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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. |
For the quarterly period ended: September 30, 2005
OR
¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
for the transition period from to
Commission File Number: 000-50887
eCOST.com, Inc.
(Exact name of registrant as specified in its charter)
Delaware | 33-0843777 | |
(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification Number) |
2555 West 190th Street, Suite 106
Torrance, CA 90504
(address of principal executive offices)
(310) 225-4044
(Registrant’s telephone number, including area code)
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 period 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 by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.):
Yes ¨ No x
There were 17,754,901 outstanding shares of common stock $0.001 par value, outstanding at November 10, 2005.
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TABLE OF CONTENTS
Page | ||
3 | ||
Item 1.Financial Statements | 3 | |
3 | ||
4 | ||
5 | ||
6 | ||
7 | ||
Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations | 13 | |
Item 3.Quantitative and Qualitative Disclosures About Market Risk | 32 | |
Item 4.Controls and Procedures | 32 | |
32 | ||
Item 2.Unregistered Sales of Equity Securities, Use of Proceeds | 32 | |
Item 5.Other Information | 33 | |
34 | ||
36 | ||
Certifications |
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PART I - FINANCIAL INFORMATION
Item 1. | FINANCIAL STATEMENTS |
BALANCE SHEETS
(in thousands, except share data)
September 30, 2005 (unaudited) | December 31, 2004 | |||||||
Assets | ||||||||
Current assets: | ||||||||
Cash and cash equivalents | $ | 6,290 | $ | 8,790 | ||||
Short-term investments | — | 7,000 | ||||||
Accounts receivable, net of allowance for doubtful accounts of $360 and $199 at September 30, 2005 and December 31, 2004, respectively | 5,080 | 2,039 | ||||||
Inventories, net | 6,737 | 1,794 | ||||||
Prepaid expenses and other current assets | 894 | 263 | ||||||
Due from Affiliate, net | — | 813 | ||||||
Deferred income taxes | — | 883 | ||||||
Total current assets | 19,001 | 21,582 | ||||||
Property and equipment, net | 1,868 | 342 | ||||||
Deferred income taxes | — | 4,467 | ||||||
Other assets | 179 | 123 | ||||||
Total assets | $ | 21,048 | $ | 26,514 | ||||
Liabilities and Stockholders’ Equity | ||||||||
Current liabilities: | ||||||||
Accounts payable | $ | 7,015 | $ | 585 | ||||
Accrued expenses and other current liabilities | 3,208 | 2,635 | ||||||
Due to Affiliate, net | 1,082 | — | ||||||
Deferred revenue | 1,167 | 2,014 | ||||||
Total current liabilities | 12,472 | 5,234 | ||||||
Total liabilities | 12,472 | 5,234 | ||||||
Commitments and contingencies (Note 5) | ||||||||
Stockholders’ equity: | ||||||||
Preferred stock, $0.001 par value; 10,000,000 shares authorized; none issued and outstanding | — | — | ||||||
Common stock, $0.001 par value; 100,000,000 shares authorized; 17,747,133 and 17,465,000 shares issued and outstanding at September 30, 2005 and December 31, 2004, respectively | 18 | 17 | ||||||
Additional paid-in capital | 34,152 | 33,834 | ||||||
Deferred stock-based compensation | (958 | ) | (1,333 | ) | ||||
Accumulated deficit | (24,636 | ) | (11,238 | ) | ||||
Total stockholders’ equity | 8,576 | 21,280 | ||||||
Total liabilities and stockholders’ equity | $ | 21,048 | $ | 26,514 | ||||
The accompanying notes are an integral part of these financial statements.
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STATEMENTS OF OPERATIONS
(unaudited, in thousands, except per share data)
Three months ended September 30, | Nine months ended September 30, | |||||||||||||||
2005 | 2004 | 2005 | 2004 | |||||||||||||
Net sales | $ | 38,186 | $ | 43,397 | $ | 134,290 | $ | 120,389 | ||||||||
Cost of goods sold | 35,456 | 39,294 | 125,084 | 109,055 | ||||||||||||
Gross profit | 2,730 | 4,103 | 9,206 | 11,334 | ||||||||||||
Selling, general and administrative expenses | 5,088 | 5,527 | 17,393 | 12,783 | ||||||||||||
Loss from operations | (2,358 | ) | (1,424 | ) | (8,187 | ) | (1,449 | ) | ||||||||
Interest income | (49 | ) | (7 | ) | (139 | ) | (7 | ) | ||||||||
Interest expense - PC Mall commercial line of credit | — | 369 | — | 1,329 | ||||||||||||
Interest income - PC Mall commercial line of credit | — | (369 | ) | — | (1,329 | ) | ||||||||||
Loss before income taxes | (2,309 | ) | (1,417 | ) | (8,048 | ) | (1,442 | ) | ||||||||
Provision (benefit) for income taxes | — | (525 | ) | 5,350 | (535 | ) | ||||||||||
Net loss | $ | (2,309 | ) | $ | (892 | ) | $ | (13,398 | ) | $ | (907 | ) | ||||
Net loss per share: | ||||||||||||||||
Basic | $ | (0.13 | ) | $ | (0.06 | ) | $ | (0.76 | ) | $ | (0.06 | ) | ||||
Diluted | $ | (0.13 | ) | $ | (0.06 | ) | $ | (0.76 | ) | $ | (0.06 | ) | ||||
Weighted average shares outstanding: | ||||||||||||||||
Basic | 17,738 | 15,155 | 17,576 | 14,385 | ||||||||||||
Diluted | 17,738 | 15,155 | 17,576 | 14,385 | ||||||||||||
The accompanying notes are an integral part of these financial statements.
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STATEMENT OF STOCKHOLDERS’ EQUITY (DEFICIT)
(unaudited, in thousands)
Common Stock | Additional | Deferred | Accumulated | Total | ||||||||||||||||
Shares | Amount | |||||||||||||||||||
Balance at December 31, 2004 | 17,465 | $ | 17 | $ | 33,834 | $ | (1,333 | ) | $ | (11,238 | ) | $ | 21,280 | |||||||
Exercise of stock options | 282 | 1 | 318 | — | — | 319 | ||||||||||||||
Stock-based compensation | — | — | — | 375 | — | 375 | ||||||||||||||
Net loss | — | — | — | — | (13,398 | ) | (13,398 | ) | ||||||||||||
Balance at September 30, 2005 | 17,747 | $ | 18 | $ | 34,152 | $ | (958 | ) | $ | (24,636 | ) | $ | 8,576 | |||||||
The accompanying notes are an integral part of these financial statements.
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STATEMENTS OF CASH FLOWS
(unaudited, in thousands)
Nine months ended September 30, | ||||||||
2005 | 2004 | |||||||
Cash flows from operating activities: | ||||||||
Net loss | $ | (13,398 | ) | $ | (907 | ) | ||
Adjustments to reconcile net loss to net cash used in operating activities: | ||||||||
Depreciation and amortization | 332 | 31 | ||||||
Deferred income taxes | 5,350 | (535 | ) | |||||
Deferred rent | 123 | — | ||||||
Stock-based compensation | 375 | 1,381 | ||||||
Changes in operating assets and liabilities: | ||||||||
Accounts receivable | (3,041 | ) | (1,232 | ) | ||||
Inventories, net | (4,943 | ) | (327 | ) | ||||
Prepaid expenses and other current assets | (631 | ) | (243 | ) | ||||
Due to/from Affiliate, net | 1,895 | — | ||||||
Other assets | (64 | ) | (78 | ) | ||||
Accounts payable | 6,430 | (322 | ) | |||||
Accrued expenses and other current liabilities | 112 | 165 | ||||||
Deferred revenue | (847 | ) | 367 | |||||
Total adjustments | 5,091 | (793 | ) | |||||
Net cash used in operating activities | (8,307 | ) | (1,700 | ) | ||||
Cash flows from investing activities: | ||||||||
Purchases of property and equipment | (1,512 | ) | (125 | ) | ||||
Sale of short-term investments | 7,000 | — | ||||||
Net cash provided by (used in) investing activities: | 5,488 | (125 | ) | |||||
Cash flows from financing activities: | ||||||||
Net repayment from Affiliate | — | 4,291 | ||||||
Book overdraft | — | 266 | ||||||
Net proceeds from initial public offering | — | 18,690 | ||||||
Payments for deferred offering costs | — | (1,684 | ) | |||||
Exercise of stock options | 319 | — | ||||||
Net cash provided by financing activities | 319 | 21,563 | ||||||
Net increase (decrease) in cash and cash equivalents | (2,500 | ) | 19,738 | |||||
Cash and cash equivalents: | ||||||||
Beginning of period | 8,790 | — | ||||||
End of period | $ | 6,290 | $ | 19,738 | ||||
Supplemental non-cash information: A warehouse construction allowance of $369 is excluded from the purchase of property and equipment for the nine months ended September 30, 2005.
The accompanying notes are an integral part of these financial statements.
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NOTES TO FINANCIAL STATEMENTS
(unaudited, in thousands, except per share data)
1. The Company and Summary of Significant Accounting Policies
The Company
eCOST.com, Inc. (“we” or “our”) is a leading multi-category online discount retailer of new, “close-out” and refurbished brand-name merchandise and operates in a single business segment, selling products primarily to customers in the United States. We were incorporated in Delaware in February 1999 as a wholly-owned subsidiary of PC Mall, Inc. (“Parent”). In September 2004, we completed an initial public offering (“IPO”) of 3,465 shares of our common stock, leaving our Parent with ownership of approximately 80.2% of the outstanding shares of our common stock. On April 11, 2005, our Parent distributed its remaining ownership interest in our company to its common stockholders (referred to as the “distribution” or the “spin-off”). For purposes of these financial statements and related notes, our former Parent and its wholly-owned subsidiaries excluding us are referred to as an “Affiliate.”
Basis of Presentation
For the three and nine months ended September 30, 2004, the statements of operations include expense allocations for certain corporate functions historically provided to us by our former Parent, including administrative services (accounting, human resources, tax services, legal and treasury), inventory management and order fulfillment, credit card processing, information systems, advertising services, and use of office space. These allocations were made on a specifically identifiable basis or using the relative percentages, as compared to our former Parent’s other businesses, of net sales, payroll, net cost of goods sold, square footage, headcount or other relevant measures. We have not made a determination of whether these expenses were comparable to those we could have obtained from an unrelated third party. In connection with our IPO, we entered into agreements with our former Parent to provide a variety of similar services under a fee arrangement for a specific term, some of which were amended commensurate with the spin-off. These services included inventory management and fulfillment through the date of distribution, administrative services such as accounting through the date of distribution, human resources, payroll and information services. The financial results for the three and nine months ended September 30, 2005 reflect these contractual service arrangements, as amended.
Our accompanying unaudited financial statements for the three and nine months ended September 30, 2005 and 2004 have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission for interim financial reporting. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such regulations. The financial statements include all normal recurring adjustments which we believe are necessary to fairly state our financial position, however, these results are not necessarily indicative of results for any other interim period or for the full year. These financial statements should be read in conjunction with the audited financial statements and the notes thereto included in our Annual Report on Form 10-K/A for the year ended December 31, 2004.
Liquidity
Historically, prior to the IPO, our primary sources of financing came from cash flows from operations and investments from our former Parent. In September 2004, we completed an IPO of 3,465 shares of our common stock, which yielded net proceeds of approximately $16,700 after underwriting discounts, commissions and offering expenses. Since completion of the IPO, we have performed our own cash management functions.
We have an asset-based line of credit of up to $15,000 with a financial institution, which is collateralized by substantially all of our assets. Borrowings under the facility are limited to a percentage of inventory and accounts receivable. As of September 30, 2005, we had no borrowings under the line of credit. The credit facility contains standard terms and conditions customarily found in similar facilities offered to similarly situated borrowers. The credit facility limits our ability to make acquisitions above pre-defined dollar thresholds, requires proceeds from any future stock issuances to repay outstanding amounts under the facility, and has as its sole financial covenant a minimum tangible net worth requirement. As of September 30, 2005, we are in compliance with the sole financial covenant. The credit facility will mature in March 2007.
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Although no assurances can be provided, we believe that current working capital, together with cash flows from operations and borrowings available under the credit facility will be adequate to support our current operating plans for the next 12 months. However, our need for cash is dependant on our operating activities and if we do not maintain or increase sales or control expenses, we will require additional cash. We will continue to evaluate our liquidity on an ongoing basis and may decide to pursue additional financing dependant upon the cost, terms and availability of funds. There can be no assurance that such additional financing will be available. If it is available, it may be senior to our common stock and dilutive to shareholders.
Inventories
Inventories consist primarily of finished goods, and are stated at the lower of cost (determined under the first-in, first-out method) or market. Additionally, we do not record revenue and related cost of goods sold until delivery. As such, inventories include goods-in-transit to customers at September 30, 2005 and December 31, 2004 of $952 and $1,794, respectively. Inventory reserves are established based upon our view of potential diminution in values due to inventories that are potentially slow moving or obsolete, potential excess levels of inventory or values assessed at potentially lower than cost.
Stock-Based Compensation
We have adopted the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 148,Accounting for Stock-Based Compensation—Transition and Disclosure, which amends Financial Accounting Standards Board (“FASB”) Statement No. 123,Accounting for Stock-Based Compensation (“SFAS 123”). As permitted by SFAS 148, we continue to measure compensation cost in accordance with Accounting Principles Board Opinion (“APB”) No. 25,Accounting for Stock Issued to Employees and related interpretations, and provide pro forma disclosures of net income (loss) and earnings (loss) per share as if the fair-value method had been applied. Accordingly, we do not record compensation expense on issuance of stock options to employees for options granted at the then-current market value at the date of grant.
The following table presents the effect on “Net loss” of recognizing stock-based compensation cost as if the fair valued based method had been applied to all outstanding and unvested stock options for each of the periods presented (in thousands, except per share amounts):
Three months ended September 30, | Nine months ended September 30, | |||||||||||||||
2005 | 2004 | 2005 | 2004 | |||||||||||||
Net loss — as reported | $ | (2,309 | ) | $ | (892 | ) | $ | (13,398 | ) | $ | (907 | ) | ||||
Less: compensation expense as determined under SFAS 123, net of related taxes | (737 | ) | (756 | ) | (2,152 | ) | (861 | ) | ||||||||
Add: stock-based compensation expense included in reported net income, net of related taxes | 125 | 809 | 325 | 869 | ||||||||||||
Net loss — pro forma | $ | (2,921 | ) | $ | (839 | ) | $ | (15,225 | ) | $ | (899 | ) | ||||
Basic net loss per share — as reported | $ | (0.13 | ) | $ | (0.06 | ) | $ | (0.76 | ) | $ | (0.06 | ) | ||||
Basic net loss per share — pro forma | $ | (0.16 | ) | $ | (0.06 | ) | $ | (0.87 | ) | $ | (0.06 | ) | ||||
Diluted net loss per share — as reported | $ | (0.13 | ) | $ | (0.06 | ) | $ | (0.76 | ) | $ | (0.06 | ) | ||||
Diluted net loss per share — pro forma | $ | (0.16 | ) | $ | (0.06 | ) | $ | (0.87 | ) | $ | (0.06 | ) | ||||
Recent Accounting Pronouncements
In May 2005, the FASB issued SFAS No. 154,Accounting Changes and Error Corrections. SFAS 154 replaces APB No. 20,Accounting Changes and SFAS No. 3,Reporting Accounting Changes in Interim Financial Statements, and changes the requirements for the accounting for and reporting of a change in accounting principle. Under APB 20, a change in accounting principle was recognized as a cumulative effect of accounting change in the income statement of the period of the change. SFAS 154 generally requires retrospective application to prior periods’ financial statements of voluntary changes in accounting principles. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. We do not expect the adoption of this standard to have a significant impact on our results of operations, financial position or cash flows.
In December 2004, the FASB issued SFAS No. 153, Exchanges of Non-monetary Assets—an amendment of APB Opinion No. 29. SFAS 153 eliminates the exception for non-monetary exchanges of similar productive assets of APB Opinion No. 29 and replaces it with a general exception for exchanges of non-monetary assets that do not have commercial substance. A non-monetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a
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result of the exchange. SFAS 153 is effective for non-monetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. We do not expect the adoption of this standard to have a significant impact on our results of operations, financial position or cash flows.
In November 2004, the FASB issued SFAS No. 151,Inventory Costs—an amendment of ARB No. 43, Chapter 4. SFAS 151 amends Accounting Research Bulletin (“ARB”) No. 43, Chapter 4,Inventory Pricing, to clarify the accounting for abnormal amounts of idle facility expense, double freight, re-handling costs and wasted material. SFAS 151 requires that these types of costs be recognized as current period expenses regardless of whether they meet the criteria of “so abnormal” as previously provided in ARB 43. In addition, SFAS 151 requires that allocation of fixed production overhead to the costs of conversion be based on normal capacity of the production facilities. SFAS 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. We do not expect the adoption of this standard to have a significant impact on our results of operations, financial position or cash flows.
In December 2004, the FASB issued SFAS No. 123 (revised 2004),Share-Based Payment (“SFAS 123R”), that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for either equity instruments of the enterprise or liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. The statement eliminates the ability to account for share-based compensation transactions using the intrinsic value method as prescribed by APB 25, and generally requires that such transactions be accounted for using a fair-value-based method and recognized as expense in our statements of operations. SFAS 123R requires companies to assess the most appropriate model to calculate the value of the options. We currently use the Black-Scholes option pricing model to value options and are currently assessing which model will be used in the future under the new statement and may deem an alternative model to be the most appropriate. The use of a different model to value options may result in a different fair value than the use of the Black-Scholes option pricing model. In addition, there are a number of other requirements under the new standard that will result in differing accounting treatment than currently required. These differences include, but are not limited to, the accounting for the tax benefit on employee stock options. In addition to the appropriate fair value model to be used for valuing share-based payments, we will also be required to determine the transition method to be used at the date of adoption. The allowed transition methods include prospective and retroactive adoption options. Under the retroactive options, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The prospective method requires that compensation expense be recorded for all unvested stock options and restricted stock at the beginning of the first quarter of adoption of SFAS 123R, while the retroactive methods would record compensation expense for all unvested stock options and restricted stock beginning with the first period restated. The SEC extended the implementation date of SFAS 123R such that the effective date of the new standard for our financial statements is the first fiscal quarter of 2006. We have not yet determined the impact of adopting SFAS 123R on our results of operations or financial position however, the effect is expected to be significant.
2. Net Loss Per Share
Basic Earnings Per Share (“EPS”) excludes dilution and is computed by dividing net income or loss by the weighted average number of common shares outstanding during the reported periods. Diluted EPS reflects the potential dilution that could occur if stock options and other commitments to issue common stock were exercised using the treasury stock method.
The computation of Basic and Diluted net loss per share is as follows:
Three months ended September 30, | Nine months ended September 30, | |||||||||||||||
2005 | 2004 | 2005 | 2004 | |||||||||||||
Net loss | $ | (2,309 | ) | $ | (892 | ) | $ | (13,398 | ) | $ | (907 | ) | ||||
Weighted average shares – Basic | 17,738 | 15,155 | 17,576 | 14,385 | ||||||||||||
Effect of dilutive stock options (a) | — | — | — | — | ||||||||||||
Weighted average shares – Diluted | 17,738 | 15,155 | 17,576 | 14,385 | ||||||||||||
Basic net loss per share | $ | (0.13 | ) | $ | (0.06 | ) | $ | (0.76 | ) | $ | (0.06 | ) | ||||
Diluted net loss per share | $ | (0.13 | ) | $ | (0.06 | ) | $ | (0.76 | ) | $ | (0.06 | ) | ||||
(a) | Potential common shares of 4,252 and 1,008 as of September 30, 2005 and 2004, respectively, have been excluded from the net loss per share computations because the effect of their inclusion would be anti-dilutive. |
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3. Stock-Based Compensation (share amounts not in thousands)
In March 2004, we granted an option under our 1999 Stock Incentive Plan (the “1999 Plan”) to purchase 560,000 shares of common stock to our Chief Executive Officer at an exercise price of $6.43 per share. This grant resulted in the recognition of deferred stock-based compensation based on the estimated deemed fair value of the common stock on the date of grant of $10.00. An aggregate of 25% of the shares of common stock subject to this option vested upon the completion of our IPO. The remainder of the shares of common stock subject to this option vests in equal quarterly installments over the three-year period following our IPO. We have recorded stock-based compensation charges of $125 and $375 for the three and nine months ended September 30, 2005, respectively, to reflect the amortization of this expense.
In accordance with the Employee Benefit Matters Agreement, dated September 1, 2004 related to our spin-off from PC Mall, all PC Mall stock options that were outstanding on the record date and unexercised on April 11, 2005, were converted to eCOST.com stock options based on a ratio equal to 1.2071 for each PC Mall option. This resulted in the issuance to PC Mall option holders of 2,715,552 eCOST.com options under our 2004 Stock Incentive Plan.
The following table summarizes information about the options that were issued to PC Mall option holders in conjunction with the spin-off from PC Mall as of September 30, 2005:
Options Outstanding | Options Exercisable | |||||||||||
Range of Exercise Prices | Number Outstanding | Weighted- Average Remaining Contractual Life (years) | Weighted- Average Exercise Price | Number Exercisable | Weighted- Average Exercise Price | |||||||
$0.44 to $0.99 | 581,000 | 4.5 | $ | 0.82 | 581,000 | $ | 0.82 | |||||
$1.00 to $1.99 | 594,000 | 6.5 | $ | 1.33 | 538,000 | $ | 1.32 | |||||
$2.00 to $4.99 | 371,000 | 5.0 | $ | 3.28 | 337,000 | $ | 3.30 | |||||
$5.00 to $7.99 | 758,000 | 8.8 | $ | 7.15 | 300,000 | $ | 7.18 | |||||
$8.00 to $11.41 | 141,000 | 8.8 | $ | 9.17 | 45,000 | $ | 9.05 | |||||
2,445,000 | 6.7 | $ | 3.76 | 1,801,000 | $ | 2.70 | ||||||
In July 2005, we granted options to purchase an aggregate 732,500 shares of common stock under our 2004 Stock Incentive Plan to employees and non-employee directors at an exercise price of $3.68 per share. For 702,500 of these option grants, 25% of the shares of common stock under these option grants vest after one year, and the remainder of the shares vest in equal quarterly installments over the ensuing three-year period. For 30,000 of these option grants, the shares of common stock under these option grants vest in equal quarterly installments over the ensuing one-year period.
In August 2005, we granted options to purchase 30,000 shares of common stock under our 2004 Stock Incentive Plan to a non-employee director at an exercise price of $2.18 per share. The shares of common stock under this option grant vest in equal quarterly installments over the ensuing three-year period.
In October 2005, we granted options to purchase an aggregate 112,500 shares of common stock under our 2004 Stock Incentive Plan to employees at an exercise price of $1.83 per share. 25% of the shares of common stock under these option grants vest after one year, and the remainder of the shares vest in equal quarterly installments over the ensuing three-year period.
4. Income Taxes
We assess the recoverability of deferred tax assets and the need for a valuation allowance on an ongoing basis. In making this assessment, we consider all available positive and negative evidence to determine whether, based on such evidence, it is more likely than not that all of the net deferred assets will be realized in future periods. This assessment requires significant judgment and is based upon a number of factors including recent operating results, estimates involving projections of future taxable income, the nature of current and deferred income taxes, tax attributes relating to the interpretation of various tax laws, historical bases of tax attributes associated with certain tangible and intangible assets and limitations surrounding the availability of deferred tax assets.
During 2003, we released the valuation allowance based on an assessment of both positive and negative evidence with respect to our ability to realize our deferred tax benefits. Specifically, at that time, our management considered current forecasts and projections supporting the future utilization of its deferred tax benefits, recent operating results and the fact that net operating losses were not limited with respect to their utilization and are available over a remaining carryover period of approximately 15 to 18 years.
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Over the latter half of fiscal 2004 and into the first half of 2005, we incurred significant operating losses which to some extent were driven by costs and expenses associated with our IPO and spin-off from our former Parent. As of the second quarter of 2005, our revised forecasts indicated a deferral in the timing of profitability, and this caused greater uncertainty with respect to our ability to generate sufficient taxable income to utilize our deferred tax assets. As required under the provisions of SFAS 109,Accounting for Income Taxes, we evaluated both positive and negative evidence to determine whether the utilization of the deferred tax assets is more likely than not. Given our recent losses incurred and quarterly trend of operating losses and the inherent risk and uncertainty associated with our forecasts and projections, we determined that under the criteria of SFAS 109 it was not more likely than not that our deferred tax assets would be realized. Accordingly, we recorded a full valuation allowance against our net deferred tax assets during the second quarter of 2005, which resulted in a tax provision in that quarter of $6,500. We will continue to monitor all available evidence in accounting for this estimate and evaluate it on an ongoing basis.
5. Commitments and Contingencies
Leases
We sublease office space from our former Parent as more fully described in Note 7. Additionally, we lease 164,000 square feet for our fulfillment center in Memphis, Tennessee along with related warehouse equipment. Minimum annual rentals under such leases at September 30, 2005 are described below.
The following table sets forth our future contractual commitments as of September 30, 2005 (in thousands):
Payment Due By Period | ||||||||||||||||||||||||
Total | 3 months remaining 2005 | 2006 | 2007 | 2008 | 2009 | 2010 | Thereafter | |||||||||||||||||
Operating leases | $ | 2,860 | $ | 109 | $ | 580 | $ | 621 | $ | 515 | $ | 515 | $ | 481 | $ | 39 | ||||||||
Service agreements with our former Parent | 440 | 120 | 320 | — | — | — | — | — | ||||||||||||||||
Employment agreements | 63 | 63 | — | — | — | — | — | — | ||||||||||||||||
Total | $ | 3,363 | $ | 292 | $ | 900 | $ | 621 | $ | 515 | $ | 515 | $ | 481 | $ | 39 | ||||||||
Other Commitments and Contingencies
On July 12, 2004, we received correspondence from MercExchange LLC alleging infringement of MercExchange’s U.S. patents relating to e-commerce and offering to license its patent portfolio to us. On July 15, 2004, we received a follow-up letter from MercExchange specifying which of our technologies MercExchange believes infringe certain of its patents, alone or in combination with technologies provided by third parties. Some of those patents are currently being litigated by third parties, and we are not involved in those proceedings. In addition, three of the four patents identified by MercExchange are under reexamination at the U.S. Patent and Trademark Office, which may or may not result in the modification of those claims. In the July 15 letter, MercExchange also advised us that it has a number of applications pending for additional patents. MercExchange has filed lawsuits alleging infringement of some or all of its patents against third parties, resulting in settlements or verdicts in favor of MercExchange. At least one such verdict was appealed to the United States Court of Appeals for the Federal Circuit and was affirmed in part. Based on our investigation of this matter to date, we believe that our current operations do not infringe any valid claims of the patents identified by MercExchange in these letters. There can be no assurance, however, that such claims will not be material or adversely affect our business, financial position, results of operations or cash flows.
On September 9, 2005, our Executive Vice President and Chief Financial Officer (“CFO”) resigned. In connection with this resignation, we and our former CFO entered into a Severance and Release Agreement, pursuant to which our former CFO agreed to a general release of our company and our affiliates and we agreed to pay our former CFO a total of $147, consisting of $118 in severance and $29 representing the remaining amount of our former CFO’s 2005 guaranteed bonus, payable in biweekly installments through March 2006. This total amount is classified in the current period as a component of Selling, General and Administrative Expenses.
6. Commercial Lines of Credit
Prior to the IPO, we were a co-borrower with joint and several liability with PC Mall and certain of its other subsidiaries (the “Borrowing Group”) under an asset-based revolving credit facility (the “Parent Commercial Line of Credit”) and a Term Note. We did not directly utilize proceeds from the facility and effective upon the closing of our IPO, were released from all of our obligations. Because we were legally a borrower under the Parent Commercial Line of Credit and the Term Note, the
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entire Parent obligation is reflected in the financial statements for periods prior to the IPO with equal amounts of interest income and expense recognized in the accompanying Statements of Operations.
We have an asset-based line of credit of up to $15,000 with a financial institution, which is collateralized by substantially all of our assets. The credit facility functions as a working capital line of credit with our borrowings restricted to a percentage of our inventory and accounts receivable. Outstanding amounts under the facility bear interest initially at the prime rate plus 0.25%. Beginning in 2006, outstanding amounts under the facility will bear interest at rates ranging from the prime rate to the prime rate plus 0.5%, depending on our financial results. The credit facility contains standard terms and conditions customarily found in similar facilities offered to similarly situated borrowers and has as its sole financial covenant a minimum tangible net worth requirement. As of September 30, 2005, we are in compliance with our sole financial covenant. The credit facility will mature in March 2007. As of September 30, 2005, we had no borrowings under our asset-based line of credit.
As of November 8, 2005, our Loan and Security Agreement with the financial institution with whom we have the credit facility was amended, reducing the minimum tangible net worth requirement from $7,000 to $5,000. In consideration, we are obligated to pay the financial institution an Amendment Fee of $113 and incremental service fees of $1 per month. In addition, the fee payable by us to the financial institution in the event of early termination of the credit facility was increased from 0.35% of the revolving loan limit (if termination occurs between the first and second anniversaries of the credit facility) or 0.20% of the revolving loan amount (if termination occurs after the second anniversary of the loan agreement) to 0.75% of the revolving loan amount, regardless of when the termination occurs.
7. Transactions with Affiliate
Since inception, our former Parent has provided various services such as administration, warehousing and distribution, information technology and use of its facilities to us. Immediately prior to the closing of the IPO, we entered into fixed-term fee agreements with our former Parent to provide for these services. The inventory management and order fulfillment agreement terminated upon completion of the spin-off. Our former Parent continues to provide us with information systems support, usage of telecommunications systems, hardware and software systems and other information technology services under an agreement with a term of two years expiring in September 2006, which either party may terminate with six months prior notice. The administrative services agreement was amended effective as of the date of the spin-off to reduce the fees and scope of services. Though the administrative services agreement expired in August 2005, we continue to receive certain services from our former Parent.
Direct and allocated costs charged from our former Parent included in the accompanying statements of operations are as follows (in thousands):
Three months ended September 30, | Nine months ended September 30, | |||||||||||
2005 | 2004 | 2005 | 2004 | |||||||||
Cost of goods sold (including cost of products, shipping and fulfillment) | $ | 15,085 | $ | 36,133 | $ | 84,109 | $ | 100,641 | ||||
Selling, general and administrative expenses | 254 | 632 | 1,077 | 1,702 |
As of September 30, 2005, we had a net payable due to our Affiliate of $1,082 primarily related to fees incurred under the various service agreements described above and other miscellaneous transactions. In addition, accounts payable includes an amount due to our Affiliate of $809 for purchases of inventory.
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Item 2. | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |
Forward-Looking Statements
This Report, including the Management’s Discussion and Analysis that follows, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements are not historical facts but rather are based on current expectations, estimates and projections about our industry, our beliefs and assumptions. Forward looking statements in this report include, without limitation, statements regarding: our intention to merge with PFSweb and the expected benefits of such a merger; our deferred tax assets; the establishment of operations in the Philippines; the measures our management focuses on in evaluating the progress of our business; the principal drivers of our revenue; the critical accounting policies that affect the more significant judgments and estimates used in preparing our financial statements; the adequacy of our current working capital and other sources of liquidity to support our operations; future impacts of inflation on our operating results; our anticipated need to raise additional capital in the future for expansion of our operations and other purposes; and our future hiring needs and advertising and marketing expenditures. Words such as “anticipate,” “expect,” “intend,” “plan,” “believe,” “seek,” “estimate,” and variations of these words and similar expressions generally identify forward-looking statements. These statements are not guarantees of future performance and are subject to certain risks, uncertainties and other factors, some of which are beyond our control, are difficult to predict and could cause actual results to differ materially from those expressed or forecasted in the forward-looking statements. These risks and uncertainties include those described in “Risk Factors” below and elsewhere in this report. Reference should also be made to the factors set forth from time to time in our SEC reports, including but not limited to, those set forth in the section entitled “Risk Factors” in our Annual Report on Form 10-K/A for the year ended December 31, 2004. All forward-looking statements in this report are made as of the date hereof, based on information available to us as of the date hereof, and we assume no obligation to update or revise any of these forward-looking statements even if experience or future changes show that the indicated results or events will not be realized.
Overview
eCOST.com, Inc. (“we” or “our”) is a leading multi-category online discount retailer of high quality new, close-out and refurbished brand-name merchandise. We currently offer over 100,000 products in twelve primary merchandise categories, including computer hardware and software, home electronics, digital imaging, watches and jewelry, housewares, DVD movies, video games, travel, bed and bath, apparel and accessories, licensed sports gear and cellular/wireless. Additionally, we offer several other categories of products and services, including pet supplies and flowers through various affiliate relationships. We appeal to a broad range of consumer and small business customers through what we believe is a unique and convenient buying experience offering two shopping formats: every day low price and our proprietary Bargain Countdown™. This combination of shopping formats helps attract value-conscious customers looking for high quality products at low prices to our eCOST.com website. Additionally, we offer a fee-based membership program to develop customer loyalty by providing subscribers exclusive access to preferential offers. We also provide rapid response customer service utilizing a strategically located distribution center and third-party fulfillment providers, as well as customer support from online and on-call sales representatives. We offer suppliers an efficient sales channel for merchandise in all stages of the product life cycle. We carry products from leading manufacturers such as Apple, Canon, Citizen, Denon, Hewlett-Packard (“HP”), Nikon, Onkyo, Seiko and Toshiba and have access to a broad and deep selection of merchandise, including new, deeply discounted close-out and refurbished merchandise.
We were incorporated in Delaware in February 1999, as a wholly-owned subsidiary of PC Mall, Inc. In September 2004, we completed an initial public offering (“IPO”) of 3,465,000 shares of our common stock, leaving PC Mall with ownership of approximately 80.2%. On April 11, 2005, PC Mall distributed its remaining ownership interest in our company to its common stockholders by means of a special dividend.
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Basis of Presentation
Our statements of operations for the three and nine months ended September 30, 2004 include expense allocations for certain corporate functions historically provided to us by PC Mall, including administrative services (accounting, human resources, tax services, legal and treasury), inventory management and order fulfillment, credit card processing, information systems operation and administration, advertising services, and use of office space. These allocations were made on a specifically identifiable basis or using the relative percentages, as compared to PC Mall’s other businesses, of net sales, payroll, net cost of goods sold, square footage, headcount or other. We have not made a determination of whether these expenses were comparable to those that could have been obtained from an unrelated third party. In connection with our IPO, we entered into agreements with an Affiliate to provide similar services under a fee arrangement for a specific term and these services included inventory management and fulfillment through date of distribution, administrative services such as accounting through date of distribution, human resources, payroll and information services. The scope and cost of some of these services was reduced commensurate with the spin-off. The financial results for the three and nine months ended September 30, 2005 reflect these contractual service arrangements, as amended.
Critical Accounting Policies and Estimates
Our financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America which require us to make estimates and assumptions that affect the reported amounts of assets, liabilities, net sales and expenses, as well as the disclosure of contingent assets and liabilities. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results could differ from those estimates, and we include any revisions to our estimates in our results for the period in which the actual amounts become known. We believe the critical accounting policies and those that require more significant judgments and estimates used in the preparation of our financial statements are described below. In addition to the disclosures provided in this Form 10-Q Quarterly Report, specific risks for these critical accounting policies are described in our Annual Report on Form 10-K/A for the year ended December 31, 2004.
Revenue Recognition. We adhere to the revised guidelines and principles of sales recognition described in Staff Accounting Bulletin (“SAB”) No. 104, Revenue Recognition. Under SAB 104, sales are recognized when the title and risk of loss are passed to the customer, there is persuasive evidence of an arrangement for the sale, delivery has occurred and/or services have been rendered, the sales price is fixed or determinable and collectibility is reasonably assured. Under these guidelines, we recognize a majority of our sales, including revenue from product sales and gross outbound shipping and handling charges, upon receipt of the product by the customer. For all product sales shipped directly from suppliers to customers, we are the primary obligor in the transaction, and we take title to the products sold upon shipment, bear credit risk, and bear inventory risk for returned products that are not successfully returned to suppliers; therefore, we recognize these revenues as gross sales. Sales are reported net of estimated returns and allowances, coupon redemptions, credit card fraud and chargebacks, all of which are estimated based upon recent historical information such as return and redemption rates, and fraud and chargeback experience. Management also considers any other current information and trends in making estimates. Our coupon redemptions are based upon the quantity of eligible orders transacted during the period and the estimated redemption rate, using historical experience rates for similar products or coupon amounts. Estimated redemption rates and the related coupon expense and liability are regularly adjusted as actual coupon redemptions for the programs are processed. If sales returns, allowances, discounts, coupon redemptions, credit card fraud and chargebacks are greater than estimated by management, additional expense may be incurred. Additionally, our revenues include commissions for travel, cellular/wireless services and other products and services provided under arrangements with third party providers for customers who link through our eCOST.com website.
Allowance for Doubtful Accounts Receivable. We maintain an allowance for doubtful accounts receivable based upon estimates of future collection using the specific identification method. We extend credit to our business customers based upon an evaluation of each business customer’s financial condition and credit history, and generally do not require collateral. Our business customers’ financial conditions and credit and payment histories are evaluated in determining the adequacy of our allowance for doubtful accounts. We also maintain an allowance for uncollectible vendor receivables which arise from vendor rebate programs, price protections and other promotions. We determine the sufficiency of the vendor receivable allowance based upon various factors, including payment history. Amounts received from vendors may vary from amounts recorded because of potential non-compliance with certain elements of vendor programs. If our estimated allowances for uncollectible accounts or vendor receivables subsequently prove insufficient, additional allowance may be required.
Reserve for Inventory Obsolescence. We maintain allowances for the valuation of inventory by estimating the obsolete or unmarketable inventory based on the difference between inventory cost and market value determined by general market conditions, nature, age and type of each product. If the inventory reserve subsequently proves insufficient, additional inventory write-downs may be required, which would be recorded as an increase in cost of goods sold.
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Income Taxes. PC Mall will file a consolidated federal income tax return and a combined state income tax return that will include our operating results for year ending December 31, 2005. This will no longer be the practice after this year end. We assess the recoverability of deferred tax assets and the need for a valuation allowance on an ongoing basis. In making this assessment, we consider all available positive and negative evidence to determine whether, based on such evidence, it is more likely than not that all of the net deferred assets will be realized in future periods. This assessment requires significant judgment and is based upon a number of factors including recent operating results, estimates involving projections of future taxable income, the nature of current and deferred income taxes, tax attributes relating to the interpretation of various tax laws, historical bases of tax attributes associated with certain tangible and intangible assets and limitations surrounding the availability of deferred tax assets. During 2003, we released the valuation allowance based on an assessment of both positive and negative evidence with respect to our ability to realize our deferred tax benefits. Specifically, at that time, our management considered current forecasts and projections supporting the future utilization of its deferred tax benefits, recent operating results and the fact that net operating losses were not limited with respect to their utilization and are available over a remaining carryover period of approximately 15 to 18 years. Over the latter half of fiscal 2004 and into the first half of 2005, we incurred significant operating losses which to some extent were driven by costs and expenses associated with our IPO and spin-off from our former Parent. As of the second quarter of 2005, our revised forecasts indicated a deferral in the timing of profitability, and this caused greater uncertainty with respect to our ability to generate sufficient taxable income to utilize our deferred tax assets. As required under the provisions of SFAS 109,Accounting for Income Taxes, we evaluated both positive and negative evidence to determine whether the utilization of the deferred tax assets is more likely than not. Given our recent losses incurred and quarterly trend of operating losses and the inherent risk and uncertainty associated with our forecasts and projections, we determined that under the criteria of SFAS 109 it was not more likely than not that our deferred tax assets would be realized. Accordingly, we recorded a full valuation allowance against our net deferred tax assets during the second quarter of 2005, which resulted in a tax provision in that quarter of $6.5 million. We will continue to monitor all available evidence in accounting for this estimate and evaluate it on an ongoing basis.
Our Relationship with and Separation from PC Mall
As a subsidiary of PC Mall, we were allocated a charge for services provided by PC Mall, including administrative services (accounting, human resources, tax services, legal and treasury), inventory management and order fulfillment, credit card processing, information systems operation and administration, advertising services, and use of office space. Immediately prior to the closing of the IPO, we entered into fixed-term, fee agreements with PC Mall to provide for these services and, commensurate with the distribution, reduced the scope of some of these services. The administrative services agreement was amended effective as of the date of the spin-off to reduce the scope of services and monthly fees and though it expired in August 2005, we continue to receive certain administrative services under this agreement. PC Mall provides us with usage of its telecommunications systems, hardware and software systems, information technology services and related support services under an agreement with a term of two years expiring in September 2006, which either party may terminate with six months prior notice. The inventory management and order fulfillment agreement terminated upon completion of the spin-off. Additionally, we entered into certain product purchase arrangements with PC Mall which afforded us the facility for a limited time, to procure certain products from PC Mall under agreed contractual terms.
Results of Operation
Consumer sales represented 51% and 65% of total net sales for the three months ended September 30, 2005 and 2004, respectively, and 58% and 64% for the nine months ended September 30, 2005 and 2004, respectively. Business sales represented 49% and 35% of our total net sales for the three months ended September 30, 2005 and 2004, respectively, and 42% and 36% for the nine months ended September 30, 2005 and 2004, respectively. The business sales growth was due to increased sales per account relationship manager compared to the same periods a year ago. No single customer accounted for more than 3% of our total net sales for the nine months ended September 30, 2005. Our revenue is dependant in part on sales of HP and HP-related products which represented 27% of our net sales in 2004 and 28% of our net sales for the nine months ended September 30, 2005. We also generate commission-based revenue for certain products and other marketing and promotional services generated through our eCOST.com website. We use third party fulfillment providers to supply the travel services (such as flights, hotels and rental cars), downloadable software, cellular phones and service and various other products and services. For these products and services, we do not have inventory risk or pricing control and do not provide customer service. Therefore, for these sales we are not considered to be the primary obligor, and record only our commission as revenue. We believe there is a certain level of seasonality in our business, reflecting fluctuations in online commerce and the general pattern of peak sales for the retail industry during the holiday shopping season.
We believe that the principal drivers of our revenue consist of the average order value placed by our customers, the number of orders placed by both existing and new customers, special offers we make available that result in incremental orders, our ability to attract new customers and advertising that impacts the aforementioned drivers of our revenue. Our net sales have declined sequentially for the last three quarters, primarily as a result of declines in the number of orders placed,
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less efficient advertising, fulfillment center issues and seasonality. Our ability to achieve profitability and maintain adequate liquidity is substantially dependant on improving gross margins and improving sales.
Cost of goods sold primarily consists of the cost of the product, inbound and outbound shipping, and fixed and variable fulfillment costs charged to us by PC Mall through the spin-off and directly incurred by us through the utilization of our Memphis distribution facility. Cost of goods sold is reduced by certain vendor consideration, such as co-op advertising funds. For the three months ended September 30, 2005 and 2004, we derived approximately 82% and 88% of our net sales, respectively, from products sold out of our own inventory or, prior to the spin-off, PC Mall’s inventory. For the nine months ended September 30, 2005 and 2004, we derived approximately 85% and 88% of our net sales, respectively, from products sold out of our own inventory, or prior to the spin-off, PC Mall’s inventory. We purchased the remaining inventory from virtual warehouse distribution suppliers.
Our gross profit margins are impacted by a number of factors. Product margins are typically higher for consumer sales than for business sales and vary by category of merchandise. Gross profit margin may also be impacted by various additional factors, including the introduction of new product categories, the relative mix of sales among our product categories, pricing of products by our vendors, fluctuations in key vendor support programs and price protection, pricing strategies, promotional programs including freight, market conditions, packaging, excess and obsolete inventory charges, and other factors.
Selling, general and administrative (“SG&A”) expenses consist primarily of advertising expenses, including online marketing activities and the costs of catalog production; personnel costs; fixed costs such as rent, common area maintenance and depreciation; variable costs such as credit card processing charges, bad debt expenditures, legal and accounting fees, and service fees from PC Mall; and other costs. As a result of our IPO and our recent spin-off from PC Mall, we have incurred and expect that we will continue to incur additional general and administrative expenses related to operating as a stand-alone public company, such as increased legal and accounting expenses, increased executive compensation, personnel and employee benefit costs; investor relations costs; non-employee director costs and higher insurance premiums.
Selected Operating Data
Three months ended September 30, | Nine months ended September 30, | |||||||||||
2005 | 2004 | 2005 | 2004 | |||||||||
Total customers (1) | 1,343,989 | 949,056 | 1,343,989 | 949,056 | ||||||||
Active customers (2) | 507,029 | 389,133 | 507,029 | 389,133 | ||||||||
New customers (3) | 56,668 | 88,147 | 257,128 | 228,634 | ||||||||
Number of orders (4) | 102,022 | 140,468 | 415,417 | 376,828 | ||||||||
Average order value (5) | $ | 389 | $ | 320 | $ | 338 | $ | 331 | ||||
Advertising expense (6) | $ | 1,307,000 | $ | 1,377,000 | $ | 4,784,000 | $ | 3,878,000 |
(1) | Total customers have been calculated as the cumulative number of customers for which orders have been taken from our inception to the end of the reported period. |
(2) | Active customers consist of the number of customers who placed orders during the 12 months prior to the end of the reported period. |
(3) | New customers represent the number of persons who established a new account and placed an order during the reported period. |
(4) | Number of orders represents the total number of orders shipped during the reported period (not reflecting returns). |
(5) | Average order value has been calculated as gross sales divided by the total number of orders during the period presented. The impact of returns is not reflected in average order value. |
(6) | Advertising expense includes the total dollars spent on advertising during the reported period, including Internet, direct mail, print and e-mail advertising, as well as customer list enhancement services. |
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Three Months Ended September 30, 2005 Compared to the Three Months Ended September 30, 2004
Net Sales. Net sales for the three months ended September 30, 2005 were $38.2 million, a decrease of $5.2 million, or 12%, from the comparable prior year period. The sales decline was primarily due to a 27% decrease in the number of orders, partially offset by a 22% increase in the average order value. Additionally, consumer sales decreased 30% from the three months ended September 30, 2004 when compared to the same period in 2005. On a product category level, the sales decline was primarily due to a $4.7 million decrease in the computer hardware and software category, a $0.9 million decrease in home electronics, offset by a $0.3 million increase in video games.
Gross Profit. Gross profit for the three months ended September 30, 2005 was $2.7 million, a decrease of $1.4 million, or 33% from the comparable prior year period. The decrease in gross profit resulted from the increased costs of running our own distribution center, increased freight costs and increased customer returns. Gross profit as a percentage of sales decreased to 7.1% from 9.5% in the comparable prior year period, primarily due to the result of a higher proportion of sales to business customers which carry lower gross margins than consumer sales, increased freight costs, and the fulfillment operation issues cited above. Gross profit may be influenced from period to period by changes in vendor support programs (including price protection, rebates and return policies), product mix, pricing strategies, competition and other factors.
Selling, General and Administrative Expenses. SG&A expenses for the three months ended September 30, 2005 were $5.1 million, a decrease of $0.4 million, or 8% from the comparable prior year period. SG&A expense for the three months ended September 30, 2005 and 2004 included approximately $0.1 million and $1.3 million, respectively, of stock-based compensation charges. Excluding these stock-based compensation charges, SG&A expense for the three months ended September 30, 2005 increased $0.7 million, or 17% over the comparable prior year period. The increase was primarily due to additional personnel costs of $0.7 million (excluding the stock-based compensation charges discussed previously) related to operating as a stand-alone company. As a percentage of net sales, SG&A expenses for the three months ended September 30, 2005 were 13%, versus 10% in the comparable prior year period (excluding the stock-based compensation charges discussed previously) and was primarily due to the increased personnel costs.
Interest Income. Interest income for the three and nine months ended September 30, 2005 reflects interest earned on the investment of our net IPO proceeds in investment-grade, interest-bearing, marketable securities. “Interest expense-PC Mall commercial line of credit” is offset in the reported period by “Interest income-PC Mall commercial line of credit.” These amounts were calculated based on the monthly applicable prime rate multiplied by the cumulative balance due to PC Mall, net of approximately one month’s inventory purchases (to approximate standard vendor terms).
Income Tax Provision. As we recorded a valuation allowance for the full amount of our deferred tax asset at June 30, 2005, no additional income tax benefit was recorded during the three months ended September 30, 2005. We recorded an income tax benefit for the three months ended September 30, 2004 of $0.5 million. The tax benefit in September 30, 2004 was calculated utilizing an effective tax rate of 37.1%.
Net Loss. Our net loss was $2.3 million, or $0.13 per share, for the three months ended September 30, 2005, compared to a net loss of $0.9 million, or $0.06 per share, for the three months ended September 30, 2004.
Nine Months Ended September 30, 2005 Compared to the Nine Months Ended September 30, 2004
Net Sales. Net sales for the nine months ended September 30, 2005 were $134.3 million, an increase of $13.9 million, or 12%, over the comparable prior year period. The sales increase was primarily the result of an increase of 10% in the number of orders. Additionally, business sales increased 31% from the nine months ended September 30, 2004 when compared to the same period in 2005. On a product category level, the sales increase was primarily due to a $10.2 million increase in the computer hardware and software category, a $5.0 million increase in home electronics, a $0.9 million increase in video games, offset by a $2.0 million decrease in digital imaging.
Gross Profit. Gross profit for the nine months ended September 30, 2005, was $9.2 million, a decrease of $2.1 million, or 18.8% from the comparable prior year period. The decrease in gross profit resulted from the additional costs of running our own distribution center, the increase in customer returns and additional freight costs. Gross profit as a percentage of sales decreased to 6.9% from 9.4% in the comparable prior year period, primarily due to the result of a higher proportion of sales to business customers, which carry lower gross margins than consumer sales, increased freight costs, and the fulfillment operation issues cited above. Gross profit may be influenced from period to period by changes in vendor support programs (including price protection, rebates and return policies), product mix, pricing strategies, competition and other factors.
Selling, General and Administrative Expenses. SG&A expenses for the nine months ended September 30, 2005 were $17.4 million, an increase of $4.6 million, or 36% over the comparable prior year period. SG&A expense for the nine months ended
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September 30, 2005 and 2004 included approximately $0.4 million and $1.4 million, respectively, of stock-based compensation charges. Excluding these stock-based compensation charges, SG&A expense for the nine months ended September 30, 2005 increased $5.6 million, or 49% over the comparable prior year period. The increase was primarily related to our operating as a stand-alone company, including additional personnel costs of $3.6 million (excluding the stock-based compensation charges discussed previously), an increase of $1.2 million in fixed costs such as rent, common area maintenance and depreciation, and an increase of $0.9 million in advertising costs. As a percentage of net sales, SG&A expenses in the nine months ended September 30, 2005 were 13% compared to 9% in the comparable prior year period (excluding the stock-based compensation charges discussed previously).
Interest Income or Expense. Interest income for the nine months ended September 30, 2005 reflects interest earned on the investment of our net IPO proceeds in investment-grade, interest-bearing, marketable securities. “Interest expense-PC Mall commercial line of credit” is offset in the reported period by “Interest income-PC Mall commercial line of credit.” These amounts were calculated based on the monthly applicable prime rate multiplied by the cumulative balance due to PC Mall, net of approximately one month’s inventory purchases (to approximate standard vendor terms).
Income Tax Provision. We recorded an income tax provision for the nine months ended September 30, 2005 of $5.4 million and a tax benefit of $0.5 million for the nine months ended September 30, 2004. Under FAS 109, we continuously evaluate whether the utilization of our deferred tax assets is more likely than not. Based upon the review of both positive and negative evidence, during the second quarter of 2005, we provided a valuation allowance of $6.5 million against our net operating losses included in our deferred tax asset. This offsets the prior tax benefit recorded during the first quarter of 2005 of $1.1 million, included in our deferred tax asset. We will continue to evaluate this asset on an ongoing basis. The tax benefit in September 30, 2004 was calculated utilizing an effective tax rate of 37.1%.
Net Loss. Our net loss after taking the income tax provision discussed above was $13.4 million, or $0.76 per share, for the nine months ended September 30, 2005 compared to a net loss of $0.9 million, or $0.06 per share, for the nine months ended September 30, 2004.
Liquidity and Capital Resources
Historically, our primary sources of financing came from cash flows from operations and investments from PC Mall. Prior to our IPO in September 2004, we participated in PC Mall’s cash management program whereby our trade cash receipts were handled by PC Mall and swept daily from our account with such cash re-advanced by PC Mall for our working capital needs. In April 2004, PC Mall extended a line of credit to us of up to $10.0 million for necessary working capital requirements, which obligation terminated upon completion of our IPO. In September 2004, we completed an initial public offering of 3,465,000 shares of our common stock, which yielded net proceeds of $16.7 million after underwriting discounts, commissions and offering expenses. Since the completion of our IPO, we have performed our own cash management functions.
The following table sets forth elements of our cash flows for the periods indicated (in thousands):
Nine months ended September 30, | ||||||||
2005 | 2004 | |||||||
Net cash used in operating activities | $ | (8,307 | ) | $ | (1,700 | ) | ||
Net cash provided by (used in) investing activities | 5,488 | (125 | ) | |||||
Net cash provided by financing activities | 319 | 21,563 |
The primary factors that affected our cash flow from operations were our year-to-date operating losses and increases in our inventory and receivables balances, offset by higher payables and accrued expenses. We expect a net usage of cash in operating activities for the next twelve months.
Accounts receivable, which include trade, credit card and vendor receivables, increased to $5.1 million at September 30, 2005, from $2.0 million at December 31, 2004, primarily due to additional receivables billed under our cooperative vendor marketing programs. These vendor marketing programs had previously been combined with PC Mall who billed, collected and allocated us a proportionate share of this income but retained the credit risk. Inventories, which include products purchased for resale, net of provision, and product shipped but not yet received by our customers, increased to $6.7 million at September 30, 2005, from $1.8 million at December 31, 2004, reflecting the stocking of product at our warehouse as we assumed responsibility for order fulfillment in conjunction with the spin-off. Accounts payable increased to $7.0 million at September 30, 2005, from $0.6 million at December 31, 2004 as we began purchasing inventory directly from product vendors subsequent to the spin-off.
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We have an asset-based line of credit of up to $15 million with a financial institution, which is collateralized by substantially all of our assets. Borrowings under the facility are limited to a percentage of our inventory and accounts receivable. Outstanding amounts under the facility bear interest initially at the prime rate plus 0.25%. Beginning in 2006, outstanding amounts under the facility will bear interest at rates ranging from the prime rate to the prime rate plus 0.5%, depending on our financial results. The credit facility contains standard terms and conditions customarily found in similar facilities offered to similarly situated borrowers. The credit facility limits our ability to make acquisitions above pre-defined dollar thresholds, requires us to use the proceeds from any future stock issuances to repay outstanding amounts under the facility, and has as its sole financial covenant a minimum tangible net worth requirement. As of September 30, 2005, we are in compliance with our sole financial covenant. The credit facility will mature in March 2007. As of September 30, 2005, we had no borrowings under our asset-based line of credit. As of November 8, 2005, our Loan and Security Agreement with the financial institution with whom we have the credit facility was amended, reducing the minimum tangible net worth requirement from $7 million to $5 million. In consideration, we are obligated to pay the financial institution an Amendment Fee of $112,500 and incremental service fees of $1,000 per month. In addition, the fee payable by us to the financial institution in the event of early termination of the credit facility was increased from 0.35% of the revolving loan limit (if termination occurs between the first and second anniversaries of the credit facility) or 0.20% of the revolving loan amount (if termination occurs after the second anniversary of the loan agreement) to 0.75% of the revolving loan amount, regardless of when the termination occurs.
Although we can not provide any assurances, we believe that current working capital, together with cash flows from operations and borrowings available under our credit facility will be adequate to support our current operating plans for the next 12 months. However, our need for cash is dependant on our operating activities and if we do not maintain or increase sales or control expenses we will require additional cash. We will continue to evaluate our liquidity on an ongoing basis and may decide to pursue additional financing dependant upon the cost, terms and availability of funds. There is no assurance that such additional financing will be available. If it is available, it may be senior to our common stock and dilutive to shareholders.
Contractual Obligations
The following table sets forth our future contractual obligations and other commercial commitments as of September 30, 2005 (in thousands):
Payment Due By Period | ||||||||||||||||||||||||
Total | 3 months remaining 2005 | 2006 | 2007 | 2008 | 2009 | 2010 | Thereafter | |||||||||||||||||
Operating leases | $ | 2,860 | $ | 109 | $ | 580 | $ | 621 | $ | 515 | $ | 515 | $ | 481 | $ | 39 | ||||||||
Service agreements with PC Mall | 440 | 120 | 320 | — | — | — | — | — | ||||||||||||||||
Employment agreements | 63 | 63 | — | — | — | — | — | — | ||||||||||||||||
Total | $ | 3,363 | $ | 292 | $ | 900 | $ | 621 | $ | 515 | $ | 515 | $ | 481 | $ | 39 | ||||||||
At the IPO, we entered into agreements with PC Mall for a variety of services such as administrative services, office space, inventory management and order fulfillment, information systems operation and administration, employee benefits, intellectual property matters, and other ongoing relationships. Our inventory management and order fulfillment agreement expired upon completion of the spin-off on April 11, 2005. The administrative services agreement was amended and reduced in scope and fees in March 2005 and expired in August 2005. PC Mall continues to provide us with information systems support, usage of telecommunications systems, hardware and software systems and other information technology services under an agreement which expires in September 2006 or which either party may terminate with six months prior notice. A more detailed discussion of these agreements with PC Mall is contained under the heading “Certain Relationships and Related Transactions” in our Annual Report on Form 10-K/A for year the ended December 31, 2004.
In January 2005, we signed a lease for our own fulfillment center located in Memphis, Tennessee. We took occupancy in April 2005 and are committed under a lease term of 70 months. The amortized lease expense commenced in April and our aggregate payment obligations over the next twelve months are $348,300. In addition, we lease certain warehouse equipment used in operations at the Memphis fulfillment center.
Inflation
Inflation has not had a material impact upon operating results, and we do not expect it to have such an impact in the near future. There can be no assurances, however, that our business will not be so affected by inflation.
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RISK FACTORS
This report, including the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934. We face a number of risks and uncertainties which could cause actual results or events to differ materially from those contained in any forward-looking statement. Factors that could cause or contribute to such differences include, but are not limited to those discussed below.
Risks Relating to Our Business
We may not be able to achieve or maintain profitability.
We have reported a net loss for the quarter ended September 30, 2005 of $2.3 million and had an accumulated deficit of $24.6 million at September 30, 2005. We do not expect to achieve profitability until at least 2006 and may not be able to achieve or maintain profitability on a quarterly or annual basis. Our ability to achieve or maintain profitability depends on a number of factors, including our ability to:
• | reduce the decline in our sales that have occurred over the last three quarters; |
• | maintain or increase sales in the future; |
• | maintain vendor relationships, procure merchandise and fulfill orders in an efficient manner; and |
• | control costs. |
We may need additional financing and may not be able to raise additional financing on favorable terms or at all, which could increase our costs, limit our ability to grow and dilute the ownership interests of existing stockholders.
We anticipate that we may need to raise additional capital in the future if our potential transaction with PFSweb does not occur. We cannot be certain that we will be able to obtain additional financing on commercially reasonable terms or at all. If we raise additional funds through the issuance of equity, equity-related or debt securities, such securities may have rights, preferences or privileges senior to those of the rights of our common stock and our stockholders will experience dilution of their ownership interests. Our agreements with PC Mall will limit our ability to issue our equity securities in the future without PC Mall’s consent for up to three years following the distribution. For a description of these limitations, please see “Risks Relating to our Relationship with PC Mall.” Our failure to obtain additional financing or our inability to obtain financing on acceptable terms could require us to incur indebtedness that has high rates of interest or substantial restrictive covenants, issue equity securities that will dilute the ownership interests of existing stockholders, scale back our operations, or fail to address opportunities for expansion or enhancement of our operations.
Our operating results are difficult to predict and may adversely affect our stock price.
Our operating results have fluctuated in the past and are likely to vary significantly in the future based upon a number of factors, many of which we cannot control. We operate in a highly dynamic industry and future results could be subject to significant fluctuations. These fluctuations could cause us to fail to meet or exceed financial expectations of investors, which could cause our stock price to decline rapidly and significantly. Revenue and expenses in future periods may be greater or less than revenue and expenses in the immediately preceding period or in the comparable period of the prior year. Therefore, period-to-period comparisons of our operating results are not necessarily a good indication of our future performance. Some of the factors that could cause our operating results to fluctuate include:
• | price competition that results in lower sales volumes, lower profit margins, or net losses; |
• | fluctuations in coupon redemption rates; |
• | the amount and timing of advertising and marketing costs; |
• | our ability to successfully implement new technologies or software systems; |
• | changes in the number of visitors to our website or our inability to convert those visitors into customers; |
• | technical difficulties, including system or Internet failures; |
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• | fluctuations in the demand for our products or overstocking or understocking of our products; |
• | management of our fulfillment center; |
• | fluctuations in shipping costs, particularly during the holiday season; |
• | economic conditions generally or economic conditions specific to the Internet, online commerce, the retail industry or the mail order industry; |
• | changes in the mix of products that we sell; and |
• | fluctuations in levels of inventory theft, damage or obsolescence. |
If we fail to successfully manage or expand our inventory management and order fulfillment operations, we may be unable to meet customer demand for our products and may incur higher expenses or additional costs.
PC Mall provided inventory management and order fulfillment services to us until the completion of the spin-off in April 2005. In January 2005, we signed a lease for our own distribution facility located near the FedEx main hub in Memphis, Tennessee and commenced operations in this facility in April 2005. Any failure to manage our inventory and order fulfillment operations could seriously disrupt our operations and cause us to be unable to meet customer demand for our products. We could incur higher fulfillment expenses than anticipated or incur additional costs as a result of many factors including lost, damaged or mis-shipped inventories.
If we fail to accurately predict our inventory risk, our margins may decline as a result of write-downs of our inventory due to lower prices obtained from older or obsolete products.
Some of the products we sell on our website are characterized by rapid technological change, obsolescence and price erosion (for example, computer hardware, software and consumer electronics), and because the distribution center may sometimes stock large quantities of particular types of inventory, inventory reserves may be required or may subsequently prove insufficient and additional inventory write-downs may be required.
Our ability to offer a broad selection of products at competitive prices is dependent on our ability to maintain existing and build new relationships with manufacturers and vendors. We do not have long-term agreements with our manufacturers or vendors and some of our manufacturers and vendors compete directly with us.
We purchase products for resale both directly from manufacturers and indirectly through distributors and other sources, all of whom we consider our vendors. We have historically relied on PC Mall for substantially all of our vendor relationships. We currently offer products on our website from over 1,000 third-party manufacturers. We do not have any long-term agreements with any of these vendors. Any agreements with vendors governing our purchase of products are generally terminable by either party upon 30 days’ notice or less. In general, we agree to offer products on our website and the vendors agree to provide us with information about their products and honor our customer service policies. As we have recently transitioned to performing inventory management and order fulfillment functions on our own, we will need to continue to build our own relationships with vendors and obtain favorable product pricing and vendor consideration. If we do not maintain relationships with vendors on acceptable terms, including favorable product pricing and vendor consideration, we may not be able to offer a broad selection of products or continue to offer products at competitive prices, and customers may choose not to shop at our website. In addition, some vendors may decide not to offer particular products for sale on the Internet, and others may avoid offering their new products to retailers such as us who offer a mix of close-out and refurbished products in addition to new products. From time to time, vendors may terminate our right to sell some or all of their products, change the applicable terms and conditions of sale or reduce or discontinue the incentives or vendor consideration that they offer us. Any such termination or the implementation of such changes could have a negative impact on our operating results. Additionally, some products are subject to manufacturer or distributor allocation, which limits the number of units of those products that are available to us and other resellers.
Our revenue is dependent in part on sales of HP and HP-related products, which represented 27% of our net sales in 2004 and 28% of our net sales for the nine months ended September 30, 2005.
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We are dependent on the success of our advertising and marketing efforts, which are costly and may not achieve desired results, and on our ability to attract customers on cost-effective terms.
Our revenues are influenced by our ability to advertise and market our products effectively. Increases in the costs of advertising and marketing, including costs of online advertising, paper and postage costs, costs and fees of third-party service providers and the costs of complying with applicable regulations, may limit our ability to advertise and market our business without impacting our financial results. If our advertising and marketing efforts prove ineffective or do not produce a sufficient level of sales to cover their costs, or if we decrease our advertising or marketing activities due to increased costs, restrictions enacted by regulatory agencies or for any other reason, our revenues and profit margins may decrease. Our success depends on our ability to attract customers on cost-effective terms. We have relationships with online services, search engines, shopping engines, directories and other websites and e-commerce businesses through which we provide advertising banners and other links that direct customers to our website. We expect to rely on these relationships as significant sources of traffic to our website and to generate new customers. If we are unable to develop or maintain these relationships on acceptable terms, our ability to attract new customers on a cost-effective basis could be harmed. In addition, certain of our existing online marketing agreements require us to pay fixed placement fees or fees for directing visits to our website, neither of which may convert into sales.
Our limited operating history makes evaluation of our business difficult.
We were originally organized in February 1999 and launched our website in April 1999. Our limited operating history will make it difficult for investors to evaluate our business and future operating results. Investors must consider our business and prospects in light of the risks and difficulties we may face as an early stage company with limited operating history. These risks and difficulties include challenges in accurate financial planning as a result of limited historical data and the uncertainties resulting from having had a relatively limited time period in which to implement and evaluate our business strategies as compared to older companies with longer operating histories.
Our historical financial information may not be representative of what our actual results would have been if we were an independent company or indicative of what our future results may be.
Prior to the completion of the spin-off, PC Mall accounted for our business for financial reporting purposes as a segment within its consolidated financial statements. The historical financial information we have included in this report does not necessarily reflect what our financial position, results of operations and cash flows would have been had we been a separate, stand-alone entity and not part of PC Mall’s consolidated group during the periods presented. The historical costs and expenses reflected in our financial statements include charges for certain corporate functions historically provided by PC Mall, including administrative services (accounting, human resources, tax services, legal and treasury), inventory management and order fulfillment, credit card processing, information systems operation and administration, advertising services and use of office space. These allocated charges were based on what were considered to be reasonable reflections of the historical utilization levels of these services required in support of our business. We have not made a determination of whether these expenses are comparable to those we could have obtained from an unrelated third party. The historical financial information is not necessarily indicative of what our results of operations, financial position and cash flows will be in the future. Charges include, for instance, increased costs for leases, senior management, insurance, technology software and support, employee benefits, financing and increased costs associated with being a publicly traded, stand-alone company.
The loss of key personnel or any inability to attract and retain additional personnel could affect our ability to successfully grow our business.
Our performance is substantially dependent on the continued services and the performance of our senior management, particularly our Chief Executive Officer, Adam Shaffer, and our President Gary Guy. Our performance will also depend on our ability to attract, hire and retain a qualified successor to Elizabeth Murray, who resigned as our Executive Vice President and Chief Financial Officer on September 9, 2005, and on our ability to retain and motivate other officers and key employees. We do not have employment agreements with any of our key executives other than Mr. Shaffer. We do not maintain “key person” life insurance policies on any of our key employees. Our future success also depends on our ability to identify, attract, hire, train, retain and motivate other highly-skilled technical, managerial, editorial, merchandising, marketing and customer service personnel. Competition for such personnel is intense, and we may not be able to successfully grow our business if we are unable to successfully attract, assimilate or retain sufficiently qualified personnel, including a new CFO.
Increased product returns or a failure to accurately predict product returns could decrease our revenues and impact profitability.
We make allowances for product returns in our financial statements based on historical return rates. We are responsible for returns of certain products ordered through our website from our distribution center as well as products that are shipped to
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our customers directly from our vendors. If our actual product returns significantly exceed our allowances for returns, especially as we expand into new product categories, our revenues and profitability could decrease. In addition, because our allowances are based on historical return rates, the introduction of new merchandise categories, new products, changes in our product mix, or other factors may cause actual returns to exceed return allowances, perhaps significantly. In addition, any policies intended to reduce the number of product returns may result in customer dissatisfaction and fewer repeat customers.
Because we experience seasonal fluctuations in our revenues, our quarterly results may fluctuate.
Our business is moderately seasonal, reflecting the general pattern of peak sales for the retail industry during the holiday shopping season. Typically, a larger portion of our revenues occur during our first and fourth fiscal quarters. We believe that our historical revenue growth makes it difficult to predict the effect of seasonality on our future revenues and results of operations. In anticipation of increased sales activity during the first and fourth quarters, we incur additional expenses, including higher inventory and staffing costs. If sales for the first and fourth quarters do not meet anticipated levels, then increased expenses may not be offset which could decrease our profitability. If we were to experience lower than expected sales during our first or fourth quarter, for any reason, our financial results and liquidity would be harmed.
Our business may be harmed by fraudulent activities on our website.
We have received in the past, and anticipate that we will receive in the future, communications from customers due to purported fraudulent activities on our website. Negative publicity generated as a result of fraudulent conduct by third parties could damage our reputation and diminish the value of our brand name. Fraudulent activities on our website could also subject us to losses. We expect to continue to receive requests from customers for reimbursement due to purportedly fraudulent activities or threats of legal action against us if no reimbursement is made.
Our facilities and systems are vulnerable to natural disasters or other catastrophic events.
Our headquarters, customer service center and the majority of our infrastructure, including computer servers, are located in California, an area that is susceptible to earthquakes and other natural disasters. Our new distribution facility, located in Memphis, Tennessee, houses substantially all of the product inventory from which a substantial majority of our orders are shipped. A natural disaster or other catastrophic event, such as an earthquake, fire, flood, severe storm, break-in, terrorist attack or other comparable problems could cause interruptions or delays in our business and loss of data or render us unable to accept and fulfill customer orders in a timely manner, or at all. Our systems are not fully redundant, and we do not have duplicate geographic locations or earthquake insurance. California has in the past experienced power outages as a result of limited electrical power supplies. These outages may recur in the future and could disrupt the operation of our business. Because our inventory and distribution facility is located in an area that is susceptible to harsh weather, a major storm, heavy snowfall or other similar event could prevent us from delivering products in a timely manner. We currently have no formal disaster recovery plan and our business interruption insurance may not adequately compensate us for losses that may occur.
Delivery of our products could be delayed or disrupted by factors beyond our control, and we could lose customers as a result.
We rely upon third party carriers for timely delivery of our product shipments. As a result, we are subject to carrier disruptions and increased costs due to factors that are beyond our control, including employee strikes, inclement weather and increased fuel costs. Any failure to deliver products to our customers in a timely and accurate manner may damage our reputation and brand and could cause us to lose customers. We do not have a written long-term agreement with any of these third party carriers, and we cannot be sure that these relationships will continue on terms favorable to us, if at all. If our relationship with any of these third party carriers is terminated or impaired or if any of these third parties is unable to deliver products for us, we would be required to use alternative carriers for the shipment of products to our customers. We may be unable to engage alternative carriers on a timely basis or on terms favorable to us, if at all. Potential adverse consequences include:
• | reduced visibility of order status and package tracking; |
• | delays in order processing and product delivery; |
• | increased cost of delivery, resulting in reduced margins; and |
• | reduced shipment quality, which may result in damaged products and customer dissatisfaction. |
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If we do not successfully enhance our website and processing systems to accommodate higher levels of traffic and changing customer demands, we could lose customers and our revenues could decline.
To remain competitive, we must continue to enhance and improve the functionality and features of our website. If we fail to upgrade our website in a timely manner to accommodate higher volumes of traffic, our website performance could suffer and we may lose customers. In addition, if we fail to expand the computer systems that we use to process and ship customer orders and process customer payments, we may not be able to fulfill customer orders successfully. As a result, we could lose customers and our revenues could decline. The Internet and the e-commerce industry are subject to rapid technological change. If competitors introduce new features and website enhancements embodying new technologies, or if new industry standards and practices emerge, our existing website and systems may become obsolete or unattractive. Developing our website and other systems entails significant technical and business risks. We may face material delays in introducing new services, products and enhancements. If this happens, our customers may forgo the use of our website and use those of our competitors. We may use new technologies ineffectively, or we may fail to adapt our website, our transaction processing systems and our computer network to meet customer requirements or emerging industry standards.
If we fail to successfully expand our merchandise categories and product offerings in a cost-effective and timely manner, our reputation and the value of our new and existing brands could be harmed, customer demand for our products could decline and our profit margins could decrease.
We have generated the substantial majority of our revenues during the past five years from the sale of computer hardware, software and accessories and consumer electronics products. In the past 18 months we launched several new product and service categories, including digital imaging, watches and jewelry, housewares, DVD movies, video games, travel, bed and bath, apparel and accessories, licensed sports gear and cellular/wireless, many of which are provided through affiliate relationships. While our merchandising platform has been incorporated into and tested in the online computer and consumer electronics retail markets, we cannot predict with certainty whether it can be successfully applied to other product categories. In addition, expansion of our business strategy into new product categories may require us to incur significant marketing expenses, develop relationships with new vendors and comply with new regulations. We may lack the necessary expertise in a new product category to realize the expected benefits of that new category. These requirements could strain our managerial, financial and operational resources. Additional challenges that may affect our ability to expand into new product categories include our ability to:
• | establish or increase awareness of our new brands and product categories; |
• | acquire, attract and retain customers at a reasonable cost; |
• | achieve and maintain a critical mass of customers and orders across all of our product categories; |
• | attract a sufficient number of new customers to whom our new product categories are targeted; |
• | successfully market our new product offerings to existing customers; |
• | maintain or improve our gross margins and fulfillment costs; |
• | attract and retain vendors to provide our expanded line of products to our customers on terms that are acceptable to us; and |
• | manage our inventory in new product categories. |
We cannot be certain that we will be able to successfully address any or all of these challenges in a manner that will enable us to expand our business into new product categories in a cost-effective or timely manner. If our new categories of products or services are not received favorably, or if our suppliers fail to meet our customers’ expectations, our results of operations would suffer and our reputation and the value of the applicable new brand and our other brands could be damaged. The lack of market acceptance of our new product categories or our inability to generate satisfactory revenues from any expanded product categories to offset their cost could harm our business. An investor in our common stock must consider the risks, uncertainties and difficulties frequently encountered by companies in new and rapidly evolving online markets such as those we have targeted.
If we are unable to provide satisfactory customer service, we could lose customers.
Our ability to provide satisfactory levels of customer service depends, to a large degree, on the efficient and uninterrupted operation of our customer service operations. Any material disruption or slowdown in our order processing systems resulting from labor disputes, telephone or Internet failures, power or service outages, natural disasters or other events could make it difficult or impossible to provide adequate customer service and support. Further, we may be unable to
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attract and retain adequate numbers of competent customer service representatives and relationship managers for our business customers, each of which is essential in creating a favorable interactive customer experience. Due to increased customer service needs during the holiday shopping season, we hire temporary employees during our third and fourth fiscal quarters. As a result, we may have difficulty properly staffing our customer service operations during our peak sales season. Further, temporary employees may not have the same levels of training or professional responsibility as full-time employees and, as a result, may be more likely to provide unsatisfactory service to our customers and potential customers. If we are unable to continually provide adequate staffing and training for our customer service operations, our reputation could be seriously harmed and we could lose customers. In addition, if our e-mail and telephone call volumes exceed our present system capacities, we could experience delays in placing orders, responding to customer inquiries and addressing customer concerns. Our customer service facility currently accommodates customer service representatives at close to its capacity during our peak sales period, so we may be required to expand our customer service facility in the near future. We may not be able to find additional suitable office space on acceptable terms or at all, which could seriously hinder our ability to provide satisfactory levels of customer service. Because our success depends in large part on keeping our customers satisfied, any failure to provide high levels of customer service would likely impair our reputation and decrease our revenues.
In addition, as a cost savings measure, we are in the process of transitioning certain of our operations to the Philippines, including a portion of our customer service functions. If we are unable to successfully execute our plans in the Philippines, including providing sufficient levels of customer service, our business will be harmed.
We may not be able to compete successfully against existing or future competitors; PC Mall and some of our largest vendors currently compete with us.
The market for online sales of the products we offer is intensely competitive and rapidly evolving. We principally compete with a variety of online retailers, specialty retailers and other businesses that offer products similar to or the same as our products. Increased competition is likely to result in price reductions, reduced revenue and gross margins and loss of market share. We expect competition to intensify in the future because current and new competitors can enter our market with little difficulty and can launch new websites at a relatively low cost. In addition, some of our product vendors have sold, and continue to intensify their efforts to sell, their products directly to customers. We currently or potentially compete with a variety of businesses, including:
• | other multi-category online retailers such as Amazon.com and Buy.com; |
• | online discount retailers of computer and consumer electronics merchandise such as Computers4Sure, NewEgg and TigerDirect; |
• | liquidation e-tailers such as Overstock.com and SmartBargains.com; |
• | consumer electronics and office supply superstores such as Best Buy, Circuit City, CompUSA, Office Depot, OfficeMax and Staples; and |
• | manufacturers such as Apple, Dell, Gateway, Hewlett-Packard and IBM, that sell directly to customers. |
Many of our current and potential competitors described above have longer operating histories, larger customer bases, greater brand recognition and significantly greater financial, marketing and other resources than we do. In addition, online retailers may be acquired by, receive investments from or enter into other commercial relationships with larger, well-established and well-financed companies. Some of our competitors may be able to secure products from manufacturers or vendors on more favorable terms, devote greater resources to marketing and promotional campaigns, adopt more aggressive pricing or inventory availability policies and devote substantially more resources to website and systems development than we are able to. PC Mall currently offers many of the same products for sale as we offer, and PC Mall is not restricted from competing with us in the future.
If the protection of our trademarks and proprietary rights is inadequate, our brand and reputation could be impaired and we could lose customers.
We have six trademarks that we consider to be material to the successful operation of business: eCOST®, eCOST.com®, eCOST.com Bargain Countdown™, eCOST.com Your Online Discount Superstore!™, Bargain Countdown™ and Bargain Countdown Platinum Club™. We currently use all of these marks in connection with telephone, mail order, catalog and online retail services. We also have several additional pending trademark applications. We rely on trademark and copyright law, trade secret protection and confidentiality agreements with our employees, consultants, suppliers and others to protect our proprietary rights. Our applications may not be granted, and we may not be able to secure significant protection for our service marks or trademarks. Our competitors or others could adopt trademarks or service marks similar to our marks, or try to prevent us from using our marks, thereby impeding our ability to build brand identity and possibly leading to customer confusion. Any claim by another party against us for customer confusion caused by our use of our trademarks or service
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marks, or our failure to obtain registrations for our marks, could negatively affect our competitive position and could cause us to lose customers.
We have also filed an application with the U.S. Patent and Trademark Office for patent protection for our proprietary Bargain Countdown™ technology. We may not be granted a patent for this technology and may not be able to enforce our patent rights if our competitors or others use infringing technology. If this occurs, our competitive position, revenues and profitability could be negatively affected.
Effective trademark, service mark, patent, copyright and trade secret protection may not be available in every country in which we will sell our products and offer our services. In addition, the relationship between regulations governing domain names and laws protecting trademarks and similar proprietary rights is unclear. Therefore, we may be unable to prevent third parties from acquiring domain names that are similar to, infringe upon or otherwise decrease the value of our trademarks and other proprietary rights. If we are unable to protect or preserve the value of our trademarks, copyrights, trade secrets or other proprietary rights for any reason, our competitive position could be negatively affected and we could lose customers.
We also rely on technologies that we license from related and third parties. These licenses may not continue to be available to us on commercially reasonable terms, or at all, in the future. As a result, we may be required to develop or obtain substitute technology of lower quality or at greater cost, which could negatively affect our competitive position, cause us to lose customers and decrease our profitability.
If third parties claim we are infringing their intellectual property rights, we could incur significant litigation costs, be required to pay damages, or change our business or incur licensing expenses.
Third parties have asserted, and may in the future assert, that our business or the technologies we use infringe on their intellectual property rights. As a result, we may be subject to intellectual property legal proceedings and claims in the ordinary course of our business. We cannot predict whether third parties will assert additional claims of infringement against us in the future or whether any future claims will prevent us from offering popular products or services or operating our business as planned.
On July 12, 2004, we received correspondence from MercExchange LLC alleging infringement of its U.S. patents relating to e-commerce and offering to license its patent portfolio to us. On July 15, 2004, we received a follow-up letter from MercExchange specifying which of our technologies it believes infringe certain of its patents, alone or in combination with technologies provided by third parties. Some of those patents are currently being litigated by third parties, and we are not involved in those proceedings. In addition, three of the four patents identified by MercExchange are under reexamination at the U.S. Patent and Trademark Office, which may or may not result in the modification of the claims. In the July 15th letter, MercExchange also advised us that it has a number of applications pending for additional patents. MercExchange has filed lawsuits alleging infringement of some or all of its patents against third parties, resulting in settlements or verdicts in favor of MercExchange. At least one such verdict was appealed to the United States Court of Appeals for the Federal Circuit and was affirmed in part.
If we are forced to defend against these or any other third-party infringement claims, whether they are with or without merit or are determined in our favor, we could face expensive and time-consuming litigation, which could result in the imposition of a preliminary injunction preventing us from continuing to operate our business as currently conducted throughout the duration of the litigation or distract our technical and management personnel. If we are found to infringe, we may be required to pay monetary damages, which could include treble damages and attorneys’ fees for any infringement that is found to be willful, and either be enjoined or required to pay ongoing royalties with respect to any technologies found to infringe. Further, as a result of infringement claims either against us or against those who license technology to us, we may be required, or deem it advisable, to develop non-infringing technology, which could be costly and time consuming, or enter into costly royalty or licensing agreements. Such royalty or licensing agreements, if required, may be unavailable on terms that are acceptable to us, or at all. We expect that participants in our market will be increasingly subject to infringement claims as the number of competitors in our industry grows. If a third party successfully asserts an infringement claim against us and we are enjoined or required to pay monetary damages or royalties or we are unable to develop suitable non-infringing alternatives or license the infringed or similar technology on reasonable terms on a timely basis, our business, results of operations and financial condition could be materially harmed.
We may be liable for misappropriation of our customers’ personal information.
Data security laws are becoming more stringent in the United States and abroad. Third parties are engaging in increased cyber attacks against companies doing business on the Internet and individuals are increasingly subjected to identity and credit card theft on the Internet. If third parties or unauthorized employees are able to penetrate our network
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security or otherwise misappropriate our customers’ personal information or credit card information, or if we give third parties or our employees improper access to our customers’ personal information or credit card information, we could be subject to liability. This liability could include claims for unauthorized purchases with credit card information, impersonation or other similar fraud claims. This liability could also include claims for other misuses of personal information, including unauthorized marketing purposes. Liability for misappropriation of this information could decrease our profitability. In such circumstances, we also could be liable for failing to provide timely notice of a data security breach affecting certain types of personal information. In addition, the Federal Trade Commission and state agencies have brought numerous enforcement actions against Internet companies for alleged deficiencies in those companies’ privacy and data security practices, and they may continue to bring such actions. We could incur additional expenses if new regulations regarding the collection, use or storage of personal information are introduced or if government agencies investigate our privacy or security practices.
We rely on encryption and authentication technology licensed from third parties to provide the security and authentication necessary to effect secure transmission of sensitive customer information such as customer credit card numbers. Advances in computer capabilities, new discoveries in the field of cryptography or other events or developments may result in a compromise or breach of the algorithms that we use to protect customer transaction data. If any such compromise of our security were to occur, it could subject us to liability, damage our reputation and diminish the value of our brand-name. A party who is able to circumvent our security measures could misappropriate proprietary information or cause interruptions in our operations. We may be required to expend significant capital and other resources to protect against such security breaches or to alleviate problems caused by such breaches. Our security measures are designed to prevent security breaches, but our failure to prevent such security breaches could subject us to liability, damage our reputation and diminish the value of our brand-name.
Moreover, for the convenience of our customers, we provide non-secured channels for our customers to communicate with us. Despite the increased security risks, customers may use such channels to send personal information and other sensitive data to us. In addition, “phishing” incidents are on the rise. Phishing involves an online company’s customers being tricked into providing their credit card numbers or account information to someone pretending to be the online company’s representative. Such incidents have recently given rise to litigation against online companies for failing to take sufficient steps to police against such activities by third parties, and may discourage customers from using online services.
We may be subject to product liability claims that could be costly and time consuming.
We sell products manufactured and distributed by third parties, some of which may be defective. If any product that we sell were to cause physical injury or damage to property, the injured party or parties could bring claims against us as the retailer of the product. Our insurance coverage may not be adequate to cover every claim that could be asserted. If a successful claim were brought against us in excess of our insurance coverage, it could expose us to significant liability. Even unsuccessful claims could result in the expenditure of funds and management time and could decrease our profitability.
If we fail to achieve and maintain adequate internal controls we may not be able to produce reliable financial reports in a timely manner or prevent financial fraud.
We may be required to document and test our internal control procedures in order to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act of 2002, which requires annual management assessments of the effectiveness of our internal controls over financial reporting and a report by our independent registered public accounting firm addressing these assessments. During the course of our testing we may identify deficiencies which we may not be able to remediate in time to meet the deadline imposed by the Sarbanes-Oxley Act of 2002 for compliance with the requirements of Section 404. In addition, if we fail to achieve and maintain the adequacy of our internal controls, as such standards are modified, supplemented or amended from time to time, we may not be able to ensure that we can conclude on an ongoing basis that we have effective internal controls over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act of 2002. Moreover, effective internal controls, particularly those related to revenue recognition, are necessary for us to produce reliable financial reports and are important in helping prevent financial fraud. If we cannot provide reliable financial reports on a timely basis or prevent financial fraud, our business and operating results could be harmed, investors could lose confidence in our reported financial information, and the trading price of our stock could drop significantly.
Our stock price may be volatile and you may lose all or a part of your investment.
The market price of our common stock may be subject to significant fluctuations. It is possible that our future results of operations may be below the expectations of investors and, to the extent our company is followed by securities analysts, the expectations of these analysts. If this occurs, our stock price may decline.
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Our business is subject to political, economic and other risks associated with the Philippines.
In order to reduce costs, we have begun to shift certain of our operations to the Philippines, which subjects us to political, economic and other uncertainties, including expropriation, nationalization, renegotiation, or nullification of existing contracts, currency exchange restrictions and international monetary fluctuations. Furthermore, the Philippines has experienced violence related to guerrilla activity.
Provisions of Delaware law and of our charter and by-laws may make a takeover more difficult.
Provisions in our amended and restated certificate of incorporation and by-laws and in the Delaware corporation law may make it difficult and expensive for a third party to pursue a tender offer, change in control or takeover attempt that our management and board of directors oppose. Public stockholders that might desire to participate in one of these transactions may not have an opportunity to do so. For example, our amended and restated certificate of incorporation and by-laws contain provisions:
• | reserving to our board of directors the exclusive right to change the number of directors and fill vacancies on our board of directors, which could make it more difficult for a third party to obtain control of our board of directors; |
• | authorizing the issuance of preferred stock which can be created and issued by the board of directors without prior stockholder approval, commonly referred to as “blank check” preferred stock, with rights senior to those of our common stock, which could make it more difficult or expensive for a third party to obtain voting control; |
• | establishing advance notice requirements for director nominations or other proposals at stockholder meetings; |
• | prohibiting stockholder action by written consent, except that PC Mall may take action by written consent as long as it or its affiliates own a majority of our outstanding shares; and |
• | generally requiring the affirmative vote of holders of at least 66 2/3% of the voting power of our outstanding voting stock to amend any provision in our by-laws, and requiring the affirmative vote of 80% of the outstanding voting stock to amend certain provisions of our amended and restated certificate of incorporation and by-laws, which could make it more difficult for a third party to remove the provisions we have included to prevent or delay a change of control. |
These anti-takeover provisions could substantially impede the ability of public stockholders to benefit from a change in control or to change our management and board of directors.
Risks Related to Proposed Merger with PFSweb
Our proposed merger with PFSweb is subject to satisfaction of numerous conditions and contingencies.
On November 10, 2005, we signed a non-binding letter of intent with PFSweb, Inc., which contemplates the merger of our company with PFSweb. The letter of intent provides that either party may discontinue negotiations with respect to the merger at any time prior to the execution of a definitive merger agreement. In addition, the parties’ ability to complete the merger is subject to a number of conditions and contingencies, including the following:
• | completion of due diligence examinations by both parties; |
• | the negotiation of a definitive merger agreement on terms acceptable to both parties; |
• | the approval of the parties’ respective boards of directors and shareholders; and |
• | receipt of all necessary third party and governmental consents, approval and waivers. |
We can give you no assurance that these and other conditions will ever be satisfied to allow us to complete the proposed merger.
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If the proposed merger with PFSweb is not completed, we will have incurred substantial costs that may adversely affect our financial results and operations and the market price of our common stock.
We anticipate that we will incur substantial costs in connection with our proposed merger with PFSweb. These costs are primarily associated with the fees of our attorneys, accountants and financial advisors. In addition, the proposed merger will divert significant management resources in an effort to reach agreement on a definitive merger agreement. In addition, assuming a merger agreement is entered into, we will likely be subject to numerous restrictions on the conduct of our business pending closing. If the merger is not completed, we will have incurred significant costs, including diversion of management resources, for which we will have received little or no benefit. In addition, if the merger is not completed, we may experience negative reactions from the financial markets and our vendors, customers and employees. Each of these factors may adversely affect the trading price of our common stock and our financial results and operations.
We may not realize all of the anticipated benefits of the proposed merger.
Assuming that our proposed merger with PFSweb is eventually consummated, the ability of the parties to realize the anticipated benefits of the merger will depend, in part, on the ability of the parties to integrate their respective businesses. The combination of two independent companies is a complex, costly and time-consuming process. This process may disrupt the business of either or both of the companies, and may not result in the full benefits expected. The difficulties of combining the operations of the companies include, among others:
• | coordinating marketing functions; |
• | unanticipated issues in integrating information, communications and other systems; |
• | unanticipated incompatibility of purchasing, logistics, marketing and administration methods; |
• | retaining key employees; |
• | consolidating corporate and administrative infrastructures; |
• | the diversion of management’s attention from ongoing business concerns; and |
• | coordinating geographically separate organizations. |
We cannot assure you that the combination of our company and PFSweb will result in the realization of the full benefits anticipated from the proposed merger.
Risks Relating to Our Relationship with PC Mall
We currently rely to some extent on PC Mall’s operational and administrative infrastructure, and our ability to operate our business will suffer if we do not develop our own infrastructure quickly and cost-effectively.
We currently use the systems, processes and personnel of PC Mall to support some of our operations, including human resources and internal computing and telecommunication operations. As part of our transition to becoming a stand-alone company, we have focused resources in an effort to create our own operational and administrative infrastructure to replace most of the services PC Mall currently provides to us. We may not be successful in quickly and cost effectively implementing these systems or processes and transitioning data from PC Mall’s systems to our own. In addition to the costs associated with system upgrades, the transition to and implementation of new or upgraded hardware or software systems may result in system delays or failures. The management information systems we utilize are run on a HP3000 Enterprise System, and Hewlett-Packard has indicated that it will support this system until 2006, by which time we expect that we will need to seek third party support for such systems or upgrade our management information systems hardware and software. Any failure or significant downtime in the systems or processes provided to us by PC Mall could prevent us from taking customer orders, shipping products or billing customers. In addition, PC Mall’s and our systems and processes require the services of employees with extensive knowledge of these information systems and processes and the business environment in which we operate. In order to successfully implement and operate our systems and processes, we must be able to attract and retain a significant number of skilled employees. We may not be able to attract and retain the skilled personnel required to implement, maintain, and operate our information systems and processes.
In addition, we are currently a party to a systems support agreement with PC Mall that expires in September 2006. If we are unable to renew this agreement, enter into a similar agreement with a third party on commercially reasonable terms, or successfully develop or own systems support capability, our business will suffer.
Third parties may seek to hold us responsible for liabilities of PC Mall that we did not assume in our agreements.
In connection with our separation from PC Mall, PC Mall agreed to retain all of its liabilities that we did not expressly assume under our agreements with PC Mall. Third parties may seek to hold us responsible for PC Mall’s retained liabilities. Under our agreements with PC Mall, PC Mall has agreed to indemnify us for claims and losses relating to these retained
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liabilities. However, if those liabilities are significant and we are ultimately held liable for them, we cannot assure you that we will be able to recover the full amount of our losses from PC Mall.
Our executive officers who own PC Mall common stock or options to acquire PC Mall common stock may have potential conflicts of interest.
Ownership of PC Mall common stock, options to acquire PC Mall common stock and other equity securities by our officers could create, or appear to create, potential conflicts of interest when our officers are faced with decisions that could have different implications for PC Mall than they do for us.
We may be required to indemnify PC Mall for taxes arising in connection with the spin-off, and the tax characteristics of the spin-off may interfere with our ability to engage in desirable strategic transactions and issue our equity securities.
Unless Section 355(e) of the Internal Revenue Code, discussed below, applies to the distribution of our stock in the spin-off, the distribution will be tax-free to PC Mall if the contribution and the distribution, taken together, qualify under section 355, 368(a)(1)(D) and related provisions of the Internal Revenue Code. PC Mall has received an opinion of counsel to the effect that the contribution and the distribution, taken together, will qualify under Sections 355, 368(a)(1)(D) and related provisions of the Internal Revenue Code. However, the opinion is based on certain representations by us and PC Mall. We are not aware of any facts or circumstances that would cause any of those representations to be untrue. Nonetheless, if the contribution and the distribution are taxable to PC Mall as a result of representations being untrue that relate to an action or omission by us that occurs after the distribution, we must indemnify PC Mall for any resulting tax-related liabilities.
Even if the contribution and the distribution, taken together, qualify as a reorganization under Sections 355, 368(a)(1)(D) and related provisions of the Internal Revenue Code, it will be taxable to PC Mall if Section 355(e) of the Internal Revenue Code applies to the distribution. Section 355(e) will apply if 50% or more of PC Mall stock or our stock, by vote or value, is acquired by one or more persons, other than PC Mall’s historic stockholders who receive our common stock in the distribution, acting pursuant to a plan or a series of related transactions that includes the distribution. Any shares of our stock acquired directly or indirectly within two years before or after the distribution generally are presumed to be part of such a plan unless we can rebut that presumption. If Section 355(e) applies to the distribution because of some action or omission by us after the distribution, then we must indemnify PC Mall for any resulting tax-related liabilities. To prevent applicability of Section 355(e) or to otherwise prevent the contribution and the distribution from failing to qualify as a reorganization under Sections 355, 368(a)(1)(D) and related provisions of the Internal Revenue Code, we have also agreed that, until three years after the distribution, we will not take any of the following actions unless prior to taking such action we have obtained (and provided to PC Mall) a written opinion of tax counsel reasonably acceptable to PC Mall or a ruling from the Internal Revenue Service to the effect that such action will not cause the distribution to be taxable to PC Mall:
• | engage in certain stock issuance transactions that, when combined with the shares issued in our public offering, comprise 40% of our stock; |
• | merge or consolidate with another corporation; |
• | liquidate or partially liquidate; |
• | sell or transfer 60% or more of the gross assets of our business (other than ordinary course sales of inventory) or substantially all of the assets transferred to us as part of the contribution; |
• | redeem or repurchase our stock (except in certain limited circumstances); or |
• | take any other action which could reasonably be expected to cause Section 355(e) to apply to the distribution. |
We will have to indemnify PC Mall if the contribution and the distribution, taken together, become taxable to PC Mall by failing to qualify under Sections 355, 368(a)(1)(D) and related provisions of the Internal Revenue Code or from the application of Section 355(e) of the Internal Revenue Code as a result of these or any other transactions that we undertake after the distribution. This obligation may also discourage, delay or prevent a merger, change of control, or other strategic or capital raising transactions involving our outstanding equity or our issuance of equity securities. If we cannot engage in equity financing transactions because of these constraints, we may not be able to fund our working capital, capital expenditure and research and development requirements, as well as to make other investments.
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Many of our competitors are not subject to similar restrictions and may issue their stock to complete acquisitions, expand their product offerings and speed the development of new technology. Therefore, these competitors may have a competitive advantage over us. In addition, substantial uncertainty exists on the scope of Section 355(e).
Risks Relating to our Industry
Our success is tied to the continued use of the Internet and the adequacy of the Internet infrastructure.
Our future revenues and profits, if any, substantially depend upon the continued widespread use of the Internet as an effective medium of business and communication. If use of the Internet declines or the Internet infrastructure becomes an ineffective medium for business transactions and communication, we may not be able to effectively implement our growth strategy and we could lose customers. Widespread use of the Internet could decline as a result of disruptions, computer viruses or other damage to Internet servers or users’ computers. Additionally, if the Internet’s infrastructure does not expand fast enough to meet increasing levels of use, it may become a less effective medium of business transactions and communications.
The security risks of e-commerce may discourage customers from purchasing goods from us.
In order for the e-commerce market to develop successfully, we and other market participants must be able to transmit confidential information securely over public networks. Third parties may have the technology or know-how to breach the security of customer transaction data. Any breach could cause customers to lose confidence in the security of our website and choose not to purchase from our website. If someone is able to circumvent our security measures, he or she could destroy or steal valuable information or disrupt our operations. Concerns about the security and privacy of transactions over the Internet could inhibit the growth of the Internet and e-commerce. Our security measures may not effectively prohibit others from obtaining improper access to our information. Any security breach could expose us to risks of loss, litigation and liability and could seriously disrupt our operations.
Credit card fraud could decrease our revenues and profitability.
We do not carry insurance against the risk of credit card fraud, so the failure to adequately control fraudulent credit card transactions could reduce our revenues and our gross margin. We may in the future suffer losses as a result of orders placed with fraudulent credit card data even though the associated financial institution approved payment of the orders. Under current credit card practices, we may be liable for fraudulent credit card transactions because we do not obtain a cardholder’s signature. If we are unable to detect or control credit card fraud, or if credit card companies require more burdensome terms or refuse to accept credit card charges from us, our revenues and profitability could decrease.
If one or more states successfully assert that we should collect sales or other taxes on the sale of our products or the products of third parties that we offer for sale on our website, our revenues and profitability could decrease.
In accordance with current industry practice, we do not currently collect sales or other similar taxes for physical shipments of goods into states other than California and Tennessee. One or more local, state or foreign jurisdictions may seek to impose sales tax collection obligations on us and other out-of-state companies that engage in online commerce. If sales tax obligations are successfully imposed upon us by a state or other jurisdiction, we could be exposed to substantial tax liabilities for past sales and penalties and fines for failure to collect sales taxes and we could suffer decreased sales in that state or jurisdiction as the effective cost of purchasing goods from us increases for those residing in that state or jurisdiction. Currently, decisions of the U.S. Supreme Court appear to restrict the imposition of obligations to collect state and local sales and use taxes with respect to sales made over the Internet. However, a number of states, as well as the U.S. Congress, have been considering various initiatives that could limit or supersede the Supreme Court’s apparent position regarding sales and use taxes on Internet sales. If any of these initiatives are enacted, we could be required to collect sales and use taxes in states other than California and Tennessee. The imposition by state and local governments of various taxes upon Internet commerce could create administrative burdens for us and our revenues and profitability could decrease.
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Existing or future government regulation could expose us to liabilities and costly changes in our business operations, and could reduce customer demand for our products.
We are subject to general business regulations and laws, as well as regulations and laws specifically governing the Internet and e-commerce. Such existing and future laws and regulations may impede the growth of the Internet or other online services. These regulations and laws may cover taxation, user privacy, marketing and promotional practices, database protection, pricing, content, copyrights, distribution, electronic contracts, email and other communications, consumer protection, product safety, the provision of online payment services, intellectual property rights, unauthorized access (including the Computer Fraud and Abuse Act), and the characteristics and quality of products and services. It is unclear how existing laws governing issues such as property ownership, sales and other taxes, libel, trespass, data mining and collection, and personal privacy apply to the Internet and e-commerce. Unfavorable resolution of these issues may expose us to liabilities and costly changes in our business operations, and could reduce customer demand for our products. The growth and demand for online commerce has and may continue to result in more stringent consumer protection laws that impose additional compliance burdens on online companies. For example, California law requires us to notify our California customers if certain personal information about them is obtained by an unauthorized person, such as a computer hacker. These consumer protection laws could result in substantial compliance costs and could decrease our profitability.
Laws or regulations relating to privacy and data protection may adversely affect the growth of our Internet business or our marketing efforts.
We are subject to increasing regulation relating to privacy and the use of personal user information. For example, we are subject to various telemarketing and anti-spam laws that regulate the manner in which we may solicit future suppliers and customers. Such regulations, along with increased governmental or private enforcement, may increase the cost of growing our business. In addition, several jurisdictions, including California, have adopted legislation limiting the uses of personal user information gathered online or require online services to establish privacy policies. Pursuant to the Children’s Online Privacy Protection Act, the Federal Trade Commission has adopted regulations regarding the collection and use of personal identifying information obtained from children under 13 years of age. Increasingly, federal, state and foreign laws and regulations extend online privacy protection to adults. Moreover, in jurisdictions where we do business, there is a trend toward requiring companies to establish procedures to notify users of privacy and security policies, to obtain prior consent from users for the collection, use and disclosure of personal information (even disclosure to affiliates), and to provide users with the ability to access, correct and delete personal information stored by companies. These data protection regulations and enforcement efforts may restrict our ability to collect, use or transfer demographic and personal information from users, which could be costly or harm our marketing efforts. Further, any violation of privacy or data protection laws and regulations may subject us to fines, penalties and damages, as well as harm to our reputation, which could decrease our revenues and profitability.
Item 3. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK |
It is our policy not to enter into derivative financial instruments. We do not have any significant foreign currency exposure since we do not transact business in foreign currencies. Therefore, we do not have significant overall currency exposure at September 30, 2005.
Item 4. | CONTROLS AND PROCEDURES |
As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of the Chief Executive Officer and Vice President of Accounting and Controller, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on this evaluation, our Chief Executive Officer and Vice President of Accounting and Controller concluded that our disclosure controls and procedures are effective in timely alerting them to material information required to be included in this report.
There has been no change in our internal control over financial reporting that occurred during our most recent fiscal quarter that has materially affected or is reasonably likely to materially affect our internal control over financial reporting.
Item 2. | UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS |
On August 27, 2004, the Securities and Exchange Commission declared effective our Registration Statement on Form S-1 (File No. 333-115199). The Registration Statement covered the sale of 3,465,000 shares of our common stock at an offering price of $5.80 per share, which was completed on September 1, 2004. Our net proceeds of the offering were $16.7 million, after deducting underwriting discounts and commissions and our offering expenses. Through September 30, 2005,
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approximately $2 million of the net proceeds have been used for capital expenditures and approximately $8 million for working capital.
Item 5. | OTHER INFORMATION |
The following item numbers correspond to the items under which the following matters would have been reported if included in a Form 8-K.
Item 1.01. | Entry into a Material Definitive Agreement. |
On November 8, 2005, we entered into an amendment to our Loan and Security Agreement dated August 3, 2004 with Wachovia Capital Finance Corporation (Western) (formerly known as Congress Financial Corporation (Western)). Pursuant to the amendment, our obligation to maintain a tangible net worth of not less than $7,000,000 as of the last day of each month as a condition to our ability to receive loans and/or letter of credit accommodations under the agreement was decreased to $5,000,000. In addition, the monthly servicing fee payable to Wachovia was increased from $1,500 to $2,500, and the fee payable to Wachovia in the event of early termination of the agreement was increased from 0.35% of the revolving loan limit (if termination occurs between the first and second anniversaries of the loan agreement) or 0.20% of the revolving loan limit (if termination occurs after the second anniversary of the loan agreement) to 0.75% of the revolving loan limit, regardless of when the termination occurs. In connection with the amendment, we paid a $112,500 fee to Wachovia. A copy of the loan agreement amendment is attached hereto as Exhibit 10.13 and is incorporated by reference herein.
Item 8.01. | Other Events. |
On November 10, 2005, we entered into a non-binding letter of intent with PFSweb, Inc., which contemplates the merger of our company with PFSweb. Pursuant to the proposed merger, PFSweb would issue to eCOST.com shareholders one PFSweb common share for each outstanding share of eCOST.com in a tax-free, share-for-share transaction. As a result, eCOST.com would become a wholly-owned subsidiary of PFSweb. The transaction is subject to due diligence, the execution of a definitive agreement, the approval of the parties’ respective boards of directors and shareholders and other customary conditions. Either party may discontinue negotiations of the merger at any time prior to the execution of the definitive merger agreement. Each party will bear its own expenses associated with the merger, including attorneys’ fees and fees of financial advisors. A copy of the letter of intent is attached hereto as Exhibit 99.1 and is incorporated by reference herein. For a discussion of certain of the risks associated with the proposed merger with PFSweb, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Factors—Risks Related to Proposed Merger with PFSweb.”
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Item 6. | EXHIBITS AND REPORTS ON FORM 8-K |
(a) Exhibits:
Exhibit Number | Description | ||
2.1 | Master Separation and Distribution Agreement, dated September 1, 2004 (included as Exhibit 10.1 hereto) (4) | ||
3.1 | Amended and Restated Certificate of Incorporation (1) | ||
3.2 | Amended and Restated Bylaws (1) | ||
10.1 | Master Separation and Distribution Agreement, dated September 1, 2004 (4) | ||
10.2 | Tax Allocation and Indemnification Agreement, dated September 1, 2004 (4) | ||
10.3 | Employee Benefit Matters Agreement, dated September 1, 2004 (4) | ||
10.4 | Administrative Services Agreement, dated September 1, 2004 (4) | ||
10.5 | Product Sales, Inventory Management and Order Fulfillment Agreement, dated September 1, 2004 (4) | ||
10.6 | Information Technology Systems Usage and Services Agreement, dated September 1, 2004 (4) | ||
10.7 | AF Services Software License Agreement, dated September 1, 2004 (4) | ||
10.8 | Amended and Restated Sublease Agreement, dated September 1, 2004 (4) | ||
10.9 | Registration Rights Agreement with PC Mall, dated September 1, 2004 (4) | ||
10.10 | Registration Rights Agreement with Frank Khulusi, dated September 1, 2004 (4) | ||
10.11 | * | eCOST.com, Inc. 2004 Stock Incentive Plan and 2004 Non-employee Director Option Program (2) | |
10.12 | Loan and Security Agreement with Congress Financial Corporation (Western), dated August 3, 2004 (3) | ||
10.13 | First Amendment to Loan and Security Agreement with Wachovia Capital Finance Corporation (Western) (formerly known as Congress Financial Corporation (Western)), dated November 8, 2005 | ||
10.14 | Form of Indemnification Agreement with directors and executive officers (4) | ||
10.15 | * | Form of Notice of Stock Option Award and Stock Option Award Agreement under 2004 Stock Incentive Plan (4) | |
10.16 | * | Form of Notice of Stock Option Award and Stock Option Award Agreement for Non-employee Directors under 2004 Stock Incentive Plan (4) | |
31.1 | Certification of the Chief Executive Officer of the Registrant pursuant to Exchange Act Rule 13a-14(a) | ||
31.2 | Certification of the Principal Financial Officer of the Registrant pursuant to Exchange Act Rule 13a-14(a) | ||
32.1 | Certification of the Chief Executive Officer of Registrant furnished pursuant to 18 U.S.C. 1350, as adopted by Section 906 of the Sarbanes-Oxley Act of 2002 | ||
32.2 | Certification of the Principal Financial Officer of Registrant furnished pursuant to 18 U.S.C. 1350, as adopted by Section 906 of the Sarbanes-Oxley Act of 2002 | ||
99.1 | Letter of Intent with PFSweb, Inc., dated November 10, 2005 |
* | The referenced exhibit is a compensatory contract, plan or arrangement |
(1) | Incorporated by reference to Amendment No. 3 to our Registration Statement on Form S-1 (File No. 333-115199), filed with the SEC on July 26, 2004. |
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(2) | Incorporated by reference to Amendment No. 2 to our Registration Statement on Form S-1 (File No. 333-115199), filed with the SEC on July 2, 2004. |
(3) | Incorporated by reference to Amendment No. 4 to our Registration Statement on Form S-1 (File No. 333-115199), filed with the SEC on August 3, 2004. |
(4) | Previously filed. |
(b) The following reports on Form 8-K were filed or required to be filed for the last quarter:
A report filed on August 9, 2005 described the registrant’s issuance of a press release setting forth its financial results for its second quarter ended June 30, 2005.
A report filed on August 26, 2005 described the resignation of a member of the registrant’s board of directors and the concurrent election of a new member.
A report filed on September 13, 2005 described the resignation of the registrant’s Executive Vice President and Chief Financial Officer and the appointment of an interim principal financial officer.
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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.
Date: November 14, 2005 | eCOST.COM, INC. | |||||||
By: | /s/ Adam Shaffer | |||||||
Adam Shaffer | ||||||||
Chief Executive Office and Chairman | ||||||||
(Duly Authorized Officer of the Registrant and Principal Executive Officer) |
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