| PLAYBOY ENTERPRISES INC Item 1A Risk Factors 14 Item 1A Risk Factors In addition to the other information contained in this Annual Report on Form 10-K, the following risk factors should be carefully considered in evaluating our business and us |
| We may not be able to protect our intellectual property rights |
| We believe that our trademarks, particularly the Playboy name and Rabbit Head Design, and other proprietary rights are critical to our success, growth potential and competitive position |
| Accordingly, we devote substantial resources to the establishment and protection of our trademarks and proprietary rights |
| Our actions to establish and protect our trademarks and other proprietary rights, however, may not prevent imitation of our products by others or prevent others from claiming violations of their trademarks and proprietary rights by us |
| Any infringement or related claims, even if not meritorious, may be costly and time consuming to litigate, may distract management from other tasks of operating the business and may result in the loss of significant financial and managerial resources, which could harm our business, financial condition or operating results |
| These concerns are particularly relevant with regard to those international markets, such as China, in which it is especially difficult to enforce intellectual property rights |
| Failure to maintain our agreements with MSOs and DTH operators on favorable terms could adversely affect our business, financial condition or results of operations |
| We currently have agreements with the nationapstas six largest MSOs |
| We also have agreements with the principal DTH operators in the United States and Canada |
| Our agreements with these operators may be terminated on short notice without penalty |
| If one or more MSOs or DTH operators terminate or do not renew these agreements, or do not renew them on terms as favorable as those of current agreements, our business, financial condition or results of operations could be materially adversely affected |
| In addition, competition among television programming providers is intense for both channel space and viewer spending |
| Our competition varies in both the type and quality of programming offered, but consists primarily of other premium pay services, such as general-interest premium channels and other adult movie pay services |
| We compete with other pay services as we attempt to obtain or renew carriage with DTH operators and individual cable affiliates, negotiate fee arrangements with these operators, negotiate for VOD and SVOD rights and market our programming through these operators to consumers |
| The competition with programming providers has intensified as a result of consolidation in the DTH and cable systems industries, which has resulted in fewer, but larger operators |
| The impact of industry consolidation, any decline in our access to, and acceptance by, DTH and/or cable systems and the possible resulting deterioration in the terms of agreements, cancellation of fee arrangements or pressure on margin splits with operators of these systems could adversely affect our business, financial condition or results of operations |
| Limits on our access to satellite transponders could adversely affect our business, financial condition or results of operations |
| Our cable television and DTH operations require continued access to satellite transponders to transmit programming to cable or DTH operators |
| Material limitations on our access to these systems or satellite transponder capacity could materially adversely affect our business, financial condition or results of operations |
| Our access to transponders may be restricted or denied if: o we or the satellite owner are/is indicted or otherwise charged as a defendant in a criminal proceeding; o the Federal Communications Commission issues an order initiating a proceeding to revoke the satellite ownerapstas authorization to operate the satellite; 14 o the satellite owner is ordered by a court or governmental authority to deny us access to the transponder; o we are deemed by a governmental authority to have violated any obscenity law; or o our satellite transponder providers fail to provide the required services |
| In addition to the above, the access of Playboy TV, Spice and our other networks to transponders may be restricted or denied if a governmental authority commences an investigation or makes an adverse finding concerning the content of their transmissions |
| Technical failures may also affect our satellite transponder providers &apos ability to deliver transmission services |
| We are subject to risks resulting from our operations outside the United States, and we face additional risks and challenges as we continue to expand internationally |
| The international scope of our operations may contribute to volatile financial results and difficulties in managing our business |
| For the year ended December 31, 2005, we derived approximately 27prca of our consolidated revenues from countries outside the United States |
| Our international operations expose us to numerous challenges and risks, including, but not limited to, the following: o adverse political, regulatory, legislative and economic conditions in various jurisdictions; o costs of complying with varying governmental regulations; o fluctuations in currency exchange rates; o difficulties in developing, acquiring or licensing programming and products that appeal to a variety of different audiences and cultures; o scarcity of attractive licensing and joint venture partners; o the potential need for opening and managing distribution centers abroad; and o difficulties in protecting intellectual property rights in foreign countries |
| In addition, important elements of our business strategy, including capitalizing on advances in technology, expanding distribution of our products and content and leveraging cross-promotional marketing capabilities, involve a continued commitment to expanding our business internationally |
| This international expansion will require considerable management and financial resources |
| We cannot assure you that one or more of these factors or the demands on our management and financial resources would not harm any current or future international operations and our business as a whole |
| Any inability to identify, fund investment in and commercially exploit new technology could have a material adverse impact on our business, financial condition or results of operations |
| We are engaged in a business that has experienced significant technological change over the past several years and is continuing to undergo technological change |
| Our ability to implement our business plan and to achieve the results projected by management will depend on managementapstas ability to anticipate technological advances and implement strategies to take advantage of technological change |
| Any inability to identify, fund investment in and commercially exploit new technology or the commercial failure of any technology that we pursue, such as VOD and SVOD, could result in our business becoming burdened by obsolete technology and could have a material adverse impact on our business, financial condition or results of operations |
| The online subscription portion of our Entertainment Group may be adversely affected by our failure to implement our business model or to satisfy consumers, by the impact of free content and by any decline in use of the Internet |
| Our online subscription business model relies on expanding our online subscriber base and increasing revenue per subscriber by selling premium content to our online subscribers |
| There can be no assurance that we will be able to provide the pricing and content necessary to attract new or retain existing subscribers and operate the online portion of our Entertainment Group profitably |
| 15 The Internet industry is highly competitive |
| If we fail to continue to develop and introduce new content, features, functions or services effectively or fail to improve the consumer experience, our business, financial condition or results of operations could be materially adversely affected |
| To the extent free or low-cost adult content on the Internet continues to be available or increases, it may negatively affect our ability to attract subscribers and other fee-paying customers |
| If use of the Internet declines or fails to grow as projected, we may not realize the expected benefits of our investments in the online business |
| Internet usage may be inhibited by, among other factors: o inadequate Internet infrastructure; o unwillingness of customers to shift their purchasing to online vendors; o security and privacy concerns; o the lack of compelling content; o problems relating to the development of the required technology infrastructure; and o insufficient availability of cost-effective, high-speed service |
| Our online operations are subject to security risks and systems failures |
| Online security breaches could materially adversely affect our business, financial condition or results of operations |
| Any well-publicized compromise of security could deter use of the Internet in general or use of the Internet to conduct transactions that involve transmitting confidential information or downloading sensitive materials in particular |
| In offering online payment services, we may increasingly rely on technology licensed from third parties to provide the security and authentication necessary to effect secure transmission of confidential information such as customer credit card numbers |
| Advances in computer capabilities, new discoveries in the field of cryptography or other developments could compromise or breach the algorithms that we use to protect our customers &apos transaction data |
| If third parties are able to penetrate our network security or otherwise misappropriate confidential information, we could be subject to liability, which could result in litigation |
| In addition, experienced programmers or "e hackers "e may attempt to misappropriate proprietary information or cause interruptions in our services that could require us to expend significant capital and resources to protect against or remediate these problems |
| Increased scrutiny by regulatory agencies, such as the Federal Trade Commission and state agencies, of the use of customer information could also result in additional expenses if we are obligated to reengineer systems to comply with new regulations or to defend investigations of our privacy practices |
| The uninterrupted performance of our computer systems is critical to the operations of our Internet sites |
| Our computer systems are located at Level 3 Communications in Chicago, Illinois, and, as such, may be vulnerable to fire, loss of power, telecommunications failures and other similar catastrophes |
| In addition, we may have to restrict access to our Internet sites to solve problems caused by computer viruses or other system failures |
| Our customers may become dissatisfied by any disruption or failure of our computer systems that interrupts our ability to provide our content |
| Repeated system failures could substantially reduce the attractiveness of our Internet sites and/or interfere with commercial transactions, negatively affecting our ability to generate revenues |
| Our Internet sites must accommodate a high volume of traffic and deliver regularly-updated content |
| These types of occurrences in the future could cause users to perceive our websites as not functioning properly and therefore induce them to frequent Internet sites other than ours |
| We are also subject to risks from failures in computer systems other than our own because our customers depend on their own Internet service providers for access to our sites |
| Our revenues could be negatively affected by outages or other difficulties customers experience in accessing our Internet sites due to Internet service providers &apos system disruptions or similar failures unrelated to our systems |
| Our insurance policies may not adequately compensate us for any losses that may occur due to any failures in our Internet systems or the systems of our customers &apos Internet service providers |
| Piracy of our television networks, programming and photographs could materially reduce our revenues and adversely affect our business, financial condition or results of operations |
| The distribution of our subscription programming by MSOs and DTH operators requires the use of encryption 16 technology to assure that only those who pay can receive programming |
| It is illegal to create, sell or otherwise distribute mechanisms or devices to circumvent that encryption |
| Nevertheless, theft of subscription television programming has been widely reported |
| In addition, theft of our competitors &apos programming can also increase our churn rate |
| Although MSOs and DTH operators continually review and update their conditional access technology, there can be no assurance that they will be successful in developing or acquiring the technology needed to effectively restrict or eliminate signal theft |
| Additionally, the development of emerging technologies, including the Internet and online services, poses the risk of making piracy of our intellectual property more prevalent |
| Digital formats, such as the ones we use to distribute our programming through MSOs, DTH and the Internet, are easier to copy, download or intercept |
| As a result, users can download, duplicate and distribute unauthorized copies of copyrighted programming and photographs over the Internet or other media, including DVDs |
| As long as pirated content is available, many consumers could choose to download or purchase pirated intellectual property rather than pay to subscribe to our services or purchase our products |
| National consolidation of the single-copy magazine distribution system may adversely affect our ability to obtain favorable terms on the distribution of Playboy magazine and special editions and may lead to declines in profitability and circulation |
| In the past decade, the single-copy magazine distribution system has undergone dramatic consolidation |
| According to an economic study released by Magazine Publishers of America in October 2001, the number of magazine wholesalers has declined from more than 180 independent distribution owners to just four large wholesalers that handle 90prca of the single-copy distribution business |
| Currently, we rely on a single national distributor, TWRSM, for the distribution of Playboy magazine and special editions to newsstands and other retail outlets |
| As a result of this industry consolidation, we face increasing pressure to lower the prices we charge to wholesalers and increase our sell-through rates |
| If we are forced to lower the prices we charge wholesalers, we may experience declines in revenue |
| If we are unable to meet targeted sell-through rates, we may incur greater expenses in the distribution process |
| The combination of these factors could negatively impact the profitability and newsstand circulation for Playboy magazine and special editions |
| If we are unable to generate revenues from advertising and sponsorships, or if we were to lose our large advertisers or sponsors, our business would be harmed |
| com to be a limited or ineffective advertising medium, they may be reluctant to advertise in our products or to be a sponsor of our Company |
| Our ability to generate significant advertising and sponsorship revenues depends upon several factors, including, among others, the following: o our ability to maintain a large, demographically attractive subscriber base for Playboy magazine and Playboy |
| com; o our ability to offer attractive advertising rates; o our ability to attract advertisers and sponsors; and o our ability to provide effective advertising delivery and measurement systems |
| Our advertising revenues are also dependent on the level of spending by advertisers, which is impacted by a number of factors beyond our control, including general economic conditions, changes in consumer purchasing and viewing habits and changes in the retail sales environment |
| Our existing competitors, as well as potential new competitors, may have significantly greater financial, technical and marketing resources than we do |
| These companies may be able to undertake more extensive marketing campaigns, adopt aggressive advertising pricing policies and devote substantially more resources to attracting advertising customers |
| We rely on third parties to service our Playboy magazine subscriptions and to print and distribute the magazine and special editions |
| If these third parties fail to perform, our business could be harmed |
| We rely on CDS to service Playboy magazine subscriptions |
| The magazine and special editions are printed at Quad at a single site located in Wisconsin, which ships the product to subscribers and wholesalers |
| We rely on a 17 single national distributor, TWRSM, for the distribution of Playboy magazine and special editions to newsstands and other retail outlets |
| If CDS, Quad or TWRSM is unable to or does not perform and we are unable to find alternative services in a timely fashion, our business could be adversely affected |
| Increases in paper prices or postal rates could adversely affect our operating performance |
| Paper costs are a substantial component of the manufacturing expenses of our publishing business and the direct marketing expenses of our online business |
| The market for paper has historically been cyclical, resulting in volatility in paper prices |
| An increase in paper prices could materially adversely affect our operating performance unless and until we can pass any increases through to the consumer |
| The cost of postage also affects the profitability of Playboy magazine and our e-commerce catalog business |
| An increase in postage rates could materially adversely affect our operating performance unless and until we can pass the increase through to the consumer |
| If we experience a significant decline in our circulation rate base, our results could be adversely affected |
| According to ABC, Playboy magazine was the 13th highest-ranking US consumer publication for the six months ended December 31, 2005 |
| Our circulation is primarily subscription driven, with subscription copies comprising approximately 91prca of total copies sold |
| If we either experience a significant decline in subscriptions because we lose existing subscribers or do not attract new subscribers, our results could be adversely affected |
| We may not be able to compete successfully with direct competitors or with other forms of entertainment |
| We derive a significant portion of our revenues from subscriber-based fees, advertising and licensing, for which we compete with various other media, including magazines, newspapers, television, radio and Internet websites that offer customers information and services similar to those that we provide |
| We also compete with providers of alternative leisure-time activities and media |
| Competition could result in price reductions, reduced margins or loss of market share, any of which could have a material adverse effect on our business, financial condition or results of operations |
| We face competition on both country and regional levels |
| In addition, each of our businesses competes with companies that deliver content through the same platforms and with companies that operate in different media businesses |
| Many of our competitors, including large entertainment and media enterprises, have greater financial and human resources than we do |
| We cannot assure you that we can remain competitive with companies that have greater resources or that offer alternative entertainment and information options |
| Government regulations could adversely affect our business, financial condition or results of operations |
| Our businesses are regulated by governmental authorities in the countries in which we operate |
| Because of our international operations, we must comply with diverse and evolving regulations |
| Regulation relates to, among other things, licensing, access to satellite transponders, commercial advertising, subscription rates, foreign investment, Internet gaming, use of confidential customer information and content, including standards of decency/obscenity |
| Changes in the regulation of our operations or changes in interpretations of existing regulations by courts or regulators or our inability to comply with current or future regulations could adversely affect us by reducing our revenues, increasing our operating expenses and exposing us to significant liabilities |
| While we are not able to reliably predict particular regulatory developments that could affect us adversely, those regulations related to adult content, the Internet, privacy and commercial advertising illustrate some of the potential difficulties we face |
| Regulation of adult content could prevent us from making our content available in various jurisdictions or otherwise have a material adverse effect on our business, financial condition or results of operations |
| The governments of some countries, such as China and India, have sought to limit the influence of other cultures 18 by restricting the distribution of products deemed to represent foreign or "e immoral "e influences |
| Regulation aimed at limiting minors &apos access to adult content could also increase our cost of operations and introduce technological challenges, such as by requiring development and implementation of age verification systems |
| Various governmental agencies are considering a number of legislative and regulatory proposals that may lead to laws or regulations concerning various aspects of the Internet, including online content, intellectual property rights, user privacy, taxation, access charges, liability for third-party activities and jurisdiction |
| Regulation of the Internet could materially adversely affect our business, financial condition or results of operations by reducing the overall use of the Internet, reducing the demand for our services or increasing our cost of doing business |
| o Regulation of commercial advertising |
| We receive a significant portion of our advertising revenues from companies selling tobacco and alcohol products |
| For the year ended December 31, 2005, beer/wine/liquor and tobacco represented 22prca and 10prca, respectively, of the total advertising pages of Playboy magazine |
| Significant limitations on the ability of those companies to advertise in Playboy magazine or on our Internet sites because of either legislative, regulatory or court action could materially adversely affect our business, financial condition or results of operations |
| In August 1996, the Food & Drug Administration announced regulations that prohibited the publication of tobacco advertisements containing drawings, colors or pictures |
| While those regulations were later held unconstitutional by the Supreme Court of the United States, future attempts may be made by other federal agencies to impose similar or other types of advertising limitations |
| Our business involves risks of liability claims for media content, which could adversely affect our business, financial condition or results of operations |
| As a distributor of media content, we may face potential liability for: o defamation; o invasion of privacy; o negligence; o copyright or trademark infringement; and o other claims based on the nature and content of the materials distributed |
| These types of claims have been brought, sometimes successfully, against broadcasters, publishers, online services and other disseminators of media content |
| We could also be exposed to liability in connection with material available through our Internet sites |
| Any imposition of liability that is not covered by insurance or is in excess of insurance coverage could have a material adverse effect on us |
| In addition, measures to reduce our exposure to liability in connection with material available through our Internet sites could require us to take steps that would substantially limit the attractiveness of our Internet sites and/or their availability in various geographic areas, which would negatively affect their ability to generate revenues |
| Private advocacy group actions targeted at our content could result in limitations on our ability to distribute our products and programming and negatively impact our brand acceptance |
| Our ability to operate successfully depends on our ability to obtain and maintain distribution channels and outlets for our products |
| From time to time, private advocacy groups have sought to exclude our programming from local pay television distribution because of the adult-oriented content of the programming |
| In addition, from time to time, private advocacy groups have targeted Playboy magazine and its distribution outlets and advertisers, seeking to limit the magazineapstas availability because of its adult-oriented content |
| In addition to possibly limiting our ability to distribute our products and programming, negative publicity campaigns, lawsuits and boycotts could negatively affect our brand acceptance and cause additional financial harm by requiring that we incur significant expenditures 19 to defend our business or by discouraging investors from investing in our securities |
| In pursuing selective acquisitions, we may incur various costs and liabilities and we may never realize the anticipated benefits of the acquisitions |
| If appropriate opportunities become available, we may acquire businesses, products or technologies that we believe are strategically advantageous to our business |
| Transactions of this sort could involve numerous risks, including: o unforeseen operating difficulties and expenditures arising from the process of integrating any acquired business, product or technology, including related personnel; o diversion of a significant amount of managementapstas attention from the ongoing development of our business; o dilution of existing stockholders &apos ownership interest in us; o incurrence of additional debt; o exposure to additional operational risk and liability, including risks arising from the operating history of any acquired businesses; o entry into markets and geographic areas where we have limited or no experience; o loss of key employees of any acquired companies; o adverse effects on our relationships with suppliers and customers; and o adverse effects on the existing relationships of any acquired companies, including suppliers and customers |
| Furthermore, we may not be successful in identifying appropriate acquisition candidates or consummating acquisitions on terms favorable or acceptable to us or at all |
| When we acquire businesses, products or technologies, our due diligence reviews are subject to inherent uncertainties and may not reveal all potential risks |
| We may therefore fail to discover or inaccurately assess undisclosed or contingent liabilities, including liabilities for which we may have responsibility as a successor to the seller or the target company |
| As a successor, we may be responsible for any past or continuing violations of law by the seller or the target company, including violations of decency laws |
| Although we generally attempt to seek contractual protections, such as representations and warranties and indemnities, we cannot be sure that we will obtain such provisions in our acquisitions or that such provisions will fully protect us from all unknown, contingent or other liabilities or costs |
| Finally, claims against us relating to any acquisition may necessitate our seeking claims against the seller for which the seller may not indemnify us or that may exceed the scope, duration or amount of the sellerapstas indemnification obligations |
| Our significant debt could adversely affect our business, financial condition or results of operations |
| We have a significant amount of debt |
| At December 31, 2005, we had total financing obligations of dlra115dtta0 million, all of which consisted of our 3dtta00prca convertible senior subordinated notes due 2025, or the convertible notes |
| In addition, we have a dlra50dtta0 million revolving credit facility |
| At December 31, 2005, there were no borrowings and dlra9dtta8 million in letters of credit outstanding under this facility, resulting in dlra40dtta2 million of available borrowings under this facility |
| The amount of our existing and future debt could adversely affect us in a number of ways, including the following: o we may be unable to obtain additional financing for working capital, capital expenditures, acquisitions and general corporate purposes; o debt-service requirements could reduce the amount of cash we have available for other purposes; o we could be disadvantaged as compared to our competitors, such as in our ability to adjust to changing market conditions; and o we may be restricted in our ability to make strategic acquisitions and to exploit 20 business opportunities |
| Our ability to make payments of principal and interest on our debt depends upon our future performance, general economic conditions and financial, business and other factors affecting our operations, many of which are beyond our control |
| If we are not able to generate sufficient cash flow from operations in the future to service our debt we may be required, among other things: o to seek additional financing in the debt or equity markets; o to refinance or restructure all or a portion of our debt; and/or o to sell assets |
| These measures might not be sufficient to enable us to service our debt |
| In addition, any such financing, refinancing or sale of assets might not be available on economically favorable terms |
| The terms of our existing credit facility impose restrictions on us that may affect our ability to successfully operate our business |
| Our existing credit facility contains covenants that limit our actions |
| These covenants could materially and adversely affect our ability to finance our future operations or capital needs or to engage in other business activities that may be in our best interests |
| The covenants limit our ability to, among other things: o incur or guarantee additional indebtedness; o repurchase capital stock; o make loans and investments; o enter into agreements restricting our subsidiaries &apos abilities to pay dividends; o create liens; o sell or otherwise dispose of assets; o enter new lines of business; o merge or consolidate with other entities; and o engage in transactions with affiliates |
| The credit facility also contains financial covenants requiring us to maintain specified minimum net worth and interest coverage ratios |
| Our ability to comply with these covenants and requirements may be affected by events beyond our control, such as prevailing economic conditions and changes in regulations, and if such events occur, we cannot be sure that we will be able to comply |
| We depend on our key personnel |
| We believe that our ability to successfully implement our business strategy and to operate profitably depends on the continued employment of some of our senior management team |
| If these members of the management team become unable or unwilling to continue in their present positions, our business, financial condition or results of operations could be materially adversely affected |
| Ownership of Playboy Enterprises, Inc, is concentrated |
| As of December 31, 2005, Mr |
| Hefner beneficially owned 69dtta53prca of our Class A common stock |
| Hefner possesses influence on matters including the election of directors as well as transactions involving a potential change of control |
| Hefner may support, and cause us to pursue, strategies and directions with which holders of our securities disagree |
| The concentration of our share ownership may delay or prevent a change in control, impede a merger, consolidation, takeover, or other transaction involving us or discourage a potential acquirer from making a tender offer or otherwise attempting to obtain control of us |
| 21 Future sales or issuances of equity could depress the market price of our common stock and be dilutive and affect our ability to raise funds through equity issuances |
| If our stockholders sell substantial amounts of our common stock or if we issue substantial additional amounts of our equity securities, or if there is a belief that such sales or issuances could occur, the market price of our common stock could fall |
| These factors could also make it more difficult for us to raise funds through future offerings of equity securities |
| In July 2001, we acquired The Hot Network, The Hot Zone and the related television assets of Califa Entertainment Group, Inc, or Califa, and the Vivid TV network and related television assets of VOD, Inc, or VODI, which we refer to as the Califa acquisition |
| In connection with the Califa acquisition, we are obligated to make remaining payments totaling approximately dlra19dtta8 million over the next six years |
| We have the option to pay up to dlra14dtta0 million of these scheduled payments in cash or shares of our Class B stock |
| In addition, we may be obligated to pay cash or issue additional shares to the sellers in the Califa acquisition as make-whole payments or as interest on unpaid portions of the purchase price |
| The obligation to make these payments would arise in the event that we opt to make scheduled payments by issuing shares of our Class B stock and the shares are not registered under the Securities Act of 1933, as amended, in a timely fashion or the proceeds from the sale of the shares to the sellers in the Califa acquisition are less than the aggregate value of those shares at the time of their issuance |
| The number of shares issued in satisfaction of each payment will be based on the market price of Class B stock surrounding the payment dates |
| See Note (C), Acquisition, to the Notes to Consolidated Financial Statements for additional information |
| See Note (D), Restructuring of Ownership of International TV Joint Ventures, to the Notes to Consolidated Financial Statements for additional information |