Our total cost of revenue increased from $22.9 million in 2003 to $30.1 million in 2004, representing a 31% increase.
Test Preparation Services cost of revenue increased from $16.2 million in 2003 to $18.4 million in 2004, representing a 14% increase, primarily as a result of increasing the number of courses, tutoring sessions and SES programs delivered year to date. Cost of revenue as a percentage of revenue increased due to reduction in the average class size.
K-12 Services cost of revenue increased from $4.5 million in 2003 to $9.4 million in 2004, representing a 107% increase. This increase is primarily attributable to an increase in costs incurred to service increasing numbers and increasingly complex contracts with school-based customers. The percentage increase in cost of revenue was significantly higher than the increase in revenue in this division primarily because we recorded the costs related to two large contracts that we are servicing, but were unable to record the corresponding revenue. Additionally, one of these contracts is primarily a relatively low margin professional development contract.
Admissions Services cost of revenue increased from $2.2 million in 2003 to $2.3 million in 2004, representing a 6% increase, primarily due to increased customer support costs.
Selling, general and administrative expenses increased from $50.4 million in 2003 to $56.8 million in 2004, representing a 13% increase. This increase resulted primarily from the following:
These increases were partially offset by a decrease of approximately $630,000 in advertising and marketing expense primarily due to lower national advertising and mass media expenditures.
The estimated effective tax rate was approximately 42% in both 2004 and 2003.
Liquidity and Capital Resources
Our current primary sources of liquidity are cash and cash equivalents on hand and cash flow from operations. Our Test Preparation Services division currently generates the largest portion of our cash from its retail classroom and tutoring courses. While historically we have had minimal bad debt write-offs, our cash receipts related to contracts with large institutions or school districts can contribute to the level of variability in the timing of our cash receipts. Increasingly, across all of our divisions, we are generating cash from contracts with institutions such as K-12 schools and post secondary institutions. As of September 30, 2004, the “days sales outstanding” was 52 days, which may increase if we experience large delays in collecting on our sales to institutions.
On June 4, 2004, we sold 10,000 shares of Series B-1 Cumulative Convertible Preferred Stock (the “Series B-1 Preferred Stock”) for $10 million in the aggregate to Fletcher International, Ltd. (“Fletcher”). Prior to conversion, each share of Series B-1 Preferred Stock accrues dividends at an annual rate of the greater of: (1) five percent (5%), and (2) the 90-day LIBOR plus one and one-half percent (1.5%), payable, at our option, in cash or registered shares of our common stock. As of September 30, 2004, the dividend rate was 5%. The shares are initially convertible into our common stock at any time at a conversion rate of $11.00 per share, subject to adjustment upon certain events. As of September 30, 2004, there were 909,091 shares of common stock reserved for issuance upon conversion of the Series B-1 Preferred Stock. Fletcher has the right, for a period of two years beginning July 1, 2005, to purchase up to $20 million in newly created series of preferred stock (the “Additional Preferred Stock”) having similar terms, conditions, rights, preferences and privileges as the Series B-1 Preferred Stock. The Additional Preferred Stock is convertible into shares of our common stock at a conversion price equal to 120% of the then prevailing price of the common stock, subject to a minimum of $11.00 per share. After 18 months, Fletcher may also redeem the value of its original investment in the Series B-1 Preferred Stock and the Additional Preferred Stock for shares of common stock based upon a redemption rate equal to 102.5% of the then prevailing price of our common stock plus the value of any accrued and unpaid dividends or, at our option, cash.
We were required to register the underlying common stock issuable upon conversion of the Series B-1 Preferred Stock with the SEC by no later than September 29, 2004. We filed a Registration Statement with the SEC in July 2004, but it has not yet become effective. As a result of the registration statement not being effective, we are not in compliance with our registration obligation under our agreement with Fletcher and, therefore, pursuant to the agreement, the dividend rate on the Series B-1 Preferred Stock increased from 5% to 15% for the month of October 2004. After the month of October, the dividend rate reverts back to the standard rate under the agreement. In addition, beginning on October 30, 2004, and every month thereafter, there will be a 5% reduction, compounded for each month the registration statement is not effective, in the conversion price of the Series B-1 Preferred Stock until the registration statement is declared effective. The registration statement is currently in the process of being reviewed by the SEC.
On May 21, 2004, we entered into a credit agreement with Commerce Bank, N.A. for a three-year revolving credit facility with a maximum available borrowing of $5.0 million. The line of credit is secured by our accounts receivable and bears a variable interest rate based on either the prime rate or 150 to 175 basis points over the London Interbank Offered Rate (“LIBOR”), in accordance with the terms of the agreement. As of September 30, 2004, the effective interest rate was 3.4%. This credit facility is subject to the our maintaining certain financial covenants and other covenants set forth in the credit agreement and requires us to pay a quarterly unused facility fee of 0.375%. We borrowed $2 million under this facility in May 2004 and used most of the proceeds to repay higher interest, fixed rate debt. As of September 30, 2004, $2.0 million was outstanding under this credit facility.
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As of September 30, 2004, we were not in compliance with a financial covenant contained in the credit agreement requiring the maintenance of a certain fixed charge coverage ratio. The balance outstanding under the line of credit has been reclassified to current liabilities as a result of such non-compliance. Unless we can obtain a waiver from the lending institution, we will be required to pay interest at a rate that is 2% higher than the rate otherwise payable by the company, and we will not be able to borrow additional amounts under the agreement, while the company remains out of compliance with this covenant. We are currently seeking to obtain such waiver, and to amend the credit agreement to modify this covenant. If we are unable to obtain the waiver and amendment of terms we seek, we may pay down some or all of the outstanding balance with cash on hand.
Our future capital requirements will depend on various factors, including market acceptance of our products and services and the resources we devote to developing, marketing, selling and supporting these products and services. Our contractual obligations in both the near and long term consist primarily of operating lease obligations and purchase obligations. We anticipate that our sources of cash will be more than sufficient to cover these obligations, the costs of revenue and the costs of our infrastructure and people, our largest uses of cash.
Net cash provided by operating activities during the nine months ended September 30, 2004 was $5.9 million, despite incurring a net loss in the period, resulting primarily from increased collections on our accounts receivable balances, increases in deferred income and depreciation and amortization. These sources of cash were partially offset by the payment to post secondary schools for application fees collected as of December 31, 2003 on their behalf, as well as the payment of trade payables due as of that date. Application fees collected on behalf of post secondary schools are typically at their highest levels at the end of December, when many schools have their application deadlines.
Net cash used in investing activities during the nine months ended September 30, 2004 was $6.0 million, resulting primarily from the purchase of fixed assets, investment in development projects and our investment in Oasis Children’s Services, LLC.
Net cash contributed by financing activities during the nine months ended September 30, 2004 was $10.0 million, resulting primarily from the issuance of preferred stock to Fletcher International for $9.9 million and the borrowing of $2.0 million under our credit facility with Commerce Bank, which were partially offset by principal payments on loans and capital equipment leases.
At September 30, 2004, we had approximately $23.9 million of cash and cash equivalents. We anticipate that our cash balances, together with cash generated from operations, will be sufficient to meet our normal operating requirements for at least the next 12 months.
Deferred Income Taxes
In determining income for financial statement purposes, we must make certain estimates and judgments. These estimates and judgments occur in the calculation of certain tax liabilities and in the determination of the recoverability of certain of the deferred tax assets, which arise from temporary differences between the tax and financial statement recognition of revenue and expense.
We must assess the likelihood that we will be able to recover our deferred tax assets. If recovery is not likely, we must increase our provision for taxes by recording a reserve, in the form of a valuation allowance, for the deferred tax assets that we estimate will not ultimately be recoverable. At September 30, 2004, we had a net deferred tax asset of approximately $17.1 million, primarily relating to our net operating loss carryforwards of $43.6 million, which expire in varying amounts between 2020 and 2024.
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Realization of our deferred tax asset is dependent on generating sufficient taxable income in the United States prior to expiration of these loss carryforwards. Although realization is not assured at September 30, 2004, we believe it is more likely than not that all of the deferred tax asset will be realized. We base this belief upon the 2003 level of taxable income, as well as projections of future taxable income. If future levels of taxable income are not consistent with our expectations, we may be required to record a valuation allowance for the entire deferred tax asset, which would have a significant impact on our consolidated financial statements.
Impact of Inflation
Inflation has not had a significant impact on our historical operations.
Seasonality in Results of Operations
We experience, and we expect to continue to experience, seasonal fluctuations in our revenue because the markets in which we operate are subject to seasonal fluctuations based on the scheduled dates for standardized admissions tests and the typical school year. These fluctuations could result in volatility or adversely affect our stock price. We typically generate the largest portion of our test preparation revenue in the third quarter. The electronic application revenue recorded in our Admissions Services division is highest in the first and fourth quarters, corresponding with the busiest times of the year for submission of applications to academic institutions. Our K-12 Services division may also experience seasonal fluctuations in revenue, but we are not yet able to predict the impact of seasonal factors on this business with any degree of accuracy.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Our portfolio of marketable securities includes primarily short-term money market funds. The fair value of our portfolio of marketable securities would not be significantly impacted by either a 100 basis point increase or decrease in interest rates due primarily to the short-term nature of the portfolio. While some of our outstanding long-term debt bears interest at fixed rates, our recently completed $5.0 million credit facility with Commerce Bank bears interest at a variable rate based on the prime rate or LIBOR. During the nine months ended September 30, 2004, interest expense associated with borrowings under this credit facility was approximately $20,000, at a weighted average interest rate of approximately 2.9%. A 100 basis point increase in the interest rate would have resulted in a $7,000 increase in interest expense during this period. Additionally, our recently issued Series B-1 Preferred Stock requires the payment of quarterly dividends at the greater of 5% or 1.5% above 90-day LIBOR. During the nine months ended September 30, 2004, we paid dividends on the Series B Preferred Stock in an aggregate amount of $162,500, at the rate of 5%. A 100 basis point increase in the dividend rate would have resulted in a $33,000 increase in dividends paid during this period. We do not currently hold or issue derivative financial instruments.
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Revenue from our international operations and royalty payments from our international franchisees constitute an insignificant percentage of our revenue. Accordingly, our exposure to exchange rate fluctuations is minimal.
Item 4. Controls and Procedures
We conducted an evaluation of the effectiveness of the design and operation of our “disclosure controls and procedures,” as defined in Rule 13a-15(e) or Rule 15d-15(e) of the Exchange Act, (“Disclosure Controls”) as of the end of the period covered by this Quarterly Report. The controls evaluation was done under the supervision and with the participation of management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”).
Scope of the Controls Evaluation
The evaluation of our Disclosure Controls included a review of the controls’ objectives and design, our implementation of the controls and the effect of the controls on the information generated for use in this Quarterly Report. In the course of the controls evaluation, we sought to identify data errors, control problems or acts of fraud and confirm that appropriate corrective actions, including process improvements, were being undertaken. This type of evaluation is performed on a quarterly basis so that the conclusions of management, including the CEO and CFO, concerning the effectiveness of the controls can be reported in our Quarterly Reports on Form 10-Q and to supplement our disclosures made in our Annual Report on Form 10-K. Many of the components of our Disclosure Controls are also evaluated on an ongoing basis by other personnel in our accounting and finance organization. The overall goals of these various evaluation activities are to monitor our Disclosure Controls and to modify them on an ongoing basis as necessary.
A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. Because of inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.
Issues Identified
In July, 2004, our independent auditor, Ernst & Young LLP reported in writing to the company and its audit committee that it had identified two “reportable conditions” (as defined under standards established by the American Institute of Certified Public Accountants) relating to our internal controls over financial reporting. One of these reportable conditions concerned the need for better controls to handle a greater volume of multiple element contracts in our K-12 Services division and address related revenue recognition issues. The other involved the need to strengthen certain review procedures during the monthly closing process within the accounting department. We are dedicating substantial resources to improving our internal control over financial reporting, both in response to the identified reportable conditions and as part of an ongoing initiative to test and strengthen internal control overall. In the course of this broad review of our internal control structure, we have identified several additional areas where our internal controls need to be improved. These additional areas include the need for greater segregation of duties in the accounting department and better documentation of certain review processes.
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To address the reportable conditions identified by our auditors and the other issues identified as part of our review, we are in the process of making various improvements in our internal control structure, including the implementation of a new accounting and financial reporting software system, which is expected to be operational in 2005. In addition, we retained consultants to assist us with the implementation of this new system and with our overall review of our internal controls in connection with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002. We have also hired and will continue to recruit and hire additional qualified personnel for the accounting department, as necessary to address segregation of duties and other identified concerns. We are not aware of any instance where the reportable conditions or other are as of our internal control structure identified by us as needing improvement have resulted in a failure to timely and accurately disclose information required to be disclosed in reports we file or submit under the Exchange Act.
Conclusions
Based upon the controls evaluation, our CEO and CFO have concluded that, subject to the limitations noted above under “Scope of the Controls Evaluation,” our Disclosure Controls were effective, as of the end of the period covered by this Quarterly Report, in ensuring that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. However, during the period covered by this Form 10-Q, we have made certain modifications to our Disclosure Controls as described above and believe that there are additional improvements that must be made. Until all such improvements are complete, we cannot be certain that our Disclosure Controls will continue to remain effective. Except as described above, there has been no change in our internal control over financial reporting identified in connection with the evaluation described above that occurred during the period covered by this Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings
From time to time, we are involved in legal proceedings incidental to the conduct of our business. We are not currently a party to any legal proceeding, which, in the opinion of our management, is likely to have a material adverse effect on us.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Not applicable.
Item 3. Defaults Upon Senior Securities
Not applicable.
Item 4. Submission of Matters to a Vote of Security Holders
Not applicable.
Item 5. Other Information
Not applicable.
Item 6. Exhibits
(a) Exhibits:
| Exhibit
Number | | Description |
|
| |
|
| 10.1 | | Lease, dated as of August 1, 2004, by and between The Rector, Church-Wardens and Vestrymen of Trinity Church in the City of New York, as Landlord and The Princeton Review, Inc., as Tenant. |
| | | |
| 31.1 | | Certification Pursuant to Rule 13a-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| | | |
| 31.2 | | Certification Pursuant to Rule 13a-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| | | |
| 32.1 | | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
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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.
| THE PRINCETON REVIEW, INC. |
| | |
| By: | /s/ STEPHEN MELVIN |
| |
|
| | Stephen Melvin
Chief Financial Officer and Treasurer
(Duly Authorized Officer and
Principal Financial and Accounting Officer) |
November 9, 2004 | | |
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