10-Q: Scores Holding Faces Going Concern Despite Q2 Profit

Scores Holding Company reported a net income for Q2 2023 but faces substantial doubt about its ability to continue as a going concern due to significant accumulated deficits and ineffective internal controls.

Summary

• Scores Holding Company, Inc. (SCRH) reported a net income of $51,013 for the three months ended June 30, 2023, a significant improvement from a net loss of $(4,284) in the same period last year.
• Royalty revenue for Q2 2023 increased to $129,500 from $73,500 in Q2 2022, primarily due to the recognition of previously deferred income under ASC 606.
• For the six months ended June 30, 2023, net income decreased substantially to $28,113 from $307,158 in the prior year, with revenue also declining to $203,000 from $487,500.
• The company's cash and cash equivalents increased to $52,168 as of June 30, 2023, up from $7,600 at December 31, 2022.
• A working capital deficit of $(175,182) and an accumulated deficit of $(6,848,485) as of June 30, 2023, raise substantial doubt about the company's ability to continue as a going concern.
• Management disclosed that disclosure controls and procedures, and internal control over financial reporting, were not effective as of June 30, 2023, citing deficiencies in financial statement review and close processes.
• All six royalty-paying licensees have reopened post-COVID-19, and management believes the worst effects of the pandemic on the adult entertainment industry are over.
• Several legal proceedings were resolved or dismissed, including a sex trafficking lawsuit against Scores Tampa (dismissed against the company) and settlements for a consultant lawsuit ($10,000) and a race discrimination lawsuit ($6,000).

Sentiment

Score: 3

Explanation: While the company showed a quarterly profit and resolved several legal issues, the pervasive 'going concern' warning, significant accumulated deficit, and disclosed material weaknesses in internal controls over financial reporting indicate severe underlying financial instability and operational risk. The substantial decline in six-month revenue and net income further dampens the outlook, outweighing the positive quarterly performance.

Positives

• Achieved net income of $51,013 for the three months ended June 30, 2023, a turnaround from a net loss of $(4,284) in the prior year's quarter.
• Quarterly royalty revenue increased significantly by 76.19% to $129,500 in Q2 2023 compared to $73,500 in Q2 2022.
• Cash and cash equivalents increased substantially to $52,168 as of June 30, 2023, from $7,600 at December 31, 2022.
• Working capital deficit improved from $(196,481) at December 31, 2022, to $(175,182) at June 30, 2023.
• Accumulated deficit decreased from $(6,876,598) at December 31, 2022, to $(6,848,485) at June 30, 2023.
• All royalty-paying licensees have reopened, indicating a recovery in business operations post-pandemic.
• Successfully resolved or dismissed several significant legal proceedings, including a sex trafficking lawsuit and a race discrimination claim, reducing potential liabilities and legal expenses.
• Legal expenses for the six months ended June 30, 2023, decreased to $5,487 from $38,234 in the same period of 2022.

Negatives

• Substantial doubt exists about the company's ability to continue as a going concern due to an accumulated deficit of $6,848,485 and a working capital deficit of $175,182.
• Net income for the six months ended June 30, 2023, significantly decreased to $28,113 from $307,158 in the prior year's period.
• Total revenue for the six months ended June 30, 2023, decreased by 58.36% to $203,000 from $487,500 in the prior year's period.
• Disclosure controls and procedures, and internal control over financial reporting, were deemed not effective as of June 30, 2023, indicating material weaknesses in financial reporting processes.
• The company relies heavily on a few licensees, with four licensees accounting for 91% of revenue in Q2 2023 and 88% in H1 2023, posing a concentration risk.
• Ongoing related party payables, totaling $90,000 as of June 30, 2023, and past abatements of rent owed to related parties, highlight dependence on related entities.

Risks

• Substantial doubt about the ability to continue as a going concern due to significant accumulated losses and working capital deficit.
• Inability to raise additional working capital through continued licensing or external financing on acceptable terms, which could lead to cessation of operations.
• Concentration of revenue from a limited number of licensees, making the company vulnerable to the performance or termination of agreements with these key partners.
• Ineffective internal controls over financial reporting, which increases the risk of material misstatements in financial statements and could impact investor confidence.
• Potential for future litigation, despite recent resolutions, given the nature of the business and past legal challenges.
• Dependence on the adult entertainment industry's recovery and sustained appeal, which could be impacted by economic downturns or changes in consumer behavior.

Future Outlook

Management believes the financial effects of the COVID-19 pandemic will not have a substantial or long-term detrimental impact on the adult entertainment industry, noting that all royalty-paying licensees have reopened. The company has observed a recent increase in interest from establishments looking to utilize the SCORES brand trademarks. The company intends to raise additional working capital through continued brand licensing with current and new operators and may seek additional financing or evaluate acquisitions/investments for future expansion.

Management Comments

• "Upon managements evaluation of relevant hospitality industry conditions and events known as of the date that these financial statements are issued it is their belief the financial effects of the Covid 19 pandemic will not have a substantial or long term effect on the financial viability of the adult entertainment industry."
• "There will be operational changes to be certain but not a consequentially detrimental impact on the industry."
• "Although there are fewer licensees and some of the licensing fees have been re-negotiated management believes the worst of the effects the Covid 19 pandemic are over."
• "The lifting of many, if not all, gathering restrictions imposed by local government has vastly improved the appeal of adult entertainment-oriented establishments. Consequently, the Company has seen a recent increase in the number of such establishments interested in utilizing the SCORES brand trademarks."

Industry Context

The company operates within the adult entertainment industry, primarily through licensing its 'Scores' trademark to gentlemens clubs. This sector experienced significant disruption due to COVID-19 related closures in 2020 and 2021, leading to a material decline in royalty revenues. However, the industry appears to be in a recovery phase, with all of the company's licensees having reopened. Management's observation of increased interest in the 'Scores' brand suggests a broader positive trend in the hospitality and entertainment sectors as gathering restrictions are lifted.

Comparison to Industry Standards

• The company's return to quarterly net income and increased Q2 revenue suggest a positive trend in line with the broader reopening of the adult entertainment and hospitality industries post-COVID-19.
• Despite the quarterly improvement, the significant accumulated deficit of $6,848,485 and ongoing working capital deficit of $175,182 indicate that the company's financial health remains well below the stability typically expected of established businesses in the entertainment sector.
• The company's reliance on a licensing model means its performance is directly tied to the operational health and success of its six licensees, which is a common business model for intellectual property holders but also concentrates risk.
• The disclosure of ineffective internal controls over financial reporting is a critical governance issue that would typically be a red flag when compared to industry best practices for public companies, regardless of sector.

Corporate Governance

Legal Proceedings

• Luisa Santos de Oliveira v. Scores Holding Company, Inc. (FLSA/NYLLs): Plaintiff voluntarily dismissed the complaint with prejudice against the Company on March 25, 2021. A related case was also discontinued against the Company and other individuals on March 26, 2021, and against Club Azure LLC on May 12, 2023.
• Scores Alabama (trademark dispute): A civil action was filed on September 5, 2019. The matter was settled for $45,000, which was paid on May 23, 2023, and the licensing agreement was terminated.
• Voronina Matter (50 models lawsuit): Settled for $1,310,000 in July 2018. The Company's portion of the settlement was facilitated by loans from related party Metropolitan, which were subsequently offset by royalty amounts owed to the Company by other related parties. The final balance of $373,068 was paid in full on March 28, 2022.
• Jane Doe v. Scores Holding Company, Inc. (sex trafficking allegations, Scores Tampa): An arbitrator found in favor of the Company and its subsidiary. The plaintiff filed an Amended Complaint on July 19, 2023, that did not include the Company or its subsidiary as defendants, meaning this legal proceeding is no longer pending against them.
• Jeremy Green v. Scores Holding Co., Inc. (consultant lawsuit): Settled for $10,000 on October 6, 2022. The first payment of $5,000 was made upon execution of the agreement, with the second payment pending as of the filing date.
• Jessica Hall v. Scores Holding Company, Inc. (race discrimination): A settlement in principle was reached on July 21, 2023, for $6,000 (to be paid by SCRH and Harvey). A settlement agreement was signed on October 2, 2023, and paid on October 5, 2023.

Related Party Transactions

• The Company previously leased office space from Westside Realty of New York, Inc. (WSR), majority-owned by Robert M. Gans (CEO). The lease was terminated on December 31, 2020, and a $22,500 balance of unpaid rent owed to WSR was abated and written off to additional paid-in capital during the period ended June 30, 2023.
• The Company has a management services agreement with Metropolitan Lumber Hardware and Building Supplies, Inc. (Metropolitan), solely owned by Robert M. Gans. The Company incurred management fees of $45,000 for the six months ended June 30, 2023, and owed $90,000 in unpaid management services as of June 30, 2023.
• Past royalty settlement agreements with IMO, Star Light, and Swan (licensees controlled by Robert M. Gans) totaling $382,259 in past due royalties and interest were offset against a portion of the $770,000 loan from Metropolitan (also owned by Robert M. Gans) used to fund the Voronina litigation settlement.

Stakeholder Impact

• Shareholders face significant risk due to the 'going concern' warning, substantial accumulated deficit, and potential for future dilution if capital raises involve equity.
• Creditors, particularly related parties, are exposed to the company's financial instability given the ongoing working capital deficit and reliance on continued operations.
• Licensees benefit from the company's continued operation and brand licensing, with all six key licensees having reopened and some licensing fees re-negotiated post-pandemic.
• Employees (specifically management) are compensated through related party agreements, indicating a close financial relationship between the company and its key executives.

Next Steps

• Continue efforts to improve internal control over financial reporting.
• Create formal policies and procedures governing the financial statement close process.
• Implement controls in the preparation, documentation, and review of journal entries and account reconciliations.
• Monitor remedial measures and the effectiveness of internal controls and procedures.
• Raise additional working capital through continued licensing of the brand with current and new operators.
• Evaluate possible acquisitions of or investments in businesses, products, and technologies that are complementary to the company's operations.
• Potentially seek additional financing through equity or debt securities or credit facilities to fund business costs or expansion.

Key Dates

Recommendation

The 'substantial doubt about the Company's ability to continue as a going concern' due to a significant accumulated deficit and working capital deficit presents a critical risk. While the company reported net income for the latest quarter and resolved several legal disputes, the overall financial health remains precarious. Furthermore, the disclosure of ineffective internal controls over financial reporting raises serious concerns about the reliability of financial statements. The substantial decline in six-month revenue and net income compared to the prior year also indicates underlying challenges. These factors collectively suggest a high-risk investment profile, making a 'Sell' recommendation prudent for most investors.

Keywords

Adult Entertainment, Trademark Licensing, SEC Filing, 10-Q, Financial Results, Going Concern, Internal Controls, Royalty Revenue, Legal Proceedings, Corporate Governance