FranklinCovey’s common stock is listed and traded on the New York Stock Exchange (NYSE) under the symbol “FC.” The following table sets forth, for the periods indicated, the high and low sale prices for our common stock, as reported on the NYSE Composite Tape, for the fiscal years ended August 31, 2005 and 2004.
Financial Highlights
The selected consolidated financial data presented below should be read in conjunction with the consolidated financial statements of Franklin Covey and the related footnotes as found in Item 8 of this report on Form 10-K.
During fiscal 2005, we determined that due to inaccurate deferred income tax calculations, our consolidated financial statements contained an error. The selected consolidated financial data has been derived from our consolidated financial statements and has been restated to reflect adjustments described in Note 2 to those consolidated financial statements. This restatement affects our fiscal 2002 income statement data and our fiscal 2004, 2003, 2002, and 2001 balance sheet data as presented below. There was no impact in any year due to this restatement on net cash provided by operating, investing, or financing activities on our consolidated statements of cash flows.
During fiscal 2002, we sold the operations of Premier Agendas and discontinued our on-line planning service offered at franklinplanner.com. Accordingly, the information set forth in the table below has been restated to reflect Premier Agendas and franklinplanner.com as discontinued operations.
| August 31, | | 2005 | | 2004 | | 2003 | | 2002 | | 2001 | |
In thousands, except per share data | | | | Restated | | Restated | | Restated | | As Previously Reported | | Restated | |
| | | | | | | | | | | | | | |
Income Statement Data | | | | | | | | | | | | | | | | | | | |
| Net sales | | $ | 283,542 | | $ | 275,434 | | $ | 307,160 | | $ | 332,998 | | $ | 332,998 | | $ | 439,781 | |
| Income (loss) from operations | | | 8,943 | | | (9,064 | ) | | (47,665 | ) | | (122,573 | ) | | (122,573 | ) | | (14,793 | ) |
| Net income (loss) from continuing operations before income taxes | | | 9,101 | | | (8,801 | ) | | (47,790 | ) | | (122,179 | ) | | (122,179 | ) | | (17,196 | ) |
| Income tax benefit (provision) | | | 1,085 | | | (1,349 | ) | | 2,537 | | | 32,122 | | | 25,713 | | | 4,000 | |
| Net income (loss) from continuing operations | | | 10,186 | | | (10,150 | ) | | (45,253 | ) | | (90,057 | ) | | (96,466 | ) | | (13,196 | ) |
| Cumulative effect of accounting change, net of income taxes | | | | | | | | | | | | (75,928 | ) | | (61,386 | ) | | | |
| Net loss attributable to common shareholders | | | (5,837 | ) | | (18,885 | ) | | (53,988 | ) | | (117,399 | ) | | (109,266 | ) | | (19,236 | ) |
| Basic and diluted loss per share | | | (.34 | ) | | (.96 | ) | | (2.69 | ) | | (5.90 | ) | | (5.49 | ) | | (.95 | ) |
| | | | | | | | | | | | | | | | | | | | |
Balance Sheet Data | | | | | | | | | | | | | | | | | | | |
| Total current assets | | $ | 105,182 | | $ | 92,229 | | $ | 110,057 | | $ | 124,345 | | $ | 120,739 | | $ | 226,911 | |
| Other long-term assets | | | 9,426 | | | 7,305 | | | 10,472 | | | 11,474 | | | 11,474 | | | 14,369 | |
| Total assets | | | 233,233 | | | 227,625 | | | 262,146 | | | 308,344 | | | 304,738 | | | 551,022 | |
| | | | | | | | | | | | | | | | | | | | |
| Deferred income tax liabilities | | | 9,715 | | | 10,047 | | | 10,538 | | | 11,739 | | | - | | | 41,326 | |
| Long-term obligations of continuing operations | | | 46,171 | | | 13,067 | | | 15,743 | | | 15,231 | | | 3,492 | | | 146,138 | |
| Total liabilities | | | 100,407 | | | 69,146 | | | 84,479 | | | 81,922 | | | 70,183 | | | 241,140 | |
| | | | | | | | | | | | | | | | | | | | |
| Shareholders’ equity | | | 132,826 | | | 158,479 | | | 177,667 | | | 226,422 | | | 234,555 | | | 309,882 | |
The following management’s discussion and analysis is intended to provide a summary of the principal factors affecting the results of operations, liquidity and capital resources, contractual obligations, and the critical accounting policies of Franklin Covey Co. (also referred to as the Company, we, us, our, and FranklinCovey, unless otherwise indicated) and subsidiaries. This discussion and analysis should be read together with our consolidated financial statements and related notes, which contain additional information regarding the accounting policies and estimates underlying the Company’s financial statements. Our consolidated financial statements and related notes are presented in Item 8 of this report on Form 10-K.
FranklinCovey seeks to improve the effectiveness of organizations and individuals and is a worldwide leader in providing integrated learning and performance solutions to organizations and individuals that are designed to enhance strategic execution, productivity, leadership, sales force performance, effective communications, and other skills. Each performance solution may include products and services that encompass training and consulting, assessment, and various application tools that are generally available in electronic or paper-based formats. Our products and services are available through professional consulting services, public workshops, retail stores, catalogs, and the Internet at www.franklincovey.com. Historically, our best-known offerings include the FranklinCovey Planner™, and a suite of new and updated individual-effectiveness and leadership-development training products based on the best-selling book The 7 Habits of Highly Effective People. We also offer a range of training and assessment products to help organizations achieve superior results by focusing and executing on top priorities, building the capability of knowledge workers, and aligning business processes. These offerings include the popular workshop FOCUS: Achieving Your Highest Priorities™, The 4 Disciplines of Execution™, The 4 Roles of Leadership™, Building Business Acumen: What the CEO Wants You to Know™, the Advantage Series communication workshops, and the Execution Quotient (xQ™) organizational assessment tool.
Our fiscal year ends on August 31, and unless otherwise indicated, fiscal 2005, fiscal 2004, and fiscal 2003, refers to the twelve-month periods ended August 31, 2005, 2004, and 2003.
Key factors that influence our operating results include the number of organizations that are active customers; the number of people trained within those organizations; the sale of personal productivity tools (including FranklinCovey Planners, personal digital assistants or “PDAs”, binders, and other related products); the availability of budgeted training spending at our clients and prospective clients, which is significantly influenced by general economic conditions; and our ability to manage operating costs necessary to provide training and products to our clients.
During the fiscal 2005 year-end closing process, the Company determined that its previously issued consolidated balance sheet for the year ended August 31, 2004 and consolidated statements of shareholders' equity for the three years in the period ended August 31, 2004 needed to be restated to correct an inaccurate deferred tax calculation that affected our statement of operations for the fiscal year ended August 31, 2002. The Company identified that, historically, the deferred income tax liability for the basis difference on indefinite-lived intangibles calculated upon the adoption of SFAS No. 142, Goodwill and Other Intangibles, was incorrectly offset against deferred income tax assets. The deferred tax liability relating to this basis difference was assumed to reverse against the deferred tax asset, which resulted in the Company not providing a sufficient valuation allowance against the deferred tax assets. Since this deferred tax liability relates to indefinite-lived assets, it was not correct to net the deferred tax assets and liabilities.
In addition, the Company determined that it should have recognized a deferred tax liability and a corresponding increase to goodwill related to the acquisition of intangible assets in a prior period. The additional goodwill should have been expensed in the cumulative effect of the accounting change resulting from the adoption of SFAS No. 142 because all goodwill was considered impaired at the date that we adopted SFAS No. 142, and the additional deferred income tax liability should have been utilized to reduce the deferred tax valuation allowance.
These inaccurate deferred tax calculations impacted the consolidated statement of operations for fiscal 2002 by increasing the income tax benefit, and by decreasing the loss from continuing operations, by $6.4 million, and by increasing the charge resulting from the cumulative effect of accounting change related to the adoption of SFAS No. 142 by $14.5 million. The net effect of these errors increases the reported $109.3 million net loss attributable to common shareholders in fiscal 2002 by $8.1 million, to $117.4 million.
For periods subsequent to fiscal 2002, these errors only affected our consolidated balance sheets through the impact of increased net deferred tax liabilities and decreased retained earnings. There was no impact in any year due to this restatement on net cash provided by operating, investing, or financing activities on the consolidated statements of cash flows.
The following discussion in this Management’s Discussion and Analysis of Financial Condition and Results of Operations reflects the effects of this restatement where applicable.
Overview
Our operating results in fiscal 2005 showed significant year-over-year improvement in nearly every area, including increased sales, improved gross margins, and lower operating costs. For the fiscal year ended August 31, 2005, we reported net income (before preferred dividends and loss on preferred stock recapitalization) of $10.2 million, compared to a net loss of $10.2 million in the prior year. Our operating income for the year ended August 31, 2005 improved by $18.0 million as we recognized operating income of $8.9 million compared to an operating loss of $9.1 million in fiscal 2004. The primary factors that influenced our financial results for the fiscal year ended August 31, 2005 were as follows:
| l | Sales Performance - Our total sales increased by $8.1 million, which represented the first increase in year-over-year sales performance in several years. The increase in total sales was due to improved training and consulting services sales, which increased $18.1 million compared to fiscal 2004. Increased training and consulting sales was attributable to improvements in both domestic and international delivery channels. During fiscal 2005 we also completed significant enhancements to our successful and well-known The 7 Habits of Highly Effective People training course and related products. We believe that our refreshed course materials and related products, in combination with our new training offerings, will contribute to continuing improvements in our training and consulting sales performance. Product sales decreased by $10.0 million, which was primarily due to the impact of closed retail stores and declining technology and specialty product sales compared to the prior year. |
| l | Gross Margin Improvement - Our gross margin improved compared to the prior year primarily due to increased training and consulting sales as a percent of total sales, favorable product and training program mix changes, reduced product costs, and lower overall costs in delivering our training and consulting service sales. |
| l | Decreased Operating Costs - Our operating costs decreased by $5.1 million, primarily due to reduced depreciation and reduced selling, general, and administrative expenses. Consistent with prior years, we continue to seek for and implement strategies that will enable us to reduce our operating costs in order to improve our profitability. |
| l | Improved Cash Flows from Operations - Our cash flows from operations improved to $22.3 million compared to $12.1 million in fiscal 2004 and $5.8 million in fiscal 2003. We were able to improve our cash flows from operations primarily through improved operating results and continued reductions of on-hand inventories. As a result of these and other factors, we were able to increase our cash and cash equivalents balance to $51.7 million at August 31, 2005. |
| l | Completion of the Preferred Stock Recapitalization - During fiscal 2005, we completed a preferred stock recapitalization that allows the Company to redeem shares of preferred stock. Although we recorded a $7.8 million non-cash loss resulting from the revaluation of our preferred stock and valuation of the newly issued common stock warrants, we were able to use a portion of the proceeds from the sale of our corporate headquarters to redeem $30.0 million, or 1.2 million shares, of preferred stock in fiscal 2005. This redemption will save $3.0 million annually in preferred dividends. Subsequent to August 31, 2005, we redeemed an additional $10.0 million of preferred stock, which will save additional dividend costs in future periods. |
Although we achieved improved financial results in fiscal 2005 and saw improvements in many other related trends, we have not yet attained our targeted business model and we are therefore continuing our efforts to increase sales, improve gross margins, and reduce operating costs in order to achieve consistently profitable operations. Further details regarding our operating results and liquidity are provided throughout the following management’s discussion and analysis.
The following table sets forth, for the fiscal years indicated, the percentage of total sales represented by the line items through income (loss) before income taxes in our consolidated statements of operations:
YEAR ENDED AUGUST 31, | | 2005 | | 2004 | | 2003 | |
| Product sales | | | 59.0 | % | | 64.3 | % | | 65.8 | % |
| Training and consulting services sales | | | 41.0 | | | 35.7 | | | 34.2 | |
| Total sales | | | 100.0 | | | 100.0 | | | 100.0 | |
| | | | | | | | | | | |
| Product cost of sales | | | 27.2 | | | 31.1 | | | 33.3 | |
| Training and consulting services cost of sales | | | 13.3 | | | 12.3 | | | 11.2 | |
| Total cost of sales | | | 40.5 | | | 43.4 | | | 44.5 | |
| Gross margin | | | 59.5 | | | 56.6 | | | 55.5 | |
| | | | | | | | | | | |
| Selling, general and administrative | | | 52.3 | | | 54.1 | | | 60.0 | |
| Impairment of and (gain) on disposal of investment in unconsolidated subsidiary | | | (0.2 | ) | | | | | 0.2 | |
| Provision for losses on management stock loans | | | | | | | | | 1.3 | |
| Recovery of investment in unconsolidated subsidiary | | | | | | | | | (0.5 | ) |
| Depreciation | | | 2.7 | | | 4.3 | | | 8.6 | |
| Amortization | | | 1.5 | | | 1.5 | | | 1.4 | |
| Total operating expenses | | | 56.3 | | | 59.9 | | | 71.0 | |
| Income (loss) from operations | | | 3.2 | | | (3.3 | ) | | (15.5 | ) |
| | | | | | | | | | | |
| Interest income | | | 0.3 | | | 0.1 | | | 0.2 | |
| Interest expense | | | (0.3 | ) | | | | | (0.1 | ) |
| Other expense, net | | | | | | | | | (0.1 | ) |
| Income (loss) before income taxes | | | 3.2 | % | | (3.2 | )% | | (15.5 | )% |
Segment Review
We have two reporting segments: the Consumer and Small Business Unit (CSBU) and the Organizational Solutions Business Unit (OSBU). The following is a brief description of these segments and their primary operating activities.
Consumer and Small Business Unit - This business unit is primarily focused on sales to individual customers and small business organizations and includes the results of the Company’s retail stores, catalog and eCommerce operations, wholesale, and other related distribution channels, including government sales, and office superstores. The CSBU results of operations also include the financial results of our paper planner manufacturing operations. Although CSBU sales primarily consist of products such as planners, binders, software, and handheld electronic planning devices, virtually any component of the Company’s leadership and productivity solutions can be purchased through CSBU channels. During fiscal 2005, we began an initiative to increase both training and product sales to small businesses through our CSBU channels with the addition of a small business sales force and other initiatives designed especially for small business clients.
Organizational Solutions Business Unit - The OSBU is primarily responsible for the development, marketing, sale, and delivery of productivity, leadership, strategic execution, goal alignment, sales performance, and effective communication training solutions directly to organizational clients, including other companies, the government, and educational institutions. The OSBU includes the financial results of our domestic sales force as well as our international operations. Our international operations include the financial results of our directly-owned foreign offices and royalty revenues from licensees.
The following table sets forth segment sales data for the years indicated. For further information regarding our reporting segments and geographic information, refer to Note 18 to our consolidated financial statements (in thousands).
YEAR ENDED AUGUST 31, | | 2005 | | 2004 | | 2003 | |
Consumer and Small Business Unit: | | | | | | | |
Retail stores | | $ | 74,331 | | $ | 87,922 | | $ | 112,054 | |
Consumer direct | | | 55,575 | | | 55,059 | | | 56,177 | |
Wholesale | | | 19,691 | | | 21,081 | | | 16,915 | |
Other CSBU | | | 3,757 | | | 2,007 | | | 7,020 | |
| | | | 153,354 | | | 166,069 | | | 192,166 | |
Organizational Solutions Business Unit: | | | | | | | | | | |
Domestic | | | 76,114 | | | 61,047 | | | 74,306 | |
International | | | 54,074 | | | 48,318 | | | 40,688 | |
| | | | 130,188 | | | 109,365 | | | 114,994 | |
| Total net sales | | $ | 283,542 | | $ | 275,434 | | $ | 307,160 | |
Product Sales - Our overall product sales, which primarily consist of planners, binders, software, handheld electronic planning devices, and publishing, which are primarily sold through our CSBU channels, declined $10.0 million, or six percent, compared to fiscal 2004. The decline in product sales was primarily due to decreased sales in our retail and wholesale delivery channels, with the majority of the decline in product sales occurring in our first quarter of fiscal 2005. The following is a description of sales performance in our CSBU delivery channels during the fiscal year ended August 31, 2005:
| l | Retail Sales - The decline in retail sales was due to the impact of fewer stores, which represented $10.7 million of the total $13.6 million decline, and reduced technology and specialty product sales which totaled $5.5 million. During fiscal 2004, we closed 18 retail store locations and we closed 30 additional stores during fiscal 2005. At August 31, 2005, we were operating 105 retail stores compared to 135 stores at August 31, 2004. Overall product sales trends were reflected in a four percent decline in year-over-year comparable store (stores which were open during the comparable periods) sales. Declining technology and specialty product sales were partially offset by increased “core” product (e.g. planners, binders, and totes) sales during fiscal 2005. |
| l | Consumer Direct - Sales through our consumer direct channels (catalog and eCommerce) were generally consistent with the prior year and the slight increase was primarily due to increased core product sales compared to the prior year. |
| l | Wholesale Sales - Sales through our wholesale channel, which includes sales to office superstores and other retail chains, decreased primarily due to a shift from contract stationer revenue channels to royalty based retail channels. As a result of this change our sales decreased, but our gross margin contribution through this channel remained consistent with the prior year. |
| l | Other CSBU Sales - Other CSBU sales primarily consist of domestic printing and publishing sales and building sublease revenues. The increase in other CSBU sales was primarily attributable to increased sublease income. We have subleased a substantial portion of our corporate headquarters in Salt Lake City, Utah and have recognized $1.1 million of sublease revenue during fiscal 2005, compared to $0.2 million in fiscal 2004, which has been classified as other CSBU sales. |
Training and Consulting Services Sales - We offer a variety of training solutions, training related products, and consulting services focused on productivity, leadership, strategy execution, sales force performance, and effective communications training programs that are provided both domestically and internationally through the Organizational Solutions Business Unit (OSBU). Our overall training and consulting service sales increased by $18.1 million, or 18 percent, compared to the same period of the prior year. The improvement in training sales was reflected in both domestic and international training program and consulting sales. Our domestic sales performance improved in nearly all sales regions and was primarily attributable to increased client facilitated sales of the enhanced The 7 Habits of Highly Effective People training course, increased sales performance group sales, and improved sales of our The 4 Disciplines of Leadership and xQ offerings.
International sales improved by $5.8 million, or 12 percent primarily due to increased sales in Japan, Mexico, Brazil, the United Kingdom, increased licensee royalty revenues, and the translation of foreign sales amounts as foreign currencies strengthened against the United States dollar during much of fiscal 2005. The favorable impact of currency translation on reported international revenues totaled $1.7 million for the fiscal year ended August 31, 2005. These increases were partially offset by decreased sales performance at our Canadian operations.
Gross Margin
Gross margin consists of sales less cost of sales. Our cost of sales includes materials used in the production of planners and related products, assembly and manufacturing labor costs, direct costs of conducting seminars, freight, and certain other overhead costs. Gross margin may be affected by, among other things, prices of materials, labor rates, product sales mix, changes in product discount levels, production efficiency, and freight costs.
We record the costs associated with operating our retail stores, call center, and Internet site as part of consolidated selling, general, and administrative expenses. Therefore, our consolidated gross margin may not be comparable with the gross margin of other retailers that include similar costs in their cost of sales.
Our overall gross margin improved to 59.5 percent of sales, compared to 56.6 percent in fiscal 2004. This overall gross margin improvement is consistent with quarterly gross margin trends during fiscal 2005 and was primarily due to increased training and consulting sales as a percent of total sales, favorable product mix changes, lower product costs, and improved margins on our training and consulting service sales. Training and consulting service sales, which typically have higher gross margins than our product sales, increased to 41 percent of total sales during fiscal 2005 compared to 36 percent in the prior year.
Our gross margin on product sales improved to 53.9 percent compared to 51.6 percent in fiscal 2004. The improvement was primarily due to a favorable shift in our product mix as sales of higher-margin paper products and binders increased as a percent of total sales, while sales of lower-margin technology and specialty products continued to decline. Additionally, the overall margin on paper and binder sales has improved through focused cost reduction efforts, and improved inventory management.
Training and related consulting services gross margin, as a percent of sales for these services, improved to 67.5 percent compared to 65.6 percent in fiscal 2004. The improvement in our training and consulting services gross margin was primarily due to a continued shift in training sales mix toward higher-margin courses and offerings, reduced costs for training materials, such as participant manuals and related items, and overall lower costs associated with training sales.
Operating Expenses
Selling, General, and Administrative - Our selling, general, and administrative (SG&A) expenses decreased $0.6 million and improved as a percent of sales to 52.3 percent, compared to 54.1 percent in fiscal 2004. Declining SG&A expenses were the direct result of initiatives specifically designed to reduce our overall operating costs and is consistent with operating expense trends during the previous two fiscal years. Our cost-reduction efforts have included retail store closures, headcount reductions, consolidation of corporate office space, and other measures designed to focus our resources on critical activities and projects. These efforts were partially offset by increased commission expenses related to increased training sales, severance costs associated with a former executive officer, expenses related to the cancellation of the CEO's compensation agreement, additional costs associated with the preferred stock recapitalization, investments in new products, and costs of hiring new sales force personnel. The primary effects of our cost-cutting initiatives were reflected in reduced rent and utilities expenses of $3.2 million and reductions in other SG&A expenses, such as outsourcing and development costs, that totaled $1.4 million compared to the prior year. We also reduced our store closure costs by $1.3 million (refer to discussion below) as many of the leases on stores that were closed expired during fiscal 2005 and did not require additional costs to exit the leases. These improvements were partially offset by $2.7 million of increased associate costs and $1.7 million of additional advertising and promotion spending.
We regularly assess the operating performance of our retail stores, including previous operating performance trends and projected future profitability. During this assessment process, judgments are made as to whether under-performing or unprofitable stores should be closed. As a result of this evaluation process, we closed 30 stores during fiscal 2005. The costs associated with closing retail stores are typically comprised of charges related to vacating the premises, which may include a provision for the remaining term on the lease, and severance and other personnel costs. These store closure costs totaled $1.0 million during fiscal 2005 and were included as a component of our SG&A expense. Based upon our continuing analyses of retail store performance, we may close additional retail stores and may continue to incur costs associated with closing these stores in future periods.
During fiscal 1999, our Board of Directors approved a plan to restructure our operations, which included an initiative to formally exit leased office space located in Provo, Utah. During fiscal 2005, we exercised an option, available under our master lease agreement, to purchase, and simultaneously sell, the office facility to the current tenant. The negotiated purchase price with the landlord was $14.0 million and the tenant agreed to purchase the property for $12.5 million. These prices were within the range of estimated fair values of the buildings as determined by an independent appraisal obtained by the Company. We paid the difference between the sale and purchase prices, plus other closing costs, which were included as a component of the restructuring plan accrual. After completion of the sale transaction, the remaining fiscal 1999 restructuring costs, which totaled $0.3 million, were credited to SG&A expense in our consolidated statement of operations.
Gain on Disposal of Investment in Unconsolidated Subsidiary - During fiscal 2003, we purchased approximately 20 percent of the capital stock (subsequently diluted to approximately 12 percent ownership) of Agilix Labs, Inc. (Agilix), for cash payments totaling $1.0 million. Agilix is a development stage enterprise that develops software applications, including the majority of our software applications that are available for sale to external customers. Although we continue to sell software developed by Agilix, uncertainties in Agilix’s business plan developed during our fiscal quarter ended March 1, 2003 and their potential adverse effects on Agilix’s operations and future cash flows were significant. As a result of this assessment, we determined that our ability to recover the investment in Agilix was remote. Accordingly, we impaired and expensed our remaining investment in Agilix of $0.9 million during the quarter ended March 1, 2003. During the quarter ended May 28, 2005, certain affiliates of Agilix purchased the shares of capital stock held by us for $0.5 million in cash, which was reported as a gain on disposal of an investment in unconsolidated subsidiary.
Depreciation and Amortization - Depreciation expense decreased $4.0 million, or 34 percent, compared to fiscal 2004 primarily due to the full depreciation or disposal of certain property and equipment balances, primarily computer software and hardware, and the effects of significantly reduced capital expenditures during preceding fiscal years. Based upon these events and current capital spending trends, we expect that depreciation expense will continue to decline compared to prior periods.
Amortization expense on definite-lived intangible assets totaled $4.2 million for the fiscal years ended August 31, 2005 and 2004. We expect intangible asset amortization expense to total $3.8 million in fiscal 2006 as certain intangible assets become fully amortized in fiscal 2006.
Interest Income and Interest Expense
Interest Income - Our interest income increased $0.5 million compared to fiscal 2004 primarily due to increased cash balances and higher interest rates on our interest-bearing cash accounts.
Interest Expense - Our interest expense increased $0.6 million primarily due to the sale of our corporate headquarters facility and the resulting interest component of our lease payments to the landlord. We are accounting for the lease on the corporate facility as a financing obligation, which is accounted for similar to long-term debt.
Income Taxes
The income tax benefit for fiscal 2005 resulted primarily from reversal of accruals related to the resolution of certain tax matters. This tax benefit was partially offset by taxes payable by foreign affiliates and taxes withheld on royalties from foreign licensees. The income tax provision for fiscal 2004 was primarily attributable to taxes payable by foreign affiliates and taxes withheld on royalties from foreign licensees. These foreign taxes were partially offset by the reversal of accruals related to the resolution of certain tax matters.
As of August 31, 2005 and 2004, given our recent history of significant operating losses, we had provided a valuation allowance against the majority of our deferred income tax assets. As of August 31, 2005 and 2004, we had net deferred tax liabilities of $6.9 million and $7.3 million, respectively. Our foreign deferred tax assets of $0.9 million and $0.8 million at August 31, 2005 and 2004 primarily relate to our operations in Japan. The net domestic deferred tax liability of $7.8 million at August 31, 2005 and the restated $8.1 million deferred liability at August 31, 2004 primarily relate to the step-up of indefinite-lived intangibles. For further information concerning deferred tax items, including the restatement of prior period deferred tax liabilities, refer to Notes 2 and 16 to our consolidated financial statements.
Loss on Recapitalization of Preferred Stock
We completed our preferred stock recapitalization during the quarter ended May 28, 2005. Due to the significant modifications to our preferred stock, we determined that previously outstanding preferred stock was replaced with new classes of preferred stock and common stock warrants. As a result, the new preferred stock was recorded at its fair value on the date of modification, which was determined to be equal to the liquidation preference of $25 per share. The difference between the aggregate fair value of the consideration given (the new Series A preferred stock and the common stock warrants) and the carrying value of the previously existing Series A preferred stock, which totaled $7.8 million, was reported as a loss on recapitalization of preferred stock, which decreased net income attributable to common shareholders in the quarter ended May 28, 2005. Subsequent to May 28, 2005, we used $30.0 million of the proceeds from the June 2005 sale of our corporate headquarters facility to redeem shares of preferred stock under terms of the recapitalization plan.
Subsequent to August 31, 2005, we redeemed an additional $10.0 million of preferred stock and announced that we intend to seek shareholder approval to amend our articles of incorporation to extend the period during which we have the right to redeem the outstanding preferred stock at 100 percent of the liquidation preference. The amendment would extend the current redemption deadline from March 8, 2006 to December 31, 2006 and would also provide the right to extend the redemption period for an additional year to December 31, 2007, if another $10.0 million of preferred stock is redeemed before December 31, 2006.
Sales
Product Sales - Our product sales, which are primarily delivered through our CSBU channels, declined $25.0 million, or 12 percent, compared to the prior year. The decline in product sales compared to fiscal 2003 was primarily attributable to the following sales performance at our various CSBU channels.
Retail sales decreased $24.1 million, or 22 percent, compared to fiscal 2003. The decline in retail sales was primarily attributable to the following:
| l | $14.3 million of the retail sales decrease is the result of the closure of retail stores. The Company closed 18 stores in fiscal 2004 in addition to 22 domestic and 10 international stores that were closed in fiscal 2003. These store closures were primarily comprised of unprofitable stores and stores located in markets where we had multiple retail operations. |
| $8.4 million of the retail store decrease was the result of declining comparable store technology sales, which include handheld electronic devices, or PDAs, and related products. Comparable stores are retail locations which have been open for the full year in the periods reported. Technology sales decreased as competition increased from office product superstores and discounters. Sales of core products remained relatively flat, decreasing less than one percent compared to fiscal 2003. |
At August 31, 2004, we were operating 135 retail stores compared to 153 stores at August 31, 2003.
Consumer direct (includes catalog and eCommerce operations) sales decreased $1.1 million, or two percent, compared with fiscal 2003. The primary factors affecting consumer direct sales were as follows:
| Technology sales, including handheld electronic devices and PDAs, through this channel decreased $1.5 million. |
| The total number of orders placed through the consumer direct channel decreased five percent from the prior year. |
During 2004, our wholesale sales increased $4.2 million, or 25 percent, as we expanded our product offerings in office superstores and discount stores. Offsetting this increase were decreased other CSBU sales, which are comprised primarily of government product and external printing sales, and declined by $5.0 million compared to the prior year. During fiscal 2004, we outsourced the sale and distribution of our products through government channels to a well-established office products distributor. Accordingly, we now only recognize royalty income from the distributor rather than the net sale and corresponding costs related to those sales.
Training and Consulting Services Sales - Our overall training and consulting service sales declined $6.7 million, or six percent, compared to the prior year. Decreased training sales were primarily due to decreased domestic training sales which experienced a slow start in fiscal 2004. Of the $13.3 million decline in domestic training sales, $10.0 million occurred during the first two quarters of fiscal 2004 and was primarily attributable to decreased client-facilitated leadership programs. Decreased leadership training was partially offset by increased productivity training and sales from our new program, The 4 Disciplines of Execution and related xQ sales. However, our training and consulting business improved significantly during late fiscal 2004, especially in the fourth quarter.
International sales, which represented 44 percent of our OSBU segment sales in fiscal 2004, increased by $7.6 million, or 19 percent compared to the prior year. International sales growth was led by our two largest international offices, located in Japan and the United Kingdom, which experienced growth rates of 25 percent and 23 percent during fiscal 2004. Currency conversion also favorably impacted international results through translation of foreign sales to U.S. dollars. Excluding the impact of foreign currency exchange fluctuations, international sales grew 10 percent compared to fiscal 2003.
Gross Margin
For fiscal 2004, our overall gross margin improved to 56.6 percent of sales compared to 55.5 percent in fiscal 2003. The improvement in our overall gross margin was primarily due to increased margins from product sales and an increase in training and service sales as a percent of total sales. Increased gross margin on product sales was primarily due to a favorable shift in our product mix away from technology and specialty products to higher-margin paper and binder products. Paper product sales, including forms and tabs, combined with binder product sales, increased as a percentage of total sales to 61 percent in fiscal 2004 compared to 58 percent in fiscal 2003. Our gross margins on paper and binder products also increased as a result of specific cost reduction initiatives.
Training solution and related services gross margin, as a percent of sales, decreased to 65.6 percent compared to 67.2 percent the prior year. The decline in our training gross margin during the year was primarily due to the delivery of certain higher-cost programs that are part of a longer-term marketing strategy. These activities include: custom programs for certain strategic clients, multiple domestic symposium events, and a series of international events that also had lower gross margins than our other training programs. These factors were partially offset by ongoing initiatives designed to reduce overall training program delivery costs that continue to have a favorable impact on our training and services gross margin.
Operating Expenses
Selling, General, and Administrative - Our selling, general, and administrative (SG&A) expenses for fiscal 2004 decreased $35.2 million, or 19 percent, compared to the prior year. Declining SG&A expenses were the direct result of initiatives specifically designed to reduce our overall operating costs and were consistent with SG&A expense trends during the previous two fiscal years. Our cost-reduction efforts have included retail store closures, headcount reductions, consolidation of corporate office space, and other measures designed to focus our resources on critical activities and projects. The primary effects of these cost-cutting initiatives were reflected in associate expense reductions totaling $18.1 million, advertising and promotional expense reductions totaling $7.7 million, reduced rent and utilities charges totaling $5.1 million, and reductions in other SG&A expenses, such as outsourcing and development costs, that totaled $5.1 million compared to the prior year. Partially offsetting these cost reduction efforts were $2.3 million of additional expenses related to retail store closures, as discussed below.
We regularly assess the operating performance of our retail stores, which includes assessment of previous operating performance trends and projected future profitability. As a result of this evaluation process, we decided to close certain stores during fiscal 2004 and fiscal 2003. During fiscal 2004, we closed 18 retail stores and incurred additional expenses related to certain store closures that occurred during fiscal 2003. These store closure costs totaled $2.3 million during fiscal 2004 and were reported as a component of our SG&A expense.
Provision for Losses on Management Common Stock Program - Prior to May 2004, we utilized a systematic methodology for determining the level of loan loss reserves that were appropriate for the management common stock loan program. Based upon this systematic methodology, we recorded a $3.9 million increase to the loan loss reserve during fiscal 2003.
As a result of modifications to the terms of the management stock loans that were approved in May 2004 and their effects on the Company and loan participants (refer to Note 11 to our consolidated financial statements for further information), we determined that the management common stock loans should be accounted for as non-recourse stock compensation instruments. While this accounting treatment does not alter the legal rights associated with the loans to the participants, the modifications to the terms of the loans were deemed significant enough to adopt the non-recourse accounting model. As a result of this accounting treatment, the remaining carrying value of the notes and interest receivable related to financing common stock purchases by related parties, which totaled $7.6 million prior to the accounting change, was reduced to zero with a corresponding reduction in additional paid-in capital.
We currently account for the non-recourse stock loans as variable stock option instruments. Under the provisions of SFAS No. 123R, which we will adopt on September 1, 2005, additional compensation expense will only be recognized on the loans if the Company takes action on the loans that in effect constitutes a modification of an option. Although we do not anticipate significant further compensation expense related to the management stock loans, this accounting treatment precludes us from recovering the amounts expensed as additions to the loan loss reserve, totaling $29.7 million, which were recognized in prior periods.
The inability of the Company to collect all, or a portion, of these management stock loan receivables could have an adverse impact upon our financial position and future cash flows compared to full collection of the loans.
Depreciation and Amortization - Depreciation expense decreased $14.6 million, or 55 percent, compared to fiscal 2003 primarily due to the full depreciation or disposal of certain computer hardware and software assets, the prior year impairment of retail store assets, which totaled $5.0 million, and the effects of significantly reduced capital expenditures during preceding fiscal years.
Amortization expense on definite-lived intangible assets totaled $4.2 million during fiscal 2004 compared to $4.4 million in the prior year. The reduction in our amortization expense was due to the full amortization of certain definite-lived intangible assets.
Income Taxes
The income tax provision for fiscal 2004 was primarily attributable to taxes payable by foreign affiliates and taxes withheld on royalties from foreign licensees. These foreign taxes were partially offset by the reversal of accruals related to the resolution of certain tax matters. The income tax benefit for fiscal 2003 was primarily attributable to reversal of accruals related to the resolution of certain tax matters and a foreign income tax benefit related to our Japan operations.
The following tables set forth selected unaudited quarterly consolidated financial data for fiscal 2005 and fiscal 2004. The quarterly consolidated financial data reflects, in the opinion of management, all adjustments necessary to fairly present the results of operations for such periods. Results of any one or more quarters are not necessarily indicative of continuing trends.
Quarterly Financial Information:
| YEAR ENDED AUGUST 31, 2005 | | | | | | | | | |
| | | November 27 | | February 26 | | May 28 | | August 31 | |
In thousands, except per share amounts | | | | | | | | | | | | | |
| | | | | | | | | | | | | | |
| Net sales | | $ | 69,104 | | $ | 82,523 | | $ | 65,788 | | $ | 66,128 | |
| Gross margin | | | 41,435 | | | 50,217 | | | 38,268 | | | 38,775 | |
| Selling, general, and administrative expense | | | 35,930 | | | 38,939 | | | 36,095 | | | 37,341 | |
| Depreciation | | | 2,178 | | | 2,320 | | | 1,848 | | | 1,428 | |
| Amortization | | | 1,043 | | | 1,043 | | | 1,043 | | | 1,044 | |
| Income (loss) from operations | | | 2,284 | | | 7,915 | | | (218 | ) | | (1,038 | ) |
| Income (loss) before income taxes | | | 2,364 | | | 8,051 | | | 63 | | | (1,377 | ) |
| Net income (loss) | | | 1,526 | | | 7,086 | | | 3,069 | | | (1,495 | ) |
| Preferred stock dividends | | | (2,184 | ) | | (2,184 | ) | | (2,184 | ) | | (1,718 | ) |
| Loss on recapitalization of preferred stock | | | - | | | - | | | (7,753 | ) | | - | |
| Income (loss) attributable to common shareholders | | | (658 | ) | | 4,902 | | | (6,868 | ) | | (3,213 | ) |
| | | | | | | | | | | | | | |
| Basic and diluted income (loss) per share attributable to common shareholders | | $ | (.03 | ) | $ | .19 | | $ | (.34 | ) | $ | (.16 | ) |
| | | | | | | | | | | | | | |
| | | | | | | | | | | | | | |
| YEAR ENDED AUGUST 31, 2004 | | | | | | | | | | | | | |
| | | | November 29 | | | February 28 | | | May 29 | | | August 31 | |
In thousands, except per share amounts | | | | | | | | | | | | | |
| | | | | | | | | | | | | | |
| Net sales | | $ | 75,031 | | $ | 78,715 | | $ | 61,248 | | $ | 60,440 | |
| Gross margin | | | 42,755 | | | 44,784 | | | 32,767 | | | 35,495 | |
| Selling, general, and administrative expense | | | 40,245 | | | 39,569 | | | 35,234 | | | 33,870 | |
| Depreciation | | | 3,591 | | | 3,222 | | | 2,509 | | | 2,452 | |
| Amortization | | | 1,043 | | | 1,043 | | | 1,043 | | | 1,044 | |
| Income (loss) from operations | | | (2,124 | ) | | 950 | | | (6,019 | ) | | (1,871 | ) |
| Income (loss) before income taxes | | | (2,150 | ) | | 1,035 | | | (5,961 | ) | | (1,725 | ) |
| Net income (loss) | | | (3,180 | ) | | 232 | | | (5,149 | ) | | (2,053 | ) |
| Preferred stock dividends | | | (2,184 | ) | | (2,184 | ) | | (2,184 | ) | | (2,183 | ) |
| Loss attributable to common shareholders | | | (5,364 | ) | | (1,952 | ) | | (7,333 | ) | | (4,236 | ) |
| | | | | | | | | | | | | | |
| Basic and diluted loss per share attributable to common shareholders | | $ | (.27 | ) | $ | (.10 | ) | $ | (.37 | ) | $ | (.21 | ) |
| | | | | | | | | | | | | | |
Our quarterly results of operations reflect seasonal trends that are primarily the result of customers who renew their FranklinCovey Planners on a calendar year basis. Domestic training sales are moderately seasonal because of the timing of corporate training, which is not typically scheduled as heavily during holiday and vacation periods.
During the fourth quarter of fiscal 2005, we reclassified certain overhead costs that were included in cost of sales to selling, general, and administrative expense. The quarterly information included above was adjusted to reflect the quarterly impact of this reclassification. Amounts reclassified from cost of sales to selling, general, administrative expense consisted of the following (in thousands):
QUARTER ENDED | | Fiscal 2005 | | Fiscal 2004 | |
| | | | | | | | |
| November | | $ | 276 | | $ | 229 | |
| February | | | 152 | | | 159 | |
| May | | | 148 | | | 106 | |
| August | | | 145 | | | 167 | |
Total reclassified | | $ | 721 | | $ | 661 | |
During the fourth quarter of fiscal 2004, we recorded an adjustment to properly record shares of Company stock held by our non-qualified deferred compensation plan. This correction resulted in a $0.6 million favorable adjustment to our SG&A expense during the fourth quarter of our fiscal year ended August 31, 2004.
Quarterly fluctuations may also be affected by other factors including the introduction of new products or training seminars, the addition of new institutional customers, the timing of large corporate orders, the elimination of unprofitable products or training services, and the closure of retail stores.
Historically, our primary sources of capital have been net cash provided by operating activities, line-of-credit financing, long-term borrowings, asset sales, and the issuance of preferred and common stock. We currently rely primarily upon cash flows from operating activities and cash on hand to maintain adequate liquidity and working capital levels. At August 31, 2005 we had $51.7 million of cash, cash equivalents, and short-term investments compared to $41.9 million at August 31, 2004. Our net working capital (current assets less current liabilities) increased to $49.9 million at August 31, 2005 compared to $36.0 million at August 31, 2004.
During fiscal 2005, we completed the sale of our corporate headquarters located in Salt Lake City, Utah and received net proceeds totaling $32.4 million. We used a portion of the proceeds from the sale of the campus to redeem $30.0 million of preferred stock, and we anticipate that additional redemptions in future periods will occur if our cash flows from operating activities continue to improve. However, in connection with the sale of our corporate campus we incurred a long-term financing obligation for the purchase price. The annual payments on the financing obligation are approximately $3.0 million per year for the first five years with two percent annual increases thereafter.
The following discussion is a description of the primary factors affecting our cash flows and their effects upon our liquidity and capital resources during the fiscal year ended August 31, 2005.
Cash Flows from Operating Activities
During fiscal 2005 our net cash provided by operating activities improved to $22.3 million compared to $12.1 million in fiscal 2004. Our primary source of cash from operating activities was the sale of goods and services to our customers in the normal course of business. The primary uses of cash for operating activities were payments to suppliers for materials used in products sold, payments for direct costs necessary to conduct training programs, and payments for selling, general, and administrative expenses. Our cash flows from operating activities were favorably affected by increased sales compared to fiscal 2004 and we recognized cash flow improvements from operating activities through reduced cash payments for costs and expenses related to generating these revenues, which was reflected by improved gross margins and income from operations. We also received $1.7 million in cash from a legal settlement rendered in our favor.
During fiscal 2005, our primary uses of cash for operating activities were related to increased accounts receivable that was primarily due to increased sales in our OSBU during the fourth quarter of fiscal 2005 and payment of income taxes on international royalty revenue and on the sale of our corporate headquarters. Partially offsetting these uses of cash were improved cash flows from reduced inventory balances. In addition to the impact of closed stores, we have actively sought to improve our inventory levels through better management of on-hand inventories, especially for electronic devices. We believe that efforts to optimize working capital balances combined with existing and planned efforts to increase sales, including sales of new products and services, and cost-cutting initiatives, will improve our cash flows from operating activities in future periods. However, the success of these efforts is dependent upon numerous factors, many of which are not within our control.
Cash Flows from Investing Activities and Capital Expenditures
Net cash provided by investing activities totaled $4.9 million for the fiscal year ended August 31, 2005. Our primary sources of investing cash were the sale of $21.4 million of short-term investments and $0.5 million of proceeds received from the sale of our investment in an unconsolidated subsidiary. These cash inflows were partially offset by purchases of short-term marketable securities totaling $10.7 million and the purchase of $4.2 million of property and equipment, which consisted primarily of tenant improvements on subleased areas of our corporate campus, computer hardware, software, and leasehold improvements in certain of our retail stores. During fiscal 2005, we also invested $2.2 million in curriculum development, primarily related to our refreshed The 7 Habits of Highly Effective People training course.
Cash Flows from Financing Activities
Net cash used for financing activities during fiscal 2005 totaled $6.0 million. As mentioned above, we completed the sale of our corporate campus in Salt Lake City, Utah during the fourth quarter of fiscal 2005 and received net proceeds totaling $32.4 million. The proceeds from the sale of our corporate campus was a financing activity. As a result of this transaction we will use cash in future periods to repay the financing obligation through our monthly lease payment (refer to the discussion under “Contractual Obligations” below). We used a portion of the proceeds from the sale of the corporate campus to redeem $30.0 million of preferred stock at its liquidation preference under the terms of our recapitalization agreement. This redemption will reduce our ongoing cash outflows for preferred dividends by $3.0 million per year. During fiscal 2005, we paid $9.0 million for preferred dividends, which included accrued dividends on the 1.2 million shares of preferred stock that were redeemed. We anticipate making additional preferred stock redemptions under the terms of our recapitalization plan if our cash flows from operating activities continue to improve.
Contractual Obligations
The Company has not structured any special purpose or variable interest entities, or participated in any commodity trading activities, which would expose us to potential undisclosed liabilities or create adverse consequences to our liquidity. Required contractual payments primarily consist of payments to EDS for outsourcing services related to information systems, warehousing and distribution, and call center operations; payments on the financing obligation resulting from the sale of our corporate campus; minimum rent payments for retail store and sales office space; cash payments for Series A preferred stock dividends; mortgage payments on certain buildings and property; and monitoring fees paid to a Series A preferred stock investor. Our expected payments on these obligations over the next five fiscal years and thereafter are as follows (in thousands):
| | | Fiscal | | Fiscal | | Fiscal | | Fiscal | | Fiscal | | | | | |
| Contractual Obligations | | 2006 | | 2007 | | 2008 | | 2009 | | 2010 | | Thereafter | | Total | |
| | | | | | | | | | | | | | | | | | | | | | | |
| Minimum required payments to EDS for outsourcing services | | $ | 23,918 | | $ | 22,591 | | $ | 22,829 | | $ | 23,076 | | $ | 23,330 | | $ | 141,467 | | $ | 257,211 | |
| Required payments on corporate campus financing obligation | | | 3,045 | | | 3,045 | | | 3,045 | | | 3,045 | | | 3,055 | | | 53,072 | | | 68,307 | |
| Minimum operating lease payments | | | 8,509 | | | 6,204 | | | 5,346 | | | 4,225 | | | 3,148 | | | 7,718 | | | 35,150 | |
Preferred stock dividend payments(2) | | | 4,930 | | | 4,734 | | | 4,734 | | | 4,734 | | | 4,734 | | | - | | | 23,866 | |
Debt payments(1) | | | 866 | | | 160 | | | 155 | | | 148 | | | 143 | | | 554 | | | 2,026 | |
Contractual computer hardware and software purchases(3) | | | 1,334 | | | 680 | | | 797 | | | 1,072 | | | 1,334 | | | 6,059 | | | 11,276 | |
Monitoring fees paid to a preferred stock investor(2) | | | 219 | | | 210 | | | 210 | | | 210 | | | 210 | | | - | | | 1,059 | |
| Total expected contractual obligation payments | | $ | 42,821 | | $ | 37,624 | | $ | 37,116 | | $ | 36,510 | | $ | 35,954 | | $ | 208,870 | | $ | 398,895 | |
| (1) | The Company’s variable rate debt payments include interest payments at 5.5%, which was the applicable interest rate at September 30, 2005. |
| (2) | Amount reflects the $10.0 million preferred stock redemption that occurred subsequent to August 31, 2005 and will decline if we determine to make future redemptions of our preferred stock. |
| (3) | We are contractually obligated by our EDS outsourcing agreement to purchase the necessary computer hardware and software to keep such equipment up to current specifications. Amounts shown are estimated capital purchases of computer hardware and software under terms of the EDS outsourcing agreement and its amendments. |
Other Items
The Company is the creditor for a loan program that provided the capital to allow certain management personnel the opportunity to purchase shares of our common stock. For further information regarding our management common stock loan program, refer to Note 11 in our consolidated financial statements. The inability of the Company to collect all, or a portion, of these receivables could have an adverse impact upon our financial position and future cash flows compared to full collection of the loans.
Going forward, we will continue to incur costs necessary for the operation and potential growth of the business. We anticipate using cash on hand, cash provided by operating activities on the condition that we can continue to improve our cash flows generated from operating activities, and other financing alternatives, if necessary, for these expenditures. We anticipate that our existing capital resources should be adequate to enable us to maintain our operations for at least the upcoming twelve months. However, our ability to maintain adequate capital for our operations in the future is dependent upon a number of factors, including sales trends, our ability to contain costs, levels of capital expenditures, collection of accounts receivable, and other factors. Some of the factors that influence our operations are not within our control, such as economic conditions and the introduction of new technology and products by our competitors. We will continue to monitor our liquidity position and may pursue additional financing alternatives, if required, to maintain sufficient resources for future growth and capital requirements. However, there can be no assurance such financing alternatives will be available to us on acceptable terms.
Our consolidated financial statements were prepared in accordance with accounting principles generally accepted in the United States of America. The significant accounting polices that we used to prepare our consolidated financial statements are outlined in Note 1 to the consolidated financial statements, which are presented in Part II, Item 8 of this Annual Report on Form 10-K. Some of those accounting policies require us to make estimates and assumptions that affect the amounts reported in our consolidated financial statements. Management regularly evaluates its estimates and assumptions and bases those estimates and assumptions on historical experience, factors that are believed to be reasonable under the circumstances, and requirements under accounting principles generally accepted in the United States of America. Actual results may differ from these estimates under different assumptions or conditions, including changes in economic conditions and other circumstances that are not in our control, but which may have an impact on these estimates and our actual financial results.
The following items require the most significant judgment and often involve complex estimates:
Revenue Recognition
We derive revenues primarily from the following sources:
| l | Products - We sell planners, binders, planner accessories, handheld electronic devices, and other related products that are primarily sold through our CSBU channels. |
| l | Training and Services - We provide training and consulting services to both organizations and individuals in strategic execution, leadership, productivity, goal alignment, sales force performance, and communication effectiveness skills. These training programs and services are primarily sold through our OSBU channels. |
The Company recognizes revenue when: 1) persuasive evidence of an agreement exists, 2) delivery of product has occurred or services have been rendered, 3) the price to the customer is fixed and determinable, and 4) collectibility is reasonably assured. For product sales, these conditions are generally met upon shipment of the product to the customer or by completion of the sale transaction in a retail store. For training and service sales, these conditions are generally met upon presentation of the training seminar or delivery of the consulting services.
Some of our training and consulting contracts contain multiple deliverable elements that include training along with other products and services. In accordance with Emerging Issues Task Force (EITF) Issue No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables, sales arrangements with multiple deliverables are divided into separate units of accounting if the deliverables in the sales contract meet the following criteria: 1) the delivered training or product has value to the client on a standalone basis; 2) there is objective and reliable evidence of the fair value of undelivered items; and 3) delivery of any undelivered item is probable. The overall contract consideration is allocated among the separate units of accounting based upon their fair values, with the amount allocated to the delivered item being limited to the amount that is not contingent upon the delivery of additional items or meeting other specified performance conditions. If the fair value of all undelivered elements exits, but fair value does not exist for one or more delivered elements, the residual method is used. Under the residual method, the amount of consideration allocated to the delivered items equals the total contract consideration less the aggregate fair value of the undelivered items. Fair value of the undelivered items is based upon the normal pricing practices for the Company’s existing training programs, consulting services, and other products, which are generally the prices of the items when sold separately.
Revenue is recognized on software sales in accordance with Statement of Position (SOP) 97-2, Software Revenue Recognition as amended by SOP 98-09. SOP 97-2, as amended, generally requires revenue earned on software arrangements involving multiple elements such as software products and support to be allocated to each element based on the relative fair value of the elements based on vendor specific objective evidence (VSOE). The majority of the Company’s software sales have elements, including a license and post contract customer support (PCS). Currently the Company does not have VSOE for either the license or support elements of its software sales. Accordingly, revenue is deferred until the only undelivered element is PCS and the total arrangement fee is recognized ratably over the support period.
Revenue is recognized as the net amount to be received after deducting estimated amounts for discounts and product returns.
Accounts Receivable Valuation
Trade accounts receivable are recorded at the invoiced amount and do not bear interest. The allowance for doubtful accounts represents our best estimate of the amount of probable credit losses in the existing accounts receivable balance. We determine the allowance for doubtful accounts based upon historical write-off experience and current economic conditions and we review the adequacy of our allowance for doubtful accounts on a regular basis. Receivable balances past due over 90 days, which exceed a specified dollar amount, are reviewed individually for collectibility. Account balances are charged off against the allowance after all means of collection have been exhausted and the probability for recovery is considered remote. We do not have any off-balance sheet credit exposure related to our customers.
Inventory Valuation
Inventories are stated at the lower of cost or market with cost determined using the first-in, first-out method. Our inventories are comprised primarily of dated calendar products and other non-dated products such as binders, handheld electronic devices, stationery, training products, and other accessories. Provision is made to reduce excess and obsolete inventories to their estimated net realizable value. In assessing the realization of inventories, we make judgments regarding future demand requirements and compare these assessments with current and committed inventory levels. Inventory requirements may change based on projected customer demand, technological and product life cycle changes, longer or shorter than expected usage periods, and other factors that could affect the valuation of our inventories.
Indefinite-Lived Intangible Assets
Intangible assets that are deemed to have an indefinite life are not amortized, but rather are tested for impairment on an annual basis, or more often if events or circumstances indicate that a potential impairment exists. The Covey trade name intangible asset has been deemed to have an indefinite life. This intangible asset is assigned to the OSBU and is tested for impairment using the present value of estimated royalties on trade name related revenues, which consist primarily of training seminars, international licensee royalties, and related products. If forecasts and assumptions used to support the realizability of our indefinite-lived intangible asset change in the future, significant impairment charges could result that would adversely affect our results of operations and financial condition.
Impairment of Long-Lived Assets
Long-lived tangible assets and definite-lived intangible assets are reviewed for possible impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. We use an estimate of undiscounted future net cash flows of the assets over the remaining useful lives in determining whether the carrying value of the assets is recoverable. If the carrying values of the assets exceed the anticipated future cash flows of the assets, we recognize an impairment loss equal to the difference between the carrying values of the assets and their estimated fair values. Impairment of long-lived assets is assessed at the lowest levels for which there are identifiable cash flows that are independent from other groups of assets. The evaluation of long-lived assets requires us to use estimates of future cash flows. If forecasts and assumptions used to support the realizability of our long-lived tangible and definite-lived intangible assets change in the future, significant impairment charges could result that would adversely affect our results of operations and financial condition.
Income Taxes
The calculation of our income tax provision or benefit, as applicable, requires estimates of future taxable income or losses. During the course of the fiscal year, these estimates are compared to actual financial results and adjustments may be made to our tax provision or benefit to reflect these revised estimates.
Our history of significant operating losses precludes us from demonstrating that it is more likely than not that the related benefits from deferred income tax deductions and foreign tax carryforwards will be realized. Accordingly, we recorded valuation allowances on the majority of our deferred income tax assets. These valuation allowances are based on estimates of future taxable income or losses that may or may not be realized.
Equity-Based Payments - In December 2004, the Financial Accounting Standards Board (FASB) approved Statement No. 123 (Revised 2004), Share-Based Payment (SFAS No. 123R), which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation. Statement 123R supersedes Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows. Generally, this new statement follows the approach previously defined in SFAS No. 123. However, SFAS No. 123R requires all share based-payments to employees, including grants of stock options and the compensatory elements of employee stock purchase plans, to be recognized in the income statement based upon their fair values. Pro forma disclosure is no longer an alternative.
We previously accounted for our stock-based compensation using the intrinsic method as defined in APB Opinion No. 25 and accordingly, we have not recognized any expense for our stock option plans or employee stock purchase plan in our consolidated financial statements. Statement No. 123R is effective for interim or annual periods beginning after June 15, 2005, and will thus be effective for our first quarter of fiscal 2006. Upon adoption, we intend to use the modified prospective transition method. Under this method, awards that are granted, modified, or settled after the date of adoption will be measured and accounted for in accordance with Statement 123R. Based upon our analysis of the requirements of SFAS No. 123R, our employee stock purchase plan will become a compensatory plan in fiscal 2006. However, due to current participation levels in the employee stock purchase plan and remaining levels of unvested stock option compensation expense, we do not believe that the adoption SFAS No. 123R will have a material impact upon our results of operations until we grant additional stock option awards or until participation in our employee stock purchase plan significantly increases. However, the transition to SFAS No. 123R will require us to reclassify our unamortized deferred compensation reported in the equity section of our balance sheet to additional paid-in capital.
For further information regarding our share-based compensation, refer to Note 3 to our consolidated financial statements.
Inventory Costs - In November 2004, the FASB approved Statement No. 151, Inventory Costs an Amendment of ARB No. 43, Chapter 4. Statement No. 151 clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) and requires that those items be recognized as a current period expense regardless of whether they meet the criteria of “so abnormal.” This statement also requires that allocation of fixed production overheads to the costs of conversion be based upon the normal capacity of the production facilities. This statement is effective for interim or annual periods beginning after June 15, 2005 and will thus be effective for our first quarter of fiscal 2006. We do not believe that the new accounting requirements of SFAS No. 151 will have a material impact on our financial statements.
Nonmonetary Exchange Transactions - In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29. Statement No. 153 amends APB Opinion No. 29, which is based upon the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged, by eliminating the exception to fair value accounting for nonmonetary exchanges of similar productive assets and replacing it with a general exception to fair value accounting for nonmonetary exchanges that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. Statement No. 153 is effective for nonmonetary asset exchanges occurring in periods beginning after June 15, 2005. We do not believe that the requirements of this statement will have a material impact upon our financial statements.
The Company is registered in states in which we do business that have a sales tax and collects and remits sales or use tax on retail sales made through its stores and catalog sales. Compliance with environmental laws and regulations has not had a material effect on our operations.
Inflation has not had a material effect on our operations. However, future inflation may have an impact on the price of materials used in the production of planners and related products, including paper and leather materials. We may not be able to pass on such increased costs to our customers.
Certain written and oral statements made by the Company or our representatives in this report, other reports, filings with the Securities and Exchange Commission, press releases, conferences, Internet webcasts, or otherwise, are “forward-looking statements” within the meaning of the Private Securities Litigation reform Act of 1995 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements include, without limitation, any statement that may predict, forecast, indicate, or imply future results, performance, or achievements, and may contain words such as “believe,” “anticipate,” “expect,” “estimate,” “project,” or words or phrases of similar meaning. Forward-looking statements are subject to certain risks and uncertainties that may cause actual results to differ materially from the forward-looking statements. These risks and uncertainties are disclosed from time to time in reports filed by us with the SEC, including reports on Forms 8-K, 10-Q, and 10-K. Such risks and uncertainties include, but are not limited to, the matters discussed under “Business Environment and Risk” below. In addition, such risks and uncertainties may include unanticipated developments in any one or more of the following areas: unanticipated costs or capital expenditures; difficulties encountered by EDS in operating and maintaining our information systems and controls, including without limitation, the systems related to demand and supply planning, inventory control, and order fulfillment; delays or unanticipated outcomes relating to our strategic plans; dependence on existing products or services; the rate and consumer acceptance of new product introductions; competition; the number and nature of customers and their product orders, including changes in the timing or mix of product or training orders; pricing of our products and services and those of competitors; adverse publicity; and other factors which may adversely affect our business.
The risks included here are not exhaustive. Other sections of this report may include additional factors that could adversely affect our business and financial performance. Moreover, we operate in a very competitive and rapidly changing environment. New risk factors may emerge and it is not possible for our management to predict all such risk factors, nor can we assess the impact of all such risk factors on our business or the extent to which any single factor, or combination of factors, may cause actual results to differ materially from those contained in forward-looking statements. Given these risks and uncertainties, investors should not rely on forward-looking statements as a prediction of actual results.
The market price of our common stock has been and may remain volatile. In addition, the stock markets in general have experienced increased volatility. Factors such as quarter-to-quarter variations in revenues and earnings or losses and our failure to meet expectations could have a significant impact on the market price of our common stock. In addition, the price of our common stock can change for reasons unrelated to our performance. Due to our low market capitalization, the price of our common stock may also be affected by conditions such as a lack of analyst coverage and fewer potential investors.
Forward-looking statements are based on management’s expectations as of the date made, and the Company does not undertake any responsibility to update any of these statements in the future. Actual future performance and results will differ and may differ materially from that contained in or suggested by forward-looking statements as a result of the factors set forth in this Management’s Discussion and Analysis of Financial Condition and Results of Operations and elsewhere in our filings with the SEC.
Market Risk of Financial Instruments
The Company is exposed to financial instrument market risk primarily through fluctuations in foreign currency exchange rates and interest rates. To manage risks associated with foreign currency exchange and interest rates, we make limited use of derivative financial instruments. Derivatives are financial instruments that derive their value from one or more underlying financial instruments. As a matter of policy, our derivative instruments are entered into for periods consistent with the related underlying exposures and do not constitute positions that are independent of those exposures. In addition, we do not enter into derivative contracts for trading or speculative purposes, nor are we party to any leveraged derivative instrument. The notional amounts of derivatives do not represent actual amounts exchanged by the parties to the instrument, and, thus, are not a measure of exposure to us through our use of derivatives. Additionally, we enter into derivative agreements only with highly rated counterparties and we do not expect to incur any losses resulting from non-performance by other parties.
Foreign Exchange Sensitivity - Due to the global nature of our operations, we are subject to risks associated with transactions that are denominated in currencies other than the United States dollar, as well as the effects of translating amounts denominated in foreign currencies to United States dollars as a normal part of the reporting process. The objective of our foreign currency risk management activities is to reduce foreign currency risk in the consolidated financial statements. In order to manage foreign currency risks, we make limited use of foreign currency forward contracts and other foreign currency related derivative instruments. Although we cannot eliminate all aspects of our foreign currency risk, we believe that our strategy, which includes the use of derivative instruments, can reduce the impacts of foreign currency related issues on our consolidated financial statements. The following is a description of our use of foreign currency derivative instruments.
Foreign Currency Forward Contracts - During the fiscal years ended August 31, 2005, 2004, and 2003, we utilized foreign currency forward contracts to manage the volatility of certain intercompany financing transactions and other transactions that are denominated in foreign currencies. Because these contracts do not meet specific hedge accounting requirements, gains and losses on these contracts, which expire on a quarterly basis, are recognized currently and are used to offset a portion of the gains or losses of the related accounts. The gains and losses on these contracts were recorded as a component of SG&A expense in our consolidated statements of operations and resulted in the following net losses for the periods indicated (in thousands):
| YEAR ENDED AUGUST 31, | | 2005 | | 2004 | | 2003 | |
| | | | | | | | | | | |
| Losses on foreign exchange contracts | | $ | (437 | ) | $ | (641 | ) | $ | (501 | ) |
| Gains on foreign exchange contracts | | | 127 | | | 227 | | | 38 | |
| Net losses on foreign exchange contracts | | $ | (310 | ) | $ | (414 | ) | $ | (463 | ) |
At August 31, 2005, the fair value of these contracts, which was determined using the estimated amount at which contracts could be settled based upon forward market exchange rates, was insignificant. The notional amounts of our foreign currency sell contracts that did not qualify for hedge accounting were as follows at August 31, 2005 (in thousands):
Contract Description | | Notional Amount in Foreign Currency | | Notional Amount in U.S. Dollars | |
| | | | | | | | |
| Japanese Yen | | | 273,000 | | $ | 2,458 | |
| Australian Dollars | | | 1,333 | | | 1,018 | |
| Mexican Pesos | | | 9,400 | | | 846 | |
Net Investment Hedges - During fiscal 2005 and 2004, we entered into foreign currency forward contracts that were designed to manage foreign currency risks related to the value of our net investment in directly-owned operations located in Canada, Japan, and the United Kingdom. These three offices comprise the majority of our net investment in foreign operations. These foreign currency forward instruments qualified for hedge accounting and corresponding gains and losses were recorded as a component of accumulated other comprehensive income in our consolidated balance sheet. During fiscal 2005 and 2004, we recognized the following net losses on our net investment hedging contracts (in thousands):
| YEAR ENDED AUGUST 31, | | 2005 | | 2004 | |
| | | | | | | | |
| Losses on net investment hedge contracts | | $ | (384 | ) | $ | (337 | ) |
| Gains on net investment hedge contracts | | | 66 | | | 130 | |
| Net losses on investment hedge contracts | | $ | (318 | ) | $ | (207 | ) |
As of August 31, 2005, we had settled our net investment hedge contracts and we had none outstanding. However, we may continue to utilize net investment hedge contracts in future periods as a component of our overall foreign currency risk strategy.
Interest Rate Sensitivity - The Company is exposed to fluctuations in U.S. interest rates primarily as a result of the cash and cash equivalents that we hold. Following the sale of our building in June 2005, our debt balances consist of the financing obligation from the sale of the corporate campus, one fixed-rate long-term mortgage, and one variable-rate mortgage on certain of our buildings and property. The financing obligation has a payment structure equivalent to a lease arrangement with an interest rate of 7.7 percent. Our fixed-rate debt has a 9.9 percent interest rate and was paid in full during September 2005 and our variable-rate mortgage has interest at the Canadian Prime Rate (5.5 percent at August 31, 2005) and requires payments through January 2015.
During the fiscal years ended August 31, 2005, 2004, and 2003, we were not party to any interest rate swap agreements or similar derivative instruments.
Our business environment, current domestic and international economic conditions, and other specific risks may affect our future business decisions and financial performance. The matters discussed below may cause our future results to differ from past results or those described in forward-looking statements and could have a material adverse effect on our business, financial condition, liquidity, results of operations, and stock price.
We have experienced significant declines in sales and corresponding net losses in recent fiscal years and we may not be able to return to consistent profitability
Although our sales increased in fiscal 2005 compared to fiscal 2004, we have experienced significant sales declines in recent years. Our sales during fiscal 2005 were $283.5 million compared to $275.4 million in fiscal 2004 and $307.2 million in fiscal 2003. While our net income (before preferred dividends and recapitalization loss) has improved to $10.2 million in fiscal 2005, declining sales have also had a corresponding adverse impact upon our operating results during recent fiscal years and we have reported net losses totaling $10.2 million in fiscal 2004 and $45.3 million in fiscal 2003. We continue to implement initiatives designed to increase our sales and improve our operating results, and have recognized significant improvements in recent years, however, we cannot assure that we will return to consistently profitable operations.
In addition to declining sales, we have faced numerous challenges that have affected our operating results in recent years. Specifically, we have experienced, and may continue to experience the following:
| l | Declining traffic in our retail stores and consumer direct channel |
| l | Increased risk of excess and obsolete inventories |
| l | Operating expenses that, as a percentage of sales, have exceeded our desired business model |
| l | Costs associated with exiting unprofitable retail stores |
Our results of operations are materially affected by economic conditions, levels of business activity, and other changes experienced by our clients
Uncertain economic conditions continue to affect many of our clients’ businesses and their budgets for training, consulting, and related products. Such economic conditions and budgeted spending are influenced by a wide range of factors that are beyond our control and that we have no comparative advantage in forecasting. These conditions include:
| l | The overall demand for training, consulting, and our related products |
| l | Conditions and trends in the training and consulting industry |
| l | General economic and business conditions |
| l | General political developments, such as the war on terrorism, and their impacts upon our business both domestically and internationally |
| l | Natural disasters |
In addition, our business tends to lag behind economic cycles and, consequently, the benefits of any economic recovery may take longer for us to realize than other segments of the economy. Future deterioration of economic conditions, particularly in the United States, could increase these effects on our business.
We may not be able to compensate for lower sales or unexpected cash outlays with cost reductions significant enough to generate positive net income
Although we have initiated cost-cutting efforts that have included headcount reductions, retail store closures, consolidation of administrative office space, and changes in our advertising and marketing strategy, if we are not able to prevent further revenue declines or achieve our growth objectives, we will need to further reduce our costs. An unintended consequence of additional cost reductions may be reduced sales. If we are not able to effectively reduce our costs and expenses commensurate with, or at the same pace as, any further deterioration in our sales, we may not be able to generate positive net income or cash flows from operations. Although we have experienced improved cash flows from operations during fiscal 2005 and 2004, an inability to maintain or continue to increase cash flows from operations may have an adverse impact upon our liquidity and ability to operate the business. For example, we may not be able to obtain additional financing or raise additional capital on terms that would be acceptable to us.
We are unable to predict the exact amount of cost reductions required for us to generate increased cash flows from operations because we cannot accurately predict the amount of our future sales. Our future sales performance depends, in part, on future economic and market conditions, which are not within our control.
Our global operations pose complex management, foreign currency, legal, tax, and economic risks, which we may not adequately address
We have Company-owned offices in Australia, Brazil, Canada, Japan, Mexico, and the United Kingdom. We also have licensed operations in numerous other foreign countries. As a result of these foreign operations and their growing impact upon our results of operations, we are subject to a number of risks, including:
| l | Restrictions on the movement of cash |
| l | Burdens of complying with a wide variety of national and local laws |
| l | The absence in some jurisdictions of effective laws to protect our intellectual property rights |
| l | Political instability |
| l | Currency exchange rate fluctuations |
| l | Longer payment cycles |
| l | Price controls or restrictions on exchange of foreign currencies |
While we are not currently aware of any of the foregoing conditions materially adversely affecting our operations, these conditions, which are outside of our control, could change at any time.
We operate in a highly competitive industry
The training and consulting industry is highly competitive with a relatively easy entry. Competitors continually introduce new programs and products that may compete directly with our offerings. Larger and better capitalized competitors may have enhanced abilities to compete for clients and skilled professionals. In addition, one or more of our competitors may develop and implement training courses or methodologies that may adversely affect our ability to sell our methodologies to new clients.
Our profitability will suffer if we are not able to maintain our pricing and utilization rates and control our costs
Our profit margin on training services is largely a function of the rates we are able to recover for our services and the utilization, or chargeability, of our trainers, client partners, and consultants. Accordingly, if we are unable to maintain sufficient pricing for our services or an appropriate utilization rate for our training professionals without corresponding cost reductions, our profit margin and overall profitability will suffer. The rates that we are able to recover for our services are affected by a number of factors, including:
| l | Our clients’ perceptions of our ability to add value through our programs and products |
| l | Competition |
| l | General economic conditions |
| l | Introduction of new programs or services by us or our competitors |
| l | Our ability to accurately estimate, attain, and sustain engagement sales, margins, and cash flows over longer contract periods |
Our utilization rates are also affected by a number of factors, including:
| l | Seasonal trends, primarily as a result of scheduled training |
| l | Our ability to forecast demand for our products and services and thereby maintain an appropriate headcount in our employee base |
| l | Our ability to manage attrition |
Our profitability is also a function of our ability to control costs and improve our efficiency in the delivery of our products and services. Our cost-cutting initiatives, which focus on reducing both fixed and variable costs, may not be sufficient to deal with downward pressure on pricing or utilization rates. As we introduce new programs and seek to increase the number of our training professionals, we may not be able to manage a significantly larger and more diverse workforce, control our costs, or improve our efficiency.
Our new training programs and products may not be widely accepted in the marketplace
In an effort to improve our sales performance, we have made significant investments in new training and consulting offerings such as the “4 Disciplines of Execution.” Additionally, we have invested in our existing programs in order to refresh these programs and keep them relevant in the marketplace, including the newly revised The 7 Habits of Highly Effective People curriculum. We expect that these new programs, combined with new product offerings, will contribute to future growth in our revenue. Although we believe that our intellectual property is highly regarded in the marketplace, the demand for these new programs and products is still emerging. If our clients’ demand for these new programs and products does not develop as we expect, or if our sales and marketing strategies for these programs are not effective, our financial results could be adversely impacted and we may need to change our business strategy.
If we are unable to attract, retain, and motivate high-quality employees, we will not be able to compete effectively and will not be able to grow our business
Due to our reliance on customer satisfaction, our overall success and ability to grow are dependent, in part, on our ability to hire, retain, and motivate sufficient numbers of talented people with the necessary skills needed to serve clients and grow our business. The inability to attract qualified employees in sufficient numbers to meet particular demands or the loss of a significant number of our employees could have a serious adverse effect on us, including our ability to obtain and successfully complete important client engagements and thus maintain or increase our sales.
We continue to offer a variable component of compensation, the payment of which is dependent upon our sales performance and profitability. We adjust our compensation levels and have adopted different methods of compensation in order to attract and retain appropriate numbers of employees with the necessary skills to serve our clients and grow our business. We may also use equity-based performance incentives as a component of our executives’ compensation, which may affect amounts of cash compensation. Variations in any of these areas of compensation may adversely impact our operating performance.
We may experience foreign currency gains and losses
We conduct a portion of our business in currencies other than the United States dollar. As our international operations continue to grow and become a larger component of our financial results, our revenues and operating results may be adversely affected when the dollar strengthens relative to other currencies and are positively affected when the dollar weakens. In order to manage a portion of our foreign currency risk, we make limited use of foreign currency derivative contracts to hedge certain transactions and translation exposure. There can be no guarantee that our foreign currency risk management strategy will be effective in reducing the risks associated with foreign currency transactions and translation.
Our product sales may continue to decline and result in changes to our profitability
In recent years, our product sales have declined. These product sales, which are primarily delivered through our retail stores, consumer direct channels (catalog call center and eCommerce), wholesale, and government product channels have historically been very profitable for us. However, due to recent declines, we have reevaluated our product business and have taken steps to restore its profitability. These initiatives have included hiring an additional sales force based at certain retail stores, retail store closures, transitioning catalog customers to our eCommerce site, outsourcing our government products channel, and increasing our business through wholesale channels. However, these initiatives may also result in decreased gross margins on our product sales if lower-margin wholesale sales continue to increase. If product sales continue to decline or gross margins decline, our product sales strategies may not be adequate to return our product delivery channels to past profitability levels.
Our strategy of outsourcing certain functions and operations may fail to reduce our costs for these services
We have an outsourcing contract with Electronic Data Systems (EDS) to provide warehousing, distribution, information systems, and call center operations. Under terms of the outsourcing contract and its addendums, EDS operates the Company’s primary call center, provides warehousing and distribution services, and supports our various information systems. Certain components of the outsourcing agreement contain minimum activity levels that we must meet or we will be required to pay penalty charges. If these activity levels are not achieved, we may not realize anticipated benefits from the EDS outsourcing agreement in these areas.
Our outsourcing contracts with EDS contain early termination provisions that we may exercise under certain conditions. However, in order to exercise the early termination provisions, we would have to pay specified penalties to EDS depending upon the circumstances of the contract termination.
We have significant intangible asset balances that may be impaired if cash flows from related activities declines
At August 31, 2005 we had $83.3 million of intangible assets, which were primarily generated from the fiscal 1997 merger with the Covey Leadership Center. These intangible assets are evaluated for impairment based upon cash flows (definite-lived intangible assets) and estimated royalties from revenue streams (indefinite-lived intangible assets). Although our current sales and cash flows are sufficient to support these intangibles, if our sales and corresponding cash flows decline, we may be faced with significant asset impairment charges.
Our sales are subject to changes in consumer preferences and buying trends
Our product sales are subject to changing consumer preferences and difficulties in anticipating or forecasting these changes may result in adverse consequences to our sales. Although we continue to have a substantial loyal customer base for many of our existing products, changes in consumer preferences, such as a shift in demand from paper-based planners to handheld electronic devices or other technology products may have an adverse impact upon our sales. While we have experienced stabilizing sales in our core products (paper-based planners, binders, and accessories) during fiscal 2005, we are still subject to consumer preferences for these products.
Our future quarterly operating results are subject to factors that can cause fluctuations in our stock price
Historically, our stock price has experienced significant volatility. We expect that our stock price may continue to experience volatility in the future due to a variety of potential factors that may include the following:
| l | Fluctuations in our quarterly results of operations and cash flows |
| l | Variations between our actual financial results and market expectations |
| l | Changes in our key balances, such as cash and cash equivalents |
| l | Currency exchange rate fluctuations |
| l | Unexpected asset impairment charges |
| l | No analyst coverage |
In addition, the stock market has experienced substantial price and volume fluctuations over the past several quarters that has had some impact upon our stock and other stock issues in the market. These factors, as well as general investor concerns regarding the credibility of corporate financial statements and the accounting profession, may have a material adverse effect upon our stock in the future.
We may need additional capital in the future, and this capital may not be available to us on favorable terms
We may need to raise additional funds through public or private debt offerings or equity financings in order to:
| l | Develop new services, programs, or products |
| l | Take advantage of opportunities, including expansion of the business |
| l | Respond to competitive pressures |
We may be unable to obtain the necessary capital on terms or conditions that are favorable to us.
We are the creditor for a management common stock loan program that may not be fully collectible
We are the creditor for a loan program that provided the capital to allow certain management personnel the opportunity to purchase shares of our common stock. For further information regarding our management common stock loan program, refer to Note 11 to our consolidated financial statements. The inability of the Company to collect all, or a portion, of these receivables could have an adverse impact upon our financial position and future cash flows compared to full collection of the loans.
We may have exposure to additional tax liabilities
As a multinational company, we are subject to income taxes as well as non-income based taxes, in both the United States and various foreign tax jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes and other tax liabilities. In the normal course of a global business, there are many intercompany transactions and calculations where the ultimate tax determination is uncertain. As a result, we are regularly under audit by tax authorities. Although we believe that our tax estimates are reasonable, we cannot assure you that the final determination of tax audits will not be different from what is reflected in our historical income tax provisions and accruals.
We are also subject to non-income taxes, such as payroll, sales, use, valued-added, and property taxes in both the United States and various foreign jurisdictions. We are regularly under audit by tax authorities with respect to these non-income taxes and may have exposure to additional non-income tax liabilities.
We may be exposed to potential risks relating to internal controls procedures and our ability to have those controls attested to by our independent auditors
While we believe that we can comply with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002, our failure to document, implement, and comply with these requirements may harm our reputation and the market price of our stock could suffer. We may be exposed to risks from recent legislation requiring companies to evaluate their internal controls and have those controls attested to by their independent auditors. We are evaluating our internal control systems in order to allow our management to report on, and our independent auditors attest to, our internal controls, as a required part of our Annual Report on Form 10-K beginning with our report for the fiscal year ended August 31, 2006.
At present, there is little precedent available with which to measure compliance adequacy. In the event we identify significant deficiencies or material weaknesses in our internal controls that we cannot remediate in a timely manner, our reputation, financial results, and market price of our stock could suffer.
We may elect to use our cash to redeem shares of preferred stock, which may decrease our ability to respond to adverse changes
Our outstanding preferred stock bears a cumulative dividend equal to 10 percent per annum. During fiscal 2005, we utilized a portion of the proceeds from the sale of our corporate headquarters to redeem $30.0 million of our preferred stock. Subsequent to August 31, 2005, we redeemed an additional $10.0 million of preferred stock and we are proposing to amend the terms of our preferred stock recapitalization that was completed in fiscal 2005 to extend the period during which we can redeem preferred stock at an amount equal to the liquidation preference. We have obtained an agreement from the majority holder of the preferred stock to vote in favor of such an amendment. We anticipate that we may redeem additional shares of preferred stock in the future to the extent that we believe sufficient cash is available to do so. Any such redemptions will reduce our cash on hand and may reduce our ability to adequately respond to any future adverse changes in our business and operations, whether anticipated or unanticipated.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Shareholders
Franklin Covey Co.:
We have audited the accompanying consolidated balance sheets of Franklin Covey Co. and subsidiaries (the Company) as of August 31, 2005 and 2004, and the related consolidated statements of operations and comprehensive income (loss), shareholders’ equity, and cash flows for each of the years in the three-year period ended August 31, 2005. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Franklin Covey Co. and subsidiaries as of August 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended August 31, 2005, in conformity with U.S. generally accepted accounting principles.
As discussed in Note 2, the consolidated financial statements as of August 31, 2004 and for each of the years ended August 31, 2004 and 2003 have been restated.
KPMG LLP
Salt Lake City, Utah
November 23, 2005
FRANKLIN COVEY CO.
| AUGUST 31, | | 2005 | | 2004 | |
In thousands, except per share data | | | | | | Restated | |
| | | | | | | | |
| ASSETS | | | | | | | |
Current assets: | | | | | | | |
Cash and cash equivalents | | $ | 51,690 | | $ | 31,174 | |
Restricted cash | | | 699 | | | | |
Short-term investments | | | | | | 10,730 | |
Accounts receivable, less allowance for doubtful accounts of $1,425 and $1,034 | | | 22,399 | | | 18,636 | |
Inventories | | | 20,975 | | | 23,693 | |
Prepaid expenses and other assets | | | 9,419 | | | 7,996 | |
Total current assets | | | 105,182 | | | 92,229 | |
Property and equipment, net | | | 35,277 | | | 40,584 | |
Intangible assets, net | | | 83,348 | | | 87,507 | |
Other long-term assets | | | 9,426 | | | 7,305 | |
| | | $ | 233,233 | | $ | 227,625 | |
| | | | | | | | |
| LIABILITIES AND SHAREHOLDERS’ EQUITY | | | | | | | |
Current liabilities: | | | | | | | |
Current portion of long-term debt and financing obligation | | $ | 1,088 | | $ | 120 | |
Accounts payable | | | 13,704 | | | 14,018 | |
Income taxes payable | | | 3,996 | | | 5,903 | |
Accrued liabilities | | | 36,536 | | | 36,158 | |
Total current liabilities | | | 55,324 | | | 56,199 | |
Long-term debt and financing obligation, less current portion | | | 34,086 | | | 1,350 | |
Other liabilities | | | 1,282 | | | 1,550 | |
Deferred income tax liabilities | | | 9,715 | | | 10,047 | |
Total liabilities | | | 100,407 | | | 69,146 | |
| | | | | | | | |
Commitments and contingencies (Notes 1, 7, and 8) | | | | | | | |
| | | | | | | | |
Shareholders’ equity: | | | | | | | |
| Preferred stock - Series A, no par value; 4,000 shares authorized, 2,294 shares issued; liquidation preference totaling $58,778 (Note 9) | | | 57,345 | | | | |
| Preferred stock - Series A, no par value; convertible into common stock at $14 per share; 4,000 shares authorized, 873 shares issued; liquidation preference totaling $89,530; recapitalized in 2005 (Note 9) | | | | | | 87,203 | |
| Common stock, $.05 par value; 40,000 shares authorized, 27,056 shares issued | | | 1,353 | | | 1,353 | |
| Additional paid-in capital | | | 190,760 | | | 205,585 | |
| Common stock warrants | | | 7,611 | | | | |
| Accumulated deficit | | | (14,498 | ) | | (16,931 | ) |
| Deferred compensation on unvested stock grants | | | (1,055 | ) | | (732 | ) |
| Accumulated other comprehensive income | | | 556 | | | 1,026 | |
| Treasury stock at cost, 6,465 shares and 7,028 shares | | | (109,246 | ) | | (119,025 | ) |
Total shareholders’ equity | | | 132,826 | | | 158,479 | |
| | | $ | 233,233 | | $ | 227,625 | |
See accompanying notes to consolidated financial statements.
FRANKLIN COVEY CO.
| YEAR ENDED AUGUST 31, | | 2005 | | 2004 | | 2003 | |
In thousands, except per share amounts | | | | | | | | | | |
| | | | | | | | | | | |
| Net sales: | | | | | | | | | | |
Products | | $ | 167,179 | | $ | 177,184 | | $ | 202,225 | |
Training and consulting services | | | 116,363 | | | 98,250 | | | 104,935 | |
| | | | 283,542 | | | 275,434 | | | 307,160 | |
| | | | | | | | | | | |
| Cost of sales: | | | | | | | | | | |
Products | | | 77,074 | | | 85,803 | | | 102,320 | |
Training and consulting services | | | 37,773 | | | 33,830 | | | 34,457 | |
| | | | 114,847 | | | 119,633 | | | 136,777 | |
| | | | | | | | | | | |
| Gross margin | | | 168,695 | | | 155,801 | | | 170,383 | |
Selling, general, and administrative | | | 148,305 | | | 148,918 | | | 184,136 | |
| Impairment of and (gain) on disposal of investment in unconsolidated subsidiary | | | (500 | ) | | | | | 872 | |
| Provision for losses on management stock loans | | | | | | | | | 3,903 | |
| Recovery of investment in unconsolidated subsidiary | | | | | | | | | (1,644 | ) |
| Depreciation | | | 7,774 | | | 11,774 | | | 26,395 | |
| Amortization | | | 4,173 | | | 4,173 | | | 4,386 | |
Income (loss) from operations | | | 8,943 | | | (9,064 | ) | | (47,665 | ) |
| | | | | | | | | | | |
| Equity in losses of unconsolidated subsidiary | | | | | | | | | (128 | ) |
| Interest income | | | 944 | | | 481 | | | 665 | |
| Interest expense | | | (786 | ) | | (218 | ) | | (248 | ) |
| Other expense, net | | | | | | | | | (414 | ) |
Income (loss) before income taxes | | | 9,101 | | | (8,801 | ) | | (47,790 | ) |
| | | | | | | | | | | |
| Income tax benefit (provision) | | | 1,085 | | | (1,349 | ) | | 2,537 | |
Net income (loss) | | | 10,186 | | | (10,150 | ) | | (45,253 | ) |
| Preferred stock dividends | | | (8,270 | ) | | (8,735 | ) | | (8,735 | ) |
| Loss on recapitalization of preferred stock | | | (7,753 | ) | | | | | | |
Net loss attributable to common shareholders | | $ | (5,837 | ) | $ | (18,885 | ) | $ | (53,988 | ) |
| | | | | | | | | | | |
| Net loss attributable to common shareholders per share: | | | | | | | | | | |
Basic and diluted | | $ | (.34 | ) | $ | (.96 | ) | $ | (2.69 | ) |
| | | | | | | | | | | |
| Basic and diluted weighted average number of common shares | | | 19,949 | | | 19,734 | | | 20,041 | |
| | | | | | | | | | | |
| COMPREHENSIVE INCOME (LOSS) | | | | | | | | | | |
| Net income (loss) | | $ | 10,186 | | $ | (10,150 | ) | $ | (45,253 | ) |
| Adjustment for fair value of hedge derivatives | | | (318 | ) | | (207 | ) | | | |
| Foreign currency translation adjustments | | | (152 | ) | | 788 | | | 725 | |
| Comprehensive income (loss) | | $ | 9,716 | | $ | (9,569 | ) | $ | (44,528 | ) |
See accompanying notes to consolidated financial statements.
FRANKLIN COVEY CO.
| | | Series A Preferred Stock Shares | | Series A Preferred Stock Amount | | Common Stock Shares | | Common Stock Amount | | Additional Paid-In Capital | | Common Stock Warrants | | Retained Earnings (Accumulated Deficit) | | Notes and Interest Receivable | | Deferred Compensa-tion | | Accumulated Other Comprehensive Income (Loss) | | Treasury Stock Shares | | Treasury Stock Amount | |
In thousands | | | | | | | | | | | | | | | | | | | | | Restated | | | | | | | | | | | | | | | | |
| Balance at August 31, 2002, as previously reported | | | 873 | | $ | 87,203 | | | 27,056 | | $ | 1,353 | | $ | 222,953 | | $ | - | | $ | 58,209 | | $ | (12,362 | ) | $ | - | | $ | (280 | ) | | (7,089 | ) | $ | (122,521 | ) |
| Restatement adjustment (Note 2) | | | | | | | | | | | | | | | | | | | | | (8,133 | ) | | | | | | | | | | | | | | | |
| Restated balance at August 31, 2002 | | | 873 | | | 87,203 | | | 27,056 | | | 1,353 | | | 222,953 | | | - | | | 50,076 | | | (12,362 | ) | | - | | | (280 | ) | | (7,089 | ) | | (122,521 | ) |
| Preferred stock dividends | | | | | | | | | | | | | | | | | | | | | (8,735 | ) | | | | | | | | | | | | | | | |
| Issuance of common stock from treasury | | | | | | | | | | | | | | | (1,485 | ) | | | | | | | | | | | | | | | | | 211 | | | 1,721 | |
| Purchase of treasury shares | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | (129 | ) | | (131 | ) |
| Cumulative translation adjustment | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | 725 | | | | | | | |
| Additions to reserve for management loan losses | | | | | | | | | | | | | | | | | | | | | | | | 3,903 | | | | | | | | | | | | | |
| CEO compensation contribution | | | | | | | | | | | | | | | 500 | | | | | | | | | | | | | | | | | | | | | | |
| Net loss | | | | | | | | | | | | | | | | | | | | | (45,253 | ) | | | | | | | | | | | | | | | |
| Restated balance at August 31, 2003 | | | 873 | | | 87,203 | | | 27,056 | | | 1,353 | | | 221,968 | | | - | | | (3,912 | ) | | (8,459 | ) | | - | | | 445 | | | (7,007 | ) | | (120,931 | ) |
| Preferred stock dividends | | | | | | | | | | | | | | | (5,866 | ) | | | | | (2,869 | ) | | | | | | | | | | | | | | | |
| Issuance of common stock from treasury | | | | | | | | | | | | | | | (27 | ) | | | | | | | | | | | | | | | | | 99 | | | 181 | |
| Purchase of treasury shares | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | (93 | ) | | (182 | ) |
| Cumulative translation adjustment | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | 788 | | | | | | | |
| Adjustment for fair value of hedge derivatives | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | (207 | ) | | | | | | |
| Modification of management stock loans | | | | | | | | | | | | | | | (7,565 | ) | | | | | | | | 7,565 | | | | | | | | | | | | | |
| Cancellation of note receivable from sale of common stock | | | | | | | | | | | | | | | 1,495 | | | | | | | | | 894 | | | | | | | | | (121 | ) | | (2,389 | ) |
| Unvested stock award | | | | | | | | | | | | | | | (4,420 | ) | | | | | | | | | | | (829 | ) | | | | | 304 | | | 5,249 | |
| Common stock held in non-qualified deferred compensation plan | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | (210 | ) | | (953 | ) |
| Amortization of deferred compensation | | | | | | | | | | | | | | | | | | | | | | | | | | | 97 | | | | | | | | | | |
| Net loss | | | | | | | | | | | | | | | | | | | | | (10,150 | ) | | | | | | | | | | | | | | | |
| Restated balance at August 31, 2004 | | | 873 | | | 87,203 | | | 27,056 | | | 1,353 | | | 205,585 | | | - | | | (16,931 | ) | | - | | | (732 | ) | | 1,026 | | | (7,028 | ) | | (119,025 | ) |
| Preferred stock dividends | | | | | | | | | | | | | | | (8,270 | ) | | | | | | | | | | | | | | | | | | | | | |
| Extinguishment of previously existing Series A Preferred Stock | | | (873 | ) | | (87,203 | ) | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Preferred stock recapitalization | | | 3,494 | | | 87,345 | | | | | | | | | | | | 7,611 | | | (7,753 | ) | | | | | | | | | | | | | | | |
| Preferred stock redemption | | | (1,200 | ) | | (30,000 | ) | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Issuance of common stock from treasury | | | | | | | | | | | | | | | (257 | ) | | | | | | | | | | | | | | | | | 42 | | | 366 | |
| Purchase of treasury shares | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | (23 | ) | | (91 | ) |
| Unvested stock awards | | | | | | | | | | | | | | | (5,192 | ) | | | | | | | | | | | (1,114 | ) | | | | | 352 | | | 6,234 | |
| Amortization of deferred compensation | | | | | | | | | | | | | | | | | | | | | | | | | | | 791 | | | | | | | | | | |
| CEO fully-vested stock award | | | | | | | | | | | | | | | (2,837 | ) | | | | | | | | | | | | | | | | | 187 | | | 3,241 | |
| Non-qualified deferred compensation plan treasury stock transactions | | | | | | | | | | | | | | | 892 | | | | | | | | | | | | | | | | | | 5 | | | 29 | |
| Payments on management common stock loans | | | | | | | | | | | | | | | 839 | | | | | | | | | | | | | | | | | | | | | | |
| Cumulative translation adjustments | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | (152 | ) | | | | | | |
| Adjustment for fair value of hedge derivatives | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | (318 | ) | | | | | | |
| Net income | | | | | | | | | | | | | | | | | | | | | 10,186 | | | | | | | | | | | | | | | | |
Balance at August 31, 2005 | | | 2,294 | | $ | 57,345 | | | 27,056 | | $ | 1,353 | | $ | 190,760 | | $ | 7,611 | | $ | (14,498 | ) | $ | - | | $ | (1,055 | ) | $ | 556 | | | (6,465 | ) | $ | (109,246 | ) |
See accompanying notes to consolidated financial statements.
FRANKLIN COVEY CO.
| YEAR ENDED AUGUST 31, | | 2005 | | 2004 | | 2003 | |
In thousands | | | | | | | | | | |
| CASH FLOWS FROM OPERATING ACTIVITIES | | | | | | | | | | |
Net income (loss) | | $ | 10,186 | | $ | (10,150 | ) | $ | (45,253 | ) |
Adjustments to reconcile net income (loss) to net cash provided by operating activities: | | | | | | | | | | |
Depreciation and amortization | | | 13,939 | | | 17,717 | | | 32,938 | |
Provision for losses on management stock loans | | | | | | | | | 3,903 | |
Recovery of investment in unconsolidated subsidiary | | | | | | | | | (1,644 | ) |
Gain on disposal of investment in unconsolidated subsidiary | | | (500 | ) | | | | | | |
Restructuring cost reversal | | | (306 | ) | | | | | | |
Deferred income taxes | | | (410 | ) | | 623 | | | (1,322 | ) |
Impairment of assets | | | | | | | | | 872 | |
Equity in loss of unconsolidated subsidiary | | | | | | | | | 128 | |
Compensation cost of CEO fully-vested stock grant | | | 404 | | | | | | | |
CEO compensation contribution | | | | | | | | | 500 | |
Amortization of deferred compensation | | | 791 | | | 97 | | | | |
Changes in assets and liabilities: | | | | | | | | | | |
Decrease (increase) in accounts receivable, net | | | (3,481 | ) | | 2,120 | | | 694 | |
Decrease in inventories | | | 2,813 | | | 13,262 | | | 2,343 | |
Decrease (increase) in prepaid expenses and other assets | | | (526 | ) | | 3,679 | | | 9,081 | |
Increase (decrease) in accounts payable and accrued liabilities | | | 532 | | | (14,271 | ) | | 11,949 | |
Decrease in income taxes payable | | | (1,832 | ) | | (649 | ) | | (8,562 | ) |
Increase (decrease) in other long-term liabilities | | | 652 | | | (348 | ) | | 175 | |
Net cash provided by operating activities | | | 22,262 | | | 12,080 | | | 5,802 | |
| | | | | | | | | | | |
| CASH FLOWS FROM INVESTING ACTIVITIES | | | | | | | | | | |
Purchases of property and equipment | | | (4,179 | ) | | (3,970 | ) | | (4,201 | ) |
Purchases of short-term investments | | | (10,653 | ) | | (18,680 | ) | | | |
Sales of short-term investments | | | 21,383 | | | 7,950 | | | | |
Curriculum development costs | | | (2,184 | ) | | (961 | ) | | | |
Cash distributions of earnings from unconsolidated subsidiary | | | | | | | | | 2,000 | |
Investment in unconsolidated subsidiary | | | | | | | | | (1,000 | ) |
Proceeds from disposal of unconsolidated subsidiary | | | 500 | | | | | | | |
Proceeds from sale of property and equipment, net | | | | | | 1,556 | | | 426 | |
Net cash provided by (used for) investing activities | | | 4,867 | | | (14,105 | ) | | (2,775 | ) |
| | | | | | | | | | | |
| CASH FLOWS FROM FINANCING ACTIVITIES | | | | | | | | | | |
Proceeds from sale and financing of corporate campus (net of restricted cash of $699) | | | 32,422 | | | | | | | |
Redemption of Series A preferred stock | | | (30,000 | ) | | | | | | |
Principal payments on long-term debt and financing obligation | | | (216 | ) | | (102 | ) | | (185 | ) |
Purchases of common stock for treasury | | | (91 | ) | | (182 | ) | | (131 | ) |
Proceeds from sales of common stock from treasury | | | 109 | | | 154 | | | 236 | |
Proceeds from management stock loan payments | | | 839 | | | | | | | |
Payment of preferred stock dividends | | | (9,020 | ) | | (8,735 | ) | | (8,735 | ) |
Net cash used for financing activities | | | (5,957 | ) | | (8,865 | ) | | (8,815 | ) |
| Effect of foreign currency exchange rates on cash and cash equivalents | | | (656 | ) | | 148 | | | 655 | |
| Net increase (decrease) in cash and cash equivalents | | | 20,516 | | | (10,742 | ) | | (5,133 | ) |
| Cash and cash equivalents at beginning of the year | | | 31,174 | | | 41,916 | | | 47,049 | |
Cash and cash equivalents at end of the year | | $ | 51,690 | | $ | 31,174 | | $ | 41,916 | |
| | | | | | | | | | | |
| Supplemental disclosure of cash flow information: | | | | | | | | | | |
Cash paid for income taxes | | $ | 1,549 | | $ | 1,069 | | $ | 4,637 | |
Cash paid for interest | | | 606 | | | 277 | | | 159 | |
| | | | | | | | | | | |
| Non-cash investing and financing activities: | | | | | | | | | | |
Accrued preferred stock dividends | | $ | 1,434 | | $ | 2,184 | | $ | 2,184 | |
Issuance of unvested stock as deferred compensation | | | 1,147 | | | 829 | | | | |
See accompanying notes to consolidated financial statements.
FRANKLIN COVEY CO.
Franklin Covey Co. (hereafter referred to as us, we, our, or the Company) provides integrated consulting, training, and performance enhancement solutions to organizations and individuals in strategy execution, productivity, leadership, sales force effectiveness, effective communications, and other areas. Each integrated solution may include components of training and consulting, assessment, and other application tools that are generally available in electronic or paper-based formats. Our products and services are available through professional consulting services, public workshops, retail stores, catalogs, and the Internet at www.franklincovey.com. The Company’s historically best-known offerings include the FranklinCovey Planner™, and a suite of new and updated individual-effectiveness and leadership-development training products based on the best-selling book The 7 Habits of Highly Effective People. We also offer a range of training and assessment products to help organizations achieve superior results by focusing and executing on top priorities, building the capability of knowledge workers, and aligning business processes. These offerings include the popular workshop FOCUS: Achieving Your Highest Priorities™, The 4 Disciplines of Execution™, The 4 Roles of Leadership™, Building Business Acumen: What the CEO Wants You to Know™, the Advantage Series communication workshops, and the Execution Quotient (xQ™) organizational assessment tool.
Fiscal Year
The Company utilizes a modified 52/53-week fiscal year that ends on August 31 of each year. Corresponding quarterly periods generally consist of 13-week periods that ended on November 27, 2004, February 26, 2005, and May 28, 2005 during fiscal 2005. Unless otherwise noted, references to fiscal years apply to the 12 months ended August 31 of the specified year.
Basis of Presentation
The accompanying consolidated financial statements include the accounts of the Company and our subsidiaries. Intercompany balances and transactions have been eliminated in consolidation.
Pervasiveness of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the financial statements, and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.
Reclassifications
Certain reclassifications have been made to the fiscal 2004 financial statements to conform to the current period presentation. Reclassifications consisted of 1) $10.7 million of cash equivalents at August 31, 2004 that were reclassified to short-term investments and 2) certain overhead costs which were reclassified from cost of sales to selling, general, and administrative expenses that totaled $0.7 million and $0.8 million for the fiscal years ended August 31, 2004 and 2003.
Cash and Cash Equivalents
We consider highly liquid investments with insignificant interest rate risk and original maturities to the Company of three months or less to be cash equivalents. Our cash equivalents consisted primarily of commercial paper and money market funds and totaled $36.7 million and $10.9 million at August 31, 2005 and 2004. As of August 31, 2005, we had demand deposits at various banks in excess of the $100,000 limit for insurance by the Federal Deposit Insurance Corporation (FDIC).
Restricted Cash
Our restricted cash represents a portion of the proceeds from the fiscal 2005 sale of our corporate campus (Note 6) that was held in escrow to repay the outstanding mortgage on one of the buildings that was sold. The mortgage was repaid in full during September 2005.
Short-Term Investments
We consider highly liquid investments with an effective maturity to the Company of more than three months and less than one year to be short-term investments. We define effective maturity as the shorter of the original maturity to the Company or the effective maturity as a result of the periodic auction of our investments classified as available for sale. We determine the appropriate classification of our investments at the time of purchase and reevaluate such designations as of each balance sheet date. At August 31, 2004, we had short-term investments of $10.7 million, which were classified as available-for-sale securities and were recorded at fair value, which approximated cost.
Realized gains and losses on the sale of available for sale short-term investments were insignificant for the periods presented. Unrealized gains and losses on short-term investments were also insignificant for the periods presented. We use the specific identification method to compute the gains and losses on our short-term investments.
Trade Accounts Receivable
Trade accounts receivable are recorded at the invoiced amount and do not bear interest. The allowance for doubtful accounts represents our best estimate of the amount of probable credit losses in the existing accounts receivable balance. We determine the allowance for doubtful accounts based upon historical write-off experience and current economic conditions and review the adequacy of the allowance for doubtful accounts on a regular basis. Receivable balances past due over 90 days, which exceed a specified dollar amount, are reviewed individually for collectibility. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. In addition, we do not have any off-balance sheet credit exposure related to our customers.
Inventories
Inventories are stated at the lower of cost or market, cost being determined using the first-in, first-out method. Elements of cost in inventories generally include raw materials, direct labor, and overhead. Our inventories are comprised primarily of dated calendar products and other non-dated products such as binders, handheld electronic devices, stationery, training products, and other accessories and were comprised of the following (in thousands):
| AUGUST 31, | | | 2005 | | | 2004 | |
| Finished goods | | $ | 18,161 | | $ | 19,756 | |
| Work in process | | | 825 | | | 978 | |
| Raw materials | | | 1,989 | | | 2,959 | |
| | | $ | 20,975 | | $ | 23,693 | |
Provision is made to reduce excess and obsolete inventories to their estimated net realizable value. At August 31, 2005 and 2004, reserves for excess and obsolete inventories were $5.3 million and $5.1 million. In assessing the realization of inventories, we make judgments regarding future demand requirements and compare these estimates with current and committed inventory levels. Inventory requirements may change based on projected customer demand, technological and product life cycle changes, longer or shorter than expected usage periods, and other factors that could affect the valuation of our inventories.
Property and Equipment
Property and equipment are recorded at cost. Depreciation, which includes the amortization of assets recorded under capital lease obligations, is calculated using the straight-line method over the expected useful life of the asset. The Company generally uses the following depreciable lives for our major classifications of property and equipment:
| Description | Useful Lives |
| Buildings | 15-39 years |
| Machinery and equipment | 3-7 years |
| Computer hardware and software | 3 years |
Furniture, fixtures, and leasehold improvements | 5-8 years |
Leasehold improvements are amortized over the lesser of the useful economic life of the asset or the contracted lease period. We expense costs for repairs and maintenance as incurred. Gains and losses resulting from the sale of property and equipment are recorded in current operations.
Indefinite-Lived Intangible Assets
Intangible assets that are deemed to have an indefinite life are not amortized, but rather are tested for impairment on an annual basis, or more often if events or circumstances indicate that a potential impairment exists. The Covey trade name intangible asset (Note 5) has been deemed to have an indefinite life. This intangible asset is assigned to the Organizational Solutions Business Unit and is tested for impairment using the present value of estimated royalties on trade name related revenues, which consist primarily of training seminars and work sessions, international licensee sales, and related products. No impairment charge to the Covey trade name was required during the fiscal years ended August 31, 2005, 2004, or 2003.
Capitalized Curriculum Development Costs
During the normal course of business, we develop training courses and related materials that we sell to our customers. Capitalized curriculum development costs include certain expenditures to develop course materials such as video segments, course manuals, and other related materials. Curriculum costs are only capitalized when a course is developed that is related to a successful training program or when there is a major revision to a course or significant re-write of the course materials or curriculum.
During fiscal 2005, we completed major revisions to our well-known and successful The 7 Habits of Highly Effective People training course and capitalized costs associated with the refreshed course. These capitalized development costs are being amortized over a five-year life, which is based on numerous factors, including expected cycles of major changes to curriculum. Capitalized curriculum development costs are reported as a component of our other long-term assets in our consolidated balance sheet and totaled $2.6 million and $1.0 million at August 31, 2005 and 2004. Capitalized curriculum development cost amortization is reported as a component of cost of sales.
Restricted Investments
The Company’s restricted investments consist of insurance contracts and investments in mutual funds that are held in a “rabbi trust” and are restricted for payment to the participants of our deferred compensation plan (Note 14). We account for our restricted investments in accordance with Statement of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity Securities. As required by SFAS No. 115, the Company determines the proper classification of its investments at the time of purchase and reassesses such designations at each balance sheet date. At August 31, 2005 and 2004, our restricted investments were classified as trading securities and consisted of insurance contracts and mutual funds. The fair value of these restricted investments totaled $1.2 million at August 31, 2005 and 2004, and were recorded as components of other long-term assets in the accompanying consolidated balance sheets.
In accordance with SFAS No. 115, our unrealized losses on restricted investments, which were immaterial during fiscal years 2005, 2004, and 2003, were recognized in the accompanying consolidated statements of operations as a component of selling, general, and administrative expense.
Impairment of Long-Lived Assets
Long-lived tangible assets and definite-lived intangible assets are reviewed for possible impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. We use an estimate of undiscounted future net cash flows of the assets over the remaining useful lives in determining whether the carrying value of the assets is recoverable. If the carrying values of the assets exceed the anticipated future cash flows of the assets, we recognize an impairment loss equal to the difference between the carrying values of the assets and their estimated fair values. Impairment of long-lived assets is assessed at the lowest levels for which there are identifiable cash flows that are independent from other groups of assets. The evaluation of long-lived assets requires us to use estimates of future cash flows. If forecasts and assumptions used to support the realizability of our long-lived tangible and definite-lived intangible assets change in the future, significant impairment charges could result that would adversely affect our results of operations and financial condition.
Accrued Liabilities
Significant components of our accrued liabilities were as follows (in thousands):
| AUGUST 31, | | 2005 | | 2004 | |
| Accrued compensation | | $ | 8,069 | | $ | 5,894 | |
| Unearned revenue | | | 4,541 | | | 5,881 | |
| Outsourcing contract costs payable | | | 4,211 | | | 4,914 | |
| Customer credits | | | 2,701 | | | 3,128 | |
| Accrued preferred stock dividends | | | 1,434 | | | 2,184 | |
| Accrued restructuring and retail store closure costs | | | 369 | | | 2,782 | |
| Other accrued liabilities | | | 15,211 | | | 11,375 | |
| | | $ | 36,536 | | $ | 36,158 | |
Foreign Currency Translation and Transactions
Translation adjustments result from translating the Company’s foreign subsidiaries’ financial statements into United States dollars. The balance sheet accounts of our foreign subsidiaries are translated into U.S. dollars using the exchange rate in effect at the balance sheet date. Revenues and expenses are translated using average exchange rates during the fiscal year. The resulting translation gains or losses were recorded as a component of accumulated other comprehensive income in shareholders’ equity. Transaction losses totaled $0.3 million, $0.2 million, and $0.3 million, during fiscal years 2005, 2004, and 2003 and were reported as a component of selling, general, and administrative expenses.
Derivative Instruments
Derivative instruments are accounted for in accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities as modified by SFAS No. 138, Accounting for Certain Derivative and Certain Hedging Activities, and SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. During the normal course of business, we are exposed to risks associated with foreign currency exchange rate and interest rate fluctuations. Foreign currency exchange rate exposures result from the Company’s operating results, assets, and liabilities that are denominated in currencies other than the United States dollar. In order to limit our exposure to these elements, we have made limited use of derivative instruments. Each derivative instrument is recorded in the balance sheet at its fair value. Changes in the fair value of derivative instruments that qualify for hedge accounting are recorded in accumulated other comprehensive income (a component of shareholders’ equity). Changes in the fair value of derivative instruments that are not designated as hedge instruments are immediately recognized as a component of selling, general, and administrative expense in our consolidated statements of operations.
Revenue Recognition
We recognize revenue when: 1) persuasive evidence of an agreement exists, 2) delivery of product has occurred or services have been rendered, 3) the price to the customer is fixed and determinable, and 4) collectibility is reasonably assured. For product sales, these conditions are generally met upon shipment of the product to the customer or by completion of the sales transaction in a retail store. For training and service sales, these conditions are generally met upon presentation of the training seminar or delivery of the consulting services.
Some of our training and consulting contracts contain multiple deliverable elements that include training along with other products and services. In accordance with EITF Issue No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables, sales arrangements with multiple deliverables are divided into separate units of accounting if the deliverables in the sales contract meet the following criteria: 1) the delivered training or product has value to the client on a standalone basis; 2) there is objective and reliable evidence of the fair value of undelivered items; and 3) delivery of any undelivered item is probable. The overall contract consideration is allocated among the separate units of accounting based upon their fair values. If the fair value of all undelivered elements exists, but fair value does not exist for one or more delivered elements, the residual method is used. Under the residual method, the amount of consideration allocated to the delivered items equals the total contract consideration less the aggregate fair value of the undelivered items. Fair value of the undelivered items is based upon the normal pricing practices for our existing training programs, consulting services, and other products, which are generally the prices of the items when sold separately.
Revenue is recognized on software sales in accordance with Statement of Position (SOP) 97-2, Software Revenue Recognition as amended by SOP 98-09. Statement 97-2, as amended, generally requires revenue earned on software arrangements involving multiple elements such as software products and support to be allocated to each element based on the relative fair value of the elements based on vendor specific objective evidence (VSOE). The majority of the Company’s software sales have multiple elements, including a license and post contract customer support (PCS). Currently we do not have VSOE for either the license or support elements of our software sales. Accordingly, revenue is deferred until the only undelivered element is PCS and the total arrangement fee is recognized ratably over the support period. During fiscal years 2005, 2004, and 2003, we had software sales totaling $4.6 million, $4.7 million, and $4.8 million, which are included in product sales in the consolidated statements of operations.
Revenue is recognized as the net amount to be received after deducting estimated amounts for discounts and product returns.
Shipping and Handling Fees and Costs
All shipping and handling fees billed to customers are recorded as a component of net sales. All costs incurred related to the shipping and handling of products or training services are recorded in cost of sales.
Advertising Costs
Costs for newspaper, television, radio, and other advertising are expensed as incurred or recognized over the period of expected benefit for direct response and catalog advertising. Direct response advertising costs consist primarily of printing and mailing costs for catalogs and seminar mailers that are charged to expense over the period of projected benefit, which ranges from three to 12 months. Advertising costs included in selling, general, and administrative expenses totaled $16.2 million, $14.0 million, and $21.2 million for the fiscal years ended August 31, 2005, 2004, and 2003. Our direct response advertising costs reported in other current assets totaled $3.1 million and $2.7 million at August 31, 2005 and 2004.
Research and Development Costs
We expense research and development costs as incurred. During fiscal years 2005, 2004, and 2003, we expensed $2.2 million, $3.6 million, and $4.9 million of research and development costs that are recorded as a component of selling, general, and administrative expenses in our consolidated statements of operations.
Income Taxes
Our income tax provision has been determined using the asset and liability approach of accounting for income taxes. Under this approach, deferred income taxes represent the future tax consequences expected to occur when the reported amounts of assets and liabilities are recovered or paid. The income tax provision represents income taxes paid or payable for the current year plus the change in deferred taxes during the year. Deferred income taxes result from differences between the financial and tax bases of our assets and liabilities and are adjusted for tax rates and tax laws when changes are enacted. A valuation allowance is provided against deferred income tax assets when it is more likely than not that all or some portion of the deferred income tax assets will not be realized.
The Company provides for income taxes on unremitted foreign earnings assuming the eventual full repatriation of foreign cash balances.
Comprehensive Income (Loss)
Comprehensive income (loss) includes changes to equity accounts that were not the result of transactions with shareholders. Comprehensive income (loss) is comprised of net income or loss and other comprehensive income and loss items. Our comprehensive income and losses generally consist of changes in the fair value of derivative instruments and changes in the cumulative foreign currency translation adjustment.
New Accounting Pronouncements
Equity-Based Payments - In December 2004, the Financial Accounting Standards Board (FASB) approved Statement No. 123 (Revised 2004), Share-Based Payment (SFAS No. 123R), which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation. Statement 123R supersedes Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows. Generally, this new statement follows the approach previously defined in SFAS No. 123. However, SFAS No. 123R requires all share based-payments to employees, including grants of stock options and the compensatory elements of employee stock purchase plans, to be recognized in the income statement based upon their fair values. Pro forma disclosure is no longer an alternative.
We previously accounted for our stock-based compensation using the intrinsic method as defined in APB Opinion No. 25 and accordingly, we have not recognized any expense for our stock option plans or employee stock purchase plan in our consolidated financial statements. Statement No. 123R is effective for interim or annual periods beginning after June 15, 2005, and will thus be effective for our first quarter of fiscal 2006. Upon adoption, we intend to use the modified prospective transition method. Under this method, awards that are granted, modified, or settled after the date of adoption will be measured and accounted for in accordance with Statement 123R. Based upon our analysis of the requirements of SFAS No. 123R, our employee stock purchase plan will become a compensatory plan in fiscal 2006. However, due to current participation levels in the employee stock purchase plan and remaining levels of unvested stock option compensation expense, we do not believe that the adoption SFAS No. 123R will have a material impact upon our results of operations until we grant additional stock option awards or until participation in our employee stock purchase plan increases significantly. However, the transition to SFAS No. 123R will require us to reclassify our unamortized deferred compensation reported in the equity section of our balance sheet to additional paid-in capital.
For further information regarding our share-based compensation, refer to Note 3.
Inventory Costs - In November 2004, the FASB approved Statement No. 151, Inventory Costs an Amendment of ARB No. 43, Chapter 4. Statement No. 151 clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) and requires that those items be recognized as a current period expense regardless of whether they meet the criteria of “so abnormal.” This statement also requires that allocation of fixed production overheads to the costs of conversion be based upon the normal capacity of the production facilities. This statement is effective for interim or annual periods beginning after June 15, 2005 and will thus be effective for our first quarter of fiscal 2006. We do not believe that the new accounting requirements of SFAS No. 151 will have a material impact on our financial statements.
Nonmonetary Exchange Transactions - In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29. Statement No. 153 amends APB Opinion No. 29, which is based upon the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged, by eliminating the exception to fair value accounting for nonmonetary exchanges of similar productive assets and replacing it with a general exception to fair value accounting for nonmonetary exchanges that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. Statement No. 153 is effective for nonmonetary asset exchanges occurring in periods beginning after June 15, 2005. We do not believe that the requirements of this statement will have a material impact upon our financial statements.
During the fiscal 2005 year-end closing process, the Company determined that its previously issued consolidated balance sheet for the year ended August 31, 2004 and consolidated statements of shareholders’ equity for the three years in the period ended August 31, 2004 needed to be restated to correct an inaccurate deferred tax calculation that affected our statement of operations for the fiscal year ended August 31, 2002. The Company identified that, historically, the deferred income tax liability for the basis difference on indefinite-lived intangibles calculated upon the adoption of SFAS No. 142, Goodwill and Other Intangibles, was incorrectly offset against deferred income tax assets. The deferred tax liability relating to this basis difference was assumed to reverse against the deferred tax asset, which resulted in the Company not providing a sufficient valuation allowance against the deferred tax assets. Since this deferred tax liability relates to indefinite-lived assets, it was not correct to net the deferred tax assets and liabilities.
In addition, the Company determined that it should have recognized a deferred tax liability and a corresponding increase to goodwill related to the acquisition of intangible assets in a prior period. The additional goodwill should have been expensed in the cumulative effect of the accounting change resulting from the adoption of SFAS No. 142 because all goodwill was considered impaired at the date we adopted SFAS No. 142, and the additional deferred income tax liability should have been utilized to reduce the deferred tax valuation allowance.
These inaccurate deferred tax calculations impacted the consolidated statement of operations for fiscal 2002 by increasing the income tax benefit, and decreasing the loss from continuing operations, by $6.4 million, and by increasing the charge resulting from the cumulative effect of accounting change related to the adoption of SFAS No. 142 by $14.5 million. The net effect of these errors increases the reported $109.3 million net loss attributable to common shareholders in fiscal 2002 by $8.1 million, to $117.4 million.
For periods subsequent to fiscal 2002, these errors only affected our consolidated balance sheets through the impact of increased net deferred tax liabilities and decreased retained earnings. The restated amounts on the consolidated balance sheet and consolidated statements of shareholders’ equity for fiscal years 2004, 2003, and 2002 resulting from these errors were as follows (in thousands):
| | | Restated | | As Previously Reported | |
Fiscal 2004 | | | | | | | |
| Prepaid expenses and other assets | | $ | 7,996 | | $ | 5,794 | |
| Total current assets | | | 92,229 | | | 90,027 | |
| Other long-term assets | | | 7,305 | | | 7,593 | |
| Total assets | | | 227,625 | | | 225,711 | |
| | | | | | | | |
| Deferred income tax liabilities | | | 10,047 | | | - | |
| Total liabilities | | | 69,146 | | | 59,099 | |
| | | | | | | | |
| Accumulated deficit at August 31, 2004 | | | (16,931 | ) | | (8,798 | ) |
| Total shareholders’ equity | | | 158,479 | | | 166,612 | |
| | | | | | | | |
Fiscal 2003 | | | | | | | |
| Retained earnings (accumulated deficit) at August 31, 2003 | | | (3,912 | ) | | 4,221 | |
| | | | | | | | |
Fiscal 2002 | | | | | | | |
| Retained earnings at August 31, 2002 | | | 50,076 | | | 58,209 | |
There was no impact in any year due to this restatement on net cash provided by operating, investing, or financing activities on the consolidated statements of cash flows. This restatement also impacts information presented in Note 16 (Income Taxes) and Note 18 (Segment Information) to these consolidated financial statements.
Overview
Through August 31, 2005, we accounted for our stock-based compensation and awards using the intrinsic-value method of accounting as outlined in Accounting Principles Board (APB) Opinion 25 and related interpretations. Under the intrinsic-value methodology, no compensation expense is recognized for stock option awards granted at, or above, the fair market value of the stock on the date of grant. Accordingly, no compensation expense has been recognized from our stock option plans or employee stock purchase plan in our consolidated statements of operations. Had compensation expense for our stock option plans and employee stock purchase plan been determined in accordance with SFAS No. 123, Accounting for Stock-Based Compensation, our net loss attributable to common shareholders and corresponding basic and diluted loss per share would have been the following (in thousands, except for per share amounts):
| YEAR ENDED AUGUST 31, | | 2005 | | 2004 | | 2003 | |
| Net loss attributable to common shareholders, as reported | | $ | (5,837 | ) | $ | (18,885 | ) | $ | (53,988 | ) |
| Fair value of stock-based compensation, net of income taxes | | | (2,228 | ) | | (774 | ) | | (876 | ) |
| Net loss attributable to common shareholders, pro forma | | $ | (8,065 | ) | $ | (19,659 | ) | $ | (54,864 | ) |
| | | | | | | | | | | |
| Basic and diluted net loss per share, as reported | | $ | (.34 | ) | $ | (.96 | ) | $ | (2.69 | ) |
| | | | | | | | | | | |
| Basic and diluted net loss per share, pro forma | | $ | (.46 | ) | $ | (1.00 | ) | $ | (2.74 | ) |
In connection with changes to our Chief Executive Officer’s (CEO) compensation (Note 19), we accelerated the vesting on the CEO’s 1.6 million stock options with an exercise price of $14.00 per share during fiscal 2005. The accelerated vesting of these options increased the stock-based compensation as shown in the table above by $1.9 million during fiscal 2005.
A Black-Scholes option-pricing model was used to calculate the pro forma compensation expense from stock option activity and the weighted average fair value of options granted. The following assumptions were used in the Black-Scholes option-pricing model for stock options that were granted in fiscal years 2004 and 2003. We did not grant any stock options during fiscal 2005.
| AUGUST 31, | | | 2004 | | | 2003 | |
| Dividend yield | | | None | | | None | |
| Volatility | | | 65.2 | % | | 65.0 | % |
| Expected life (years) | | | 2.9 | | | 2.9 | |
| Risk free rate of return | | | 4.2 | % | | 4.2 | % |
The weighted average fair value of options granted under our stock option plans during fiscal years 2004 and 2003 was $0.75 per share and $0.44 per share.
The estimated fair value of options granted is subject to the assumptions made in the Black-Scholes option-pricing model and if the assumptions were to change, the estimated fair value amounts could be significantly different.
The following is a summary of our stock-based compensation plans.
Stock Options
Our Board of Directors have approved an incentive stock option plan whereby options to purchase shares of our common stock are issued to key employees at an exercise price not less than the fair market value of the Company’s common stock on the date of grant. The term, not to exceed ten years, and exercise period of each incentive stock option awarded under the plan are determined by a committee appointed by our Board of Directors. In addition to stock options granted from the incentive stock option plan in prior years, we granted a fully vested stock award and other unvested stock awards during fiscal 2005 (refer to discussion below) from the incentive stock option plan, which also reduced the number of shares available for granting under the incentive option plan. At August 31, 2005, we had approximately 770,000 shares available for granting under this incentive stock option plan.
A summary of our stock option activity is presented below:
| | | Number of Stock Options | | Weighted Avg. Exercise Price | |
Outstanding at August 31, 2002 | | | 3,044,281 | | $ | 12.63 | |
| Granted | | | 20,000 | | | 0.99 | |
| Forfeited | | | (329,670 | ) | | 11.31 | |
Outstanding at August 31, 2003 | | | 2,734,611 | | | 12.71 | |
| Granted | | | 70,000 | | | 1.70 | |
| Forfeited | | | (298,952 | ) | | 12.84 | |
Outstanding at August 31, 2004 | | | 2,505,659 | | | 12.37 | |
| Granted | | | - | | | - | |
| Exercised | | | (15,000 | ) | | 1.73 | |
| Forfeited | | | (204,775 | ) | | 12.58 | |
Outstanding at August 31, 2005 | | | 2,285,884 | | $ | 12.40 | |
The following table summarizes exercisable stock option information for the periods indicated:
| AUGUST 31, | | 2005 | | 2004 | | 2003 | |
| Exercisable stock options | | | 2,248,384 | | | 810,659 | | | 1,023,486 | |
| Weighted average exercise price per share | | $ | 12.58 | | $ | 10.22 | | $ | 11.37 | |
The following information applies to our stock options outstanding at August 31, 2005:
| l | A total of 261,474 options outstanding have exercise prices between $1.70 per share and $7.00 per share, with a weighted average exercise price of $5.26 per share and a weighted average remaining contractual life of 4.6 years. At August 31, 2005, 223,974 of these options were exercisable. |
| l | We have 347,500 options outstanding that have exercise prices ranging from $7.19 per share to $9.69 per share, with a weighted average exercise price of $9.08 per share and a weighted average remaining contractual life of 4.0 years. At August 31, 2005, all of these options were exercisable. |
| l | We granted 1,602,000 options to our CEO under terms of a Board and shareholder approved employment agreement. These options have an exercise price of $14.00 per share, with a weighted average remaining contractual life of 5.0 years. As a result of changes to the CEO’s compensation arrangement in fiscal 2005 (Note 19), all of these options were vested in fiscal 2005 and were exercisable at August 31, 2005. |
| l | The remaining 74,910 stock options outstanding have exercise prices between $17.69 per share and $21.50 per share, with a weighted average exercise price of $18.57 per share and a weighted average remaining contractual life of less than one year. At August 31, 2005, all of these options were exercisable. |
Unvested Stock Awards
During fiscal years 2005 and 2004, the Company granted shares of our common stock to certain employees and non-employee members of our Board of Directors in the form of unvested stock awards. A summary of our unvested stock award activity during these years is presented below (in thousands, except share amounts):
| | | Number of Unvested Stock Awards | | Compensation Cost | |
Outstanding at August 31, 2003 | | | - | | | - | |
| Granted | | | 303,660 | | $ | 829 | |
| Amortization of compensation | | | n/a | | | (97 | ) |
Outstanding shares and unamortized compensation cost at August 31, 2004 | | | 303,660 | | | 732 | |
| Granted | | | 376,090 | | | 1,147 | |
| Vested | | | (258,205 | ) | | - | |
| Forfeited | | | (12,250 | ) | | (33 | ) |
| Amortization of compensation | | | n/a | | | (791 | ) |
Outstanding shares and unamortized compensation cost at August 31, 2005 | | | 409,295 | | $ | 1,055 | |
Employee Awards - Unvested stock awards granted to employees vest five years from the grant date or on an accelerated basis if we achieve specified earnings levels. The compensation cost of the unvested stock awards was based on the fair value of the shares on the grant date, which was recorded as deferred compensation in shareholders’ equity. The compensation cost related to these unvested stock awards will be expensed on a straight-line basis over the vesting period of the shares and will be accelerated when we believe that it is more likely than not that we will achieve the specified earnings thresholds and the shares will vest.
In connection with these unvested stock awards, the participants are eligible to receive a cash bonus for a portion of the income taxes resulting from the grant. The participants could receive their cash bonus at the time of grant or when the award shares vest. These cash bonuses totaled $0.5 million for awards granted in fiscal 2005, which was expensed as the bonuses were paid to the participants on or around the grant date. For fiscal 2004 awards, the cash bonuses totaled $0.4 million, of which $0.2 million was paid and expensed at the grant date. The remaining $0.2 million will be expensed on a straight-line basis over the vesting period, subject to acceleration, if necessary.
During our third quarter of fiscal 2005, we achieved the specified earnings thresholds required to accelerate the vesting for one-half of the unvested stock awards granted in fiscal 2004 and to our CEO in December 2004. Accordingly, during fiscal 2005 we expensed an additional $0.5 million of deferred compensation for the accelerated vesting of these unvested stock awards.
The unvested award shares were issued from common stock held in treasury and had a cost basis of $5.2 million for awards granted in fiscal 2005 and 2004. The difference between the fair value of the unvested shares granted and their cost, which totaled $4.2 million for fiscal 2005 awards and $4.4 million for fiscal 2004 awards, was recorded as a reduction to additional paid-in capital.
Subsequent to August 31, 2005, our Board of Directors approved a long-term incentive plan in which certain employees of the Company may be granted unvested share awards. This proposed long-term incentive plan is subject to shareholder approval.
Board of Director Awards - During fiscal 2005, we awarded 76,090 shares of common stock as unvested stock awards to non-employee members of the Board of Directors as part of a shareholder approved long-term incentive plan. The fair value of these shares were calculated on the grant date and the corresponding compensation cost was recorded as deferred compensation in shareholders’ equity and will be recognized over the vesting period of the awards, which is three years. These awards were valued at the closing market price of our common stock on the measurement date and resulted in a $0.2 million increase to deferred compensation in our balance sheet. The cost of the common stock issued from treasury stock was $1.3 million and the difference between the cost of the treasury stock and fair value of the award, which totaled $1.1 million, was recorded as a reduction of additional paid-in capital.
Fully-Vested Stock Award
In connection with changes to our CEO’s compensation plan (Note 19), the CEO was granted 187,000 shares of fully-vested common stock during the second quarter of fiscal 2005. The fully-vested stock award was valued at $2.16 per share, which was the closing market price of our common stock on the measurement date and resulted in $0.4 million of expense that was included as a component of selling, general, and administrative expense in fiscal 2005. The cost of the common stock issued from treasury was $3.2 million and the difference between the cost of the treasury stock and fair value of the award, which totaled $2.8 million, was recorded as a reduction of additional paid-in capital.
Our property and equipment were comprised of the following (in thousands):
| AUGUST 31, | | 2005 | | 2004 | |
| Land and improvements | | $ | 1,848 | | $ | 1,822 | |
| Buildings | | | 34,763 | | | 34,589 | |
| Machinery and equipment | | | 31,660 | | | 31,444 | |
| Computer hardware and software | | | 61,820 | | | 69,459 | |
| Furniture, fixtures, and leasehold improvements | | | 43,798 | | | 46,078 | |
| | | | 173,889 | | | 183,392 | |
| Less accumulated depreciation | | | (138,612 | ) | | (142,808 | ) |
| | | $ | 35,277 | | $ | 40,584 | |
On June 21, 2005 we completed the sale and leaseback of our corporate headquarters facility, located in Salt Lake City, Utah. The sale price was $33.8 million in cash and after deducting customary closing costs, including commissions and an amount held in escrow for payment of the remaining mortgage on one of the buildings, we received net proceeds totaling $32.4 million. In connection with the transaction, we entered into a 20-year master lease agreement with the purchaser, an unrelated private investment group. Although the corporate headquarters facility was sold and the Company has no legal ownership of the property, SFAS No. 98, Accounting for Leases, precluded us from recording the transaction as a sale since we have subleased more than a minor portion of the property. Accordingly, we have accounted for the sale as a financing transaction, which required us to continue reporting the corporate headquarters facility as an asset and to depreciate the property over the life of the master lease agreement. We also recorded a liability to the purchaser (Note 6) for the sale price. At August 31, 2005, the carrying value of the corporate headquarters facility was $23.4 million. The master lease agreement also contains six five-year renewal options, which allows us to maintain our operations at the current location for up to 50 years.
As a result of projected negative cash flows at certain retail stores, we recorded impairment charges totaling $0.2 million, $0.3 million, and $5.0 million, during fiscal years 2005, 2004, and 2003 to reduce the carrying values of the stores’ long-lived assets to their estimated fair values. These impairment charges were related to assets that are to be held and used by the Company and were included as a component of depreciation expense in our consolidated statements of operations.
Certain land and buildings are collateral for mortgage debt obligations (Note 6).
Our intangible assets were comprised of the following (in thousands):
AUGUST 31, 2005 | | Gross Carrying Amount | | Accumulated Amortization | | Net Carrying Amount | |
Definite-lived intangible assets: | | | | | | | | | | |
| License rights | | $ | 27,000 | | $ | (6,480 | ) | $ | 20,520 | |
| Curriculum | | | 58,232 | | | (25,146 | ) | | 33,086 | |
| Customer lists | | | 18,774 | | | (12,032 | ) | | 6,742 | |
| Trade names | | | 1,277 | | | (1,277 | ) | | - | |
| | | | 105,283 | | | (44,935 | ) | | 60,348 | |
Indefinite-lived intangible asset: | | | | | | | | | | |
| Covey trade name | | | 23,000 | | | - | | | 23,000 | |
| | | $ | 128,283 | | $ | (44,935 | ) | $ | 83,348 | |
| | | | | | | | | | | |
| AUGUST 31, 2004 | | | | | | | | | | |
Definite-lived intangible assets: | | | | | | | | | | |
| License rights | | $ | 27,000 | | $ | (5,543 | ) | $ | 21,457 | |
| Curriculum | | | 58,221 | | | (23,067 | ) | | 35,154 | |
| Customer lists | | | 18,774 | | | (10,878 | ) | | 7,896 | |
| Trade names | | | 1,277 | | | (1,277 | ) | | - | |
| | | | 105,272 | | | (40,765 | ) | | 64,507 | |
Indefinite-lived intangible asset: | | | | | | | | | | |
| Covey trade name | | | 23,000 | | | - | | | 23,000 | |
| | | $ | 128,272 | | $ | (40,765 | ) | $ | 87,507 | |
The range of remaining estimated useful lives and weighted-average amortization period over which we are amortizing the major categories of definite-lived intangible assets at August 31, 2005 were as follows:
Category of Intangible Asset | | Range of Remaining Estimated Useful Lives | | Weighted Average Amortization Period |
| | | | | |
| License rights | | 21 years | | 30 years |
| Curriculum | | 1 to 21 years | | 26 years |
| Customer lists | | 1 to 6 years | | 13 years |
Our aggregate amortization expense from definite-lived intangible assets totaled $4.2 million, $4.2 million, and $4.4 million, for the fiscal years ended August 31, 2005, 2004, and 2003. Estimated amortization expense for the next five years is expected to be as follows (in thousands):
| YEAR ENDING AUGUST 31, | | | |
| 2006 | | $ | 3,810 | |
| 2007 | | | 3,613 | |
| 2008 | | | 3,613 | |
| 2009 | | | 3,613 | |
| 2010 | | | 3,613 | |
Our long-term debt and financing obligation were comprised of the following (in thousands):
| AUGUST 31, | | 2005 | | 2004 | |
| Financing obligation on corporate campus, payable in monthly installments of $254 for the first five years with two percent annual increases thereafter (imputed interest at 7.7%), through June 2025 | | $ | 33,739 | | | | |
| Mortgage payable in monthly installments of $9 CDN ($7 USD at August 31, 2005), plus interest at CDN prime plus 1% (5.5% at August 31, 2005) through January 2015, secured by real estate | | | 889 | | $ | 889 | |
| Mortgage payable in monthly installments of $8 including interest at 9.9%, secured by real estate, and paid in full in September 2005 | | | 546 | | | 581 | |
| | | | 35,174 | | | 1,470 | |
| Less current portion | | | (1,088 | ) | | (120 | ) |
| Total long-term debt and financing obligation, less current portion | | $ | 34,086 | | $ | 1,350 | |
The mortgage loan on our Canadian facility requires the Company to maintain certain financial ratios at our directly owned Canadian operation. During fiscal 2005 our Canadian operation was not in compliance with the debt covenants on this mortgage. However, we obtained a waiver from the lender regarding this instance of non-compliance.
On June 21, 2005, we completed the sale and leaseback of our corporate headquarters facility, located in Salt Lake City, Utah. The sale price was $33.8 million in cash and after deducting customary closing costs, we received net proceeds totaling $32.4 million. In connection with the transaction, we entered into a 20-year master lease agreement with the purchaser, an unrelated private investment group. Although the corporate headquarters facility was sold and the Company has no legal ownership of the property, SFAS No. 98, Accounting for Leases, precluded us from recording the transaction as a sale since we have subleased a significant portion of the property that was sold. Accordingly, we have accounted for the sale as a financing transaction which required us to continue reporting the corporate headquarters facility as an asset (Note 4) and record a financing obligation for the sale price. The future minimum payments under the financing obligation for the initial 20 year lease term are as follows (in thousands):
| YEAR ENDING AUGUST 31, | | | | |
| 2006 | | $ | 3,045 | |
| 2007 | | | 3,045 | |
| 2008 | | | 3,045 | |
| 2009 | | | 3,045 | |
| 2010 | | | 3,055 | |
| Thereafter | | | 53,072 | |
| Total future minimum financing obligation payments | | | 68,307 | |
| Less interest | | | 35,880 | |
| Present value of future minimum financing obligation payments | | $ | 32,427 | |
The difference between the carrying value of the financing obligation and the present value of the future minimum financing obligation payments represents the carrying value of the land sold in the financing transaction, which is not depreciated. At the conclusion of the master lease agreement, the remaining financing obligation and carrying value of the land will be written off the Company’s financial statements. The lease agreement also contains six five-year renewal options that allow us to maintain our operations at the current location for up to 50 years.
Future principal maturities of our long-term debt and financing obligation were as follows at August 31, 2005 (in thousands):
| YEAR ENDING AUGUST 31, | | | | |
| 2006 | | $ | 1,088 | |
| 2007 | | | 579 | |
| 2008 | | | 618 | |
| 2009 | | | 659 | |
| 2010 | | | 715 | |
| Thereafter | | | 31,515 | |
| | | $ | 35,174 | |
In September 2005, we used a portion of the proceeds from the sale of our corporate headquarters to repay the mortgage, including a prepayment penalty totaling $0.1 million, on one of the buildings sold. The proceeds from the sale of the corporate headquarters facility that were used to repay the mortgage were reported as restricted cash on our August 31, 2005 consolidated balance sheet.
Lease Expense
In the normal course of business, we lease retail store and office space under noncancelable operating lease agreements. The majority of our retail stores are leased in locations that generally have significant consumer traffic, such as shopping malls and other commercial districts. We also rent office space, primarily for regional sales administration offices, in commercial office complexes that are conducive to administrative operations. These operating lease agreements generally contain renewal options that may be exercised at our discretion after the completion of the base rental term. In addition, many of the rental agreements provide for regular increases to the base rental rate at specified intervals, which usually occur on an annual basis. At August 31, 2005, we had operating leases that have remaining terms of one to 11 years. The following table summarizes our future minimum lease payments under operating lease agreements at August 31, 2005 (in thousands):
| YEAR ENDING AUGUST 31, | | | |
| 2006 | | $ | 8,509 | |
| 2007 | | | 6,204 | |
| 2008 | | | 5,346 | |
| 2009 | | | 4,225 | |
| 2010 | | | 3,148 | |
| Thereafter | | | 7,718 | |
| | | $ | 35,150 | |
We recognize lease expense on a straight-line basis over the life of the lease agreement. Contingent rent expense is recognized as it is incurred. Total rent expense in selling, general, and administrative expense from operating lease agreements was $13.6 million, $15.3 million, and $18.9 million for fiscal years 2005, 2004, and 2003. Additionally, certain retail store leases contain terms that require additional, or contingent, rental payments based upon the realization of certain sales thresholds. Our contingent rental payments under these arrangements were insignificant during the fiscal years ended August 31, 2005, 2004, and 2003.
During fiscal 2005, we completed the sale of our corporate headquarters facility, located in Salt Lake City, Utah. In connection with the transaction, we entered into a 20-year master lease agreement with the purchaser, an unrelated private investment group, which also contains six five-year renewal options. Although the corporate headquarters facility was sold and the Company has no legal ownership of the property, SFAS No. 98, Accounting for Leases, precluded us from recording the transaction as a sale and a lease since we have subleased more than a minor portion of the property. Accordingly, we have accounted for the sale as a financing transaction which required us to continue reporting the corporate headquarters facility as an asset and to continue depreciating the property (Note 4). We also recorded a liability to the purchaser (Note 6) for the sale price.
Lease Income
During fiscal 2005 and 2004, we subleased a significant portion of our corporate headquarters office space located in Salt Lake City, Utah to multiple, unrelated tenants. The cost basis of the office space available for lease was approximately $23.3 million and had a carrying value of $16.7 million at August 31, 2005. We also have sublease agreements on two retail store locations that we have exited, but still have a remaining lease obligation (Note 15). Future minimum lease payments due to us from these sublease agreements at August 31, 2005, are as follows (in thousands):
| YEAR ENDING AUGUST 31, | | | |
| 2006 | | $ | 1,875 | |
| 2007 | | | 2,155 | |
| 2008 | | | 2,230 | |
| 2009 | | | 2,230 | |
| 2010 | | | 1,495 | |
| Thereafter | | | 2,156 | |
| | | $ | 12,141 | |
Total sublease payments made to the Company totaled $1.9 million, $2.4 million, and $2.2 million during fiscal 2005, 2004, and 2003 of which $0.8 million, $2.3 million, and $2.2 million was recorded as a reduction of rent expense associated with underlying lease agreements in our selling, general, and administrative expense. The remaining sublease income was from leases at our corporate headquarters and was reported as a component of product sales in our consolidated statement of operations for fiscal 2005 and 2004.
EDS Contract
The Company has an outsourcing contract with Electronic Data Systems (EDS) to provide warehousing, distribution, information systems, and call center operations. Under terms of the outsourcing contract and its addendums, EDS operates our primary call center, provides warehousing and distribution services, and supports our software products and various information systems. The outsourcing contract and its addendums expire on June 30, 2016 and have remaining required minimum payments totaling approximately $257.2 million, which are payable over the life of the contract. During fiscal years 2005, 2004, and 2003, we expensed $30.4 million, $33.8 million, and $35.9 million for services provided under terms of the EDS outsourcing contract. The total amount expensed each year under the EDS contract includes freight charges, which are billed to the Company based upon activity, that totaled $9.6 million, $9.6 million, and $10.7 million, during fiscal years 2005, 2004, and 2003. The following schedule summarizes our required minimum payments to EDS for services over the life of the outsourcing contract and its addendums (in thousands):
| YEAR ENDING AUGUST 31, | | | |
| 2006 | | $ | 23,918 | |
| 2007 | | | 22,591 | |
| 2008 | | | 22,829 | |
| 2009 | | | 23,076 | |
| 2010 | | | 23,330 | |
| Thereafter | | | 141,467 | |
| | | $ | 257,211 | |
Actual expenses resulting from the outsourcing contracts may exceed required minimum payments if actual services provided under the contracts exceed specified minimum levels.
Under terms of the outsourcing agreement with EDS, we are contractually obligated to purchase the necessary computer hardware and software to keep such property and equipment up to certain specifications. Amounts shown below are estimated capital purchases of computer hardware and software under terms of the EDS outsourcing agreement and its amendments (in thousands):
| YEAR ENDING AUGUST 31, | | | |
| 2006 | | $ | 1,334 | |
| 2007 | | | 680 | |
| 2008 | | | 797 | |
| 2009 | | | 1,072 | |
| 2010 | | | 1,334 | |
| Thereafter | | | 6,059 | |
| | | $ | 11,276 | |
In addition to the minimum required outsourcing contract payments that were due in fiscal 2004, we paid an additional $11.6 million related to invoices outstanding for the period from December 2002 through May 2003. These payments had been postponed until certain software system implementation issues were resolved. Under terms of the revised payment schedule, we paid EDS interest at the monthly prime rate as quoted in the Wall Street Journal plus one percent on the outstanding balance of these invoices.
The outsourcing contracts contain early termination provisions that the Company may exercise under certain conditions. However, in order to exercise the early termination provisions, we would have to pay specified penalties to EDS depending upon the circumstances of the contract termination.
Legal Matters
During fiscal 2002, we received a subpoena from the Securities and Exchange Commission (SEC) seeking documents and information relating to our management stock loan program and previously announced, and withdrawn, tender offer. We have provided the documents and information requested by the SEC, including the testimonies of our Chief Executive Officer, Chief Financial Officer, and other key employees. The Company has cooperated, and will continue to fully cooperate, in providing requested information to the SEC. The SEC and the Company are currently engaged in discussions with respect to a potential resolution of this matter.
In fiscal 2002, we brought legal action against World Marketing Alliance, Inc., a Georgia corporation (WMA) and World Financial Group, Inc., a Delaware corporation and the purchaser of substantially all assets of WMA, for breach of contract. The jury rendered a verdict in our favor and against WMA on November 1, 2004 for the entire unpaid contract amount of approximately $1.1 million. In addition to the verdict, we recovered legal fees totaling $0.3 million and pre- and post-judgment interest of $0.3 million from WMA. The Company received payment in cash for the legal settlement during the third quarter of fiscal 2005. However, shortly after paying the legal settlement, WMA appealed the jury decision to the 10th Circuit Court of Appeals. As a result of the appeal, we recorded the cash received and a corresponding increase to accrued liabilities, and will not recognize the gain from the legal settlement until the case is completely resolved.
The Company is also the subject of certain legal actions, which we consider routine to our business activities. At August 31, 2005, we believe that, after consultation with legal counsel, any potential liability to the Company under such actions will not materially affect our financial position, liquidity, or results of operations.
Overview
On March 4, 2005, at the Annual Meeting of Shareholders, our shareholders approved a plan to recapitalize the Company’s preferred stock. Under terms of the recapitalization plan, we completed a one-to-four forward split of the existing Series A preferred stock and then bifurcated each share of Series A preferred stock into a new share of Series A preferred stock that is no longer convertible into common stock, and a warrant to purchase shares of common stock. The new Series A preferred stock retains its common-equivalent voting rights and will automatically convert to shares of Series B preferred stock if the holder of the original Series A preferred stock sells, or transfers, the preferred stock to another party. Series B preferred stock does not have common-equivalent voting rights, but retains substantially all other characteristics of the new Series A preferred stock.
Each previously existing Series A preferred shareholder received a warrant to purchase a number of common shares equal to 71.43 shares for each $1,000 ($14 per share) in aggregate liquidation value of Series A preferred shares held immediately prior to the recapitalization transaction. The exercise price of each warrant is $8.00 per share (subject to customary anti-dilution and exercise features) and the warrants will be exercisable over an eight-year term.
The preferred stock recapitalization transaction enables us to:
| l | Have the conditional right to redeem shares of preferred stock; |
| l | Place a limit on the period in which we may be required to issue common stock. The new warrants to purchase shares of common stock expire in eight years, compared to the perpetual right of previously existing Series A preferred stock to convert to shares of common stock; |
| l | Increase our ability to purchase shares of our common stock. Previous purchases of common stock were limited and potentially subject to the approval of Series A preferred shareholders; |
| l | Create the possibility that we may receive cash upon issuing additional shares of common stock to Series A preferred shareholders. The warrants have an exercise price of $8.00 per share compared to the previously existing right of Series A preferred shareholders to convert their preferred shares into common shares without paying cash; and |
| l | Eliminate the requirement to pay common stock dividends to preferred shareholders on an “as converted” basis. |
New Preferred Stock Rights
Upon completion of the recapitalization transaction, Series A preferred rights were amended to prevent the conversion of Series A preferred stock to shares of common stock. Series B preferred stock rights were amended to be substantially equivalent to Series A rights, except for the eliminated voting rights. The rights of the new Series A and Series B preferred stock include the following:
| l | Liquidation Preference - Both Series A and Series B preferred stock have a liquidation preference of $25.00 per share plus accrued unpaid dividends, which will be paid in preference to the liquidation rights of all other equity classes. |
| l | Conversion - Neither Series A nor Series B preferred stock is convertible to shares of common stock. Series A preferred stock converts into shares of Series B upon the sale or transfer of the Series A shares. Series B preferred stock does not have any conversion rights. |
| l | Dividends- Both Series A and Series B preferred stock accrue dividends at 10.0 percent, payable quarterly, in preference to dividends on all other equity classes. If dividends are in arrears for six or more quarters, the number of the Company’s Board of Directors will be increased by two and the Series A and Series B preferred shareholders will have the ability to select these additional directors. Series A and Series B preferred stock may not participate in dividends paid to common stockholders. |
| l | Redemption - We may redeem any of the Series A or Series B preferred shares during the first year following the recapitalization at a price per share equal to 100 percent of the liquidation preference. Subsequent to the first anniversary of the recapitalization and before the fifth anniversary of the transaction, we may only purchase preferred shares (up to $30.0 million in aggregate) from Knowledge Capital, which holds the majority of our preferred stock, at a premium that increases one percentage point annually. After the sixth anniversary of the recapitalization, we may redeem any shares of preferred stock at 101 percent of the liquidation preference on the date of redemption. |
| l | Change in Control - In the event of any change in control of the Company, Knowledge Capital, to the extent that it still holds shares of Series A preferred stock, will have the option to receive a cash payment equal to 101 percent of the liquidation preference of its Series A preferred shares then held. The remaining Series A and Series B preferred shareholders have no such option. |
| l | Voting Rights - Although the new Series A preferred shareholders will not have conversion rights, they will still be entitled to voting rights. The holder of each new share of Series A preferred stock will be entitled to the voting rights they would have if they held two shares of common stock. The cumulative number of votes will be based upon the number of votes attributable to shares of Series A held immediately prior to the recapitalization transaction less any transfers of Series A shares to Series B shares or redemptions. In the event that a Series A preferred shareholder exercises a warrant to purchase the Company’s common stock, their Series A voting rights will be reduced by the number of the common shares issued upon exercise of the warrant. This feature will prevent the holders of Series A preferred stock from increasing their voting influence through the acquisition of additional shares of common stock from the exercise of the warrants. |
| l | Registration Rights - We were required to use our best efforts to register the resale of all shares of common stock and shares of Series B preferred stock issuable upon the transfer and conversion of the Series A preferred stock held by Knowledge Capital and certain permitted transferees of Knowledge Capital within 240 days following the initial filing of the registration statement covering such shares. The initial filing of the registration statement was required to occur within 120 days following the closing of the recapitalization transaction. However, we obtained an extension on this filing from Knowledge Capital and the registration statement was filed and became effective in September 2005. |
Accounting for the Recapitalization
In order to account for the various aspects of the preferred stock recapitalization transaction, we considered guidance found in SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liability and Equity, Emerging Issues Task Force (EITF) Issue 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock, EITF Issue D-98 Classification and Measurement of Redeemable Securities, and EITF Issue D-42, The Effect on the Calculation of Earnings per Share for the Redemption or Induced Conversion of Preferred Stock. Based upon the relevant guidance found in these pronouncements, we accounted for the various aspects of the preferred stock recapitalization as follows:
New Series A and Series B Preferred Stock - The new shares of preferred stock will continue to be classified as a component of shareholders’ equity since its conversion into cash or common stock is solely within the Company’s control as there are no provisions in the recapitalization documents that would obligate us to redeem shares of the Series A or Series B preferred stock. In addition, by virtue of the Utah Control Shares Act, the Company’s Bylaws, and the special voting rights of the preferred shareholders, there are no circumstances under which a third party could acquire controlling voting power of the Company’s stock without consent of our Board of Directors and thus trigger our obligation to redeem the new preferred stock. Due to the significant modifications to existing shares of Series A and Series B preferred stock, we believe that the previously outstanding preferred stock was replaced with new classes of preferred stock and common stock warrants. As a result, the new preferred stock was recorded at its fair value on the date of modification. Consistent with other equity instruments, the carrying value of the new preferred stock will not be subsequently adjusted to its fair market value at the end of any reporting period.
We engaged an independent valuation firm to determine the fair value of the newly issued shares of preferred stock prior to the March 8, 2005 recapitalization closing date. The fair value of the new preferred stock under this valuation was preliminarily determined to be $20.77 per share, or $4.23 per share less than the preferred stock’s liquidation preference of $25.00 per share. Based upon this valuation, we would have recorded a recapitalization gain of approximately $7.7 million during the quarter in which the recapitalization transaction was completed and also would have recorded losses in future periods for preferred stock redemptions made at the liquidation preference.
Subsequent to this valuation, we completed the sale of our corporate headquarters facility and redeemed $30.0 million, or 1.2 million shares, of Series A preferred stock at its liquidation preference and we are considering additional redemptions of preferred stock at the liquidation preference in the near future. Based upon these considerations and other factors, including the improvements in our operating results, we determined that the liquidation preference ($25.00 per share) is more indicative of the fair value of the preferred stock at the date of the recapitalization transaction. Accordingly, we recorded a $7.8 million loss from the recapitalization transaction since the aggregate fair value of the new shares of preferred stock and warrants (see warrant discussion below) exceeded the carrying value of the old preferred stock.
Warrants - EITF Issue 00-19 states that warrants should be classified as a component of shareholders’ equity if 1) the warrant contract requires physical settlement or net-share settlement or 2) the warrant contract gives the Company a choice of net-cash settlement or settlement in its own shares. We determined that the warrants should be accounted for as equity instruments because they meet these requirements.
Accordingly, we recorded the warrants at their fair value, as determined using a Black-Scholes valuation model on the date of the transaction, as a component of shareholders’ equity. Subsequent changes in fair value will not be recorded in our financial statements as long as the warrants remain classified as shareholders’ equity in accordance with EITF Issue 00-19. At the date of the recapitalization transaction, the warrants had a fair value of $1.22 per share, or approximately $7.6 million in total. We issued 6.2 million common stock warrants in connection with the recapitalization transaction.
Derivatives - The modified preferred stock agreement contains a feature that allows us to redeem preferred stock at its liquidation preference in the first year following the recapitalization transaction and at 101 percent of the liquidation preference after the sixth anniversary of the recapitalization transaction. In accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, we have determined that this embedded call feature is not a derivative because the contract is both 1) indexed in our stock, and 2) is classified in stockholders’ equity on our balance sheet.
A separate agreement exists with Knowledge Capital, the entity that holds the majority of the Series A preferred stock, which contains a call option to redeem $30.0 million of preferred stock at 100 percent to 103 percent of the liquidation preference as well as a “change in control” put option at 101 percent of the liquidation preference. This agreement is a derivative and meets the criteria found in paragraph 11 of SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity, to be separately accounted for as a liability. However, the fiscal 2005 $30.0 million redemption of Knowledge Capital preferred stock extinguished the call option in the recapitalization agreement and the corresponding liability derivative. Therefore, the incremental change of control feature (the amount in excess of 100 percent of liquidation preference in the change of control put option) will be valued at fair value based upon the likelihood of exercise and the expected incremental amount to be paid upon the change of control provision of the agreement. This derivative-based liability will require adjustment to fair value at each reporting period and had an initial value of zero on the date of the recapitalization transaction. At August 31, 2005, the fair value of this derivative-based liability was zero.
Subsequent to August 31, 2005, we redeemed an additional $10.0 million of preferred stock and announced that we intend to seek shareholder approval to amend our articles of incorporation to extend the period during which we have the right to redeem the outstanding preferred stock at 100 percent of the liquidation preference (Note 22). The amendment would extend the current redemption deadline from March 8, 2006 to December 31, 2006 and also provide the right to extend the redemption period for an additional year to December 31, 2007, if another $10.0 million of preferred stock is redeemed before December 31, 2006.
Preferred Stock
Series A - Following the recapitalization of our preferred stock in fiscal 2005, which included a one-to-four forward split of existing Series A preferred stock, we had 3.5 million shares of Series A preferred stock outstanding. Following the sale of our corporate headquarters facility, we used $30.0 million of the proceeds from the sale to redeem 1.2 million shares of Series A preferred stock held by Knowledge Capital at the liquidation preference of the preferred stock as allowed by the recapitalization agreement. At August 31, 2005, we had 2.3 million shares of Series A preferred stock outstanding.
Series A preferred stock dividends accrue at an annual rate of 10.0 percent and are payable quarterly in cash. At August 31, 2005 and 2004, we had $1.4 million and $2.2 million, respectively, of accrued Series A preferred dividends, which were recorded in accrued liabilities in our consolidated balance sheets. For further information regarding the rights and preferences of our recapitalized Series A preferred stock, refer to the disclosures in Note 9, “Preferred Stock Recapitalization.”
Series B - The preferred stock recapitalization completed in fiscal 2005 significantly changed the rights and preferences of our Series B preferred stock. Our new Series A preferred stock automatically converts to shares of Series B preferred stock if the holder of the original Series A preferred stock sells, or transfers, the preferred stock to another party. Series B preferred stock does not have common-equivalent voting rights, but retains substantially all other characteristics of the new Series A preferred stock. At August 31, 2005, there were 4.0 million shares of Series B preferred stock authorized and no shares of Series B preferred stock outstanding.
Common Stock Warrants
Pursuant to the terms of the preferred stock recapitalization plan, we completed a one-to-four forward split of the existing Series A preferred stock and then bifurcated each share of Series A preferred stock into a new share of Series A preferred stock that is no longer convertible into common stock, and a warrant to purchase shares of common stock. Accordingly, we issued 6.2 million common stock warrants with an exercise price of $8.00 per share (subject to customary anti-dilution and exercise features), which will be exercisable over an eight-year term. These newly issued common stock warrants were recorded at fair value on the date of the recapitalization, as determined by a Black-Scholes valuation methodology, which totaled $7.6 million. During the fiscal year ended August 31, 2005 no common stock warrants were exercised.
Treasury Stock
During the fiscal years ended August 31, 2005, 2004, and 2003, we issued 42,263; 99,137; and 211,245 shares of our common stock held in treasury to participants in the Company’s employee stock purchase plan and as the result of the exercise of stock options. Proceeds from the issuance of these shares totaled $0.1 million, $0.2 million, and $0.2 million during fiscal years 2005, 2004, and 2003. In addition, we issued 563,090 and 303,660 shares of our common stock held in treasury in connection with unvested and fully-vested stock awards during fiscal 2005 and 2004 (Note 3).
Our Board of Director approved plans to purchase shares of our common stock consisted of the following at August 31, 2005 (in thousands):
Description | | Total Approved Shares or Amount | | Total Shares Purchased or Amount Utilized | | Total Shares That May Yet Be Purchased | |
| All plans prior to December 1, 2000 | | | 8,000 | | | 7,705 | | | 295 | |
| December 1, 2000 plan | | $ | 8,000 | | $ | 7,085 | | | 131 | |
| Total approximate number of shares remaining in purchase plans | | | | | | | | | 426 | |
The approximate number of shares that may yet be purchased under the plans was calculated for the December 1, 2000 plan by dividing the remaining approved amount by $7.00, which was the closing price of the Company’s common stock on August 31, 2005. No shares of our common stock were purchased during fiscal years 2005, 2004, or 2003 under terms of these purchase plans. However, during the fiscal years ended August 31, 2005, 2004, and 2003, we purchased 22,500; 92,300; and 129,300 shares of our common stock with a corresponding cost of $0.1 million, $0.2 million, and $0.1 million for exclusive distribution to participants in the Company’s employee stock purchase plan.
During the fiscal year ended August 31, 2000, certain of our management personnel borrowed funds from an external lender, on a full-recourse basis, to acquire shares of our common stock. The loan program closed during fiscal 2001 with 3.825 million shares of common stock purchased by the loan participants for a total cost of $33.6 million. The Company initially participated on these management common stock loans as a guarantor to the lending institution. However, in connection with a new credit facility obtained during the fourth quarter of fiscal 2001, we acquired the loans from the external lender at fair value and are now the creditor for these loans. The loans in the management stock loan program have historically accrued interest at 9.4 percent (compounded quarterly), are full-recourse to the participants, and were originally due in March 2005. Although interest accrues on the outstanding balance over the life of the loans, the Company ceased recording interest receivable (and related interest income) related to these loans during the third quarter of fiscal 2002. However, loan participants remain obligated to pay all accrued interest upon maturity of the loans.
In May 2004, our Board of Directors approved modifications to the terms of the management stock loans. While these changes have significant implications for most management stock loan program participants, the Company did not formally amend or modify the stock loan program notes. Rather, the Company is foregoing certain of its rights under the terms of the loans and granting participants the modifications described below in order to potentially improve their ability to pay, and our ability to collect, the outstanding balances of the loans. These modifications to the management stock loan terms apply to all current and former employees whose loans do not fall under the provisions of the Sarbanes-Oxley Act of 2002. Loans to the Company’s officers and directors (as defined by the Sarbanes-Oxley Act of 2002) were not affected by the approved modifications. Accordingly, the Company collected $0.8 million, which represented payment in full, from an officer and members of the Board of Directors that were required to repay their loans on March 30, 2005.
The modifications to the management stock loan terms were as follows:
| | Waiver of Right to Collect - The Company will waive its right to collect the outstanding balance of the loans prior to the earlier of (a) March 30, 2008, or (b) the date after March 30, 2005 on which the closing price of the Company’s stock multiplied by the number of shares purchased equals the outstanding principal and accrued interest on the management stock loans. |
| | Lower Interest Rate - Effective May 7, 2004, the Company prospectively waived collection of all interest on the loans in excess of 3.16 percent per annum, which was the “Mid-Term Applicable Federal Rate” for May 2004. |
| | Use of the Company’s Common Stock to Pay Loan Balances - The Company may consider receiving shares of our common stock as payment on the loans, which were previously only payable in cash. |
| | Elimination of the Prepayment Penalty - The Company will waive its right to charge or collect any prepayment penalty on the management common stock loans. |
These modifications, including the reduction of the loan program interest rate, were not applied retroactively and participants remain obligated to pay interest previously accrued using the original interest rate. Also during fiscal 2005, our Board of Directors approved loan modifications for a former executive officer and a former director substantially similar to loan modifications previously granted to other loan participants in the management stock loan program as described above.
Based upon guidance found in EITF Issue 00-23, Issues Related to the Accounting for Stock Compensation under APB Opinion No. 25 and FASB Interpretation No. 44, and EITF Issue 95-16, Accounting for Stock Compensation Agreements with Employer Loan Features under APB Opinion No. 25, we determined that the management common stock loans should be accounted for as non-recourse stock compensation instruments due to the modifications approved in May 2004 and their corresponding effects on the Company and the loan participants. While this accounting treatment does not alter the legal rights associated with the loans to the employees as described above, the modifications to the terms of the loans were deemed significant enough to adopt the non-recourse accounting model as described in EITF 00-23. As a result of this accounting treatment, the remaining carrying value of the notes and interest receivable related to financing common stock purchases by related parties, which totaled $7.6 million prior to the loan term modifications, was reduced to zero with a corresponding reduction in additional paid-in capital.
We currently account for the management common stock loans as variable stock option arrangements. Under the provisions of SFAS No. 123R, which we will adopt effective September 1, 2005, additional compensation expense will only be recognized on the loans if the Company takes action on the loans that in effect constitutes a modification of an option. This accounting treatment also precludes us from reversing the amounts expensed as additions to the loan loss reserve, totaling $29.7 million, which were recognized in prior periods. As a result of these loan program modifications, the Company hopes to increase the total value received from loan participants; however, the inability of the Company to collect all, or a portion, of these receivables could have an adverse impact upon our financial position and future cash flows compared to full collection of the loans.
Fair Value of Financial Instruments
The book value of our financial instruments approximates their fair values except as noted below. The assessment of the fair values of our financial instruments is based on a variety of factors and assumptions. Accordingly, the fair values may not represent the actual values of the financial instruments that could have been realized at August 31, 2005 or 2004, or that will be realized in the future, and do not include expenses that could be incurred in an actual sale or settlement. The following methods and assumptions were used to determine the fair values of our financial instruments, none of which were held for trading or speculative purposes:
Cash and Cash Equivalents - The carrying amounts of cash and cash equivalents approximate their fair values due to the liquidity and short-term maturity of these instruments.
Accounts Receivable - The carrying value of accounts receivable approximate their fair value due to the short-term maturity and expected collection of these instruments.
Other Assets - Our other assets, including notes receivable, were recorded at the net realizable value of estimated future cash flows from these instruments.
Long-Term Debt and Financing Obligation - At August 31, 2005, our long-term debt consisted of a variable rate mortgage, a fixed rate mortgage, and a financing obligation resulting from the June 2005 sale of our corporate headquarters (Note 6). Further information regarding the fair value of these liability instruments is provided below.
Variable-Rate Debt - The fair value of our variable debt approximated its carrying value since the prevailing interest rate is adjusted to reflect market rates that would be available to us for similar debt with the corresponding remaining maturity.
Fixed Rate Debt - Our fixed-rate debt consists of a mortgage on one of the corporate campus buildings that was sold in June 2005 and was paid in full during September 2005. Due to the short-term nature of the mortgage at August 31, 2005, the fair value of this liability approximated its carrying value. At August 31, 2004, the fair value of this fixed-rate mortgage was $0.7 million compared to its carrying value of $0.6 million.
Financing Obligation - The fair value of the financing obligation approximates its carrying value as the interest rate on the obligation approximates the rate that would be available to us for similar debt with the same remaining maturity.
Derivative Instruments
During the normal course of business, we are exposed to fluctuations in foreign currency exchange rates due to our international operations and interest rates. To manage risks associated with foreign currency exchange and interest rates, we make limited use of derivative financial instruments. Derivatives are financial instruments that derive their value from one or more underlying financial instruments. As a matter of policy, our derivative instruments are entered into for periods that do not exceed the related underlying exposures and do not constitute positions that are independent of those exposures. In addition, we do not enter into derivative contracts for trading or speculative purposes, nor are we party to any leveraged derivative instrument. The notional amounts of derivatives do not represent actual amounts exchanged by the parties to the instrument and thus, are not a measure of exposure to the Company through its use of derivatives. Additionally, we enter into derivative agreements only with highly rated counterparties.
Foreign Currency Exposure - Due to the global nature of our operations, we are subject to risks associated with transactions that are denominated in currencies other than the United States dollar, as well as the effects of translating amounts denominated in foreign currencies to United States dollars as a normal part of the reporting process. The objective of our foreign currency risk management activities is to reduce foreign currency risk in the consolidated financial statements. In order to manage foreign currency risks, we make limited use of foreign currency forward contracts and other foreign currency related derivative instruments. Although we cannot eliminate all aspects of our foreign currency risk, we believe that our strategy, which includes the use of derivative instruments, can reduce the impacts of foreign currency related issues on our consolidated financial statements.
Foreign Currency Forward Contracts - During the fiscal years ended August 31, 2005, 2004, and 2003, we utilized foreign currency forward contracts to manage the volatility of certain intercompany financing transactions and other transactions that are denominated in foreign currencies. Because these contracts do not meet specific hedge accounting requirements, gains and losses on these contracts, which expire on a quarterly basis, are recognized currently and are used to offset a portion of the gains or losses of the related accounts. The gains and losses on these contracts were recorded as a component of selling, general, and administrative expense in our consolidated statements of operations and resulted in the following net losses for the periods indicated (in thousands):
| YEAR ENDED AUGUST 31, | | 2005 | | 2004 | | 2003 | |
| | | | | | | | | | | |
| Losses on foreign exchange contracts | | $ | (437 | ) | $ | (641 | ) | $ | (501 | ) |
| Gains on foreign exchange contracts | | | 127 | | | 227 | | | 38 | |
| Net losses on foreign exchange contracts | | $ | (310 | ) | $ | (414 | ) | $ | (463 | ) |
At August 31, 2005, the fair value of these contracts, which was determined using the estimated amount at which contracts could be settled based upon forward market exchange rates, was insignificant. The notional amounts of our foreign currency sell contracts that did not qualify for hedge accounting were as follows at August 31, 2005 (in thousands):
Contract Description | | Notional Amount in Foreign Currency | | Notional Amount in U.S. Dollars | |
| | | | | | | | |
| Japanese Yen | | | 273,000 | | $ | 2,458 | |
| Australian Dollars | | | 1,333 | | | 1,018 | |
| Mexican Pesos | | | 9,400 | | | 846 | |
Net Investment Hedges - During fiscal 2005 and 2004, we entered into foreign currency forward contracts that were designed to manage foreign currency risks related to the value of our net investment in directly-owned operations located in Canada, Japan, and the United Kingdom. These three offices comprise the majority of our net investment in foreign operations. These foreign currency forward instruments qualified for hedge accounting and corresponding gains and losses were recorded as a component of other comprehensive income in our consolidated balance sheet. During fiscal 2005 and 2004, we recognized the following net losses on our net investment hedging contracts (in thousands):
| YEAR ENDED AUGUST 31, | | 2005 | | 2004 | |
| | | | | | | | |
| Losses on net investment hedge contracts | | $ | (384 | ) | $ | (337 | ) |
| Gains on net investment hedge contracts | | | 66 | | | 130 | |
| Net losses on investment hedge contracts | | $ | (318 | ) | $ | (207 | ) |
As of August 31, 2005, we had settled our net investment hedge contracts. However, we may continue to utilize net investment hedge contracts in future periods as a component of our overall foreign currency risk strategy.
Interest Rate Risk Management - Due to the limited nature of our interest rate risk, we do not make regular use of interest rate derivatives and we were not a party to any interest rate derivative instruments during fiscal years 2005 or 2004.
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During fiscal 2003, the Company purchased approximately 20 percent of the capital stock (subsequently diluted to approximately 12 percent ownership) of Agilix Labs, Inc. (Agilix), a Delaware corporation, for cash payments totaling $1.0 million. Agilix is a development stage enterprise that develops software applications, including the majority of our software applications that are available for sale to external customers. We used the equity method of accounting for our investment in Agilix, as the Company appointed a member to Agilix’s board of directors and had the ability to exercise significant influence over the operations of Agilix. Although we continue to sell software developed by Agilix, uncertainties in Agilix’s business plan developed during our fiscal quarter ended March 1, 2003 and their potential adverse effects on Agilix’s operations and future cash flows were significant. Based on these factors, we determined that our ability to recover the carrying value of our investment in Agilix was remote. Accordingly, we impaired and expensed our remaining investment in Agilix of $0.9 million during fiscal 2003.
During fiscal 2005, certain affiliates of Agilix purchased the shares of capital stock held by the Company for $0.5 million in cash, which was reported as a gain on disposal of investment in unconsolidated subsidiary. Following the sale of the Agilix capital stock, we have no remaining ownership interest in Agilix, no representative on their board of directors, or any remaining obligations associated with our investment in Agilix.
Profit Sharing Plans
We have defined contribution profit sharing plans for our employees that qualify under Section 401(k) of the Internal Revenue Code. These plans provide retirement benefits for employees meeting minimum age and service requirements. Qualified participants may contribute up to 50 percent of their gross wages, subject to certain limitations. These plans also provide for matching contributions to the participants that are paid by the Company. The matching contributions, which were expensed as incurred, totaled $0.8 million, $0.7 million, and $1.0 million, for the fiscal years ended August 31, 2005, 2004, and 2003.
Employee Stock Purchase Plan
The Company has an employee stock purchase plan that offers qualified employees the opportunity to purchase shares of our common stock at a price equal to 85 percent of the average fair market value of the Company’s common stock on the last trading day of each fiscal quarter. A total of 27,266; 99,136; and 211,245 shares were issued under this plan in the fiscal years ended August 31, 2005, 2004, and 2003. On August 31, 2004, our previously existing employee stock purchase plan expired. Since the new employee stock purchase plan was not ratified by shareholders until March 2005, the Company did not withhold employee contributions for approximately six months in fiscal 2005 and substantially fewer shares were issued to plan participants during fiscal 2005 than in previous years.
Through August 31, 2005, we accounted for our employee stock purchase plan using the intrinsic method as defined in the provisions of APB Opinion 25 and related interpretations (Note 1).
Deferred Compensation Plan
The Company has a non-qualified deferred compensation plan that provided certain key officers and employees the ability to defer a portion of their compensation until a later date. Deferred compensation amounts used to pay benefits are held in a “rabbi trust,” which invests in insurance contracts, various mutual funds, and shares of our common stock as directed by the plan participants. The trust assets, which consist of the investments in insurance contracts and mutual funds, are recorded in our consolidated balance sheets because they are subject to the claims of our creditors. The corresponding deferred compensation liability represents the amounts deferred by plan participants plus or minus any earnings or losses on the trust assets. The deferred compensation plan’s assets totaled $1.2 million at August 31, 2005 and 2004, while the plan’s liabilities totaled $1.3 million and $1.6 million at August 31, 2005 and 2004. At August 31, 2005, the rabbi trust also held shares of our common stock with a cost basis of $0.6 million. The assets and liabilities of the deferred compensation plan were recorded in other long-term assets, treasury stock, additional paid-in capital, and long-term liabilities, as appropriate, in the accompanying consolidated balance sheets.
We expensed charges totaling $0.8 million, $0.2 million, and $0.2 million during each of the fiscal years ended August 31, 2005, 2004, and 2003 related to our deferred compensation plan. Due to increases in the market value of our common stock held by the deferred compensation plan during fiscal 2005 which increased the plan liability to participants without a corresponding increase in plan assets, we recorded increased expenses associated with our deferred compensation plan. To reduce expenses from the plan in future periods, we modified the deferred compensation plan to require participants who hold shares of our common stock to receive distributions in common stock rather than cash. Accordingly, $0.9 million of the plan liability at the date of the modification was reclassified to additional paid-in capital.
Due to legal changes resulting from the American Jobs Creation Act of 2004, the Company determined to cease compensation deferrals to this plan after December 31, 2004. Other than the cessation of compensation deferrals and the requirement to distribute investments in Company stock with shares of stock, the plan will continue to operate and make payments under the same rules as in prior periods.
Restructuring Costs
During fiscal 1999, our Board of Directors approved a plan to restructure our operations, reduce our workforce, and formally exit certain leased office space located in Provo, Utah. The Company, under a long-term agreement, leased the Provo office space in buildings that were owned by partnerships, the majority interest of which were owned by the Vice-Chairman of the Board of Directors and certain other employees and former employees of the Company. During the first quarter of fiscal 2005, we exercised an option, available under our master lease agreement, to purchase, and simultaneously sell, the office facility to the current tenant, an unrelated party. Based on the continuing negative cash flow associated with these buildings, and other factors, we determined that it was in our best interest to exercise the option and sell the property.
The negotiated purchase price with the landlord was $14.0 million and the tenant agreed to purchase the property for $12.5 million. These prices were within the range of estimated fair values of the buildings as determined by an independent appraisal obtained by the Company. We paid the difference between the sale and purchase prices, plus other closing costs, which were included as a component of the restructuring plan accrual. After accounting for the sale transaction, the remaining fiscal 1999 accrued restructuring costs, which totaled $0.3 million, were reversed and recorded as a reduction to selling, general, and administrative expenses in our condensed consolidated statement of operations. Following the sale of these buildings, we have no further obligations remaining under the fiscal 1999 restructuring plan.
Retail Store Closure Costs
We regularly assess the operating performance of our retail stores, including previous operating performance trends and projected future profitability. During this assessment process, judgments are made as to whether under-performing or unprofitable stores should be closed. As a result of this evaluation process, we closed 30 retail stores during fiscal 2005, 18 retail stores in fiscal 2004, and we may close additional retail locations in future periods if further analysis indicates that our operating results may be improved through additional closures. We have incurred severance and lease termination costs related to these store closure activities, which are included as a component of selling, general, and administrative expenses in our condensed consolidated statements of operations.
The components of the remaining restructuring and store closure accruals were as follows for the periods indicated (in thousands):
| | | Severance Costs | | Leased Space Exit Costs | | Total | |
| Balance at August 31, 2003 | | $ | 304 | | $ | 3,146 | | $ | 3,450 | |
| Charges to the accrual | | | 224 | | | 1,482 | | | 1,706 | |
| Amounts utilized | | | (512 | ) | | (1,862 | ) | | (2,374 | ) |
| Balance at August 31, 2004 | | | 16 | | | 2,766 | | | 2,782 | |
| Charges to the accrual | | | 279 | | | 293 | | | 572 | |
| Amounts utilized | | | (266 | ) | | (2,719 | ) | | (2,985 | ) |
| Balance at August 31, 2005 | | $ | 29 | | $ | 340 | | $ | 369 | |
At August 31, 2005, accrued store closure costs were recorded as a component of accrued liabilities in our consolidated balance sheet. During fiscal 2005 we accrued and expensed additional leased space exit costs totaling $0.2 million related to changes in estimated sublease receipts on three retail store closures that occurred during prior fiscal years. Although we believe that our accruals for retail store closures are adequate at August 31, 2005, these amounts are partially based upon estimates and may change if actual amounts related to these activities differ.
The benefit (provision) for income taxes from continuing operations consisted of the following (in thousands):
| YEAR ENDED AUGUST 31, | | 2005 | | 2004 | | 2003 | |
| Current: | | | | | | | | | | |
Federal | | $ | 1,857 | | $ | 1,615 | | $ | 1,940 | |
State | | | (2 | ) | | 151 | | | (29 | ) |
Foreign | | | (1,180 | ) | | (2,492 | ) | | (696 | ) |
| | | | 675 | | | (726 | ) | | 1,215 | |
| | | | | | | | | | | |
| Deferred: | | | | | | | | | | |
Federal | | $ | (2,132 | ) | $ | 3,440 | | $ | 15,739 | |
State | | | (285 | ) | | 310 | | | 836 | |
Foreign | | | 378 | | | (623 | ) | | 1,322 | |
Valuation allowance | | | 2,449 | | | (3,750 | ) | | (16,575 | ) |
| | | | 410 | | | (623 | ) | | 1,322 | |
| | | $ | 1,085 | | $ | (1,349 | ) | $ | 2,537 | |
Income (loss) from operations before income taxes consisted of the following (in thousands):
| YEAR ENDED AUGUST 31, | | 2005 | | 2004 | | 2003 | |
| United States | | $ | 6,094 | | $ | (10,716 | ) | $ | (49,247 | ) |
| Foreign | | | 3,007 | | | 1,915 | | | 1,457 | |
| | | $ | 9,101 | | $ | (8,801 | ) | $ | (47,790 | ) |
The differences between income taxes at the statutory federal income tax rate and income taxes reported from continuing operations in the consolidated statements of operations were as follows:
| YEAR ENDED AUGUST 31, | | 2005 | | 2004 | | 2003 | |
| Federal statutory income tax rate | | | 35.0 | % | | 35.0 | % | | 35.0 | % |
| State income taxes, net of federal effect | | | 3.2 | | | 5.7 | | | 1.7 | |
| Deferred tax valuation allowance | | | (26.9 | ) | | (49.1 | ) | | (32.7 | ) |
| Foreign jurisdictions tax differential | | | (2.9 | ) | | (7.1 | ) | | 1.2 | |
| Tax differential on income subject to both U.S. and foreign taxes | | | 5.1 | | | (9.5 | ) | | (2.5 | ) |
| Resolution of tax matters | | | (29.6 | ) | | 8.8 | | | 2.8 | |
| Other | | | 4.2 | | | .9 | | | (0.2 | ) |
| | | | (11.9 | )% | | (15.3 | )% | | 5.3 | % |
A recent history of operating losses has precluded the Company from demonstrating that it is more likely than not that the benefits of domestic operating loss carryforwards, together with the benefits of deferred income tax assets, deferred income tax deductions, and foreign tax carryforwards, will be realized. Accordingly, we recorded valuation allowances on our net deferred income tax assets generated in the United States.
We paid significant amounts of withholding tax on foreign royalties during fiscal years 2005, 2004, and 2003. However, no domestic foreign tax credits were available to offset the foreign withholding taxes during those years.
Various income tax matters were resolved during fiscal 2005, 2004, and 2003, which resulted in net tax benefits to the Company.
We restated the fiscal 2004 deferred tax liabilities related to intangibles and the valuation allowance for errors that occurred in prior periods (Note 2). Significant components of our deferred tax assets and liabilities were comprised of the following (in thousands):
| YEAR ENDED AUGUST 31, | | 2005 | | 2004 | |
| | | | | | | Restated | |
| Deferred income tax assets: | | | | | | | |
| Net operating loss carryforward | | $ | 15,313 | | $ | 21,268 | |
| Loan loss reserve on management stock loans | | | 15,234 | | | 14,709 | |
| Sale and financing of corporate headquarters | | | 12,383 | | | - | |
| Impairment of investment in Franklin Covey Coaching, LLC | | | 3,341 | | | 3,901 | |
| Foreign income tax credit carryforward | | | 2,246 | | | 2,246 | |
| Inventory and bad debt reserves | | | 2,103 | | | 2,466 | |
| Sales returns and contingencies | | | 1,954 | | | 1,559 | |
| Intangible asset amortization and impairment | | | 1,878 | | | 2,646 | |
| Vacation and other accruals | | | 1,438 | | | 1,199 | |
| Deferred compensation | | | 815 | | | 582 | |
| Alternative minimum tax carryforward | | | 748 | | | 478 | |
| Restructuring and severance cost accruals | | | 24 | | | 902 | |
| Property and equipment depreciation | | | - | | | 5,452 | |
| Investment in Agilix | | | - | | | 375 | |
| Other | | | 766 | | | 642 | |
| Total deferred income tax assets | | | 58,243 | | | 58,425 | |
| Less: valuation allowance | | | (38,180 | ) | | (40,629 | ) |
| Net deferred income tax assets | | | 20,063 | | | 17,796 | |
| | | | | | | | |
| Deferred income tax liabilities: | | | | | | | |
| Intangibles and property and equipment step-ups | | | (23,533 | ) | | (24,347 | ) |
| Property and equipment depreciation | | | (2,636 | ) | | - | |
| Unremitted earnings of foreign subsidiaries | | | (377 | ) | | (666 | ) |
| Other | | | (461 | ) | | (78 | ) |
| Total deferred income tax liabilities | | | (27,007 | ) | | (25,091 | ) |
| Net deferred income taxes | | $ | (6,944 | ) | $ | (7,295 | ) |
Deferred income tax amounts are recorded as follows in our consolidated balance sheets (in thousands).
| YEAR ENDED AUGUST 31, | | 2005 | | 2004 | |
| | | | | | | Restated | |
| Other current assets | | $ | 2,396 | | $ | 2,202 | |
| Other long-term assets | | | 375 | | | 550 | |
| Deferred income tax liability | | | (9,715 | ) | | (10,047 | ) |
| Net deferred income tax liability | | $ | (6,944 | ) | $ | (7,295 | ) |
A federal net operating loss of $32.9 million was generated in fiscal 2003. In fiscal 2005, $13.5 million of the 2003 loss carryforward was utilized, leaving a remaining loss carryforward from fiscal 2003 of $19.4 million, which expires on August 31, 2023. The federal net operating loss carryforward generated in fiscal 2004 totaled $20.5 million and expires on August 31, 2024.
The state net operating loss carryforward of $32.9 million generated in fiscal 2003 was reduced by the utilization of $13.5 million in fiscal 2005 for a net carryforward amount of $19.4 million, which primarily expires between August 31, 2006 and August 31, 2018. The state net operating loss carryforward of $20.5 million generated in fiscal 2004 primarily expires between August 31, 2007 and August 31, 2019.
The amount of federal and state net operating loss carryforwards remaining at August 31, 2005 and deductible against future years’ taxable income may be subject to limitations imposed by Section 382 of the Internal Revenue Code and similar state statutes. The Company has not determined the impact, if any, of Section 382 limitations as of August 31, 2005.
The net deferred tax asset relating to the loan loss reserve on our management stock loans is entirely offset by a valuation allowance. Because of the accounting treatment of the management stock loans (Note 11), any tax benefit eventually realized on these loans will be recorded as an increase to additional paid-in capital, rather than reducing our income tax expense.
As discussed in Note 6, we completed the sale and financing of our corporate headquarters facility during fiscal 2005. For financial reporting purposes, the sale of the facility was treated as a financing transaction and no gain was recognized on the sale. However, for tax purposes, the transaction was accounted for as a sale, resulting in a taxable gain of $11.4 million.
Our foreign income tax credit carryforward of $2.2 million that was generated during fiscal 2002 expires on August 31, 2012.
Basic earnings (loss) per common share (EPS) is calculated by dividing net income or loss available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted EPS is calculated by dividing net income or loss available to common shareholders, by the weighted-average number of common shares outstanding plus the assumed exercise of all dilutive securities using the treasury stock method or the “as converted” method, as appropriate. Following the preferred stock recapitalization (Note 9), our preferred stock is no longer convertible or entitled to participate in dividends payable to holders of common stock. Accordingly, we no longer use the two-class method of calculating EPS as defined in SFAS No. 128, Earnings Per Share, and EITF Issue 03-6, Participating Securities and the Two-Class Method under FASB Statement No. 128, for periods after February 26, 2005. The following table presents the computation of our EPS for the periods indicated (in thousands, except per share amounts):
| YEAR ENDED AUGUST 31, | | 2005 | | 2004 | | 2003 | |
| Net income (loss) | | $ | 10,186 | | $ | (10,150 | ) | $ | (45,253 | ) |
| Non-convertible preferred stock dividends | | | (3,903 | ) | | | | | | |
| Convertible preferred stock dividends | | | (4,367 | ) | | (8,735 | ) | | (8,735 | ) |
| Loss on recapitalization of preferred stock | | | (7,753 | ) | | | | | | |
| Net loss attributable to common shareholders | | $ | (5,837 | ) | $ | (18,885 | ) | $ | (53,988 | ) |
| | | | | | | | | | | |
| Undistributed income (loss) through February 26, 2005 | | $ | 4,244 | | $ | - | | $ | - | |
| Common stock ownership on an “as converted” basis | | | 76 | % | | - | | | - | |
| Common shareholder interest in undistributed income through February 26, 2005 | | | 3,225 | | | | | | | |
| Undistributed loss in fiscal year indicated | | | (10,081 | ) | $ | (18,885 | ) | $ | (53,988 | ) |
Common shareholder interest in undistributed loss(1) | | $ | (6,856 | ) | $ | (18,885 | ) | $ | (53,988 | ) |
| | | | | | | | | | | |
| Weighted average common shares outstanding - Basic | | | 19,949 | | | 19,734 | | | 20,041 | |
Common share equivalents(2) | | | - | | | - | | | - | |
| Weighted average common shares outstanding - Diluted | | | 19,949 | | | 19,734 | | | 20,041 | |
| | | | | | | | | | | |
| Basic EPS Common | | $ | (.34 | ) | $ | (.96 | ) | $ | (2.69 | ) |
| Diluted EPS Common | | $ | (.34 | ) | $ | (.96 | ) | $ | (2.69 | ) |
(1) Preferred shareholders do not participate in any undistributed losses with common shareholders; therefore, no adjustments to the fiscal 2004 or fiscal 2003 loss per share information were made.
(2) For the fiscal years ended August 31, 2005, 2004 and 2003, conversion of common share equivalents is not assumed because such conversion would be anti-dilutive.
Due to their anti-dilutive effect, the following incremental shares from Series A preferred stock calculated on an “as converted” basis and the potential common stock equivalents resulting from options to purchase common stock and unvested stock deferred compensation awards that were calculated using the treasury stock method have been excluded from the diluted EPS calculation (in thousands):
| YEAR ENDED AUGUST 31, | | 2005 | | 2004 | | 2003 | |
| Number of Series A preferred stock shares on an “as converted” basis | | | - | | | 6,239 | | | 6,239 | |
| Common stock equivalents from the assumed exercise of “in-the-money” stock options | | | 58 | | | 22 | | | 2 | |
| Common stock equivalents from unvested stock deferred compensation | | | 175 | | | - | | | - | |
| | | | 233 | | | 6,261 | | | 6,241 | |
At August 31, 2005, 2004, and 2003, we had approximately 2.0 million, 0.8 million, and 1.1 million stock options outstanding (Note 3) which were not included in the computation of diluted weighted average shares outstanding because the options’ exercise prices were greater than the average market price of the Company’s common stock. Also, as a result of the preferred stock recapitalization (Note 9), we issued 6.2 million common stock warrants during fiscal 2005 with an exercise price of $8.00 per share that were not included in the diluted EPS calculation because their exercise price was higher than the average market price of the Company’s common stock. These warrants, which expire in eight years, may have a dilutive impact on our EPS calculation in future periods.
Reportable Segments
The Company has two segments: the Consumer and Small Business Unit (CSBU) and the Organizational Solutions Business Unit (OSBU). The following is a description of our segments, their primary operating components, and their significant business activities:
Consumer and Small Business Unit - This business unit is primarily focused on sales to individual customers and small business organizations and includes the results of our domestic retail stores, consumer direct operations (catalog and eCommerce), wholesale operations, and other related distribution channels, including government product sales and domestic printing and publishing sales. The CSBU results of operations also include the financial results of our paper planner manufacturing operations. Although CSBU sales primarily consist of products such as planners, binders, software, and handheld electronic planning devices, virtually any component of our leadership, productivity, and strategy execution solutions may be purchased through CSBU channels. During fiscal 2005, we have expanded our efforts to increase sales to small businesses through our CSBU channels, including the addition of a sales force dedicated to small business organizations.
Organizational Solutions Business Unit - The OSBU is primarily responsible for the development, marketing, sale, and delivery of strategic execution, productivity, leadership, sales force performance, and communication training and consulting solutions directly to organizational clients, including other companies, the government, and educational institutions. The OSBU includes the financial results of our domestic sales force and our international operations. The domestic sales force is responsible for the sale and delivery of our training and consulting services in the United States. Our international sales group includes the financial results of our directly owned foreign offices and royalty revenues from licensees.
Our chief operating decision maker is the CEO, and each of the segments has a president who reports directly to the CEO. The primary measurement tool used in business unit performance analysis is earnings before interest, taxes, depreciation, and amortization (EBITDA), which may not be calculated as similarly titled amounts are calculated by other companies. For segment reporting purposes, our consolidated EBITDA can be calculated as our income or loss from operations excluding depreciation and amortization charges.
In the normal course of business, we may make structural and cost allocation revisions to our segment information to reflect new reporting responsibilities within the organization. All prior period segment information has been revised to conform to the most recent classifications and organizational changes. We account for our segment information on the same basis as the accompanying consolidated financial statements.
SEGMENT INFORMATION
(in thousands)
| | | Consumer and Small Business Unit | | Organizational Solutions Business Unit | | | | | |
Year Ended August 31, 2005 | | | Retail | | | Consumer Direct | | | Wholesale | | | Other CSBU | | | Domestic | | | International | | | Corporate and Eliminations | | | Consolidated | |
| Sales to external customers | | $ | 74,331 | | $ | 55,575 | | $ | 19,691 | | $ | 3,757 | | $ | 76,114 | | $ | 54,074 | | | | | $ | 283,542 | |
| Gross margin | | | 42,455 | | | 32,157 | | | 9,184 | | | (1,388 | ) | | 49,515 | | | 36,772 | | | | | | 168,695 | |
| EBITDA | | | 4,425 | | | 23,828 | | | 8,408 | | | (23,303 | ) | | 6,773 | | | 12,772 | | $ | (12,013 | ) | | 20,890 | |
| Depreciation | | | 2,589 | | | 527 | | | 1 | | | 663 | | | 306 | | | 1,295 | | | 2,393 | | | 7,774 | |
| Amortization | | | | | | | | | | | | 344 | | | 3,816 | | | 7 | | | 6 | | | 4,173 | |
| Segment assets | | | 7,992 | | | 76 | | | | | | 5,387 | | | 86,514 | | | 21,180 | | | 112,084 | | | 233,233 | |
| Capital expenditures | | | 996 | | | 72 | | | | | | 166 | | | 501 | | | 740 | | | 1,704 | | | 4,179 | |
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | |
Year Ended August 31, 2004 | | | | | | | | | | | | | | | | | | | | | | | | | |
| Sales to external customers | | $ | 87,922 | | $ | 55,059 | | $ | 21,081 | | $ | 2,007 | | $ | 61,047 | | $ | 48,318 | | | | | $ | 275,434 | |
| Gross margin | | | 47,420 | | | 31,172 | | | 9,544 | | | (3,933 | ) | | 38,555 | | | 33,043 | | | | | | 155,801 | |
| EBITDA | | | 793 | | | 19,753 | | | 8,623 | | | (22,958 | ) | | (627 | ) | | 10,073 | | $ | (8,774 | ) | | 6,883 | |
| Depreciation | | | 3,385 | | | 1,053 | | | 1 | | | 1,137 | | | 604 | | | 1,383 | | | 4,211 | | | 11,774 | |
| Amortization | | | | | | | | | | | | 344 | | | 3,816 | | | 7 | | | 6 | | | 4,173 | |
| Segment assets | | | 9,867 | | | 550 | | | | | | 7,760 | | | 90,783 | | | 23,807 | | | 94,858 | | | 227,625 | |
| Capital expenditures | | | 220 | | | 257 | | | | | | 1,534 | | | 127 | | | 741 | | | 1,091 | | | 3,970 | |
| | | | | | | | | | | | | | | | | | | | | | | | | | |
Year Ended August 31, 2003 | | | | | | | | | | | | | | | | | | | | | | | | | |
| Sales to external customers | | $ | 112,054 | | $ | 56,177 | | $ | 16,915 | | $ | 7,020 | | $ | 74,306 | | $ | 40,688 | | | | | $ | 307,160 | |
| Gross margin | | | 56,598 | | | 31,181 | | | 7,330 | | | (1,552 | ) | | 48,398 | | | 28,428 | | | | | | 170,383 | |
| EBITDA | | | (4,020 | ) | | 17,663 | | | 6,314 | | | (27,134 | ) | | (1,861 | ) | | 7,031 | | $ | (14,877 | ) | | (16,884 | ) |
| Depreciation | | | 11,291 | | | 2,423 | | | 6 | | | 2,173 | | | 1,707 | | | 1,110 | | | 7,685 | | | 26,395 | |
| Amortization | | | | | | | | | | | | 365 | | | 4,007 | | | 7 | | | 7 | | | 4,386 | |
| Significant non-cash items: | | | | | | | | | | | | | | | | | | | | | | | | | |
| Provision for losses on management stock loan program | | | | | | | | | | | | | | | | | | | | | 3,903 | | | 3,903 | |
| Recovery of investment in unconsolidated subsidiary | | | | | | | | | | | | | | | (1,644 | ) | | | | | | | | (1,644 | ) |
| Loss on impaired assets | | | | | | | | | | | | 872 | | | | | | | | | | | | 872 | |
| Segment assets | | | 20,598 | | | 1,365 | | | | | | 12,547 | | | 95,068 | | | 19,580 | | | 112,988 | | | 262,146 | |
| Capital expenditures | | | 905 | | | 1,137 | | | | | | 210 | | | 112 | | | 786 | | | 1,051 | | | 4,201 | |
A reconciliation of reportable segment EBITDA to consolidated income (loss) before taxes is provided below (in thousands):
| YEAR ENDED AUGUST 31, | | 2005 | | 2004 | | 2003 | |
| Reportable segment EBITDA | | $ | 32,903 | | $ | 15,657 | | $ | (2,007 | ) |
| Provision for losses on management stock loans | | | | | | | | | (3,903 | ) |
| Gain on disposal of investment in unconsolidated subsidiary | | | 500 | | | | | | | |
| Corporate expenses | | | (12,513 | ) | | (8,774 | ) | | (10,974 | ) |
| Consolidated EBITDA | | | 20,890 | | | 6,883 | | | (16,884 | ) |
| Depreciation | | | (7,774 | ) | | (11,774 | ) | | (26,395 | ) |
| Amortization | | | (4,173 | ) | | (4,173 | ) | | (4,386 | ) |
| Consolidated income (loss) from operations | | $ | 8,943 | | $ | (9,064 | ) | $ | (47,665 | ) |
| Equity in earnings (losses) of unconsolidated subsidiary | | | | | | | | | (128 | ) |
| Interest income | | | 944 | | | 481 | | | 665 | |
| Interest expense | | | (786 | ) | | (218 | ) | | (248 | ) |
| Other expense, net | | | | | | | | | (414 | ) |
| Income (loss) before income taxes | | $ | 9,101 | | $ | (8,801 | ) | $ | (47,790 | ) |
Interest expense and interest income are primarily generated at the corporate level and are not allocated to the segments. Income taxes are likewise calculated and paid on a corporate level (except for entities that operate in foreign jurisdictions) and are not allocated to segments for analysis.
Corporate assets, such as cash, accounts receivable, and other assets are not generally allocated to business segments for business analysis purposes. However, inventories, intangible assets, goodwill, identifiable fixed assets, and certain other assets are classified by segment. A reconciliation of segment assets to consolidated assets is as follows (in thousands):
| AUGUST 31, | | 2005 | | 2004 | | 2003 | |
| Reportable segment assets | | $ | 121,149 | | $ | 132,767 | | $ | 149,158 | |
| Corporate assets | | | 113,478 | | | 95,823 | | | 113,780 | |
| Intercompany accounts receivable | | | (1,394 | ) | | (965 | ) | | (792 | ) |
| | | $ | 233,233 | | $ | 227,625 | | $ | 262,146 | |
Enterprise-Wide Information
Our revenues are derived primarily from the United States. However, we also operate directly owned offices or contract with licensees to provide products and services in various countries throughout the world. Our consolidated revenues and long-lived assets were as follows (in thousands):
| AS OF OR FOR YEAR ENDED AUGUST 31, | | 2005 | | 2004 | | 2003 | |
Net sales: | | | | | | | | | | |
United States | | $ | 229,469 | | $ | 227,116 | | $ | 262,463 | |
Japan/Greater China | | | 22,251 | | | 18,625 | | | 15,026 | |
United Kingdom | | | 9,707 | | | 9,251 | | | 7,521 | |
Canada | | | 6,910 | | | 7,093 | | | 7,701 | |
Mexico | | | 4,181 | | | 3,609 | | | 5,030 | |
Australia | | | 3,944 | | | 3,642 | | | 3,428 | |
Brazil/South America | | | 2,053 | | | 1,559 | | | 1,859 | |
Singapore | | | 985 | | | 1,189 | | | 999 | |
Others | | | 4,042 | | | 3,350 | | | 3,133 | |
| | | $ | 283,542 | | $ | 275,434 | | $ | 307,160 | |
| | | | | | | | | | | |
Long-lived assets: | | | | | | | | | | |
United States | | $ | 122,937 | | $ | 129,416 | | $ | 145,009 | |
Americas | | | 2,620 | | | 2,484 | | | 2,531 | |
Japan | | | 1,527 | | | 2,409 | | | 3,414 | |
United Kingdom | | | 641 | | | 694 | | | 671 | |
Australia | | | 326 | | | 393 | | | 464 | |
| | | $ | 128,051 | | $ | 135,396 | | $ | 152,089 | |
Inter-segment sales were immaterial and were eliminated in consolidation.
During November 2004, our Board of Directors approved a proposal to change a number of items in the CEO’s employment agreement. At the request of the CEO, this new compensation arrangement included the following:
| l | The previously existing CEO employment agreement, which extended until 2007, was canceled and the CEO became an “at-will” employee. |
| l | The CEO signed a waiver forgoing claims on past compensation not taken. |
| l | The CEO agreed to be covered by change in control and severance policies provided for other Company executives rather than the “golden parachute” severance package in his previously existing agreement. |
| l | In accordance with the provisions of the Sarbanes-Oxley Act of 2002, the CEO will not be entitled to obtain a loan in order to exercise his stock options. |
In return for these changes to the CEO’s compensation structure and in recognition of the CEO’s leadership in achieving substantial improvements in our operating results, the following compensation terms were approved:
| l | The CEO’s cash compensation, both base compensation and incentive compensation, remained essentially unchanged. |
| l | Acceleration of the vesting on the CEO’s 1.6 million stock options with an exercise price of $14.00 per share (Note 3). |
| l | A grant of 225,000 shares of unvested stock was awarded as a long-term incentive consistent with the unvested stock awards made to other key employees in January 2004. In addition, the Company granted the CEO 187,000 shares of common stock that is fully vested. The compensation cost of both of these awards was $0.9 million, of which $0.4 million was expensed and the other $0.5 million was initially recorded as deferred compensation in shareholders’ equity and amortized over five years, subject to accelerated vesting if certain performance thresholds are met (Note 3). |
| l | We have provided life insurance and disability coverage in an amount equal to 2.5 times the CEO’s cash compensation, using insurance policies that are similar to those approved for other executives. |
These changes were approved and enacted during fiscal 2005.
Effective March 29, 2005, Val J. Christensen, Executive Vice-President, General Counsel and Secretary of the Company, terminated his service as an executive officer and employee of the Company. Under the terms of the corresponding Separation Agreement, we paid Mr. Christensen a lump-sum severance amount totaling $0.9 million, less applicable withholdings. In addition, he received the cash performance bonus he would have been entitled to for the current fiscal year as if he had remained employed in his prior position and his performance objectives for the year were met, which is estimated to be $0.2 million. In addition to these payments, his shares of unvested stock were fully vested and he received a bonus of $0.1 million, which was equivalent to other bonuses awarded in the January 2004 unvested stock award, to offset a portion of the income taxes resulting from the vesting of this award. The Company also waived the requirement that his fully-vested stock options be exercised within 90 days of his termination and allowed the options to be exercised through the term of the option agreement. We accounted for the stock option modifications under APB Opinion 25 and related pronouncements and did not recognize additional compensation expense in our financial statements as the fair value of the Company’s stock was less than the exercise price of the modified stock options on the re-measurement date. However, the fair value of these stock option modifications using guidance in SFAS No. 123 was approximately $0.1 million and was included in the pro forma stock-based compensation expense reported in Note 3.
Subsequent to his separation, the Board of Directors approved modifications to his management stock loan substantially similar to the modifications granted to other loan participants by the Board of Directors in May 2004 under which the Company will forego certain of its rights under the terms of the loans in order to potentially improve the participants’ ability to pay, and our ability to collect, the outstanding balances of the loans (Note 11).
Subsequent to entering into the Separation Agreement, the Company and Mr. Christensen entered into a Legal Services Agreement that is effective March 29, 2005. Under terms of the Legal Services Agreement, we retained Mr. Christensen as independent legal counsel to provide services for a minimum of 1,000 hours per year. The Legal Services Agreement allows the Company to benefit from Mr. Christensen’s extensive institutional knowledge and experience gained from serving as our General Counsel as well as his experience representing us as external counsel for several years prior to joining the Company. We will pay Mr. Christensen an annual retainer in the amount of $0.2 million, the equivalent of $225 per hour for each hour of legal services, and $325 per hour for every hour of legal services, if any, provided in excess of 1,000 hours in any given year. Further, Mr. Christensen will be an independent contractor and not entitled to Company benefits for performing these services.
The Company, under a long-term agreement, leased office space in buildings that were owned by partnerships, the majority interest of which were owned by the Vice-Chairman of the Board of Directors and certain other employees and former employees of the Company. During fiscal 2005 we exercised an option, available under our master lease agreement, to purchase, and simultaneously sell, the office facility to the current tenant, an unrelated party. The negotiated purchase price with the landlord was $14.0 million and the tenant agreed to purchase the property for $12.5 million. These prices were within the range of estimated fair values of the buildings as determined by an independent appraisal obtained by the Company. We paid the difference between the sale and purchase prices, plus other closing costs, which were included as a component of our restructuring plan accrual (Note 15). We paid rent and related building expenses to the partnership totaling $0.5 million, $2.4 million, and $2.0 million, for the fiscal years ended August 31, 2005, 2004, and 2003. Following completion of this sale, we have no further obligations to the related partnerships.
The Company pays the Vice-Chairman and a former Vice-Chairman of the Board of Directors a percentage of the proceeds received for seminars that they present. During the fiscal years ended August 31, 2005, 2004, and 2003, we expensed charges totaling $3.3 million, $1.6 million, and $0.9 million, to the Vice-Chairman and former Vice Chairman for their seminar presentations. At August 31, 2005 and 2004, we had accrued $1.7 million and $0.4 million payable to the Vice-Chairman and former Vice-Chairman under these agreements. These amounts were included in our accrued liabilities in the accompanying consolidated balance sheets.
During the fiscal year ended August 31, 2003, our CEO chose to forgo his salary, which totaled $0.5 million. In accordance with SEC rules and regulations, we recorded compensation expense for the unpaid salary and recorded a corresponding increase to paid-in capital. During fiscal 2004, at the urging of our Board of Directors, the CEO elected to resume receipt of his salary.
As part of a preferred stock offering to a private investor, an affiliate of the investor, who was then a director of the Company, was named as the Chairman of the Board of Directors and was later elected as CEO. This individual continues to serve as the Company’s Chairman of the Board and CEO at August 31, 2005. In addition, two affiliates of the private investor were named to our Board of Directors. In connection with the preferred stock offering, we paid an affiliate of the investor $0.4 million per year for monitoring fees, which will be reduced by redemptions of outstanding Series A preferred stock.
During fiscal 2002, we entered into a consulting agreement with a member of the Board of Directors to assist the Company with various projects and transactions, including the sale of Premier and new product offerings. The consulting agreement expired in December 2002 and we paid $0.1 million during fiscal 2003 for services under terms of the agreement.
During fiscal 2003, we issued a non-exclusive license agreement for certain intellectual property to a former officer and member of the Board. The Company received a nominal amount to establish the license agreement and license payments required to be paid under terms of this license agreement were insignificant during fiscal years 2005 and 2004.
During fiscal 2002, the Company licensed certain intellectual property, on a non-exclusive basis, to a company in which a former Vice-Chairman of the Board of Directors was a principal shareholder. Under terms of the non-exclusive license agreement, which expires on September 1, 2007, we will not receive payments from the use of this intellectual property.
As part of a severance agreement with a former CEO, the Company offered the former CEO the right to purchase 121,250 shares of our common stock for $0.9 million. In order to facilitate the purchase of these shares, we received a non-recourse promissory note, which was due September 2003, and bore interest at 10.0 percent. During September 2003, the former CEO declined the opportunity to purchase these shares and the note receivable, which was recorded as a reduction of shareholders’ equity at August 31, 2003, was canceled. The shares, which were held by the Company pending the purchase of the shares, were returned to treasury stock during fiscal 2004.
On October 21, 2005, we announced that we had given notice to the holders of our Series A Preferred Stock for the redemption of $10.0 million, or approximately 400,000 shares, of currently outstanding Series A Preferred Stock. The preferred stock was redeemed on November 11, 2005.
We also announced that we intend to seek shareholder approval to amend our articles of incorporation to extend the period during which we have the right to redeem the outstanding preferred stock at 100 percent of the liquidation preference, or $25 per share plus accrued dividends. The amendment would extend the current redemption deadline from March 8, 2006 to December 31, 2006. The extension agreement would also provide the right to extend the redemption period for an additional year to December 31, 2007, if another $10.0 million of preferred stock is redeemed before December 31, 2006. Knowledge Capital, an entity which holds nearly all of our outstanding preferred stock, has signed an agreement to vote in favor of the proposal to extend the redemption period.
