,936
    
    
    
    (1,459
    )
    
    
    6,802
    
    
    
    (2,601
    )PROVISION (BENEFIT) FOR INCOME TAXES
    
    
    609
    
    
    
    (566
    )
    
    
    2,357
    
    
    
    (1,012
    )NET INCOME (LOSS)
    
    
    1,327
    
    
    
    (893
    )
    
    
    4,445
    
    
    
    (1,589
    )PREFERRED STOCK DIVIDENDS
    
    
    375
    
    
    
    375
    
    
    
    1,125
    
    
    
    1,125UNDISTRIBUTED EARNINGS ALLOCATED TO
PARTICIPATING PREFERRED STOCK
    
    
    217
    
    
    
    
    
    
    
    759
    
    
    
    NET INCOME (LOSS) AVAILABLE TO COMMON
STOCKHOLDERS
    
    $
    735
    
    
    $
    (1,268
    )
    
    $
    2,561
    
    
    $
    (2,714
    )BASIC INCOME (LOSS) PER SHARE
    
    $
    0.13
    
    
    $
    (0.22
    )
    
    $
    0.45
    
    
    $
    (0.47
    )BASIC WEIGHTED AVERAGE SHARES OUTSTANDING
    
    
    5,750,736
    
    
    
    5,758,888
    
    
    
    5,719,677
    
    
    
    5,752,287DILUTED INCOME (LOSS) PER SHARE
    
    $
    0.12
    
    
    $
    (0.22
    )
    
    $
    0.42
    
    
    $
    (0. 47
    )DILUTED WEIGHTED AVERAGE SHARES OUTSTANDING
    
    
    6,160,484
    
    
    
    5,758,888
    
    
    
    6,029,523
    
    
    
    5,752,287
 The accompanying notes are an integral part of these
unaudited condensed consolidated financial statements. 5




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EMAK WORLDWIDE, INC. CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (IN THOUSANDS)
 (UNAUDITED)
 Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2003
    
    2004
    
    2003
    
    2004NET INCOME (LOSS)
    
    $
    1,327
    
    
    $
    (893
    )
    
    $
    4,445
    
    
    $
    (1,589
    )OTHER COMPREHENSIVE INCOME (LOSS):Foreign currency translation adjustments (Note 2)
    
    
    34
    
    
    
    (93
    )
    
    
    540
    
    
    
    227Unrealized gain (loss) on foreign currency
forward contracts (Note 2)
    
    
    67
    
    
    
    (267
    )
    
    
    (109
    )
    
    
    (61
    )COMPREHENSIVE INCOME (LOSS)
    
    $
    1,428
    
    
    $
    (1,253
    )
    
    $
    4,876
    
    
    $
    (1,423
    )
 The accompanying notes are an integral part of these
unaudited condensed consolidated financial statements. 6




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EMAK WORLDWIDE, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
 (UNAUDITED)
 Nine Months EndedSeptember 30,2003
    
    2004CASH FLOWS FROM OPERATING ACTIVITIES:Net income (loss)
    
    $
    4,445
    
    
    $
    (1,589
    )Adjustments to reconcile net income (loss) to net cash
used in operating activities:Depreciation and amortization
    
    
    1,434
    
    
    
    1,529Provision for doubtful accounts
    
    
    232
    
    
    
    147Gain on disposal of fixed assets
    
    
    (19
    )
    
    
    Tax benefit from exercise of stock options
    
    
    75
    
    
    
    65Amortization of restricted stock
    
    
    259
    
    
    
    621Other
    
    
    
    
    
    
    (13
    )Changes in operating assets and liabilities:Increase (decrease) in cash and cash equivalents:Accounts receivable
    
    
    17,664
    
    
    
    1,948Inventories
    
    
    (381
    )
    
    
    (3,408
    )Prepaid expenses and other current assets
    
    
    738
    
    
    
    (1,195
    )Other assets
    
    
    (837
    )
    
    
    (556
    )Accounts payable
    
    
    (15,160
    )
    
    
    497Accrued liabilities
    
    
    (11,369
    )
    
    
    (2,926
    )Long-term liabilities
    
    
    85
    
    
    
    (758
    )Net cash used in operating activities
    
    
    (2,834
    )
    
    
    (5,638
    )CASH FLOWS FROM INVESTING ACTIVITIES:Purchases of fixed assets
    
    
    (527
    )
    
    
    (1,080
    )Proceeds from sale of fixed assets
    
    
    74
    
    
    
    20Purchase of marketable securities
    
    
    (1,500
    )
    
    
    Payment for purchase of SCI, net of cash acquired of $162
    
    
    (6,075
    )
    
    
    Payment for purchase of JGI
    
    
    
    
    
    
    (4,614
    )Net cash used in investing activities
    
    
    (8,028
    )
    
    
    (5,674
    )CASH FLOWS FROM FINANCING ACTIVITIES:Borrowings under line of credit
    
    
    
    
    
    
    863Payment of preferred stock dividends
    
    
    (1,125
    )
    
    
    (1,125
    )Purchase of treasury stock
    
    
    (974
    )
    
    
    (211
    )Proceeds from exercise of stock options
    
    
    935
    
    
    
    538Net cash provided by (used in) financing activities
    
    
    (1,164
    )
    
    
    65Net decrease in cash and cash equivalents
    
    
    (12,026
    )
    
    
    (11,247
    )Effects of exchange rate changes on cash and cash equivalents
    
    
    (1
    )
    
    
    13CASH AND CASH EQUIVALENTS, beginning of period
    
    
    25,833
    
    
    
    19,291CASH AND CASH EQUIVALENTS, end of period
    
    $
    13,806
    
    
    $
    8,057SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:CASH PAID FOR:Interest
    
    $
    164
    
    
    $
    148Income taxes, net of refunds
    
    $
    3,275
    
    
    $
    77
 The accompanying notes are an integral part of these
unaudited condensed consolidated financial statements. 7




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EMAK WORLDWIDE, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
(UNAUDITED) NOTE 1    ORGANIZATION AND BUSINESS EMAK Worldwide, Inc., a Delaware corporation and subsidiaries (EMAK or
the Company), is a leading marketing services company based in Los
Angeles, with offices in Chicago, Minneapolis, New York, Ontario (CA),
London, Paris, Hong Kong and Shanghai. The Company focuses on the design
and execution of strategy-based marketing programs, with particular
expertise in the areas of: strategic planning and research, entertainment
marketing, design and manufacturing of custom promotional products,
promotion, event marketing, collaborative marketing, and environmental
branding. The Companys clients include Burger King Corporation,
Kelloggs, Kohls, Macys, Nordstrom, Procter & Gamble, and Subway
Restaurants, among others. The Company complements its core marketing
services business by developing and marketing distinctive consumer
products, based on emerging and evergreen licensed properties, which are
sold through specialty and mass-market retailers. The Company primarily
sells to customers in the United States and Europe. The Companys
functional currency is the United States dollar. Equity Marketing Hong Kong, Ltd., a Delaware corporation (EMHK), is a
100% owned subsidiary of the Company. EMHK manages production of the
Companys products by third parties in the Far East and currently is
responsible for performing and/or procuring product sourcing, product
engineering, quality control inspections, independent safety testing and
export/import documentation. Logistix Limited, a United Kingdom corporation (Logistix), is a 100%
owned subsidiary of the Company which was acquired on July 31, 2001.
Logistix is a marketing services agency which focuses primarily on
assisting consumer packaged goods companies in their efforts to market to
children between the ages of seven and fourteen by developing and executing
premium-based promotions and by providing marketing consulting services.
Logistix also derives a portion of its revenues from a consumer products
business. The Companys Upshot division (Upshot), which was acquired on July 17, 2002,
is a marketing agency, specializing in promotion, event, collaborative
marketing, retail design and environmental branding. The Companys SCI Promotion division (SCI), which was acquired on
September 3, 2003, is a promotional marketing services business
specializing in the development and execution of promotional campaigns that
utilize purchase-with-purchase, gift-with-purchase and incentives,
promotional licenses and promotional retail programs, principally for the
retail department store industry. Johnson Grossfield, Inc., a Delaware corporation (JGI), is 100% owned
subsidiary of the Company, which was formed in January 2004 to acquire the
promotions business of Johnson Grossfield, Inc., a Minnesota corporation.
The JGI business, which was acquired on February 2, 2004 (effective January
31, 2004), is a promotional marketing services business specializing in
providing custom licensed premiums for the kids marketing program of Subway
Restaurants. NOTE 2    BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES In the opinion of management and subject to year-end audit, the accompanying
unaudited condensed consolidated financial statements have been prepared in
accordance with accounting principles generally accepted in the United States
for interim financial information and with the instructions to Form 10-Q and
Article 10 of Regulation S-X. Accordingly, they do not include all the
information and footnotes required by accounting principles generally accepted
in the United States for complete financial statements. In the opinion of
management, all adjustments considered necessary for fair presentation have
been included. The results of operations for the interim periods are not
necessarily indicative of the results for a full year. These condensed
consolidated financial statements should be read in conjunction with the
consolidated financial statements and footnotes thereto included in the
Companys Annual Report on Form 10-K for the year ended December 31, 2003. Certain reclassifications have been made to the condensed consolidated balance sheet as December 31,
2003 to conform it to the 2004 presentation. Advances under an import/letter
of credit facility (see Note 3) which were originally recorded as accounts
payable as of December 31, 2003 have been reclassified to short-term debt. 8




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Net Income Per Share Basic net income (loss) per share (EPS) is computed by dividing net income
(loss) available to common stockholders by the weighted average number of
common shares outstanding during each period. Net income (loss) available to
common stockholders represents reported net income (loss) less preferred stock
dividend requirements and less undistributed earnings allocated to
participating preferred stock. Diluted EPS reflects the potential dilution that could occur if securities or
other contracts to issue common stock were exercised or converted into common
stock. Diluted EPS includes in-the-money options using the treasury stock
method. During a loss period, the assumed exercise of in-the-money stock
options has an antidilutive effect. As a result, these shares are not included
with the weighted average shares outstanding used in the calculation of diluted
loss per share for the three and nine month periods ended September 30, 2004.
Options to purchase 1,146,666 and 2,108,666 shares of common stock, $.001 par
value per share (the Common Stock), as of September 30, 2003 and 2004,
respectively, were excluded from the computation of diluted EPS as they would
have been anti-dilutive. For the three and nine months ended September 30, 2003
and 2004, preferred stock convertible into 1,694,915 shares of common stock was
excluded from the computation of diluted EPS as it would have been
anti-dilutive. Earnings per share for the third quarter and nine months ended September 30,
2003 reflect a restatement pursuant to Emerging Issues Task Force Issue No.
03-6, Participating Securities and the Two-Class Method under SFAS No. 128,
Earnings Per Share (EITF 03-6). EITF 03-6 requires that companies with
participating securities calculate earnings per share using a two-class method.
The Companys cumulative participating mandatorily redeemable preferred stock
qualifies as participating securities since it is entitled to dividends
declared on the Companys common stock; therefore, EITF 03-6 requires the
allocation of a portion of undistributed earnings to preferred stock. As a
result, earnings per basic common share were reduced by $0.04 for the third
quarter of 2003, to $0.13 from $0.17 as reported in the prior year. The
earnings per diluted common share were reduced by $0.03 for the third quarter
of 2003, to $0.12 from $0.15 as reported in the prior year. The earnings
results per basic common share were reduced by $0.13 for the nine months ending
September 30, 2003, to $0.45 from $0.58 as reported in the prior year. The
earnings results per diluted common share were reduced by $0.13 for the nine
months ending September 30, 2003, to $0.42 from $0.55 as reported in the prior
year. EITF 03-6 had no impact on 2004 per share amounts because of the net
loss. The following is a reconciliation of the numerators and denominators of the
basic and diluted EPS computation for income available to common shareholders
and other disclosures required by Statement of Financial Accounting Standards
(SFAS) No. 128, Earnings per Share and EITF 03-6: For the Three Months Ended September 30,2003
    
    2004Income
    
    Shares
    
    Per Share
    
    Loss
    
    Shares
    
    Per Share(Numerator)
    
    (Denominator)
    
    Amount
    
    (Numerator)
    
    (Denominator)
    
    AmountBasic EPS:Income (loss) available to
common stockholders
    
    $
    735
    
    
    
    5,750,736
    
    
    $
    0.13
    
    
    $
    (1,268
    )
    
    
    5,758,888
    
    
    $
    (0.22
    )Effect of dilutive securities:Options and warrants
    
    
    
    
    
    
    331,598Restricted stock units
    
    
    
    
    
    
    78,150
    
    
    
    
    
    
    
    
    
    
    
    Dilutive EPS:Income (loss) available to common
stockholders and assumed conversion
    
    $
    735
    
    
    
    6,160,484
    
    
    $
    0.12
    
    
    $
    (1,268
    )
    
    
    5,758,888
    
    
    $
    (0.22
    )
 For the Nine Months Ended September 30,2003
    
    2004Income
    
    Shares
    
    Per Share
    
    Loss
    
    Shares
    
    Per Share(Numerator)
    
    (Denominator)
    
    Amount
    
    (Numerator)
    
    (Denominator)
    
    AmountBasic EPS:Income (loss) available to
common stockholders
    
    $
    2,561
    
    
    
    5,719,677
    
    
    $
    0.45
    
    
    $
    (2,714
    )
    
    
    5,752,287
    
    
    $
    (0.47
    )Effect of dilutive securities:Options and warrants
    
    
    
    
    
    
    258,912Restricted stock units
    
    
    
    
    
    
    50,934
    
    
    
    
    
    
    
    
    
    
    
    Dilutive EPS:Income (loss) available to common
stockholders and assumed conversion
    
    $
    2,561
    
    
    
    6,029,523
    
    
    $
    0.42
    
    
    $
    (2,714
    )
    
    
    5,752,287
    
    
    $
    (0.47
    )
 9




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Inventories Inventories consist of (a) production-in-process which primarily represents
tooling costs which are deferred and amortized over the life of the products
and deferred costs on service contracts and (b) purchased finished goods held
for sale to customers and purchased finished goods in transit to customers
distribution centers. Inventories are stated at the lower of average cost or
market. As of December 31, 2003 and September 30, 2004, inventories consisted
of the following: December 31,
    
    September 30,2003
    
    2004Production-in-process
    
    $
    3,363
    
    
    $
    1,573Finished goods
    
    
    11,736
    
    
    
    17,693$
    15,099
    
    
    $
    19,266
 Foreign Currency Translation Net foreign exchange gains or losses resulting from the translation of foreign
subsidiaries accounts whose functional currency is not the United States
dollar are recognized as a component of accumulated other comprehensive income
in stockholders equity. For such subsidiaries, accounts are translated into
United States dollars at the following rates of exchange: assets and
liabilities at period-end exchange rates, equity accounts at historical rates,
and income and expense accounts at average exchange rates during the period. For subsidiaries with transactions denominated in currencies other than their
functional currency, net foreign exchange transaction gains or losses are
included in determining net income (loss). Transaction gains included in net income
(loss) for the quarters ended September 30, 2003 and 2004 were $179 and $186,
respectively. Transaction gains or (losses) included in net income (loss) for
the nine months ended September 30, 2003 and 2004 were $507 and $(136),
respectively. Derivative Instruments The Company adopted SFAS No. 133, Accounting for Derivative Instruments
and Hedging Activities, which establishes accounting and reporting
standards for derivative instruments and for hedging activities. SFAS No.
133 requires that an entity recognize derivatives as either assets or
liabilities on the balance sheet and measure those instruments at fair
value. The accounting for changes in the fair value of a derivative depends
on the intended use of the derivative and the resulting designation. The Company designates its derivatives based upon criteria established by
SFAS No. 133. For a derivative designated as a fair value hedge, the gain
or loss is recognized in earnings in the period of change together with the
offsetting loss or gain on the hedged item attributed to the risk being
hedged. For a derivative designated as a cash flow hedge, the effective
portion of the derivatives gain or loss is initially reported as a
component of accumulated other comprehensive income and subsequently
reclassified into earnings when the hedged exposure affects earnings. The
ineffective portion of the gain or loss is reported in earnings
immediately. The Company adopted SFAS No. 149, Amendment of Statement 133 on Derivative
Instruments and Hedging Activities which amends and clarifies accounting for
derivative instruments, including certain derivative instruments embedded in
other contracts, and for hedging activities under SFAS No. 133. SFAS No. 149
is effective for contracts entered into or modified after June 30, 2003 and for
hedging relationships designated after June 30, 2003. The guidance was applied
prospectively. The Company uses derivatives to manage exposures to foreign currency. The
Companys objective for holding derivatives is to decrease the volatility
of earnings and cash flows associated with changes in foreign currency.
The Company enters into foreign exchange forward contracts to minimize the
short-term impact of foreign currency fluctuations on foreign currency
receivables, investments, and payables. The gains and losses on the foreign
exchange forward contracts offset the transaction gains and losses on the
foreign currency receivables, investments, and payables recognized in
earnings. The Company does not enter into foreign exchange forward
contracts for trading purposes. Gains and losses on the contracts are
included in other income (expense) in the condensed consolidated statements
of operations and offset foreign exchange gains or losses from the
revaluation of intercompany balances or other current assets, investments,
and liabilities denominated in currencies other than the functional
currency of the reporting entity. The Companys foreign exchange forward
contracts related to current assets and liabilities generally range from
one to eleven months in original maturity. 10




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The Companys Logistix subsidiary entered into foreign currency forward
contracts aggregating GBP 7,481 to sell Euros in exchange for British
pounds and United States dollars and to sell British pounds in exchange for
United States dollars. The contracts will expire by August 4, 2005. At
September 30, 2004, the foreign currency forward contracts had an estimated
fair value of $(112). The fair value of the foreign currency forward
contracts is recorded in accrued liabilities in the accompanying condensed
consolidated balance sheet as of September 30, 2004. The unrealized loss
on the contracts is reflected in accumulated other comprehensive income. The Companys JGI subsidiary entered into foreign currency forward
contracts aggregating $412 to sell Canadian dollars in exchange for United
States dollars. The contracts will expire by January 31, 2005. At
September 30, 2004, the foreign currency forward contracts had an estimated
fair value of $(20). Goodwill and Other Intangibles SFAS No. 141, Business Combinations and SFAS No. 142, Goodwill and Other
Intangible Assets were approved by the Financial Accounting Standards Board
(FASB) effective June 30, 2001 for business combinations consummated after
June 30, 2001. SFAS No. 141 eliminates the pooling-of-interests method for
business combinations and requires use of the purchase method. SFAS No. 142
changes the accounting for goodwill and certain other intangible assets from an
amortization approach to a non-amortization (impairment) approach. The
statement requires amortization of goodwill recorded in connection with
previous business combinations to cease upon adoption of the statement by
calendar year companies on January 1, 2002. Accordingly, beginning on January
1, 2002, the Company has foregone all related goodwill amortization expense. The change in the carrying amount of goodwill from $41,893 as of December 31,
2003 to $44,325 as of September 30, 2004 reflects: a foreign currency
translation adjustment of $178, an adjustment to reflect the net increase to
goodwill for the SCI acquisition of $932 (see Note 6) and $1,322 for the
acquisition of JGI (see Note 6). Of the goodwill balance, $0 relates to the
consumer products segment and $44,325 relates to the marketing services
segment. Identifiable intangibles of $1,252 as of December 31, 2003 and, $3,250 as of
September 30, 2004 a portion of which are subject to amortization, are included
in other intangibles in the condensed consolidated balance sheets. Under the provisions of SFAS No. 142, the carrying value of assets
acquired, including goodwill, are reviewed annually. During such a review
the Company will estimate the fair value of the reporting unit to which the
assets were assigned by discounting the reporting units estimated future
cash flows before interest. The Company will compare the discounted cash
flows to the carrying value of the acquired net assets to determine if an
impairment loss has occurred. If such assets are considered to be
impaired, the impairment to be recognized is measured by the amount by
which the carrying value of the assets exceeds their estimated fair values.
In the fourth quarter of 2003, the Company performed the annual impairment
test required by SFAS No. 142 and determined that its goodwill was not
impaired as of December 31, 2003. Royalties The Company enters into agreements to license intellectual properties such
as trademarks, copyrights, and patents. The agreements may call for minimum
amounts of royalties to be paid in advance and throughout the term of the
agreement, which are non-refundable in the event that product sales fail to
meet certain minimum levels. Advance royalties resulting from such
transactions are stated at the lower of the amounts paid or the amounts
estimated to be recoverable from future sales of the related products.
Furthermore, minimum guaranteed royalty commitments are reviewed on a
periodic basis to ensure that amounts are recoverable based on estimates of
future sales of the products under license. A loss provision will be
recorded in the consolidated statements of operations to the extent that
future minimum royalty guarantee commitments are not recoverable.
Estimated future sales are projected based on historical experience,
including that of similar products, and anticipated advertising and
marketing support by the licensor. Stock-Based Compensation In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based
Compensation  Transition and Disclosure. SFAS No. 148 amends SFAS No.
123, Accounting for Stock-Based Compensation, to provide alternative
methods of transition for a voluntary change to the fair-value for
stock-based employee compensation. In addition, SFAS No. 148 amends the
disclosure requirements of SFAS No. 123 to require prominent disclosures in
both annual and interim financial statements about the method of accounting
for stock-based employee compensation and the effect of the method used on
reported results. 11




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##### Table of Contents



As of September 30, 2004, the Company had three stock-based compensation
plans  the 2000 Stock Option Plan, the 2004 Stock Incentive Plan and the
2004 Non-Employee Director Stock Incentive Plan. In accordance with
provisions of SFAS No. 123, the Company applies Accounting Principles Board
(APB) Opinion No. 25 and related interpretations in accounting for its
stock-based compensation plans and, accordingly, does not recognize
compensation cost for grants whose exercise price equals the market price
of the stock on the date of grant. If the Company had elected to recognize
compensation cost based on the fair value of the options granted at grant
date as prescribed by SFAS No. 123, net income (loss) and earnings (loss)
per share would have been reduced to the pro forma amounts indicated in the
table below: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2003
    
    2004
    
    2003
    
    2004Net income (loss) available to common stockholders  as reported
    
    $
    735
    
    
    $
    (1,268
    )
    
    $
    2,561
    
    
    $
    (2,714
    )Less:Compensation expense (a)
    
    
    398
    
    
    
    119
    
    
    
    1,236
    
    
    
    442Net income (loss) available to common stockholders  pro forma
    
    $
    337
    
    
    $
    (1,387
    )
    
    $
    1,325
    
    
    $
    (3,156
    )Earnings (loss) per share:Basic earnings (loss) per share, as reported
    
    $
    0.13
    
    
    $
    (0.22
    )
    
    $
    0.45
    
    
    $
    (0.47
    )Pro forma basic earnings (loss) per share
    
    $
    0.06
    
    
    $
    (0.24
    )
    
    $
    0.23
    
    
    $
    (0.55
    )Diluted earnings (loss) per share, as reported
    
    $
    0.12
    
    
    $
    (0.22
    )
    
    $
    0.42
    
    
    $
    (0.47
    )Pro forma diluted earnings (loss) per share
    
    $
    0.05
    
    
    $
    (0.24
    )
    
    $
    0.22
    
    
    $
    (0.55
    )
  (a)
    
    Determined under fair value based method for all awards, net of tax. Recent Accounting Pronouncements In January 2003, the FASB issued FIN 46, Consolidation of Variable Interest
Entities, which addresses the consolidation of business enterprises (variable
interest entities) to which the usual condition (ownership of a majority voting
interest) of consolidation does not apply. The interpretation focuses on
financial interests that indicate control. It concludes control through voting
interests, a companys exposure (variable interest) to the economic risks and
potential rewards from the variable interest entitys assets and activities are
the best evidence of control. Variable interests are rights and obligations
that convey economic gains or losses from changes in the values of the variable
interest entitys assets and liabilities. Variable interests may arise from
financial instruments, service contracts, nonvoting ownership interests and
other arrangements. If an enterprise holds a majority of the variable
interests of an entity, it would be considered the primary beneficiary. The
primary beneficiary would be required to include the assets, liabilities and
the results of operations of the variable interest entity in its financial
statements. In December 2003, the FASB issued a revision to FIN 46 to address
certain implementation issues. The adoption of FIN 46 and FIN 46 (revised) did
not have an impact on the Companys results of operations or financial
position. In March 2004, the FASB published an Exposure Draft, Share-Based Payment, an
Amendment of FASB Statements No. 123 and 95. The proposed change in accounting
would replace existing requirements under SFAS No. 123 and APB Opinion No. 25.
The proposed statement would require public companies to recognize the cost of
employee services received in exchange for equity instruments, based on the
grant-date fair value of those instruments, with limited exceptions. The
proposed statement would also affect the pattern in which compensation cost
would be recognized, the accounting for employee share purchase plans, and the
accounting for income tax effects of share-based payment transactions. The
Exposure Draft also notes that the use of a lattice model, such as the binomial
model, to determine the fair value of employee stock options, is preferable.
The Company currently uses the Black-Scholes pricing model to determine the
fair value of its employee stock options. Use of a lattice model to determine
the fair value of employee stock options may result in compensation cost
materially different from those pro forma costs disclosed above under
Stock-Based Compensation in this Note 2 to the condensed consolidated
financial statements. The effective date of the proposed standard is for
periods beginning after June 15, 2005. The Company is currently determining
what impact the proposed statement would have on its results of operations or
financial position. 12




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##### Table of Contents



In November 2003 and March 2004, the Emerging Issues Task Force (EITF)
reached final consensus on EITF Issue No. 03-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments.
The EITF requires a company to apply a three-step model to determine whether an
impairment of an investment, within the scope of SFAS No. 115, Accounting for
Certain Investments in Debt and Equity Securities, is other-than-temporary.
EITF Issue No. 03-1 shall be applied prospectively to all current and future
investments, in interim or annual reporting periods beginning after June 15,
2004. The adoption of EITF Issue No. 03-1 did not have a material impact on
the Companys results of operations or financial position because the Company
does not have any investments in marketable securities as September 30, 2004. In April 2004, the EITF reached final consensus on EITF 03-6, Participating
Securities and the Two-Class Method under FASB Statement No. 128, which
requires companies that have participating securities to calculate earnings per
share using the two-class method. This method requires the allocation of
undistributed earnings to the common shares and participating securities based
on the proportion of undistributed earnings that each would have been entitled
to had all the periods earnings been distributed. EITF 03-6 is effective for
fiscal periods beginning after March 31, 2004 and earnings per share reported in
prior periods presented must be retroactively adjusted in order to comply with
EITF 03-6. The Company has adopted EITF 03-6 for the quarter ended June 30,
2004. As a result, earnings per basic common share were reduced by $0.04 for
the third quarter of 2003, to $0.13 from $0.17 as reported in the prior year.
The earnings per diluted common share were reduced by $0.03 for the third
quarter of 2003, to $0.12 from $0.15 as reported in the prior year. The
earnings results per basic common share were reduced by $0.13 for the nine
months ending September 30, 2003, to $0.45 from $0.58 as reported in the prior
year. The earnings results per diluted common share were reduced by $0.13 for
the nine months ending September 30, 2003, to $0.42 from $0.55 as reported in
the prior year. EITF 03-6 had no impact on 2004 per share amounts because of
the net loss. In September 2004, the consensus of EITF Issue No. 04-10, "Applying Paragraph 19
of FASB Statement No. 131, 'Disclosures about Segments of an Enterprise and Related
Information,' in Determining Whether to Aggregate Operating Segments That Do Not
Meet the Quantitative Thresholds," was published. EITF Issue No. 04-10 addresses
how an enterprise should evaluate the aggregation criteria of SFAS No. 131 when
determining whether operating segments that do not meet the quantitative thresholds
may be aggregated in accordance with SFAS No. 131. The provisions of EITF Issue No.
04-10 are effective for fiscal years ending after October 13, 2004. The Company is
currently in the process of determining the impact of this consensus on its financial
results. NOTE 3  LINE OF CREDIT On April 24, 2001, the Company signed a credit facility (the Facility) with
Bank of America. On April 26, 2004, the maturity date of the Facility was
extended through June 30, 2005. The credit facility is secured by
substantially all of the Companys assets and provides for a line of credit of
up to $35,000 with borrowing availability determined by a formula based on
qualified assets. Interest on outstanding borrowings will be based on either a
fixed rate equivalent to LIBOR plus an applicable spread of between 1.50 and
2.25 percent or a variable rate equivalent to the banks reference rate plus an
applicable spread of between zero and 0.50 percent. The Company is also
required to pay an unused line fee of between zero and 0.60 percent per annum
and certain letter of credit fees. The applicable spread is based on the
achievement of certain financial ratios. The Facility also requires the
Company to comply with certain restrictions and covenants as amended from time
to time. On November 14, 2001, February 8, 2002, September 30, 2002, November
14, 2003, April 26, 2004, August 12, 2004 and November 15, 2004, certain
covenants under the facility were amended. As of September 30, 2004, the
Company was in compliance with the amended restrictions and covenants. In
addition to amending certain covenants, the November 15, 2004 amendment imposed
a temporary $12,000 cap on total outstanding borrowings and letters of credit.
Bank of America will reassess the cap in December 2004. This amendment also
increases the maximum interest rate on outstanding borrowings by 0.25 percent.
The Facility may be used for working capital and acquisition financing
purposes. As of September 30, 2004, there were no borrowings outstanding under
the Facility.


Letters of credit outstanding under the Facility as of December 31, 2003 and
September 30, 2004 totaled $823 and $3,358, respectively. In addition to the Facility, in October, 2003 the Companys Logistix subsidiary
established an import/letter of credit facility with Hong Kong Shanghai Bank
Corp. (HSBC) to provide short-term financing of product purchases from Asia.
The total availability under this facility is 1,000 GBP. Under this facility
HSBC may pay Logistixs vendors directly upon receipt of invoices and shipping
documentation. Logistix in turn is obligated to repay HSBC within 120 days.
As of December 31, 2003 and September 30, 2004, advances outstanding under
this facility totaled approximately $626 and $1,489, respectively, and were
recorded in short-term debt in the accompanying condensed consolidated balance
sheet. NOTE 4  STOCK REPURCHASE On July 21, 2000, the Companys Board of Directors authorized up to $10,000
for the repurchase of the Companys common stock over a twelve month
period. In the period from July 21, 2000 to July 21, 2001, the Company
spent $6,430 to purchase an aggregate of 523,594 shares at an average price
of $12.28 per share including commissions. On July 24, 2001, the Companys
Board of Directors authorized up to an additional $10,000 for the
repurchase of the Companys common stock over a twelve month period. In
the period from August 2, 2001 through July 11, 2002, the Company spent
$5,605 to purchase 454,715 shares at an average price of $12.33 per share
including commissions. On July 12, 2002, the Companys Board of Directors
authorized up to an additional $10,000 for the repurchase of the Companys
common stock. The Company spent $3,505 to repurchase 267,650 shares at an
average price of $13.10 per share including commissions under this
authorization through September 30, 2004. The duration of the current
buyback program is indefinite; provided, however, that the Companys Board
of Directors 13




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##### Table of Contents



intends to review the program periodically. Purchases are
conducted in the open market at prevailing prices, based on market
conditions when the Company is not in a quiet period. The Company may also
transact purchases effected as block trades, as well as certain negotiated,
off-exchange purchases not in the open market. Since initiating the
overall buyback program on July 20, 2000, the Company has spent $15,540 to
purchase a total of 1,245,959 shares at an average price of $12.47 per
share including commissions through September 30, 2004. There were no
purchases for the quarter ended September 30, 2004. This repurchase
program is being funded through working capital. NOTE 5  SEGMENTS The Company has identified two reportable segments through which it conducts
its continuing operations: marketing services and consumer products. The
factors for determining the reportable segments were based on the distinct
nature of their operations. They are managed as separate business units
because each requires and is responsible for executing a unique business
strategy. The marketing services segment designs and produces promotional
products used as free premiums or sold in conjunction with the purchase of
other items at a retailer or quick service restaurant and provides various
services such as strategic planning and research, entertainment marketing,
promotion, event marketing, collaborative marketing, retail design, and
environmental branding. Marketing services programs are used for marketing
purposes by both the companies sponsoring the promotions and the licensors of
the entertainment properties on which the promotional programs are often based.
The consumer products segment designs and contracts for the manufacture of
toys and other consumer products for sale to major mass market and specialty
retailers, who in turn sell the products to consumers. Earnings of industry segments and geographic areas exclude interest income,
interest expense, depreciation expense, restructuring charges/gains, integration costs, and other unallocated corporate
expenses. Income taxes are allocated to segments on the basis of operating
results. Identified assets are those assets used in the operations of the
segments and include inventory, receivables, goodwill and other
intangibles. Corporate assets consist of cash, certain corporate
receivables, fixed assets, and certain trademarks. Certain information presented in the tables below has been restated to
conform to the current management structure as of January 1, 2004.
Specifically, the results and assets of the USI division, which had
previously been reported as part of Consumer Products, are now being
reported as part of Marketing Services, which is consistent with management
responsibility for this business. Effective January 1, 2004, the USI
division was carved out of the Companys Consumer Products division and
consolidated with the Companys SCI division (acquired September 3, 2003)
which is part of the Marketing Services segment. The vast majority of the
revenues for the USI division represent sales of made-to-order custom
product to oil & gas and other retailers who in turn sell the products to
consumers. 14




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##### Table of Contents



Industry Segments As of and For the Three Months Ended September 30, 2003Marketing
    
    ConsumerServices
    
    Products
    
    Corporate
    
    TotalTotal revenues
    
    $
    42,157
    
    
    $
    6,791
    
    
    $
    
    
    
    $
    48,948Income (loss) before provision (benefit)
for income taxes
    
    $
    6,128
    
    
    $
    628
    
    
    $
    (4,820
    )
    
    $
    1,936Provision (benefit) for income taxes
    
    
    1,998
    
    
    
    204
    
    
    
    (1,593
    )
    
    
    609Net income (loss)
    
    $
    4,130
    
    
    $
    424
    
    
    $
    (3,227
    )
    
    $
    1,327Fixed asset additions
    
    $
    
    
    
    $
    
    
    
    $
    154
    
    
    $
    154Depreciation and amortization
    
    $
    66
    
    
    $
    21
    
    
    $
    411
    
    
    $
    498Total assets
    
    $
    84,378
    
    
    $
    6,373
    
    
    $
    31,043
    
    
    $
    121,794
 As of and For the Three Months Ended September 30, 2004Marketing
    
    ConsumerServices
    
    Products
    
    Corporate
    
    TotalTotal revenues
    
    $
    50,717
    
    
    $
    7,338
    
    
    $
    
    
    
    $
    58,055Income (loss) before provision (benefit)
for income taxes
    
    $
    3,726
    
    
    $
    (347
    )
    
    $
    (4,838
    )
    
    $
    (1,459
    )Provision (benefit) for income taxes
    
    
    1,461
    
    
    
    (132
    )
    
    
    (1,895
    )
    
    
    (566
    )Net income (loss)
    
    $
    2,265
    
    
    $
    (215
    )
    
    $
    (2,943
    )
    
    $
    (893
    )Fixed asset additions
    
    $
    
    
    
    $
    
    
    
    $
    144
    
    
    $
    144Depreciation and amortization
    
    $
    89
    
    
    $
    
    
    
    $
    453
    
    
    $
    542Total assets
    
    $
    93,886
    
    
    $
    9,626
    
    
    $
    22,828
    
    
    $
    126,340
 As of and For the Nine Months Ended September 30, 2003Marketing
    
    ConsumerServices
    
    Products
    
    Corporate
    
    TotalTotal revenues
    
    $
    132,155
    
    
    $
    21,313
    
    
    $
    
    
    
    $
    153,468Income (loss) before provision (benefit)
for income taxes
    
    $
    18,400
    
    
    $
    2,393
    
    
    $
    (13,991
    )
    
    $
    6,802Provision (benefit) for income taxes
    
    
    6,565
    
    
    
    869
    
    
    
    (5,077
    )
    
    
    2,357Net income (loss)
    
    $
    11,835
    
    
    $
    1,524
    
    
    $
    (8,914
    )
    
    $
    4,445Fixed asset additions
    
    $
    
    
    
    $
    
    
    
    $
    527
    
    
    $
    527Depreciation and amortization
    
    $
    113
    
    
    $
    83
    
    
    $
    1,238
    
    
    $
    1,434Total assets
    
    $
    84,378
    
    
    $
    6,373
    
    
    $
    31,043
    
    
    $
    121,794
 As of and For the Nine Months Ended September 30, 2004Marketing
    
    ConsumerServices
    
    Products
    
    Corporate
    
    TotalTotal revenues
    
    $
    144,400
    
    
    $
    17,245
    
    
    $
    
    
    
    $
    161,645Income (loss) before provision (benefit)
for income taxes
    
    $
    12,971
    
    
    $
    (1,186
    )
    
    $
    (14,386
    )
    
    $
    (2,601
    )Provision (benefit) for income taxes
    
    
    5,046
    
    
    
    (461
    )
    
    
    (5,597
    )
    
    
    (1,012
    )Net income (loss)
    
    $
    7,925
    
    
    $
    (725
    )
    
    $
    (8,789
    )
    
    $
    (1,589
    )Fixed asset additions
    
    $
    
    
    
    $
    
    
    
    $
    1,080
    
    
    $
    1,080Depreciation and amortization
    
    $
    249
    
    
    $
    
    
    
    $
    1,280
    
    
    $
    1,529Total assets
    
    $
    93,886
    
    
    $
    9,626
    
    
    $
    22,828
    
    
    $
    126,340
 15




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##### Table of Contents



NOTE 6  ACQUISITIONS On September 3, 2003, the Company acquired substantially all of the assets of
SCI Promotion Group, LLC (SCI-LLC), a privately held promotional marketing
services company based in Ontario, California (the SCI Acquisition). The
Company financed the SCI Acquisition through its existing cash reserves. The
SCI Acquisition was consummated pursuant to an Asset Purchase Agreement dated
September 3, 2003, by and among the Company, SCI-LLC and Joseph J. Schmidt, III
(the Purchase Agreement). Under the terms of the Purchase Agreement, the
Company acquired substantially all of the assets of SCI-LLC for a cash purchase
price of $5,683 (net of a holdback of $250 for a closing balance sheet working
capital adjustment), plus related transaction costs of $538 and a commitment to
pay additional earnout consideration of up to $3,500 based upon future
performance of the acquired business. The Company also assumed the operating
liabilities of the business in connection with the acquisition. The earnout
consideration is based upon the acquired business achieving targeted levels of
earnings before interest, taxes, depreciation and amortization (EBITDA) over
the period from 2003 through 2006. The earnout payments, if required, are
payable 50% in cash and 50% in shares of the Companys common stock. The
additional consideration, if any, will be recorded as goodwill. The SCI Acquisition has been accounted for under the purchase method of
accounting. The financial statements reflect the allocation of the purchase
price to the acquired net assets based on their estimated fair values as of the
acquisition date. During the nine months ended September 30, 2004, the
preliminary allocation of the purchase price was adjusted to revise the
estimated value of prepaid expenses ($64 decrease), receivable from SCI ($55
decrease) and accrued liabilities ($13 increase). The allocation reflects a
receivable from SCI-LLC resulting from a closing balance sheet working capital
adjustment of $800, accruing interest at the rate of 5% per annum, that will
offset additional earnout consideration. Based on the results for 2003,
additional consideration of $800 was earned and offset the receivable from
SCI-LLC. The additional earnout consideration was recorded as additional
goodwill as of September 30, 2004. The Companys allocation of purchase price
for the acquisition, based upon estimated fair values is as follows: Net current assets
    
    $
    6,357Receivable from SCI
    
    
    800Property, plant and equipment
    
    
    37Other non-current assets
    
    
    13Net current liabilities
    
    
    (5,755
    )Estimated fair value, net assets acquired
    
    
    1,452Goodwill
    
    
    4,041Other intangible assets
    
    
    728Total purchase price
    
    $
    6,221
 The intangible assets of $728 are comprised of customer contracts and related
customer relationships and sales order backlog, and are being amortized over
estimated useful lives ranging from 4 months to 5 years. On February 2, 2004 (effective January 31, 2004), the Company acquired certain
assets of Johnson Grossfield, Inc. (JGI-MN), a privately held promotional
marketing services company based in Minneapolis, Minnesota (the JGI
Acquisition). The Company financed the JGI Acquisition through its existing
cash reserves. The acquisition was consummated pursuant to an Asset Purchase
Agreement dated January 16, 2004, by and among the Company, JGI, JGI-MN, Marc
Grossfield and Thom Johnson (the Purchase Agreement). Under the terms of the
Purchase Agreement, the Company purchased the assets of JGI-MNs promotional
agency business for approximately $4,325 in cash (net of a holdback of $250)
and 35,785 shares of the Companys common stock (which, based upon the January
30, 2004 closing market price of $14.80, had a value of $530), plus related
transaction costs of $184 and a commitment to pay additional earnout
consideration of up to $4,500 based upon future performance of the acquired
business. The Company also assumed the operating liabilities of the
promotional agency business in connection with the acquisition. The earnout
consideration is based upon the acquired business achieving targeted levels of
earnings before interest, taxes, depreciation and amortization (EBITDA) over
the period from 2004 through 2008. The earnout payments, if required, are
payable 50% in cash and 50% in shares of the Companys common stock. The
additional consideration, if any, will be recorded as goodwill. The JGI Acquisition has been accounted for under the purchase method of
accounting. The financial statements reflect the preliminary allocation of the
purchase price to the acquired net assets based on their estimated fair values
as of the acquisition date. The Company is in the process of finalizing
valuations of the individual assets and liabilities which may result in an
adjustment to goodwill and other intangibles. The allocation of the purchase
price may change based upon these valuations. However, the Company does not
expect significant changes to the preliminary allocation of the purchase price.
As of September 30, 2004, the preliminary allocation of the purchase price was
adjusted to revise the estimated value of accounts receivable ($31 decrease),
inventory ($68 decrease) and accrued liabilities ($19 decrease). During the
second quarter of 2004, additional consideration was paid in the amount of $105
as a working 16




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##### Table of Contents



capital adjustment. The Companys preliminary allocation of
purchase price for the JGI Acquisition, based upon estimated fair values is as
follows: Net current assets
    
    $
    2,758Property, plant and equipment
    
    
    8Other non-current assets
    
    
    7Net current liabilities
    
    
    (1,194
    )Estimated fair value, net assets acquired
    
    
    1,579Goodwill
    
    
    1,322Other intangible assets
    
    
    2,243Total purchase price
    
    $
    5,144
 The intangible assets of $2,243 are comprised of customer relationships and a
non-competition agreement, and are being amortized over estimated useful lives
ranging from 2 years to 12 years. In connection with the SCI and JGI Acquisitions, the Company formulated and
implemented an integration plan and incurred integration costs, including
travel, training and consulting costs. Such costs totaled $0 and $136 for the
three month and nine month periods ended September 30, 2004, respectively, and
were recorded as integration costs in the condensed consolidated statements of
operations. The following selected unaudited pro forma consolidated results of
operations are presented as if the SCI and JGI Acquisitions had occurred as
of the beginning of the year preceding the period of acquisition after
giving effect to certain adjustments for the amortization of intangibles,
reduced interest income and related income tax effects. The pro forma data
is for informational purposes only and does not necessarily reflect the
results of operations had the businesses operated as one during the period.
No effect has been given for synergies, if any, that may have been realized
through the acquisitions. Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2003
    
    2004
    
    2003
    
    2004Pro forma revenues
    
    $
    58,871
    
    
    $
    58,055
    
    
    $
    181,086
    
    
    $
    163,109Pro forma net income (loss)
    
    $
    1,816
    
    
    $
    (893
    )
    
    $
    5,561
    
    
    $
    (1,431
    )Pro forma basic earnings (loss) per share
    
    $
    0.19
    
    
    $
    (0.22
    )
    
    $
    0.60
    
    
    $
    (0.44
    )Pro forma diluted earnings (loss) per share
    
    $
    0.18
    
    
    $
    (0.22
    )
    
    $
    0.57
    
    
    $
    (0.44
    )
 Refer to Note 2 for further discussion of the method of computation of earnings
per share. NOTE 7  RELATED PARTIES On July 15, 2003, the Company entered into an agreement with U.S.
Capital Investors, Inc. (USCI), an entity controlled by Jeffrey S. Deutschman, pursuant to which USCI served as an advisor to the Company with respect to
potential mergers and acquisitions through December 31, 2003 (the 2003 Agreement).  On August 23, 2004, the Company entered into another advisory agreement
with USCI for services during 2004 (the 2004 Agreement).  Mr. Deutschman currently serves on the Board of Directors of the Company as the representative of
the holder of the Company's Series A Preferred Stock. The Company's agreements with USCI provide for the payment of a discretionary success fee for completed
acquisition transactions in an amount determined by an independent committee of the Board.  The 2003 Agreement sets forth guidelines for fees payable upon
successful completion of an acquisition transaction of $200 for up to $10,000 of consideration, 1.5% of consideration from $10,000 to $25,000 and 1% of
consideration over $25,000; provided, however, that the success fee for the first transaction under the agreement has an initial fee guideline of $275
for up to $10,000 of consideration. Notwithstanding the guidelines, the independent committee has absolute discretion in determining the amount, if any,
of the success fee for any transaction. The 2004 Agreement does not include success fee guidelines.  The USCI agreements provide for the payment of a
refundable advance against success fees in the aggregate amount of $275 under the 2003 Agreement and $322 under the 2004 Agreement.  The Company believes
that these agreements are enhancing its ability to analyze and close merger and acquisition transactions in a manner that is more cost effective than
traditional outside advisory firms. In connection with the acquisition of SCI (see Note 6), USCI earned a success fee of $275. This success fee is recorded
as a transaction cost of the SCI acquisition.  In connection with the February 2004 acquisition of JGI, USCI earned a success fee of $125.  This success fee
is recorded as a transaction cost of the JGI acquisition. 17




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##### Table of Contents



NOTE 8  MANDATORILY REDEEMABLE PREFERRED STOCK On March 29, 2000, Crown EMAK Partners, LLC, a Delaware limited liability
company (Crown), invested $11,900 in EMAK in exchange for preferred stock
and warrants to purchase additional preferred stock. Under the terms of the
investment, Crown acquired 11,900 shares of Series A mandatory redeemable
senior cumulative participating convertible preferred stock, par value
$.001 per share, (the Series A Stock) with a conversion price of $14.75
per share. In connection with such purchase, the Company granted to Crown
five year warrants (collectively, the Warrants) to purchase 5,712 shares
of Series B senior cumulative participating convertible preferred stock,
par value $.001 per share, (the Series B Stock) at an exercise price of
$1,000 per share, and 1,428 shares of Series C senior cumulative
participating convertible preferred stock, par value $.001 per share, (the
Series C Stock) at an exercise price of $1,000 per share. The Warrants
were immediately exercisable. The conversion prices of the Series B Stock
and the Series C Stock were $16.00 and $18.00 per share, respectively. On
June 20, 2000, Crown paid EMAK an additional $13,100 in exchange for an
additional 13,100 shares of Series A Stock with a conversion price of
$14.75 per share. In connection with such purchase, EMAK granted to Crown
additional Warrants to purchase another 6,288 shares of Series B Stock and
another 1,572 shares of Series C Stock. Each share of Series A Stock is
convertible into 67.7966 shares of Common Stock, representing 1,694,915
shares of Common Stock in aggregate. Each share of Series B Stock and
Series C Stock was convertible into 62.5 and 55.5556 shares of Common
Stock, respectively, representing 916,666 shares of Common Stock in
aggregate. Also in connection with such purchase, the Company agreed to
pay Crown a commitment fee in the aggregate amount of $1,250, paid in equal
quarterly installments of $62.5 commencing on June 30, 2000 and ending on
June 30, 2005. No payment was made during the quarter ended September 30,
2004. On March 19, 2004, the Company entered into a Warrant Exchange Agreement
with Crown whereby Crown received new warrants to purchase an aggregate of
916,666 shares of Common Stock (New Warrants) in exchange for
cancellation of the existing Warrants to purchase shares of Series B Stock
and Series C Stock (which, upon issuance, would have been convertible into
916,666 shares of Common Stock). The New Warrants consist of warrants to
purchase 750,000 shares and 166,666 shares of Common Stock at exercise
prices of $16.00 and $18.00 per share, respectively. Of each tranche,
47.6% expire on March 29, 2010 and 52.4% expire on June 20, 2010. As a
result of the exchange transaction, Crown received an extension of time in
which to exercise its right to purchase additional equity in EMAK, and EMAK
obtained an elimination of the preferred rights and preferences as well as
the preferred dividend associated with the now eliminated Series B Stock
and Series C Stock. The exchange was recorded as a reduction to preferred
stock of $531 and an increase to additional paid-in-capital of $487, net of
transaction costs of $44. Upon any voluntary or involuntary liquidation, dissolution or winding-up of
the Companys affairs, Crown, as holder of the Series A Stock, will be
entitled to payment out of assets of the Company available for distribution
of an amount equal to the greater of (a) the liquidation preference of
$1,000 per share (the Liquidation Preference) plus all accrued and unpaid
dividends or (b) the aggregate amount of payment that the outstanding
preferred stock holder would have received assuming conversion to Common
Stock immediately prior to the date of liquidation of capital stock, before
any payment is made to other stockholders. The Series A Stock is subject to mandatory redemption at the option of the
holder at 101% of the aggregate Liquidation Preference plus accrued and
unpaid dividends if a change in control occurs. Crown has voting rights equivalent to the number of shares of Common Stock
into which their Series A Stock is convertible on the relevant record date.
Crown is also entitled to receive a quarterly dividend equal to 6% of the
Liquidation Preference per share outstanding, payable in cash. The
dividends for the quarter ended September 30, 2004 totaled $375 and were
paid in October 2004 and recorded in accounts payable in the accompanying
condensed consolidated balance sheet as of September 30, 2004. Crown currently holds 100% of the outstanding shares of Series A Stock, and
has designated one individual to the Board of Directors of the Company.
Crown currently has the right to designate two additional directors. The Series A Stock is recorded in the accompanying condensed consolidated
balance sheets at its Liquidation Preference net of issuance costs. The
issuance costs total approximately $1,951 and include an accrual of
approximately $1,000 for the present value of the commitment fee discussed
above. 18




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##### Table of Contents



NOTE 9-COMMITMENTS AND CONTINGENCIES Operating Leases The Company has operating leases for its properties and equipment, which
expire at various dates through 2014. Future minimum lease payments under non-cancelable operating leases as of
September 30, 2004 are as follows: Year2004
    
    $
    1,2722005
    
    
    4,7692006
    
    
    4,2162007
    
    
    4,0162008
    
    
    3,614Thereafter
    
    
    6,183Total
    
    $
    24,070
 Aggregate rental expenses for operating leases were $787 and $883 for the
three months ended September 30, 2003 and 2004, respectively. Guaranteed Royalties For the three months ended September 30, 2003 and 2004, the Company
incurred $1,112 and $1,067, respectively, in royalty expense. License
agreements for certain copyrights and trademarks require minimum guaranteed
royalty payments over the respective terms of the licenses. As of September
30, 2004, the Company has committed to pay total minimum guaranteed
royalties as follows: Year2004
    
    $
    1,7852005
    
    
    4,2712006
    
    
    2,5462007
    
    
    1,076Total
    
    $
    9,678
 License agreements for certain copyrights and trademarks in the Consumer
Products segment require minimum commitments for advertising over the
respective terms of the licenses. The commitment for advertising
expenditures is determined as a percentage of the sales (typically up to 10
percent) of certain licensed properties over the terms of their respective
agreements. Employment Agreements The Company has employment agreements with key executives. Guaranteed
compensation under these agreements as of September 30, 2004 are as
follows: Year2004
    
    $
    7622005
    
    
    6002006
    
    
    3252007
    
    
    3252008
    
    
    200Thereafter
    
    
    1,800Total
    
    $
    4,012
 NOTE 10  RESTRUCTURING During the second quarter of 2004, the Company formulated and implemented a
restructuring plan in connection with the realignment of centralized resources
in its Marketing Services business in order to combine and streamline the
operations. In connection with this plan the Company recorded a restructuring
charge of $105. This charge represents severance for one employee in the
Companys Los Angeles office, who was terminated, and is reflected as a
restructuring charge in the accompanying condensed consolidated statement of
operations. During the third quarter of 2004 there was a restructuring gain of
$25 that represents a reversal of a portion of the 2003 restructuring charge
related to the severance for workforce reductions at Upshot. 19




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##### Table of Contents



NOTE 11  LOSS ON CHICAGO LEASE In 2003, the Company finalized its exit plan with respect to vacating half of
its leased space (approximately thirty thousand square feet) at Upshots
Chicago, Illinois office. In June 2003, this resulted in an adjustment to the
liabilities recorded and an increase to goodwill of $1,900 for the present
value of the remaining lease payments for the vacated office space in excess of
the estimated sub-lease income. The liabilities assumed in connection with this
restructuring plan totaled $3,535 and are included as part of goodwill in
accordance with EITF Issue No. 95-3, Recognition of Liabilities in Connection
with a Purchase Business Combination. In June 2004, the Company recorded
expense of $311 due to lower than estimated sublease income for the vacated
office space. The office space has been subleased at rates modestly below the
Companys initial estimates, due to softness in the current Chicago real estate
market. NOTE 12  SUBSEQUENT EVENT On
November 10, 2004, the Company completed the acquisition of all
of the outstanding capital stock of Megaprint Group Limited
(Mega), a privately held creative promotions agency
headquartered in the United Kingdom, for approximately
2.25 million British pounds (approximately US$4.16 million)
in cash, plus additional consideration up to a maximum of
2.45 million British pounds based on future performance through
2009. The Company financed the transaction through its existing
credit facility with Bank of America. Mega is currently generating
approximately $16.0 million in annualized revenue. Founded in
1969 in the Netherlands, Mega provides a wide range of promotional
tools and specializes in the creation and production of programs
utilizing two-dimensional (2-D) premiums for blue-chip
corporate clients primarily in Western European markets. Its two
largest clients, Kelloggs and PepsiCo, together generate more
than 50% of Megas total sales. Other clients included
Masterfoods/Mars, Nestlé, Readers Digest, Unilever,
Gillette and Danone. Mega has operations in the U.K. and Ireland, the
Netherlands, Germany and France, and operates through sales agents in
Scandinavia, the Czech Republic and the Middle East. 20




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##### Table of Contents



ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS Except as expressly indicated or unless the context otherwise requires, as used
herein,EMAK, the Company, we, our, or us, means EMAK Worldwide,
Inc., a Delaware corporation and its subsidiaries. Unless otherwise
specifically indicated, all dollar amounts herein are expressed in thousands. Organization and Business EMAK Worldwide, Inc., a Delaware corporation and subsidiaries, is a leading
marketing services company based in Los Angeles, with offices in Chicago,
Minneapolis, New York, Ontario (CA), London, Paris, Hong Kong and Shanghai.
We focus on the design and execution of strategy-based marketing programs,
with particular expertise in the areas of: strategic planning and research,
entertainment marketing, design and manufacturing of custom promotional
products, promotion, event marketing, collaborative marketing, and
environmental branding. Our clients include Burger King Corporation,
Kelloggs, Kohls, Macys, Nordstrom, Procter & Gamble, and Subway
Restaurants, among others. We complement our core marketing services
business by developing and marketing distinctive consumer products, based
on emerging and evergreen licensed properties, which are sold through
specialty and mass-market retailers. Equity Marketing Hong Kong, Ltd., a Delaware corporation (EMHK), is a
100% owned subsidiary. EMHK manages production of our products by third
parties in the Far East and currently is responsible for performing and/or
procuring product sourcing, product engineering, quality control
inspections, independent safety testing and export/import documentation. Logistix Limited, a United Kingdom corporation (Logistix), is a 100%
owned subsidiary which was acquired on July 31, 2001. Logistix is a
marketing services agency which focuses primarily on assisting consumer
packaged goods companies in their efforts to market to children between the
ages of seven and fourteen by developing and executing premium-based
promotions and by providing marketing consulting services. Logistix also
derives a small portion of its revenues from a consumer products business. Our Upshot division (Upshot), which was acquired on July 17, 2002, is a
marketing agency, specializing in promotion, event, collaborative marketing,
retail design and environmental branding. Our SCI Promotion division (SCI), which was acquired on September 3,
2003, is a promotional marketing services business specializing in the
development and execution of promotional campaigns that utilize
purchase-with-purchase, gift-with-purchase, promotional licenses and
promotional retail programs, principally for the retail department store
industry. Johnson Grossfield, Inc. (JGI), is a 100% owned subsidiary, the
operations of which were acquired on February 2, 2004 (effective January
31, 2004). JGI is a promotional marketing services business specializing
in providing custom licensed premiums for the kids marketing program of
Subway Restaurants. Overview Revenues for the third quarter of 2004 increased $9,107 to $58,055 as compared
to $48,948 recorded in the prior year as a result of revenue contributions from
our recent acquisitions as well as revenue growth in our existing marketing
services business. SCI and JGI combined generated approximately $6,935 of
revenue during the quarter. Despite the revenue growth, our third quarter 2004
performance was negatively impacted by shortfalls in our Consumer Products
segment and SCI Promotion business, two areas that typically generate higher
margins. We recorded a net loss of $0.22 per diluted share for the third quarter of 2004
compared to net income of $0.12 per diluted share in the prior year quarter.
The net loss per share was primarily attributable to the following factors:  
    
    While sales in the Consumer Product segment (which includes both Pop
Rocket and the consumer products business of Logistix) increased $547
from the prior year quarter, gross profit margins decreased to 18.5% of
sales from 36.8% in the prior year quarter. The moderate sales growth
in this segment is due to the contribution of some of our newer products
such as Crayola® branded bath toys and our Baby Einstein line of
products. However, the overall revenues in this segment fell well short
of our expectations, as retailers are being more conservative than we
anticipated with their inventory positions ahead of the holiday season,
and some of our product lines, particularly Scooby-Doo, have not
performed as well as expected. The gross profit margin deterioration
for Consumer Products is attributable to a highly competitive retail
pricing environment, resulting in pricing and markdown concessions to
retailers. Secondly, our raw materials costs have risen significantly
due to higher plastic resin costs resulting from record-high oil prices.
As a result, Consumer Product margins are being pressured 21




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##### Table of Contents



from both revenues and cost of sales.
    
    Gross profit margins in the Marketing Services segment decreased to
21.8% in the third quarter of 2004, as compared to 25.9 percent in the
prior year. This reduction was due to the deferral of fee-based
services to the fourth quarter, as well as a rapid rise in raw materials
costs which could not be recaptured from clients due to long lead times
on programs.
    
    Collectively, SCI and JGI were $0.03 dilutive per share as a result
of net losses at SCI. The results for SCI for the quarter fell well
short of expectations. The weakness at SCI is attributable to deferrals
of scheduled promotional programs into 2005, as well as cancellations of
promotional programs due to specific business issues at client
companies. As a result, we did not achieve the sales volume necessary
to absorb the largely fixed cost structure of this business. This
resulted in increased operating expenses as a percentage of revenues.
    
    Operating expenses in the third quarter of 2004 include approximately
$190, or $0.02 per diluted share, in non-cash expense related to grants
of restricted stock units, compared with $62, or $0.01 per diluted share
recognized in the same period of 2003. We began using restricted stock
units as our primary means of stock based compensation in the second
quarter of 2003 and made additional grants at the beginning of the
second quarter of 2004. Our Burger King business performed in line with our expectations. During the
quarter we implemented two domestic premium programs and three international
ones. This is essentially the same number of promotional programs that we
have typically produced for Burger King in the third quarter. For the third
quarter, unit volumes for the domestic programs have increased relative to the
prior year. As we expected, we are seeing the trend of lower domestic unit
volumes which we experienced in the first half of 2003 begin to turn around as
a result of the recent improvements in Burger King system sales of Kids Meals. Despite the year to date losses, we expect to generate positive net income for
the fourth quarter of 2004 as a result of the holiday promotions of several of
our largest clients. However, due to the weakness in the Consumer Products and SCI businesses, the
Company will likely not be profitable on a full year basis for 2004. Results of Operations The following table sets forth, for the periods indicated, the Companys
operating results as a percentage of total revenues: Three Months
    
    Nine MonthsEnded September 30,
    
    Ended September 30,2003
    
    2004
    
    2003
    
    2004Revenues
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %Cost of sales
    
    
    72.6
    
    
    
    78.6
    
    
    
    73.3
    
    
    
    75.6Gross profit
    
    
    27.4
    
    
    
    21.4
    
    
    
    26.7
    
    
    
    24.4Operating expenses:Salaries, wages and benefits
    
    
    12.6
    
    
    
    13.8
    
    
    
    11.4
    
    
    
    14.3Selling, general and administrative
    
    
    11.3
    
    
    
    10.4
    
    
    
    11.1
    
    
    
    11.2Integration costs
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    0.1Loss on Chicago lease
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    0.2Restructuring charge
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    0.1Total operating expenses
    
    
    23.9
    
    
    
    24.2
    
    
    
    22.5
    
    
    
    25.9Income (Loss) from operations
    
    
    3.5
    
    
    
    (2.8
    )
    
    
    4.2
    
    
    
    (1.5
    )Other income (expense), net
    
    
    0.4
    
    
    
    0.3
    
    
    
    0.3
    
    
    
    (0.1
    )Income (Loss) before provision (benefit) for income taxes
    
    
    3.9
    
    
    
    (2.5
    )
    
    
    4.5
    
    
    
    (1.6
    )Provision (Benefit) for income taxes
    
    
    1.2
    
    
    
    (1.0
    )
    
    
    1.6
    
    
    
    (0.6
    )Net income (loss)
    
    
    2.7
    %
    
    
    (1.5
    )%
    
    
    2.9
    %
    
    
    (1.0
    )%
 22




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##### Table of Contents



Three Months Ended September 30, 2004 Compared to Three Months Ended September
30, 2003: Revenues Revenues for the three months ended September 30, 2004 increased $9,107, or
18.6%, to $58,055 from $48,948 in the comparable period in 2003. Marketing
Services revenues increased $8,560, or 20.3%, to $50,717 as a result of
increased revenues resulting from the JGI Acquisition, additional revenues
generated by our Logistix subsidiary and our Burger King business, partially
offset by decreased revenues in our SCI business. Our Logistix business had
increased revenues from Kelloggs promotional programs compared to the same
period in 2003. Revenues for the Burger King business increased as the volume
of units for domestic promotional programs were higher in the third quarter of
2004 compared to the same period in 2003. In addition, net foreign currency translation impact contributed
approximately $1,299 to revenues for Logistix versus the prior year period
average exchange rates. Results for the third quarter of 2003 include one month of revenues for SCI
Promotion (acquired September 3, 2003) and excludes JGI (acquired February 2,
2004). Excluding the impact of the SCI and JGI Acquisitions, Marketing
Services revenues increased 7.1% for the three months ended September 30, 2004
compared to the same period in 2003. Consumer Product revenues increased $547, or 8.1%, to $7,338. The increase is
primarily attributable to the continued growth of
Crayola® branded bath toys,
increased international sales of Scooby-Doo product, and the addition of the
Baby Einsteinproducts. Our third quarter 2004 Consumer Product revenues were
primarily comprised of Scooby-Doo, Crayola®, Baby Einstein, and Kim Possible
product. In January 2004, we began distributing the first toy products based
on Baby Einstein, the best selling brand of videos specifically designed for
infants and toddlers. We have granted exclusive distribution to Target and
Babies R Us for 2004. The growth in our Crayola® line of bath toys, which was
launched in the second half of 2003, was attributable to an expanded product
line and expanded distribution channels. The growth in Scooby-Doo
international revenues for the quarter was attributable to the brand receiving
more exposure on television in Europe and Latin America. The growth in
international sales of Scooby-Doo was partially offset by a decline in
domestic Scooby-Doo sales. Cost of sales and gross profit Cost of sales increased $10,132 to $45,645 (78.6% of revenues) for the three
months ended September 30, 2004 from $35,513 (72.6% of revenues) in the
comparable period in 2003. The gross margin percentage decreased to 21.4% for the three months ended
September 30, 2004 from 27.4% in the comparable period for 2003. The gross
profit percentage for Marketing Services for the three months ended September
30, 2004 decreased to 21.8% compared to 25.9% for the comparable period in
2003. This decrease is attributable to the deferral of higher margin fee-based
services to the fourth quarter as well as a rapid rise in raw materials costs
which could not be recaptured from clients due to long order lead times. The
gross profit percentage for Consumer Products decreased to 18.5% for the three
months ended September 30, 2004 from 36.8% in the comparable period in 2003.
This decrease is primarily the result of a highly competitive retail pricing
environment resulting in pricing and markdown concessions to retailers,
increased costs for plastic resin resulting from higher oil prices and a higher
mix of international sales which carry lower margins. International sales,
which are sold through distributors who bear more of the risk and incur the
bulk of the selling expenses, tend to carry lower gross margins than domestic
sales. Salaries, wages and benefits Salaries, wages and benefits increased $1,845, or 30.0%, to $7,986 (13.8% of
revenues) for the three months ended September 30, 2004 from $6,141 (12.6% of
revenues) in the comparable period for 2003. This increase was primarily
attributable to the addition of approximately 55 employees from the SCI and JGI
Acquisitions as well as annual employee merit pay increases and additional
compensation expense resulting from grants of restricted stock units. Salaries, wages and benefits increased as a percentage of revenues from 12.6%
to 13.8% as a result of revenues increasing at a lesser rate. Due to the
weakness at SCI, which was attributable to deferrals and cancellations of
scheduled promotional programs, we did not achieve the sales volume necessary
to absorb the largely fixed cost structure of this business. Selling, general and administrative expenses Selling, general and administrative expenses increased $541, or 9.8%, to $6,087
(10.4% of revenues) for the three months ended September 30, 2004 from $5,546
(11.3% of revenues) in the comparable period for 2003. The increase is
attributable to additional operating expenses resulting from the SCI and JGI
Acquisitions. 23




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##### Table of Contents



Selling, general and administrative expenses decreased as a percentage of
revenues from 11.3% to 10.4% as a result of a reduction in selling expenses as
a percentage of revenues due primarily to reduced freight out costs. The
reduction in freight out is attributable to a shift in the delivery location
for product sales to a large customer. Restructuring gain We recorded a restructuring gain of $25 for the three months ended September
30, 2004. This represents a reversal of a portion of the 2003 restructuring
charge related to the severance for workforce reductions at Upshot. Other income Other income, net decreased $9 to $179 for the three months ended September 30,
2004 from $188 in the comparable period for 2003. Provision (benefit) for taxes The effective tax rate for the three months ended September 30, 2004 was 38.8%
compared to 31.5% for the same period in 2003. The increase in the effective
tax rate is the result of a net loss being generated domestically in 2004
relative to net income in 2003 which was primarily generated internationally in
territories which have more favorable tax rates. Net income (loss) Net income decreased $2,220 to a net loss of $893 ((1.5)% of revenues) in 2004
from net income of $1,327 (2.7% of revenues) in 2003 primarily due to lower
gross profit margins and increased salaries, wages and benefits attributable to
the SCI and JGI Acquisitions. Nine
Months Ended September 30, 2004 Compared to Nine Months Ended September 30,
2003: Revenues Revenues for the nine months ended September 30, 2004 increased $8,177, or
5.3%, to $161,645 from $153,468 in the comparable period in 2003. Marketing
Services revenues increased $12,245, or 9.3%, to $144,400 primarily as a result
of increased revenues resulting from the SCI and JGI Acquisitions. The
increase in Marketing Services revenues was also attributable to additional
revenues generated by our Logistix subsidiary. Our Logistix business had
increased revenues from Kelloggs promotional programs compared to the same
period in 2003. In addition, net foreign currency translation impact
contributed approximately $3,463 to revenues for Logistix versus the prior year
period average exchange rates. Revenues for the Burger King business decreased
as the volume of units for domestic promotional programs were lower in the
first half of 2004 compared to the same period in 2003. Results for the nine months ended September 30, 2003 include one month of
revenues for SCI Promotion (acquired September 3, 2003) and excludes JGI
(acquired February 2, 2004). Excluding the impact of the SCI and JGI
Acquisitions, Marketing Services revenues decreased 3.0% for the nine months
ended September 30, 2004 compared to the same period in 2003. SCI and JGI
combined generated approximately $17,635 of revenues in the current year
period. Consumer Product revenues decreased $4,068, or 19.1%, to $17,245. The decrease
is primarily attributable to a significant one-time stocking of Kim Possible
merchandise in the nine months ended September 30, 2003. Our Kim Possible
line was launched in the nine months ended September 30, 2003 as a Wal-Mart
exclusive; distribution expanded to other major retailers beginning in January
2004. The decrease was partially offset by increased international sales of
Scooby-Doo product, the continued growth of Crayola® branded bath toys, and
the addition of the Baby Einsteinproducts. Revenues for the nine months
ended September 30, 2003 were primarily comprised of Scooby-Doo, Crayola®,
Baby Einstein and Kim Possible product. In January 2004, we began
distributing the first toy products based upon Baby Einstein, the best selling
brand of videos specifically designed for infants and toddlers. We have
granted exclusive distribution to Target and Babies R Us for 2004. The
growth in our Crayola® line of bath toys, which was launched in the nine months
ended September 30, 2003, was attributable to an expanded product line and
expanded distribution channels. The growth in Scooby-Doo international
revenues for the nine months ended September 30, 2004 was attributable to the
brand receiving more exposure on television in Europe and Latin America. The
growth in international sales of Scooby-Doo was partially offset by a decline
in domestic Scooby-Doo sales. 24




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Cost of sales and gross profit Cost of sales increased $9,666 to $122,232 (75.6% of revenues) for the nine
months ended September 30, 2004 from $112,566 (73.3% of revenues) in the
comparable period in 2003 due to higher sales volume in 2004. The gross margin percentage decreased to 24.4% for the nine months ended
September 30, 2004 from 26.7% in the comparable period for 2003. The gross
profit percentage for Marketing Services for the nine months ended September
30, 2004 decreased to 24.5% compared to 25.0% for the comparable period in
2003. This decrease is attributable to the deferral of higher margin fee-based
services to the fourth quarter as well as a rapid rise in raw materials costs
which could not be recaptured from clients due to long order lead times. The
gross profit percentage for Consumer Products decreased to 23.0% for the nine
months ended September 30, 2004 from 36.6% in the comparable period in 2003.
This decrease is primarily the result of a highly competitive retail pricing
environment resulting in pricing and markdown concessions to retailers,
increased costs for plastic resin resulting from higher oil prices and a higher
mix of international sales which carry lower margins. International sales,
which are sold through distributors who bear more of the risk and incur the
bulk of the selling expenses, tend to carry lower gross margins than domestic
sales. The decrease in Consumer Products margins is also partially
attributable to a significant one-time stocking of high margin Kim Possible
merchandise in the second quarter of 2003. Salaries, wages and benefits Salaries, wages and benefits increased $5,624, or 32.1%, to $23,163 (14.3% of
revenues) for the nine months ended September 30, 2004 from $17,539 (11.4% of
revenues) in the comparable period for 2003. This increase was primarily
attributable to the addition of approximately 55 employees from the SCI and JGI
Acquisitions as well as annual employee merit pay increases and additional
compensation expense resulting from grants of restricted stock units. Salaries, wages and benefits increased as a percentage of revenues from 11.4%
to 14.3% as a result of revenues increasing at a lesser rate. Due to the
weakness at SCI, which was attributable to deferrals and cancellations of
scheduled promotional programs, we did not achieve the sales volume necessary
to absorb the largely fixed cost structure of this business. In addition, the
reduction in Burger King unit volume in the first half of 2003 had a
significant impact on this metric, as our staffing levels required to service
this account are largely fixed. Selling, general and administrative expenses Selling, general and administrative expenses increased $1,087, or 6.4%, to
$18,143 (11.2% of revenues) for the nine months ended September 30, 2004 from
$17,056 (11.1% of revenues) in the comparable period for 2003. The increase is
primarily the result of additional operating expenses resulting from the SCI
and JGI Acquisitions. Integration costs We recorded integration costs of $136 (0.1% of revenues) for the nine months
ended September 30, 2004. These are primarily travel, training and consulting
costs directly related to the integration of SCI and JGI. Loss on Chicago lease We recorded a charge for the loss on the Chicago office lease of $311 (0.2% of
revenues) for the nine months ended September 30, 2004. This is due to lower
than estimated sublease income for vacated office space in the Upshot business.
The office space has been subleased at rates modestly below our initial
estimates, due to softness in the current Chicago real estate market. Restructuring charge We recorded a net restructuring charge of $80 (0.1% of revenues) for the nine
months ended September 30, 2004. This is associated with the realignment of
centralized resources in our Marketing Services business, partially offset by a
reversal of a portion of the 2003 restructuring charge related to the severance
for workforce at Upshot. Other income (expense) Other income (expense), net, decreased $676 to $(181) for the nine months ended
September 30, 2004 from $495 in the comparable period for 2003. This decrease
was due to foreign currency transaction losses in the first quarter of 2004 as
a result of the strengthening Euro relative to the British Pound. The growth
in the pan-European business at Logistix during the first quarter of 2004
surpassed the currency hedges in place covering the British pound against the
Euro. 25




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Provision (benefit) for taxes The effective tax rate for the nine months ended September 30, 2004 was 38.9%
compared to 34.7% for the same period in 2003. The increase in the effective
tax rate is the result of a net loss being generated domestically in 2004
relative to net income in 2003 which was primarily generated internationally in
territories which have more favorable tax rates. Net income (loss) Net income (loss) decreased $6,034 to a net loss of $1,589 ((1.0)% of revenues)
in 2004 from net income of $4,445 (2.9% of revenues) in 2003 primarily due to
lower gross profit margins, increased salaries, wages and benefits and selling,
general and administrative expenses attributable to the acquisitions of SCI and
JGI. The decrease is also the result of foreign currency transaction losses as
a result of the strengthening Euro relative to the British pound and the loss
on the Chicago lease. Financial Condition and Liquidity At September 30, 2004, cash and cash equivalents were $8,057, compared to
$19,291 as of December 31, 2003. The decrease in cash and cash equivalents was
attributable to the JGI Acquisition, the net loss for the nine months ended
September 30, 2004, an investment in inventories ahead of an anticipated
seasonally strong fourth quarter, and purchases of fixed assets. As of September 30, 2004, our net accounts receivable decreased $74 to $36,691
from $36,765 at December 31, 2003. As of September 30, 2004, inventories increased $4,167 to $19,266 from $15,099
at December 31, 2003. This increase in inventories is primarily the result of
purchases of inventory ahead of an anticipated seasonally strong fourth
quarter. In addition, the increase was due to additional inventories acquired
as a result of the JGI Acquisition. Marketing Services inventories represent
72% and 71% of total inventories as of September 30, 2004 and December 31,
2003, respectively. Promotional product inventory used in Marketing Services
generally has lower risk than Consumer Product inventory, as it usually
represents product made to order. As of September 30, 2004, short-term debt increased $863 to $1,489 from $626 at
December 31, 2003. This increase is associated with the bank advances to our
Logistix subsidiary to finance inventory purchases. Advances under this
facility as of December 31, 2003 were originally recorded in accounts payable
and have been reclassified to conform to the current period presentation. As of September 30, 2004, accounts payable increased $1,093 to $29,332 from
$28,239 at December 31, 2003. This increase was attributable to the increased
inventory purchases as well as additional payables as a result of the JGI
Acquisition. As of September 30, 2004, accrued liabilities decreased $2,139 to $15,056 from
$17,195 at December 31, 2003. This decrease is primarily attributable to the
payment of administrative fees collected from distribution companies during the
fourth quarter of 2003 on behalf of promotional customers, as well as, the
payment of royalties and income taxes. This decrease was partially offset by
additional accrued liabilities as a result of the JGI Acquisition. As of September 30, 2004, working capital was $22,836 compared to $29,447 at
December 31, 2003. Cash used by operations for the nine months ended September
30, 2004 were $5,638 compared to $2,834 in the prior year. Cash flows used in
operations in the nine months ended September 30, 2004 were primarily the
result of the net loss for the nine months ended September 30, 2004 as well as
purchases of inventories ahead of an anticipated seasonally strong fourth
quarter. Cash flows used in investing activities for the nine months ended
September 30, 2004 were $5,674 compared to $8,028 in the prior year. This
decrease is the result of the SCI Acquisition in September 2003 and reduced
purchases of marketable securities partially offset by the JGI Acquisition in
2004 and increased purchases of fixed assets. Cash flows provided by financing
activities for the nine months ended September 30, 2004 were $65 compared to
cash used of $1,164 in the prior year primarily as a result of an increase in
short-term borrowings at Logistix and a decrease in the repurchase of treasury
stock partially offset by a decrease in proceeds from the exercise of stock
options. Our current strategy and business plan calls for the consummation of additional
acquisitions. We plan
to evaluate the level of such expenditures in the context of the capital
available to us and to changing market conditions. As of the date hereof, we believe that cash from operations, cash on hand at
September 30, 2004 and our credit facility will be sufficient to fund our
working capital needs for at least the next twelve months. The statements set
forth herein are forward-looking and actual results may differ materially. 26




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Future minimum annual commitments for guaranteed minimum royalty payments
under license agreements, non-cancelable operating leases and employment
agreements as of September 30, 2004 are as follows: 2004
    
    2005
    
    2006
    
    2007
    
    2008
    
    Thereafter
    
    TotalOperating Leases
    
    $
    1,272
    
    
    $
    4,769
    
    
    $
    4,216
    
    
    $
    4,016
    
    
    $
    3,614
    
    
    $
    6,183
    
    
    $
    24,070Guaranteed Royalties
    
    
    1,785
    
    
    
    4,271
    
    
    
    2,546
    
    
    
    1,076
    
    
    
    
    
    
    
    
    
    
    
    9,678Employment Agreements
    
    
    762
    
    
    
    600
    
    
    
    325
    
    
    
    325
    
    
    
    200
    
    
    
    1,800
    
    
    
    4,012Total
    
    $
    3,819
    
    
    $
    9,640
    
    
    $
    7,087
    
    
    $
    5,417
    
    
    $
    3,814
    
    
    $
    7,983
    
    
    $
    37,760
 We had no material commitments for capital expenditures at September 30, 2004.
Letters of credit outstanding as of December 31, 2003 and September 30, 2004
totaled $823 and $3,358, respectively. Credit Facilities On April 24, 2001, we signed a credit facility (the Facility) with Bank of
America. On April 26, 2004, the maturity date of the Facility was extended
through June 30, 2005. The credit facility is secured by substantially all of
our assets and provides for a line of credit of up to $35,000 with borrowing
availability determined by a formula based on qualified assets. Interest on
outstanding borrowings will be based on either a fixed rate equivalent to LIBOR
plus an applicable spread of between 1.50 and 2.25 percent or a variable rate
equivalent to the banks reference rate plus an applicable spread of between
zero and 0.50 percent. We are also required to pay an unused line fee of
between zero and 0.60 percent per annum and certain letter of credit fees. The
applicable spread is based on the achievement of certain financial ratios. The
Facility also requires us to comply with certain restrictions and covenants as
amended from time to time. On November 14, 2001, February 8, 2002, September
30, 2002, November 14, 2003, April 26, 2004, August 12, 2004 and November 15,
2004, certain covenants under the facility were amended. As of September 30,
2004, we were in compliance with the amended restrictions and covenants. In
addition to amending certain covenants, the November 15, 2004 amendment imposed
a temporary $12,000 cap on total outstanding borrowings and letters of credit.
Bank of America will reassess the cap in December 2004. This amendment also
increases the maximum interest rate on outstanding borrowings by 0.25 percent.
The Facility may be used for working capital and acquisition financing
purposes. As of September 30, 2004, there were no amounts outstanding under
the Facility except for letters of credit of $3,358. In addition to the Facility, in October, 2003 our Logistix subsidiary
established an import/letter of credit facility with Hong Kong Shanghai Bank
Corp. (HSBC) to provide short-term financing of product purchases from Asia.
The total availability under this facility is 1,000 GBP. Under this facility
HSBC may pay Logistixs vendors directly upon receipt of invoices and shipping
documentation. Logistix in turn is obligated to repay HSBC within 120 days.
As of December 31, 2003, advances outstanding under this facility totaled
approximately $626 and were recorded in short-term debt in the accompanying
condensed consolidated balance sheet. As of September 30, 2004, $1,489 was
outstanding under this facility. Acquisitions On September 3, 2003, we acquired substantially all of the assets of SCI
Promotion Group, LLC (SCI-LLC), a privately held promotional marketing
services company based in Ontario, California (the SCI Acquisition). We
financed the SCI Acquisition through our existing cash reserves. The SCI
Acquisition was consummated pursuant to an Asset Purchase Agreement dated
September 3, 2003, by and among EMAK, SCI-LLC and Joseph J. Schmidt, III (the
Purchase Agreement). Under the terms of the Purchase Agreement, we acquired
substantially all of the assets of SCI-LLC for a cash purchase price of
approximately $5,900 (before the closing balance sheet working capital
adjustment), plus additional earnout consideration of up to $3,500 based upon
future performance of the acquired business. Net of a holdback of $250, we paid
$5,683 in cash plus related transaction costs of $538. We also assumed the
operating liabilities of the business in connection with the acquisition. The
earnout consideration is based upon the acquired business achieving targeted
levels of earnings before interest, taxes, depreciation and amortization
(EBITDA) over the period from 2003 through 2006. The earnout payments, if
required, are payable 50% in cash and 50% in shares of our common stock. The
additional consideration, if any, will be recorded as goodwill. Based on the
results for 2003, additional consideration of $800 was earned and recorded as
goodwill. 27




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On February 2, 2004, we acquired certain assets of Johnson Grossfield, Inc.
(JGI-MN) a privately held promotional marketing services company based in
Minneapolis, Minnesota (the JGI Acquisition). We financed the JGI Acquisition
through our existing cash reserves. The JGI Acquisition was consummated
pursuant to an Asset Purchase Agreement dated January 16, 2004, by and among
the Company, Johnson Grossfield, Inc., a Delaware corporation wholly owned by
us (JGI), JGI-MN, Marc Grossfield and Thom Johnson (the Purchase
Agreement). Under the terms of the Purchase Agreement, we purchased the
assets of JGI-MNs promotional agency business for approximately $4,600 in cash
and 35,785 shares of our common stock (which, based upon the January 30, 2004
closing market price of $14.80, had a value of $530), plus additional earnout
consideration of up to $4,500 based upon future performance of the acquired
business. We also assumed the operating liabilities of the promotional agency
business in connection with the acquisition. The earnout consideration is based
upon the acquired business achieving targeted levels of earnings before
interest, taxes, depreciation and amortization (EBITDA) over the period from
2004 through 2008. The earnout payments, if required, are payable 50% in cash
and 50% in shares of our common stock. The additional consideration, if any,
will be recorded as goodwill. Issuance of Preferred Stock On March 29, 2000, Crown EMAK Partners, LLC, a Delaware limited liability
company (Crown), invested $11,900 in EMAK in exchange for preferred stock
and warrants to purchase additional preferred stock. Under the terms of the
investment, Crown acquired 11,900 shares of Series A mandatory redeemable
senior cumulative participating convertible preferred stock, par value
$.001 per share, (the Series A Stock) with a conversion price of $14.75
per share. In connection with such purchase, we granted to Crown five year
warrants (collectively, the Warrants) to purchase 5,712 shares of Series
B senior cumulative participating convertible preferred stock, par value
$.001 per share, (the Series B Stock) at an exercise price of $1,000 per
share, and 1,428 shares of Series C senior cumulative participating
convertible preferred stock, par value $.001 per share, (the Series C
Stock) at an exercise price of $1,000 per share. The Warrants were
immediately exercisable. The conversion prices of the Series B Stock and
the Series C Stock were $16.00 and $18.00 per share, respectively. On June
20, 2000, Crown paid us an additional $13,100 in exchange for an additional
13,100 shares of Series A Stock with a conversion price of $14.75 per
share. In connection with such purchase, we granted to Crown additional
Warrants to purchase another 6,288 shares of Series B Stock and another
1,572 shares of Series C Stock. Each share of Series A Stock is
convertible into 67.7966 shares of Common Stock, representing 1,694,915
shares of Common Stock in aggregate. Each share of Series B Stock and
Series C Stock was convertible into 62.5 and 55.5556 shares of Common
Stock, respectively, representing 916,666 shares of Common Stock in
aggregate. Also in connection with such purchase, we agreed to pay Crown a
commitment fee in the aggregate amount of $1,250, paid in equal quarterly
installments of $62.5 commencing on June 30, 2000 and ending on June 30,
2005. No payment was made during the quarter ended September 30, 2004. On March 19, 2004, we entered into a Warrant Exchange Agreement with Crown
whereby Crown received new warrants to purchase an aggregate of 916,666
shares of Common Stock (New Warrants) in exchange for cancellation of the
existing Warrants to purchase shares of Series B Stock and Series C Stock
(which, upon issuance, would have been convertible into 916,666 shares of
Common Stock). The New Warrants consist of warrants to purchase 750,000
shares and 166,666 shares of Common Stock at exercise prices of $16.00 and
$18.00 per share, respectively. Of each tranche, 47.6% expire on March 29,
2010 and 52.4% expire on June 20, 2010. As a result of the exchange
transaction, Crown received an extension of time in which to exercise its
right to purchase additional equity in EMAK, and we obtained an elimination
of the preferred rights and preferences as well as the preferred dividend
associated with the now eliminated Series B Stock and Series C Stock. The
exchange was recorded as a reduction to preferred stock of $531 and an
increase to additional paid-in-capital of $487, net of transaction costs of
$44. Upon any voluntary or involuntary liquidation, dissolution or winding-up of
our affairs, Crown, as holder of the Series A Stock, will be entitled to
payment out of our assets available for distribution of an amount equal to
the greater of (a) the liquidation preference of $1,000 per share (the
Liquidation Preference) plus all accrued and unpaid dividends or (b) the
aggregate amount of payment that the outstanding preferred stock holder
would have received assuming conversion to Common Stock immediately prior
to the date of liquidation of capital stock, before any payment is made to
other stockholders. The Series A Stock is subject to mandatory redemption at the option of the
holder at 101% of the aggregate Liquidation Preference plus accrued and
unpaid dividends if a change in control occurs. Crown has voting rights equivalent to the number of shares of Common Stock
into which their Series A Stock is convertible on the relevant record date.
Crown is also entitled to receive a quarterly dividend equal to 6% of the
Liquidation Preference per share outstanding, payable in cash. The
dividends for the quarter ended September 30, 2004 totaled $375 and were
paid in October 2004 and recorded in accounts payable in the accompanying
condensed consolidated balance sheet as of September 30, 2004. Crown currently holds 100% of the outstanding shares of Series A Stock, and
has designated one individual to our Board of 28




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##### Table of Contents



Directors. Crown currently
has the right to designate two additional directors. The Series A Stock is recorded in the accompanying condensed consolidated
balance sheets at its Liquidation Preference net of issuance costs. The
issuance costs total approximately $1,951 and include an accrual of
approximately $1,000 for the present value of the commitment fee discussed
above. Stock Repurchase On July 21, 2000, our Board of Directors authorized up to $10,000 for the
repurchase of our common stock over a twelve month period. In the period
from July 21, 2000 to July 21, 2001, we spent $6,430 to purchase an
aggregate of 523,594 shares at an average price of $12.28 per share
including commissions. On July 24, 2001, our Board of Directors authorized
up to an additional $10,000 for the repurchase of our common stock over a
twelve month period. In the period from August 2, 2001 through July 11,
2002, we spent $5,605 to purchase 454,715 shares at an average price of
$12.33 per share including commissions. On July 12, 2002, our Board of
Directors authorized up to an additional $10,000 for the repurchase of our
common stock. We spent $3,505 to repurchase 267,650 shares at an average
price of $13.10 per share including commissions under this authorization
through September 30, 2004. The duration of the current buyback program is
indefinite; provided, however, that our Board of Directors intends to
review the program periodically. Purchases are conducted in the open market
at prevailing prices, based on market conditions when we are not in a quiet
period. We may also transact purchases effected as block trades, as well
as certain negotiated, off-exchange purchases not in the open market.
Since initiating the overall buyback program on July 20, 2000, we has spent
$15,540 to purchase a total of 1,245,959 shares at an average price of
$12.47 per share including commissions through September 30, 2004. There
were no purchases for the quarter ended September 30, 2004. This
repurchase program is being funded through working capital. Subsequent Event On
November 10, 2004, the Company completed the acquisition of all
of the outstanding capital stock of Megaprint Group Limited
(Mega), a privately held creative promotions agency
headquartered in the United Kingdom, for approximately
2.25 million British pounds (approximately
US $4.16 million) in cash, plus additional consideration up
to a maximum of 2.45 million British pounds based on future
performance through 2009. The Company financed the transaction
through its existing credit facility with Bank of America. Mega is
currently generating approximately $16.0 million in annualized
revenue. Founded in 1969 in the Netherlands, Mega provides a wide
range of promotional tools and specializes in the creation and
production of programs utilizing two-dimensional (2-D)
premiums for blue-chip corporate clients primarily in Western
European markets. Its two largest clients, Kelloggs and
PepsiCo, together generate more than 50% of Megas total sales.
Other clients include Masterfoods/Mars, Nestlé, Readers Digest,
Unilever, Gillette and Danone. Mega has operations in the U.K. and
Ireland, the Netherlands, Germany and France, and operates through
sales agents in Scandinavia, the Czech Republic and the Middle East. Recent Accounting Pronouncements In January 2003, the Financial Accounting Standards Board (FASB) issued
FIN 46, Consolidation of Variable Interest Entities, which addresses the
consolidation of business enterprises (variable interest entities) to which
the usual condition (ownership of a majority voting interest) of
consolidation does not apply. The interpretation focuses on financial
interests that indicate control. It concludes that in the absence of clear
control through voting interests, a companys exposure (variable interest)
to the economic risks and potential rewards from the variable interest
entitys assets and activities are the best evidence of control. Variable
interests are rights and obligations that convey economic gains or losses
from changes in the values of the variable interest entitys assets and
liabilities. Variable interests may arise from financial instruments,
service contracts, nonvoting ownership interests and other arrangements.
If an enterprise holds a majority of the variable interests of an entity,
it would be considered the primary beneficiary. The primary beneficiary
would be required to include the assets, liabilities and the results of
operations of the variable interest entity in its financial statements. In
December 2003, the FASB issued a revision to FIN 46 to address certain
implementation issues. The adoption of FIN 46 and FIN 46 (revised) did not
have an impact on our results of operations or financial position. In March 2004, the FASB published an Exposure Draft, Share-Based Payment,
an Amendment of FASB Statements No. 123 and 95. The proposed change in
accounting would replace existing requirements under Statement of Financial
Accounting Standards (SFAS) No. 123 and APB Opinion No. 25. The proposed
statement would require public companies to recognize the cost of employee
services received in exchange for equity instruments, based on the
grant-date fair value of those instruments, with limited exceptions. The
proposed statement would also affect the pattern in which compensation cost
would be recognized, the accounting for employee share purchase plans, and
the accounting for income tax effects of share-based payment transactions.
The Exposure Draft also notes that the use of a lattice model, such as the
binomial model, to determine the fair value of employee stock options, is
preferable. We currently use the Black-Scholes pricing model to determine
the fair value of its employee stock options. Use of a lattice model to
determine the fair value of employee stock options may result in
compensation cost materially different from those pro forma costs disclosed
in Note 2 to the consolidated financial statements. The effective date of
the proposed standard is for periods beginning after June 15, 2005. We are
currently determining what impact the proposed statement would have on our
results of operations or financial position. In November 2003 and March 2004, the Emerging Issues Task Force (EITF)
reached final consensus on EITF Issue No. 03-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain
Investments. The EITF requires a company to apply a three-step model to
determine whether an impairment of an investment, within the scope of SFAS
No. 115, Accounting for Certain Investments in Debt and Equity
Securities, is other-than-temporary. EITF Issue No. 03-1 shall be applied
prospectively to all current and future investments, in interim or annual
reporting periods beginning after June 15, 2004. The adoption of EITF Issue No. 03-1 will not have a material impact on our results of operations or
financial position because we do not have any investments in marketable
securities as September 30, 2004. 29




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In April 2004, the EITF reached final consensus on EITF 03-6,
Participating Securities and the Two-Class Method under FASB Statement No.
128, which requires companies that have participating securities to
calculate earnings per share using the two-class method. This method
requires the allocation of undistributed earnings to the common shares and
participating securities based on the proportion of undistributed earnings
that each would have been entitled to had all the periods earnings been
distributed. EITF 03-6 is effective for fiscal periods beginning
after March 31, 2004 and earnings per share reported in prior periods presented must be
retroactively adjusted in order to comply with EITF 03-6. We have adopted
EITF 03-6 for the quarter ended June 30, 2004. As a result, earnings per
basic common share were reduced by $0.04 for the third quarter of 2003, to
$0.13 from $0.17 as reported in the prior year. The earnings per diluted
common share were reduced by $0.03 for the third quarter of 2003, to $0.12
from $0.15 as reported in the prior year. The earnings results per basic
common share were reduced by $0.13 for the nine months ending September 30,
2003, to $0.45 from $0.58 as reported in the prior year. The earnings
results per diluted common share were reduced by $0.13 for the nine months
ending September 30, 2003, to $0.42 from $0.55 as reported in the prior
year. EITF 03-6 had no impact on 2004 per share amounts because of the net
loss. In September 2004, the consensus of EITF Issue No. 04-10, "Applying Paragraph
19 of FASB Statement No. 131, 'Disclosures about Segments of an Enterprise and
Related Information,' in Determining Whether to Aggregate Operating Segments
That Do Not Meet the Quantitative Thresholds," was published. EITF Issue No.
04-10 addresses how an enterprise should evaluate the aggregation criteria of
SFAS No. 131 when determining whether operating segments that do not meet the
quantitative thresholds may be aggregated in accordance with SFAS No. 131.
The provisions of EITF Issue No. 04-10 are effective for fiscal years ending after
October 13, 2004. We are currently in the process of determining the impact of this
consensus on our financial results. 30




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Cautionary Statements and Risk Factors Marketplace Risks  
    
    Dependence on a single customer, Burger King, which may adversely affect our financial condition and results of operations.  
    
    Concentration risk associated with accounts receivable. We regularly extend credit to several distribution companies in
connection with our business with Burger King and more recently to a subsidiary of Burger Kings purchasing cooperative
which is expected to increase to 70% of our sales to the Burger King system by the end of 2004.  
    
    Dependence on nonrenewable product orders by Burger King, which promotions are in effect for a limited period of time.  
    
    Dependence on the popularity of licensed entertainment properties, which may adversely affect our financial condition and
results of operations.  
    
    Significant quarter-to-quarter variability in revenues and net income, which may result in operating results below the
expectations of securities analysts and investors.  
    
    Increased competitive pressure, which may affect our sales of products and services.  
    
    Dependence on foreign manufacturers, which may increase the costs of our products and affect the demand for such products.  
    
    Variations in product costs due to fluctuations in raw materials prices, including plastic resin. Financing Risks  
    
    Currency fluctuations, which may affect our suppliers and reportable income. Other Risks  
    
    Products that we develop or sell may expose us to liability from claims by users of such products for damages including,
but not limited to, bodily injury or property damage. We currently maintain product liability insurance coverage in
amounts that we believe are adequate. There can be no assurance that we will be able to maintain such coverage or obtain
additional coverage on acceptable terms in the future, or that such insurance will provide adequate coverage against all
potential claims.  
    
    Exposure to liability for the costs related to product recalls. These costs can include legal expenses, advertising,
collection and destruction of product, and free goods. Our product liability insurance coverage generally excludes such
costs and damages resulting from product recall.  
    
    Potential negative impact of past or future acquisitions, which may disrupt our ongoing business, distract senior
management and increase expenses (including risks associated with the financial condition and integration of the
businesses which we acquire).  
    
    Adverse results of litigation, governmental proceedings or environmental matters, which may lead to increased costs or
interruption in normal business operations.  
    
    Changes in laws or regulations, both domestically and internationally, including those affecting consumer products or
environmental activities or trade restrictions, which may lead to increased costs.  
    
    Strike and other labor disputes which may negatively impact the distribution channels for our products.  
    
    Exposure to liabilities for minimum royalty commitments in connection with license agreements for entertainment
properties. We enter into significant minimum royalty commitments from time to time in connection with its consumer
products business.  
    
    Potential negative impact of Severe Acute Respiratory Syndrome (SARS), which could adversely affect our vendors in the
Far East. We undertake no obligation to publicly release the results of any revisions to
forward-looking statements, which may be made to reflect events or circumstance
after the date hereof or to reflect the occurrence of unanticipated events.
The risks highlighted herein should not be assumed to be the only items that
could affect future performance. In addition to the information contained in
this document, readers are advised to review our Form 10-K for the year ended
December 31, 2003, under the heading Managements Discussion and Analysis of
Financial Condition and Results of Operation  Cautionary Statements and Risk
Factors. 31




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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK For quantitative and qualitative disclosures about market risk affecting
the Company, see Item 7A Quantitative and Qualitative Disclosures About
Market Risk of our Annual Report on Form 10-K for the year ended December
31, 2003. Our exposure to market risks has not changed materially since
December 31, 2003. 
 ITEM 4. CONTROLS AND PROCEDURES The Company maintains disclosure controls and procedures, as defined in
Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934 (the
Exchange Act) , that are designed to ensure that information required to
be disclosed by the Company in the reports that it files or submits under
the Exchange Act is recorded, processed, summarized and reported within the
time periods specified in the Securities and Exchange Commissions rules
and forms and that such information is accumulated and communicated to the
Companys management, including its Chief Executive Officer and Chief
Financial Officer, as appropriate to allow timely decisions regarding
required disclosure. The Company carried out an evaluation, under the
supervision and with the participation of the Companys management,
including the Companys Chief Executive Officer and Chief Financial
Officer, of the effectiveness of the design and operation of the Companys
disclosure controls and procedures as of September 30, 2004. Based on the
evaluation of these disclosure controls and procedures, the Chief Executive
Officer and Chief Financial Officer concluded that the Companys disclosure
controls and procedures were effective There were no changes in the Companys internal control over financial
reporting, as defined in Rule 13a-15(f) promulgated under the Exchange Act,
during the quarter ended September 30, 2004, that have materially affected,
or are reasonably likely to materially affect, the Companys internal
control over financial reporting. 32




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PART II. OTHER INFORMATION 
 ITEM 2. CHANGE IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY
SECURITIES During the third quarter of 2004, EMAK did not purchase any of its common
stock. ISSUER PURCHASES OF EQUITY SECURITIES Total Number of Shares
    
    Maximum Dollar ValuePurchased as Part of
    
    of Shares that May Yet BeTotal Number of
    
    Average Price Paid
    
    Publicly Announced
    
    Purchased Under the ProgramPeriod
    
    Shares Purchased
    
    per Share
    
    Program
    
    (in thousands)July 1 - July 31
    
    
    
    
    
    $
    
    
    
    
    
    
    
    $
    6,495Aug. 1 - Aug. 31
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,495Sept. 1 - Sept. 30
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,495Total
    
    
    
    
    
    $
    
    
    
    
    
    
    
    $
    6,495
 In July 2002, EMAKs board of directors approved a share repurchase program of
up to $10,000. Through September 30, 2004, EMAK repurchased 267,650 shares at a
cost of $3,505 pursuant to this program. In the nine months ended September
30, 2004, EMAK repurchased 16,550 shares at a cost of $211 pursuant to this
program. EMAKs share repurchase program has no expiration date. 
 ITEM 6. EXHIBITS Exhibit 31.1
    
    Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.Exhibit 31.2
    
    Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.Exhibit 32.1
    
    Certification of Chief Executive Officer pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.Exhibit 32.2
    
    Certification of Chief Financial Officer pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002.
 33




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized. 
 EMAK Worldwide, Inc.Date November 15, 2004
    /s/ ZOHAR ZIVZohar ZivSenior Vice President and Chief Financial Officer
(Principal Financial and Accounting Officer) 34